Financial analysis: Why Musk's Twitter purchase is such a disaster

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Twitter still made a billion dollars in revenue in the fourth quarter of 2022, The Information reports, citing insiders. Considering the destructiveness with which Elon Musk is taking his social network to task, that is a considerable chunk of money. However, it is also a good third less revenue than in the fourth quarter of the prior year. Back then, Twitter set its revenue record of $1.57 billion in three months.

There is no talk of that now. According to the source, the current daily turnover is 40 percent below the previous year's result. More than 500 of the most important advertisers have stopped their ads on Twitter, at least for the time being, since Elon Musk took over Twitter. As for the major automakers, Musk had to anticipate this: The corporations have no desire to throw their own money at the largest shareholder of Tesla, the most valuable car company according to stock market valuation, as long as they can achieve comparable advertising effects at similar prices elsewhere.

As for the other pausing advertisers, their withdrawal is the result of Musk's decisions. He fired those responsible for security on the platform, abolished the advisory board and promised a new one, but then admitted that this promise was a lie.

Of course you may do that, as a private owner. But not if you want to boost advertising sales. Customers seek Disney-like feel-good environments; seeing their baby milk powder or holiday cruise advertised next to calls for violence or conspiracy narratives rarely makes them reach for their wallets.

New Loans Crush Twitter

If Twitter were just a playground for a few super-rich people like Elon Musk and co-investors like Larry Ellison and al-Walid ibn Talal Al Saud, it wouldn't matter financially. However, the gentlemen have only financed part of the huge takeover price of 44 billion U.S. dollars (plus a few billion in expenses) themselves. At least $13 billion came from loans - and these loans were not taken out by the new owners, but by Twitter, Inc. itself.

Sounds like the company is pulling itself out of the mire by its own shoelaces, but the setup is not at all unusual in the world of finance. Of course, this means that the company will have to service this mountain of debt going forward. In Twitter's case, that translates to interest of about $1.5 billion this year (or more if interest rates continue to rise, which is widely expected), according to the Financial Times. That is only interest and does not include repayment installments.

The problem: Twitter can't afford it. Twitter couldn't have afforded it even before the sales slump. "Yes," is heard over and over again, "But Twitter was already losing money before Musk. 221 million dollars in 2021!" So Twitter was doomed financially anyway, Musk fans in particular think. If their idol might not be able to save the bird after all, he would at most have accelerated its swan song, but at least he would have tried to save it.

The "Net Loss" Misunderstanding

It is fundamental misunderstandings of accounting principles that tempt such views. While it is technically correct that Twitter reported $221 million in net loss for 2021, that is only true on paper; in no way does it mean that Twitter spent $221 million more than it took in. The net loss is relatively unimportant for the company's continued existence in the medium term.

To be able to pay interest and other expenses, you need money. You have to be "liquid". Liquidity is measured in terms of cash flow. To put it simply, expenses are deducted from income. Income can come from actual operations, from "investments" (at Twitter and many other data companies, speculation with securities, but also proceeds from the sale of capital goods), and from loans or the sale of new shares. If we consider only the income from operations, we call it operating cash flow.

10 Years of Operating Cash Flow

And this operating cash flow has been positive for Twitter every year since 2013. So Twitter's operations have made more money than they've cost, year in, year out. True, the amounts were nowhere near as staggering as at Facebook/Meta Platforms, Google/Alphabet, and some other data conglomerates; but Twitter was not a doomed Titanic. The company could even afford to buy back a chunk of its own shares.

Question: So how come Twitter has had to report net losses on a regular basis? Answer: Securities. More precisely: Twitter shares. The company paid its employees only partly in cash, and partly in shares or stock options. Twitter simply printed the corresponding shares. This is an accepted and widespread method in the U.S. tech industry.

The financial advantage for the company is obvious: it has to spend less of its own money to compensate its workforce. At the same time - so the hope - shares and stock options spur employees to apply themselves at work in such a way that the share price rises as much as possible. At the same time - in the U.S. tax system - income taxes but no social security contributions are due on certain options granted. In addition, there may be tax advantages depending on the setup of the scheme and share price development.

