Shares of Twitter, Inc. (NYSE:TWTR) generate enormous controversy as a battle between those citing grossly-stretched fundamental valuations and those who consider the shares to represent a dominant communication and media force of the future. But somewhat confusingly, the discussion rarely focuses on perhaps the most important factor influencing Twitter's share price: Its enormous short interest. This likely results from a short-term anomaly that conceals Twitter's true effective short interest and ignores how it will change dramatically in the near future.
Based on widely-reported numbers, Twitter's short interest seems to be between 7.0% and 9.7%, as reported by E*Trade and Yahoo, respectively. But digging deeper reveals a staggeringly-high effective short interest that is greater than 40% of TWTR shares currently trading. Inserting Twitter's effective short interest into the chart in this article would make it the 6th most heavily-shorted stock on the list. Such an enormous short interest, coupled with a limited float, can result in classic conditions of a short squeeze, including sharp, erratic price swings and valuations completely detached from reality. In other words, it can result in exactly what TWTR shares have experienced.
But with Twitter, there's a catch. A massive infusion of new TWTR shares will hit the market by May 2014, and it will fundamentally alter the influence of the currently enormous short interest. Consider the following:
1. Latest figures (as of Jan 31) show 33.82 million TWTR shares short (up from 32.7 million two weeks earlier).
2. Based on these 33.82 million shares short, Yahoo states that the "Short % of Float" is 9.70% while E*Trade states it is only 7.03%. This 38% difference is based on different determinations by Yahoo, E*Trade and others about Twitter's outstanding shares. For example, Yahoo claims Twitter has 362.6 million outstanding shares. But Google Finance and E*Trade state Twitter has 544.7 million shares. Meanwhile, NYSE and another page on E*Trade claim that TWTR has 555.2 million shares. Twitter's own disclosure suggests there may soon be 596.4 million shares:
Upon completion of this offering, stockholders owning an aggregate of up to 386,952,743 shares will be entitled, under contracts providing for registration rights, to require us to register shares of our common stock owned by them for public sale in the United States. In addition, we intend to file a registration statement to register 209,449,274 shares reserved for future issuance under our equity compensation plans.
3. Confusion about Twitter's actual share count can result in enormously disparate valuation estimates. This should be meaningful to any investor who cares about anything other than momentum or charts. With the February 13 closing price of $56.47, Twitter has one of the following market caps (depending on what the share count is):
Twitter's Real Market Cap Depends on Its Share Count
|Source||Share Count||Market Cap|
|Yahoo||362.6 million||$20.48 billion|
|Google, E*Trade 1||544.7 million||$30.76 billion|
|NYSE, E*Trade 2||555.2 million||$31.35 billion|
|Twitter Prospectus||596.4 million||$33.68 billion|
4. While market capitalization is an important valuation metric, it is not particularly important in explaining day-to-day trading activity. Much more important for that is knowing the short interest. After all, an extremely high short interest leaves a stock susceptible to seemingly irrational and erratic price movements. And while the 38% difference between E*Trade's 7.0% and Yahoo's 9.7% reported short interest is troubling, in reality neither figure would likely result in that being a predominant influence on daily trading activities. Much more troubling is that the effective short interest is enormously understated by any meaningful measure.
5. Currently there are only about 80.5 million shares trading. That's the 70 million shares priced at the IPO plus the 10.5 million over-allotment described in the Twitter prospectus. Applying this to the 33.82 million short shares reveals a monstrous 42% effective short interest, i.e., it is about 42% of shares currently available for trading. And for purposes of understanding TWTR trading since the IPO, those 80.5 million shares are the only one that matter. With more than 40% of those shares shorted, the effective short interest likely influences price activity on a nearly day-to-day basis.
In a typical short squeeze situation, a common concern is that the limited availability of shares is held in relatively few hands, and those few hands can control the supply of shares available for extended periods of time, constantly squeezing shorts. That's where Twitter's situation is dramatically different.
The first mini lock-up restriction expired this Saturday, February 15, and a new 9.9 million shares can be traded. These shares are owned by "employees who are not executive officers" and this limited expiration is to allow sales so employees can pay taxes on their IPO proceeds. It is likely that many of these shares will be sold into the market within the next few days or weeks. Of course, adding 9.9 million shares only increases the effective float to about 90.4 million, leaving a still-enormous 37% effective short interest. Both the selling and the establishment of new short positions might cause a temporary price dip, but with an effective short interest at 37%, the few new February shares will likely get absorbed quickly into the market and TWTR will remain highly vulnerable to short squeezes.
