Elon Musk Buys Twitter, Musk’s Financing, The Status Quo and Future Variance

Good morning,

I mentioned at the end of Beyond Aggregation: Amazon as a Service that some merchants were hesitant to share data with Amazon; several readers pressed this point further, arguing that this — along with Amazon’s general bullying of suppliers and merchants — would do a lot to prevent uptake of “Buy With Prime”. Amazon could ameliorate these concerns by unbundling Amazon Pay from Fulfillment By Amazon, but I suspect that Amazon isn’t interested in just being a FedEx or UPS clone; I’m assuming that data is part of the point. We shall see though — this is going to take months to fully roll out.

On to the update:

Elon Musk Buys Twitter

From the Wall Street Journal:

Twitter Inc. accepted Elon Musk’s bid to take over the company and go private, a deal that would give the world’s richest person control over the social-media network where he is also among its most influential users. The $44 billion deal marks the close of a dramatic courtship and a change of heart at Twitter, where many executives and board members initially opposed Mr. Musk’s takeover approach. The deal has polarized Twitter employees, users and regulators over the power tech giants wield in determining the parameters of discourse on the internet and how those companies enforce their rules. The two sides worked through the night to hash out a deal in which Mr. Musk plans to take Twitter private in a deal that values the company at $54.20 a share.

The last time we discussed the Twitter saga — i.e. a week ago — there was speculation about alternative offers for Twitter. What seems clear is that those alternative offers did not materialize, and the most obvious reason why is Twitter’s anemic cash generation. Twitter’s free cash flow from operating activities was $630 million in 2021, and has averaged $976 million annually for the last three years. This matters because leveraged buyouts (LBOs) depend on free cash flows; typically in an LBO:

  • An acquirer borrows the money necessary to take a company private.
  • The company’s free cash flows are used to cover interest payments while the now-private company is restructured and rebuilt.
  • The repackaged company is brought back to the market via an IPO, which provides the funds to pay back the principal (and provide a profit).

Assuming that a Twitter LBO was 90% debt and 10% equity (UPDATE: Modern LBOs typically require 35%~40% cash; that doesn’t change the point but does change the numbers), matching Musk’s offer would require $4.4 billion in cash and $39.6 billion in debt; if we were generous to Twitter and assumed $1 billion in free cash flow, that would necessitate an interest rate of 2.53% just to cover the interest payments. However, interest rates for BBB-rated debt — speculative but investment-grade — are at 4.51%. That would limit borrowing to only $22 billion (I don’t actually know what grade Twitter debt would be, but the point holds regardless).

In short, there was no white knight for the board, and here I wonder how much of a role Twitter’s upcoming earnings played; from CNBC on Monday:

Twitter may want to finalize a takeover deal with Elon Musk ahead of the company’s first-quarter earnings report on Thursday, according to analysts…“Locking a deal up today or tomorrow may sound pretty appealing for someone who knows they are in possession of bad news,” Gordon Haskett said in a Monday note…Wedbush analyst Dan Ives told CNBC on Monday that advertising models are slowing and subscriber growth has continued to pose a challenge. A difficult macro environment could weigh on results, KeyBanc said in an April 14 note. The company has banned advertising in Ukraine and Russia due to the war, and any softness in Europe ad spending could also hurt second-quarter projections, according to a note earlier this month from MKM Partners.

We’ll see what happens on Thursday, but you can certainly see how difficult it might be for the board to turn down Musk’s offer — which would already kill the stock, given it would not only end the Musk premium but also include his vote of no confidence in management — because they claim their plan is better, particularly if there were fresh evidence to the contrary.

Musk’s Financing

So how did Musk get it done? From Reuters:

More than two-thirds of the $46.5 billion financing package that Musk unveiled on Thursday in support of his bid for Twitter Inc would come from his assets, with the remainder coming from bank loans secured against the social media platform’s assets. That is the reverse of how most investors structure buyouts, with debt secured against the assets of the target company typically comprising the majority of the financing.

What is more, Musk has agreed to take out a risky $12.5 billion margin loan, secured against his stock of Tesla Inc (TSLA.O), the electric-car maker that he leads, to pay for some of the $33.5 billion equity check. Were Tesla’s stock to drop by 40%, he would have to repay that loan, a regulatory filing shows…Musk’s loan against his Tesla stock to finance his Twitter bid is also expensive, potentially costing him about $1 billion annually in interest and amortization expenses, a regulatory filing shows. That gives him an incentive to refinance the proposed debt package at the earliest opportunity.

It is not clear how much of the $21 billion in cash that Musk has committed to the deal is immediately available to him, and whether he would have to cash out on some of his assets. They include stakes in rocket maker SpaceX and tunneling startup Boring Co.

So to summarize:

  • $13.5 billion of Musk’s offer is a loan to Twitter; the aforementioned 4.51% interest rate would mean $609 million in annual interest payments, which, you will note, was just covered by last years free cash flow of $630 million.
  • That leaves $33.5 billion of Musk’s offer as cash for equity.
  • $12.5 billion of that cash is a margin loan against Musk’s Tesla stock; $21 billion is out-of-pocket…somehow.

The first thing to note is that Musk is taking on enormous risk, and doing so in a way that actually limits his potential return. Remember, most LBO’s entail putting up around 10% of the purchase price, not 72%; the benefit of that approach is not simply less downside risk, but also more leverage to generate a higher return. This certainly lends credence to Musk’s insistence that this acquisition isn’t about the economics.

