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The Stock That’s in Trouble Because of Facebook’s Flop

Earlier this week, I questioned whether or not Facebook’s (Nasdaq: FB) IPO signaled that social networking stocks were due to fall.

The answer is no.

Social networking stocks have their problems – and I don’t favor them as an investment – but Facebook’s falling stock has nothing to do with it.

However, there’s one stock that’s headed for trouble thanks to Facebook’s botched IPO.

I’m talking about Nasdaq OMX Group (Nasdaq: NDAQ).

Of course, Nasdaq OMX Group runs the Nasdaq Exchange, upon which Facebook’s shares trade.

But it turns out that Nasdaq doesn’t run it all that well.

Some problems were immediately apparent. The start of trading was delayed by 30 minutes while Nasdaq grappled with technical problems. Once shares did start trading, everything seemed to be okay – aside from Facebook’s falling share price.

And it soon became clear that things weren’t going well.

Nasdaq’s systems didn’t function properly and investors who entered buy and sell orders couldn’t tell if they had been executed or not. That’s a harrowing position for institutions trading millions of dollars and not knowing whether or not they’re holding a falling stock.

An anonymous hedge fund manager called Business Insider to relay his experience. Apparently, Nasdaq was taking orders but wasn’t actually executing the trades because the systems weren’t working.

Essentially, they were writing down buy and sell orders and thinking, “We’ll figure it out later.”

Nasdaq has admitted it screwed up and that it should have delayed the IPO further to sort out the problems. The SEC and FINRA have already announced investigations. And at least one investor has filed a class action suit, though that number is bound to rise.

When the next big IPO chooses what exchange to list on, you can be sure that this incident won’t be forgotten. Whether it’s enough to drive future offerings to the New York Stock Exchange run by NYSE Euronext (NYSE: NYX) remains to be seen. But if so, Nasdaq will lose out on listing fees (Facebook paid $250,000) and the earnings from all the future volume of trading.

The Facebook IPO alone doesn’t warrant such a harsh stance on Nasdaq’s future, but it has plenty of other problems.

Over the last year, 89 companies have chosen to come to market on the NYSE, compared to Nasdaq’s 71.

An even greater issue is that exchanges like the Nasdaq make money on volume – but volume on major exchanges is decreasing. There’s no two ways about it. Ever since the 2008 boom years, stocks simply haven’t traded on the NYSE and the Nasdaq as heavily.

The pattern of stock trading volume on US exchanges

One reason is that there’s just less trading than there used to be.

But another reason is that a large amount of volume is moving off of the major exchanges to small exchanges – like BATS and Direct Edge – and to unregulated “dark pools.” While overall volume declines, the marketshare of dark pools continues to grow, reaching 13% last month.

These smaller exchanges don’t face the same regulations that hamper major public bourses, allowing them to out-compete the major exchanges on several fronts, including secrecy, fractional penny pricing and charging different prices to different customers.

In other words, Nasdaq (and the NYSE) is being out-innovated in its own backyards.

As of now, the peak of Nasdaq’s revenue was 2008 but earnings have continued to grow through cost cutting. And earnings growth that’s achieved through efficiency gains can only continue for so long.

Nasdaq’s valuations are low enough – around eight-times earnings and yielding 2.4% – that it’s not a clear short candidate right now, but the price-to-earnings has been compressing for the last three years. Notable shareholders like Citadel Partners, Goldman Sachs (NYSE: GS) and SAC Capital all reduced their holdings last quarter.

Bottom line: When it comes to social networking stocks, you could make the argument that the potential for future growth justifies the lofty valuations. But Facebook’s IPO shows that Nasdaq doesn’t have such a bright future.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk