Just five months into 2022, can we already select Elon Musk's recent successful $45 billion bid to acquire Twitter as the "Deal of the Year"--not because of size, not because of its expected leverage, but because it's Elon Musk, it's Twitter, and everybody has an opinion about both.
In some ways, the deal was unpredictable, because, yes, not many knew a year or two ago Musk might have been eyeing the company, although he surely had a dominating and controversial presence on the platform.
The swiftness in which the deal (still not yet consummated, but unlikely to be slowed down by government regulators) got done proves how rapidly banks, markets and boards of directors can move to reach an objective. (Documentation in this deals permits opt-outs if required steps are not taken before yearend.)
While many in the media (and on Twitter itself!) are expressing views on what Musk will do to the platform, what will Musk (along with other private-equity investors who might join him) acquire?
The company had earnings losses in 2021, a disappointing year after the company had begun to show a promising and upward bottom line. The loss in 2021 still needs to be reckoned with and understood. (From 2013-17, it recorded a string of net losses, often attributed to its being in start-up mode. During that period, it also went public in 2013 via an IPO and was blessed with billions in cash reserves to help cushion operating losses.)
In 2022, Musk and crew are purchasing an enterprise that generates about $500-900 million in annual operating cash flow (before investments and capital expenditures). And they present the case they can stir up the magic that will boost earnings to where they can be. As a private company, it will be able to spur growth as its own pace and without being second-guessed each quarter by a broader market.
The company had its best years in 2018-19, topping $1 billion in each year in earnings, and operating cash flow also topped $1billion and the company could finance growth, investments, acquisitions, and capital expenditures without increasing debt much. Before Musk's involvement, Twitter debt had reached a manageable $5 billion, much of it related to lease obligations.
Results have been puzzling since then. Revenues continue to grow quickly (even at last year's 35% pace), but expenses and unusual costs seemed to have spiraled upward. For example, litigation-related expenses and other unusual items topped $700 million last year.
Until the acquistion announcement, debt was not yet a burden, partly because the company has maintained cash reserves of at least $6 billion on its books since 2016. Some of the cash on the balance sheet was gathered from IPO proceeds, and it has remained there in part because shareholders haven't demanded dividends in great numbers and they haven't often pressed for big buy-backs.
The new Musk-led buyout will layer tiers of debt on the operation and put pressure on the business to generate the consistent cash flow to service levels of debt that could exceed $15 billion in the new private entity.
Musk-led enterprises aren't afraid of debt. Tesla continues to operate with debt totals above $20 billion, although cash flow there has reached stratospheric proportions (almost $12 billion in 2021--before capital expenditures--amidst revenue growth that has quintupled the past four years. Revenues ($53 billion last year) could stall in growth as all other automakers dip into electric-vehicle (EV) waters. Yet despite recent declines in Tesla shares (related to the debt financing in the Twitter deal), Tesla reported one of its best quarters ever in 2022's first three months.
Twitter, on the other hand, is a different beast--different business model, different kinds of competition, different relationships with its stakeholders (customers, users, shareholders), less capital-intensive. It doesn't need to address labor issues and concerns about raw materials and battery production or tend to risks related to production, assembly lines, and supply availability of silicon chips.
In a classic leveraged-buyout approach, banks lined up eagerly to provide the financing (about $25 billion in total). Musk and his small troop of other equity investors will invest another $20 billion in equity. When all the documentation is signed and the deal finally closes, there will be a new consolidated balance sheet that will feature at least $13-15 billion in debt and perhaps as much as $35 billion-plus in "goodwill," the accounting intangible that shows how much the group paid above the book value of current Twitter.
The deal is complex, but not unusual. Musk will sell Tesla stock to come up with $20 (and consider raising some of that total from private-equity-fund friends). Musk will separately borrow $12-13 billion from a Morgan Stanley-led bank group and pledge more than $20 billion in Tesla stock to collateralize the loan. A newly formed parent company will be capitalized by those Musk contributions and then will gain funding from additional debt of $12-13 billion. The total fundraising will be sufficient to purchase the net assets of Twitter.
Bankers likely got comfortable (and did so quickly) for their various fund-providing roles because of the bundles of cash sitting on the balance sheet already and because of the pledge of notably liquid, but volatile collateral--some of Musk's Tesla stock holdings. As a highly leveraged transaction, investors and banks providing debt at the new parent company will seek the typical safeguards, protections and security interests (collateral on just about all assets available for pledging, covenant restrictions on new debt, minimum cash flow to ensure interest is paid on time, limitations on dividends and buy-backs, etc.).
Debt investors and bank are relying on (or praying for!) steady growth in Twitter operating cash flow, and the expectation Twitter's new owners are not seeking dividend payouts and share-buys (at least not early on).
Banks will rely, therefore, on the performance of two businesses: Twitter and Tesla. While Tesla shares have grown remarkably the past few years (by almost 8-times in value the past three years), its values can be unbearably volatile. (The beta of the stock--one mesaure of volatility--exceeds 2.00).
Two unrelated businesses will become connected. If Twitter's performance declines, that increases banks' reliance on Tesla stock, which boosts the probability that banks could seize and sell down substantial holdings.
The deal still comes down to what are Musk and team purchasing: The brand? Expected growth? Growth spurred by a novel strategy? An ability to manage unexplained costs? Access to Twitter accounts? Operating cash flows?
The company's core business revolves around generating advertising revenue. That business grew 41% last year, yet (a) the company still reported losses after expenses, (b) it generated negative operating cash flow after investments and capital expenditures and (c) it encounters fierce competition from the other digital-advertising behemoths (Facebook, Google, e.g.).
A balance sheet with debt that required it to pay only $51 million in interest expense will transform into one where interest costs (above $400 milion?) could carve out as much as half of operating cash flow.
The media have focused on Musk caring less about the deal's financials (the revenue streams, growth rates, expenses, debt levels and cash flow) and more on Musk's agenda to use Twitter as a platform for non-financial strategies (unrestricted free speech, e.g.). Notwithstanding the non-financial objectives, investors (lenders, bond-holders, and private-equity funds) seek performance to service the debt or to build value.
The excess leverage on the new balance sheet (consolidated) requires cash flow and won't tolerate periods of reinvention or business-model remodeling. So while Musk tends to the non-financial goals, the new organization must tend to conventional leveraged-buyout mandates: cost-cutting, cost-savings (via labor layoffs), operational efficiencies, core revenue growth, quarterly interest payments, and long strategy sessions to come up with ideas to generate consistent cash flow today.
Tracy Williams
See also:
CFN: Twitter's Turn to Do an IPO, 2013
CFN: Facebook's IPO: What Went Wrong? 2012
CFN: Evaluating Debt Ratios, 2015
CFN: Will Yahoo Ever Rebound? 2015
CFN: Analysis of Corporate Debt, 2021
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