Why Salesforce Tried To Acquire Twitter

When a stock is undervalued, one of the more intelligent things that a management team can do is repurchase the stock. If a stock is worth x but trading at 0.85x, a stock repurchase gives you an immediate 15% return (on this, reality is harsher than theory because corporate executives are biased to always think that their stock is worth more than the market quotation suggests.)

When a stock is overvalued, the intelligent course of action is to acquire other companies and issue your own stock as compensation. This is because part of the value that you are transferring will soon prove illusory. If your stock is worth x but is trading at 1.15x, a stock merger will really cost you 15% less than a cash merger.

This is why you cannot possibly answer questions like “Is it wise to accept stock when I sell my company?” in the abstract because it hinges upon the quality, growth, and valuation of the business doing the issuing stock. Selling your shoe business for undervalued Berkshire Hathaway stock in the early 1990s? Highly intelligent. Selling your Ohio pipeline for highly overvalued Enron stock in the mid-1990s? Not so much.

The risk of stock mergers that involve the issuance of overvalued stock is that many of the factors that make something get overvalued are the same factors that would make a target company be willing to give up their own business for an ownership stake in the acquirer.

There has been a lot reported about why Salesforce.com wanted to acquire Twitter, and the common narrative suggested that Salesforce.com wanted to expand beyond cloud computing and task management and make a statement entrance into the world of social media.

Perhaps there is something to that, but the story I see is one involving an overvalued company eager to issue its own stock to fund an acquisition. Salesforce.com regularly trades in the $70-$75 per share range which is a valuation of $50 billion.

The catch is that the company has lost money for the previous five years, and is only expected to make around $0.40 per share in profits next year. That’s a P/E ratio of 185 for a company worth tens of billions of dollars!

The highest ten-year earnings projections call for Salesforce.com to earn $1.50 per share by 2026. That is almost 49x optimistic earnings projections a decade from now! No wonder Snapchat wants to have an IPO now. Like a lot of other social media companies, Salesforce.com is enjoying this moment of the sector’s fashionability where people are so optimistic about future profits that they are willing to bake in years and years of double-digit growth into the current stock price.

It makes sense that LinkedIn chose Microsoft as its suitor rather than Salesforce.com earlier this year. It is all cash, so you know that the $26.2 billion deal is actually giving you $26.2 billion in value. That is highly favorable compared to whatever stock option that Salesforce.com would have offered with its own shares that are trading at a higher value than deserved.

You might be wondering: Why does it matter if the stock is overvalued? Can’t you just turn around and sell it? The answer is that, a lot of times, there are investors that own stakes in the business that are many times the daily volume. If you try to sell a couple hundred million instantly, you will sway the market and bring it down. The largest shareholders need to rely upon a scheduled selling program that can take 2-3 years. That time represents the risk of a highly overvalued stock returning to fair value (for people with a few hundred shares of stock, this is much less of a consideration as you have quick liquidation options.)

Because there is so much variance in projections for Salesforce.com’s future, it is hard to peg a current fair value on the company. Depening on whether it grows at 12% or 18% for a decade, you could be looking at valuation ranges between $20 and $34 per share (compared to the market quote in the $70-$75 range.)

Since we are not sacrificing much in accuracy by oversimplifying, let’s say that Salesforce.com is trading at double its fair valuation. Given that Twitter trades at $12 billion, it could probably be acquired for $16 billion. If Salesforce.com used its stock to make the deal, it would really only be transferring $8 billion in long-term value so it would effectively be getting a half-priced discount on Twitter. This acquisition was an opportunity to get one of the big three social media platforms at ⅔ of its pre-existing value.

You can see why Salesforce.com spent some significant time mulling over a deal. When your stock is trading at twice the price it is worth, any merger that involves the issuance of stock means that you will be looking back on that acquisition in ten years and thinking “I got a 50% discount by issuing Salesforce.com stock instead of paying for the business outright.” The losers in this scenario are the large shareholders of the acquired company that cannot sell the acquirer’s stock readily, and the small investors that hold onto the overvalued acquirer’s stock for the long haul.

But Salesforce.com was wise to flirt with LinkedIn and Twitter, and it would be wise to make an acquisition that involves the issuance of stock while the price remains in the $70s. From the perspective of management, undervalued stock is for repurchases and overvalued stock is for acquisitions, and it is wise of Salesforce.com’s management team to act accordingly on the latter.