Twitter: the circus will have a happy ending

Mark Zuckerberg once called Twitter the clown car that fell into a gold mine. I’ve been laughing internally at that description recently, because Twitter’s deal with Elon Musk has moved them fully from a gold mine into a complete circus.

I covered the Twitter / Elon drama a bit last week (and on Twitter this morning), but I wanted to do an update because there’s now been a little more time to think about the deal / situation and because there’s lots of new info thanks to Elon’s Twitter rampage against the deal (raging against a deal to buy Twitter on Twitter certainly has some irony to it!).

I’ll break down all the new info (the FT had a nice summary here), but let me jump ahead to my main conclusion: the more I think about this deal, the more likely I think the story is to have a happy ending for Twitter shareholders. The fact pattern here for Elon is terrible. If he breaks the merger contract and goes to court, he is going to lose. As a Twitter shareholder, my biggest worry is not Elon trying to break the merger contract; my biggest worry is that the board of directors will not have the guts to sue him if he does. Because (again) if this goes to court, Elon will get destroyed.

My most likely scenario here is that this gets very acrimonious; Elon will exert maximum pressure on Twitter to try to break the deal (he’s already doing that!). But if the board calls his bluff and sues him to close, he will eventually lose. In the end, the board will probably take a small price cut for certainty of a quick close; that’s fine. But if they take anything more than a token amount they should honestly be sued for breach of fiduciary duty. They will win a court case, and they should ignore the noise and negotiate with Elon from a position of strength.

Anyway, the most important recent news is Elon was at a conference yesterday; I’d encourage you to listen to it. Honestly, the appearance makes me a little angry just because Elon gets no push back on any of his claims, and all of the hosts are frequently egging him on and talking about how awful Twitter is (despite being out there raising money for a SPV to back Elon’s Twitter deal that is just laced with fees). Elon’s railing against bots on Twitter like it’s a new issue that suddenly popped up and surprised him after the deal was signed. It’s the dumbest thing I’ve ever seen; I get Elon is funny and charming, but the dude signed a $44B merger with no due diligence and is now railing against a problem that’s been obvious for years and no one’s calling him out on it? The press release announcing the deal literally has a quote from Elon noting that one of his goals for taking over Twitter is “defeating the spam bots,” and when he was trying to pressure Twitter into selling one of his rallying cries was “If our twitter bid succeeds, we will defeat the spam bots or die trying!” He’s the brightest entrepreneur of our generation, but he didn’t realize the bots might be an issue until after signing a $44B merger (despite talking about them constantly)?

(PS- one more thing on the hosts. At the 6:10 mark Jason supports Elon’s claim that Twitter’s numbers don’t make sense by saying YouTube has ~1B users and the most popular videos get billions of views while the most popular tweets get a low single digit % of Twitter’s users to like them; that comparison makes literally no sense. People rewatch the most popular YouTube videos; you don’t “relike” the most popular Tweets. And tweets age really rapidly; no one goes back and reads old tweets, but you would go back and watch old YouTube videos. A better comparison would be how many likes do the most popular Facebook posts get, though even that isn’t a great comparison. It’s just a silly comment, and it’s coming from a guy trying to raise millions of dollars in a fee laced vehicle to support the Elon’s TWTR take private. You couldn’t have raised those questions before raising the SPV?)

Anyway, aside from my anger at the hosts just letting Elon say anything without any pushback, the appearance is worth listening to for how Elon talks about Twitter. The most important things to me are:

• At the 6:55 mark, he notes that Twitter has a “material” number of bot.

• At the 22:00 minute mark, he says he’s waiting on a logical explanation from waiting on a logical explanation from twitter on bots and real users

• 22:55 this is a material adverse mistatement

• 23:55 you can’t pay the same price for a worse property

• 24:15 asked if a different price could make the deal work

• 24:45 I need to see how these things are calculated, because Twitter relies on brand advertising

• 25:45 Twitter’s revenue will be significantly impaired

• 25:55 A host finally asks a hard question and asks if Elon asked about these issues in his negotiation; Elon says he relied on Twitter’s public statements

Why does all this matter? Elon is choosing his words very carefully. Look at how many times he says “material” misstatement and “relied on Twitter’s public statements.” Those are legal terms that would form the basis for Elon to legally walk away and break the Twitter deal.

I think Elon is going to really, really struggle with those arguments. The fact pattern is really poor for him; again, these were all known issues, and in his rush to buy Twitter Elon waived due diligence. If Elon goes to a judge and says “look at all these bots,” Twitter can respond “that was a known problem, and we offered Elon access to our private data room where he could have seen the exact numbers for himself. He waived that right in his rush to buy Twitter.” If it comes to a lawsuit where Elon is trying to break the deal based on the bot problem, the law and contract are going to be on Twitter’s side here.

