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Long/Short Investments in L/S Equity: Valuation and Ideas,

Google Probably Still Best Positioned for Twitter Purchase

 Evaluating Accretion/Dilution in a Potential Twitter M&A Deal

Rumors have swirled for years about Twitter (TWTR) possibly being acquired given its position on the social media popularity scale. In terms of outright financial factors, Twitter is cheap relative to where it’s been in the past. The stock’s 52-week high sits at 36.75 and into the weekend traded at 18.08, or less than 50% lower. Twitter’s user growth has also been stalling over the past 5-6 quarters, which might suggest it’s running out of steam on its own, and sets the stage for an acquisition. It could be logically reasoned that four main companies would be realistic players in getting a deal done – namely, large cap tech giants who could use Twitter as a means for business diversification or to diversify its existing social media holdings.

Like many, I consider there to be four main “frontrunners”: Apple (AAPL), Google (GOOG, GOOGL), Facebook (FB), and Microsoft (MSFT). Apple has little presence into social media, Google has its Google+ network and YouTube, Facebook has its flagship platform and Instagram, and Microsoft recently made a high-profile acquisition of LinkedIn (LNKD) to pair with its business products.

This post will be dedicated to looking at which firm would see the best results from a pro forma earnings per share (EPS) standpoint. That is, what firm would see its EPS rise the most as a percentage?

I ran this same exact analysis last year as of the market close on August 10, 2015. Google made the most sense last year from a pro forma EPS and business standpoint and I personally would like to assess the results again this year. Apple, in particular, has always been known for its high cash balance, which always helps when it comes to purchasing something, but its financial performance has cooled off in the past year. But the other companies have plenty in cash reserves as well.

To keep things constant, each of the four hypothetical deals would occur under the same compensation structure, either 100% cash or 100% stock. The main goal is to assess accretion/dilution impact (i.e., whether it raises or lowers EPS), and this can be assessed by looking at matters from opposite sides of the spectrum. All-cash deals will be most accretive. All-stock deals will be least accretive to EPS given that new shares need to be issued in the transaction, thereby diluting existing shareholders. Combination cash/stock deals will land somewhere in the middle.

I’m also ignoring financing costs for mergers and acquisitions advising and synergies that aren’t immediately calculable. I will also assume a 40% premium is paid to acquire Twitter (i.e., Twitter will be paid 140% of its value to be acquired).

All company financial metrics will be taken as of the official market close on July 15, 2015. Net income and EPS figures will be based on the cumulative totals of the prior four reported quarters. Therefore, P/E ratios listed will be based on trailing twelve months income. Twitter's P/E is forward-looking but is irrelevant for purposes of the analysis.

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Apple acquires Twitter in a 100% Cash Transaction

Apple currently has the following financial characteristics:

  • Share price = $98.78
  • Shares outstanding = 5.48 billion
  • Market capitalization = $541.06 billion
  • Net income = $50.68 billion
  • Earnings per share (EPS) = $9.25
  • P/E = 10.7

Twitter’sprofile appears as follows:

  • Share price = $18.08
  • Shares outstanding = 694.85 million
  • Market capitalization = $12.56 billion
  • Net income = -$438.32 million
  • Earnings per share (EPS) = -$0.98
  • P/E = 27.4

If Apple is paying a 40% premium for Twitter, then the price it would be willing to pay for one share would be:

$18.08 * 1.40 = $25.31 per share

It would pay that share price for all of Twitter’s shares – 694.85 million – for a total price of:

$25.31/share * 694.85 shares = $17.587 billion

To find the pro forma EPS, it would be as simple as adding together their net incomes and dividing by the number of outstanding shares of Apple, as all Twitter shares were swept off the market in the cash transactions. Given Apple is taking control of Twitter, we use the former’s share count:

[$50.68 billion + (-$438.32 million)] / 5.48 billion shares = $9.17 EPS

We can calculate the new stock price of the company by multiplying its current P/E ratio by the new EPS estimate. The new stock price of Apple would therefore be $98.12 (10.7 * $9.17).

Even in an all-cash deal, the associated earnings accretion of this deal is quite small. It represents a $0.08 decrease over the original $9.25 EPS, or 0.9% dilutive. The increase is naturally small due to Twitter’s negative net income.

As we can imagine, as soon as stock is placed into this deal, this would be dilutive with such small-percentage accretion in the all-cash deal.

