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Online social networking mogul Facebook (FB) is scheduled to start trading on the  Nasdaq Stock Market today at around 11.00 a.m. Yesterday, its much-hyped initial public offering (IPO) yielded approximately $16 billion from 33 investment banks, led by Morgan Stanley (MS). Given Facebook’s size, the investment banks underwriting the issue are expected to charge as much as 3% of the proceeds as their commission.

At the time of IPO filing, Facebook’s price band was $28 to $35 per share. However, earlier this week (May 15, 2012), Facebook raised the price range to $34 to $38 per share and the very next day (May 16, 2012) the company increased the size of the offering by 25% to 421 million, representing a 15% float. Facebook eventually priced its IPO at $38.00 per share, implying that retail investors will be able to buy the stock at this price.

Facebook’s agreement with the underwriters also has a “Greenshoe” option, which means that the underwriters can sell up to 15% extra shares above the 421 million offered. If this option is exercised, the number of shares is expected to increase by at least 3% which will fetch another $2.4 million, thus making this the second largest IPO in the U.S. after Visa Inc (V).

Facebook- A Brief History

Currently valued at $104 billion, Facebook is considered the pioneer of online social networking. Formed within the walls of a Harvard dormitory in 2004, by Mark Zuckerberg and his college friends Dustin Moskovitz, Chris Hughes and Eduardo Saverin, the company has come a long way and now boasts of more than 900 million users.

The startup received investments from venture capitalists and institutional investors such as PayPal co-founder Peter Thiel, who is currently a member of the Board of Directors. Mr. Thiel is expected to gain $640 million for his 17 million shares. Some other eminent initial investors include Reid Hoffman, co-founder of LinkedIn Corp. (LNKD) and Mark Pincus, founder of the social gaming giant Zynga Inc. (ZNGA). Both of them are expected to garner $34.0 million and $36.3 million from the IPO.

Among the institutional investors, venture capitalist Accel Partners is selling the largest stake and is expected to gain approximately $1.77 billion. One of the biggest investors, DST Global Ltd and its affiliates (run by Russian millionaire Yuri Milner) is expected to gain $1.74 billion by selling a total of 45.7 million shares. Another prominent investor was Goldman Sachs (GS), whose 28.7 million shares are expected to fetch more than $1 billion.

However, the biggest gainer will be Mark Zuckerberg. The 28-year old founder is expected to sell 30.2 million shares for approximately $1.15 billion, retaining 503.6 million shares or 32% of Facebook’s total shares (total stake valued at $19.1 billion @ $38 per share). Most importantly, Mr. Zuckerberg will continue to hold 56.0% of the voting rights, which means that he will continue to be the final decision making authority.

Facebook- Financials, Fundamentals and Valuation

Given its current valuation, Facebook is larger than a host of U.S. tech behemoths including Hewlett-Packard (HPQ), Dell Inc. (DELL) and Amazon Inc. (AMZN). Its IPO is the third largest globally, behind two Chinese banks, Agricultural Bank of China in 2010 ($133 billion) and Industrial and Commercial Bank of China in 2006 ($132 billion), according to financial data provider Dealogic.

According to Reuters, Facebook’s $38 share price reflects 100 times historical earnings compared to Apple’s (AAPL) 14 times and Google’s (GOOG) 19 times, which many analysts consider lofty. This was primarily due to the not-so-impressive March quarter results.

In its May 9 amendment to the S1 filing, Facebook reported revenues of $1.06 billion, up 45.0% year over year in the three months ended March 31, 2012. However, operating income declined slightly to $381.0 million from $388.0 million reported in the year-ago quarter, primarily due to a significant increase in operating expenses (97% year-over-year). Facebook reported earnings of 9 cents, which declined slightly from 11 cents reported in the year-ago quarter.

The only concern clouding Facebook’s outlook is regarding its revenue from mobile products, which the company stated that is not significant. Although Facebook reported 488 million monthly average users (MAU) for its mobile products as of March 31, the company expressed doubts regarding the success of its monetization efforts in the mobile segment.

This is primarily due to the fact that historically Facebook has been totally focused on the desktop segment. Hence its applications were cumbersome for mobile users and small windows of mobile phones. Also, Facebook has never really had any ad coverage on mobile platforms. In March this year, Facebook included sponsored stories in users’ mobile for the first time in its history.

However, mobile is a different ballgame altogether. Unlike personal computers, mobile users navigate much faster over their devices and applications as they are mainly done on the move. Hence, mobile applications need to be smart, simple and fast. Ads along with these applications need to be much catchier and less time consuming than the ads aimed at desktops.

In its quarterly report, Facebook noted that higher usage of mobile devices boosted its daily active users (DAUs) much more rapidly than the number of ads delivered in the March quarter. Facebook reported 526 million daily active users (DAUs) on average in March 2012, an increase of 41% year over year. We believe that Facebook will take some time to generate significant ad revenue from mobile products.

The effectiveness of ads on Facebook is also under question since automobile maker General Motors (GM) announced its decision to drop paid ads. According to Reuters, General Motors said that Facebook ads were less effective compared to Google’s AdSense.

Although Facebook instantly received a pat on the back from rival Ford (F) on the effectiveness of its ads over traditional media, we believe that the company will need to take some damage control measures to prevent further slide in its advertising client base. Facebook reported advertising revenue of $872.0 million, up 37% year over year in the March quarter.

Our Take

Facebook’s IPO has generated a lot of expectations and hype. Over the last 18 months, the market has seen a number of social-media IPOs which include LinkedIn (LNKD), Groupon (GRPN), Pandora (P) and Zynga (ZNGA). But none of them were of such magnitude and popularity. We expect strong demand from retail investors to boost share prices in the opening session.

We believe that Facebook is well positioned to grow over the long term based on its large customer base and proven business model. The company enjoys a first mover advantage in the social networking market. Although advertising revenue has somewhat slowed down in recent months, we note that non-advertising revenues increased five fold in 2011.

This is the revenue Facebook earns from third party developers and through the sale of Facebook Credits (a form of virtual currency). As more and more third party developers flock to Facebook, we believe that non-advertising revenue will increase going forward.

However, increasing competition from established players such as Google as well as new entrants, uncertainty in the mobile segment and Mr. Zuckerberg’s continuing dominance can limit upside going forward. Currently, Facebook has a Zacks #3 Rank, which implies a Neutral rating over the short term (1-3 months).

 
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