A Critical Analysis Of The Facebook IPO
My Two CentsIt will likely go down in history as one of the biggest flops the stock market has ever seen - at least initially. The comedy of errors that have resulted in the loss of billions of dollars of market capitalization and shareholder value is noteworthy. The greed of many that led up to the flop really needs to be dissected though. The purpose of this article, however, is not merely to bash Facebook or anyone else, but rather to shine the light of day on what are generally accepted business practices. Since Facebook has become a household word in the past few weeks, it presents an outstanding opportunity to connect the dots in the hopes of educating retail investors and tipping the scales a bit in favor of the little guy; at least in the information department.
24 May 2012
Media Hype - Justified or Unjust?
The headlines alone in the days and weeks preceding the IPO would have had market newcomers believing that Facebook was about to save the world, at least in terms of its benefit to the financial markets. It was going to be the offering that would bring retail investors off the sidelines and get them active in the markets again. This was a classic pump and dump. The media got people frothy and I took phone calls from numerous clients and interested parties, many of whom said they felt that the stock would immediately go to $150 or more a share just because everyone was talking about it.
It truly reminded me of the dot com days when offerings would take off just because the company had a fair amount of web traffic and had the letter 'e' in its name. Fundamentals were forgotten and money was put on the line. Obviously we know how that ended. The best friend of underwriters and insiders is a public whipped into a frenzy about an IPO. It allows the insiders to cash out at above market equilibrium prices, make a fortune, and as a result lose most of their incentive to ensure the company's success moving forward. We've seen it hundreds of times already, yet this time it was going to be different. The question must be asked then, who exactly does the financial media work for anyway? If you need a roadmap to answer this question, it is probably best to stop reading here because what follows will likely be very upsetting.
The media once again has shown its true colors and its inclination towards sensationalism. At best this is a symptom of the 24-hour news cycle we've become immersed in as a society and the competition for ratings. At worst, it is another piece of evidence that builds a very convincing prima facie case that the media is nothing more than extension of the financial establishment, used once again to the betterment of the establishment at a great cost to retail investors.
Imperfect Information - Are Markets Really Efficient?
One of the things often recited much in the way a sacred creed would be is the idea of something called the Efficient Market Theory, aka Efficient Market Hypothesis (EMT). This is the idea that the marketplace is always efficient. This efficiency is based on five major criteria, one of which is the construct of perfect information. The assumption in EMT is that all financial and economic agents have equal information. With the advent of the Internet, one might falsely assume that this is actually true. Sure we know a whole lot more thanks to the Internet than we did before it, but is the playing field equal? Not a chance. This IPO was another shining example of that.
For evidence I submit an article posted on CNBC's website on Tuesday May 22, 2012. The article asserted that Morgan Stanley, the principal underwriter (bank in charge of offering Facebook shares) released a note to 'major clients' regarding the opinion of its consumer Internet analyst on the Facebook offering.
"In the run-up to Facebook's $16 billion IPO, Morgan Stanley, the lead underwriter on the deal, unexpectedly delivered some negative news to major clients: The bank's consumer Internet analyst, Scott Devitt, was reducing his revenue forecasts for the company.
The sudden caution very close to the huge initial public offering, and while an investor roadshow was underway, was a big shock to some, said two investors who were advised of the revised forecast.
They say it may have contributed to the weak performance of Facebook shares, which sank on Monday - their second day of trading - to end 10 percent below the IPO price. The $38 per share IPO price valued Facebook at $104 billion."
We could argue all day and into the next about Morgan Stanley's obligation towards all of its clients to release this very pertinent information. For however large of a point that is, it pales in comparison to the idea of perfect information in the marketplace. There is no such thing and this is living, breathing proof. People who seek to refute the notion of EMT generally point at insiders and the illegal distribution of information to third parties as being the only thing that makes the playing field unequal. However, the fact of the matter is that critical information is nearly always reserved for 'preferred' clients over the masses. And as you'll find over the coming weeks and months, the bank will likely get away with it from a legal perspective. However, as a retail investor, understanding that you're most likely not getting the whole story is critical to protecting yourself against these types of situations.
Morgan Stanley may well end up getting itself sued by the balance of its clients - everyday folks who trusted the firm to make wise decisions on their behalf - but that is only half the story. Retail investors with no ties to the underwriter were also negatively affected by this imbalance of information. So much for the idea of market efficiency.
Epitome of Greed
As more and more information comes out about how this deal went down and the decisions that were made, it should become very apparent to even the most casual of observers that greed was the driving force throughout the entire process. While this may not come as a shock to most folks, the rather transparent nature of the greed in this case is definitely noteworthy.
