Facebook Debacle: The Rise and Fall of the IPO

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The much awaited and anticipated Facebook IPO, fell flat on its face. It was dubbed the IPO of the century, it sure made the history books for this century. Facebook’s problems has led it being broiled into the law books. The court battles over the fizzled IPO could run for years. Besides bankers, it would also be the lawyers profiting from the misfired IPO.

Despite raising $16 billion, the largest ever for a tech company, it ended its first day only 0.6% above its IPO price, and since then the stock price has taken a nose dive.

The downward trend continues. On Tuesday 29 May, the stock price went down 9.62% to end at $28.84 down over $3 on the day. Shares are now down 24% from their initial public offering price of $38.

The steep stock drop has hurt the fortunes of the company and its founder Mark Zuckerberg, financially. At the time of its IPO, Facebook was worth $104 billion. Now that its stock has gone down nearly a quarter, the company itself has gone down $25 billion, and is now worth $79 billion.

Zuckerberg has also seen his personal stake go down around the same amount, falling from $19.1 billion to $14.5 billion since the IPO.

What went wrong?

A number of things went wrong with regards to the IPO. The primary blame was placed on NASDAQ, the company’s chosen exchange froze and delayed the IPO three times in the space of an hour because it couldn’t handle the volume of orders from investors – a good number of whom appeared to be rushing for the exits to sell the stock. Then the blame was transferred on the “hype” which the company and its underwriters had created for the IPO. Amid pointed fingers and flying tempers, a deeper dig into the issue opened the Pandora’s box.

CEO attitude

Lets start off with Facebook CEO Mark Zuckerberg. From the beginning it was clear that he was not interested in the company’s IPO. Rumour abuzz that he was forced into announcing the IPO and was not happy about the initial price. A source close to the matter told Arabian Gazette that Zuckerberg had planned his wedding days before the IPO as to show the board of directors that he would be enjoying his honeymoon and not worried about the IPO.  This to me smells funny. It could mean that the CEO was expecting such a debacle.

Pricing of the IPO

“The IPO was doomed from the beginning” James Morwell, an independent analyst based in the UK, told Arabian Gazette. “The price was highly inflated and the market believed it was correct. Little did we know!”

Heidi More of The Guardian stated that pricing an IPO correctly – to predict, in essence, its fair market price – is a delicate art, which is supposed to balance how much investors may like a company with how much they’re willing to pay for it. It seemed that Facebook deliberately priced it much higher than the real value. She compare Facebook shares with Apple. People love Apple enough to pay $400 a share for it. But if Apple were valued the same way as Facebook, each Apple share would be worth more than $3,000, Heidi stated.

Greed

Greed played an important part of the debacle. The IPO was introduced in a primary way to enrich the fortunes of the executives and insiders, rather than the company’s. Their stock dump accounted for 57% of the shares sold in the offering, reinforcing the old joke that “IPO” stands not for “initial public offering”, but “insider profit opportunity”. To stuff more money into the pockets of these insiders and the company coffers, Morgan Stanley, the lead underwriter, hiked the price the company was charging investors – $38 – and flooded the market with tens of millions of extra shares. The investment bank then had to rush back into the market and buy millions of those shares to artificially support the price of the stock on the first day.

Deeper and deeper

While many would turn around and say that this is how some of the IPO’s in the past worked and everyone had come out richer and happier. So where did it go wrong for Facebook?

The whole fiasco started at the development and dissemination of information. In early May, Facebook and its research analysts at the company’s lead underwriters developed financial forecasts to facilitate the marketing and pricing of the IPO. These estimates which have been developed through close collaboration between the underwriters’ research analyst and company management, would be viewed by a handful of sophisticated investors. They are perceived as revenue and earnings targets that the company has reviewed and is confident it will hit. Sophisticated investors use these estimates when they are developing “bids” for the stock, as a tool with which to help determine the price they are willing to pay.

The point which needs to be taken into consideration is that these “estimates” are not published anywhere. However, they are “conveyed verbally” to institutional investors who are considering investing in the IPO. This practice is in conjunction with the industry convention. Therefore Facebook has not done anything wrong as of yet! So everyone was on cloud nine and there was a lot of institutional enthusiasm for the stock.

However, the enthusiasm was dampened after 9 May when Facebook filed an amended IPO prospectus with the Securities Exchange Commission (SEC). There was this following new clause that had not previously appeared in the company’s recent financial and user trends:

“Based upon our experience in the second quarter of 2012 to date, the trend we saw in the first quarter of DAUs increasing more rapidly than the increase in number of ads delivered has continued. We believe this trend is driven in part by increased usage of Facebook on mobile devices where we have only recently begun showing an immaterial number of sponsored stories in News Feed, and in part due to certain pages having fewer ads per page as a result of product decisions.”

