Will Twitter's IPO Fly Like Google Or Crash Like Facebook?

| About: Twitter, Inc. (TWTR)

Twitter's (NYSE:TWTR) trading debut is fast approaching. Much effort has been spent by others trying to determine whether the IPO price is a good deal or not. The reality, however, is that while the IPO price makes a good story, few traders are going to get a piece of the IPO. For them, it's how the company trades on its debut and beyond, that is going to be more important and drive their profits or losses.

What makes a high profile IPO?

Companies around the world go public all the time, but only a few capture the imagination of the street, the media and the general public. These are usually larger companies with millions of customers and fans that are very familiar and who are looking for a piece of the action.

There are usually only so many shares available for sale in an IPO and when demand outstrips supply, nobody gets as much as they want, leaving individual investors and traders ready and waiting to purchase shares when they debut in the open market.

This unfilled demand tends to drive the initial trading spikes on the debut that attracts the press. While these price spikes may be great for those lucky enough to get IPO stock, do they leave any room for anyone else to make money?

Avoiding the Facebook disaster

The Twitter IPO is mainly being compared with last year's Facebook (NASDAQ:FB) IPO as both companies are well known social media plays. Twitter appears to be trying to do what it can to avoid the problems that plagued Facebook through its first year of trading.

Although it wouldn't seem like it today, with the stock having nearly doubled in the last three months, Facebook got off to a rocky start with trading problems in the exchange on its debut, a lower close on the first day, and continued declines from there. This led to accusations that Facebook's IPO was over-hyped and over-priced. To try and avoid a repeat of Facebook's troubles, Twitter has decided to list on a different exchange (NYSE instead of NASDAQ) and to price at a lower valuation than Facebook did.

Post-debut trading trends for new technology stocks

Analysis of previous technology and social media IPOs with high public profiles over the last ten years shows that, while shares have tended to get off to a strong start (even Facebook briefly traded above its IPO price on the first day), initial gains are not usually sustainable for a number of reasons.

First, as with sports teams, there is a lot of attention paid to opening day from the media and fans that then drops off. Once leftover demand from the IPO is filled, it becomes another of thousands of stocks available for trading.

Second, there is a quiet period for research following IPOs. Analysts with firms that underwrite the IPO are prohibited by regulation to publish research on the IPO company for a specific number of days following an IPO. This tends to take the wind out of a new stock's sails for a while until the blackout ends and brokers/analysts are able to get out and drum up interest again.

Third, IPOs are about imagination and projections but trading is about results. Once in the marketplace, a new stock has to report earnings and sales just like existing stocks and needs to deliver on expectations. A heavily hyped and high priced IPO or a big spike in initial trading may create extremely high expectations, raising the risk of disappointment when cold, hard numbers start to come out.

Fourth, the problem is that IPOs are usually undertaken to raise money for new initiatives that can take a while to be implemented and become profitable. This can lead to disappointment with the first few earnings reports. With Facebook, it took over a year for its mobile advertising offering to really take off, at which point the shares doubled in value in under three months.

Fifth, throughout the first year of trading, the supply of shares steadily increases as shares that had been held when it was a private company come out of lockup, which can weigh on the market at different points in time.

Because of these factors, after an initial flurry of activity on their debut, high profile technology names have then tended to go through a lull period where they drop back in price.

It takes time for companies that are new to the markets to build a track record. Trading in the days following an IPO can be particularly volatile and can create opportunities to profit from moves in both directions. Eventually, trading tends to be driven by company performance and broad market conditions, just as it is for more established stocks.

Performance of previous high profile technology IPOs

Source: CMC Markets

The chart above shows that there have been significant differences in performance among technology IPOs in their first 100 weeks (two years) of trading.

Google (NASDAQ:GOOG) has been the gold standard, consistently trading above its IPO price through the first two years. Even with this superior performance, note that after an initial rally, the shares consolidated and went sideways for several months before resuming their uptrend.

LinkedIn (NYSE:LNKD) and Baidu (NASDAQ:BIDU) appear to be the middle-of-the-road cases, starting out steady, dropping back under their IPO price for a while and then steadily climbing after about eight months of trading.

Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA) represent the worst-case scenario: companies that fell in the months following their IPOs and never recovered.

Facebook's performance has been somewhere between LinkedIn's and Groupon's. Its debut was not impressive and it spent nearly all of its first year of trading under its IPO price. In the last three months, however, it has finally caught fire with traders and has started to trend higher.

How a stock performs on its opening day gives an indication of how well underwriters performed on pricing the deal. A big opening day means the deal was underpriced, a poor open suggests the deal was overpriced. Google traded essentially flat on its opening day in 2004 and steadily gained steam from there.

It's important for traders to realize that opening day or even opening week success does not necessarily mean anything about the future prospects of the stock. Regardless of how they started out, all of the other companies studied traded below their IPO price within 6 to 8 months.

A particularly strong opening may only raise the risk of a deeper correction later as we saw with Baidu and Zynga. On the other hand, a poor debut could scare off potential traders as we saw with Facebook and Groupon.

Twitter recently increased the offering price range to $23.00 to $25.00 from $17.00 to $20.00. This raises the bar for the first day, but also indicates strong demand for the stock. The higher the IPO and initial trading price, however, the more difficult it may be able to sustain gains after the initial flurry of interest fades and the greater the potential it could end up trading underwater at some point during the initial year.

Can Twitter shake off the curse of post-IPO tech trading?

Twitter seems to have learned from Facebook's missteps. It appears to be doing all the right things to sell its IPO while trying to avoid over-hyping the issue.

Twitter arrives on the scene at an opportune time. Internet and social media companies have been performing strongly in recent months. In addition to Facebook's double over the last three months, Google has broken through $1,000 per share and continued to climb. On Halloween, Chinese internet company 58.com (NYSE:WUBA) staged a strong debut, trading as high as $27.00, a 58% rise from its $17.00 IPO price.

In this environment, it's possible Twitter could have a strong opening day. Regardless of how it performs initially, history suggests that at some point it could have a period of consolidation and may even trade under its IPO price for a time.

The first few months of trading for Twitter coincide with what has historically been the strongest time of the year for stocks. The six to eight month time frame when previous IPOs have seen weakness, however, coincides with May and June, historically one of the weaker times of the year for stocks. Earnings reports, lockup dates and other developments may also create significant opportunities for trading throughout the next year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.