24/7 Wall St.

It seems as though almost everyone wants a piece of the Facebook IPO.  The social networking giant is set to come public this Friday in what will be one of the most highly watched initial public offerings of a lifetime.  The price range was lifted to $34 to $38 per share with a value of roughly $100 billion.  With potentially even more shares being sold by holders now, it is time to ask about what some of the risks are in this huge IPO. The deal was already oversubscribed with more than a week to go, and the order books are already said to be full.

Most investors and watchers are focused on how large Facebook is and how big its opportunities are in the future.  There may be a side of caution with a super-premium valuation at the IPO here.  24/7 Wall St. wants to at least run up some of the less obvious flags of caution which investors should at least consider on the risk side before throwing their life savings into the social networking leader.

Leadership is a huge risk here… Facebook is effectively going to be controlled by 28-year old Mark Zuckerberg.  He will hold or have the ability to control approximately 57% of the voting power of the outstanding capital stock following this offering.  The fact that Zuckerberg’s ‘hoodie’ stood out in the IPO roadshow more than anything else may bring some caution.  Zuckerberg also apparently gets to appoint a successor, making this somewhat like a kingdom rather than a public company.

NO real voting power for holders… Facebook has this dual-class of shares.  This gives what is effectively zero power to common shareholders. Shares of the Class A common stock are entitled to one vote per share while shares of Class B common stock are entitled to ten votes per share.  This is another example of a public company that might as well not even hold annual shareholder meetings.

Google hype versus Facebook hype… The last big frenzy of this sort that comes to mind is Google Inc. (NASDAQ: GOOG).  Facebook will already be worth half of what Google is worth today, yet Google is expected to generate almost $35.5 billion in sales in 2012.  If you just annualize the first quarter Facebook revenues with 10% growth sequentially in each quarter, the Facebook revenues would come to about $4.9 billion in 2012.

Sequential revenue growth has already faltered… We just noted the revenue path if Facebook grows revenues 10% sequentially each quarter, but the reality is that in the first quarter of 2012 the social media giant saw negative sequential revenue trends.  Facebook generated revenues of $1.06 billion versus $731 million a year earlier and net income attributable to shareholders was listed as $137 million versus $153 million.  Facebook saw its first sequential decline in revenues as the fourth quarter of 2011 had combined revenues of $1.131 billion.  Despite seasonality, the growth opportunity here is so large that the company should still be growing sequentially at this point.

Are Too many insiders selling?… Facebook is offering 180,000,000 Class A shares versus some 241,233,615 Class A shares being sold by existing shareholders.  It is often expected that the insiders and backers can get a chance to sell shares, but many investors are probably hoping that an offering of this size could be mostly for the benefit of the company rather than an offering that is instantly going to create thousands of new liquid millionaires rather than paper millionaires.

Buying up outfits regardless of price… Facebook has already shown that it will make acquisitions without an explanation of revenue ambitions.  Oddly enough, word was out that the company was not going to do that but it did.  The latest $1 billion deal for Instagram has been criticized and it looks like Mark Zuckerberg over-rode any objections from board members to this deal.  How many more deals are lurking out there where no revenues are on the table?

Skeptics are out in force… A recent poll shows that the Facebook is facing public distrust and also facing apathy from display advertisers who have been very disappointed in the ad results from Facebook compared to results at Google and elsewhere.  A CNBC-AP poll showed that 57% of users never click on Facebook ads and another 26% said they hardly ever click on ads on Facebook.

The pre-IPO analysts… Two Wall Street analysts have already issued “Buy” ratings (or equivalent) with one target at $44 and one at $46 per share.  What happens if the stock opens too close to those ratings or opens above those target prices?  It will be weeks before the underwriters can issue their own ratings due to a quiet period of underwriting firms.  Morningstar put its fair value target initially at $32 per share, which already creates some caution here if you look for other independent views outside of Wall Street.  Whether or not this guy’s past is convoluted or not in analyzing internet companies is one thing, but Henry Blodgett of Business Insider recently called the Facebook IPO “Muppet Bait.”  IPOdesktop.com puts its price projection for Facebook at $18 a share six to nine months from now.

Big dilution or widening out of the free float ahead… This is another IPO where a small portion of the shares will be available in the free-float after the initial public offering.  In six months (or less if the company moves up its lock-up expiration) will come one giant shareholder lock-up expiration.  That will allow for even more insiders and shareholders to unload shares that will increase the float substantially.  A much larger float may drive down the share price after the IPO frenzy has cooled.

