Facebook's (FB) IPO Falls Flat

"Facebook (FB: Charts, News) Friday" has come and gone, and the social media giant has baffled investors with its lackluster market debut. Shares of Facebook, which were priced last Thursday on the IPO market at $38, closed on Friday with an anemic 0.61% gain at $38.23. Trouble started early in the trading day, with massive volume causing technical glitches at Nasdaq and online brokerages, which halted trading until 11:30 AM.

Shares briefly traded above $41 per share before plummeting back to $38, causing its main underwriters, such as Morgan Stanley (MS: Charts, News), to swoop in with massive purchases to prop up the stock to prevent an embarrassing first day crash.

Daily Chart
The trouble didn't end there, however. The day before Facebook's IPO, General Motors (GM: Charts, News) withdrew its ads from Facebook, claiming that its paid ads on the social network were less effective than traditional Internet display ads, such as Google's (GOOG: Charts, News) AdSense program. GM withdrew $10 million in paid and $30 million in unpaid advertising, but still maintains a Facebook business page. This caused many investors to reevaluate Facebook's future profitability, as the company is completely dependent on ad revenue.

In addition, a class action lawsuit against Facebook was announced on Friday morning, in which a group of subscribers sued the company for "privacy violations" in "tracking Internet usage". The lawsuit alleges that Facebook violated the U.S. Wiretap Act, and should pay up to $15 billion for statutory damages. While Facebook is unlikely to lose $15 billion, the news threw cold water on the rally, once again raising concerns regarding the company's privacy violations.

However, most analysts believe that Facebook's poor IPO performance was due to the simple metrics of valuation and float. At $38, Facebook trades at 122 times trailing earnings, with a market cap of $81.74 billion. That makes it larger than Walt Disney (DIS: Charts, News) and nearly the size of McDonald's (MCD: Charts, News), which both trade at less than 17 times past earnings. In comparison to its tech brethren, Apple (AAPL: Charts, News) has a market cap of $495 billion, but has a P/E of 12.9, while Microsoft has a market cap of $246 billion with a P/E of 10.7. Even Google (GOOG: Charts, News), to which Facebook is often compared, trades with a P/E of 18.2 despite its $196 billion market cap. To most astute investors, Facebook, even at IPO price, no longer looked like a bargain.

Many investors also noted that Facebook increased the size of its IPO by nearly 25% to 421 million shares, floating 15% of its outstanding shares. This indicated that insiders were eager to sell the stock, and that the massive float would ultimately form a bottleneck on any first day rally. Facebook also extended its IPO to discount brokerage E*Trade (ETFC: Charts, News) in the hopes of reaching more investors, which increased the hype surrounding the stock. Morgan Stanley acknowledged that with an offering of this magnitude - the third largest IPO in history - it would be hard to expect a first day rally beyond the single digits. Investors who were expecting a LinkedIn (LNKD: Charts, News) style rally - where shares doubled on the first day - were sorely disappointed. Many analysts had projected a 50% gain on the first day.

Many investors used LinkedIn's IPO as a point of reference for the Facebook IPO, just as Visa's (V: Charts, News) IPO investors referred to Mastercard's (MA: Charts, News) past performance. However, the two stocks, while both social networking companies, have very different underlying metrics. Although LinkedIn still trades with an eye-popping P/E of 612, the company is only worth 10.23 billion. This was due to the small amount of shares (9%) floated during its IPO. A low-float IPO puts a bottleneck on supply, and the right amount of demand can cause shares to skyrocket. The drawback is far less cash from the sale. However, company insiders still profit handsomely from the bump in stock price.

Looking forward, Facebook has some big expectations to meet if it hopes to mature into a true tech heavyweight. By most calculations, Facebook needs to double its revenue in 2012, double it again in 2013 and retain its gains with annual revenue growth of 30% starting in 2014 in order to achieve a more balanced P/E of 20. Margins - which have been steadily eroded by increased Sales & Marketing and Research & Development expenses - must also stay intact throughout these years as well. These expenses, at $1.95 billion last year, are currently triple those of Google's.

85% of Facebook's revenue comes from display advertising. While the segment posted 169% growth in 2010, that number plunged to 69% in 2011. Analysts are rightly concerned that Facebook's 2012 display advertising numbers could be disastrous. CEO Mark Zuckerberg also acknowledged that while display advertising is profitable on desktop computers, it is not profitable on mobile platforms - such as smartphones and tablets. Mobile apps block Facebook's display ads, which appear on the side columns of the website.

Facebook's one avenue of rising revenue growth is social game maker Zynga (ZNGA: Charts, News), which now accounts for nearly 15% of the company's revenue. Its contributions to "micro-payments", made via Facebook's currency or other methods, are increasingly popular. Last year, the segment posted $557 million in sales. Facebook takes a 30% cut from all game and app purchases within its site.

It's still too early to say whether Facebook will fail or succeed, but its lofty valuation and tough hurdles ahead should be red flags for the everyday investor. However, Facebook should still be on most investors' watchlists, as its inherent value could still be realized in years to come.

Other News About FB
Facebook Stock Seen Facing Crucial Week After Modest Debut
Will Facebook's underwriters continue supporting the stock after its lukewarm debut?
Nasdaq CEO Explains Facebook IPO's Bungle
Nasdaq CEO in the hot seat after costly trading delays bungle Facebook's IPO. Other Stocks in the News
Apple, Samsung Ordered Into Patent Settlement Conference
Apple and Samsung's ongoing patent war may be close to a cease fire.
Google wins China clearance For Motorola deal
Google is finally cleared for takeoff, but can its Motorola handsets compete?

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Published on May 21, 2012
By Leo Sun
Leo Sun
Leo Sun is a freelance finance writer and position trader. He focuses on a combination of value and momentum investing, with a strong interest in the trading philosophies of Warren Buffett and Peter Lynch. Leo also has experience writing articles to help small business owners acquire loans and manage their finances. He regularly contributes to the Stock of the Day analysis.

Copyrighted 2020. Content published with author's permission.

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