The main lock up expiration event happens on May 6, 2014. Based on the Twitter prospectus,
A total of [474.7 million], or 87.1%, of the outstanding shares of our common stock after this offering will be restricted from immediate resale, but may be sold on a stock exchange in the near future.
Assuming that 90.4 million shares will be trading before the May expiration, the May 6 event will release more than five shares for every one currently trading. This will greatly diminish the prospects of any near term short squeeze.
Naturally, not all of those 474.7 million shares will be sold. But certainly many owners of those shares (management, employees, investment funds) will want to diversify. These owners probably know better than anyone that TWTR shares are grossly overvalued compared to anything in an otherwise overvalued industry. One well-done New Yorker article compared 20 Internet companies, including TWTR, Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), Yahoo (NASDAQ:YHOO), Groupon (NASDAQ:GRPN), Priceline (NASDAQ:PCLN), Expedia (NASDAQ:EXPE), Zynga (NASDAQ:ZNGA), etc. The article was written after TWTR's quarterly report. Reviewing multiple valuation metrics, the article stated that:
-Based on price to earnings ratio, Twitter is at the bottom of the list because it has never even made a profit.
-Based on price to book ratio, Twitter is the most expensive at 33x book (triple that of Facebook and LinkedIn).
-Based on PEG ratio, Twitter "had a PEG close to three hundred-a stupendously high figure. By Friday, Yahoo Finance wasn't supplying a PEG ratio for the company; evidently, its earnings future is too hard to figure out." (Currently, Yahoo lists the TWTR PEG at negative 950.)
-Based on enterprise value to cash flow, Twitter is the most overvalued. In fact, Twitter is one of only two companies with a negative EBITDA.
The article concludes:
[T]he most overvalued Internet company of all, according to old-fashioned valuation metrics, is Twitter. It loses a bundle of money, it generates negative cash flow (after deducting the costs of stock-based compensation), and it's still very highly valued relative to its assets and its growth rate. Even after its big fall this week, the stock is still trading at more than twice the price at which it went public last November: the I.P.O. figure was twenty-six dollars; on Friday, the stock closed at $54.35.
… [F]rom a traditional standpoint, the numbers say that Twitter takes the prize as the queen of overvalued Internet companies.
Since that article was written, TWTR shares are up more than 15%.
Twitter supporters claim that the lockup expiration will be a non-event. They argue that new shares hitting the market will not alter the market cap, P/E, P/S, or any other fundamental metric of TWTR. Of course, this is true. But the fallacy of this argument is the presumption that current valuations are reasonable; they are almost certainly not. Current valuations are stretched because TWTR has been in a quasi-classic short squeeze situation for months; rational investors recognize it is grossly overvalued but the supply of shares is limited. (I say quasi-classic because most short squeezes do not face the prospect of the float increasing five-fold within weeks.)
Twitter stock will eventually find a market price that fairly incorporates the value of its technology and prospects. But that is unlikely to happen until after the May lockup expiration. Until then, the most important number to keep in mind for Twitter is the enormous effective short interest, which is currently among the highest stocks in the entire stock market. With such a high effective short interest and relatively small effective float, TWTR will remain subject to huge price swings and susceptible to short squeezes that are relatively easy to control. And with any short squeeze, truly irrational prices can be obtained, completely regardless of any fundamental valuation.
Thus, anyone currently having or considering a position in TWTR, whether long or short, should recognize they are assuming enormous risk, and they should recognize that publicly-reported figures for short interest, outstanding shares, and market cap might be unreliable, at least until the May lockup expiration and better consensus about the accurate number of TWTR's outstanding shares. Those with short positions should have contingency plans for having the shares called back at any time (including the most inconvenient time) and for a short squeeze that takes the shares to $75 or $100. In fact, why not $150 or $200? Meanwhile, those long TWTR shares should recognize that at any moment TWTR shares could drop by $20 or $30 per share and still remain overvalued by common fundamental metrics. The best way to protect against such uncertainty is to be long options. Premiums may be high, but a long option position cannot be taken away and losses can be limited.
Disclosure: I am short TWTR. 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.
Additional disclosure: As stated in the article, my short position is with options only.