- Twitter’s shares have revalued 36% higher since Elon Musk announced in July that he didn’t want to buy Twitter anymore.
- Revaluation gains are entirely unjustified and indicate misplaced optimism regarding a potential closure of the merger deal.
- Shares of Twitter are overvalued again.
After Elon Musk announced that he was backing out of the proposed $44B deal to acquire social media company Twitter, Inc. ( TWTR ), the stock initially dropped heavily. However, in recent weeks, Twitter stock has developed some new momentum which has driven the share price back to where it was in May. Since Twitter in the meantime also submitted its Q2'22 earnings card , which continued to show weakening fundamentals, the recovery may be an opportunity to sell Twitter stock into the strength!
Twitter's share price recovery fundamentally unjustified
I was previously bullish on Twitter, in large part because the company was growing its number of users consistently. Moderate average daily user growth and a strong rebound in advertising revenues in FY 2021 indicated to me that Twitter faced improving prospects for free cash flow growth as well. Then came Elon Musk. The billionaire's acquisition offer valued Twitter at $44B. The ensuing debate over Twitter's bot accounts, however, changed the risk analysis for me profoundly.
While Elon Musk has tried to back out of the deal due to growing concerns over the actual number of bot accounts on the Twitter platform, the social media company's lawyers insist that the deal will be completed based on the agreed-upon merger agreement. After the take-over offer was submitted, I recommended investors to sell the news and secure what was left of the deal premium at the time.
However, in recent weeks, optimism has returned to the Twitter trade and the stock has moved up to $44.26, showing a nearly 36% gain since July 11 which is when Elon Musk spoke out against the acquisition of Twitter.
I believe there is no fundamental reason for the upside revaluation in recent weeks since the likelihood of the deal closing has not improved and Twitter's Q2'22 results, which were released in the meantime, showed that macroeconomic headwinds are starting to affect the social media business.
Weakening business fundamentals in Q2'22 indicate a struggling advertising business
While Twitter's second-quarter average monetizable daily active users increased 16.6% year over year to 237.8M, the social media company's revenues actually declined 1% year over year to $1.18B due to persistent headwinds in the macro environment and deal uncertainty that caused advertisers to take a more cautious approach to ad campaign spending. Meta Platforms ( META ), Snap ( SNAP ) and to some extent even Alphabet ( GOOG , GOOGL ) experienced the same topline headwinds in the second quarter, so they are not unique to the Twitter platform.
What was concerning to me was that Twitter's profitability regarding free cash flow nosedived in Q2'22 and the social media company has so far reported negative free cash flow of $158.6M for the current fiscal year. And I don't expect Twitter to generate positive free cash flow in this environment in the short term either which could start to weigh on Twitter's valuation. The social media company's cash flow margins have also turned negative in FY 2022, indicating profound profitability challenges to which Twitter has not yet found a solution.
$ in 000's | FY 2019 | FY 2020 | FY 2021 | Q1'22 | Q2'22 |
Revenues | $3,459,329 | $3,716,349 | $5,077,482 | $1,200,984 | $1,176,660 |
Cash Flow From Operating Activities | $1,303,364 | $992,870 | $632,689 | $126,091 | $29,696 |
Purchases of PPE | -$534,530 | -$864,184 | -$1,003,084 | -$160,692 | -$153,646 |
Free Cash Flow | $768,834 | $128,686 | -$370,395 | -$34,601 | -$123,950 |
Free Cash Flow Margin | 22.2% | 3.5% | -7.3% | -2.9% | -10.5% |
(Source: Author)
Twitter is expensive again
Twitter's 36% upside revaluation has made the social media company, despite weakening fundamentals, significantly more expensive over the last month. I believe that Twitter - given the difficult advertising market, topline challenges, negative free cash flow margins and merger deal risks - is fundamentally overvalued with a P-S ratio of 5.4 X.
Twitter's revenue estimates have also started to fall...
Risks with Twitter
From a commercial perspective, the biggest risks for Twitter are eroding platform metrics: slowing daily active user growth, a weakening advertising business potentially affected by smaller ad budgets during a recession and negative free cash flow are all specific and significant risk factors for Twitter. Additionally, Twitter is at risk of having to make new disclosures about the number of bot accounts on its platform, which could not only serve to help Elon Musk's case for deal termination, but they could also repel advertisers and lead to lower engagement on the platform as a whole.
Final thoughts
Twitter's fundamentals in Q2'22 have not improved so much as to justify the significant upwards revaluation of Twitter's shares that we have seen over the last month. Likely, some investors are speculating on U.S. courts compelling Elon Musk to complete the merger deal despite Twitter's Q2'22 indicating a struggling marketing business and the bot controversy remaining unresolved. If court proceedings revealed that Twitter indeed understated its bot count, it would not only help Elon Musk terminate the deal for good but likely also hurt the integrity of the Twitter platform in the long term. Because of the unjustified upwards revaluation, Twitter stock is a sell again!
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Twitter Stock Is A Sell Again