Twitter (NYSE:TWTR) hasn’t had a great couple of days. Twitter stock started sliding on January 5 and fell precipitously after officially banning Donald Trump for life. Far from being a disaster, though, this latest dip is just an opportunity to buy Twitter at reduced prices.
I wrote in October that the company was worth between $56.25 and $67.50, between 34% and 46% more. I still think that Twitter stock is worth the upper end of this range.
One of the reasons I liked Twitter was its hefty free cash flow (FCF). However, in Q3, Twitter dramatically raised its capital expenditure spending.
Free Cash Flow and Twitter Stock
On page 12 of its shareholder letter, Twitter said that this was due to spending on building out its data centers to handle more audience growth and product innovation. This had the effect of lowering its free cash flow into negative territory. Twitter said that its adjusted FCF fell to negative $74.
This was because capex spending rose from $169 million last year to $289 million in Q3. As its cash flow from operations was $215, the deduction of $289 million in capex took FCF to negative $74 million.
Moreover, Twitter said that its capex spending in Q4 will stay at an elevated level of $250 million as it keeps on building out data centers. This heavily implies that its Q4 FCF will stay negative.
Keep in mind that the cash flow from operations (CFFO) minus capex spending equals FCF. If FCF goes negative from higher capex spending than CFFO, it essentially has to either draw down cash from its balance sheet or else borrow money to cover the deficit.
Therefore, to study whether the underlying business is doing well we can look at CFFO, instead of FCF. This is especially so since it looks the excess capex spending will be temporary while the data centers are being built.
For example, Twitter made $214.9 million in CFFO during Q3. This was 6.9% higher than the $201 million in CFFO it produced during Q2. In other words, despite the negative FCF, Twitter had underlying CFFO cash flow growth in Q3 over Q2.
What to Do With Twitter Stock
I suspect this underlying CFFO growth will continue as the economy returns to normal. For example, Twitter’s peak CFFO quarter was in Sept. 2018, which you can see here on this Seeking Alpha page.
It made $443.9 million in CFFO that quarter, over twice the CFFO it made this past quarter ($214.9 million). In other words, I expect that cash flow could double over the next year or so as its growth returns to normal.
For example, once CFFO reaches $450 million per quarter, and assuming capex returns to its normal $125 million to $150 million level, Twitter will be making $300 to $325 million in FCF each quarter. This amounts to $1.2 to $1.3 billion annually.
Now we can estimate Twitter stock’s underlying value. For example, if we divide $1.25 billion (the mid-point of our estimate of annual FCF) by say 2.5%, the target market cap will be $50 billion. This is the result when we divide $1.25 billion by an average FCF yield of 2.5%.
Therefore Twitter’s target market cap is $50 billion, vs. $40.84 billion today. That implies that Twitter stock should be 22.4% higher than today. In other words, the stock is worth $63.00 per share (i.e., 1.2243 times today’s price of $51.48).
This is $63.00 Twitter stock price target is in between my original $56 to $67 price target in my last article. Keep in mind that it assumes that twitter’s CFFO returns to its previous highs of $450 million or so and its capex spending returns to normal historical levels.
What Drives Its Growth
In other words, Twitter’s ad revenue and data fees will return to normal as more people use the service. This is likely to happen since Twitter says its monetizable daily active usage grew 29% year-over-year in Q3. This is what drives its growth – a larger and larger audience.
Therefore look for Twitter stock to hit $63.00 or 22% higher in the next year or so.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Mark Hake runs the Total Yield Value Guide which you can review here.
