Shares of Twitter (NYSE:TWTR) exploded higher in early February, as the social media company’s impressive fourth-quarter user growth boosted Twitter stock. The company’s Q4 results led investors to believe that its product innovations are improving the experience of its users, driving more users to the platform. Advertisers tend to follow users, so Twitter’s accelerated user growth today should lead to accelerated revenue and profit growth for the company tomorrow.
That’s why Twitter’s shares are up 15% in 2020 and are trading near their highest levels since October 2019. Investors expect the company’s financial growth to accelerate in the second half of 2020.
But, for a few reasons, I think investors should be cautious about Twitter stock at its current, elevated levels.
First, the company’s revenue growth trends remain sluggish, and increasing competition coupled with easing digital ad market trends suggest that the company’s revenue growth may not accelerate as Wall Street expects. Second, its profit growth trends remain sluggish, and the intensive investments in products and security it will make in 2020 imply that its profit growth will stay sluggish for a long time. Third, the valuation of Twitter stock appears exceedingly full, with little room for gains even if everything goes right for the company.
Given these points, I’m not chasing this rally. Instead, I’m selling Twitter’s shares as the stock rises.
Twitter May Not Deliver
The recent strength of Twitter stock can be chalked up to hopes regarding what will happen, not excitement surrounding what has happened.
While the website’s daily active users rose 21% YoY in Q4 amid several product improvements, including giving users the ability to follow Topics, Twitter’s financial trends remained bearish. Its revenues rose just 11% year-over-year, while its expenses jumped almost 25% YoY. Its earnings before interest, taxes, depreciation, and amortization (EBITDA), excluding some items, fell more than 6% YoY, thanks to a drop of nearly seven percentage points in its EBITDA margins.
The Street expects these financial trends to improve, driven by high user growth and ad product improvements
That will happen, but perhaps not to the extent the Street is expecting. That’s because certain risks may prevent Twitter’s revenue growth from accelerating to 20%-plus.
First, the entire digital ad market is slowing from 20%-plus growth to under 20% growth. Second, Twitter is facing increasing competition for digital ads from Snap (NYSE:SNAP), Pinterest (NYSE:PINS), and Tik Tok .
At the same time, Twitter’s margins will remain under pressure. That’s because Twitter will have to hire many more people to implement its platform and product improvements. As a result, the company’s expenses are expected to jump 20% in 2020. So, if its revenues don’t rise more than 20% this year, than Twitter will be looking at yet another year of profit margin declines.
Twitter’s Valuation Is Full
Twitter stock will also likely be held back in 2020 by worries about its valuation.
Twitter trades at 36 times analysts’ average 2020 earnings estimate. Digital ad giants Facebook (NASDAQ:FB) and Alphabet (NASDAQ:GOOG) trade for around 25 times their forward earnings. Yet the revenue of Facebook and Alphabet are rising by 20%-plus with steady profit margins. Twitter’s revenue is climbing 10%-plus with declining profit margins.
So Twitter doesn’t deserve its current, elevated valuation.
Twitter will exploit its platform and ad product improvements to maintain its market share in the ultra-competitive digital ad industry. That industry is expected to grow at a low double-digit-percentage compound annual growth rate through 2025. Twitter’s revenue growth rates should be similar to that of the industry. Meanwhile, its profit margins will inch higher as its product investments moderate. Profit margin expansion on top of low double-digit revenue growth should result in 15%-plus profit growth.
Based on these assumptions, I estimate that Twitter’s earnings per share will reach $2 by 2025. Applying a forward earnings multiple of 25, which is average for the digital ad sector, and a 10% annual discount rate, I arrive at a 2020 price target for the shares of $34.
The Bottom Line on Twitter Stock
Twitter is a solid company with a great product. Its decision to allow its users to follow Topics as well as its inclusion of more video content on the platform will be huge positive drivers of user engagement. Going forward, the company’s financial trends should improve as its engagement keeps rising.
But all of these trends are already fully priced into Twitter stock, so chasing the shares’ rally seems foolish.
As of this writing, Luke Lango was long FB and PINS.
