Santa Claus: You'll shoot your eye out, kid.
Elon Musk's bid for Twitter at $54.20 share came at the final stages of a technology stock bubble and at the early stages of a central bank-induced global recession
It was only roughly a year ago that Apple banned in-app tracking, upending the digital advertising landscape - Twitter must manage those ongoing seismic changes in the midst of stormy economic times
Adding to the advertising revenue woes, questions about the trust and reliability of Twitter as a brand platform have arisen since the deal closed in October 2022 resulting from uneven messaging, feature roll-outs and ultimately questions around ad-spend ROIC
Will Elon ultimately shoot his eye out like Ralphie did after getting what he wanted?
We dig in.....
Expanding Our Horizon
A post on the Twitter take-private transaction with a capital structure and cash flow analysis admittedly doesn't fit our typical Energy content niche and we don't expect to do much of this kind of work, but a Tweet on the topic went viral last month so we are formalizing the work here. As long-term Twitter users, we followed the Elon Musk take-private transaction from afar, mostly unconcerned about changes to the platform. We did not follow the transaction litigation closely nor do we have any proprietary information.
This analysis mostly entails a read of the proxy statement, debt commitment letter, listening to Elon Musk in a recent Twitter Spaces, and back-of-the-envelope calculations on potential future cash flows.
We are hopeful Twitter survives and thrives but the near-term challenges are material.
Estimated Transaction Sources & Uses
- Fees & expenses are estimated
- Debt refinancing likely included additional premiums
- Estimated rollover equity includes $1.9 billion from Prince Alwaleeda bin Talal, $978 million from Jack Dorsey, $375 million from Qatar sovereign wealth fund
- Reported co-investors include:
Elon Musk received a commitment from Morgan Stanley, Bank of America, Barclays, BNP Paribas, Mizuho, Societe Generale and MUFG Bank for $13 billion of credit facilities.
The proxy statement presumes $12.5 billion of the facilities were funded to close the deal, with the $500 million revolver remaining unfunded at close.
- Total interest expense appears to be roughly $1.25 billion per year today
- The revolver (A) has a maximum 1st lien leverage ratio covenant that is set at a 40% cushion to the acquisition model and only tested if greater than 35% drawn
- The term loans have no financial covenants
- The revolver and $6.5 billion term loan (B) share in the collateral / security on a 1st lien basis; security is effectively the stock of subsidiaries, with guarantees from those subsidiaries also provided
- The revolver has a 0.50% (50 bps) undrawn fee that is paid whether used or not
- In credit, there can be contractual or structural seniority/subordination; here, the $3 billion secured term loan (C) shares in the security the revolver and term loan (B) receive, but there is an intercreditor agreement that makes the $3 billion secured term loan (C) contractually subordinate to A & B
- The $3 billion secured term loan (C) is effectively a 2nd lien facility
- The $3 billion unsecured term loan (D) is subordinate to all other debt
- The $3 billion secured term loan (C) and $3 billion unsecured term loan (D) have one-year initial maturity dates, at which time they convert at the lenders option into extended term loans or exchange notes
- Credit facilities C & D are classic bridge loans, with increasing interest rate spreads as incentives for refinancing the debt in the capital markets - getting it off the bank balance sheets
Unfortunately, for Elon and his co-investors, the Twitter buyout debt agreement from April 2022 was all floating-rate debt and tied to SOFR, the Secured Overnight Financing Rate. SOFR is tracking Federal Reserve rate hikes and has made the cost of the financing much more expensive than originally contemplated.
SOFR was 0.30% when the deal was announced in April 2022. Today it is 4.30%.
It doesn't quite work out this way, but a 4% increase in interest rates on $12.5 billion in debt increases the annual interest burden by $500 million per year. Fortunately for Elon and unfortunately for the banks holding the 2nd lien and unsecured debt, those two tranches have rate caps that limit interest rate increases and would have been negotiated and disclosed between the parties in a side letter that was not filed publicly.
It was reported by Bloomberg that the unsecured credit facility had a rate cap of 11.75%. We estimate the 2nd lien rate cap is 9.75%. These caps are 'saving' Twitter approximately $200 million per year. It should be noted the banks holding this debt may have also negotiated 'market flex' provisions that could offset the rate cap in their favor very marginally.
The $6.5 billion 1st lien term loan has no rate cap, however. As the Federal Reserve continues to hike short-term rates, SOFR and thus Twitter interest expense will continue to increase. With term loan facilities C&D capped, a 1% increase in SOFR will increase the 1st lien and total interest expense by $65 million annually.
