A longtime Wall Street banker friend wrote to me on Friday night, after the news that Elon Musk had finally pulled the plug on his $44 billion all-cash deal to buy Twitter, to express his distaste for the whole 10-week spectacle. “This is like watching a train wreck in slow motion,” he wrote. “What a clown.”
I asked if, in his forty-plus years of M&A experience, this banker had ever seen anything before like what Elon had just done: thoroughly embarrassing and discrediting himself by signing a merger agreement to buy a company and then reneging on that deal in a fit of buyer’s remorse. “Yeah,” he replied. “When he tried to take Tesla private,” a reference to Elon’s last pathetic M&A failure, in 2018, when he tweeted that he was going to buy Tesla for $420 a share and that he had “funding secured” to do it. Elon did not, of course, have “funding secured,” and paid a $20 million fine, among other penalties, for misleading shareholders.
But Elon has well and truly screwed the pooch this time. As a result of this little stunt, he and his companies—Tesla, SpaceX, The Boring Company—will now be as big pariahs on Wall Street as Donald Trump, as a result of all his shenanigans over the years. Who on Wall Street is going to want to do business with Elon after he ginned up a takeover of Twitter, signed a legally binding agreement to do so for $44 billion in cash, put the biggest banks to work on the deal (and thereby used their credibility to help legitimize his offer) and then manufactured a half-assed excuse for why he no longer wanted to do it?
It’s one thing to abandon a deal for valid legal reasons uncovered during due diligence—for instance, if there really is a “material adverse change” to the business, or “a force majeure,” or some such. But to try to terminate the merger agreement over claims that Twitter is in “material breach of multiple provisions” of the agreement because it made “false and misleading representations” to Elon to get him to sign the merger agreement on April 25 is farcical. He simply appears to have had a childish fit of regret, especially at the price he agreed to pay, given the market correction in the tech market, and was probably unable to persuade the Twitter board to cave to a retrade at a lower price. As elegantly as he handled the process leading up to the signing of the merger agreement on April 25, he’s made a hash of it ever since, in a way that would permanently damage his credibility, all things being equal.
But, like many extremely wealthy people, Elon expects to get his way without any repercussions, as his legal strategy suggests. According to the aggressive and fact cherry-picking Skadden letter, written by partner Mike Ringler to Vijaya Gadde, Twitter’s chief legal officer, Elon is claiming that he walked away because Twitter failed repeatedly to provide him with the information he wanted to assess how many Twitter users were fake, or bots, or both. “This information is fundamental to Twitter’s business and financial performance,” Ringler wrote. Really?
Ringler also wrote that Twitter breached its obligation to Elon to conduct its business in the “ordinary course” between the signing of the merger agreement, on April 25, and the contemplated closing of the deal, once thought to be October 2022. Ringer claimed that Twitter’s “conduct” in “firing two key, high-ranking employees,” as well as its announcement, on July 7, that it was “laying off a third” of its talent acquisition team, “implicates the ordinary course provision,” as does the “general hiring freeze” that Twitter instituted.
Ringer also claimed that the resignation of three executives since the merger agreement was signed violated the merger agreement. Twitter, he wrote, did not receive Elon’s “consent” for “changes in the conduct of its business.” At the end of 2021, Twitter had 7,500 full-time employees. I’m not a lawyer, but it seems like a stretch to suggest that the departure of five of those 7,500 employees is a material breach of an agreement to run the business in the “ordinary course.”
Legal Holy War
It appears Twitter and Elon will be heading now for years of litigation. “The Twitter Board is committed to closing the transaction on the price and terms agreed upon with Mr. Musk and plans to pursue legal action to enforce the merger agreement,” Twitter board chairman Bret Taylor tweeted shortly after Elon filed the Skadden Arps letter terminating the merger agreement with the Securities and Exchange Commission late Friday afternoon. “We are confident we will prevail in the Delaware Court of Chancery.” Them’s fighting words. And the right thing for Taylor to write and for the Twitter board to do after Elon’s appalling behavior.
