What A Twitter Buyout Means For Square

| About: Twitter, Inc. (TWTR)
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Buying Twitter solely on the premise of a buyout is too risky for most investors.

Buying Square in anticipation of a Twitter buyout exposes investors to far less risk but allows them to participate in much of the upside.

I believe that if Twitter gets a bid, Jack Dorsey will be replaced as CEO and will be able to focus on running Square.

Investors have spent the last several weeks watching Twitter (NYSE:TWTR) euphorically rise and precipitously fall in seemingly endless fashion. The blue bird's rumored buyout has created a lot of distraction and noise within the technology sector and notably volatile trading days for prospective suitors, namely Salesforce.com (NYSE:CRM) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). Though the former is still rumored to be in talks with Twitter, it appears as though many of the offers on the table have dried up - for now.

In my opinion, Twitter, the product, is quite unique and has immense value. Twitter, the company, cannot seem to please investors. Many Twitter bag holders are pleading for the company to divest Vine, the six-second video sharing platform, and sell mobile-development platform Fabric to Microsoft (NASDAQ:MSFT). Whether these initiatives will come to fruition and, more importantly, whether they will increase shareholder value, I know not. However, it is possible that a Twitter suitor will look at the aforementioned assets and think similarly, which could be the reason why some are still rumored to be in talks with the company at large.

To be frank, I believe that Twitter will ultimately decide to sell itself to the right buyer. With that said, I cannot justify buying any stock solely on the basis of a possible takeover. As investors have witnessed with Twitter's recent price action, hyper inflation due to takeover rumors can lead to a catastrophic drop when the air is let out of the bag. In effect, prospective takeovers are rather binary and far too risky for most investors.

Interestingly, I think the best way to profit from Twitter's possible takeover is to initiate a position in Square (NYSE:SQ). Although true that such a position does not expose investors to as much potential upside, it would allow them to participate in some of the upside with far less risk. My reason behind this thesis is that investors may believe that while concurrently the CEO of two multibillion-dollar, publicly-traded corporations, Jack Dorsey is spread too thinly. Many believe that the 39-year-old chief executive has enough on his plate with Twitter, needless to say with Square, too. As such, investors may be devaluing shares of both Twitter and Square.

Given Twitter's floundering stock price and the wide frustration that has emerged under Dorsey's reign, it is possible that Twitter's acquirer would look to appoint new blood to the role of chief executive. This would allow Dorsey to focus all of his efforts on Square and warrant a higher valuation for the stock.

In its current state, my investment thesis for Square contradicts my previous statement that I cannot justify buying a stock solely on the basis of a takeover. However, Square has bullish characteristics on its own, and a possible buyout of Twitter would only add to the bullish thesis.

I believe that much of Square's volatility since its IPO roughly one year ago is due to the market environment in which it came public. In other words, I think that the stock's volatile performance is due to external forces rather than company-specific worries.

In November of 2015, the broader market was near its top and fell rapidly in the coming months. As a newly issued stock, Square posed a great risk to investors and, as such, was among the first assets to be sold when the market turned sour.

In recent months, however, investors have been able to stomach more risk. Recent IPOs Twilio (NYSE:TWLO) and Acacia Communications (NASDAQ:ACIA) were applauded by investors and are now well above their public offering price, a sign of a risk-on environment. Another sign of a market that has an appetite for risk is that the Nasdaq and Russell 2000 have been outperforming the S&P and Dow Jones. In the last few months, while the latter two indices have been making lower highs, the former two have been making higher highs. In my opinion, this divergence signals that investors have been rotating out of big-cap names and into small-caps and technology, which have a reputation of risk and volatility.

With the backdrop of investors' increasing appetite for risk and IPOs, if Twitter catches a bid, I believe that investors will circle back to the previously over-looked Square and appreciate the company's fundamentals.

Although not recent news, I believe that Square's integration into Apple's (NASDAQ:AAPL) iMessage will prove to be very sticky. iPhone users can now send money to their friends and family with Square Cash all without ever opening their phone (with Siri). It is also worth noting that the recent problems with the Samsung Galaxy Note have been rumored to increase iPhone sales to the tune of 15 million. If true, this would lead to an unexpectedly large new-user base for Square, which could cause an upside surprise in total revenue.

With that said, Square has many competitors, namely PayPal (NASDAQ:PYPL) and PayPal-owned Venmo. However, I think that the convenience of Square Cash within iMessage differentiates the company's product. Additionally, Square has developed a trustworthy relationship with its users, something that cannot be done overnight. In a previously published piece on PayPal I discussed the trust associated with virtual payments. In my view, trust is the greatest barrier to entry in the online payments space. It explains why companies like Facebook (NASDAQ:FB) and Snap (Private:CHAT) have had trouble integrating financial transactions into their platforms.

Fundamentally, Square reported adjusted revenue of $171 million for the second quarter, which represents an increase of 54% year-over-year. The company forecasted adjusted revenue for the year between $655 and $670 million, up 6% from the midpoint of their previous guidance. Despite the revised guidance, I suspect that Square will guide higher in their upcoming quarter due to conservative estimates regarding the success of Square Cash on the iPhone.

Couple the above prospects with the possibility of Dorsey focusing all of his attention on Square, and I think that the company should be seen in a bullish light. Buying Twitter solely on the premise of a possible buyout is incredibly risky - many investors witnessed this last week. Instead, buying Square in anticipation of the implications of a Twitter buyout exposes investors to far less risk while also allowing them to participate in the upside potential from Dorsey's undivided attention.

Disclosure: I am/we are long AAPL, FB, PYPL.

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.