Twitter's (NYSE:TWTR) stock jumped significantly after the company announced its Q2 2014 results. It reported an uptick in its monthly active user additions and strong advertising revenue growth. Even though EBITDA margins are still thin, there was a significant year-over-year improvement. Overall, the results indicated growing financial strength, which ultimately fueled market optimism. However, we continue to believe that Twitter's stock is overpriced considering its limited features, its appeal to a niche base (as compared to Facebook's worldwide reach) and the fact that there is still an oversupply of ad inventory. These factors will limit the extent to which Twitter can grow, and the growth rate is likely to come down notably in coming years.
Our price estimate for Twitter stands at $32, implying a discount of about 30% to the market price.
Ad Revenue Growth Is Strong, But Ad Pricing Is Facing Some Pressure
Twitter's advertising revenues grew 129% year over year, amounting to $277 million for the second quarter of 2014.  The sequential growth stood at 22.5%. These figures are commendable considering that mobile accounts for a large chunk of Twitter's usage. Figuring out a successful monetization strategy is a key to the future of most Internet-based companies. Mobile accounted for 81% of Twitter's revenues during the quarter, which is much higher than the figure for its competitor Facebook.  So what exactly drove the growth in Twitter's ad revenues?
We can break down ad revenues into the number of ad impressions and average ad pricing. The company stated that the total number of ad engagements (or impressions) grew by 250% in Q2 2014 compared to the same period a year ago.  However, the cost per ad engagement or average ad pricing declined 35%.  This is a little surprising and completely opposite of what Facebook is witnessing. We believe that Twitter still has a long way to go in terms of selling its ad inventory, which is why the number of ads are growing fast. Additionally, it appears that currently there is oversupply, which explains the decline in the average ad pricing. The situation seems similar to that of Pandora (NYSE:P), which is still in the process of catching up with its user base growth in terms of optimally selling available ad inventory.
We feel that the real test of Twitter's ad products will come when it reaches optimal ad density and the average ad pricing becomes the dominant factor in determining the company's ad revenue growth. For now, the path seems fairly clear. Twitter wants to sell as many ad slots as possible and considering the platform's targeting capabilities, advertisers are likely to divert more of their budget toward marketing on Twitter.
Active User Addition Picked Up Sequentially
As we previously expected, Twitter saw some sequential growth in its active user additions in the second quarter of 2014. The company gained roughly 3 million monthly active users in the U.S., same as the first quarter. Sustaining the absolute increase isn't bad considering that the user base growth has somewhat dwindled in recent times. In international markets, the figure increased from 11 million to 13 million. We believe that FIFA World Cup 2014 played a notable role in this growth and spurred the activity on Twitter. The impact will be visible in the company's third quarter results as well. Overall 652 million tweets were sent related to World Cup Football 2014.  It is highly probable that the uptick in active user base growth will be temporary, and could moderate by the fourth quarter of this year.
Twitter's stock has fallen sharply from its all-time high of $74 due to a slowdown in its active user base growth. Both year-over-year and sequential growth dropped significantly in the fourth quarter of 2013. However, the situation has improved slightly since then. In Q1 2014, Twitter added 3 million monthly active users compared to a gain of 1 million in the fourth quarter of 2013.  Also, international active user additions went up sequentially from 8 million to 11 million. Even the number of timeline views increased both in the U.S. and international markets following a decline in the previous quarter.
Disclosure: No positions.