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Apple acquires Twitter in a 100% Stock Transaction

We calculated Apple’s purchase price of Twitter’s stock to be $25.31 per share. Now we must compute a stock-for-stock exchange ratio to determine how many shares will need to be issued as part of the transaction. This step separates the basic math of an all-cash deal from one of an all-stock deal, due to the fact that new shares must be issued as part of the transaction. We do this by taking Twitter’s new stock price and dividing it by Apple’s current stock price:

$18.08 / $98.78 = 0.183

As of last year, this ratio was all the way up at .345 assuming the same 40% takeover premium. This means that a stock for stock deal would be better (i.e., more accretive) for Apple this time around given the cheapness of Twitter’s stock relative to its price point at this time last year.

We then take this figure and multiply it by the number of shares of Twitter to determine the number of new shares issued:

0.183 * 694.85 million shares = 127.18 million shares

We then add these shares to the number of pre-deal shares of the acquirer (Apple):

127.18 million + 5.48 billion = 5.607 billion

We then sum the two companies’ net incomes and divide by the share total, as we do in an all-cash deal:

[$50.68 billion + (-$438.32 million)] / 5.607 billion shares = $8.96 EPS

The new stock price of Apple in this case would be $95.87 (10.7 * $8.96).

This provides one example where the pro forma EPS can actually go from accretive to dilutive based on the initial math in the transaction based on the difference in compensation structure. The deal goes from being $0.08 or 0.9% accretive initially in an all-cash transaction to $0.29 or 3.1% dilutive in an all-stock transaction.

If Apple were to sell this deal at all to its shareholders, it would need to very likely bank on an all-cash $27.737 billion deal to at least have some level of accretion to begin with. And this way, its shareholders would also own 100% of Twitter. In an all-stock deal, Apple would own (1 – 127.18 million / 5.607 billion) = 97.7% of itself, whereas Twitter shareholders would own 2.3% of Apple due to the shares transfer.

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Google acquires Twitter in a 100% Cash Transaction

Google had the following financial characteristics:

  • Share price = $719.95
  • Shares outstanding = 687.32 million
  • Market capitalization = $494.77 billion
  • Net income = $17.04 billion
  • Earnings per share (EPS) = $24.58
  • P/E = 29.3

Twitter’s financials:

  • Share price = $18.08
  • Shares outstanding = 694.85 million
  • Market capitalization = $12.56 billion
  • Net income = -$438.32 million
  • Earnings per share (EPS) = -$0.98
  • P/E = 27.4

As we established earlier, the price of one Twitter share is equal to $25.31 due to the 40% premium paid on its current trading price of $18.08.

We can go ahead and add the net incomes of Google and Twitter and divide by the number of shares of Google outstanding given no additional shares are being distributed in the transaction:

[$17.04 billion + (-$438.32 million)] / 687.32 million shares = $24.15 EPS

The all-cash deal provides an 1.8% dilution rate (1 – $24.58 / $24.15).The new stock price of Google would be $707.60 (29.3 * $24.15).

From the initial standpoint of accretion/dilution math, it’s a much better deal out of the gate for Apple than Google overall. Of course in an all-cash deal, the company would own 100% of Twitter as the company was fully integrated within its stock price.

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Google acquires Twitter in a 100% Stock Transaction

First we need to find the stock-exchange ratio (new target company stock price divided by current acquirer stock price):

$25.31 / $719.95 = 0.0352

That means we’ll be issuing out a number of shares determined by the product of the stock-exchange ratio and the number of target company shares (Twitter):

0.0352 * 694.85 million shares = 24.43 million shares

The number of new shares of Google and Twitter as a combined company would be equal to the pre-existing number of Google shares added to the number found above:

687.32 million shares + 24.43 million shares = 711.75 million shares

Now with the new total share count, we can assess the pro forma EPS:

($17.04 billion + -$438.32 million) / 711.75 million shares = $23.33 EPS

An all-stock transaction would therefore represent a 5.1% rate of dilution (1 – $23.33 / $24.58) versus the 1.8% dilution through an all-cash transaction.The new share price of Google in an all-stock deal would be $696.63 (29.86 * $23.33).

In the all-stock transaction, Google shareholders would own 96.6% of Google (687.32 million shares / 711.75 million shares), while Twitter shareholders would receive the other 3.4%.

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Facebook acquires Twitter in a 100% Cash Transaction

Of all the deals, this is perhaps the most interesting of the four, given it makes the most business sense in terms of the social media theme. However, it doesn’t make the most sense in terms of direct competition as Facebook and Twitter aren’t overlapping social media platforms that might take away from the other, as Facebook and MySpace might be. With that said, let’s compare the transaction from an all-cash and all-stock perspective.

