Twitter: A Long-Term Investment With A Big 'If'

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About: Twitter, Inc. (TWTR)
by: Dennis Viliardos
Summary

Currently, I rate Twitter a hold, and a buy at $30 or lower (until further notice).

There is a lot of growth potential, limited competition within the industry and some major short-term risks (short-term correction, mid-term recession).

US elections should give revenues a boost, but if economic conditions turn worse, the company’s revenue basis could witness a drop.

The prospect of stock price “multiples” is not that realistic, at an average growth rate of around 20-30% (over the years), with relatively low margins (when compared to direct peers).

The fact that Twitter (and social mediums as a whole) is “nothing new” anymore, means that no industry-related “hypes” are to be expected. The industry is maturing.

Sitting on my couch, after a long and stressful day at work, I grabbed my tablet and checked out the latest portfolio news on Seeking Alpha. When I ended up studying Twitter (TWTR) (again) I thought “what a roller-coaster, my god. Investors can’t catch a breath.”

I own the stock for quite some time now, but sold 50% of it in 2018. Bought and sold some again later, at a minor gain. I normally stick with a company that witnesses a turnaround without trading it (I’m not good at predicting swings, it’s not my “thing”). But with Twitter conditions are not as clear as I would like them to be. Let me elaborate:

Twitter’s turnaround is mostly business-related, less so product- related and not user-related (yet). i.e. the company has managed to salvage its financials by cutting expenses (mostly). It also reignited its revenue streams by upgrading its client-relevant products (by clients I mean advertisers). Users however are not yet happy with platform developments.

So based on the above, the company’s turnaround is “shaky.” If for whatever reason revenues stall again, Twitter’s scaling effort (hiring more people) will turn into a nightmare. After successfully cutting back on expenses in 2018, Dorsey decided (well Ned Segal) that circumstances are ripe enough for expansion again (in just 1 year).

What if he’s wrong? Well, cash flows would take a hit and management would have to resort on diluting shareholders and that is what investors fear the most. Twitter has a terrible history when it comes to dilution.

At this point in time, the company is “maturing,” which means that any dilution rate that surpasses 3-4% is not acceptable. Management cannot anymore claim that it is financing the platform’s groundwork. Twitter is no longer a start-up.

But, I’d rather talk about Twitter’s positive potential. How weird is that? The purpose of the above introduction was to remind you that Twitter is a risky investment. But jokes aside, the company could indeed become a steady ship, leaving port for a long and prosperous journey. Bear with me.

Product: Becoming the new way for people to communicate anywhere in the world

Twitter has two broad product categories: The user product and the client product.

The user product’s equivalent of “sales” is the number of users that utilize the platform (and are monetizable). The client product’s success on the other hand is measured in dollars. Both depend on each other, so they are equally important to the business.

Now let us talk about the user-relevant product. Typically, what a social medium does, is building the groundwork (platform) so that social ecosystems can form. In the case of Twitter, that groundwork would include the communication tools (Public profile/presence, commenting and sharing systems, private messaging system, cam capabilities, etc.) and a security network to add a safety net to it all. After that has been constructed (it develops continuously of course), the medium hopes for users to join in and start generating content.

Now the fundamental difference between Facebook (FB) and Twitter is, that the latter has an unrealistic vision. Facebook stated a simple mission, “To connect the people of the world,” which simply requires users to link in and start sharing anything. Twitter on the other hand stated that it wanted to be the place “where everything happens first and where live events are being shared.” That mission would require users to be willing to share a lot of content for free. And these users could either be Jimmy going to a concert and sharing the moment or BBC sharing its shows live. And even if these users wanted to share a lot, they would be limited to the total time one has available when uploading a video (for example). You see media processing comes at a cost for Twitter (additional server power is needed).

Unfortunately, Twitter still resorts to that failing vision and collaborating with media companies for live event coverage will make little difference. Twitter just can’t compete with other mediums that have way bigger cash flows and cash reserves (paying for sports coverage makes some sense, if the goal is to create a sports-related social ecosystem).

Twitter - New comment thread update My suggestion? Well, Twitter should focus on further refining its platform, putting more attention into specific communication tools. The company has already announced that it is testing a new way for comment threads to appear and it is also working on a better camera application. But more effort should be put into designing a better private messaging application, the likes of Facebook’s messenger. If Twitter really wants to become a serious company, it needs to turn into a product people need. One that can upgrade our smartphones, transforming Twitter into the new digital communication alternative – that includes commenting, live chatting, messaging and video sharing all in one.

