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Twitter: Concentrate On Core Metrics In This Remarkably Irrational Market

About: Twitter, Inc. (TWTR)
by: Roman Luzgin
Roman Luzgin
Long/short equity, special situations, medium-term horizon, portfolio strategy

Twitter reported its Q3 2019 results, slightly missing on EPS and missing on revenue by $51 million.

The stock plummeted more than 20% in the first three days after earnings. This represents about $7 billion in lost market capitalization.

The company's monetizable user base increased by impressive 17%. This is the metric that matters most.

The panic is significantly overblown. Twitter's stock is even more undervalued after earnings.

Twitter reports miss on both metrics. The stock plummets 20%

On October 24, Twitter (TWTR) reported its Q3 results, missing on EPS and on revenue. The results came $0.01 lower than consensus for EPS and about $51 million lower for revenue.

Expectedly, the negative headline sent the stock down since the degree of expectations is quite high for the social media stocks. For instance, Twitter's peer Snap (SNAP) was also down about 3% after earnings despite beating on both metrics. It seems that investors now demand more rapid improvements in the profitability than they used to in the past.

ChartData by YCharts

However, the sharp drop in the stock price may look like an extreme overreaction. In the case of Twitter, the 25% plunge in the stock price reflects about $7 billion in lost market capitalization. In other words, the market expects Twitter's current and future problems will lead to a $7 billion reduction in discounted future cash flows.

Twitter indeed made some missteps in the recent quarter, which will also affect Q4 2019 results, according to the management. However, the company's fundamental, core business did not deteriorate at all. In fact, the opposite is true: Twitter's mDAU (monetizable daily active users) increased significantly in the recent quarter, providing an even more solid basis for the company to generate higher revenues in the future. This is the most important metric for a growth-oriented social media stock like Twitter. Therefore, the current sell-off in TWTR might provide a decent opportunity to invest in the stock while it is relatively cheap.

The real reason behind the miss is a bug in the system. Fundamentals continue to look solid

Twitter missed on top and bottom lines in the recent quarter, but the real reasons behind that event are not some problems with the core business or the company's strategy.

It turns out the primary catalyst behind Twitter's problems with monetization is the "bugs in map ads," according to Twitter CEO Jack Dorsey. Ned Segal, CFO, also mentioned this during the earnings call:

We discovered and took steps to remediate bugs that largely affected our legacy MAP product. These bugs affected our ability to target ads and share data with measurement and add partners. We also discovered that certain personalization and data settings were not operating as expected. These issues were in our control and we will work to do better.

This means that the fact that Twitter missed on financial metrics in Q3 is something that will unlikely be a long-term problem. It is also claimed that the work that is being done today to address the bugs will make the core systems even more resilient to any potential problems.

Our goal in rebuilding our core add and map technology stacks was to address exactly these sorts of issues and increase engineering agility. Because of this work, we are much better equipped to identify and fix issues we come across today than we were just 1 to 2 years ago. Still painful, but no longer existential as it was in our past.

Although the management claims the issues will also affect the company's top- and bottom-line performance in the final quarter of 2019, the team is on track to resolve the issues, which will allow Twitter to return to the usual earnings growth. And when it comes to the future, the prospects remain more than encouraging. This is because the corporation showed meaningful progress in the main metric that matters most for social media companies - monetizable audience.

Hence, it is reported Twitter has reached 145 million in monetizable daily active users (mDAU), up 17% year-over-year. With $823 million in quarterly revenue, Twitter generated about $5.7 per mDAU in the quarter. This demonstrates that the platform continues to be attractive for users and the company sees a way to monetize this audience in one way or another, be it advertising or data services.


(Source: Earnings Slides)

Other things equal, a continuing increase in the audience should lead to a similar increase in revenue. For instance, taking the current numbers, a similar growth in mDAU next year would result in about $142 million in additional quarterly revenue (25 million new mDAU with a $5.7 ARPU).

However, Twitter also has a positive track record regarding improvements in monetization, which I discussed in detail in my previous article on the corporation. There, I projected that the average annual revenue per user of $12 will be a target for Twitter to achieve in the near future, with a 6% average annual growth in the user base.

If the company continues to expand its audience as rapidly as in Q3, Twitter's stock will likely exceed the level of $46 (this was the target calculated using DCF analysis with scenario modelling) in the medium term, even despite the continuing technical issues. In light of that, the panic seems more than unwarranted, which creates a valuable opportunity to invest in the company with a significant margin of safety.

Although certain issues exist, the current sell-off is a significant overreaction

Despite solid performance in Twitter's core business, there are still certain issues that will loom over the stock in the near term.

Most importantly, the company issued a downside guidance for Q4, expecting $940-1010 million in revenue, compared to the consensus of $1060 million. Although the degree of this difference is arguably small, the very fact that a high-growth social media company reduced its guidance will deter some cautious investors and create a pressure on the stock price, despite the fact that the reason behind this event is a temporary technical issue.

Looking ahead, while we are taking steps to remediate the product issues we described, we expect them to continue to weigh on the overall performance of our ads business in the near term. Specifically, we expect the moderate performance in MAP and issues discussed in our personalization and data settings will likely result in four or more points of reduced year-over-year growth for total revenue in Q4 from three or more points of impact in Q3, reflecting a full quarter impact in Q4 versus only a partial quarter impact in Q3. This is incorporated into our guidance.

(Source: Earnings Slides)

Additionally, there is always uncertainty regarding the company's ability to translate core business improvements into financial results. This quarter, Twitter demonstrated a relatively poor management in that regard, and there is clearly no guarantee that the situation will improve fast.

For instance, the bugs in the system and the need to dedicate man-hours to fix them led to a significant jump in the cost of revenue - the metric soared 15.6%, compared to a 8.6% growth in revenue. The company also increased other expenses such as R&D, marketing, and SG&A expenses.

However, the current sell-off is still a significant overreaction on the news. Twitter reported a miss of just $51 million on revenue in Q3, and while its Q4 guidance is also about $85 million lower than expected, this does not add up to more than $7 billion that Twitter has lost in its market capitalization over the last week. Moreover, it can be argued that since the company puts more effort into sales and marketing, there is likely to be a lag between the time when the costs occur and the actual improvements in revenue associated with the activity.

Considering the solid growth rate in Twitter's monetizable user base and the company's prompt response to the issues and market dynamics, I reiterate my target of $46 for TWTR, although it will probably be achieved later than the end of 2019.

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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.