Pando

If Twitter's for sale (which, like it or not, it is), here's why Google should buy

By Kevin Kelleher , written on July 21, 2015

From The Money Desk

Twitter, it's generally agreed, is not in a good place.

Only a few weeks after Dick Costolo cleared out of the CEO suite, the company has sunk into an even deeper state of uncertainty. If anything seems certain about the future of Twitter, it's that an acquisition by a larger company is looking like the most probable endgame.

That, at least, is the thinking in the markets if not the desire inside Twitter's boardroom. Only a week ago, someone faked a Bloomberg news story saying the influential social network was in talks to be bought for $31 billion, a 33 percent premium to its market cap at the time. And instead of falling on their asses laughing, investors credulously drove up Twitter's stock price by 8 percent.

Speculation about tech M&A often runs rampant before any deal is ever signed. For every obvious merger like Nokia-Alcatel, there are multiple transactions nobody saw coming. I'm not alone in thinking that an acquisition of Twitter is logical, even if it isn't inevitable, with Google the most sensible buyer. But instead of adding to more speculation, I'm going to try and just make the case why it would make sense.

There are good reasons why Google – or any company thinking clearly – would opt not to buy Twitter. The social network is struggling to go mainstream in the way Instragram or even Tumblr has. Twitter keeps posting sizable losses (that is, if you follow generally accepted accounting rather than the company's magical-thinking math). And it has a $24 billion market cap (Time Warner, an old-school media company with double-digit profit growth, is worth $22 billion.)

Given all this, it's understandable that Twitter would give off a repellent scent to any prospective suitors. But an independent Twitter may not remain a thriving Twitter for long. Think for a second where that would lead. Even the bullish scenario that Costolo painted at Twitter's analyst day last November (a scenario, moreover, that he painted even as he was contemplating his exit from the company) would require a few rocky years to effect. In the meantime investors are demanding returns next quarter, not in a few years.

Last quarter, Twitter's stock tumbled after it said its direct-response ads - the kind of Facebook-ish ads needed to deliver on its promise – needed time to take root, as did its campaigns to draw in more users. As a publicly traded company, time is exactly what Twitter doesn't have. Another disappointing quarter or two and the activist shareholders will surely appear, knives in hand. They could demand an end to the plans Costolo laid out, if not an arranged marriage to an unsuitable partner.

If Twitter does get bought out, as I'm sure you've read over and over, the most promising buyers are named either Facebook or Google. Facebook's hands-off approach to its big acquisitions might provide a better environment for growth than the hostile stock market. What's more, Facebook, which buys what it can't build itself, hasn't been able to replicate the thing that keeps Twitter influential – its ability to reveal, in real time, what matters beyond our carefully curated (often impoverished) village of friends.

Facebook is unlikely to buy Twitter. If it's going to spend tens of billions of dollars on a buyout, it's looking at the media companies we'll be using in five or ten years, not the ones we've been using in the recent past. The only thing Facebook would gain from buying Twitter now is cutting off the best chance Google has of staying competitive with Facebook.

This is the main reason why I think Google might pay $30+ billion for a publicly traded company that lost more than $1.2 billion over the past two years. Twitter is the best option for getting the shot in the arm that Google needs in mobile ads.

Last week, we learned that Google may not be faring as poorly in mobile ads as many had feared. Ad clicks continue to increase at a decent pace, Google said, while cost-per-click rates are actually rising on mobile ads. (It's hard to tell for sure since Google rarely breaks out metrics by platform, so all we have is the selective and cheery “color” its executive dish out). What's clear, though, is that Google's ad-revenue growth remains anemic compared to what Facebook has been seeing.

In short, Google needs a new platform – preferably one with a broad mobile user base - where it can sling its targeted ads. And Twitter has such a platform, but its direct-response (i.e., targeted) ads aren't working because it lacks the granular data on user intentions Facebook has excelled at collecting. There is only one company that can come close to Facebook's great database of online behavior. That company is Google.

