Wall Street and its investment banks are beating their drums on the next big thing. The Twitter (NYSE:TWTR) IPO is here and it's consuming a lopsided amount of the financial media airwaves. The investment banks are looking for a rebound stock after the highly anticipated botched Facebook (NASDAQ:FB) IPO. After being approached so many times about my opinion of the Twitter IPO, I decided to write a short article to rationalize my thoughts.
Some of the people that have approached me are regular people with limited knowledge of the investment world. They have been caught up in the Twitter hype believing they will get rich. When they ask for my opinion, I tell them that I like Twitter as a company and that I have an account but it's not investment worthy. Then they get defensive. They tell me that since the financial media spends most of its time talking about Twitter, it's obviously a guaranteed winner. I will address the financial media issue in more detail below. It's important to specify that a good company does not necessarily guarantee that it will be an excellent investment. A great investment is when you buy an asset below its intrinsic value and sell it above it. That's how you make money in investing. The rest is speculation, which is a game that I don't play because I hate losing money. The point of the article is to educate readers and to approach Twitter with caution.
There are a few red flags surrounding the Twitter IPO that should be addressed such as the IPO, the hype surrounding the stock, the lack of profits, the slowing growth and its valuation.
Initial Public Offering
First, it's an IPO. Most of the time an IPO is there to benefit the insiders, the venture capitalists and the investment banks. It's structured to benefit them and certainly not the mom and pop investor. It's in their interest to get the highest price possible. They price the stock, they don't value it. The higher the price the underwriter receives, the higher the payout. Who contributes to the high prices? The mom and pop investors that get caught up in the frenzy looking for an easy way to get rich.
Twitter recently announced an increase in its proposed share price range to between $23 and $25 a share, up from between $17 and $20 a share because of a wave of strong demand. I wonder how many potential investors actually sat down and took the time to read the filings. If you haven't, here are the links: SEC EDGAR Twitter Filings
However, IPOs are the trend of the hour. Here's a table provided by Renaissance Capital that pro-Twitters would appreciate. Again, the table does not guarantee that Twitter will explode out of the gate.
It's the Popular Stock
Twitter is a momentum stock. It's a bandwagon stock. It's a hot stock. Label it what you want, Twitter is at risk of swinging in any direction when it's out of the gate. The stock might fly based on one good tweet and after one piece of bad news it will crash. It does not take much to scare the bandwagon crowd away. Just ask Tesla (Tesla stock burned by car fire video, downgrade).
I wouldn't also buy into a stock where journalists are writing business plans for you. The financial media are all over Twitter. It's important for the reader to understand that CNBC is not there to serve the listener's interest. CNBC is in the business of ratings and getting advertisement dollars. Who are CNBC's advertisers? OptionMonster, eSignal, TD Ameritrade, and E-Trade among others. What are the advertiser's interests? High frequency trading. E-Trade would be out of business if everyone bought Berkshire Hathaway and decided to hold it forever.
The theme here is similar to an article I wrote on Facebook last month (Facebook - It's The Valuation Stupid (Lessons For Twitter)). I will not repeat what the article says but overall a stock has a price and a value and often there is a disconnect between the two. Very often they are not in sync with each other. Twitter is a nice successful story, but its valuation is out of whack. For a more in-depth discussion on the topic, I welcome you to read my article.
Why are people lining up to invest in Twitter? Because of its future potential. The buyers don't care about the current losses. When you invest in a hot stock like Twitter, Tesla (NASDAQ:TSLA), Facebook, or Netflix (NLFX), you are betting on its long-term high growth potential. The Twitter bulls will say not to worry about the current valuation metrics because Twitter will grow into it. They believe that the growth will be explosive for the next couple of years and that justifies the current price. This is a dangerous way of thinking and is one of the main ingredients in the formation of a bubble. Growth is never linear, just like trees will never grow to the skies.
In the tech world, we know it's impossible to predict what the earnings will be in five years. Analysts have a terrible time getting the next quarter numbers right, so how can they be so sure about the accuracy of their projections? This is the tech world, not Coca-Cola (NYSE:KO). Do you remember the projections for BlackBerry (NASDAQ:BBRY)? This is a headline as early of 2012: RIM Stock Price: Goldman Sachs Upgrade Sends Shares Soaring
Here is a table of other high flying stocks with a bubble minded herd following.
These are very optimistic valuations in high-growth rate companies. By investing in any of these companies, you are paying a very high price for them. At that price you should only expect perfection from them.
Twitter is floating around a ~$17 billion market for its IPO. There's no metric that can justify such a high valuation. I would advise prudence and a focus on more reasonable companies. Critics will be quick to point out that "this time it's different" and that "You don't get it", two of the most popular phrases that were thrown around during the tech bubble.
Twitter is unprofitable and continues to dig a hole. The company reported a $64.6 million loss in the third quarter, nearly three times its loss the previous third quarter ($21.6m), as costs continue to outpace revenues. Twitter has accumulated a $483.2 million deficit and nobody seems to care. The counter argument is this: It's a startup. It's a tech stock.
It certainly does look like a traditional IPO since it's a company without profit still in its growth stage. However, Twitter is not a startup. Twitter has been around for 7 years. After seven years you don't qualify for the startup label. After seven years a certain level of profit would have been expected. According to analysts' predictions compiled by Bloomberg, Twitter isn't anticipated to make money until 2015. Again this is to take with a grain of salt since a lot of these analysts work for the firms leading the underwriting.
Two criteria I look for while investing is growth and profits. Twitter's growth is slowing down and as mentioned above profits aren't expected until 2015 if we rely on analysts' estimates.
Source: Twitter S1
The graph above is certainly not a trend I like to see. It's a definite red flag, especially for someone with a long-term horizon.
In the tech world, there's always new competition and social media is not immune to it. It's impossible to predict where the top five social media companies will be in five years. Facebook is experiencing a slowdown with the teenage crowd. Google+ (NASDAQ:GOOG) is slowly gaining ground and Pinterest is rapidly gaining momentum. The top social media in 2006 was MySpace. Do I need to mention Bebo and Friendster? In hindsight it looks ridiculous but back then they were the exiting websites. Today it's Facebook. If history is correct, the top five list is expected to change in the next five years. Somebody right now is working on the next big thing.
Twitter also disclosed it received a letter from IBM (NYSE:IBM) alleging Twitter infringed on three patents. According to the letter Twitter has infringed on at least three patents held by IBM, including a "method for presenting advertising in an interactive service." Twitter was also hit with a $124 million lawsuit by two companies claiming the social media darling fraudulently had them organize a private sale of its shares. Twitter also doesn't generate much revenue per users.
I hope I was able to provide a different point of view and to better inform the readers. As mentioned above, I would approach the Twitter IPO with caution. It's easy to get caught up in the mania and the herd mentality can easily blind us. Read the filings and do your homework. From a professional standpoint, I can't recommend a potential investor to get on the Twitter bandwagon IPO because of the red flags mentioned above. Twitter is not a cheap stock. However, IPOs are hot right now and Twitter is going public when there's euphoria for social media stocks. I'm sure many traders will look for that "pop" once it's out of the gate, but this is pure speculation. I suggest it is important for investors to have an idea of where Twitter should be valued over an investment horizon before buying on the first day of trading. Long-term investment success is based on investment discipline and buying undervalued companies, not sexy stocks. Good luck.