Be Careful With Twitter Stock

Advertisement

Twitter (NYSE:TWTR) stock soared in late July after the social-media company reported second-quarter  revenue and profits which came in below analysts’ average estimates.  Twitter’s top line fell 19% year-over-year.  Its bottom line consisted of a loss of over $1 billion, versus a profit of more than $1 billion during the same quarter a year earlier.

twitter on a phone screen

Source: Worawee Meepian / Shutterstock.com

TWTR stock rallied on earnings that looked bad because its user growth smashed expectations. Twitter’s daily active users (DAUs) jumped 34% year-over-year to 20 million in Q2. That was the highest growth of DAUs on record since Twitter started reporting them. The company’s management also talked up the revenue potential of a new subscription service, which got Wall Street excited.

But I think this rally of TWTR stock is overdone.

There is a growing disconnect between Twitter’s user growth and  its revenue growth, mostly because ads and the company’s platform simply don’t mix well. That is a fundamental problem which will forever put a lid on Twitter’s revenue and profit-growth potential.

A subscription service for the most frequent users will help alleviate some of the firm’s revenue-growth problems. But the service’s potential doesn’t justify the recent surge of the stock, which is now the most richly valued social-media stock in the market, by a long shot.

Given these points, I think that investors should steer clear of TWTR stock at its current levels.

Here’s a deeper look.

Twitter’s Earnings Weren’t Great

Don’t let the surge of TWTR stock fool you. Twitter’s Q2 report was not good.

Its revenue fell 19% year-over-year. Sure, that drop can be blamed on the Covid-19 pandemic. But just a few days earlier, Snap (NYSE:SNAP) reported 17% YOY revenue growth for Q2. Plus, Snap said that its revenue in July was climbing about 30%. Twitter, on the other hand, said its ad revenue declined 15%YOY during the last three weeks of June.

In other words, Twitter’s bad Q2 revenue was not entirely caused by the pandemic; unlike Twitter, other digital-ad businesses are still reporting robust revenue growth during this period.

Twitter’s expenses actually rose 5% YOY, against the backdrop of a 19% revenue decline. As a result, its profit margins got killed, with Twitter’s  operating margins plunging from 9%, to -18%.

The one silver lining of the report — which Wall Street is choosing to focus on — was its 34% YOY user growth in the quarter.

But that metric is much less meaningful than some believe.

Fundamental Problems

Supercharged user growth is meaningless for a social-media company unless it’s followed by supercharged revenue growth.

Twitter has a history of not following supercharged user growth with supercharged revenue growth. Since the first quarter of 2017, the company’s daily active user growth rate has averaged above 15%. Over that same time period, its revenue growth has averaged 9%

The reason for the disconnect is the fact that ads and the Twitter platform don’t mix that well.

There are really two reasons for that.

First, the Twitter platform isn’t built to support ads. That is, its ads are most effective when they are visual and immersive. In visual-heavy, full-screen-image social-media feeds like Instagram, TikTok and Snap, full-page, immersive visual ads fit in seamlessly with the other content on the platforms.

But Twitter is a feed of tweets, which are a smorgasbord mixture of 120-character messages and some small images and memes. Effective ads simply don’t fit well into that feed.

Secondly, Twitter’s users aren’t going to the platform to find out about products and services. They are going to Twitter to read about the news, see what’s happening in the world and scroll through entertaining exchanges of views.

So when an ad pops up while users are reading about Kanye West’s meltdown at his first campaign rally on Twitter, it does not exactly add to the experience; actually, it’s intrusive. And chances are high that users will ignore the ad and go back to reading about Kanye.

That, of course, stands in stark contrast, again, to platforms like Instagram, TikTok, Snap and Pinterest (NYSE:PINS), where influencers, brands and users are already using those platforms to recommend products and services. Consequently, product and service discovery has become part of the missions of those websites.

On those platforms, ads work.

Sure, Twitter can innovate and do things to fix these fundamental problems. But, as of right now, ads and Twitter simply don’t mix well. As long as that remains the case, the company’s long-term revenue and earnings-growth potential will be capped.

Twitter Is Richly Valued

My base case on Twitter is fairly simple.

Because Twitter is one of the largest social media platforms in the world, which provides differentiated value to users, along with a sticky user base and robust reach, Twitter’s ad business will grow in-line with the global digital-advertising market.

But because Twitter provides less compelling value to advertisers than other platforms, the company will not grow its share of the global digital-advertising pie. That’s especially true because other ad platforms like Snap, Pinterest, TikTok and Amazon (NASDAQ:AMZN) are ramping.

As a consequence, Twitter’s ad business will steadily grow about 10% per year.

A new subscription business would add some revenue firepower, but not much. About 10% of Twitter’s users drive 80% of the conversation on the platform, so about 15 million to 20 million users could potentially join the service. Assuming 10 million sign up for a subscription service at $10 per month, it would be a $1.2 billion annual revenue opportunity for Twitter.

After factoring the $1.2 billion into my estimates, I see Twitter marching towards nearly $10 billion of revenue by 2030. Assuming its operating margins expand to 30%+, I think that $10 billion of revenue will likely translate into earnings per share of $3.50.

Social-media stocks typically trade for a forward price-earnings ratio of around 20 times their forward earnings. A 20-times forward multiple on EPS of $3.50 in 2030 results in a 2029 price target of Twitter stock of $70. Discounted back by 8.5% per year, that works out to a 2020 price target for Twitter of $34.

The Bottom Line on TWTR Stock

Twitter is a great platform, but Twitter’s ad business is not so great.

Wall Street is expecting supercharged user growth today to lead to supercharged revenue growth tomorrow. Twitter’s history and fundamentals say that isn’t going to happen.

If it doesn’t, then TWTR stock could fall further.

Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he was long SNAP, PINS, and AMZN. 


Article printed from InvestorPlace Media, https://investorplace.com/2020/07/be-careful-with-twitter-stock/.

©2024 InvestorPlace Media, LLC