Facebookhad the following financial characteristics:

  • Share price = $116.86
  • Shares outstanding = 2.31 billion
  • Market capitalization = $334.26 billion
  • Net income = $4.69 billion
  • Earnings per share (EPS) = $2.03
  • P/E = 57.6

Twitter’s financials:

  • Share price = $18.08
  • Shares outstanding = 694.85 million
  • Market capitalization = $12.56 billion
  • Net income = -$438.32 million
  • Earnings per share (EPS) = -$0.98
  • P/E = 27.4

At 40% premium, Facebook would pay $25.31 for each share of Twitter.

We can directly calculate pro forma EPS by adding net income and dividing by the number of shares of the acquirer:

[$4.69 billion + (-$438.32 million)] / 2.31 billion shares = $1.84 EPS

This transaction would be9.4% dilutiveoff the bat for Facebook given Twitter’s negative net income has enough pull on Facebook’s small net income (relative to Apple and Google) to result in a dilutive transaction. This would accordingly decrease Facebook’s stock to $105.98 (57.6 * 1.84).

This transaction would not work for Facebook at face value and would be a very tough sell to its shareholders, especially as the stock would take an immediate 9% slide out of the gate. As is the common observation, stocks of acquirers usually go down in value after the news of a purchase is released anyway due to skepticism over the potential realization of synergy in the deal. With that said, let’s look at an all-stock transaction anyway.

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Facebook acquires Twitter in a 100% Stock Transaction

First we need the stock-exchange ratio, or the new Twitter stock price over Facebook’s current trading price:

$25.31 / $116.86 = 0.217

As of last August, this ratio was all the way up at .44, with Twitter trading above $29 and Facebook still at $94.

We then use the stock-exchange ratio to calculate the number of new shares distributed in the deal by multiplying it by the target company’s outstanding share count:

0.217 * 694.85 million shares = 150.49 million shares

We can then add together the number of original shares of Facebook to this newly distributed total:

2.31 billion shares + 150.49 million shares = 2.46 billion shares

We can then use that figure in the denominator when calculating pro forma EPS with combined net income supplying the numerator:

[$4.69 billion + (-$438.32 million)] / 2.46 billion shares = $1.73 EPS

This is 14.8% dilutive and would provide a new stock price of $99.65 (57.6 * $1.73). In terms of ownership percentage, Facebook shareholders would continue to own 93.9% of the company (2.31 billion shares / 2.46 billion shares), while Twitter shareholders would own 6.1% of Facebook.

This would be an impossible sell to Facebook shareholders so a Twitter acquisition would make practically zero sense at this point both in terms of pro forma impact and in terms of business due to Facebook’s lack of direct competition from Twitter.

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Microsoft acquires Twitter in a 100% Cash Transaction

Lastly, we have Microsoft. Apple is in the lead mathematically, so let’s see what kind of financial sense it might make for Microsoft in terms of the raw numbers.

Microsoft had the following financial characteristics:

  • Share price = $53.70
  • Shares outstanding = 7.86 billion
  • Market capitalization = $422.11 billion
  • Net income = $10.48 billion
  • Earnings per share (EPS) = $1.33
  • P/E = 40.3

Twitter’s financials:

  • Share price = $18.08
  • Shares outstanding = 694.85 million
  • Market capitalization = $12.56 billion
  • Net income = -$438.32 million
  • Earnings per share (EPS) = -$0.98
  • P/E = 27.4

Twitter, as the same, would obtain a share price of $25.31 at 40% premium. We calculate pro forma EPS by adding net incomes and dividing by Microsoft’s shares outstanding:

[$10.48 billion + (-$438.32 million)] / 7.86 billion shares = $1.28 EPS

This puts the deal at 3.8% dilutive for Microsoft.

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Microsoft acquires Twitter in a 100% Stock Transaction

As usual, we find the stock-exchange ratio by taking the target company’s new price (i.e., premium included) and dividing by the acquiring company’s current price:

$25.31 / $53.70 = 0.471

This type of transaction would be more viable for Microsoft than it was last year, when this ratio totaled a ratio of .944 due to the expensiveness of Twitter’s stock and the cheapness of Microsoft’s, which was over 20% lower relative to where it is now. We can then take the stock-exchange ratio and multiply by the number of shares of the target company (Twitter) currently outstanding:

0.471 * 694.85 million = 327.27 million

By comparison, last year 634 million shares would have needed to have been distributed, causing a greater amount of dilution.

Our total new share count is then:

7.86 billion + 327.27 million = 8.19 billion

We then add our net incomes and divide by the sum of Microsoft’s share count and the new share count to obtain pro forma EPS:

[$10.86 billion + (-$438.32 million)] / 8.19 billion shares = $1.27 EPS

This is 4.5% dilutive (1 – $1.27 / $1.33). The new stock price of Microsoft would be $51.18 (40.3 * 1.27 EPS).

