Why You Should Not Buy the Facebook IPO

Zuckerberg Facebook IPOThe Facebook Fizzle

On Friday morning I brewed myself a nice strong cup of coffee and happened to catch the debut of Facebook (FB). This was the much-anticipated IPO (Initial Public Offering) of a prize racehorse about to belt off the starting line. I felt that I was watching a part of history for the largest IPO in history, and BNN proudly had a real-time quote taking up the whole screen ready to go! The opening, however, was marred by a lengthy half-hour delay. Once Facebook shares started to trade from the IPO price of $38, FB shares went as high as $42 within minutes of opening and settled back to a closing price of $38.23 by the end of the trading day (See chart below).

This was obviously a win for day-traders who already were able to purchase their shares at the IPO price of $38 and offload them at $42, a tidy 10% return for a few minutes of work. But for those investors who bought in after the IPO, they have already lost money, and I believe they may even lose more in the weeks to follow.

Facebook on first day of trading

Facebook stock price on IPO Day (Globe and Mail)

Before the opening bell, the underwriters of Facebook valued the stock at $38 a share, pricing the company at $104 billion. This is the largest valuation to date for a newly public company. Throughout the day, over 580.4 million shares traded for Facebook, also making it the largest IPO by volume. According to a CNBC post, Some 82 million shares changed hands in the first 30 seconds and volume passed 100 million after four minutes. The Facebook IPO on Friday was certainly history being made on those two counts, valuation, and volume of shares.

What wasn’t historical was the less than stellar close of the stock price only 23 cents above its initial offering price, which disappointed many in the financial community. According to an article in the Wall Street Journal, Facebook struggled to stay above the IPO price for most of the day, forcing underwriters to buy back shares to support the price. Compare this to the IPO of LinkedIn last May, where shares of LinkedIn rose as much as 171 percent in the first day of trading on the NYSE, closing at $94.25 per share from the opening IPO of $45 per share.

Some would say that the IPO price for Facebook was fairly valued by the underwriters, since it stayed near the IPO price, and perhaps it’s a relief that investors didn’t get carried away and shoot for the moon. Others view the less than spectacular rise in Friday’s Facebook share price, and lengthy opening delay, as a bad omen – an early sign of things to come. Regardless, it’s too early to tell, and generally never a good idea to buy stocks on IPO day.

The Top 10 Reasons

Now that Facebook is a publically traded company, and the Facebook IPO has already debuted, here are the Top 10 Reasons why you shouldn’t even consider buying Facebook.

1. IPOs Are Risky Investments

IPO’s (initial public offerings) are inherently risky investments because they simply have no history. When you buy an IPO you are placing your trust in future earnings, potential growth, and your future belief in a company. Generally, recent IPOs haven’t fared very well.

Take the recent IPO of Groupon Inc. (GRPN) last November as an example, another online IPO megalith like Facebook. Groupon’s IPO was valued at over $12.7 billion dollars, far short of Facebook’s $100 billion. Groupon’s IPO was also received with much optimism and hype, and shares soared eventually closing at $26.11, a 30.55% increase above the $20 IPO price. After numerous legal proceedings and questions of conduct and accounting practices, Groupon trades at $11.58 per share. This is an overall loss of over 50% for investors who bought in on IPO Day.

LinkedIn (LNKD) was another social media giant IPO launched last year in May 2011.  Investors have been taken for a gut-wrenching ride on this IPO, with share prices oscillating wildly between $100 per share, down to $60 and back up to the closing price on Friday of $99.02 per share. But LinkedIn has fared much better than Groupon. For those investors who had the stomach of steel to hold their LinkedIn shares or bought at the bottom, they would have had a positive return. But for investors who sold after the initial decline in share price, this would have been a sharp loss to swallow.

IPO’s are always going to be a wild ride, especially with high-profile companies. So what makes Facebook different?  That’s the $100 billion dollar question. 😉

2. Facebook may be overvalued

Facebook filed for an initial public offering on February 1, 2012, and the preliminary prospectus stated that the company was seeking to raise $5 billion. Before the IPO the underwriters valued Facebook at $38 a share, pricing the company at over $104 billion, the largest valuation to date for a newly public company. During the trading day, those underwriters had to buy-back shares to keep the price above the $38 IPO price.