Now the model IPO or as some investors had called the “blessed IPO” started to make the sophisticated investors more nervous. The appearance of this language was interpreted as a negative sign by the selected investors. It seemed to them that Facebook’s business might have been deteriorating as the language was vague for not making clear that Facebook’s second quarter was weaker than expected.

Tipped or tapped

Soon after Facebook amended its prospectus, all three analysts at the company’s lead underwriters—Morgan Stanley, JP Morgan, and Goldman Sachs—cut their estimates for Facebook’s Q2 and the full year.

Before we look into consensus of the three companies, lets try to make sense of the new language. Shouldn’t the analysts of the lead underwriters who were working so intimately with Facebook be aware of this information? Is it possible that these analysts, when calculating the stock price, were kept in the dark about the expected Q2 performance? Or were they aware of the information but decided to keep quiet?

Anyhow, soon after Facebook amended its prospectus, all three analysts at the company’s lead underwriters—Morgan Stanley, JP Morgan, and Goldman Sachs—cut their estimates for Facebook’s Q2 and the full year. It should be noted that the estimate cuts were conveyed verbally to sophisticated institutional investors. And, not surprisingly, these investors viewed the estimate cuts as a startling and negative development.

One important question, of course, was why all three underwriter analysts cut their estimates at the same time. Did they come to the conclusion that the second quarter was weaker after reading the prospectus or were they tipped off?

The likely conclusion was that someone had ‘directed’ the analysts to cut their estimates, someone who had inside knowledge about Facebook’s Q2 progress. Business Insider reported that this was what actually happened: One of the underwriter’s analysts said he was told by a Facebook financial executive to cut his estimates.

According to another source with insight into the Facebook IPO process, until the underwriters’ analysts cut their estimates, demand for Facebook’s stock among sophisticated institutional investors was high. Once these investors heard about the estimate cut, however, they became more cautious about the IPO.

Meanwhile, during private IPO meetings, Facebook executives were reportedly “signaling” to some sophisticated investors that the company’s advertising revenue would not grow as rapidly as expected. The executives made it clear that this would limit the rate at which Facebook’s ad business could grow.

Now the institutional investors become nervous. All of this has been happening behind closed doors and things were much different in reality.  The demand for Facebook stock was hitting a fever pitch. One senior stockbroker at a major brokerage firm reported that he “had never seen such demand” for an IPO.

These individual investors, needless to say, were not likely aware that the research analysts at the company’s lead underwriters had cut their estimates for the company. They were also, presumably, unaware that Facebook’s Q2 was weaker than expected.

‘Institutional investors’, having digested the news of the underwriter estimate cut, were comfortable buying Facebook stock at $32 a share.

‘Retail investors’, on the other hand, who were presumably unaware of the estimate cut, were comfortable buying Facebook at $40 a share.

Knowing that a big percentage of the IPO stock could be sold to retail investors instead of institutional investors, Facebook and Morgan Stanley decided to price the IPO at $38.

On Friday, 18 May, Facebook’s stock opened at $42. It spent most of the day above $40, giving short-term traders a chance to flip for a quick gain, and then sank quickly. With heavy support from Morgan Stanley, the stock closed on Friday at just above the IPO price.

Given the amount of stock that had been sold, Morgan Stanley could not support Facebook’s stock price indefinitely without exposing itself to huge losses. In two trading days last week, as the IPO hype wore off and news of the analyst-estimate cut spread, Facebook’s stock plummeted.

Basically, Facebook collided with three major underwriters and played with small time investors. Those investors who were not informed that the Facebook stock was being devalued are suing Facebook, Zuckerberg and the underwriters for damages. Both Houses of Congress, the SEC and FIRA are all investigating.

The Saga continues

The Facebook Saga does not end here. It simply gets thicker…

Fortunes at Facebook may have been depleted or even devastated but one man seems to be sitting pretty. Jim Breyer, one of Facebook’s board member, has been reported to have made over $100 million from the Facebook IPO. It should also be noted that Breyer is a board member on five different companies, Facebook, Dell, Wallmart, News Corp and Brightcove. All but Brightcove are now facing “high profile problems,” the New York Times reported.

Newscorp is embroiled in a phone hacking scandal; Walmart is being accused of bribery in Mexico; and Dell is having major financial difficulties.

Breyer more than doubled his shares of Facebook days before the IPO, as smaller investors who did not have the same knowledge saw their shares sink. It is unclear at this time how Breyer’s stake has been affected since the IPO.

However, some crumbs have come to light, it is just a matter of time before the bread is discovered.

Source: Reuters, Business Insider, The Guardian

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