Saturday, February 04, 2012

The Facebook S1 Filing - Stay Away from the IPO: I mean it

So, this evening, I finally took some time out of my really busy schedule of snacking on Pop Chips and drinking free soda at the Google microkitchens to read the Facebook S1 filing (PDF) (yes, I read that whole thing from cover to cover). It was an interesting read: full of financial mumbo jumbo that doesn't quite feel interesting until you start keeping track of who earns how much due to what deals struck between which parties. It's all pretty convoluted, yet pretty simple too. To make sense of everything in that document, all you need to do is to keep in mind the character played by Jesse Eisenberg in "The Social Network" (Trailer). Yeah, everything that that movie depicts - very likely true.


So, before going ahead with my deconstruction of that opaque document full of legalese, here's my first reaction that I was about to post to Google+ before writing this post:


Compare the S-1 IPO filing documents for Google (PDF) and Facebook(PDF). Look at the *DIAMETRICALLY* opposite views that Zuckerberg and Larry/Sergey hold of their investors.

The Google S-1 is structured as a document that aims to inform investors as to why they should buy into the stock of the company for the long term at a sustainable price through a fair pricing mechanism and the Facebook S-1 is structured as a document that informs investors that they're going to lose money, their overpriced shares are going to be diluted upon purchase at the IPO, their IPO proceeds will go towards paying the taxman and not growing the company, decision making power is concentrated in the hands of the CEO (which is an official "risk factor" for the company), even directors, founders and significant shareholders have their voting powers pledged, there's no long term vision to speak of and retail investors should be prepared for everything going wrong. It all sounds pretty funky to me. I'd stay as far away from this as possible. Read it and see for yourself.



Yeah. As you can see - the IPO isn't really encouraging through the spectacles I'm wearing, and here's why:

Image Credit: The Hacker News
Let's start with the basics - if you have to buy shares in a company, how do you evaluate how much you should pay for them?

Metric 1: The par or face value and PE

The value of each share as issued by the company as a proxy of ownership on its assets. In the event of a bankruptcy, this is what the company will attempt to pay you when liquidating its assets after repaying its creditors. So, what's the par value of a Facebook share?  $0.000006 - that's really a lot of money, isn't it? And what is Facebook (FB) asking per share? Let's take a round figure of about $30. Hmm 5 million times the face value? Something isn't right there, or is it?

Well, in reality, most companies don't really trade close to their par values as the stock markets factor in intangible assets like smart people, software codebases (which really have an asset value of 0, but are presumably immensely valuable to companies like Apple, Google, Amazon etc.), market dominance, locked in customer relationships, contracts for future income etc. which naturally cause the market value to rise. A better understanding of the price of the share can be obtained by looking at the Price/Earnings ratio. Google (GOOG) has a PE of around 20 (and it's considered expensive), Apple (AAPL) has a PE of just 13 and it has a stock price going North all the way for the past 3 years and a cash chest comparable to a few small countries, Amazon (AMZN) is an exception to the rule with a PE of 136 but it has some funky accounting behind it. Effectively, its PE is around the Google range or slightly more expensive (I would love to cite a source on this, but I did this research some time ago and I don't remember the exact figures anymore). So, people, PE in this industry, even for hot companies should range in the range of 10-20. And how does Facebook fare in this regard? FB wants an IPO PE value of 100 (20x total revenue, not earnings) similar to what Google got in its IPO as part of it's growing phase, but isn't it obvious that Facebook is at the top of the S shaped growth curve?

So, at the end of this all, effectively,  the market value of this stock is in no way related to the actual brick and mortar assets of this company. Okay. Point noted. We need to look elsewhere to evaluate the assets of this company. So, let's start looking!

Metric 2: How much money does this company earn per annum? 

That's a softball question. Here's the answer straight from the filing books:


  
Year Ended December 31,
      2009          2010          2011    
  (in millions, except per share data)
Consolidated Statements of Income Data:      
Revenue
  $777    $1,974    $3,711  
Costs and expenses(1):
      
Cost of revenue
  223    493    860  
Marketing and sales
  115    184    427  
Research and development
  87    144    388  
General and administrative
  90    121    280  
  


  


  


Total costs and expenses
  515    942    1,955  
  


  


  


Income from operations
  262    1,032    1,756  
Other expense, net
  8    24    61  
  


  


  


Income before provision for income taxes
  254    1,008    1,695  
Provision for income taxes
  25    402    695  
  


  


  


Net income
  $229    $606    $1,000  
  


  


  


Net income attributable to Class A and Class B common stockholders
  $122    $372    $668  
  


  


  


Earnings per share attributable to Class A and Class B common stockholders(2):
      
Basic
  $  0.12    $0.34    $0.52  
  


  


  


Diluted
  $0.10    $0.28    $0.46  
  


  


  


Pro forma earnings per share attributable to Class A and Class B common stockholders(2):
      
Basic
      $0.49  
      


Diluted
      $0.43  
Source: The S1 documents filed by Facebook with the SEC. Oh, and make sure you spend some time looking at the Marketing and Sales cost figures right beneath this table - they're going to be more representative of the company going ahead.

