Standard & Poor's gave Twitter an unsolicited BB- credit rating yesterday, and I sort of wonder if that was a stunt cooked up by its social media team. Why give any company an unsolicited rating, really? The defining feature of an unsolicited rating is, no one asked you. S&P's statement explains the reasoning behind the rating, but not the reasoning behind doing it in the first place, so I will just blithely assume was to increase its follower count on Twitter.
My favorite reason to do an unsolicited rating is to punish the issuer for not paying you to do a solicited one. That sometimes happens, or at least, ratings agencies sometimes accuse each other of doing that. But it doesn't seem to be what's going on here. Twitter has only convertible debt outstanding, which is not normally rated, so it didn't exactly snub S&P. It's not like it paid anyone else to rate those bonds.
Also that BB- doesn't seem particularly punitive? It seems sort of fine? Fine to generous? The thing about ratings is that they are typically a lagging indicator: The market usually knows a company's creditworthiness before the ratings agencies do. So it's a bit strange that Twitter's stock was down 5.9 percent yesterday on the back of its surprise junk rating. Did people think that Twitter was an investment-grade company?
I mean, maybe. Its financials are ... I guess more Internet-grade than either investment-grade or high-yield. It's got $1.8 billion of debt ( two convertible bonds it issued last month), $3.6 billion of cash, negative net income and around $200 million of EBITDA. On present income it looks pretty junky, though S&P is optimistic about 'healthy growth in monthly active users and revenues, the possibility of positive discretionary cash flow in 2016, and ongoing minimal debt leverage.'
But of course Twitter issued debt two months ago. And, without the benefit of S&P's wisdom, the market went and figured out Twitter's creditworthiness. And you can back out the market's thoughts from how that debt priced two months ago.
That is a bit confounded by the fact that Twitter's debt came in the form of convertible bonds, but we can deal with that. One way to deal with it is to use a convertible bond pricing model to back out the credit component, though that requires some inputs. (And a convertible bond pricing model. ) The main inputs are the trading prices of Twitter's convertible and its stock, both of which you can more or less figure out, and the expected volatility of Twitter's stock over the next five or seven years, which is harder. That makes pricing a convertible more of an art than a science, and I have somewhat lost the knack over the last three years. But my best guess would be a credit spread of about 300 basis points, meaning that if Twitter issued non-convertible bonds today they'd come at a rate of a bit under 5 percent for five years, or a bit under 5.5 percent for seven.
You don't have to trust my guess, though. You can trust Twitter's guess! A convertible bond is a combination of a bond (pays interest, pays back principle at maturity) and a call option on Twitter's stock. For accounting purposes, Twitter was required to split up the convertible by separately valuing the bond and the call option, using some basic bond math. Twitter issued a 5-year bond with a 0.25 percent interest rate, and a 7-year with a 1 percent interest rate. Those are not the 'right' interest rates for Twitter bonds. Apple just did an 8-year bond with a 1 percent interest rate, and Twitter is no Apple. So Twitter went and applied its 'right' interest rate to the bonds, to figure out what they should be worth. And that 'right' interest rate is right there in the 10-Q from a week ago:
In accordance with accounting guidance on embedded conversion features, the Company valued and bifurcated the conversion option associated with the 2019 Notes and 2021 Notes from the respective host debt instrument, which is referred to as debt discount, and initially recorded the conversion option of $214.6 million for the 2019 Notes and $267.4 million for the 2021 Notes in stockholders' equity. The resulting debt discounts on the 2019 Notes and 2021 Notes are being amortized to interest expense at an effective interest rate of 5.75% and 6.25%, respectively, over the contractual terms of the notes.
Emphasis added, and probably ignore the rest. Twitter is saying that a regular non-convertible Twitter bond would pay interest of 5.75 percent for five years, or 6.25 percent for seven. That's higher than my guess, some of which may be due to new-issue premiums, and some of which may be due to conservatism in accounting. A third and even stranger way of doing the math gets a credit spread of around 260-270 basis points.
What does that tell you? Well, it lets you construct hypothetical debt instruments for Twitter -- say, a 5-year credit default swap spread of about 300 basis points, or a hypothetical new 7-year high-yield bond price of about 5.25 to 5.5 percent. Then you can compare those instruments to real instruments. For instance, E*Trade just priced a new 8-year high-yield bond at 5.375 percent. E*Trade is rated Ba3 by Moody's and B+ by S&P, or one notch below Twitter. And here are some credit default swap spreads for other companies with BB- ratings:
So if you believe my pricing, Twitter looks like a weak BB-, maybe a B+. If you believe Twitter's own pricing of its debt in its financial statements, it looked more like a single-B-area credit.
If you believed that Twitter was an investment-grade company ... why? The convertible bond market knew that Twitter was junk months ago. And Twitter told everyone a week ago. If stock investors are surprised that Twitter is not an investment-grade company, it's only because they weren't listening.
To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.
To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.
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