Scott Olson
Certainty versus probabilities
I love certainty. It is one of the things I most value in a counterparty, especially when it is applied to utterly unknowable outcomes. As events unfold, the certain voices are often the loudest – in politics, in business, and in investing – with those certain and wrong quieting down and those certain and at least temporarily right shouting the results. One way that I like trading against the certain is to generally be a writer instead of buyer of equity options.
If someone thinks that they know the future including 1) a specific stock price and 2) the date it will be achieved, I’m generally available to write options that they can buy. My experience is that they are wrong more than right. There is an entire insurance industry, but there is no “buying insurance” industry; similarly, it is on average more lucrative to write policies than to buy them when it comes to stocks.
Instead of investing based on certainty, I try to invest based on probabilities, to understand the probability-weighted outcomes and then invest only when I can underpay. This is the rare case (and first one I’ve written up on Seeking Alpha) where one can best express this via buying options.
Whatever the right conclusion (I offer mine below, but if I fairly lay out the premises, then this could be a useful exercise even if you reach a different one), it has absolutely nothing whatsoever to do with your cost basis, a factor that doesn’t rank in the top ten things that matter and has almost nothing to do with what you should do next (I’d say “nothing” except for your tax considerations). Ignore sunk costs. The lower the quality of discussion, the more sunk costs seem to factor in; once you get to anonymous internet trolls in public comment sections, they utterly dominate. One of the reasons why I started StW is to have a better quality comment section; happily, members have delivered on that hope.
Downside
The Twitter (NYSE:TWTR) definitive merger agreement was signed on April 25, 2022 but the proposal was made earlier, on April 14, 2022 with at least some deal speculation priced in before that. March 7, 2022 is the date I picked for a recent low with no discernible deal speculation. Twitter is up by about 14% since then while the Global X Social Media ETF (SOCL) is down by 12%. That would imply a downside of around $29. While I think that is reasonable for where TWTR could settle out, I am using a $20 assumption in a deal break with no termination fee with the view that the process itself would at least temporarily impair the company. Any kind of successful material adverse change litigation would add to the downside.
There would be upside potential at $20: other bidders or a shareholder activist could emerge. It has always been an undermanaged and under monetized franchise. It has a weak board with surprisingly little connection to the product or economic exposure to the equity; in a deal failure, they should be replaced. But whatever the opportunities, it would be a different situation requiring fresh analysis as a standalone company.
Upside
While reasonable people can disagree about the downside within a range around the $20s, the upside is pretty clear: $54.20. The buyer did TWTR shareholders a favor by attempting to terminate now instead of at the last possible moment which expedites the process of reaching resolution. Both sides are willing to litigate. Musk’s termination letter implies litigation and the Twitter board is unambiguous stating that:
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. We are confident we will prevail in the Delaware Court of Chancery.
However, there is some shot that the buyer agrees to a trivial cut. A cut similar to what Tiffany agreed to when LVMH tried to cut the deal price in another rich guy temper tantrum would take the deal price down to about $53. A 5% cut would take it to around $51.50. But much bigger than that would be rejected by the sellers unless further adverse information comes to light.
Probability
At around $35, the market implied probability is close to 1 in 2 that the company prevails in Delaware. It is priced at 44% of the way from my downside to the deal price. How sure does one need to be to want to buy this or short it here? It requires no great certainty. If you think that the odds are closer to 1 in 3 that Twitter wins in court, you could short it. If you agree with me that the odds are greater than 2 in 3, it is worth owning today.
I am more confident than ever that the odds are far greater than 2 in 3. The true odds are closer to 4 in 5 than the 1 in 2 market implied probability. Lots of casual commentators sound certain that the odds are 0 in 1, which is both absurd as a probability and doubly absurd to be so certain about a future trial with substantial unknowable factors (such as who the judge will be).
Musk’s termination letter is quite weak. They lead with their best stuff, but even their best stuff is pretty thin. Section 6.4 describes access to information, but contains a key carveout:
… nothing herein shall require the Company or any of its Subsidiaries to disclose any information to Parent or Acquisition Sub if such disclosure would, in the reasonable judgment of the Company, (i) cause significant competitive harm to the Company or its Subsidiaries if the transactions contemplated by this Agreement are not consummated, (II) violate applicable Law or the provisions of any agreement to which the Company or any of its Subsidiaries is a party, or (III) jeopardize any attorney-client or other legal privilege.
Whenever lawyers are trying to make a specific point, it is always crucial to read the surrounding language for context. In this case, “i” and “ii” gives Twitter a ton of space to limit access, especially given Musk’s perfect record of violating confidentiality agreements. “Reasonable judgment” is broad and Twitter’s decisions appear to hit that broad target. And even if they didn’t, it would be capable of being cured, which could be enough for Musk to delay a closing but not to walk away. Marginal information access disputes are not termination events.