$100 billion dollars is not pocket change. To put this amount into context, Apple (AAPL) is valued at over $494.5 billion, Microsoft at $245 billion; Google is valued at $195 billion and Amazon at $97 billion. A stalwart blue-chip stock like Johnson and Johnson is valued at over $173 billion, and Canada’s largest bank, the Royal Bank, is valued at $74.5 billion.

With the lofty valuation for Facebook at the top end, it’s no surprise Facebook Shares barely budged in trading and were slow off the finish line. Is Facebook the next Google or the next Apple? Should investors rush in to grab a piece of history or stand on the sidelines and wait? I believe investors should hold off on Facebook and give some time before making a decision, at least until first quarter results. The real question investors should ask themselves is whether Facebook is really a $100 billion dollar company and whether that valuation is sustainable?

3. The Stock is already being shorted

Although it’s already after the fact, support for Facebook’s IPO is not looking good. Indeed the $100 billion dollar valuation for the Facebook IPO at $38 per share is looking to be overvalued. Investors dumped and shorted their shares of Facebook (FB) this morning, within the first few minutes of trading. FB shares were down to a low of $33.00 per share within the first 15 minutes of trading, a $5.23 loss or negative -13.6% decline from the Friday closing price. For the first day of trading after the IPO day, Facebook shares closed at $34.03 per share, down $4.20 per share or -10.99%.

The decline in share price was largely the result of investors selling their Facebook shares, after Friday’s dismal IPO, and widespread shorting of the stock. Moving forward, Facebook shares can be expected to face downward pressure this week, with lower lows, and even lower if the lead underwriter Morgan Stanley stops supporting the stock. When a stock is being shorted, and the lead underwriter may pull its support, it’s not a good sign moving forward.

4. Is the economic moat impenetrable?

Does Facebook have an economic moat? Is it a business that is safe from its competitors? Does it have an economic competitive advantage?  This is the one area where Facebook actually shows some strength since it has actually been around for over 8 years with a huge subscribership and user base.

While Google has tried to encroach on Facebook’s popularity with Google +1 and Twitter has become a leading social media platform, Facebook still remains the dominant social media giant. Right now that dominance looks poised to continue, especially among the teenage generation who have grown up with Facebook, not only on their laptops but on their phones. It is as much a part of their life as waking up to a cup of java is for me.

However, continuing privacy issues, personal data mining for marketing purposes, complex privacy controls, and a constantly changing interface for users may begin to alienate Facebook’s own users. Many people have already begun deactivating their facebook accounts, yours truly included.

A new social media platform, with simple privacy standards and an easy to understand user interface may give Facebook a wakeup call down the road. If you invest in Facebook, then you must believe Facebook is immune from competition and has an economic moat as wide as Google’s. For now, the Facebook moat looks impenetrable, but that is certainly not reason enough to become an investor.

5. What is the business model?

How does Facebook generate its revenue? What is the bottom line for profits? Like most online businesses, Facebook claims to generate most of its revenue from advertising.  But Facebook is no AdSense, and advertisers have seen poor results with Facebook ads. The main reason people use Facebook is to share photos and communicate with their friends, hence Facebook ads often go ignored by regular users.

Facebook ads are tied into Bing with Microsoft, and generally have a very low click-through rates (CTR), compared to Google’s AdSense. There are also the direct Facebook Ads which are sold to business, but again I’ve been told Facebook ads have the lowest click-through rates in the industry. The CTR is critical for advertisers. If Facebook is primarily claiming to make its revenue from online advertising, then investors may become sorely disappointed once the earnings reports for advertising start to roll in for Q1 and Q2.

Most of Facebook’s business practices appear to be more secretive than an open book, and borderline on privacy issues and the use of personal information. It’s very difficult to understand how the Company really generates profits, or what its real business model may be. It is one thing to use Facebook and upload photos of your Saturday barbeque, and chat with your friends. But it’s another matter to invest your hard-earned money into the company. So the real question to ask as an investor is – do you understand the business model?

