A Blog by Jonathan Low


Jul 13, 2018

Twitter's Comeback Is a Feel-Good Story That's Probably Wrong

It has more to do with financial market dynamics than operational performance. JL

Felix Salmon reports in Slate:

After Jack Dorsey came back, he laid off employees, cut back on stock-based compensation, and started running more video ads, to the point that video now accounts for more than half of the company’s ad revenue. Those moves put an end to Twitter’s quarterly losses and the erosion of its share price. (But) Twitter can be found on the list of most-shorted stocks. When a company has a large short interest that drives the stock upward. The higher the stock rises, the stronger that force becomes. The rise in Twitter’s price can be attributed to stock-market dynamics, as opposed to corporate fundamentals.
It’s the feel-good business story of the summer: “How Twitter Made The Tech World’s Most Unlikely Comeback,” as the headline of one much-praised BuzzFeed article put it. After being left for dead, eclipsed by younger upstarts like Snapchat and QZone, Twitter is currently resurgent, the narrative goes. Just look at its stock price!
Certainly a healthy stock price is great news for companies, and for Twitter more than most. For many years, Twitter was one of the companies spending the most money on stock-based compensation: In some quarters of 2014, the cost of the stock it was giving away to employees managed to exceed 50 percent of its entire revenue. The result was a vicious cycle in which Twitter would shovel out more and more stock options to retain its employees, those stock options would dilute existing shareholders, the share price would fall because of the dilution, miserable employees would find themselves underwater on their shareholdings, and the company would have to grant them even more options, at even lower strike prices, in order to keep their total package competitive.
The dynamic was so ingrained, and so predictable, that investors figured out that they could make good money by shorting Twitter stock—by betting that it was going to go down rather than up.
Twitter can perennially be found on the list of most-shorted stocks—the list of companies where investors have made the biggest bets that the shares are going to fall in price. Value investors in particular, who invest in companies they think are undervalued, love to short Twitter, which they are convinced is overvalued. That’s because it’s pretty much impossible to justify its share price from its quarterly financial statements. When Twitter was losing money every quarter, the value of its future earnings looked like it was probably negative; even now, when it’s putting up modest profits, those profits ($61 million in the first quarter of this year) are still way too small to justify a valuation of more than $30 billion.
Presiding over a much-shorted stock might look like a really bad spot for a CEO, but it’s also a fantastic basis for a turnaround story. After Jack Dorsey came back as CEO in 2015, he laid off employees, cut back sharply on stock-based compensation, and started running a lot more video ads, to the point that video now accounts for more than half of the company’s ad revenue. Those moves together managed to put an end to Twitter’s quarterly losses and to the steady erosion of its share price. Almost overnight, the vicious cycle got turned on its head. As the share price rose past the levels of previous option grants, employees started to see their net worth soar, which did wonders for employee morale and helped to reduce the need for the company to give out even more options. And the virtuous cycle is even stronger than the vicious cycle, because it is turbocharged by the existence of all those shorts.
When a company has a large short interest—when a lot of people have shorted the shares of that stock—that acts as a powerful force driving the stock upward. What’s more, the higher the stock rises, the stronger that upward force becomes. It’s called a short squeeze, it can be one of the most profitable moves in finance, and it has no regard whatsoever for the fundamental valuation of the company. (It’s notable that in articles about why Twitter’s shares are rising, you never see anything about valuation. It’s easy to come up with reasons why Twitter stock should be worth more than it was a year ago; it’s much harder to come up with reasons why it should be trading anywhere near its current levels.)
A lot of the rise in Twitter’s share price, then, can be attributed to stock-market dynamics, as opposed to corporate fundamentals. And short squeezes never last forever. At some point, the squeeze will end, and the stock will drop back down to a more natural level.
If the rising share price has done wonders for morale, how will employees feel when the stock starts falling again? Twitter employees can certainly feel good about the centrality of their platform to the national conversation, and about the fact that they’re now working for a profitable company with a steadily-improving product. But can those good feelings make up for the disappointment they’re likely to feel if and when the share price starts falling again?
Or, to put it another way: Do people at Twitter think that it’s normal and reasonable for the shares to trade at their current level? After all, this is roughly where they traded when Twitter went public five years ago, before the rise of Snapchat and the consolidation of the Google–Facebook advertising duopoly. Many current employees surely believe on some level that if the share price made sense in 2013, it can make sense in 2018, and that the current mark-to-market value of their Twitter stock is both sustainable and reasonable. Those employees, and even long-term shareholders who are currently smiling, are likely to find themselves rather disillusioned once the short games end. The big question is whether they’ll still believe in the corporate turnaround, or whether the whole thing will turn out to have been largely predicated on the caprices of the share price.
The same is true for the broader narrative surrounding Twitter. Right now, while the share price is rising, it’s easy to find people who will cheer Dorsey’s strategy. But it’s equally easy to imagine a world where a belated pivot to video, along with the shuttering of popular products like Vine, can be read as misguided and desperate. In other words, the share price is driving the narrative. When the share price inevitably starts going down rather than up, you can expect a slew of articles second-guessing Dorsey’s decisions and asking how he could have snatched defeat from the jaws of victory. We’re going to have to wait for Twitter’s short interest to come down substantially before we will be able to discover whether Dorsey’s current victory is merely a stock-market artifact, or truly substantial.


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