An Autopsy of the Facebook IPO

Alex Barbi takes a look at the reasons behind the significant fall in Facebook's post-IPO share price and the key challenges the social network company is facing to monetise its platform on mobile.

In a quarter when technology stocks performed reasonably well and Internet stocks were generally in favour, a major disappointment for many investors was probably the collapse of the Facebook stock price. 

From its Initial Public Offer (IPO) of $38 in May 2012, it reached a low of $17.55 in September 2012.  Platinum did not participate in the placement, taking a view that the offer was way overvalued and better opportunities were available in existing alternative Internet names.

At listing, the company was valued at more than $80 billion of market capitalisation, with forecast sales of $4.9 billion and net profit of $500 million for 2012, resulting in an estimated P/E of 160x forecast net earnings.  Definitely not cheap!  Even adjusting earnings ‘pro-forma’ as Wall Street analysts prefer to do with tech stocks (which choose to ignore the cost of issuing stock options), you would have paid around 76x expected earnings.

The familiarity of the name with the masses and the success of its dominant social network application among almost one billion active users globally, made it the perfect growth story for a successful IPO.  The theme of booming digital advertising is an obvious label you can attach to a story like Facebook.  Advertisers always looking for ‘eyeballs’ to capture and serve with digital adverts would surely flock to the dominant player.  If anything, revenues were growing at more than 45% year-on-year at the time of the IPO (albeit less than the 100% growth rate recorded in 2011).

However, when such an over-hyped IPO comes to the market there is always the risk to disappoint excessive expectations, and in this case if you looked carefully you could find many red flags.  Prior to the IPO, one could have turned a blind eye to the fact that Wall Street underwriters had pushed the final listing price $4 above the original estimated range right at the last minute due to the strong demand from the public.  Or you could have ignored the fact that 57% of the shares being offered in the float were coming from existing shareholders (including $1 billion from founder Mark Zuckerberg).  Or that a further 1.7 billion shares (or 63% of total shares outstanding!) from existing shareholders (venture capitalists, founders and employees) would be available for sale at various stages for 12 months after the IPO date, creating a potential enormous overhang on the stock price in the near-term.

All signs were potentially there that really you would be buying a very ‘hot’ stock which ultimately could burn you…  If a stock trades at a very high valuation multiple by traditional standards, it is obviously discounting a highly successful outcome.  In other words, there is upside only if the company is more successful than existing high expectations from investors; and a lot of downside if it disappoints.

According to a reconstruction of the events around the IPO, a few days before the listing the underwriters had started privately warning some potential clients of possible downward revisions to Facebook’s revenue growth for the incoming quarter.  Many investors started feeling duped and scaled back their allocation demands for the new stock.  What happened really?  The company had warned through a regulatory filing, that a large portion of users were increasingly using Facebook on smartphones, but this mobile application was nowhere near as profitable in terms of advertising revenues as the traditional PC based one.  (The majority of Facebook revenues derive from the space the company sells to advertisers on its website, and its mobile phone version offers much less screen space for those adverts, hence a much lower interaction and profitability per user.  We estimate that mobile adverts earn $0.70 per user per year on average versus $5 to $6 of the desktop version).

When Facebook eventually reported its second quarter results in July, it emerged in fact that annual sales growth was decelerating to 32% and monthly active users in the US and Europe were almost plateauing, suggesting a near saturation of the platform in developed markets.  On the contrary, Facebook mobile users were growing much faster, and mostly in emerging markets, where people are more likely to have their first experience with the Internet through a mobile phone rather than a PC.  Facebook revenues from mobile adverts are estimated to be only around 5% of total revenues for 2012 and this is where the big challenge for the company lies.

In the past we have seen Internet stories stumbling initially but then progress to huge success (Amazon) and others (MySpace) take-off rapidly only to end up in the dustbin.  While it is still early days for advertising on social networks, and Facebook has already established a huge global footprint, its business model is clearly still immature and management are now trying to address its weaknesses by exploring new ways of ‘monetising’ advertisers/users.

At around the same time of the Facebook IPO, we at Platinum discussed its implications for the industry at large and its impact on competitors in particular.  When a new business manages to build-up a follower base of one billion people in such a relatively short period of time, absorbing more of the ‘users’ Internet time’ to the detriment of existing platforms, it can potentially become a clear threat to incumbents’ profitability.  Companies like Google, Apple, Yahoo and Microsoft all have to deal with the new entrant and its disruptive role.

However, we reached the conclusion that while everybody’s attention was focused on the new kid in town, the market was giving us an opportunity to add to our position in Google at a very attractive price.  As the Google price lay neglected on a valuation of 13-14x forecast P/E, we considered the market was emphasising the negative perception that Facebook would ultimately cannibalise large parts of its competitor’s business.

With a clear focus on digital advertising through an established dominant position in on-line search and video (YouTube), and a fast growing on-line display business, Google seemed to us a much better investment opportunity and its solid growth credentials (revenues + 35% year-on-year accelerating in the second quarter) didn’t look like the company was suffering that much from the new competitor, at least not yet.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.