Twitter Looks Like a Bargain Here
On April 25, Twitter (NYSE: TWTR) agreed to allow Elon Musk to buy the company for $54.20, or $44 billion in cash. The problem is the stock trades for just $40.72 as of May 13. On April 21, right before Musk disclosed his stake of 9% in TWTR stock, it traded for $45.51, much higher than the stock today.
What happened? On May 13, Musk tweeted that he was putting the deal on hold "temporarily." But later in the day, 2 hours later, he said he was "still committed to acquisition." The Wall Street Journal, lawyers close to Mr. Musk urged him to send that follow-up tweet.
Moreover, the WSJ pointed out that the signed agreement waived due diligence on the purchase contract. The truth is that he really has no choice. He is going to have to purchase Twitter.
The only issue is the price. That is going to be very difficult to cut. Musk says that he relied on the company's releases that only 5% of its accounts were bots or fake accounts. That seems to imply that if he finds out otherwise he could go back on his deal and try to reprice it.
The problem is the probability of getting a lower price is very low, probably less than 50%. We can use that to come up with a way to estimate the merger arbitrage opportunity now for investors in TWTR stock.
Using Probability to Assess the Merger Arb Return
It's very simple. Let's say there is a 40% probability that Musk can successfully force Twitter to accept a lower price. For one, he would have to give up $1 billion. He would also look pretty stupid and his reputation would be scarred. Musk cares about his rep, so I don't think the likelihood is high he would pay out the $1 billion breakup fee.
So, let's say that there is a 40% probability he pays $43.36 per share or 20% below the $54.20 he originally agreed. That leaves a 60% probability of going through with the $54.20 deal.
Next, we add up these two probability-weighted prices. For example, 40% x $43.36 = $17.34. And, 60% x $54.20 = $32.52. So, if we add together $17.34 with $32.52, the expected price is $49.86. That provides a very good return to investors today at $40.72, as of May 13. In other words, the potential return is 22.4% (i.e., $49.86/$40.72-1=0.224).
This implies that there is a very merger arb opportunity. In fact, any price up to about $45.30 or so provides a good return, since that means that this will provide a probability-weighted 10% return to investors.
Where This Leaves Investors in TWTR Stock
Twitter reported negative free cash flow (FCF) during Q1. Its adjusted FCF fell from $210.8 million last year to -$34.6 million in Q1 2022. Moreover, Net cash provided by operating activities in the quarter was $126 million, compared to $390 million in the same period last year. In other words, the company is having trouble generating cash from its operations.
For example, its advertising revenue was down 23% to $1.11 billion during Q1. Moreover, its subscription revenue was off 31% to $94 million. So it is facing declining revenue streams as well.
The adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) of $1.18 billion. But this included $315.4 million in taxes added back, which is an outlier. If we eliminate this the adj. EBITDA falls to $864.6 million, or 72% of revenue. If we use the forecast for 2022 of $5.89 billion, the adj. EBITDA works out to $4.24 billion.
So the projected takeover price of $44 billion is about 10.3 times adj. EBITDA. That seems high since most private equity firms like to acquire companies for no more than 4 to 6 times EBITDA. This is likely why Musk is trying to lower the acquisition cost.
As a result, this is a good deal for investors. Even a 20% lower takeover price would still lower the price/EBITDA to less than 8 times. So investors in TWTR stock should take the deal and run. Assuming the deal gets locked down soon this represents a very good potential return for investors. In fact, they should consider buying more shares now if this will lower their acquisition cost.
Mark R. Hake, CFA