That noted, I suspect that margin loan in particular is something Musk would like to get rid of as soon as possible. The best way to do that is to bump up Twitter’s cash flow and refinance that $12.5 billion, and the easiest way to increase cash flow is to make big cuts to Twitter’s workforce. Here are some rough calculations on what that might look like:

  • Twitter, as of the end of 2021, had 7,500 full-time employees. That, to be perfectly honest, is a lot, particularly given the anemic nature of Twitter’s business: the average Twitter employee generates $677k in revenue (for reference, each of the 35,587 71,970 Facebook employees generates $3.3 $1.6 million in revenue).
  • Twitter spends just over $3 billion on Research & Development, Sales & Marketing, and General & Administrative; for the sake of argument let’s assume that those costs are Twitter’s employee costs, which means each employee costs Twitter around $401k/year (this obviously isn’t correct, but it’s close enough for this exercise).
  • $12.5 billion more in debt (to refinance the margin loan) would require $564 million more a year in free cash flow (at an interest rate of 4.51%); that is about 1,400 employees at $401,000/employee.

That’s about 19% of the workforce; interestingly, the New York Times reported yesterday:

Many Twitter employees feel personally invested in the company’s effort to encourage healthy conversation — even if they do not directly work on content moderation — and have pressed executives to crack down further on hate speech and misinformation, six employees said. They see Mr. Musk’s proposal to revert to Twitter’s early, lax approach as a rebuke of their work.

But other employees have argued in internal messages seen by The Times that their co-workers have shifted too far to the left side of the political spectrum, making employees who support Mr. Musk’s plans too uncomfortable to speak up. In a worker-run survey of nearly 200 Twitter employees on Blind, an anonymous workplace review app, 44 percent said they were neutral on Mr. Musk. Twenty-seven percent said they loved Mr. Musk, while 27 percent said they hated him.

The survey is obviously not remotely scientific, so take the results with 240 grains of salt; the point of raising it is to note that Musk could very well seek to kill two blue birds with one stone: I don’t think he is going to be too concerned about a significant employee exodus in the near term, if that both makes it easier to change course and increases cash flow. As for the medium to long-term, the more that Twitter cuts costs the more optionality it has in determining an alternate strategy — that’s the big benefit of being private.

The Status Quo and Future Variance

So will anything actually change?

The smart take, honestly, is “no.” The furore over Musk taking over reminds me of the furore over reclassifying ISP’s from “Title I information services” to “Title II telecommunication providers”; if that sounds impossibly dry, well, that’s what I thought too, until I wrote in favor of the re-classification and received death threats for being against net neutrality and supporting the imminent destruction of the Internet. Which, it’s worth noting, didn’t happen! To that end, it’s easy to imagine worst case scenarios — particularly when it it costs nothing to publish them on Twitter — and to forget that the status quo usually wins (particularly when network effects are involved).

Similar skepticism should be applied to other extreme scenarios as well, such as massively positive business outcomes. It’s possible that Twitter is just a bad business, and that even more aggressive approaches like my proposal to split the company in two are unworkable and unsuccessful; that has been the story of Twitter for 16 years now, and should be the null hypothesis. The same reasoning applies to Musk’s declaration that he is motivated to return Twitter to its free speech roots, and also to defeat spam bots — the reason to list these together is that the latter are examples of free speech, which is to say that moderation is hard and complicated, and while Musk may make a difference at the margins, the end result may not end up looking much different.

All that noted, this is Elon Musk we are talking about: in retrospect, was it so unreasonable to doubt that the same guy who made electric cars cool and lands rockets on drone ships could come up with $44 billion in funding? Moreover, there is the fact that Musk said he was making a take-it-or-leave-it offer, and the Twitter board felt it had no choice but to take it. If culture is set during a company’s founding, it is worth noting that this new chapter for Twitter was founded on Musk imposing his will and getting results.

Founder and former-CEO Jack Dorsey is certainly on board; he wrote in a tweet thread (that starts here with a link to Radiohead’s “Everything In Its Right Place”):

I love Twitter. Twitter is the closest thing we have to a global consciousness. link

The idea and service is all that matters to me, and I will do whatever it takes to protect both. Twitter as a company has always been my sole issue and my biggest regret. It has been owned by Wall Street and the ad model. Taking it back from Wall Street is the correct first step. link

In principle, I don’t believe anyone should own or run Twitter. It wants to be a public good at a protocol level, not a company. Solving for the problem of it being a company however, Elon is the singular solution I trust. I trust his mission to extend the light of consciousness. link

Elon’s goal of creating a platform that is “maximally trusted and broadly inclusive” is the right one. This is also @paraga’s goal, and why I chose him. Thank you both for getting the company out of an impossible situation. This is the right path…I believe it with all my heart. link

I’m so happy Twitter will continue to serve the public conversation. Around the world, and into the stars! link

I’ll be perfectly honest: I don’t know what is going to happen (although I’m in favor of the protocol-first approach). I’m not going to predict doom, and I’m not going to predict nirvana (or even a profitable IPO). Twitter has both theoretical potential and realized mediocrity, and, after this week in particular, conventional wisdom that this new future is going to be a disaster. What is true is the range of outcomes are much wider than they were a few weeks ago, and variance alone goes further than you think to justifying Musk’s premium.

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