On Wednesday, we turned to Sam Hamadeh, CEO of IPO research firm PrivCo, who was a Facebook bear before it was fashionable. Hamadeh seemed fairly prescient when he provided us with seven reasons to sit out the Facebook IPO two days before it went public. In fact, one of the top reasons Hamadeh gave for his bearish views on the company (he pegs the real value of Facebook at $25 per share) is that it doesn't have a good way to monetize mobile users. And that, in fact, was the very reason Facebook cited when it told its underwriters to reduce their estimates, according to sources in this Reuters report.
Hamadeh called the new analyst ratings released this week "fairly tepid," but said they were still too high. In our conversation, he also said that when it comes to analyst ratings, things haven't changed much on Wall Street since the dot-com scandals of the late 1990s and early 2000s, when a lack of separation between the research and business arms of the big firms incentivized analysts, ostensibly independent evaluators of securities, to vastly inflate their assessments of what stocks were worth. (Check out the difference between public and private analyst opinions at Merrill Lynch during that era here.)
These conflicts of interests were supposedly addressed in 2003 by the so-called Global Settlement, which mandated a separation between the banking and research departments at the big Wall Street firms.
In reading this, you should keep in mind that Hamadeh's independent research firm is a competitor of the big banks that he is criticizing here. This is an edited transcript:
JON BROOKS: So what do you think of the ratings?
PRIVCO'S SAM HAMADEH: It's important for readers to understand that although underwriter research analysts are supposed to be independent, it's expected that virtually all of them of course issue positive recommendations for the company. It's fairly unusual for analyst reports from the underwriter firms involved in the IPO to issue any negative ratings. It would get a lot of publicity but would certainly cost the person their job.
JON BROOKS: But there was an analyst from one of the underwriting firms who seemed to be quite negative, putting the value of Facebook shares at $25 per share, like you...
SAM HAMADEH: That was a brave move. I think that analyst is doing so at his peril.
JON BROOKS: You mean by virtue of this person issuing a low rating his job is in danger?
SAM HAMADEH: I worked at Goldman Sachs on the investment banking side in the 1990s, before the legal settlement making the research arms that issue ratings more separate from the banking side. But as a practical matter, these guys work in the same building, eat in the same cafeteria -- the analyst is chatting with investors during the road show… It certainly is a job-risking statement to come out with a price target below the IPO price or any sort of underperform rating like that.
JON BROOKS: So that was a big issue in the 1990s, with the underwriters putting pressure on their analysts to come up with pumped up ratings. Correct?
SAM HAMADEH Absolutely. In the 1990s, technically there was no legal separation between banking and research. You had a lot of emails surface during litigation following the market crash in 2000 and 2001 that showed the bankers telling the analysts we could land this IPO, so we're promising them if we get the IPO, our analysts will issue a buy recommendation for the stock, will talk it up during the road show to investors, and will set a very high price target.
The difference today is instead of those emails going back and forth, they do it verbally. That's the only difference. As someone who has been on Wall Street and is no longer on Wall Street but have many connections there, we know how the business works, and the pressure now is done verbally as opposed to email.
Today, instead of research analysts' pay being tied to a bonus structure taking into account things like the number of IPOs the firm brings in, they're rewarded with restricted stock based on the company's overall performance or the team's performance, as well as intangibles.
The problem is those intangibles include are you being a team player, are you beating up our IPOs as soon as the 40-day quiet period expires? Any analyst that does this repeatedly, from our experience, they shouldn't expect a job at that firm.
I've seen the sausage get made. We talk to a lot of investment bankers and people on deal teams off the record, because we have to verify information. As part of those conversations we get other insights as to how the deal is being quote marketed. Which is Wall Street parlance. They literally call it marketing a deal as opposed to explaining or analysis. That's what it is: advertising. Instead of selling soap, you're selling the stock.
So as part of the marketing process we have off the record chats about how the star Internet or tech analyst is going to talk to big institutional investors verbally and pump up the stocks' forecast.
So for example, what Facebook's going to do in 2015 – that's a judgment call. The analyst has leeway whether they want to predict Facebook is going to do $10 billion in revenue in five years or $30 billion in revenue in five years. With the bank that's the lead underwriter in the deal, you can fully expect the pressure is both explicit and implicit, that the expectation is the analyst is going to be on the high end of those projections.
When I was in investment banking in the 1990s, it was very clear we were all part of the same team, we attended pitch meetings together. The goals were to A get the deal, and B have the deal succeed and priced as high as possible; the research analyst's job was to support that effort.
For another opinion, I turned to New York Times financial editor and columnist Gretchen Morgenson, who herself broke a story in 2006 involving the very situation that Hamadeh describes. Here's the lead to that report:
ALMOST four years have passed since securities regulators and Wall Street firms signed the $1.4 billion research settlement intended to remove bias from brokerage firm analysts' work. Has enough time gone by for business as usual to return to the Street?
That seems to be what some on Wall Street hope, judging from the story of Matthew N. Murray, a veteran analyst and portfolio manager who was recently fired from his post at Rodman & Renshaw, a small brokerage firm in New York City. Mr. Murray, 38, lost his job in March after downgrading the stock of Halozyme Therapeutics, a small biotechnology company he had followed since September 2005. Full article
I read Ms. Morgenson Hamadeh's statements, and here's what she had to say:
I think you can see probably that the predisposition to be positive about companies, particularly those with investment banking clients, does continue to be an issue. I haven't done the arithmetic lately, but if you wrre to look out over the horizon and see how many sell ratings you saw out there, they would be few and far between. That alone is an indication that we're still in the accentuate-the-positive mode. As long as that goes on, investors should be wary of putting too much credence in these analysts' ratings.
I think the analyst that you quote – his points are well taken.
One thing, though: Financial regulators are now looking into Facebook's alleged selected guidance to analysts that they lower their forecasts, which they did. Doesn't that contradict Hamadeh's claim that analysts for underwriters always inflate their estimates? I asked him in a follow-up, and here's what he said:
Yes, Facebook's underwriters did the rare reduction in forecasts in the middle of its IPO roadshow, which is virtually unheard of. And that is now the subject of much securities litigation and SEC and FINRA regulatory scrutiny.
Aside from the fairly unprecedented case of Facebook, IPO underwriter analysts virtually always do two things:
1.) Set the forecast for the first quarter as a public company as low as possible, so that the company is all but guaranteed to beat them. No newly public company can be seen missing its first quarter. (In Facebook's case, the underwriter analysts already had fairly lowball estimates for the current, second quarter, but they were directed by Facebook's CFO to lower them even further given how weak the 2nd quarter numbers were coming in.
2.) Set the forecasts for future periods as high as possible. And Facebook's underwriter analysts kept financial forecasts for further out periods (2014-2016) as high as they were initially. This is par for the course to justify the IPO's valuation. Typically the firms quietly reduce them long after the IPO.
