The ONE Thing Stopping Me From Shorting Twitter (TWTR)

When the stock market hits a rough patch (and I think the current period pretty much qualifies!) many companies’ shares get unfairly punished and offer incredible bargains.

Equally, however, there are the “weak hands” – companies with sub-par fundamentals, whose share prices were being unreasonably propped up by the rising tide.

Step forward, Twitter (TWTR).

[ad#Google Adsense 336×280-IA]The company appears to be the perfect example.

Its vulnerabilities (slowing user growth, no full-time CEO, etc.) are already taking a toll.

Shares have suffered the hardest among tech giants in August, dropping as much as 22%.

This is one case where shares are not priced at bargain levels due to the market’s tumble. There’s plenty more downside potential yet.

In fact, if Twitter shares get dumped like those of former social media darling Yelp (YELP), the stock could tumble another 60% based on Yelp’s current price-to-sales ratio.

Here’s why I believe such an epic crash and burn is possible for Twitter – but with one important caveat…

Five Key Reasons to Short Twitter

I’ve never been a Twitter buyer because of its inflated valuation and rapidly decelerating user growth rates. Indeed, for over a year now I’ve warned about Twitter’s questionable fundamentals. Metrics that only deteriorated more noticeably with time.

In fact, the list of unenviable fundamentals keeps getting longer. Topping that list are…

  1. Anemic Growth: In the most recent quarter, core monthly active users (MAUs) checked in at 304 million, up a mere two million from the previous quarter. Twitter execs, of course, tried to soften the blow by inflating MAUs using the stat that there were 12 million “SMS Fast Followers.” Nice try! Basic math reveals the underlying growth problem. Worse still, it’s not a problem that can be easily or quickly corrected, as interim CEO Jack Dorsey himself concedes: “We do not expect to see sustained meaningful growth [in MAUs] until we start to reach the mass market. We expect that will take a considerable period of time.” Forget “considerable,” it could take forever. Why? See No. 2…
  2. Questionable Utility for the Masses: Former Twitter CEO, Dick Costolo, repeatedly stated that it was his goal to reach “everyone on the planet.” At this point, that’s a pipe dream. As I shared on CNBC last year, “Mom, dad, even grandma understand Facebook (FB). But they don’t have a clue what Twitter’s for.” The proof is in the numbers. There are now more than one billion inactive accounts on Twitter. “We haven’t communicated why people should use Twitter, nor made it easy for them to understand how to use Twitter,” contends Dorsey. Um… not quite, Jack! Over one billion have tried it… and didn’t like it enough to continue! At the end of the day, Twitter is immensely useful to people in the media and financial world, but not so much to everyone else. And since social media stocks are all about the network – the bigger, the better, as it means there’s more potential to generate revenue – being relegated to a niche product is a long-term problem for Twitter and, by association, its shareholders.
  3. Accounting Shenanigans: I already mentioned the sudden inclusion of SMS users to beef up this quarter’s numbers. But Twitter has tried the switcheroo so many times with its key metrics (remember timeline views?) that even the SEC is taking notice now. A letter in April reveals the regulator questioned the practice of using “alternative metrics” to explain user engagement. The SEC also peppered the company about its increasing foreign losses and the different streams of revenue from advertising types. The SEC is hyper-sensitive to reporting now, having notoriously missed previous accounting shenanigans. (Remember Enron?) The fact that it’s catching on to potentially misleading practices means the attempts to fluff the figures are particularly egregious. The only thing worse than slowing growth is executives repeatedly trying to hide it.
  4. A Leadership Void: It’s been nearly three months since Costolo’s abrupt departure. Interim CEO Dorsey isn’t fit to serve, either. Not while he’s also running mobile payment company Square, Inc. as it prepares for an IPO. As for Revenue Chief Adam Bain, who’s been mentioned as an internal CEO candidate, he’s not even sure if he wants to run the company, according to sources. Such a leadership vacuum takes a toll. As one current employee recently told Business Insider, “Morale is beyond low. So many people who I’d have never guessed now want to leave.” The longer Twitter remains leaderless, the worse the impact on the underlying business.
  5. Technical Breakdown: Employees aren’t the only ones discouraged. So are early investors. Recent trading took shares of Twitter below its November 2013 IPO price of $26. That’s a key technical level. With this level now broken, the stage is set for shares to fall much further still.

So what’s keeping me from shorting the stock? It’s simple, really…

The Vultures Are Circling

The lower Twitter shares go, the higher the chance the company gets acquired. And being short a stock if an announcement like this hits makes it difficult, if not impossible, to exit the position profitably.

And the likelihood of a takeover is high.

In fact, investment banker Victor Basta believes a Twitter buyout is inevitable.

I agree. Another tech giant could certainly find a way to monetize Twitter’s user base more effectively. Who are the candidates? The usual suspects…

Google (GOOGL) makes the most sense, as it has an enormous amount of cash ($68 billion) and a hole in its portfolio for a true social media product after the failure of Google+.

But Twitter’s fellow social media giant, Facebook, has also been rumored as a potential buyer – a development that would see Zuckerberg & Co. wipe out their main competition in a stroke.

Apple (AAPL), Microsoft (MSFT), and even Amazon (AMZN) are also possible acquirers.

Needless to say, it all boils down to price. The magic number where Twitter becomes an irresistible acquisition target is unknowable.

At $30 per share – equal to a market cap of about $20 billion – an acquisition would be too pricey.

As a frame of reference, Facebook paid $22 billion for WhatsApp when it was in the early innings of its growth spurt. It’s since doubled in size to more than 800 million MAUs. So it’s hard to imagine a suitor paying that much for Twitter’s smaller and slower-growing user base.

But what if Twitter falls to $15 per share – about a $10-billion market cap? In this case, things get much more tempting for suitors. And Twitter’s fundamentals could certainly lead shares down to those levels.

Here’s the rub: It’s impossible to know exactly when a takeover offer would materialize. But the lower the stock goes, the greater the chances of a buyout. So while the carrot of a Yelp-like 60% profit from a Twitter collapse is compelling, an all-out short sale simply isn’t worth the risk.

Ahead of the tape,

Louis Basenese

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Source: Wall Street Daily