The disadvantage for employees is the uncertain future value of the securities, for social security and government coffers their lower revenues, and for existing shareholders the fact that their shares represent a smaller share in the company each year because the company is constantly printing new shares. Unless there are share buyback programs or other special measures. But as long as shareholders support such employee stock programs, everything is legally fine. (Moreover, stock programs could be used to enforce employee non-compete agreements, which are illegal under some state's employment laws. That Twitter would have availed itself ot his loophole has not come to the author's attention).

Net Loss is not Cash Flow

For accounting purposes (under Generally Accepted Accounting Principles, GAAP), new securities awarded to employees as compensation are considered an expense and are recorded accordingly, thus reducing profit. At Twitter, this has meant that, on paper, except for 2018 and 2019, there have always been net losses. But these losses have not had the same impact on the company's cash position. After all, cash flow has been positive for the last ten years. As a result of the securities allocations, wealth has not moved from Twitter's coffers to its employees, but from the owners (shareholders) to the employees. And as long as the shareholders approved it, that could have continued.

Suddenly, however, everything is different. Musk and his equally financially powerful backers didn't just secure a majority stake in the company, they bought out all existing shares and delisted Twitter's shares. The purchase price of $54.20 per share was 38 percent higher than the price on April 1, 2022, the last trading day before Musk announced he had become Twitter's largest shareholder.

The subsequent overall takeover was financed, among other things, by a $13 billion loan package taken out in Twitter's name. And Twitter now has to pay interest on this, in real money. But while Twitter had positive operating cash flow before the acquisition, it didn't have enough for that. Musk's eviction of customers and firing of sales staff didn't exactly help.

Takeover Causes Salary Costs to Rise

In addition, employees must now be paid in real money in their entirety. On the one hand, Twitter must pay out certain stock options due to the fired employees at the price of $54.20 each. At the same time, the remaining employees continue to acquire stock options, and Twitter must also redeem them at the fixed unit price. This is no surprise either; Musk committed to this in the purchase agreement.

Even the old Twitter would not have been happy with the higher cash salaries. In 2021, the securities awards to employees amounted to $630 million, pretty much the amount of operating cash flow ($633 million after $766 million in shareholder class action settlement net costs) and, by order of magnitude, three times the net loss ($221 million). The cash settlements of the securities awards required now weigh particularly heavy on Twitter's finances, not least because Musk has driven away so many advertisers.

Acts of Desperation at the Expense of Others

Which leads to the question of where the money for the interest payments is supposed to come from, and explains Musk's panic. The man is trying to keep money in the company's coffers by any means necessary. Even if that means breaking existing contracts and legal obligations. The wheels of justice grind slowly, after all. Obviously, the multi-billionaire can live with the fact that his brute force method also affects families who don't have it easy.

Even at its headquarters in San Francisco, Twitter now owes millions in rent. Courts there and in several other cities, therefore, have extra work. How well regulators around the world can live with the fact that Twitter has fired those employees who ensured compliance with legal obligations remains to be seen.

Musk's attempt in December to get his co-investors to pump fresh money into Twitter was oblique. The "offer": they could subscribe to new shares at the known buyout price of $54.20. Because those are new shares, they would reduce the per-share securitized company stake of all shares - so a per-share price that stayed the same meant a price increase. Musk's offer seemed absurd; the bird was already in freefall, and Musk himself had spoken of a possible bankruptcy.

Musk had to Pay a High Price

One of Musk's co-investors was investment bank Fidelity Investments (or rather its clients). Fidelity realized their mistake back in November and wrote off 56 percent of its new Twitter investment. So it's truly no surprise that there was no run on Musk's offer of new shares at $54.20 in December.