That is what I think Twitter should turn towards. That is a true and honest vision: “Becoming the new way for people to communicate anywhere in the world (by sharing, commenting, chatting and video sharing/calls).” Different application versions for each smartphone type could then also be made available, in order to maximize usability. And the fact that the platform is at its core minimalistic (as opposed to Facebook, which is overwhelming with groups, pages, market etc.), can turn it into the ideal communication application. That’s how Twitter should see itself, as an application that simplifies communication in various formats.

On a separate note, I’d like to add that Twitter’s profile page should allow for videos and photos to be organized into albums. Much like YouTube allows (and Facebook, Instagram), so that creators can organize their work and add value to their page.

As far as the client-relevant product is concerned, let me be brief and say that growing revenues in combination with limited user-growth (the latter is debatable) seems to prove that Twitter’s team is doing a good job (in this field). While the minimalistic structure of the platform means that less data per user is being collected (limited profile customization, no groups or pages, no emoticons etc.), the integration of Smyte translates into “cleaner data” (real behavior, not bot behavior). The latter statement can be verified by an increasing engagement rate with ads, on average (bots don’t click on ads, so if you cut out all the fake accounts, the average engagement rate will increase).

Business: Twitter needs to diversify its revenue sources and cool on scaling

Twitter’s revenue growth potential hinges on politicization, i.e. the creation of a relevant social ecosystem on its platform. Upcoming elections can give the business a boost in terms of user engagement, which will in turn entice clients (ad companies) to increase spending.

And although the majority of analysts are now on board with the company, there is something that bothers me quite a lot: Guidance. Specifically management’s failure to successfully predict quarterly results. After all they are the ones that have all the data available. And if they are unable to predict the direction of the business, then how certain should we investors be about our own assessments?

At the very least, we can be somewhat certain that management isn’t “playing some kind of game” with us. On February the 7th, officials announced that Twitter was expecting a rough first quarter (2019). And although this guidance turned out to be over-pessimistic, Segal and Dorsey did only have one month of data available at the time. So revenues most likely picked up after that (February and March, which could be a good indicator for Q2/2019).

In essence then, management needs to reduce this volatility in results by diversifying its revenue source more:

  • It should focus on self-serve ads that cover only a small percentage of ad revenues (most come from mid and large tier clients).
  • It should also put an effort in expanding sales abroad. The US alone covers about 55% of total ad revenues (Q1/2019), with only about 21% of total mDAUs (28 million versus 134 in total). And both the US and Japan cover 70% of ad revenues.

The latter point paints a positive picture in terms of growth potential. Twitter has still so much room to grow abroad. Collaborating with governments across the world (Dorsey did visit India to talk about security issues in relation to elections) could be an easy way to expand. If officials (ministers, etc.) start utilizing the platform, more users would eventually join in.

Moving on, the fact that management cut expenses in 2018 and decided to only post monetizable DAU and not MAU data, is a clear sign that the company is maturing. Henceforth, user growth will not anymore be a matter of “awareness” (a big chunk of the social media market has tried or heard about Twitter by now) and relevant expenses should therefore be cut (Snap (NYSE:SNAP) for example is “not there yet,” hence the non-sustainable expenses and severe dilution rates).

Personally, I’d prefer it if Twitter was separately posting mDAU and DAU developments, so that manipulation is not possible. I understand of course that management wants to be able and “manage investor sentiment” when financials are poor, by boosting the mDAU rate for a particular weak quarter.

Aside from that, posting MAU data was indeed misleading. Why? Because whenever a non-active user clicks on a Twitter quote on some article of the NYT, he/she is counted as being active. Even if that person hasn’t visited his/her profile page for months. The mDAU metric is in that respect more honest.

And now a little bit about financials.

  • Cash flows have been showing a positive trend, although a lot of one-time events have added to that.
  • Dilution has stabilized at an acceptable rate per year (acceptable for the social media industry).
  • But margins are still running low when compared to Facebook, Weibo (WB) and others. Of course, Twitter seems to be including Depreciation and Amortization expenses under cost of revenue, which drags down the gross margin percentage (there is a reason for that).

Additionally, I would like to point out that Twitter is indeed scaling its business and that is the reason why expenses grew (and are expected to grow even more). Initially I thought that expenses saw a boost because governments (and especially the US government) pushed the company to make sure no election-relevant security threats will exist in the future. If that was the case, Twitter would have to hire more people to perform manual checks of any unusual behavior. But after a closer look at the company’s financial statements, expenses were equally allocated along all relevant (expense) categories.

