Jack Dorsey’s excellent year continues. Square Inc (NYSE:SQ) is up 77% year-to-date and more than 150% over the past 12 months, and Twitter Inc (NYSE:TWTR) is performing equally well. Twitter stock, not to be outdone, is up 75% year-to-date, and close to 140% over the past 12 months.
Investors had substantial doubts about Dorsey’s management chops as recently as last year. Now, he’s got the golden touch.
But will Dorsey’s magical run continue? Square stock is a topic for a different day. But as far as Twitter goes, there are some reasons you should be concerned. Technical factors, namely the S&P 500 index adding Twitter stock, have powered much of the run.
On top of that, Twitter has achieved profitability via severe cost-cutting rather than top-line growth. That said, Twitter is doing plenty of things correctly as well.
Twitter Stock Cons
S&P 500 Momentum Will Fade: TWTR stock has blasted to new 52-week highs in large part due to being including in the S&P 500. Previously, Twitter had not been eligible for the S&P 500 due to not generating profits. Now that it has achieved that threshold, TWTR stock is a member of the big leagues.
This is good news in the long run (I’ll elaborate in a moment). However, in the short-term, we should expect Twitter stock to sell off. Hedge funds often buy stocks that are likely to be added to major indexes. Then they dump them once the ETFs and other passive money flows are forced to buy in as well.
Given the popularity of these strategies, you generally will see significant selling pressure in the following weeks once an index rebalancing occurs. With Twitter stock up so sharply heading into the S&P news, the next move should be a decline.
Profitability Via Cost-Cutting: Twitter hasn’t taken the usual tech route to profitability. Normally, a technology company aims to achieve scale. It builds out a platform, and then rounds up enough users to make revenues on it exceed the operational costs to keep things humming.
Twitter has not done this. Instead, Twitter, with its flatlining revenues, has instead cut costs relentlessly. In this manner, Twitter has achieved profitability. But it comes at a cost. From its peak with more than 4,000 employees, Twitter is down to 3,400 today. They slashed the R&D budget by about $200 million last year.
When trying to keep up with Facebook (NASDAQ:FB) and Alphabet, Inc. (NASDAQ:GOOGL) in digital advertising, along with other smaller rival social platforms such as Snap, Inc. (NYSE:SNAP), you’d rather see Twitter have an open checkbook to keep talent around.
Tech companies shouldn’t waste money spending extravagantly, but on the other end of the spectrum, Twitter’s cut to the bone model risks technological obsolescence.
Political Issue: Last week, we learned that Democratic Senator Mark Warner is investigating Twitter and Alphabet. Warner wants to learn more about their connections with Chinese vendors.
Specifically, Warner asked about connections between Alphabet and Twitter and vendors ZTE, TCL, and Lenovo. To Twitter in particular, Warner also inquired into their relationship with Huawei.
The investigation deals with the handling of consumer data. Given the problems that Facebook has had with mishandled data, it’s not hard to see how this could become a problem for TWTR stock depending on what information Warner turns up.
Twitter Stock Pros
S&P 500 Index Constituent: Right now, the market cap threshold for joining the S&P 500 is around $5 billion. Twitter, with a market cap of $30 billion now, has long cleared that mark. However, TWTR stock remained outside of the index for another reason: it didn’t make money.
Now that Twitter has earned a net profit over the past 12 months, it has met all the requirements to join the S&P 500. This attracts a ton of passive investing money into ETFs such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).
SPY alone has $267 billion in assets, and hundreds of billions more follow the S&P 500 index in other passive funds. S&P sector funds such as the Technology Select Sector SPDR ETF (NYSEARCA:XLK) also are forced to invest in TWTR stock now that the company joined the main S&P index.
All this passive money inflow represents a new fixed investor base in Twitter stock that previously didn’t exist. More locked-up stock in passive ETFs means that the effective TWTR stock float decreases. With less supply of Twitter stock available to traders and active investors, the valuation should rise over time.
Facebook and Google Stumbles: Alphabet and Facebook (especially Facebook) have gotten into trouble with regulators both in the U.S. and Europe in recent months.
Various European parties, for example, are suing the two companies for almost $9 billion for violations of the newly-enacted GDPR rules over there. And Facebook’s problems in the U.S. with the Cambridge Analytica scandal are well-known at this point.
All that adds up to an opportunity for Twitter. Google controls around 32% of the digital ad market, with Facebook in the low 20s. The two are a sort of duopoly now. Twitter is in third place, but with under 5% of the market.
However, with the big two facing heightened regulatory scrutiny, now is the moment for Twitter to pick off advertisers from its two bigger rivals. It remains to be seen if they can do it, especially while in cost cutting mode, but the window of opportunity is there.
Rising Profitability: Analysts forecast that Twitter will be able to build on its recent successes. The consensus analyst forecast sees the company’s profits almost doubling over the next year.
Should those expectations play out, Twitter would move from around 85x trailing earnings today to under 50x next year’s earnings. That still wouldn’t make TWTR stock cheap by any means. But it’d be a plausible valuation at least.
TWTR Stock Verdict
Congratulations to Twitter for finally becoming profitable and entering the S&P 500 Index. They’ve made it out of the money-losing phase and have validated that the business is sound and built for the long-haul.
At the time of this writing, the author owned FB stock. You can reach him on Twitter at @irbezek.