Twitter Is Moving In The Right Direction

About: Twitter, Inc. (TWTR)
by: Andres Cardenal, CFA

Twitter is making progress in terms of users, revenue, and cash flows.

The company is outperforming expectations, and fundamental momentum is a powerful return driver for the stock.

The stock is no bargain at all, but it's not overvalued either at current prices.

Twitter has a lot of room to continue improving, if this happens, the stock could deliver big gains for investors over the middle term.

Twitter (TWTR) stock is on fire lately, shares of the short-message social network have gained nearly 28% year-to-date on the back of strong financial performance from the business and accelerating momentum. The stock is no bargain at all at current prices, but Twitter is moving in the right direction, and it has a lot of room for further growth if management plays its cards well.

Moving In The Right Direction

Twitter is deeply focused on building a healthier ecosystem for users, and the company is applying machine learning technologies to the detection of abuse, harassment, and any content that violates the terms of service. According to management, of all the tweets that the company takes down every week for abuse of content, 38% of them are now being detected by machine learning models.

On the product front, the company is actively betting on events, and enhancements such as the Explore tab, the addition of the Tweet Activity feature, and the Engage and Dashboard apps are resonating well with users.

The numbers from the first quarter of 2019 confirm that Twitter is moving in the right direction. The company ended the period with 134 million daily users, an 11% increase and representing an acceleration in growth versus prior quarters.

Source: Twitter Investors Relations

Total revenue amounted to $787 million during the quarter, an increase of 18% in US dollars and 20% in constant currency terms. Expenses are growing at a slower speed than revenue, so profit margins are moving in the right direction and cash flows are growing rapidly. Adjusted free cash flow came in at $271 million, a huge increase versus $135 million in the same quarter last year.

Outperforming Expectations

Fundamental momentum can be a powerful return driver for stock prices, and Twitter is displaying vigorous momentum. Market prices reflect a particular set of expectations about the future of a business. If a company can consistently deliver better than expected numbers, this generally means that the stock price will tend to rise in order to better reflect those increasing expectations.

The chart shows the expected earnings figures and the actual reported numbers for Twitter in the past four quarters. The company is not only consistently beating expectations, but it's also doing so by an increasing margin.

Source: Seeking Alpha

The chart below shows the evolution of the stock price in comparison to earnings expectations for Twitter in 2019 and 2020. We can clearly see that market prices and earnings expectations tend to move in the same direction over time. The two variables bottomed in 2017, and fundamental momentum has been a major tailwind for Twitter stock since then.

Chart Data by YCharts

Reasonable Valuation

The discounted cash flow valuation for Twitter stock is based on the following assumptions:

  • Current sustainable free cash flow is $800 million
  • Free cash flow will grow at 20% annually over the next five years
  • Free cash flow growth will slow down to 12.5% in the five years period after that.
  • The terminal growth rate is 3%
  • The required rate of return is 10%

Based on these assumptions, Twitter should be priced at $41.89 per share, which implies that the stock is trading 11% below fair value.

Sum of Present Value of Cashflows (Millions) $11,847
Perpetuity Value of Final Cashflow (Millions) $20,350
Equity Value (Millions) $32,197
Implied Share Price $41.89
Discount/Premium to Current Price 11.05%

Twitter is a relatively high-risk stock, so the margin of safety is not particularly large at current prices. However, the discounted cash flow valuation above is incorporating pretty conservative assumptions above free cash flow growth.

It's important to note that Twitter is expected to generate $3.54 billion in revenue during 2019, while bigger companies in online advertising make much more money. As a reference, Facebook (FB) is expected to make $69.4 billion in sales this year, and Google (GOOG) (GOOGL) is expected to generate $160.5 billion. Even better, both Facebook and Google keep growing at an impressive speed with revenue growth expectations at 24.3% for Facebook and 17.3% for Google in 2019.

Growth tends to naturally slow down as a company gains size over time. If Facebook and Google can keep producing these vigorous growth rates in spite of being much larger than Twitter, then Twitter has an opportunity to sustain rapid growth for long periods of time from a much smaller revenue base.

In simple terms, the stock is not particularly undervalued based on conservative assumptions about future growth. However, Twitter could easily outperform those conservative assumptions if management finds the right ways to generate user traction and accelerate monetization.

Multi-Factor Analysis

Valuation is an important return driver for stocks, but it's obviously not the only quantitative factor to consider when making investment decisions. Besides, valuation levels need to be interpreted in their due context.

A company with strong financial performance and vigorous momentum should clearly trade at higher valuation levels than one producing lackluster financial performance and deteriorating momentum. However, it can sometimes be difficult to incorporate the different quantitative metrics in a single tool.

The PowerFactors system is a quantitative algorithm available to members in The Data Driven Investor. This system basically ranks companies in a particular universe according to four quantitative return drivers: financial quality, valuation, fundamental momentum, and relative strength.

Twitter is in the top 3% of stocks in the US market, with a PowerFactors ranking of 97.43 as of the time of this writing. The stock has strong metrics across the four dimensions considered: quality (95.84), value (74.39), fundamental momentum (98.72), and relative strength (77.04).

Data from S&P Global via Portfolio123

According to the backtested performance data, companies with the strongest quantitative rankings tend to generate superior performance in the long term.

Backtested performance does not guarantee future returns. Because of its own nature, the algorithm is based on past data and forward-looking expectations Twitter will need to meet or exceed those expectations in order to deliver attractive returns for shareholders. That said, it's good to know that the quantitative return numbers are currently looking bullish for Twitter stock.

The Bottom Line

Twitter is taking steps in the right direction and outperforming expectations, this provides an important driver for the stock. Valuation levels are not particularly attractive at current prices, but Twitter has a lot of room to continue improving performance in the years ahead. If this happens, the stock could offer material upside potential from current levels.

In a nutshell, Twitter looks like a reasonable investment today, and it could turn into a huge winner if the company continues delivering accelerating growth in key metrics such as users, revenue, and free cash flow.

Disclosure: I am/we are long FB, GOOG. 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.