It’ll be fascinating to watch whether Elon pays the $1 billion walk-away penalty, or whether paying that money becomes part of a bigger litigation between Twitter and Elon about whether there really were “multiple breaches” of the merger agreement that would enable Elon to break the agreement and walk away without paying the $1 billion, or more, and actually try to get Twitter to pay him the $1 billion so that it could walk away. “You’ve got to show that Twitter really bamboozled him,” explains Charles Elson, the founding director of the Weinberg Center for Corporate Governance at the University of Delaware. “No way that’s going to happen. He’ll probably end up paying some part of that billion dollars, or negotiate. Remember that this isn’t about the reality. This is negotiating, right? You use the lawyer as a negotiating tool.” The Elon-Twitter battle is somewhat reminiscent of the one, in 2020, between LVMH, the French luxury conglomerate, and Tiffany. In the end, the deal got down, at $15.8 billion for Tiffany, after the two sides agreed to a modestly lower purchase price per share—$131.50 compared to the original $135. Maybe Elon is angling for something similar.
But wait a minute here. Let’s take a step back and look at this situation with a bit more distance. If I were still a banker at JPMorgan Chase, or at Goldman Sachs or at Allen & Co.—the three firms Twitter retained to represent it to deal with Elon—and I were advising the Twitter board, I would posit whether it makes sense for Twitter to litigate with the world’s richest man. Elon has infinitely more resources for litigation than does Twitter. Perhaps instead of firing off the nukes, the two sides can reach some sort of face-saving settlement, as Elson suggests, that will allow both Twitter and Elon to pretend this never happened.
If you really think about it, Twitter remaining an independent company, free of Elon Musk, is perhaps the best possible outcome here in the long run for Twitter employees, Twitter users, and maybe even for the country as a whole (no Trump return to Twitter, etc). In the short run, the Twitter shareholders will be hurt. They were counting on $54.20 a share in cash, which was a number they won’t be seeing for a long while now. In the few hours after Elon filed Skadden’s termination letter with the SEC, the Twitter stock fell to around $34 a share, some $20 per share, or 37 percent, below what Elon promised them. That stings. And I would expect the Twitter stock to quickly fall further into the $20s-per-share from here, as the market grapples with the reality of Twitter remaining a publicly traded tech company. (This is not investment advice.)
But, in the longer term, I think this may be the best outcome for Twitter. It can wrestle with its problems, free of Elon’s peccadilloes, figure out how to generate more than $1 billion in EBITDA a year and slowly regain its footing, and its stock price. Call me crazy, but at some point in a few years, if it does the work, an independent and refurbished Twitter could be trading higher than $54.20 a share, and be far better off without Elon Musk. (Again, this is not investment advice.)
The folks who will be licking their wounds for a long time here—and will be hating on Elon for a long time, too—are the arbs, the Wall Street traders who bought the Twitter stock at a discount to $54.20 a share and were hoping to get that payment out of Elon. Their losses are going to be legendary, and will add to wrath from Wall Street directed Elon’s way as a result of this fiasco. “Musk will get sued, pay damages and still be the richest guy,” one Wall Street arb told me. “He breaks all the rules and gets away with it.”
Then there are the bankers. I’m sure the folks at Morgan Stanley cannot be happy about this turn of events. Between the M&A fees and the financing fees, the firm was looking at a payday in the hundreds of millions of dollars. Now, not so much. The firm will be paid millions for its commitment on the $12.5 billion senior debt portion of the financing for Elon’s acquisition, even though obviously that commitment will not be used. It will probably be paid millions for helping Elon raise the $7.1 billion in equity commitments he hauled out of a group of 18 eclectic investors who stepped up to help him. It will also probably get paid for the work it did helping Elon build his 73.1 million share position in Twitter. And it will probably get paid for some of its M&A advice, getting Elon to the April 25 merger agreement. But many more millions will be left on the table that Morgan Stanley won’t get as a result of Elon’s temper tantrum.
