Facebook's IPO: what it really means

Facebook's eagerly anticipated IPO finally happened, and its stock price immediately fell off a cliff, dropping over 16% by the end of the first week, leading Bloomberg to declare it the worst large IPO of the decade. Reports of misdealing on the part of the company and the underwriters cast a further pall over the proceedings, and even Nasdaq had technical difficulties. If that wasn't enough, analysis of Facebook's finances raise questions about the company's ability to continue its meteoric growth.

It was a bad week for Facebook and its investors, but it's not all bad. Facebook has turned itself from an Internet start-up with huge growth, into a company with plenty of cash, lots of potential for future earning, and a healthy inertia to sustain it through challenging periods. Unfortunately, while it did a great job convincing investors it was worth $104 billion, its real value may be much lower, meaning some investors may indeed be in for a haircut, but Facebook should come out pretty well.

Whatever happens, Facebook is highly unlikely to spontaneously implode. The company is still growing and although that growth is slowing, it hasn't crested a peak towards a downward trajectory - the big question for Facebook will be whether it can leverage its injection of IPO cash into new business opportunities to turn the crest into an inflection point back upwards.

Facebook's IPO can't be seen as a failure (unless you bought in at the sticker price), but looking inside the guts of the deal does offer hints of how the market may evolve over the next year. Other tech IPOs, though, could suffer Facebook's (and its underwriters') hangover.

Facebook's offer price was $38 per share, valuing the company at $104 billion, the highest ever for a newly public company. After increasing the number of shares by 25% pre-launch, the company raised $16 billion, and is expected raise a further $2.4 billion later, making it the second-highest US IPO (Visa raised $19.6 billion in 2008). At the time of its IPO, Facebook boasted a user base of around 900 million active users and projected revenue for 2012 of around $4.8 billion, with an expected profit just over $1 billion. That's a 30%+ growth over 2011, but in that year the company grew revenue by 88%.

In 2007, Microsoft's purchase of 1.6% of Facebook for $240 million gave the company a valuation of around $15 billion (an investment which has now paid handsome dividends).

Although never a concrete bellwether, Facebook's P/E (price/earning) ratio was around 100 at IPO, a sign many observers pointed out as indicative of over-value. For comparison, Google's P/E is around 18, Apple's about 13, and hardware manufacturers including Dell and HP are currently sitting around eight. Unless Facebook can find a way to monetise its huge user base and kick its revenue generation into high gear, justifying its market valuation is going to be a tall order.

The purpose of an IPO is not to enrich day traders, but to raise as much capital as possible. Stocks which “pop” - show strong upward movement after launch - usually indicate undervaluation, and mean the companies in question could have done better. Stocks which sell out but then stay level or drop, as Facebook's did, suggest the company maximised its IPO value.

Facebook, priced at $38, raised $16 billion in its IPO. Investors who got in at the ground floor will suffer, but that's the nature of investing. Most analysts seem to think somewhere around $30 is more reasonable for FB, though some estimates are considerably lower. Only the market will tell. The share price won't actually matter much to Facebook, until it plans another share offering.

The underwriters, especially Morgan Stanley, did pretty well out of the IPO, but are now embroiled in lawsuits and complaints, which may cost both money and reputation, and could have lingering effects. But Facebook, which banked somewhere over $16 billion, according to reports, should be laughing.

Should be laughing, but may have to wait to really enjoy the fruits of its IPO. The reports show, among other irregularities, that revised estimates for the share price were withheld from the public pre-launch, which has resulted in an investigation into the underwriters by Wall Street's Financial Industry Regulatory Authority, and a separate investigation by the Massachusetts Secretary of State into Morgan Stanley's role, in particular. A class action lawsuit claiming damages up to $2.5 billion has been launched by investors angry at the stock's performance. And the Nasdaq itself experienced embarrassing glitches in its trading systems, resulting in delayed trades and mishandled information, adding to the whole mess.

The dust will settle, and when it does, Facebook will emerge with a very healthy bank balance. Future share offerings may suffer from the IPO's aftertaste, but that will be a problem for another day. Overall, the company's executives will likely be delighted with its IPO. None more so than Mark Zuckerberg, who saw his personal worth swell by $19 billion.

