Two weeks ago, we put out a piece suggesting that we thought Snapchat (NYSE: SNAP) was likely to follow the path of Fitbit and not the path of Facebook. You can read that piece here if you’re interested. Its certainly been a rollercoaster ride for the early shareholders of Snapchat. After an absolutely electric first two days for the company, the shares have been slowly declining over the past two weeks. As of Friday's close the shares are now down below their IPO price, and are currently at $19.54.
So how does this happen? Surely the company cannot have changed all that much in two weeks to make investors suddenly want to stay away from the company. The investment banks responsible for the IPO may lead to an answer to this question
Just ask Goldman Sachs and Morgan Stanley
It’s important to take a refreshing look at how IPOs actually work, to show that the company’s eye-popping gains on the first two days since going public didn't have anything to do with the fundamentals of the company. The two-week decline in the shares of the company are much more revealing.
Just as a quick lesson, IPOs for the most part work something like this; when a company wants to go public they talk to a bunch of investment banks. These banks help the company determine what they are worth, how much they should price their shares for, do the legal work and help find investors to buy the initial shares.
For the less finance savvy among us, it is important to remember that all parties involved are trying their best to make the IPO successful. This success, in most people’s minds is ensuring that on the first day of listing the stock price goes up for the company and hopefully in the future. Snapchat wants this to ensure they are making as much money as they expected. The bankers want this to make sure they can legitimize all of the fees they charge. And the original shareholders want to make sure they aren’t buying into a losing company.
Goldman Sachs and Morgan Stanley were the leading banks picked to take the company public. These companies are the biggest players in the industry and have plenty of experience with these sorts of deals - including the IPOs of Twitter and Facebook. Part of the work that these bankers do is to canvas the big players (hedge funds, pensions, etc.) to see what the interest is in the shares of Snapchat. They can weigh this against the amount of capital that the company wants to raise to determine the appropriate price. The sweet spot is where they can expect to sell all of the shares, find the right price, and minimize their own risk.
So what does this mean for Snapchat? It means that there was no way Goldman and MS were going to botch the initital offering. The shares had nowhere to go but up on the first day of the IPO. These banks ensure that there were enough demand from the "big boys" to increase the share price. The last thing they wanted was to be stuck with Snapchat shares that were worth less than what they thought.
The fundamental questions that we posed in the last article haven’t changed. Are they going to be able to profitably operate their app? Will they be able to profitably enter the wearable technology market when so many other companies have had difficulty? How does their core product compare to fully integrated social platforms like Facebook? Will the blatant copying of core feature by Instagram stall company growth?
Two plus weeks of market results seem to validate our concerns. Clearly other investors are equally concerned about the stiff competition the company faces. No new information has been released by the company and thus investors will have to wait for the next quarterly financial release to move past the speculation in the company.
Disclaimer: *I am not a financial advisor, please contact one before making any trading decisions of your own. This piece serves as my personal opinion and should not be taken on the basis of a recommendation of trading strategy. *