And what about Twitter’s bankers? Well, I’d say they did the job they were hired to do. Goldman and JPMorgan Chase gave the fairness opinions they were hired to give to the Twitter board. They advised the Twitter board on how to do its fiduciary duty for the Twitter shareholders. And as a special bonus, they can claim credit for the outcome Twitter really wanted, which was to be independent and free of Elon Musk. They can have their cake and eat it too, as well as their millions in advisory fees. ($10 million plus each, perhaps?) As for Allen & Company, I still have no idea what that firm did for Twitter, although it hosts a fine gathering in Sun Valley, Idaho, I hear, at which Musk spoke last week. So the bankers on West Street and Park Avenue are pretty happy with this outcome while the ones on 1585 Broadway are less happy than they were hoping to be.
In truth, as another longtime private equity investor wrote to me after the news broke, no one comes off looking particularly well here. Although in terms of long-term reputational damage no one comes off worse than Elon Musk. It remains to be seen whether, like Trump, he’ll suffer any consequences whatsoever for his disastrous and puerile behavior. But unlike Trump, Musk’s wealth is real and calculable, and it will be interesting to see who on Wall Street shows up to the party to help him pull off the next stunt.
Netflix’s Fuzzy Math
I wouldn’t have thought a five-alarm fire would be ignited by my assertions on Wednesday about, of all things… the amount of Netflix’s EBITDA. But apparently on Wall Street the topic is more than a little controversial. Part of the problem originates with Netflix itself, which in its public filings with the Securities and Exchange Commission makes no mention of “EBITDA,” or the words that make up the acronym, Earnings Before Interest, Taxes, Depreciation and Amortization. Many companies these days, especially media and technology companies, make a point of mentioning EBITDA, or the loathsome “Adjusted EBITDA,” in their public filings, if only because, on Wall Street, and with many investors, EBITDA provides a better understanding of a company’s ability to generate cash from its business and therefore Wall Street bankers like to look at multiple of EBITDA to determine whether a company is properly valued by the market or undervalued, or overvalued.
But since Netflix doesn’t delve into the netherworld of EBITDA in its public filings, Wall Street analysts, bankers, traders, private-equity denizens and hedge-fund managers, among others, are pretty much left to their own devices when it comes to figuring it out. Is Netflix’s EBITDA for the twelve months ended March 31, 2022 the $19.1 billion that Macrotrends LLC uses? (Macrotrends describes itself as “the premier research platform for long-term investors.”) Or is Netflix’s LTM (last twelve months) EBITDA $6.5 billion, as something called finbox.com asserts? Or is Netflix’s (dreaded) LTM “adjusted EBITDA” the $6.9 billion that Netflix slipped into the bottom of a “letter to shareholders” on April 19? Which of course leads to the all-important question of whether Netflix’s $80 billion equity valuation looks cheap at 4x EBITDA—as I suggested on Wednesday—or whether its equity valuation is still robust at 12.3x EBITDA of $6.5 billion, or 11.6x the “adjusted EBITDA” of $6.9 billion? Is Netflix worth buying because it looks to be valued very cheaply or is it better to avoid the stock because it is still fully valued? It’s a rather important question for investors, which Netflix does nothing to help clarify.
It seems it all comes down to a line on Netflix’s cash flow statement labeled, “Amortization of content assets,” which in 2021 was a not inconsiderable $12.2 billion. If this is added back to Netflix’s 2021 “operating income” of $6.2 billion, along with another $200 million of other depreciation, you can quickly get to Macrotrends $18.6 billion EBITDA number for 2021. A similar exercise gets you to the $19.1 billion LTM EBITDA number.
So what is “amortization of content assets” anyway? According to the Netflix 10K, these are expenses “directly associated with the acquisition, licensing and production of content.” Some $8 billion of the $12.2 billion of amortization of these costs were derived from content that Netflix’s licenses with the balance coming from the amortization of costs related to original, produced content. There is a difference between the incurring of these costs and the actual production of the content to which these costs are related, as Netflix noted in the S.E.C. filing, and thus there is a difference between the amount of money Netflix spent in 2021 on the payments for content assets—$17.5 billion—and the amortization of those assets—the $12.2 billion. The amortization of these content assets seems to me, as well as to others on Wall Street, to be a legitimate add-back to Netflix’s operating income to get to something like an EBITDA number. Others don’t agree. And so the conundrum.
