The Twitter IPO moved into its final phase, with the announcement last week of the preliminary pricing estimates per share and details of the offering. The company surprised many investors by setting an offering price of $17 to $20 per share, at the low end of market expectations, and pairing it with a plan to sell 70 million shares. Having posted on my estimate of Twitter’s price when the IPO was first announced and following up with my estimate of value, when the company filed its prospectus ( ) with Twitter, I thought it would make sense to both update my valuation, with the new information that has emerged since, and to try to make sense of the pricing game that Twitter and its bankers are playing.
Reading the pricing tea leaves
- The underwriting skew: The Twitter IPO, like most public offerings, is backed by an underwriting guarantee from bankers that they will deliver the agreed upon offering price. If the offering price is set too high, relative to the fair price, that creates a substantial cost to the bankers, whereas if it is set too low, the cost is much smaller. Not surprisingly, IPOs tend to be underpriced, on average, by about 10-15% as I noted in this prior post.
- The PR twist: There is a public relations and marketing component to what happens on the offering date that cannot be under estimated. To provide a contrast, look at the reactions to the Facebook and Linkedin offerings in both the immediate aftermath of and in the weeks after the offering. While both IPOs were mispriced by the same lead banker ( ), with Facebook being over priced and Linkedin being under priced, Morgan Stanley was bashed for doing the former and emerged relatively unscathed from the latter. In the months after the offering, Facebook saw its shares lose more ground, as institutional investors abandoned it, while LinkedIn shares were carried higher, at least partly because of the opening day momentum.
- The feedback loop: I know that the bankers have been testing out the level of enthusiasm among investors for the Twitter offering and I find it difficult to believe that they are not incorporating that into their pricing. In other words, if they want excitement at the road show, it will come from investors thinking that they are getting a bargain and not from being offered a fair deal.
- The road show will be well received and the bankers will announce (reluctantly) that the high enthusiasm shown by investors has pushed them to set the offering price at $20/share.
- Institutional investors will start lining up for their preferred allotments at that offering price and the enthusiasm bubble will grow.
- On the offering date, the stock will jump about 20%-25%, leading to headlines the next day about the riches endowed on those who were lucky or privileged enough to get the shares in the offering.
- Some of the rest of us, who were not lucky or privileged enough to be part of the offering, will be drawn by these news stories into the stock, pushing the price higher, and keeping the momentum game going.
- In a few months or perhaps a year, some of the owners of Twitter (big investors and venture capitalists) will be able to sell their shares and cash out.
So, what can go wrong with this script? The biggest actor in this play is Mr. Market, a notoriously moody, unpredictable and perhaps bipolar (though that may require a clinical judgment) character. As was the case in Facebook, a last minute tantrum by Mr. Market can lay waste the best laid plans of banks and analysts.
- Only a small fraction of the equity is being offered to the public on the offering date: If all of Twitter being offered for sale on the offering date, an underpricing of 20% (selling the shares at $20, when the fair price is $25) would cost investors almost $3 billion in value (since the company would be priced at $12 billion instead of $15 billion). However, as noted earlier, only $1.2 to $1.6 billion will be offered to investors in the IPP. Even if you take the upper end of this amount ($1.6 billion), a 20% under pricing would translate into a loss of $400 million to the owners. While that may be a lot of money to most of us, it would work out to about 3% of overall value for the existing owners.
- The existing investors in Twitter are neither babes in the wood nor naive fools: The current owners in Twitter are a who's investing, entirely capable of watching out for their own interests and just as likely to use bankers as they are to be used by them. Rather than being victims here of the under pricing, they are willing accomplices in this pricing process, who view the loss on the opening day as a small cost to pay for a more lucrative later exit.