Notwithstanding anything to the contrary set forth above, at no time, other than as provided under the heading “Default Rate” below, shall the per annum yield on the Secured Bridge Loans exceed the amount specified in the Fee Letter in respect of the Secured Bridge Facility as the “Secured Total Cap”.
Notwithstanding anything to the contrary set forth above, at no time, other than as provided under the heading “Default Rate” below, shall the per annum yield on the Unsecured Bridge Loans exceed the amount specified in the Fee Letter in respect of the Unsecured Bridge Facility as the “Unsecured Total Cap”.
Cash & Cash Flow
Elon Musk recently spoke on a Twitter Spaces, which was posted on Youtube in which he discussed Twitter's financial situation. Some highlights and quotes:
- "This is probably like the biggest amount of change that has happened in an acquisition in history"
- Headcount is near 2,000 compared to 8,000 at the time of deal close
- "The most essential thing to be done at Twitter was to cut the burn rate so that Twitter does not just go bankrupt next year."
- Elon believes it is essential to quickly move to more of a subscription revenue base as a recession appears likely and he expects discretionary brand advertising to be cut, indeed he says they are seeing a "rapid decline in brand advertising."
- Twitter was tracking to spend $5 billion in 2023 (COGS + Opex + Capex?)
- $1 to $1.5 billion of interest outflows due to the Fed "going crazy"
- 2023 revenue is tracking to $3 billion
- "Since Twitter has $1 billion in cash, so that's why I spent the last five weeks cutting costs like crazy."
- "I've spoken with a number of the advertisers their requests are not fuzzy or irrational or anything, they're like quite reasonable they're ike just show us an ROI that makes sense and I'm like I agree if I were in that position I would also want an ROI that makes sense especially when headed into difficult economic times."
- "I mean free speech let me tell you that if somebody's got to pay the servers okay so those features gotta cost at least eight dollars oh because otherwise how do we pay the freaking server bill um you know there's like a billion and a half ish you know of oil and server-related costs um and you know we're trying to get that lower but it's a lot it's like not trivial um and a minimum you know like there's like somebody's got to pay the bills"
We push back on the cash balance comment. Twitter had $6.1 billion in cash and short-term investments as of June 2022, the last period for publicly available financials. We estimate Twitter will have $5 billion cash at year-end 2022, providing significant near-term liquidity. Unless cash balances were used as part of the transaction financing and not disclosed in the proxy statement or other merger-related filings, we believe asserting Twitter has $1 billion in cash today is hyperbole.
We took Twitter's historical financial statements and de-constructed them to look at cash costs only. Stock compensation is backed out from operating costs to calculate cash operating costs as a percent of revenue.
From there we compared the calculated operating cash flow with reported cash flow, which shows a close historical correlation.
- We tend to look at Funds From Operations (FFO), which is Cash From Operations (CFO) before working capital changes
- FFO aligns well with our calculated operating cash flow
- Twitter generated roughly $83 million in Free Cash Flow (FFO less Capital Expenditures) over the last 12-months, a 2% FCF margin
- Elon and his co-investors appear to have paid 530 times trailing free cash flow
- Twitter capital expenditures as a percent of sales have been running at 15-20%
Twitter Costs - Cutting to the Bone
Twitter has four primary cost line items: (i) cost of revenue; (ii) research & development expenses; (iii) sales and marketing expenses; and (iv) general and administrative expenses. As discussed below, only R&D, S&M and G&A expenses are tied to personnel and headcount and can be easily slashed. Indeed Twitter has approximately $400 million per year through 2026 of "non-cancelable contractual commitments primarily related to....infrastructure services and other services arrangements."
Elon is doing what any rationale person would do in the current situation, cutting as many costs as possible as quickly as possible.
Cost of revenue includes infrastructure costs, revenue share expenses, amortization of acquired intangible assets, amortization of capitalized labor costs for internally developed software, allocated facilities costs, as well as traffic acquisition costs (TAC). Infrastructure costs consist primarily of data center costs related to our co-located facilities, which include lease and hosting costs, related support and maintenance costs and energy and bandwidth costs, public cloud hosting costs, as well as depreciation of servers and networking equipment; and personnel-related costs, including salaries, benefits and stock-based compensation, for our operations teams. TAC consists of costs we incur with third parties in connection with the sale to advertisers of our advertising products that we place on third-party publishers’ websites, and applications or other offerings collectively resulting from acquisitions. Certain elements of our cost of revenue are fixed and cannot be quickly reduced in the near term in response to market conditions.