But Twitter has even more on their side. Twitter’s CEO did a long text thread on spam and bots yesterday; again, encourage you to read it all, but there’s one specific tweet that I thought was absolutely damning.

Parag Agrawal @paraga

Our estimate is based on multiple human reviews (in replicate) of thousands of accounts, that are sampled at random, consistently over time, from *accounts we count as mDAUs*. We do this every quarter, and we have been doing this for many years.

Why’s that so important?

Elon is trying to break this deal by saying Twitter’s bot problem is out of control and caused him to falsely rely on their mDAU number. Parag is telling Elon that Twitter is adjusting for bots when they report their mDAUs. In court, Twitter is going to be able to say “your honor, Elon is breaking the deal under bad pretense; if he had simply done due diligence, he would have been able to see how we adjust for bots in presenting our mDAUs. But he waived DD!”

Absolutely damning. (PS- stratechery this morning had a nice review of Twitter’s bot disclosure that comes out reasonably favorable for TWTR).

Moving on, I obviously think Twitter is going to have a field day with Elon in court if and when it comes to a lawsuit. One of the things a few people have said to me about the Elon / Twitter saga is that you can’t rely on contracts when it comes to Elon. Money Stuff had a nice way of saying it: “If you’re reading the contact, you’ve lost.”

I disagree; I think history shows that the court room is often the only place where trolls / gadflys are held accountable. They’re willing to break every rule and norm that regular people follow, so they can often win fights through the media because they’ll go places other people won’t…. but in a court that willingness to cross the line comes back at them with a vengeance. Elon’s used to getting his way in everything he does by throwing around his money / influence / power, and that has generally worked spectacularly for him. But the court room is different; you can’t just bluster your way through a multi-billion dollar trial. Facts and misstatements come back to haunt you in a trial, and the paper trail here for Elon is going to be damning. Consider that in the interview I just mentioned Elon said something along the lines of “Twitter gets their money from advertisements; ads need humans. If TWTR can’t figure out how to calculate bots, how can advertisers trust them?”

That sounds reasonable…. but, again, Elon waived the right to diligencing Twitter to close the deal quickly. If he had diligence’d Twitter, he could have teased out their user numbers. He could have called advertisers and asked them how they judged their return on ad spend. These are all common moves that a sophisticated buyer would make in their diligence process. Elon waived that right… but, even more than that, Elon told prospective investors that he planned on turning Twitter into a subscription model. So, in a court room, Elon is going to have to argue that Twitte'r’s bot problem was a material misstatement, he’s going to have to argue that he couldn’t have caught it by performing due diligence, and he’s going to have to refute Twitter’s rebuttal that “hey, doesn’t matter…. you wanted to turn us into subscription business anyway.”

Not impossible…. but again, it’s a long slog for Elon, and I don’t think a court room is going to be very friendly to him.

Another example of how the paper trail can come back to bite you in a court case: over the weekend, elon discussed doing a random sample of 100 followers of Twitter to figure out how many were bots. That’s going to be a disaster for him in a court case; Twitter’s lawyer will put him on the stand and say “if this was such a concern, why didn’t you do that before you signed the merger? You’re using public sources for that “check;” you could have done that any time over the past decade. Why chose now? Is it because you overpaid and got cold feet?”

I said last week that the Elon / TWTR saga reminded me of LVMH / TIF. LVMH had a rich buyer who got cold feet because the environment changed and he realized he’d overpaid. TIF sued, and the deal ended up closing after a token price cut. I still think that’s the most likely scenario here.

But I did want to show just how high the bar for breaking a deal based on misstatements is.

In early February 2016, Abbott announced a deal to buy Alere at $56/share. Almost the moment the ink was dry on that deal, things started to fall apart at Alere (I’d encourage you to read their proxy for the full background to the deal). A few weeks after the deal, they note they can’t file their 10-K because they’re reviewing their revenue recognition and internal controls. In March, they get hit with a DOJ subpoena for violating the Foreign Corrupt Practices Act. Things are really bad at Alere, and Abbott wants out of the merger. Per the proxy, in April Abbott asks Alere to call off the deal; in exchange, Abbott will give Alere $30-50m to cover Alere’s deal costs and expenses. That is an insanely small number (it comes out to ~$0.50/share); obviously it’s offered as a first move / negotiation in Abbott trying to get out of the deal, but that they’d even offer such a small number shows how bad Abbott thinks the situation at Alere is and how much leverage they think they have for getting out of the deal.

Fast forward to August, and Alere is still struggling. The company needs to amend their credit facility because they’re about to breach covenants, and they’re unable to file their 10-Qs for Q1 and Q2. On August 25, Alere sues Abbott, arguing Abbott has “buyer’s remorse” and is slow walking the regulatory process in an effort to break the deal. In November, Abbott sues Alere for breach of contract, and in December Abbott argues Alere had a material adverse effect (MAE) and that Abbott can terminate the merger without penalty.