Brain drain risks, the exodus… Another problem exists after insiders and employees make their millions of dollars from this IPO.  These people may opt to leave to go form their own start-ups.  This is the risk of a brain-drain early on in the company.  The New York Times recently showed how Facebook insiders have already left to go out to new start-ups and ventures.  This is a risk for any IPO making many millionaires, but it is a risk nonetheless.

Corporate backlash risks… Companies may start to limit Facebook access at work by their employees.  Some companies already block Facebook as a ‘productivity killer.’  This trend has not taken on a full swing ahead yet, but at some point companies have to consider security.  That Koobface worm/virus infiltrated many computers at work and at home, and companies have to consider network security and the costs associated with allowing access to sites where viruses can infiltrate the system.

Virus/Worm risks… Maybe this sounds redundant, but if another version of Koobface surfaces through the Facebook network, it could harm the company’s reputation.  It could also create more distrust among Facebook users, particularly if they have to go pay $50 or $100 to get the virus removed.  This is perhaps one of the largest long-term risks and caveats for this company.

Reliance upon Zynga… Zynga Inc. (NASDAQ: ZNGA) is tied too closely to Facebook or Facebook is tied closely to Zynga for social gaming as a percentage of sales.  The filing showed that in 2011 and the first quarter of 2012, up to 19% and 15% of Facebook’s revenue, respectively, was derived from payments processing fees from Zynga, direct advertising from Zynga, and revenue from third parties for ads shown on pages generated by Zynga apps. Zynga is already trying to diversify its reliance and Facebook’s filing under Risks noted, “If Zynga does not maintain its level of engagement with our users or if we are unable to successfully maintain our relationship with Zynga, our financial results could be harmed.”

The mobile dominance risks… Facebook recently showed that it was getting more focused on mobile Facebook users.  The problem is that mobile users are incredibly hard to make any revenues off of if you are not directly selling something to them.  The hype has been around for years about the hope of mobile advertising, yet mobile advertising generates very little in advertising dollars compared to desktop advertising.  If everyone is just accessing Facebook through their iPhone and Droid smartphones, Facebook could find revenues challenging.

Outside pressure from other companies (and owners)… Another risk to Facebook, despite the Zuckerberg control, is that many companies may be able to force this company into doing things it might not want to do.  Microsoft Corporation (NASDAQ: MSFT) was a fairly early investor and it may take a larger stake.  That creates the opportunity for Bing to be the ‘Facebook search of choice” at a time when Google’s U.S. shares of search is still more than double that of Bing.

What if Facebook is fully valued at the IPO?…  If Facebook shares get priced too high and something unexpected happens that causes the shares to drop right out of the gate, then Main Street investors would likely feel on last time that they have no chance to win by investing in stocks.  It would be a morale-killer of epic proportions due to the major hype that has gone into this IPO and great growth story.

Post-IPO loss possibilities from chasing shares… Perhaps the largest risk is not really in the IPO shares at all, but in the aftermarket.  Facebook is expected to open at a premium to the pricing, but if too many investors buy into the open market after the IPO and then see their share values tank over the hours or days after the IPO, then they may feel a bit duped.

One last thought of risks, the easy money may have been made already… There are already many owners of Facebook shares ahead of the IPO.  It is possible that even the IPO subscribers are getting in after the smart money already figured out how to get in here ahead of the IPO.  That is probably more of a risk for the post-IPO buyers but it is an ongoing risk.  We have said that there are still some ways to buy into Facebook ahead of the IPO, and those alternatives as ways to get exposure to Facebook now are here.

*****

So, you have heard risk after risk here.  We skipped over the competitive risks, the risks to user privacy, the currency risks, and many of the other obvious risks that exist in any IPO.  The reality is that as of now Facebook is going to be able to sell as many shares as it wants to, and the share price might not even matter at first.  Still, investors need understand the risks of any story even if it is the great growth story of Facebook.  A ‘caveat emptor’ review should be considered before making any investment.

We have been asked multiple times about whether or not investors should subscribe to the Facebook IPO and our answer has been, “Yes, as long as you have no lock-up restrictions that prevent you from being able to take a profit right after the IPO if you want.”

JON C. OGG