6. Are the earnings sustainable?

Once a company becomes publically traded, it is accountable to shareholders and the public. One measure of that accountability is bottom line earnings, profit, and revenue. Shareholders like to see increasing quarterly growth and profits. In early 2012, Facebook disclosed that its profits had jumped 65% to $1 billion in the previous year when its revenue, which is mainly from advertising, had jumped almost 90% to $3.71 billion (from Wikipedia).

Moving forward Facebook will need to increase revenue and profits on a quarterly basis and report these profits to shareholders. Constant growth in subscribership and advertising revenue is critical for Facebook’s success. Is continuing growth in subscribership and revenue sustainable? Some believe Facebook has already achieved its pinnacle of growth and success, and that there is more potential for decline. Either way, as an investor are you willing to take a risk on future growth and future profitability?

The Honeymoon for Facebook is Over  

Chan and Zuckerberg Wedding photoThings are not looking good for Facebook or for its main underwriter Morgan Stanley. It also looks like the honeymoon plans for Facebook CEO and recent newlywed Mark Zuckerberg, will soon be over as well. On the third day of trading, the main underwriter Morgan Stanley, the subsidiary underwriters, and Mark Zuckerberg of Facebook has already had several class action lawsuits filed against them from investors.  You can view the press releases for Facebook on the Globe and Mail site, to see the firms that have already filed suit, and many more are likely to follow. The U.S. Senate Banking Committee has also expressed interest in the Facebook IPO.

The lawsuits aren’t just about the fact that retail investors lost money, which they did, rather the potential for known information which was not disclosed to all investors in a proper manner. Since 420 million shares were issued at a $38 IPO price, there are billions of dollars which were lost to retail investors, primarily within the first day of trading.

As the Glancy Binkow & Goldberg lawsuit points out, “the complaints allege that Facebook, certain of the Company’s executive officers and directors and the underwriters of the IPO failed to disclose… and cut their earnings forecasts and that news of the estimate cut was passed on only to a handful of large investor clients, and not to the public.” Many investors who purchased shares from Friday to Tuesday were not aware of the alleged reports of lower earnings by analysts, being different from the reported earnings in the IPO prospectus. If substantiated, it implies that retail investors were not privy to the same information as a handful of other investors and that revenue was misrepresented.

However, as a recent Globe and Mail article points out, pertaining to disclosure of the Facebook IPO “… it’s perfectly legal for a securities firm to disclose analyst research to only some classes of clients and not to others -so long as the research process is untainted by interference from the investment bankers involved in the underwriting .” Regardless, whether it may be legal practice or not, or even ethical, full disclosure to all investors and the process of disclosure appears to be in question.

7. Costs from legal proceedings of the IPO

Regardless of the outcome, as an investor in Facebook, you are picking up the tab for all the current legal fees surrounding these allegations and lawsuits around the Facebook IPO. Many of these lawsuits could drag on for months if not years, with mounting costs. More importantly, if Facebook should be found guilty or agrees to a settlement, billions of dollars will have to be paid back to investors. That money will come out of any profits on top of all the ongoing legal fees.

8. Accountability and privacy issues

Putting aside the recent legal issues surrounding the Facebook IPO, there are other legal issues that could potentially surface for Facebook in the months to follow. Facebook has a sketchy past with privacy policies.

Zuckerberg’s first prototype for Facebook was called Facemash which he launched in October 2003 while at Harvard. To populate the content for the site, Zuckerberg hacked into Harvard’s security network and copied the student ID images used by dormitories and used them to populate Facemash, according to Wikipedia.  The site was shut down a few days later by the Harvard administration, who also laid charges against Zuckerberg for violating security, copyrights, and individual privacy. The charges were later dropped, but shortly thereafter in January 2004, Zuckerberg then went on to build Thefacebook. This was the predecessor to today’s Facebook which was incorporated in 2004.