In February 2017, while these lawsuits are still raging, Alere announces that they can’t file their 2016 10-K because they’re still trying to figure out revenue recognition for their Korean and Japanese locations, and they’re investigating “inappropriate conduct” at their South Korean subsidiary.

While all of this is happening, Alere’s business is also falling off a cliff; you can find their original deal projections on p. 49 of this proxy and their revised projections in 2017 on p. 51 of this proxy. Management’s original transaction forecast 2018 EBITDA of $904m; one year later they’re targeting 2018 EBITDA of $575m and saying they won’t even hit their original 2018 EBITDA forecast by 2020 (their new forecast calls for $709m of EBITDA in 2020).

So Alere is literally a complete dumpster fire. They’re getting investigated by the DOJ, they can’t file their financial statements, and the business is doing terrible. I mean, the court case basically writes itself. Abbott goes to trial and says “your honor, this business is falling apart. We agreed to buy them on one set of numbers, and it turns out their internal controls were a mess and those numbers were fake. Even worse, the numbers were awful, and the profits that were there were in part being driven by bribes and illicit deals. And the business is falling off a cliff; profits are materially lower than what was forecast. Add it all up, and it’s clear this business has suffered a material adverse event, and the company breached their reps and warranties.”

Despite all of that ammo, Alere and Abbott go into mediation, and in April 2017 they agree to cut the deal price from $56/share to $51/share.

That’s right. Bribes, misstatements, business falling off a cliff…. add it all up, and Abbott went to mediation and said “the best we can do is take a <10% haircut.”

Compare that to Elon / Twitter. Elon is arguing that Twitter has a bot problem. This bot problem was known for years, and Elon waived the right to all due diligence when signing the deal.

If Abbott went into mediation with all of the cards they held for Alere and said “ the best we can do is a <10% haircut,” what type of price cut do you think the Twitter situation would deserve?

My guess would be nothing. If this goes to court, the deal is going to close on terms.

That doesn’t mean Elon won’t try to win in court. Han Solo famously told C-3PO “never tell me the odds;” I feel like Elon will be telling his lawyers something similar if and when they tell him he has a losing court case. Elon’s history has been to bet the ranch on everything he does, and he’s generally come out successful even against crazy odds.

But I don’t think he succeeds this time. In the end, contracts have meaning. And the more Elon tries to flail and pressure Twitter into letting him out the contract, the more he is hanging himself with a paper trail that will prove very unfavorable in court.

The history of merger arb is that you generally want to buy a target when a buyer has cold feet / buyer’s remorse and is trying to get out of a contract that they have the means to close. Twitter is trading at a massive discount to the deal price; Elon has pulled rabbits out of his hat before, but I’m willing to play the odds and bet that in the end he will be forced to close the deal on initial terms or maybe with a slight discount.

Long Twitter.

PS- nothing on this site is investing advice, and I think Twitter wins in the end…. but I do think this is going to be a rocky process. I’ve got a nice sized Twitter position, but I’m keeping a little dry powder because the history of merger arb is a stock bottoms the day a lawsuit is filed / the merger contract officially breaks. Maybe that’s not the case here because Elon is so publicly trying to break the deal that the stock doesn’t fall materially the day the deal breaks, but I’m guessing Elon tweets “I’m breaking the Twitter contract and suing them for breaching their reps and warranties” during market hours at some point in the near future. Again, I think Twitter wins a court case pretty easily, but I want to have dry powder to buy the day that headline hits.

PPS- again, I think Elon gets slaughtered in court. I honestly think the biggest risk to Twitter is not the court case itself, but if the board is willing to take this case to court. Elon will make their life hell if Twitter does sue (I’m sure he will personally attack all of them through the media / on Twitter), but in the end I just can’t imagine that the board wouldn’t do the right thing and sue Elon if he tried to walk.

PPPS- Twitter filed their prelim proxy this morning. I’m still reviewing, but the more I look at it the more I think Elon is harming himself with his public paper trail. Elon offers Twitter a “seller friendly” merger contract to entice them into a deal (see p. 52); his only outs are really if his financing disappears (which would likely require Tesla collapsing) or if a government body stalls out the regulatory approval. By going this publicly at Twitter, Elon’s almost certainly taken his two outs off the table. If his financing disappears, Twitter can now argue that it disappeared because Elon scared it away, and a judge can order him to close by using his substantial assets (selling more Tesla stock, SpaceX, etc.). If a regulatory body doesn’t approve the deal before the out date, Twitter can argue Elon slow walked the regulatory process to get out of the deal (similar to what Alere argued Abbott did).