- Twitter's trading history and its relevance.
- Key issues with Twitter's stock holders and structure.
- Valuation issues at current levels.
Any Wall Street technician will tell you the best way to know where a stock is headed is to know where it's been. Unfortunately, this misses the point of why the stock traded where it did. Since investors, commentators and analysts are enamored with Twitter (NYSE:TWTR) trading in the low $30's, which is down 60% from the high of $74, it seems worth exploring why it had such an epic run, why the run should be completely ignored, and why the stock probably trades lower, well into the $20's.
When Twitter came public the IPO was designed to succeed as not to replicate the Facebook IPO fiasco. How was this accomplished? First, the number of free trading shares in the float was limited. The 85 million shares sold in the IPO were only 12% of the total diluted shares. Second, Twitter received all proceeds from the IPO because no insiders were permitted to sell -- this left Twitter well-funded. Third, the IPO was priced well below the supply demand balance in order to minimize selling pressure. In the Facebook IPO, although the deal demand was many times oversubscribed, once the stock traded at or below the $38 IPO price tremendous selling pressure was created. But, in general, many institutional owners will comfortably hold the shares if the IPO trades well.
With a small float, Twitter's stock traded well, helped by analyst price targets and momentum investors. Although Twitter's first earnings report had yet to be released, several analysts issued aggressive price targets with ambitious financial and user metrics. In general, in the absence of an earnings report, investors are more inclined to rely on analysts & commentators. An MKM Partners analyst stated on CNBC that Twitter will be worth $150 per share; Jordan Rohan from Stifel issued a $75 target, although his mostly unrealistic 2017 assumptions got little focus. Stifel's target had topped the $70 price targets of Evercore Partners and Telsey Advisory Group, supposedly independent research firms.
Why wasn't it obvious Twitter was overvalued, and why weren't skeptics more vocal? In a bull run skeptical voices get drowned out by market forces, and seem out of touch to those who think, 'the stock doesn't lie.' Even James Cramer from CNBC, who was skeptical when Twitter came public in the $40's, called Jordan Rohan's Twitter research and price target the work of "rigorous analysis," and could be trusted. However, there was a steadfast cadre of cautious analysts and journalists.
In addition, Twitter's primary share count, which at the time was about 555 million, got most media attention, rather than the 705 million fully diluted shares. Basically, 150 million shares, valued at over $10 billion, were ignored by most in the media and even some analysts. In December, I spoke with WSJ reporters regarding their reporting on Twitter's $40 billion market capitalization, which ignored the fully diluted value of over $50 billion. The feedback from the WSJ was that their policy was to report using only the basic share count not fully diluted shares, even if it omitted the over 25% option and restricted stock unit (RSU) dilution, with over $10 billion in market value. The problem with the WSJ policy is: Earnings per share are reported on fully diluted shares, so a rudimentary analysis of underlying future profitability to market capitalization must consider the fully diluted share count when calculating market cap to determine the P/E ratio. (The difference for calculating a 25 P/E stock with a $40 billion market cap to one with a $50 billion market cap is $400 million in profits.)
After Twitter's first earnings report the most bullish analysts took a more negative view. However, with the limited float, downside momentum was limited. Only after Twitter's sobering second earnings release and epic lock-up expiration, which increased the stock eligible for sale from 95 million to 575 million shares, has reality taken hold.
Yet even as Twitter stock is down, many analysts and investors see opportunity in the shrunken share price. Most seem to key off the 60% fall in the shares, and believe, at minimum, there is a trading opportunity for Twitter to recover lost ground due to selling from the share unlock. I cannot argue that Twitter can bounce, especially on shifting sentiment, however, in all likelihood the shares will only find footing at lower levels, probably in the mid to low 20's.
Twitter will continue to significantly dilute its shareholders by the issuance of stock for takeovers and employee compensation. For this fiscal year's incentive plan Twitter has reserved 68.3 million shares to issue to employees. The lower the stock price, the more likely the vast majority of those shares will be issued. In total, that issuance would be over 9% dilutive. For 2013, Twitter issued about 58.7 million RSUs.
In its history Twitter has done about 30 acquisitions. Most of the acquisitions were done before Twitter came public, and most consisted of stock and RSUs. All the shares were issued pre IPO when the stock traded below $20. Since the RSUs vest over time, there is a strong likelihood that currently eligible stock gets sold to lock in the acquisition value. Keep in mind, insiders were disallowed from selling at the $26 IPO, therefore it's a disingenuous argument that early investors won't continue to sell with the stock trading at a premium to its IPO price and over a 50% premium to the value Twitter issued in stock for its acquisitions.
The point of selling currently eligible shares stems from the fact that many of the same owners of shares will still own stock options and RSUs, which vest over time. Currently, Twitter insiders and employees have over 42 million stock options with an exercise price average of $1.89. Also, over 95 million RSUs have been issued, all valued under $20 per share when issued.
Why won't the current selling just get cleaned up helping the stock move higher? In short, I'm doubtful there will be significant institution demand with the high valuation. On a fully diluted basis Twitter's 720 million shares value the company at about $24 billion. Forward revenue estimates of $1.3 billion leave the stock trading at over 18x revenue; hard enough to justify at its current stock price, let alone anticipating an even higher market premium.
Another way to anticipate future value would be to assume Twitter will achieve a similar non-GAAP bottom line profit margin as Facebook, which is about 30% of revenue. In order for Twitter to have a palatable p/e of 30, assuming 30% of its revenue falls to the bottom line, revenue would need to be in the neighborhood of $2.6 billion. Projected revenue of $1.3 billion for fiscal year 2014, which ends in April 2015, would have to double to achieve that potential profit. If all goes well, perhaps during fiscal year 2017, revenue can achieve that amount. In summary, buying at its current price might imply owning the stock with a 30 P/E after three full years of growth, not including additional dilution from stock based compensation, and using non-GAAP earnings, which excludes the expense of stock awards.
Fortunately Twitter does carry a $429 million federal and $268 million state net operating loss tax carry forward, which at least should give the company a reasonable chance of reporting decent profits in future years.
Admittedly, this article should have been written earlier, and will be considered late with the stock down 60% from its highs. In this article, however, I've attempted to demonstrate that the stock only traded at those lofty levels due to Wall Street machinations including: a limited float, aggressive analyst recommendations within an information vacuum prior to its first earnings report, and a favorable stock market backdrop for technology companies.
With its much larger float since the lock-up expiration, continued shareholder dilution and high valuation, investors are still paying too much for Twitter for anything but a trade. Truly investable levels would only be 20-30% below the current market price of $33.
I recognize Twitter's social importance and potential, but I also recognize its limitations as a service. I believe investors will take a wait and see approach until Twitter can demonstrate sustainably strong increases in its user base from an improved user experience. This leaves an over-valued stock vulnerable to continued market pressure and early investors' further profit taking.