Softbank, a private equity fund or a strategic investor?
Softbank (OTCPK:SFTBY) as a potential acquirer is the latest rumor in Twitter's (NYSE:TWTR) never ending saga. The rumor gained some credence last week in the wake of a partnership announcement between the Japanese conglomerate and the Saudi Arabia Sovereign Wealth Fund to launch a tech fund.
While Softbank is admittedly one of world's most ambitious tech investors with a stomach to take large overseas bets, the acquisition of Twitter would be its most risky bet thus far. With a stretched balance sheet in the aftermath of its latest acquisition ($32B for ARM, a UK chipmaker), Softbank should at least look for a partner to offload some of the risk of the project. In contrast with its previous acquisitions, Softbank would also need to adopt a hands-on approach to turn Twitter around, and there is little evidence that the company possesses sufficient expertise for such a challenging endeavor. Last but not least, cultural issues may complicate Twitter's restructuring plan post-acquisition as "a jewel of Silicon Valley falls into the Japanese hands."
The expectation that cost-cutting initiatives will be a signficant part of any restructuring plan supports the case for a private equity type of deal. For one, private equity investors bring the kind of operational turnaround expertise corporate buyers typical buy. Moreover, private equity firms have the ability to implement unpopular changes since they operate away from the public spotlight that could complicate the implementation process.
Still, only few private equity players could pay the ticket and be comfortable with the risks associated with such an acquisition. Twitter is not the typical turnaround case that private equity has mastered over the years. The acquirer would have to manage business development risks that fall outside its traditional expertise. All things considered, the price of the deal will most probably be the ultimate deal breaker for a private equity investor. If valuation is an art, Wall Street and Silicon Valley are just different kind of artists.
A large tech company (i.e. Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL)) still remains Twitter's best potential suitor. Such an investor has a better understanding of Twitter's culture, the resources to rapidly implement changes and the patience to wait for the payoff. More importantly, even if things don't work out, the acquisition will hardly make a serious dent on the financials of an acquirer that large.
In other words, if Google that can squeeze synergies out of this acquisition by seamlessly integrating Twitter with its core search service, is not interested in buying Twitter, why should anybody else be interested?
Hostile takeover or a friendly deal?
The recent decline of Twitter's stock price may have strengthened the case for a hostile takeover highlighting the disagreement of Twitter's shareholders with the BOD's decisions. Three reasons though, render a hostile takeover a very remote possibility:
First, a hostile takeover is a very lengthy process - it could take more than one year to consummate the acquisition. In the meantime, Twitter's strategic position could be severely weakened in light of an extremely fluid competitive environment. To put things in perspective, Twitter is currently the sixth most important social media platform in terms of engagement (daily active users), down from second just a couple of years ago. In this context, any turnaround effort requires swift action. If Twitter continues loses market share at this rate, it may soon damage its already eroded competitiveness beyond repair.
Second, the acquirer risks losing a significant part of Twitter's human capital during the acquisition process as the most capable/critical employees jump ship in light of impending uncertaintly. This risk is today greater than ever before, given the frothy state of the job market in Silicon Valley that has caused a fierce competition for talent. Historically, hostile takeovers for market consolidation and value creation on assets unaffected by the takeover process (real estate, patents, licenses) have been much more successful.
Third, as the recent events have demonstrated, a hostile takeover would be a very expensive. Twitter's BOD could drum up enough interest from other parties and smartly manage market expectations to make the deal very expensive, if not impossible. Given that the stock, in the absence of any acquisition premium, would probably trade between $12-$13 (2.5x EV/revenues), an acquirer may have to pay a hefty premium (>70%) to get the deal done.
Luckily for Twitter's shareholders, even in the case of a friendly acquisition, Twitter could fetch a significant premium of up to 50% given that:
First, the company is mismanaged and there is a significant untapped potential both on the revenues and the cost side.
Second, a buyer could materialize Twitter's value as a platform for the development of other businesses/services.
Third, Twitter is a trophy asset because of its widespread impact on politics, culture and sports.
However, the risk remains that a friendly deal may be pursued only when it is too late and all the alternatives have been exhausted. With a net cash position in excess of $2B and a minimal cash burn as a result of a heavy stock issuance (stock-based compensation expense amounts to 30% of revenues), it could take significant time for the market to enforce discipline to a viable long-term path.
Three uncomfortable questions about an unusual sale process
Why did the interest of potential buyers leak to the media? The leaks decidedly influenced the final outcome by inviting Salesforce shareholders into the decision room. A case can be made that Salesforce would not have withdrawn from the process had the deal not leaked.
"The deal leaked and when it did leak our stockholders voted their displeasure."
Marc Benioff, Salesforce CEO, CNBC, Friday October 21st 2016
Why did the Board set an overly ambitious timeline to consummate the sale within just a few weeks? For a deal of this size, only the completion of due diligence and the negotiation of the SPA agreement would require at least 5 weeks. Twitter effectively demanded that potential buyers make binding offers with little preparation about their financing and no proper due diligence.
"The timeline is hugely ambitious in the context of most mergers and acquisitions, given that Twitter began mulling sale only last month." Reuters, October 5th 2016.