The buyout price was well above the company's value from the start. However, Musk had to bid well above the stock market price, otherwise Twitter's supervisory board would have sought to prevent the hostile takeover. Musks calculation (if any) could still have worked out, by cutting costs and significantly increasing sales. Musk has, however, failed to achieve the latter.

According to an estimate by market watcher Pathmatics, 14 of Twitter's top 30 customers have stopped buying ads altogether since Musk's acquisition, while four others have reduced their buying by 92 to 99 percent. Only six of the top 30 have spent more, Pathmatics believes, including Apple and Amazon - but Amazon told Reuters that was incorrect.

What's Next for Twitter

Normally, the lending bank consortium - led by the financial institutions Morgan Stanley, Bank of America, Barclays and Mitsubishi - would sell on the Twitter loans to other investors. Of course, that's not possible in this case, at least not without significant losses, so the banks are left sitting on the credit risk for now.

Musk is trying to boost sales with unprecedented discounts on advertising rates and the reintroduction of political ads. That certainly helps a bit, and explains how Twitter still managed more than a billion dollars in quarterly revenue. (The first third of the year-end quarter was before the acquisition, note). The hefty discount, however, sets a price anchor that could depress advertising prices on the social network in the long run.

At the same time, Musk rents out the once coveted blue checkmarks for "verified" Twitter accounts. Musk even takes the eight dollars per month from Taliban leaders, allowing them to adorn themselves with the tick and reach more Twitter users. This "revenue stream" is primarily an entertainment offering that keeps Twitter talking. Financially, this revenue is nothing more than the proverbial drop in the bucket. They have no significance for Twitter's battle for financial survival.

Musk's Options

This battle has not been decided. Twitter still has hundreds of millions of dollars in cash reserves that are yielding interest. The company could sell that future interest at a discount to raise money in the short term to pay an interest installment. While that would deepen the financial trouble later on, it would provide some breathing room.

Musk could again try to raise fresh money by selling new shares. In doing so, he would have to set a significantly lower price and probably accept that the new co-owners would have a say in how to run Twitter. That is likely to be difficult for him.

Another option would be to renegotiate the loans; perhaps the banking syndicate will take fresh Twitter stock instead of cash? Unfortunately for the banks, Musk is not personally liable for the Twitter debt. But perhaps he would be willing to take on liability? The banks would probably lower the interest rate if Musk offered his Tesla shares as collateral.

The leeway is not infinite, but it is sufficient: Musk has already pledged over 60 percent of his Tesla shares for other debts, not least for tax reasons (but that's another story). And Tesla's regulations state that Tesla executives may only pledge their shares for a quarter of their value. So for every billion in guarantees, Musk would have to deposit four billion worth of Tesla stock. At the current Tesla share price, Musk still has plenty of Tesla shares, even though he recently sold shares worth several billion dollars.

Debt Gambit for Billionaires

For any owner of a small or medium-sized company, the situation at Twitter would be devastating. But a multi-billionaire could even capitalize on such a disaster: Mr. Musk himself could (possibly with the help of his business friends) offer to pay off the loans granted to Twitter at a discounted price. Then Twitter would have debts to Musk & Co themselves, instead of to pesky banks. For the banks, this would probably be more attractive than a lengthy bankruptcy procedure.

However, Musk would also have to sell or at least pledge Tesla shares for this. This could depress the Tesla share price, which could again lead to so-called margin calls: Musk, after all, already has extensive debt that is secured by Tesla stock. If these shares fall below a certain price, they are automatically sold to cover the loans.

Maximum Punishment for Musk

Elon Musk probably still has a few million options to purchase Tesla shares at a fraction of the stock market price. However, if he exercises these options, he will immediately have to pay ~40 percent tax on the difference between the purchase price and the stock market price, which will, then force him to sell shares. Yet the man would so much like to remain Tesla's strong man.

Whatever the financial outcome of the Twitter takeover, Elon Musk does not have to worry about his private financial situation at the moment. But his reputation as a business genius is gone. And that is probably the most severe punishment for Elon.

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