On November 13, 2014, S&P downgraded Twitter (NYSE: TWTR) debt to a BB- rating, or junk status. In doing so, S&P described Twitter's risk profile as 'significant,' while also projecting that the holders of a September $1.8 billion convertible debt offering may recover 70% of principal, in the event of bankruptcy. Wall Street clearly was not pleased with this news, as traders promptly sold off Twitter stock to $40.04, to close out the session with a 5.9% loss. This recent chain in events was the latest setback for a social media company that has largely failed to take flight as a publicly traded corporation, despite the ongoing stock market rally.
Still, aggressive traders out to make a quick buck should not take out a short position in Twitter stock. This call should not be mistaken for any bullish sentiment toward the Twitter business model. In the short-term, the Web 2.0 economy has all the makings of the second coming of 'irrational exuberance.' As such, going short Twitter would be a far too risky proposition in this environment.
The Mechanics of Shorting Twitter Stock (click to enlarge)
Twitter stock has been especially volatile since its November 7, 2013, initial public offering. For the IPO, Twitter set its minimum price at $26 per share. From there, Twitter opened at $45.10 and immediately spiked to $50.09, before ultimately closing out this first session at $44.90. As a publicly traded company, Twitter opened for business with $14 billion in market capitalization, after tacking on 72.6% gains through the IPO date. Still, Forbes contributor Hersh Shefrin thoroughly ripped the Twitter IPO as a 'failure.' For his part, Shefrin suggested that Twitter's low offering price might have left billions of dollars on the table. From there, Shefrin did parallel the Twitter IPO to the expansion of the 1990's dot-com bubble.
In his closing arguments, Hersh Shefrin cited research out of University of Florida finance professor Jay Ritter suggesting that a high-flying opening day IPO would ultimately underperform the broader market over the next year. To date, Shefrin and Ritter have both been vindicated, as Twitter shares lost 16.5% in value between the $50.09 November 7, 2013, session apex high and $41.85 November 14, 2014, close. For the sake of comparison, the S&P 500 has tacked on 16.8% in gains and successive record highs throughout this same time frame. The past, of course, is no clear indicator for future returns. Short sellers should still avoid Twitter, despite the prognostications for underperformance.
A trader interested in shorting Twitter stock would first borrow shares from an investor before immediately selling out of that position for cash. At a later date, the short seller will return to the market and 'buy to cover' Twitter shares to replace the original stock loan. Short sellers therefore turn profits amid stock market declines. In theory, of course, share prices may range between zero and infinity, which would expose a short seller to unlimited losses. As of October 31, 2014, traders had sold short 28.9 million out of 625.2 million shares of Twitter stock outstanding.
Be advised further that short sellers also may bear the brunt of a 'short squeeze' due to the volatile price action of Twitter stock. A short squeeze occurs when frantic traders buy to cover to avoid staggering losses amid a stock market rally. Stocks such as Twitter, with its relatively small float and market capitalization, are especially prone to short squeeze events. Float describes the amount of shares that are actually available for trading, outside of restricted stock, usually held by corporate officers. Twitter float stood at 531.9 million shares heading into this November.
The Web 2.0 Bubble
A 1913 Act of Congress established the Federal Reserve with the contradictory dual mandate of managing the economy toward full employment, while also maintaining a stable price level. To do so, the Federal Reserve was tasked with influencing interest rates upon overnight loans between member banks to meet reserve requirements at the institution. In Q4 2008, the Federal Reserve dropped its overnight lending rate to an unprecedented zero, amid the credit crisis and housing bust that roiled financial markets, at the time. From there, Treasury and Federal Reserve officials also installed the Term Asset-Backed Securities Loan Facility (TALF) and Troubled Asset Relief Program, in order to supply even more liquidity into the domestic economy.
By November 12, 2014, the already bloated Federal Reserve balance sheet had swelled to $4.5 trillion. For its part, the S&P 500 Index did advance from 903 to 2040, between January 1, 2009, and November 14, 2014. Still, much of this growth may have arrived courtesy of traders leveraging cheap money to buy into many of the more speculative assets. Again, much of this capital has flooded into Web 2.0 stocks as somewhat of a throwback to the late 1990s.
Web 2.0 stocks integrate a social component within the dot-com business model. After capturing traffic, the Web 2.0 outfit then operates as a literal broker-dealer to match goods and services against an established user base. Beyond Twitter, prominent Web 2.0 companies would include Facebook (NASDAQ: FB), Amazon (NASDAQ: AMZN) and Pandora (NASDAQ: P). Each Web 2.0 stock is notable for arguably outrageous market valuations relative to underlying business performance. Again, Twitter closed out the November 13, 2014, trading session at $40.04, which did then calculate out to $24.6 billion in market capitalization. Twitter has already racked up $452.5 million in losses upon $923.9 million in revenue through the first nine months of fiscal 2014.
Famed British economist John Maynard Keynes once quipped, 'the market can stay irrational longer than you can stay solvent.' Keynes' advice does not bode well for the immediate prospects of Twitter short sellers. Again, the next leg up in Twitter share prices may trigger another short squeeze and rout for short sellers. Markets may now be defined as irrational, with interest rates at zero.
The Bottom Line
Owners of Twitter stock may have bought into shares largely based upon implicit growth potential as the social media enterprise has failed to turn a profit as a publicly traded corporation. For fiscal Q3 2014 ended September 30, Twitter did rack up $175.5 million in losses off $361.3 million in revenue. Q3 2014 revenue did more than double in comparison to Q3 2013, when Twitter posted $168.6 million in total net sales. Loss per share also contracted from 48 cents to 29 cents through this same time frame. Much of this bottom line improvement, however, may be attributed to the dramatic expansion in shares of common stock outstanding from 133.7 million to 614.4 million, through the same year-over-year time frame.
To date, Twitter costs also have expanded alongside exponential revenue growth at the company. Interestingly, research and development costs and revenue have surged by 156% and 118%, respectively, when comparing the first nine months of fiscal 2014 against the same year-over-year time frame. At any moment, Twitter executives may simply agree to slash costs and narrow losses. Short sellers may then be exposed to staggering losses if Twitter begins showing signs of moving toward turning a profit over the course of the next twelve months.
For now, financial markets remain irrational. Going forward, traders shorting Twitter may only be vindicated, if interest rates were to rise sharply off the floor. At that point, capital would flow out of riskier stock market investments and into credit securities.
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