The high cost of Twitter's IPO, the steep hill for investors

November 8, 2013: 12:52 PM ET

How much will Twitter have to make in profits to pay for the $1 billion it left on the table?

131107171439-twitter-ipo-620xaFORTUNE -- Twitter's debut as a public company stunningly illustrates that two of the most baffling customs in the investment business are back in full force. Both are hallmarks of frothy markets that typically retreat in tough times. The first is Wall Street's preferred IPO process that enriches the banks and institutional investors but penalizes their clients. That grip weakened with the botched Facebook (FB) offering in 2012. Now the banks are back in control, engineering one-day gains reminiscent of 2000 and 2001. Here we go again.

The second is investors' enthusiasm for glamorous tech offerings, resulting in gigantic opening valuations for newly minted companies. The math didn't work for most of the IPOs during the tech craze. Nor does it work well with Twitter (TWTR).

On the IPO, judging whether an offering is successful or not depends on the objective. If the goal is to generate buzz and kudos from analysts and TV anchors, then a huge pop may spell "success." The pop may enhance the brand and attract grateful institutional investors who pledge to remain loyal. If management takes the traditional view that an IPO should serve as a financing event in which the company raises the most money at the least cost, thereby maximizing its market value and capital for growth, then a soaring price on day one is far from desirable.

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Yesterday, Twitter garnered far less money than if its goal were to maximize cash in its coffers. In the process, it handed a windfall to both the investment bankers and their mainly institutional clients. Call the windfall the real "cost" of the IPO. Twitter's seven underwriters, a group that includes Morgan Stanley (MS), Goldman Sachs (GS), and Bank of America (BAC), sold 70 million shares at a fixed price of $26 prior to the stock's debut. Those sales raised $1.76 billion for Twitter, after the banks' fees of $59 million.

Twitter's shares soared in a terrible market yesterday, rising $18.74. Hence, investors made a gain of $1.325 billion. That's not the entire story. Twitter's offering statement discloses that the investment banks have the right to purchase 10.5 million shares at the offering price of $26. Assuming the underwriters exercised that fabulous option, those seven banks booked combined gains of $199 million yesterday. They also pocketed another $3 million in fees, bringing Wall Street's total take to $261 million.

In total, Twitter left $1.524 billion "on the table," the $1.325 billion from the original IPO allotment, and the $199 million on the second tranche awarded to the banks. All told, Twitter raised $2.03 billion ($1.76 tranche from the first tranche and $270 million from the Wall Street allotment). Hence, it paid around $1.5 billion to raise $2 billion, an effective fee of 75%. No wonder Wall Street never ceases to amaze.

So what's the chance that investors will profit handsomely from this celebrated IPO? Twitter's opening market value tells you nothing about how much money it will earn. But it provides a strict measure of what it has to earn. Since 2010, Twitter has booked combined losses of over $400 million. Its market cap now stands at almost $25 billion. Let's say investors demand a 10% annual return on what is clearly a risky investment. So by the end of 2020, Twitter would need a valuation of $50 billion to really reward yesterday's investors.

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Let's further assume that Twitter boasts a premium 25 price-to-earnings multiple in seven years. To get there, it would need net earnings of $2 billion a year. Then we'll forecast that after making that high hurdle, Twitter experiences a gradual decline in its multiple to a still formidable 18 five years later. Hence, by 2025, Twitter would need to earn $4 billion a year. Even assuming a 30% operating margin, its sales would have to rise to the $18 billion range.

It's impossible to predict if yesterday's investors were right. A few tech stars have indeed climbed hills that are even steeper. We do know that if Twitter had put the $1.35 billion into cash on its balance sheet rather than effectively spent it on the IPO, it would have a lot more money to spend on building its business (and its market cap would be over $1 billion higher).

Twitter is an exciting new company. Its IPO was conducted according to Wall Street's most prized traditions.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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