Facebook's dream IPO is starting to look like a nightmare


Facebook's dream IPO is starting to look like a nightmare

Beck Diefenbach / REUTERS

The sun rises behind the entrance sign to Facebook headquarters in Menlo Park, Calif.

By Roland Jones

The hotly-anticipated Facebook IPO was supposed to be a watershed moment in social media and one of the biggest stock offerings to ever hit Wall Street.

Instead, the event is turning out to be a major humiliation for Facebook, its underwriters and the Nasdaq Stock Market, where Facebook opted to list its shares (although CNBC reported Wednesday it is now considering a move to the NYSE, though the exchange denied any conversations with the company).

Critics say the underwriting banks set the price of the offering too high and sold too many shares to the public, and the IPO debacle is raising broader questions from regulators about the IPO process, according to news reports Wednesday.

In the latest blow to the company, three shareholders filed a lawsuit against Facebook Wednesday, saying its chief executive Mark Zuckerberg and several banks led by Morgan Stanley omitted or misrepresented material information about the social networking leader’s business ahead of its IPO. The lawsuit seeks class-action status for all Facebook shareholders, except the defendants.

A Facebook spokesperson said the lawsuit is without merit and the company plans to fight it “vigorously.”

Capitol Hill is also focused on the company. The Senate Banking Committee said Wednesday it is investigating issues related to Facebook’s IPO. The development comes one day after the top financial regulator, the Securities and Exchange Commission, said it would be looking into the company’s IPO. Facebook also faces a lawsuit from an investor from California.

Shares of the newly-public company have reflected investor confusion over the offering. Instead of the usual first-day “pop” seen in most high-tech IPOs, they have pulled back since they began trading on Friday. Since hitting an intra-day high of $45 a share on Friday the company's stock price has fallen 31 percent to close Tuesday at $31, although the stock price rebounded 3 percent in Wednesday's trading session.

An IPO that wobbles in its debut isn’t necessarily a bad sign, as many new public companies -- such as Amazon.com -- have started out poorly and gone on to be top performers. But the share price tumult is suggestive of a botched and disorderly IPO process, experts say.

Despite the first-day trading debacle, Facebook’s IPO has succeeded in raising $16 billion for the company and some of its early investors, and it has valued the company at just over $100 billion.

But the offering -- the largest ever for a U.S. Internet company -- has left many individual investors who bought into the company on Friday with paper losses.

Two days after Facebook entered the public markets for the first time, details are emerging about the machinations behind its offering.

According to a Reuters report, just days before Facebook went public, analysts at Morgan Stanley and other underwriting firms started advising clients to rein in their expectations for the company’s growth.

Related: Zuckerberg, banks sued over Facebook IPO

As institutional investors worked to digest the developments, Morgan Stanley tried to set the price and size of the stock offering, The New York Times reported, noting that, while some big institutions scaled back on their plans, others placed large orders and retail investors clamored to buy shares of the tech icon.

Eventually, Facebook and Morgan Stanley decided there was enough demand and interest in the IPO to justify an offering price of $38 a share, even as other bankers involved in the deal pushed back, concerned about the company’s growth prospects, particularly in the mobile space, the Times reported.

Facebook’s Chief Financial Officer David Ebersman, who worked closely on every aspect of the IPO with Morgan Stanley’s co-head of global technology banking Michael Grimes, was instrumental in deciding to increase the number of shares Facebook would offer in the IPO by 25 percent, according to The Wall Street Journal.

In the end, given the muted reception to the IPO, the $38 a share offering price -- and the increased allocation of shares -- may have neutralized any first-day price jumps, which are seen by Wall Street banks as the trademark of a successful IPO.

“They misjudged what the real demand was,” Quinten Stevens, chief investment officer at Stevens Asset Management, told CNBC, referring to the underwriting banks on the deal.

Stevens noted that, given the hype surrounding the IPO and the fact that the offering was so heavily oversubscribed, it would have been very difficult to accurately gauge demand from investors. Once an IPO loses momentum in the first hours and days of trading, it “turns to the downside and becomes a busted IPO,” he added.

Anindya Ghose, an associate professor at NYU’s Stern School of Business, reckons the bankers pricing the deal overestimated the company’s projected revenue growth rate. With a more modest outlook for future revenue growth, he reckons Facebook shares would be worth a price “in the mid to upper 20s” -- closer to the first estimate of $28 the company gave investors.

Indeed, a handful of Wall Street estimates analyzed and modeled by Thomson Reuters StarMine finds that Facebook would be more fairly priced at just below $10. The analysis projects an annualized earnings growth over the next 10 years of 10.8 percent, almost exactly the mean for the technology sector and far below the 24 percent growth rate implied by the current stock price.

Related: Still hope for Facebook, despite poor start

“Investors are looking for much more growth than the analysts covering the company,” said Greg Harrison, corporate earnings research analyst at Thomson Reuters.

Worries about Facebook’s growth prospects emerged in early May when the company disclosed potential challenges in a regulatory filing. Of greatest concern was the increasing use of Facebook on mobile devices -- a realm where the company is not making much money from ads.

Top financial regulators said on Tuesday the issues around the Facebook IPO should be reviewed. One area of concern, according to reports, could be the disclosure of lower growth forecasts to certain big institutional investors, which may leave both Facebook and Morgan Stanley open to accusations of selective disclosure.

“I think there is a lot of reason to have confidence in our markets and in the integrity of how they operate, but there are issues that we need to look at specifically with respect to Facebook,” Securities and Exchange Commission Chairman Mary Schapiro told reporters Tuesday as she exited a Senate Banking Committee hearing.

The SEC is also investigating setbacks following a technology glitch on the Nasdaq exchange.

Meanwhile, Massachusetts state securities regulators have already issued a subpoena to Morgan Stanley seeking information about its analysts' discussions with investors about Facebook.