Okay, now let's back up a bit - this company, which gets revenues of around 4 billion dollars per annum and makes profits of 1 billion dollars per annum in its most profitable year till date is proposing to sell to the general public 5 billion dollars worth of paper that represents about 5-10% of the company? Hmmm... Come again?

Okay. Let me put it this way: Let's say that I'm a working guy and I have an income of 1 billion dollars. I tell you - hey! I'm probably going to be working for 100 years, so in this time I will have earned 100 billion dollars - pay me 5 billion dollars now and I'll put 5% of my salary in your bank account for the next 100 years. If I go bankrupt before then, I'll just pay you $5000. Would you do that? That too when the guy's in the technology sector where his peers don't even last for 5 years? (Remember Orkut? or Myspace?)

Oh, and by the way, after giving FB 5 billion dollars, you won't even have a say in the way the company functions - Mark Zuckerberg holds all the voting power via Class B voting stocks (10 votes per share) and at the IPO you'll just be given the stupidly standard Class A (1 vote per share) common stock. So, effectively, in the words of the esteemed Washington Post (whose CEO is an FB board member by the way) -

The public will hold "a majority economic position and a minority voting position"

Rather unfair isn't it? Gambling with other people's money? Oh, and by the way, as part of the risk factors mentioned in the prospectus, one of the risk factors to the company is the CEO himself (S1 pg. 20). How ironic.

At the end of it all, let's do some maths:
Let's buy 1 GOOG share at $600 and the equivalent FB shares at $30 apiece.
GOOG has an Earnings Per Share of around $29-30. FB has an EPS of $0.47 this year and we can buy 20 FB shares at the same price. So, share to share, GOOG earns $30 against FB's $8. Okay, so let's give the little kiddo the benefit of the doubt - he's going to grow rapidly:
FB - $8, $12, $18, $27 - growing at 50% year on year giving it approximately 50% of the world population as monthly ACTIVE members at the end of 4 years. Wildly optimistic scenario? Well... even if Google just maintains its current earnings, the net earnings for the shares held would exceed that of FB over these 4 years. So, why should you pay this much? The answer, dear investor, is not to pay! And to give you further fortitude, Forbes agrees with me on this!

Metric 3: How much earning potential does it still have?

Image Credit: www.pokerblog.com
Facebook has about 800 million monthly active users. If it continues its current rate of exponential growth, it will exceed the projected world population of 8 billion people in about 4 years or so? Take it from me, friend, that isn't going to happen as that will include every single man, woman and child on this planet Earth. So the long term outlook of this company indicates moderating growth unless it can find other sources of revenue (more Zynga gamers, more payments, deals, local etc.). Given the way things are going, I strongly believe that this company is setting itself up for disappointment. (And I'm not the only one. Check out Forbes' analysis of hype versus substance and Reuters sobering look at Facebook for starters.) For context, see the way that Zynga, Pandora, and LinkedIn have performed post their much hyped IPOs - they're all trading well below their IPO prices today. Given how much FB is overvalued, I really doubt that the hype can save it. So, what's the saving grace? Well, the ace up Facebook's sleeve is the fact that it doesn't serve even a single mobile ad on its apps. All this income is just from desktop apps. Given that Facebook is the number one downloaded mobile app across all mobile categories, the day those floodgates open, Facebook will directly bump up its revenue in an instant. So just wait: Facebook will launch mobile ads soon before or just after its IPO and its stock price is going to hit the roof! That's their crown jewel and that's what their investors are depending on to cash out of this company.

Final words

It would have been awesome if the Facebook filing showcased that the people in the company had matured and had a long term future for the company. Just look at the Google guys! But, sadly, that is not to be. Facebook doesn't have any plans for the money it will raise from the IPO and all the shares that Mr. Zuckerberg is selling to the public will be used to pay down the tax that he will owe in exercising his own options to buy himself more Class B voting shares. I shan't bore you further with the details (Goldman Sachs losing out to Morgan Stanley in being the underwriters of the final offer despite being the ones originally valuing the company at $50b to secure a huge chunk of shares to sell privately; a $2.5b unused line of credit for a cash and pre-IPO equity rich company solely to provide income to the banks that back it etc. etc.). Suffice to know that this stock is a Wall Street mud pit and as a retail investor, you should stay away from it. Oh, any by the way, if you don't agree with me, feel free to drop me an email or write a comment below (comments are moderated, spammers, please stay away).

Postscript

Forbes has consistently been bearish on Facebook valuations. You might have fun playing around with Trefis' analysis of FB's stock price (slightly outdated PDF). Check it out! Hopefully, they'll have an updated analysis based on the recent S1 filing soon enough.

Also, before leaving, please checkout the ever newsworthy Mashable's Facebook Hall of "Fame" Infographic.

Hope you've made up your mind now! Take care and invest wisely! :)