Facebook: To buy or not to buy? That is the question

Note added 5/17/2012 Price of the IPO set at the high end $38 per share

Note added 5/16/2012: Number of shares to be sold raised by 94 million

Note added 5/14/2012: Price of IPO raised to $34-$38, getting expensive here….

Since I have been involved with buying stocks, I have not received as many inquiries as I have on whether to buy Facebook shares or not when it comes public on May 18th. In fact, in many cases, people don’t even want my opinion on buying them; they want my opinion on how much to buy, as if it were a sure thing that Facebook shares will be a good investment.

In what follows I describe what I think about the Facebook IPO and while I am a little bit weary of people jumping into it right away.

The Google Comparison

While everyone compares the Facebook IPO to Google’s, I disagree. When Google came public, there was hype months before the IPO, but as the IPO approached, there were many doubts thrown into the future of Google. The negative sentiment was such that the price of the IPO even had to be lowered because of the low demand in the “auction” part of the book. Originally, the plan was to sell the shares at US$ 121, but the price was lowered to $85 per share and the number of shares to be sold was actually reduced.

This was actually good for those interested in the $GOOG IPO. The stock did not “pop up” sharply on the first day and began going up more gradually, giving investors plenty of time to get in if they wanted to as shown below:

As you can see, the stock, sold at $85 per share, opened at $100 and stayed there for the rest of the first day. It then rose to about $112 on the third day, went back down to $99 and began a steady rise that took it to $200 in less than two months. Today $GOOG shares trade around $600.

The Netscape similarity

What the Facebook IPO really reminds me off, is the Netscape IPO. Netscape, a company that made the main Internet browser at the time, but had few revenues, scheduled to go public in August 1995, saying that it would sell its shares at $14 per share to the public. The hype and the frenzy was such, that everyone wanted to get some shares. The bankers then decided to price them at twice the original price, selling them at $28 to those lucky enough to get their hands on any shares. Most individual investors got only 100 shares, a small $2,800 investment.

On the first day of trading, the shares of Netscape opened at more than twice the price, at $56, rising fast to $75, before settling back down to near the opening price, closing at $58.25. Anyone that bought that first day near the high had to wait two months to see the price above the first day’s high, but within four months had doubled the money, as can bee seen in this graph:

By 1998, Netscape had lost market share with Microsoft Explorer overtaking Netscape, the stock price dropped below the IPO price, before AOL bought the company for a higher price.

The Netscape IPO marked the beginning of the tech bubble, which ended badly in 2001. (The Nasdaq reached 5,132 in March 2001. Today, eleven years later; it still sits near 3,000, 40% below that high)

Facebook: Fundamentals

You can see Facebook’s roadshow video here or Facebook’s S-1 SEC filing here.

With almost a billion users, there are no companies that can count on so many eyeballs day after day. This huge number of users translates into strong revenue growth, in 2007 Facebook had revenues of US$ 272 million and in 2011 it had revenues of 3.7 billion, a jump of more than ten times. In 2008 it lost six US$ cents per share, while in 2011 it made $0.46 per share.

These earnings come mostly from advertising (US$ 3.2 billion in 2011), which doubled in the last two years, but increasingly, Facebook makes money from fees from gamers and the like (US$ 500 million in 2011), which has increased 500% in the last two years.

There are two concerns with Facebook: First, from the last quarter 2011 to the first quarter 2012, revenues were flat and earnings per share were down. Earnings were down because of the company spent more on research and development, which could have been made on purpose to make comparables look better later on, after it goes public.

But longer term, the revenue model for Facebook is a little less clear. As Facebook itself says it in it’s filing, it has no clear revenue model or monetization of its webpage for smartphones. As more and more cellphone users move to smartphones which can surf the web, fewer people click on ads. The overall Internet model seems to be switching from search and ads on computers, to using games and apps on smartphones. Facebook is trying to promote the latter, but they are clearly not as good yet at generating revenues from this, compared with simple ads in a computer.

But these are longer-term issues. For now, a billion users is a lot of users and that is what people are fixating on: Can Facebook keep them, sell them things and make even more money?

That, my friends, is the question. We don’t know the answer yet.