Of course, Twitter might still have to hire more people to perform manual checks as US elections close in. I remain wary of this change, especially since the company reduced expenses by a lot in 2018 to generate a profit. Have the prospects changed so much in just 12 months? And with guidance being so “off” at times, should we trust the choices management is making and continue betting on Twitter?

Takeaway: A long-term investment, with a big “if”

Twitter is mostly an interesting stock for the mid-term (2-3 years). The upcoming elections in the US (Twitter’s most important market) should bring in more revenues. The “Political Ecosystem” that has been forming on the platform is currently the one that might give it a boost. Without it, growth could stall for a brief period and then continue with an uptrend later.

With Facebook backing away from political ads (it is no longer paying commissions to employees who sell such ads) and with US presidential candidates betting on social media ads, the mid-term future for Twitter looks quite bright. Just take a look at the graphs below:

Twitter - Political spending & Political ads market potential

To the left, you can see how much US presidential candidates are spending (30th Dec. 2018–10th March 2019). Social media ads are believed to have played a key role in Donald Trump’s election. And sooner or later, other candidates will have to follow suit. If such ads turn out to become the norm for political campaigns, other nations aside from the US will invest in them as well.

The graph to the right then, reveals the potential of this ad market. If Twitter manages to monopolize it (in the West), it could “feed” the company for years – allowing for some growth stability the company needs for shares to appreciate by a lot.

Here are a few other positive points:

  • Data have shown that Facebook and Twitter are in fact “sharing” users (graph). If the latter manages to transform into a useful communications tool, it has an “opening” that will allow it to “grab” users from Facebook.

Twitter - Using more than one social medium

  • The fact that most of the revenues come from the US and Japan (up to 70%), means that there is a lot of potential for growth abroad. If the “experiment” turns out to be a success in the US (political ads to become the basis for relevant campaigns), other nations will follow. Politicians themselves will promote the platform, so user growth is also to be expected.
  • Twitter’s platform is minimalistic in structure. In a world of complexity and over-customization (options), this is a positive characteristic.
  • Aside from the rising political ecosystem, other such interacting groups could form. Twitter of course needs to figure out other ways to fund its growth. Ads are a volatile market.

It’s also important to assess industry and economy conditions:

  • Within the social media industry, there is limited competition for Twitter. In fact, it is almost “peacefully” co-existing with Facebook, Instagram and other mediums (in the West). The overall health of the industry is more of a concern, now that it is maturing. Will social media stay relevant over time? Will they develop into something new (ex. Messenger, WhatsApp etc.)? Will they continue to depend on ads to survive or will they turn to subscriptions (Creator Fan subscriptions, Ad-free subscriptions)?
  • The economy remains a huge risk for Twitter. There is a lot of talk around the possibility of a recession coming up, mainly as a result of the US-China trade war. Ads are always the first thing companies cut when conditions turn sour. Although political ads (US mostly) would not witness a decline, the bigger part of Twitter’s revenue comes from other sources. Personally, I think that there is a high probability of a short-term correction (has already started). But with elections closing, Donald Trump will want to have something to show for, namely a deal with China. The worse things get, the closer we are to a deal (most likely a temporary one). I still remember the spat between the US and North Korea. Just when we thought we’d have a nuclear war, a (temporary) deal was sealed. It’s all for show.

Current Rating: HOLD

So as of now, I rate Twitter a hold. There is a lot of growth potential, limited (sort of) competition within the industry and some major short term risks. US elections should give revenues a boost, but if economic conditions turn worse, the company’s revenue basis could witness a drop.

The company’s average growth rate over the years has been around 20-30%. Coupled with relatively low margins (when compared to direct peers), the prospect of stock price “multiples” is not that realistic.

Added to the above, is the fact that Twitter (and social mediums as a whole) is “nothing new” anymore. Which means that no industry-related “hypes” are to be expected (like the 3D industry hype a couple of years back or the cannabis industry hype or the current plant-based meat industry hype, see Beyond Meat (BYND)). There is also no more room for a “financial turnaround hype,” as Twitter has already been through it. Fortunately, there is still room for a “user-growth hype” and a “Buy-out or joint-venture hype”.

Twitter remains a buy at $30 or lower. Until further notice.

Note: It frustrates me that Twitter has the groundwork in place (a working platform and its first sizable social ecosystem, i.e. the political ecosystem), but is still unable to move to the next level. The initial step was hard – surviving. Now it’s fairly clear what needs to be done. But Twitter seems to lack a proper vision and talent. And these two components are of course linked to each other, since no talent will come, if the vision remains unclear. There is a lot of fear among management, that they might “break” something if the framework is altered.

Disclosure: I am/we are long TWTR. 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.