Should You Buy the Twitter IPO?

Twitter has mobile figured out, but the valuation could be a problem

By Tom Taulli, InvestorPlace Writer & IPO Playbook Editor

The Twitter IPO is almost here, and so far, Wall Street has given the deal a giant thumbs-up. On Monday, Twitter upped its price range on the offering to $23 – $25, up from the initial range of $17 – $20.

But there are some doubters, of course. According to an AP-CNBC poll, nearly half of active investors think the Twitter IPO will not be a good investment.

So who is right?

Twitter IPO Pros

Founded in 2006, Twitter now has more than 230 million monthly active users and more than 100 million daily active users. They help to generate roughly 500 million tweets every day.

A key advantage is that Twitter doesn’t have to pay for any of its content. What’s more, millions of people actively promote the service to their friends and fan bases, even across other social networks.

For the most part, Twitter generates revenues with advertising. But the campaigns are based on something called the “Interest Graph,” which targets campaigns based on user behavior. According to the S-1: “We believe a user’s Interest Graph produces a clear and real-time signal of a user’s interests, greatly enhancing the relevance of the ads we can display for users and enhancing our targeting capabilities for advertisers.”

But it also helps that conversations are at the core of Twitter. Such real-time activity provides advertisers with lots of opportunities to build their brands and sell products.

Mobile is also critical for Twitter. Unlike other social operators like Facebook (FB), Zynga (ZNGA) and LinkedIn (LNKD), Twitter started as a mobile-first company. Its 140-character limit is ideal for the medium, so it’s no surprise that about 70% of advertising revenues come from mobile sources.

Yet it still looks like the company is in the early stages of monetization as we race toward the Twitter IPO. After all, the company didn’t even introduce advertising until 2010.

In fact, perhaps,the biggest opportunity ahead is Twitter’s role as the “second screen.” That is, it is common for users to use the service while watching television — and the result can be juicy opportunities for targeted, relevant ads. Twitter recently signed deals with CBS (CBS), Comcast (CMCSA), Disney (DIS) and the NFL.

There’s little doubt that Twitter is a tremendous success story and should continue to benefit from the growth in mobile advertising. But that doesn’t mean the company is without its challenges.

Twitter IPO Cons

Yesterday, I put together a post for the IPO Playbook that details four major risk factors. Two are particularly troubling.

One is that TWTR is suffering from deceleration in the ramp of monthly active users. YOY growth at the end of Q3 was 47.8%, barely up from 44.37% in Q2. The trend is even worse on a QOQ basis, slowing from 10.27% in Q1 to 6.9% in Q2 and 6.13% in Q3. Consider that when Facebook reached more than 200 million MAUs, the QOQ ramp was 20%.

So what’s behind that stalling user growth? The service generally gets high engagement when there is a major global event, which doesn’t happen often. Additionally, it may not have mainstream appeal. (Your grandma might be on Facebook, but is she on Twitter?) According to a recent report from Twopcharts, about 651 million registered users have actually abandoned Twitter — far more than the number of monthly active users.

As for the other big risk factor for the Twitter IPO, you can’t ignore the nose-bleed valuation. Based on the high end of the price range, TWTR stock sits at a whopping 26X. This compares to Facebook’s 18X and LinkedIn’s (LNKD) 19X.

Buy or Avoid?

It certainly looks like Twitter will have a strong opening tomorrow. Based on what we’ve seen from other tech deals, the Twitter IPO could pop 50% or more. The problem, of course, is that most retail investors won’t get the chance to buy shares at the offering price.  Instead, they’ll have to wait and pay a premium price for the stock.

Besides, the social stocks have already staged a huge rally this year, as investors have factored in much of the good news from the mobile megatrend.

Ultimately, retail investors should avoid the Twitter IPO. The valuation is out-of-whack with its social peers, which have already had big moves. Going forward, Twitter may also have a tougher time generating strong revenues because of its lagging user growth. As seen with Facebook’s latest earnings report, even hints of deceleration can be a drag on the stock price.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He also is the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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