There appears to be a lot of zealous hype around social media stocks this year, and in particular of this past month in light of performance, with Twitter (TWTR). I am most shocked by how the valuation analysis focuses on numbers, and less about the qualitative aspects of Twitter's business model. I suspect it is because those who are doing the valuation work are not Twitter users (ie. Age 18-35, sorry!). As a result, I wanted to share a very simple and human approach to understanding Twitter's business model in the context of its user base behavior versus its competitors, including my own, instead of using unknown numbers as unknown plugs to unknown models. At its core, Twitter is unlike Facebook (FB) or LinkedIn (LNKD) and I think this differentiation warrants a human discussion to truly extrapolate its growth potential that justifies its fundamental value proposition.
Are TWTR users content generators or readers?
Unlike FB or LNKD, Twitter is used by an eclectic pool of people whose behavior cannot be easily bucketed or predicted. Twitter claims to have over ~200mm users, but all of these users fall into different pockets of monetizable behaviors. For example, how many users create content, versus just consume content? How much of this content is personal versus professional? How many use Twitter just as a platform to access other platforms? How many users actually log on to TWTR to share a meaningful social experience versus as private experience? (Hint: this is important, and is one of the fundamental differences between FB and LNKD, and why LNKD has not been able to grow as quickly as FB). More importantly, how engaged are TWTR users relative to other social networks? (Is it a longer visit less frequently, or shorter visit more frequently?) Furthermore, the growth of user base itself has been mediocre at best with quarterly gains ranging from 7 to 10% over the last two years. Network companies like TWTR should be experiencing triple digit growth numbers like FB to truly capture an engaged community. So just what is Twitter exactly, anyway?
Limited Ad Market
What people forget is that while mobile ad is a new and growing market, it is not an infinite pool of cash. We all have limited time on this Earth, and so it does not mean that more functions mean more browsing on the web/phone. It will have to become cannibalistic as all mature markets become, and Twitter's gains will have to come at losses by Facebook, Google (GOOG), and many others. This is a really important point to understand - a teenager is not going to double his time on his phone because Twitter has "excellent releases/updates" - he will just spend less time on a different platform. Now, we all must assume that management of these social companies are extremely bright and capable, quick to adjust, and so it's very difficult to think we can predict this cannibalization. For now, let's keep this number in mind: the mobile ad market was about $9bn in 2012, of which FB captured 25%.
Tail risks of innovation
Twitter can of course introduce services that totally blow the market away. I believe this is the inherent risk of being negative towards this company. It may be the first to incorporate Square (in a social way, like Venmo - and this could be radically huge), or it may release more AWS services in combination with its programming language Bootstrap. It may even go into home entertainment somehow, or it may find a way to monetize gaming. It may completely create something we can't even know. This is the primary risk to being short, and it would certainly keep me awake at night should any whisper of such came to light.
My Personal user experience
I use all of the mentioned social networks and more. However, I use them all in different ways, and I can see why mobile ad revenue monetization is easier in one platform versus another. I believe that FB has created an amazing and sticky experience that combines content generation / readership in a seamless way that is enhanced by targeted ads. I also believe that LNKD has a strong and inelastic user base requiring certain professional functions and advertisements regarding industry products that makes it a valuable proposition for a consumer. The important question here is - why would I seek ads on Twitter? I use Twitter in a way that I suspect most people do - to create a semi-anonymous but certainly public voice to share my thoughts with the world, whoever that may be. I do not use Twitter to gather news primarily (though at times, I will browse), and I do not use Twitter to discover brands/products of my followers. As a result, if I see ads on Twitter, I am more likely to be bothered by it. I already get a large amount of DM since the release of the feature that I find to be annoying and of little value. In short, Twitter exists in some form to allow the creation of a follower base - for what function, that is the truly unknown. I am not going to buy a book that someone on Twitter advertises for me because he or she wrote it, simple!
...And my Professional user experience
I considered using Twitter to share ads. However, I ultimately chose not to use it for several reasons. 1) the targeted demographics are limited. This is because Twitter just doesn't have as much information about you as the rest of the social networks collect, which is ultimately a part of its corporate identity. 2) Twitter doesn't have ready recipients of ads - I have noticed that everyone on Twitter are already those who are trying to promote their own content. Why would they waste time promoting yours? 3) My personal experience with ads - I find ads on Twitter to be misplaced and abrupt. It does not flow well, and does not come with recommendations in a meaningful social context. It just pops up. It's in fact more annoying than Google's ad results, because with Google at least, I am usually searching for the business. With Twitter, it feels intrusive.
Now, the valuation part
Valuation is an art with this name. However, I think a worthwhile exercise is to size the market, and predict its best and worst scenarios. It is in this light that I present my valuation case for Twitter.
1) Let's start with the top line. Twitter has ~535mm in revenue over last 12 months. Facebook has ~5,100mm, and LinkedIn has ~1,400mm. For the benefit of doubt, I am going to assume that Twitter can not only double or triple, but quadruple its top line over the next year. It certainly has happened, though it is an optimistic assumption. For example, in 2009, Facebook went from 633mm to 1785mm over the year. And this was Facebook, whose user base was growing by multiples. Twitter may be able to do it faster because it is a more tested market now with educated customers, and so that's why I'm using 4x. This number is also educated by the fact that the total mobile ad market is going to be 13bn in 2013. This is an optimistic assumption given Twitter is mainly a mobile product (again, another differentiator vs FB and LNKD), and a difficult one since it implies it's going to capture 15% of mobile ads in one year. Facebook currently only has about 25% of the mobile market, and their user base is not only more engaged but absolutely astronomically larger, and they took more time to do it.
2) Gross margin - Facebook is operating at 75%, Twitter is operating at 60%. I am going to assume that TWTR can run just as well as FB and take the 75% margin. From there, I take the usual adjustments to predict a net margin of 15%, which surprisingly comes in line with Facebook (LNKD is at 3-6% for the last 3 years). This brings net income to 320mm.
3) This net income, using fully diluted shares, assumes an EPS of 57 cents. I am going to apply a whopping 60x PE which values the stock today at 34.65. The 60x PE is using Facebook's forward PE ratio, which is the most educated PE ratio we can use from the capital markets.
You can take whatever assumptions you want to then make the bullish case to get Twitter to its current price - Change the PE from 60 to 120, or assume 8x Revenue growth in 1 year, or assume the Twitter's margins can be better than the current behemoths. To further highlight why TWTR is overvalued in all sense of optimism, we come back to the P/S which is the only sensible ratio to value TWTR given it has no visibility to profitability into 2015. P/S for FB, LNKD, and TWTR is respectively 19x, 17x, and 65x. The last one clearly stands out, and truly implies that TWTR must grow revenue by 400% within the year.
I now use Hedgemony.us to check institutional ownership of the stocks that are publicly available. For LNKD, we see several institutional owners as well as reputable hedge funds. Landsdowne Partners for example increased its stake by 40% during the past quarter. We also see that Conatus Capital is involved (although its stake decreased to now just 3% of the Fund's long portfolio). Coatue Management, a Tiger cub, owns 1mm shares at 2.5% of the fund's long portfolio, which increased about 8% since last quarter. I already covered Facebook's ownership in a previous article. What would be interesting to note is whether we find these same hedge funds owning Twitter when the December 2013 13F is released. This will either confirm or deny the thesis that TWTR is unlike the others, in which these hedge funds spend millions of dollars to differentiate their research. But as I explained from my personal story, which is sometimes all it takes to know why a business works or doesn't, its path to profitability remains less predictable than any Wall Street model.