Twitter - Solid End To 2018, Margin Concerns For 2019

About: Twitter, Inc. (TWTR)
by: The Value Investor

Twitter ended 2018 on a solid note and has delivered on real margin gains last year.

The issue is that sales growth is expected to slow down in Q1, while costs continue to rise quite aggressively.

I understand the cautious reaction by investors as Twitter still has lots to prove to justify the current valuation.

Twitter (TWTR) is the platform which shows what is happening in the world and what people are talking about, as the talk about Twitter itself is not so positive as investors were not impressed with the fourth quarter earnings release. While the release itself was quite good, the issue was more with the guidance, as the company is seeing a real growth slowdown in Q1, while costs are expected to rise quite aggressively in 2019, suggesting margin pressure to come.

These developments, in combination with more modest sales growth suggests that earnings might not really grow at all this year, making investors very cautious given the elevated valuation multiples attached to the platform.

About The Numbers

After the initial run up in the popularity of the platform, Twitter has seen real issues in recent years with engagement due to trolls, wrong advertising, and wrong upgrades. As the company has addressed these issues to an important extent, these improvements can now be seen in the actual financial results of the business.

Revenues for the fourth quarter rose by 24% to $909 million, with growth being pretty evenly distributed between the home market in the US and overseas markets, as well as equal growth between advertising and data licensing business. Notably the latter segment is a potential hot issue given the increasing privacy awareness of platform users around the globe, although data licensing ¨only¨ makes up 13% of fourth quarter revenues.

Furthermore, fourth quarter sales growth was in line with the full year revenue growth rates reported as annual sales just came in above the $3 billion mark. With the trolling issues being addressed, the company has made changes to the engagement statistics of the user base. Hence it is discontinuing the monthly active user numbers and is now reporting so-called ¨monetisable daily active users¨, a number which rose by 9% to 126 million for the quarter.

The company has done a good job at making improvements to the bottom line. Total revenue growth for the fourth quarter comfortably exceeded a 13% increase in costs, as full year costs rose by ¨just¨ 8%. This makes that Twitter reported operating earnings of $453 million for the year, as flattish net interest expenses make this a real profit number ahead of taxes.

While changed tax regulation makes that the GAAP profit of $1.2 billion looks very good, I end up with a $363 million net profit while using a 20% tax rate, as being a more realistic number. With 776 million shares outstanding that comes down to earnings power just a few pennies away from $0.50 per share. Note that these are real ¨cold hard¨ GAAP profits, with no adjustments made for amortisation charges or really expensive stock-based compensation costs.

Valuation Talks

Despite the very large liquidity position, and the fact that money comes in from operations currently, Twitter has raised cash balances last year by issuing more convertible bonds. The company now holds $6.2 billion in cash and equivalents, offset by about $2.6 billion in convertible loans, for a $3.6 billion net cash position.

With 776 million shares outstanding (on a diluted basis) that net cash balance works down to more than $4 per share, a sizeable amount by all means. With shares down 10% to $31 per share, that implies that operating assets are valued at around $27, for still sky high multiples based on trailing earnings power just shy of half a dollar.

This negative reaction should be seen in connection with the outlook. For the first quarter, Twitter sees sales between $715 and $775 million, seeing GAAP operating income between $5 and $35 million. The guidance suggest sales growth anywhere between 8 and 16%, marking quite a big slowdown in sales momentum as earnings will miss last year´s operating earnings number of $75 million by a huge degree.

Investors were furthermore not comforted in the guidance that operating expenses for the full year are seen up by 20%, while no sales guidance was given. To keep margins flat, and considering the soft guidance for Q1, that suggests +20% sales growth required in Q2/Q3 and Q4, which seems a daunting task. Stock based compensation is seen at $350-$400 million, but that is already baked into the expense guidance, as capital spending is seen at $550-$600 million, up from $470 million in 2018, although the liquidity position of the firm remains very good.

What Now?

Last time when I checked on Twitter was last summer as the company posted solid second quarter results at the time. At the time, shares plunged to $31 (same levels as today) after having run from the mid-teens to $47 ahead of the earnings report, driven by a huge momentum run. In reality the company has done better than I expected in recent quarters, reporting realistic earnings just shy of half a dollar in 2018. This compares to my outlook, calling for earnings of about thirty cents per share last summer, as this good news is overshadowed by the guidance issued for 2019.

While sales undoubtedly continue to grow this year, margins will be flat at very best, as I believe one should look for actual earnings stagnation in 2019. That is of course an issue given that shares trade around 60 times estimated earnings.

Nonetheless, growth continues. If the company can become a $5-6 billion giant in a year or three, while posting operating margins of 30-40%, operating margins of around $2 billion allow for real after tax profits of $1.6 billion, or +$ 2 per share. That number and net cash works down to a $45 valuation at a reasonable 20 times multiple, yet requires real execution and a year or 3 to be realised.

Working with a $45 valuation as a given and requiring 20% returns per annum to account for execution risks and general market returns, I continue to see fair value at $23-26 per share based on a three to four year time window before such numbers can be delivered upon.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.