FORTUNE -- 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.
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.
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.
Twitter made a ton of money from its IPO, but its bankers got the better deal.
FORTUNE -- Twitter began trading this morning at $45.10 per share, after pricing its IPO last night at $26 per share. Or, put another way, Twitter (TWTR) left more than $1.3 billion on the table. Or, put even another way, more than twice what the company will generate in revenue this year.
To be sure, Twitter MOREDan Primack - Nov 7, 2013 11:09 AM ET
Twitter's investment bankers are telling their clients one thing while Main Street hears a different story.
FORTUNE -- Once again, Wall Street is telling its top-paying clients one thing, and the rest of us are getting a different story. This time it's the Twitter (TWTR) IPO.
According to the Wall Street Journal, analysts who work for Goldman Sachs (GS) and other banks on the IPO, which raised $1.8 billion, have been privately MOREStephen Gandel, senior editor - Nov 7, 2013 5:00 AM ET
Twitter prices 70 million shares at $26 each.
FORTUNE -- Twitter this evening raised $1.82 billion in its initial public offering, and tomorrow morning is expected to begin trading its shares on the New York Stock Exchange under ticker symbol TWTR.
The micro-messaging service price 70 million shares at $26 per share, which is higher than both its original $17-$20 price range and its recently-revised price range of $23-$25 per share. It MOREDan Primack - Nov 6, 2013 6:41 PM ET
Twitter's largest outside investor used a brilliantly simple way to avoid detection.
FORTUNE -- When Twitter (TWTR) unveiled its IPO registration last month, a lot of folks were stunned to learn that the company's two largest institutional owners weren't any of the venture capital firms known to have invested in the company. Instead, they were Michigan-based private equity firm Rizvi Traverse (17.9% stake) and entities affiliated with J.P. Morgan (10.3%). Both firms MOREDan Primack - Nov 6, 2013 9:57 AM ET
The king of limited media has an unlimited budget for research.
FORTUNE -- One of the long-time knocks on Twitter is that it doesn't do a very good job of innovating. Users came up with hashtags. TweetDeck was created by another company that Twitter had to buy. Twitter is reportedly considering shutting down a music site that it launched earlier this year. Go to Twitter.com and you will basically see the MOREStephen Gandel, senior editor - Oct 25, 2013 5:00 AM ET
The social media company uses estimates to determine some of its revenue.
FORTUNE -- Twitter changed and expanded the description of how it tallies sales from some of its advertising deals in its IPO filings.
The first version of its IPO filing, or S-1, which it confidentially filed to the SEC in July but did not initially release to the public, implied Twitter did not have a consistent policy to determine how MOREStephen Gandel, senior editor - Oct 14, 2013 9:16 AM ET
Why is Twitter using the same accounting tricks that have been criticized so many times before?
FORTUNE -- When it comes to its bottom line, Twitter would like potential investors to put on some heavily tinted rose-colored glasses.
In the registration statement for its upcoming IPO, which was filed on Thursday, Twitter said through the "eyes of management" the company had a profit of just over $21 million in the first six MOREStephen Gandel, senior editor - Oct 8, 2013 5:00 AM ET
No one wants to live through that again.
By Joshua Morgan Brown
FORTUNE -- If the modern financial media had been around in 1858, while Cyrus West Field was laying the first transatlantic telegraph cable under the ocean, we'd have been treated to hundreds of screeching headlines about the project's lack of immediate profitability -- rather than marveling at the instantaneous connection being established between two continents. I think there is MOREOct 7, 2013 11:03 AM ET
The social media darling's first substantive public filing paints a picture of a somewhat troubled and deeply unprofitable digital media company with lackluster growth and an exploding cost base.
By Cyrus Sanati
FORTUNE -- It now makes sense why Twitter initially filed its IPO in secret -- its books aren't pretty.
The social media darling's first substantive public filing paints a picture of a somewhat troubled and deeply unprofitable digital media company MOREOct 4, 2013 9:43 AM ET
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