Even more important to understand is how the Facebook executives and underwriters sacrificed their implied and express fiduciary responsibilities to those who would become Facebook shareholders. Morgan Stanley is already being 'investigated' by FINRA and the SEC over its alleged warning of certain large clients regarding the findings of its internal analyst just prior to the IPO. The real problem here is that if we assume hypothetically that Morgan Stanley is found to have acted improperly, nothing of substance will be done. Sure, they'll have to pay a fine and it may be several hundred thousand dollars or more. They'll sacrifice a middle manager or low-level executive or two and will claim to have learned the lesson well and will promise to reform. The sad thing is that this is tantamount to you and I doing 120 in a 55 to complete a deal worth a few thousand dollars and receiving a three-dollar speeding ticket. Morgan Stanley released the following statement regarding the distribution of its analyst's pre-IPO change of heart:
"Morgan Stanley followed the same procedures for the Facebook offering that it follows for all IPOs. These procedures are in compliance with all applicable regulations," the brokerage said in a statement to CNBC.
"After Facebook released a revised S-1 filing on May 9 providing additional guidance with respect to business trends, a copy of the amendment was forwarded to all of MS's institutional and retail investors and the amendment was widely publicized in the press at the time.
In response to the information about business trends, a significant number of research analysts in the syndicate who were participating in investor education reduced their earnings views to reflect their estimate of the impact of the new information. These revised views were taken into account in the pricing of the IPO."
There is just too much incentive in today's financial structure to cheat, lie, and obfuscate. The penalties don't serve as an effective deterrent and the practice goes on unabated. This is certainly not an isolated incident. The only reason we're even hearing this much about it is because of the publicity surrounding the offering. And this also plays into the idea of market efficiency's major assumption - that all actors and economic agents have access to the same information.
The Fallacy of Retail Demand
The real chicken dinner winner of the whole Facebook IPO was the idea of record retail demand. The company marketed its offering feverishly and was certainly successful in ginning up a lot of talk and speculation, but when it came down to it, there were way too many shares offered. Showing a complete lack of understanding of demand, Morgan Stanley went as far as to increase the number of shares floated by 25% just before the offering commenced.
Even in the first hours of trading, the financial press was almost giddy at what was called 'record retail demand' as the shares went from $38 to $45. That initial burst of buying was replaced almost immediately by fervent selling and before the first session was over, underwriters had to step in and support the offering by buying up shares. In short, there were too many shares out there and not enough buyers. While there may have been 'record demand', there were way too many shares otherwise prices wouldn't have tanked. There were scads of reports of funds of all stripes receiving double and even triple the allotment of shares they requested. Their obvious first step was to trim their positions.
Exacerbating the problem was the inability of Nasdaq OMX to handle the flow of orders. Traders and investors were relegated to tracking their positions on spreadsheets and legal pads for much of Friday while Nasdaq struggled to fix the problems. The delay in order processing resulted in losses for many investors and at least one lawsuit has already been filed with likely many more to follow.
Lack of 'Value'
Tying into the fallacy of Morgan Stanley's claim that the new information was priced into the IPO is the reality that of the two potential ranges of price offerings given pre-IPO, the final price was at the highest possible level of the two ranges - $38/share. That created a Price/Forward Earnings multiple of around 100, which is several orders of magnitude higher than that of established tech stalwart Google (P/E around 23). For most investors, Google was the only parallel example in recent memory as pertained to the scope and hype of the offering.
It doesn't take a Wall Street analyst to point out that Facebook, despite all of its popularity among users and tentacles throughout the web, still derives nearly all of its revenues from advertising. And that advertising is contracting in 2012 and is expected to continue to do so in 2013. The hubris of those involved in the decision-making process regarding the pricing of the IPO is unequalled in recent memory. The thought process clearly at work here was that people would be willing to pay an exorbitant premium just because it would be cool to own Facebook. At least that is the distinct impression this author got. Ironically, this time I'm not alone by any stretch as many mainstream analysts and money managers shared that opinion as well.
Take Home Lessons
The simple lesson that can be learned from this whole experience (which is nowhere near over yet by the way) is that in the end fundamentals will rule. The past two weeks are very reminiscent of the hype surrounding the boatloads of IPOs by various Internet companies in the late 1990s. This was to be the biggest ever and so far it has gone down as a huge flop. Absent significant propping by either large shareholders, the underwriters themselves or an aggressive stock buyback program, it would seem that Facebook shares are doomed to mediocrity; at least for now. A second lesson to learn is to never underestimate hype and the greater fool principle that there will always be someone willing to pay more than you did. After nearly a week out on the tiles, many singed Facebook investors are learning what value investors have known for a long time - occasionally, IPOs are nothing more than hot air.
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Andrew W. Sutton, MBA
Chief Market Strategist
Sutton & Associates, LLC
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