NEW YORK (TheStreet) -- Twitter (TWTR) took a lot of headline heat after Standard & Poor's slapped a junk-bond rating on the $1.8 billion of convertible debt the microblogging service issued last month. But the logic behind the rating is actually pretty good news -- for Twitter's stock.
The company's new BB- rating, three steps below investment grade, is hardly a death sentence. It means Twitter is "less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions." And the things that make S&P wary of the bonds, which were oversubscribed when they were brought to market, are the very things equity investors should like about Twitter.
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Specifically, S&P's report makes the simple, rather obvious observation that the company's very active capital investment plan raises its financial risk. Which it does. The thing is, investing in innovative new products has also been where Twitter's growth and emerging profitability has come from. (In the first nine months of the year, Twitter's sales rose 118% to $924.9 million and profits before interest, taxes, depreciation and amortization were about $160 million, with EBITDA profit margin reaching 19% in the third quarter).
"We assess Twitter's business risk profile as "fair," reflecting its unique real-time social networking service at scale; strong brand recognition; very large audience base; [a] service which is well-suited to mobile environment; and healthy EBITDA margin," S&P analysts led by Andy Liu wrote. "These considerations are balanced by intense competition with larger competitors that have more resources and high new-entrant risk. ... The company will need to make continual, sizable investments in its products and services to ensure growth and innovation, as well as maintain its relevance with its users."
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Well, yes. To all of this. It's a very fair assessment of where Twitter is, including the presence of competitors either larger (like Facebook (FB) ) or richer (like Yahoo! (YHOO) , looking to spend the bonanza it reaped from Alibaba's (BABA) initial public offering) or both. The question is how much you get paid to take even that modest risk.
Twitter's paying 0.25% and 1% interest, on bonds that mature in five and seven years, respectively. Even if there's only a modest chance of not being repaid, you're going to fall behind inflation anyway. So the paper's real appeal, unless you're a flat-earther who thinks all kinds of assets are headed for the toilet but still thinks Twitter will repay the bonds on time, is to get the right to convert the bonds into Twitter shares at $77.48. Twitter's shares are right around $40, after a third quarter whose details fell short of analyst forecasts.
At 0.25%, you're not getting paid to take the modest risk that Twitter will somehow slip off a financial log and fall into a raging stream. (When Amazon.com (AMZN) issued similar debt in 1999, it paid 4.75%). You're better off buying the shares and getting the extra $37 per share you'll collect if your bullishness on the company proves correct.
The company's investor day this week bolsters that case. Chief Financial Officer Anthony Noto told analysts the company has only managed to grab about $1 billion of its $14 billion in potential annual revenues. The company's plan to get the rest begins with simply running more ads to existing users -- its so-called "ad load" is about a quarter of Facebook's. he said. Most of the rest involves product refinements the bond offering will help pay for. He also raised the company's long-term goal for profit margins (using EBITDA) to between 40% and 45% -- a goal RBC Capital analyst Mark Mahaney says is credible.
Paying for more of the needed investment with debt simply means there's more left over for shareholders. And that's a good thing.
A better way to grab income from the New Economy is the 4% bonds SolarCity (SCTY) began selling to retail investors the same week, backed by the income from long-term contracts related to the rooftop solar systems the company installs on people's houses. S&P rates SolarCity bonds as investment grade, because the income stream from them is much steadier and more predictable than Twitter's. That income stream is also much smaller than Twitter's potential -- there's less risk, and the paper offers less reward.
Bonds and stocks are both useful, but each has its purpose. The best way to chase reward, most of the time, is to buy stocks. The best way to get income is to seek out steadiness. Risk is good -- but you should get paid to take it.
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At the time of publication, the author held no positions in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
TheStreet Ratings team rates FACEBOOK INC as a Hold with a ratings score of C+. TheStreet Ratings Team has this to say about their recommendation:
"We rate FACEBOOK INC (FB) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, largely solid financial position with reasonable debt levels by most measures and impressive record of earnings per share growth. However, as a counter to these strengths, we find that the stock itself is trading at a premium valuation."
You can view the full analysis from the report here: FB Ratings Report