Research and development expenses consist primarily of personnel-related costs, including salaries, benefits and stock-based compensation, for our engineers and other employees engaged in the research and development of our products and services. In addition, research and development expenses include amortization of acquired intangible assets, allocated facilities costs, and other supporting overhead costs.
Sales and marketing expenses consist primarily of personnel-related costs, including salaries, commissions, benefits and stock-based compensation for our employees engaged in sales, sales support, business development and media, marketing, corporate communications and customer service functions. In addition, marketing and sales-related expenses also include advertising costs, market research, trade shows, branding, marketing, public relations costs, amortization of acquired intangible assets, allocated facilities costs, and other supporting overhead costs.
General and administrative expenses consist primarily of personnel-related costs, including salaries, benefits and stock-based compensation, for our executive, finance, legal, information technology, human resources and other administrative employees. In addition, general and administrative expenses include fees and costs for professional services, including consulting, third-party legal and accounting services and facilities costs and other supporting overhead costs that are not allocated to other departments.
If we assume 15% revenue decline in 2022 and 35% in 2023, offset partially by subscription revenue from one million subscribers in 2023, we track pretty closely to Elon's $3 billion estimate for next year revenue.
- The model below assumes cost of revenue is taken down 15% and all other cost line items are reduced by 65%
- Capital expenditures are flatlined at $600 million per year, much lower than the last three-year average
- Twitter will burn approximately $500 million per year the next four years on these assumptions
- Leverage today is 9-10 times cash flow and doesn't get below six times cash flow through 2028
These numbers suggest the $44 billion paid for Twitter represents 30-40 times 2028 free cash flow (pre-interest burden). Elon and team have a lot of wood to chop.
Twitter's revenue has historically been comprised of 90% advertising revenue. The transition to subscription revenue will be no easy task. Every 1 million subscribers at $8 per month is only $96 million in revenue per year. Facebook, Google, Amazon, Apple and Snap are on average down 35% since the Twitter buyout was announced. Inflation and higher interest rates are pressuring discretionary spending. Consumption is lower globally, so brands and advertisers will naturally cut discretionary spending and any ad-spend that doesn't result in a return on investment.
But why will subscriptions be any different? Why will subscribers not want a return on their monthly investment and can Twitter grow subscriptions at scale without articulating the value proposition? We may very well be on the backside of a content creation bubble. There are headwinds on the subscription side of the business ledger as well as advertising.
The value of Twitter is in the network. Twitter Blue subscriptions only have value if they improve the current network value for users, which in effect relies on mass adoption. The value proposition appears unclear today. Can a pay-for-presence network effect exist at scale and still be considered the 'town square' if those willing to spend more get their voices amplified?
- There were media reports that the 1st lien term loan was bid at 60 cents on the dollar. Using rough math, 40 points over seven years equates into 5.75% of additional spread-to-maturity. If it traded at 60 cents, the 1st lien term loan would yield 15%.
- If the 1st lien trades at 15%, its not unreasonable to think the unsecured tranche would trade with yields in the low-20% context. Given the interest rate is capped at 12% on the unsecured debt, it would need to trade near 20 cents on the dollar to trade at 22%.
- It is difficult to inject equity into the capital structure with the debt theoretically in such a distressed position.
- It has been reported Twitter is seeking new equity at the previous $54.20 price. Colonizing Mars seems easier.
- That Elon and his co-investors massively overpaid for Twitter is not controversial. Elon himself has said as much.
- The current cash balance will likely drive near-term Twitter strategy and feature roll-out cadence. If the cash balance is anywhere close to the $1 billion discussed by Elon recently, the runway is much shorter than expected thus massive changes should be expected. Elon may have reduced his equity contribution at closing by utilizing balance sheet cash.
- Elon can always pony up more cash to repay debt and reduce the interest burden, but no rational investor would come into the equity at the prior valuation, so any additional equity capital raises likely result in significant impairment of prior equity raises.
- Twitter has 135 days from the end of the year to deliver audited financial statements to the lender group (120 days after the first year). Prior to an IPO, the company must also provide annual forecasts on the same timeframe. By mid-April lenders will know the balance sheet situation and strategic and financial plan better.
- Interestingly, one affirmative covenant requires Twitter to use commercially reasonable efforts to maintain credit ratings. At least one credit agency has dropped Twitter ratings due to lack of disclosure.
Here is to hoping Elon doesn't shoot his eye out!