Facebook, according to the filing, has or will have 2.9 billion shares on a fully diluted basis, as it is clearly stated in Note 2 of the IPO S-1 filing (page F-21). Here I should make a note: This number is difficult to find in all of the hype about the IPO, instead one hears that at $35 per share the company would be worth US$ 95.95 billion dollars. I have no idea where this number comes from, but it seems to have been propagated in the web. Using the 2.9 billion shares from the S-1, at $35 per share, the value of Facebook would be US$ 161 billion, no question about that.

What this means is that the company would be valued as follows:

At the low IPO price of $28 per share US$ 82 billion, Price/Earnings (2012)= 45

At the high IPO price of $35 per share US$ 103 billion, Price/Earnings (2012)= 56

And so that you have a quick table to look up on the first day of trading, here are the P/E’s for 2011 and estimated values for 2012 at different prices all the way up to $150 per share, which would be truly crazy:

To give you an idea, $AAPL’s P/E is currently 14, while $AMZN at the other end is at 184. Both companies have a legion of followers, but somehow they like more the low margin, mostly US-centric business of $AMZN, than the high margin, more international business at $AAPL. Go figure.

However, at a P/E of 200, Facebook would be worth 50% more than what $GOOG is worth, which seems very hard to justify. Below is a table of the current market caps and revenues of $AMZN, $AAPL, $GOOG and $FB:

I think it would be hard to justify that $FB is worth more than $GOOG today, which would say no more than US$ 200 billion, that implies a price of no more than $75, or twice the upper range of the expected IPO price (Which could be increased).

Can I get shares at the IPO?

That is the first question I get, even from people who have never owned a stock before in their life. The answer is likely to be no, unless you have an account with any of the 33 brokers involved in the placement of the IPO (see the Prospectus), it is unlikely that you will get any shares. Those will be reserved to the good clients, some individuals, some institutional.

But even if you do have an account, it is unlikely you will get many anyway. Facebook may have 4.53 billion shares, but the owners are not selling just yet, they are selling some shares to raise money to continue operating. But they will only sell 333 million of them. That is less than 7.4% of the total number of shares.

With the hype and the frenzy, I think it is unlikely that any individual, unless you give thousands in commissions every year to your broker, will get more than 100 shares (If three million people ask for shares that is 100 shares per person, give or take). At the high end of the pricing, that would be all of US$ 3,500. But I imagine most of you want to invest more than that.

Note also, that the fact that only 333 million shares will be sold implies there will be scarcity, which will help drive the price up when it starts trading.

Finally, the range from US$ 25 per share to US$ 35 per share is not written in stone. The lead brokers could decide to increase it

So, what do you recommend?

Well, I think this is a very high risk game. Without knowing a) At what price it is sold to investors at the IPO, b) At what price does it begin trading on May 18th, I have no recommendation for you.

First, the brokers could increase the price even more, which would only increase the hype and the frenzy. Second it could open at any price and I can’t possibly suggest that you buy a stock if any company at any price. So, I will not know the answer until May 18th.

But I can tell you what I think will happen.

Look at the two charts above for Netscape and $GOOG. Even though the dynamics were so different, one was full hype, the other was not, they had similarities. They “popped” at the beginning, went down and then slowly began rising.

Thus, there are two things people can do:

1) Play the crazy pop: This is only advisable to those that have access to real time pricing and can place orders automatically in electronic fashion. Try to buy Facebook shares as soon as it opens and sell on the same day at the sign of any weakness. And I do mean “any” weakness, just the smallest hint. If on the first day Netscape traded, you had done this, you could have bought at say $60, sold at $85. With $GOOG you would have not made much or lost much.

2) The more reasonable approach, is not to do anything the first few days. Let the stock “pop”, let the bubble deflate. Once it starts settling down, wait for it to go back to the original high of the “pop”. You could buy there.

This is an old trick of technical analysis. If a stock starts trading at $60 and it pops to $90 and then goes back down to say $70, there will be a lot of people who bought between $80-plus all the way up to $90. At $70, they are losers, but they don’t want to take the loss. Buyers have to come in and buy stock from all those that bought it between $70 and $90. Until all of those guys are cleared, the stock will not go up.

In either of these two cases you will be buying the stock at a fundamentally “expensive” price. But between the hype and the scarcity, it most likely will work until people start perceiving that Facebook will not grow as fast as they thought.

And if the price goes truly crazy, hey, why not buy $GOOG or $AAPL instead?