The next question is what to do with that $16 billion windfall? Whatever happens to the stock price is almost irrelevant now: the company itself now has a considerable war-chest with which to operate.

And Zuckerberg is not afraid to spend. Pre-IPO he snapped up Instagram, the photo-sharing app, for a cool billion dollars. That acquisition raised many eyebrows and drew some criticism, but is now widely regarded as a pretty savvy move, ring-fencing not just a group of users, but a whole category of user activity. This activity drives a great deal of fundamental social network engagement, and thus entrenches Facebook's position and raises a barricade against start-up challengers. Pinterest, another photo-sharing service, was valued at $1.5 billion in a round of venture funding, which raised $100 million.

One thing is certain: Facebook needs to diversify its revenue stream: its growth in its traditional business is unlikely to be sustainable.

Facebook, at IPO, claimed 900 million active users. Most of the company's value is locked up in the demographic data of those users, which enables it to serve tailored advertising, offer platforms for social media marketing, and mine the data for value. Advertising, the bulk of Facebook's revenue, is only one of many ways it could expand its operations, and indeed it may have to: many feel the advertising segment is heading for a fall.

That 900 million-user figure is questioned in some quarters (what counts as “active”, anyway?), but what is unquestioned are the facts that the company has tremendous reach in online communities, and that the user growth is slowing. Facebook's own growth figures show monthly user growth slowing to 1.75% for the period just pre-IPO, compared to a rate consistently around 3.5% for several successive periods before that.

Like its users, the company's core revenue is also growing, but decelerating. About 85% of the company's revenue is generated from advertising, and about 15% from other sources likes the Facebook payment gateway, which processes transactions for apps (which are required to use Facebook's system for purchases, ceding 30% to Facebook). But banner advertising on the social network yields much lower click-through rates than other sites, and the revenue is, while still growing, decelerating quite quickly. Some high-profile clients (notably General Motors) have abandoned Facebook entirely, and Facebook has admitted that its subscriber numbers are growing faster than its growth in ad revenue, made worse by the increase in mobile usage where ad revenue is much worse than online. So, the ad revenue outlook for Facebook is one of growth but deceleration, which puts that high P/E in even less flattering light.

More optimistically, the payment gateway revenue is growing more strongly, and has good prospects as Facebook establishes itself as a platform rather than just a social hangout. In 2011, the company generated $557 million from these payments (out of $3.7 billion total revenue), up from $106 million in 2010 and $13 million in 2009.

Right now, that revenue is dominated by traffic from Zynga, the company which produces such games as Farmville. About 12% of Facebook's revenue (advertising and otherwise) is generated from Zynga's activity on the Facebook network. Facebook has an exclusivity deal with Zynga in place until 2015.

But Zynga's fortunes could be on the wane - the company's stock price has been declining ($6.61 as this is written, from a high of over $15), and moves such as the $210 million acquisition of OMGPOP (makers of Draw Something) have been met with stiff criticism. Draw Something, an online Pictionary clone, experienced a classic bubble - huge growth followed by dramatic decline once the novelty had worn off. Zynga made the blunder of buying the app's creators while it was at its peak, only to watch its popularity plummet almost immediately. Bad news for Zynga is bad news for Facebook.

If online advertising does decline, it will hurt Facebook, but of course, also its competitors. The company, with its IPO, now has breathing space and capital to explore and develop new streams of revenue, as are all the other players, notably Google, which is so completely dependent on advertising for its (currently booming) revenue.

Facebook is, like Google, positioning itself as a central agent for identity - a growing number of sites eschew standalone sign-up options in favour of “log in with Facebook” (or Twitter, or Google, or OpenID...). Social networks are angling to be the entry points into walled gardens, and the mobile marketplace is a strong example of that in action. Those walled gardens may be in for radical evolution if HTML5 changes the game, but for now, they are growing money like weeds.

In many respects, the battleground of the future is rapidly shaping up to be Facebook vs Google, and although the companies are very different in size and scope, they both want the same things: your online identity, your demographic data, and your advertising budget. Apple, Amazon and Microsoft will also be fighting to stay in the game, and all have different footholds from which to move forward.