A few years later in the summer of 2009, Facebook came under pressure from the Federal Privacy Commission over privacy concerns. The Canadian government was concerned the social networking website was violating Canadian privacy law, by keeping people’s personal information indefinitely. Facebook was also criticized for sharing users’ files with nearly one million third-party software developers. On July 16th, 2009, Facebook was given 30 days to comply with the Privacy Commissioner Jennifer Stoddart’s recommendations.

In fact, even if you deactivate your Facebook account, Facebook still stores all your personal information unless you delete it. But therein lays the dark secret behind Facebook, which is really more of a data-mining company through apps and personal profiles, than a real advertising company. Next to Google, Facebook probably has the largest amount of personal information about people on the web – maybe even more. This information is likely more valuable to Facebook for marketing than displaying a billion Bing or Facebook ads. The recent addition of Facebook’s timeline is a scary lesson on just how much information Facebook has about you. The recent timeline not only encouraged me to deactivate my personal Facebook account but to actually delete it!

At some point, Facebook will come under more public and legal scrutiny regarding its privacy policies, now that it is a publically traded company – you can count on it. 😉

(PS If you want to permanently delete your Facebook account, and not just deactivate it, you can do it here. Facebook will give you 14 days from the day you request to delete it before they actually do.)

9. The Groupon Effect

Groupon (GRPN) was another large internet company that went public in November 2011. From the onset, Groupon was plagued with legal issues surrounding its IPO, with questions surrounding its accounting and revenue practices. Some analysts compared Groupon’s IPO to a Ponzi scheme, and others criticized Groupon’s decision to pay out over $940 million of its venture capital it to its founders and early backers (from Wikipedia, see initial public offering filing). It was estimated that Groupon was losing $100 million dollars per quarter.

Groupon (GRPN)

Groupon (GRPN) one year chart

It’s been a long steady decline for those who bought Groupon on IPO day at $20, or more per share. Although Groupon shares increased some 30% shortly after the IPO, legal issues surrounding its accounting and revenue practices surfaced early on, hammering the stock price. The stock price hit lows of $9.63 per share in May 2012. Today, Groupon now trades at $12.05 dollars per share, -39.7% below its IPO price.

Facebook is already dealing with the legal issues surrounding its IPO, and there may indeed be more questions about its advertising revenue, stock valuation, and profit margins. Like Groupon, although for different reasons, Facebook is already wrangling in legal issues as a newly traded company. As an investor, that is not a good sign.

10. Other reasons not to invest 

There are other reasons why you shouldn’t invest in Facebook. (1) A recent Globe and Mail article points to Facebook’s intrinsic value which also indicates an overvalued stock price. In that article, many analysts give Facebook a share price between $9.69 and $29 per share based on what is termed intrinsic value, and the latter is assuming “Google-like growth”.  (2) Facebook has a Price to Earnings Ratio of 81, meaning the price of the stock is valued 81 times above its earnings. Investors will often invest in stocks with higher PE ratios of 15 to 20, but 81 is simply dangerous. (3) Zuckerberg is the majority shareholder, with a 57% stake control of voting shares as of the IPO. This means that retail investors have no say in company policy or voting control.

Conclusion

Although Facebook is the second most used website behind Google, it doesn’t necessarily mean it’s a great investment as a shareholder.  Facebook may indeed be a worthwhile investment a year down the road, but buying an IPO always has inherent risk. Within the first few days of trading, there are already class action lawsuits against the company and underwriters. Many are already questioning the Facebook IPO, lofty stock valuation, and potential for future revenue and earnings. Considering the Facebook IPO has been the largest in history, and there is more room for concern, there is also more room for downside than upside.

If you already own Facebook and your nursing a loss, then consider selling and get out before the real problems hit the fan. These are real considerations, such as: (1) revenue and profit that appears to be misrepresented to retail investors, (2) potentially lower than expected revenue come Q1 reports,  (3) a stock valuation that is now confirmed as overvalued, and (4) the beginning of numerous class-action legal suits against the company and its underwriters, which will cost the company money.

Even if you really believe in the Facebook business model, you should wait until these major issues are resolved before you buy in.  Facebook may follow in the steps of Groupon, with a long declining share price amid legal wrangling, and lower than expected earnings and revenues. Time will tell.

Readers, what’s your take?