This has the makings of a Reece's-candy merger – two once tasty, now slightly stale companies awaiting the collision that will yield a new confection. They complement each other's weaknesses, fill in the exact holes that investors have been complaining about. If Google gives Twitter the independence Facebook has offered Instagram, it could leverage search and YouTube data to help brands reach out to Twitter users in new, less irrelevent ways. In return, Twitter could deliver ads with engagement levels closer to the ones driving up Facebook's revenue.

The alternative is that Facebook will continue to kick the asses of both Google and Twitter. And for all the strategic sense that may exist in such a deal, there is a separate reason why Google might want to hold back: Twitter's $24 billion valuation. Twitter is expensive. And right now, on its own, it's looking like a broken company. And nobody wants to spend a premium for a broken company.

Unless, of course, Twitter is fixable inside Google. When synergy – that mythical offspring of M&A – can be conjured, it's not imprudent for buyers to pay a premium over the market price. Verizon paid a 23 percent premium when it bought AOL for $4.4 billion, a deal in which anyone has yet to spot a glimmer of synergy. Twitter's future looks much brighter than AOL's. AOL's revenue grew 5 percent in its last reported quarter (ad revenue grew 8 percent). And Twitter? Its revenue grew 74 percent.

So is Twitter too expensive for Google? The company went public at $26 a share, shot up to $74 a share before falling as low as $31 a share last summer. It's currently trading around $36 a share, about 38 percent above the price that IPO underwriters deemed to be fair value and half of the irrational level that investors pushed it up to in late 2013. 

Assuming the underwriters got it right, Twitter is commanding a 38 percent premium to its value 20 months ago. And while it has continued to post a net loss, Twitter has also seen its revenue rise to $1.4 billion in 2014, versus the $535 million in revenue it saw in the 12 months prior to its IPO. Twitter is still burning through cash - $1.1 billion in 2014 – but that burn rate is delivering on strong revenue growth, much like Netflix and Amazon. Which, unlike Twitter, investors adore.

There's another problem. Twitter remains an awfully big pill for Google to swallow: Google bought YouTube for $1.65 billion and DoubleClick for $3.1 billion, two deals that were among the smartest Google ever made. It also bought Motorola Mobility for $12.5 billion, a transaction that – well, let's just say it was no YouTube. Since Motorola, Google has made only one billion-dollar purchase: Nest Labs (for $3.2 billion). It's understandably gunshy.

In light of this, it's unlikely Google will make an aggressive bid for Twitter as long as things stay as they are. But in the tech markets, things never stay as they are, and there are three changes easy to imagine happening that could end up making a Google purchase of Twitter much more palatable.

The first is a further deterioration in Twitter's stock performance. Again, Twitter's growth plan requires time to bring in new users and deliver ads they want to engage with. If this doesn't happen in the next two or three quarters, the stock could sink and angry investors could clamor for a merger.

(As a sidenote, I think Costolo's premature departure suggests this is likely. When Costolo left, he forfeited $16 million in stock awards. Which, when you think back on the worst job you ever had, you'd almost always hang on for one more year if it meant another $16 million.)

The second factor is the bull market in US stock in general – and tech stocks in particular – is now in its seventh year. Nobody knows when it will end, but there is a sense it's lasted this long not on its own merits but because there is nowhere better to invest money. Once it's clear the balance has tipped from bull market to bear, there will likely be a M&A frenzy. Companies like Google will look around and see what they can buy with their stock before its value diminishes.

Finally, there is the strong possibility that some company will buy Twitter eventually. Google may not care for Twitter today, but companies have a crazy habit of suddenly wanting to overpay to keep a rival from making an acquisition, as Facebook was said to do when it bought Instagram three years ago. Facebook paid what seemed like a high premium then to keep it out of Google's ownership. But it ended up being a shrewd deal on its own merits.

So Google may not be ready to move right away on buying Twitter. But like it or not, Twitter is either for sale or it's in trouble. And its high valuation? Well, that's the thing about high-ticket, high-premium acquisitions. No company in their right mind would ever make them. But things happen that make companies step out of their right minds when it comes to M&A deals. They become irrational, even desperate once the buying gets going. It's better to buy them before going gets too weird.