The argument that the BOD wanted to remove the uncertainty about the future of the company as soon as possible doesn't hold water. The process could have been kept in secret and the potential buyers should have been given sufficient time to assess the deal. That would be just standard M&A practice.
Why did Twitter BOD ask for a minimum price per share of $29 - a significant premium to LinkedIn's valuation- despite Twitter's remarkably worse growth and profitability profile? Setting a minimum price at such a high level made little sense. The fact that multiple parties expressed interest in the process should have been sufficient to ensure that Twitter shareholders would have gotten a fair deal.
An out of consensus view of what has happened
At the peak of the speculative fever and just a couple of days before the withdrawal of potential buyers from the process, the article "the deal is dying, long live the deal" brought up the idea that the sale process may have been purposefully designed to fail. A case was made that what was happening was a parody of a sale process that would have never been mulled, let alone initiated, were it not for the (unsolicited) interest of Salesforce (NYSE:CRM). It seems that someone close to Jack Dorsey somehow formulated this idea in a politically correct way:
"Now we all know that (Mr. Dorsey) tried selling the company and nobody can be accusing him of not exploring that option. This has been a distraction for him and the company. The failure of the sale process is a blessing in disguise."
Unnamed venture capital investor close to Jack Dorsey - Financial Times, October 14th 2016 (note: there is at least one venture capital investor sitting in the BOD of Twitter).
Is it possible that the sale process has been just a pretense to save face in light of an increasing number of disgruntled shareholders? A BOD that has developed such an intimate relationship with a CEO that it could accommodate his request to work part-time, should have never been expected to lightheartedly decide the sale of the company against CEO's outright disagreement. While it may be legally challenging to make the case that the BOD has breached its fiduciary duty, the collapse of the stock price right after the withdrawal of Google and Salesforce from the process is a tangible proof of shareholders' disagreement with BOD's choices.
The stock and the Q3 results
The recent press releases about new features and partnerships should be indicative of the tremendous pressure CEO Jack Dorsey faces to revive Twitter's growth. However, none of his recent initiatives are significant enough to move the needle in the short term and counterbalance the pricing pressure in advertising rates. From a behavioral point of view, three reasons point to mediocre quarterly results and uninspiring guidance:
First, Twitter's BOD would not have initiated a sale process if things were going exceptionally well. In another sign of potential underlying troubles, cost cutting measures were reportedly discussed on the BOD meeting of September 8th.
Second, the apparent rush to conclude a deal (or to effectively terminate the sale process) ahead of the announcement of the quarterly results, could potentially emanate from BOD's fear that shareholders would exert pressure for a lower deal price in the wake of a disappointing third quarter. This idea rests on the argument that BOD had no true intention to sell the company.
Third, with the sale process effectively dead, management should be more conservative on guidance to avoid a revenue miss that would lead to a resurgence of M&A chatter.
Still, the company could hit its EPS targets given the various opportunities to trim expenses. What would happen then to the stock? A top line miss/bottom line beat should be negative for the stock because:
1)Twitter has historically traded at an EV/revenues multiple as revenue growth has been perceived to be more indicative of company's prospects
2) Potential acquisition targets have been traditionally valued at an EV/revenues multiple too, on the assumption that a strategic buyer could adapt the cost base of the target to its standards in due time.
On a similar note, the need to initiate a major cost reduction plan in the medium term will negative influence the stock too, because the market tends to interpret any downsizing as a sign of a gloomier top line outlook and consequently, a reason for a lower valuation. An improved profitability outlook as a result of the new plan would provide little support to the stock, because the valuation floor underpinned by Twitter's earnings potential (on an EV/EBITDA and P/E basis) is significantly lower than the current price of the stock.
The silver lining is that the announcement of a restructuring plan, whenever this happens, could provide a good entry point for Twitter stock as market expectations are reset. In the aftermath of such an announcement, the stock could hit a medium-term bottom particularly if such a plan is accompanied by a management change (1). Whether Twitter's co-founder Jack Dorsey, who managed the company relatively well during its early growth phase, possesses the skills and the political capital to carry out the new plan is a matter of further discussion (2).
(1) The Groupon (NASDAQ:GRPN) case could serve a blueprint of how things could play out with Twitter. Back In August 2013, Groupon co-founder, Eric Lefkofsky took over the helm of the ailing company in a management shake-up that cost another Groupon co-founder, Andrew Mason, the CEO position (in a striking similarity with the struggle between Jack Dorsey and Evan Williams). With a successful track record on several new ventures (like Dorsey) and a flair for business development, Lefkofsky led Groupon through an ambitious global expansion. As long as Groupon continued to enter new markets/territories, revenues grew modestly, but at the expense of an ever deteriorating profitability. When the situation became finally unsustainable, Lefkofsky resigned and the company subsequently withdrew from several markets. In the aftermath of his resignation and the announcement of a major restructuring plan (November 2015), Groupon stock, that was trading at an EV/Revenues multiple, collapsed, but it has modestly recovered since then.
(2) A key takeaway from both Groupon and Twitter cases is that co-founders, with big egos and an insatiable appetite for top line growth may find difficult to navigate their companies through the maturity phase that calls for a CEO with a completely different expertise. However, as long as their companies are not dependent on capital markets to fund their expansion plans, these insiders may hold on to power.
Disclosure: I am/we are short TWTR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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