Is Twitter Making a Mistake with a Higher IPO Price?



Twitter’s (NYSE:TWTR) initial public offering grows larger on the horizon every day. Sources familiar with the matter told Bloomberg that the underwriters — led by Goldman Sachs (NYSE:GS) — stopped taking orders at noon on Tuesday, and that a final price should be set on Wednesday. That price is now expected to fall in a range between $23 and $25 per share, up from a range between $17 and $20 per share that was floated earlier in October.

That Twitter is increasing the price of its offering is not necessarily surprising, but the move has helped fuel concerns among tech and Internet bubble watchers. At the top of the new range, Twitter would raise about $1.75 billion, have a market cap of around $13.6 billion, and trade at a forward (expected 2014) price-to-sales ratio of 11.8.

In a vacuum, this may not seem that abnormal, but no investment decision should be made in a vacuum. The key comparison floating through the ether is to Facebook (NASDAQ:FB), which trades at a forward P/S of about 11.4. This means that investors are willing to pay a little more for a dollar of Twitter sales than for a dollar of Facebook sales — but it’s not that much more, so what’s the big deal?

The big deal — or, at least, the deal (its size is yet to be determined) — is that where many people see a strong argument for Facebook’s P/S ratio, they do not see an equally strong argument for a comparable Twitter P/S ratio.

During the build-up to its IPO, Twitter management appeared eager to distance the company from the Facebook IPO in every way possible. The S-1 prospectus was initially filed confidentially, and the firm valued itself modestly. Twitter wanted to curb speculation and hype from the onset and thereby hopefully curb post-IPO price volatility. As ZT Wealth chief economist and strategist Max Wolff said to Bloomberg: “A tech IPO like Twitter with no profit is an emotional event, not a fundamental event. Above $26, I think this thing starts to look a little dicey.”

The expectation is, of course, that Twitter stock will surge on its first trade on the New York Stock Exchange. One of the issues with a highly anticipated IPO like Twitter’s is that everybody wants a piece of pie, but there’s only so much to go around. Relatively few investors actually get allocated stock at the IPO price, while the rest are left to buy at whatever the market commands, and history has shown that highly hyped stocks like Twitter’s often go for enormous prices relative to actual earnings.

Data compiled by Forbes shows that of all the IPOs priced since September 12, 19 have returned over 20 percent, averaging a 69 percent gain over just a few weeks. On average, these stocks opened for trading on the day of their IPO at a price 49 percent higher than their IPO price and experienced about 9 percent further upside on average for the rest of the day.

That’s one hell of a pop. If the same thing happens to Twitter at the top of its IPO price, shares could close their first day of trading at $37 or more. This is obviously by no means guaranteed to happen, but if it did, Twitter would claim a totally out-of-whack valuation.

At the top of its IPO range, Twitter will be valued at about $17.4 billion. It will be interesting to see how the market moves this valuation following the IPO, but many market watchers — like Wolff — fear that movement will be driven more by emotion than fundamentals. Twitter’s growth potential does appear enormous, but it is still in a dubious position.

The company listed $64.6 million in the September quarter, a larger loss than a year ago, and the firm is not expected to become profitable until 2015. That is a long time to sit on a stock while it grows into a high valuation.

If you’re unfamiliar with Twitter’s business, here’s a (very brief) breakdown.

Twitter breaks its revenue down into two streams, advertising services and data licensing. For the year ended 2012, Twitter pulled in $316.9 million in revenue, $269.4 million of which (85 percent) was from advertising and $47.5 million of which (15 percent) was from data licensing. This is a very different mix from 2011, when Twitter pulled in $106.3 million in revenue, $77.7 million of which (73 percent) was from advertising and $28.6 million of which (27 percent) was from data licensing. In 2010, this mix was 26 percent advertising and 74 percent data licensing.

As Twitter’s user base increased and it fine-tuned its platform and built relationships with brands and businesses, ad revenue has exploded. Ad revenue grew 961 percent in 2011 to $77.7 million and by 247 percent in 2012 to $269.4 million. As of the third quarter, ad revenue was up 113 percent on the year at $121 million, or 87 percent of total revenue. This means that Twitter’s largest revenue stream is also growing the fastest.

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