21 Responses to “Why You Should Not Buy the Facebook IPO”

  1. Kurt @ Money Counselor

    May 20. 2012

    Ninja: What do you think the chances are that FB has already hit its all-time high price?

    • The Dividend Ninja

      May 20. 2012

      Kurt, I think that is a very likely possibility… We shall find out the continuation of this story on Monday morning. 😉

      Cheers!

  2. Eddie

    May 20. 2012

    Avrom,
    Great article. You raise some very valid points. I always said even before FB launched that it will be hard for FB to live up to all the hype, simply because it’s slowly running out of ideas on generating new income streams. I wasn’t surprised at all to see the stock close 23 cents higher, after a lot of people expected the stock to double or triple on Friday.

    • The Dividend Ninja

      May 20. 2012

      Eddie, thanx! Wait till you read Part-2. 😉 The problems for Facebook are many, even if it is an established social media giant. The top end valuation of $100 billion leaves more rooom for decline than an increase. We shall see…

      Cheers!

      • Eddie

        May 21. 2012

        Yes, we shall see.
        The more I think about FB, the more I can’t come up with any possible new revenue generation. Unlike Google, who runs 95% of the online searching, their options are unlimited for bringing in additional revenue.

  3. Poor Student

    May 20. 2012

    While I will not be buying Facebook, I must disagree with the “never IPO’s on IPO day”. I just read The Intelligent Investor, the latest edition with commentary by Jason Zweig.

    I forget the number but traders can clean up on IPOs. If you buy at the opening and sell the next day you net a very tidy profit. This doesn’t fit into my investing strategy or yours but it can work for lots of people.

    That was just being the devil’s advocate. I don’t consider IPOs and think that Facebook will not prove to be a great investment at these prices, and look forward to reading your other eight reasons.

    I have missed your writing Ninja!

    • The Dividend Ninja

      May 20. 2012

      Hey Poor Student, thanx its good to be back – though full time work doesn’t feel like much of a break!

      If you can get in at the IPO price, then sure you could make some nice change on the swing in price over a day or two. Only problem is very few people are able to get the IPO price. In the case of Facebook many people have already bought in at the $40 plus price point.

      Cheers!

  4. My Own Advisor

    May 21. 2012

    Well written article.

    I’ve read so often, don’t buy into IPOs, so I don’t.

    IPOs are mostly about hype, a trader’s dream.

    I prefer to own companies that people don’t talk about very much, don’t trade very much, rather, they take the company and its products for granted. Those are the companies you want to own for the long-haul…at least I do 🙂

    Maybe I’m missing out on the next Google, but that won’t bother me. I like to know where my cash flow (dividends) and gains will be coming from. Facebook, who knows where this will be in 10 years.

    I guess that makes me a conservative investor, or like Dividend Ninja.

    • The Dividend Ninja

      May 21. 2012

      MOA nice to have you drop by. 😉 I would take your investing approach any day over a potential high flyer like Facebook. Even though Facebook has been around for 8 years, and obviously has some type of moat around it in the social media scene – investing in it is another matter. So far Facebook (FB) opened the bell 12% lower…

      Poor Student had an interesting comment on IPOs, I’m going to have to check out that article he referred to.

      Cheers!

  5. Nice topic. I agree that IPOs are generally very risky considering the hype around many companies going through an IPO.

    On the other hand, not all IPOs are risky since preferred shares from well established companies also go through IPOs. The reason I mention that is that you might not want to ignore the IPO notification feature from your broker – I regularly see income oriented investment. I know that’s not the kind of IPO you were referring to here.

    FB is definitely not for me. Did you notice how Zynga got dinged during the IPO … Both of them are in bed with each other and depends on each other for revenues at the moment.

  6. Peter

    May 21. 2012

    Shares are already down on Monday.

  7. Nikita Sharma

    Jun 09. 2012

    From the point of view of the company , Facebook itself, of course it was a roaring success. They were able to raise a good chunk of capital to develop and expand the business. That’s what an IPO is, at heart, about. Early investors in the company did well too: they were able to cash out some portion of their earlier investment at good prices.

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