But you would have thought I’d blown a hole in the time-space continuum based on the reaction I got from some readers. One banker insisted that I had made a mistake and pointed me to Netflix’s letter to shareholders with the “adjusted EBITDA” of $6.9 billion. But that analysis, which is not consistent with GAAP, or generally accepted accounting principles, does not include the amortization of the “content assets” or any explanation of why it doesn’t. He also kindly attached a Bloomberg screenshot of Netflix, which pegs Netflix’s “enterprise value”—its equity value of $80 billion plus its “net debt” number of $8.6 billion, or a total of $88.6 billion—at 14.4x LTM EBITDA, which would make the LTM EBITDA something like $6.1 billion—a number I don’t see anywhere—and likewise ignores the addback for the “amortization of content assets” without explanation. A source at Apollo Global Advisers, the big asset management firm, also came in hot. He said I needed to look at “actual cash earnings” and then adjust “for all the stock based compensation they have.” He wrote that an EBITDA of around $20 billion is “massively overstated” because of “amortization vs. cash spend on content.” He says Netflix is “really trading at 15x EBITDA.” He directed me to research from MoffettNathanson, “who looks at it properly.”
I got a copy of MoffettNathanson’s February 22 report about Netflix’s amortization of content. It was plenty interesting but alas makes no mention of Netflix’s EBITDA, or whether the amortization of “content assets” should be added back to the company’s operating income. There is this somewhat amusing and cryptic line, “…the decay rate on streaming content (especially content that is released to be binged in a night) is incredibly rapid.” The Wall Street research firm wrote that there were two consequences of this phenomenon: 1) that Netflix and other streamers have to keep up the spend on the new content at a voracious pace or risking losing subscribers; and 2) that investors are relying on Netflix’s operating income and margins as “the driver of valuation” but that this metric “is flawed as content is amortized over three to four years while actually being consumed over a period of weeks.” As I said, I was hoping for some additional insight about the implications for Netflix’s EBITDA but it was not forthcoming. (In February, MoffettNathanson had a price target of $375 per share for Netflix, which it reduced in June to $245 per share.)
Another reader, who works for a Netflix competitor, Warner Bros. Discovery, directed me to Morgan Stanley research, which has Netflix’s enterprise value (the equity plus the net debt) at 12/13x EBITDA. “No add back can get from [$] 6-7 [billion] of EBITDA to [$]20 [billion] from amort[ization],” he wrote. “If you added back that much amort[ization], cash spend vs amort[ization] would be wildly far apart.” An old banker friend wrote pretty much the same thing.
Of course, what would be most helpful to investors is if Netflix would clarify in its S.E.C. filings precisely what its actual EBITDA is, since there is a material difference between $19.1 billion and $6.5 billion. I wrote to Netflix, hoping the company would settle the matter once and for all. On background, a company spokesman directed me to use Netflix’s “operating income” of $6.5 billion. But since I asked about EBITDA, and not “operating income,” which is often after depreciation and amortization have been deducted, I repeated a version of my original question. This time I was told what I already knew—that Netflix doesn’t report EBITDA—and that Netflix’s peers don’t add back to operating income the amortization of content assets because “that cost is core to their business,” whatever that means. (Aren’t, say, jets core to the airline industry? But they still get depreciated on an airline’s balance sheet.) The spokesperson allowed that some of Netflix’s peers, like Paramount Global (which really isn’t a Netflix peer, but anyway) report “OIBDA”—Operating Income before Depreciation and Amortization—but not Netflix.
What I’ve learned through this experience is that it would be helpful if Netflix did everyone a favor and reported EBITDA and that in the meantime the consensus on Wall Street seems to be that Netflix is trading at a much higher multiple than 4 of whatever its EBITDA is. Anyway, enough of this.