The other charges are worded as vague allusions instead of specific assertions. They back away from arguing that Twitter’s numbers are incorrect and just generally wave towards not being able to endorse them. Oh and maybe business is bad enough to constitute a material adverse change. This ignores the clear carve outs from what can be cited as a MAC:
(i) any condition, change, effect or circumstance generally affecting any of the industries or markets in which the Company or its Subsidiaries operate;
(II) any change in any Law or GAAP (or changes in interpretations of any Law or GAAP);
(III) general economic, regulatory or political conditions (or changes therein) or conditions (or changes therein) in the financial, credit or securities markets (including changes in interest or currency exchange rates) in the United States or any other country or region in the world;
(iv) any acts of God, force majeure events, natural disasters, terrorism, cyberattack, data breach, armed hostilities, sabotage, war or any escalation or worsening of any of the foregoing;
(V) any epidemics, pandemics or contagious disease outbreaks (including COVID-19) and any political or social conditions, including civil unrest, protests and public demonstrations or any other COVID-19 Measures that relate to, or arise out of, an epidemic, pandemic or disease outbreak (including COVID-19) or any change in such COVID-19 Measures, directive, pronouncement or guideline or interpretation thereof, or any continuation or of any of the foregoing, in the United States or any other country or region in the world;
(vi) the negotiation, execution, announcement, performance, consummation or existence of this Agreement or the transactions contemplated by this Agreement, including (A) by reason of the identity of Elon Musk, Parent or any of their Affiliates or their respective financing sources, or any communication by Parent or any of its Affiliates or their respective financing sources, including regarding their plans or intentions with respect to the conduct of the business of the Company or any of its Subsidiaries and (B) any litigation, claim or legal proceeding threatened or initiated against Parent, Acquisition Sub, the Company or any of their respective Affiliates, officers or directors, in each case, arising out of or relating to the this Agreement or the transactions contemplated by this Agreement, and including the impact of any of the foregoing on any relationships with customers, suppliers, vendors, collaboration partners, employees, unions or regulators;
(VII) any action taken pursuant to the terms of this Agreement or with the consent or at the direction of Parent or Acquisition Sub (or any action not taken as a result of the failure of Parent to consent to any action requiring Parent’s consent pursuant to Section 6.1);
(VIII) any changes in the market price or trading volume of the Company Common Stock, any failure by the Company or its Subsidiaries to meet internal, analysts’ or other earnings estimates or financial projections or forecasts for any period, any changes in credit ratings and any changes in any analysts’ recommendations or ratings with respect to the Company or any of its Subsidiaries (provided that the facts or occurrences giving rise to or contributing to such changes or failure that are not otherwise excluded from the definition of “Company Material Adverse Effect” may be taken into account in determining whether there has been a Company Material Adverse Effect); and (IX) any matter disclosed in the Company SEC Documents filed by the Company prior to the date of this Agreement (other than any disclosures set forth under the headings “Risk Factors” or “Forward-Looking Statements”).
According to Tulane law professor Ann Lipton:
Merger agreements are drafted to avoid exactly what Musk is doing, which is try to find some tiny little false thing and then say, ‘Whoops, I get to walk away now. They specifically say things like, you can’t back out unless it’s not just false, but incredibly false, hugely false, massively damaging to the company… Musk will have to prove these are real breaches of the agreement but because his conduct up until now so brazenly demonstrated he was looking for any excuse to back out, he’s going to start the case with a serious credibility problem.
In short, if Delaware lets Musk get away with this, then contact law doesn’t matter. Columbia Law School’s John Coffee said that:
I think we are finally going to see if Elon Musk is ‘above the law’. I am confident that in the Delaware courts the answer is no. The law is fairly clear that you cannot pull out from a deal in the manner he is seeking.
Musk has run over the SEC for years; this is the test of whether he can run over Delaware, too.
Caveat
The equity and credit markets have been weak since the deal was announced, making the buyer less likely to want to compromise. The buyer is grandiose and unstable. He’s largely reliant on sales of Tesla (TSLA) to pay for the deal, especially if he nukes outside financing. If Tesla or Elon Musk blows up, it could blow up the deal. That is a real risk and has always been the biggest one (but one that TWTR owners can partially hedge with TSLA puts or shorts).
Also, Delaware is a court of equity. While the likelihood that a judge sides with Twitter in some form is probably 9 out of 10 (given the current set of facts), the judge has a lot of leeway in terms of crafting a remedy. A judgment for specific performance is somewhat less likely (I am using 4 out of 5, but by the time we see the filings it could be as low as 3 out of 4 if Twitter’s reaction is weaker than anticipated on the bot stats, etc.).
If there were an iron-clad new contract – zero outs, cash in escrow, a $10 per share penalty for violating any terms or any non-disclosure or non-disparagement agreement (which the buyer has a perfect record for violating) – it would be worth recutting to around $47.50, around the probability-weighted value of the equity heading into court. If it could save time and add certainty, that would be a plausible re-cut which could hurt the value of my options idea.
Timing
This is about to move fast. The definitive proxy could come out this month in time for a shareholder vote next month. On the regulatory side, the deal needs CFIUS as well as UK CMA and NSI approvals. Then it is onto Delaware which will involve several months of preparatory filings, trial, then waiting for a decision.
Conclusion
The market is full of arb tourists with confident, casual pronouncements that don’t even try to take into account the signed contract or Delaware corporate law. They seem to know that the deal is off, that litigation will take years, and that Musk will do whatever he wants with Twitter just like he does whatever he wants on Twitter. I take the other side. The most leveraged way to bet would be to buy January 20, 2023 TWTR $52.50 calls which last traded for $0.40. One could lower the strike to $50 in order to win if there is a trivial Tiffany-like price cut. But I prefer to pay up to both lower the strike and give myself some more time in case the negotiating dynamics sour and the process drags a bit: down to $47 and out to June, 2023. By then, the calls should be profitable or the outcome was bad. The downside outcome of any call is obviously $0.00. Size accordingly.
TL; DR
Buy TWTR or — sized appropriately — June 16, 2023 $47 TWTR calls, which last traded for $2.25 with a $1.56 bid and a $4.15 ask.
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