Twitter (NYSE:TWTR) stock has been here before. After a well-received second quarter earnings report last month, Twitter stock has cleared $40 for the first time in over a year, save for a brief stretch in early May.
In the past, that hasn’t been good news for TWTR stock. A price above $40 earlier this year held for just a few sessions. Last year’s trip to $46 ended suddenly after a disappointing second quarter report; Twitter stock would wind up falling over 40% to December lows. Similar trading played out in 2014 and 2015.
Perhaps this time is different. I’ve long been a skeptic toward TWTR, but even I admitted late last year that Twitter was a better company. Valuation, particularly in this market, isn’t extreme. That’s particularly true given that Twitter has managed to tackle its long-running stock-based compensation problem.
But the fact is that current prices above $42 still presume quite a bit of earnings growth is ahead. Yet 2019 results haven’t been all that impressive. Users are growing. Margins, however, are not expanding. That might change starting next year – but if it doesn’t, $40 once again will prove to be a bridge too far for Twitter stock.
The Margin Problem for Twitter Stock
Last year, Facebook (NASDAQ:FB) posted the largest one-day loss of market value in history. The catalyst was a disappointing Q2 earnings report.
The issue wasn’t earnings themselves: revenue and profits were basically in line with expectations. Rather, among the issues that spooked investors was guidance for an enormous increase in operating expenses, in a bid to tackle privacy concerns and to clean up unwanted activity on its platforms.
Coincidentally, TWTR shares would plunge the following day, albeit for different reasons. (Its user numbers disappointed.) But looking at Twitter’s 2019, it’s not hard to see echoes of the same problem that led investors to flee FB stock last year and not completely return. (FB remains about 18% below pre-earnings highs.)
Twitter’s spending this year seems notably elevated. It’s guiding for a 20% year-over-year increase in operating expenses for the full year. Strong revenue growth — 18% in each of Q1 and Q2 — has kept those expenses from completely offsetting profit growth.
But margins still have stalled out. Through the first half of the year, Adjusted EBITDA was 35.4% of revenue, against 37% the year before. That’s not a huge decline, obviously, but it matters.
More importantly, it’s the opposite of how social media platforms hopefully work. Incremental margins should be enormous, as extra advertising dollars and higher engagement cost the company very little. That’s exactly what Snap (NYSE:SNAP) has done so far this year, a key reason its stock has soared.
Valuation Concerns for TWTR Stock
Margin pressures don’t make Twitter a short, to be sure. But they do suggest an issue with bottom-line growth going forward. If Twitter’s earnings rise mostly in line with revenue going forward, that puts a lot of pressure on revenue and user growth.
And it’s possible that’s OK, even with Twitter near a 52-week high. Users have been growing double-digits of late. Revenue per user is increasing, albeit modestly.
But increases in users, and user engagement, may slow. At least one analyst cited a risk from a potential loss of the “Trump effect” come 2021 (assuming a Democratic candidate wins the 2020 election). User growth had stalled out until the last few years; it’s possible both the president himself and the heightened political environment are factors in its acceleration.
In terms of revenue per user, this is a notably more competitive time for online advertising. The duopoly of Facebook and Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) at one point was driving almost 100% of online advertising growth. But per figures cited by online ad player Digital Turbine (NASDAQ:APPS), the two companies lost share in 2018.
Twitter likely has taken some of that share, but so has Snap. So have myriad independent publishers, whose growth has boosted ad-tech names like APPS, The Rubicon Project (NASDAQ:RUBI), The Trade Desk (NASDAQ:TTD), and many others. Growth of rivals may well continue.
On the whole, Twitter can move profits higher. But if margins and revenue per user both are at or near a ceiling, that profit growth comes down almost solely to users. And that creates a narrow path — and bigger post-earnings risk if those user numbers disappoint at all.
On the Sidelines
TWTR may still rise from here. Valuation, looking to 2020 EPS estimates, isn’t prohibitive. Twitter stock trades at about 32x 2020 consensus, backing out roughly $5 in share in net cash.
That’s not a huge multiple, even if it is a premium to both FB and GOOGL. But it’s a number that still includes a hefty amount of stock-based compensation: some $350-$400 million this year. Back that out (on an after-tax basis) and the forward P/E multiple likely moves to over 40x.
In other words, there’s a lot of growth priced in here, but there are some headwinds to that growth in coming quarters and in coming years. In the past, that combination hasn’t worked out well for TWTR stock. I wouldn’t be stunned if the same thing happened this time around.
As of this writing, Vince Martin has no positions in any securities mentioned.