Microsoft shareholders would own 96.0% of Microsoft (7.86 billion shares / 8.19 billion shares), while ceding the other 4.0% to Twitter shareholders as part of the stock distribution.

Like Facebook, the accretion/dilution math doesn't work out the best although an immediate ~4% dilution is much better than ~10%. And, as aforementioned, Microsoft would likely have the least use for Twitter from a business perspective. The LinkedIn integration makes some level of sense due to potential synergies between their Microsoft Office products, which are inherently business-oriented, but Twitter wouldn’t seem to mesh best with Microsoft’s business among the candidates considered in this write-up.

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Conclusion

We can sum up the four main candidates’ hopes of having the ability and business benefit in acquiring Twitter as follows:

Apple – 0.9% dilutive in an all-cash deal; 3.1% dilutive in an all-stock deal. Apple had a $55.3 billion cash (and cash equivalents) balance as of March 31, 2016. It would cost approximately $17.6 billion to acquire Twitter using its current stock price and the assumption of a 40% takeout premium. Therefore, this is a deal that Apple could realistically pursue. But management would need to ask itself whether it was serious about making a foray into social media. Of the other three candidates, it’s shown the least amount of interest.

Google – 1.8% dilutive in an all-cash deal; 5.1% dilutive in an all-stock deal. Out of the gate, mathematically it loses out to Apple in terms of the accretion/dilution math. It does have a better social media infrastructure already set up with YouTube and its flagship platform Google+, so there is some immediate cross-synergy potential. It also had a cash and equivalents balance of $75.3 billion as of the end of Q1 2016. A Twitter acquisition could possibly consume less than one-quarter of that.

Facebook – 9.4% dilutive in an all-cash deal; 14.8% dilutive in an all-stock deal. Facebook is the market leader in social media, but it may not have any direct interest in acquiring Twitter due to the lack of meaningful direct competition with its own platforms. The company had a $20.6 billion cash balance at the end of the first quarter.

Microsoft – 3.8% dilutive in an all-cash deal; 4.5% dilutive in an all-stock deal. The tight spread between these figures is a consequence of Microsoft’s very high share count (close to 8 billion; the other companies are only in the hundreds of millions). Even if Microsoft had to issue shares as part of the transaction, it would not dilute significantly due to the issuance of a very small number of shares relative to its pre-existing total. Microsoft has a cash and equivalents balance of $105.6 billion and could fully be willing to finance it using its own money. But as noted above, I don’t believe it makes a ton of sense for Microsoft from a business angle.

So who’s the best choice, or “the winner”?

As one might infer, in terms of probability based on finances and the general accretion/dilution arithmetic, I would rank the four accordingly if there ever hypothetically was a so-called Twitter sweepstakes:

  1. Apple
  2. Google
  3. Microsoft
  4. Facebook

In terms of business sense, I would rank them as follows:

  1. Google
  2. Facebook
  3. Microsoft
  4. Apple

By this logic and combining the two criteria, if a first-place vote was worth four points, a second-place vote three points, third-place two, and fourth-place one, the final standings would go as:

  • Google – 7
  • Apple – 5
  • Microsoft – 4
  • Facebook – 4

For those who favor Facebook due to its potential to have ownership of Instagram, Twitter, and its own flagship platform, shareholders would not at all be happy with an instant 10% drop in stock price. Accordingly, it finishes at the bottom along with Microsoft.

The deal would NOT be easy to do with the addition of debt, as all of these companies, with the exclusion of Apple, trade at very high P/E ratios. The debt in an M&A transaction is accretive so long as the interest rate stays below the after-tax earnings-to-price ratio (i.e., inverse of the P/E ratio).

Facebook, for example, trades at a 57.6 P/E currently using the formula {current stock price / (TTM net income / shares outstanding)}. That gives an inverse P/E ratio of 1.7%. Assuming 25% tax, the debt used in this transaction would need to be priced below 1.3%, which isn’t happening.

Apple’s inverse P/E, by contrast, stands at 9.3%. Assuming 25% tax, so long as the debt is priced below 7% interest the deal would be accretive going the debt route. That might be an additional positive for Apple, although like Facebook and Google, the company is fairly debt allergic.

Nonetheless, it may not even be feasible to expect Twitter to consider selling itself at around just $17.6 billion even in light of its stalling user growth. It may still feel confident of its future prospects to grow its stock price and consequently hold off on any low-ball vulture offers that might come its way as a result of this past year’s tribulations. Twitter might, as a result, value itself significantly higher in terms of premium considering the $25.31 share price (40% built-in premium) is over 30% lower than its 52-week high of $36.75.