- The Twitter hype is fading away as Facebook continues to pull further away from it.
- As the third biggest social media company, can Twitter show any user growth?
- At its current market cap, I believe the Twitter stock still has room to drop another 9%.
Twitter (NYSE:TWTR) does not seem interested in innovating its product line. It’s an area that has drawn the attention of investors, as Twitter’s research and development costs have grown year over year, preventing it from turning positive in terms of cash flow. Since Twitter has negative operating margins, their long-term debt is growing and their cash is shrinking. However, there is a small ray of hope. Twitter’s operating margins, although poor, have improved mostly due to a reduction in sales, general and administrative costs. Twitter’s operating margin for the trailing twelve months is -24%, compared to -38% for the fiscal year of 2014. So, as Twitter’s topline grows and the company comes closer to turning a profit, there are 2 key things investors must watch out for in the upcoming earnings reports, users, and advertising revenue.
Twitter needs to justify its high operating costs with more serious growth in its user base. The 1% increase in users reported in the third quarter is not going to cut it this time around. Twitter has already taken a backseat to Facebook’s Instagram and is now only the third most popular social media company. With only 320 million monthly active users, Twitter has to grow its monthly active user base at a CAGR of 6% for 4 years to catch up with Instagram, assuming the latter's user base remains stagnant. So with Twitter’s user base growing at unacceptable rates compared to their competitors, they need to show stronger growth in this area to drive investor interest.
Twitter's Advertising Revenue
This is the bread and butter that investors will be watching keenly. If Twitter can’t grow their user base, then they better show that they can grow revenue at a decent clip. Facebook (NASDAQ:FB) saw advertising revenue increase by 57% year over year in their fourth quarter results, and Twitter is now slower, even with a significantly smaller revenue base. If Twitter wants to prove that its advertising business is sustainable, scalable, and profitable, then it will need to do something, and quickly. I think investors will expect Twitter’s advertising revenue growth rate to be at least in line Facebook’s growth, therefore coming in around at 60% up YOY.
The hardest part about Twitter is finding the appropriate valuation. A lot of people think that the current drop means it is time to buy blindly. However, I would disagree. Below I’ve outlined my DCF calculation for Twitter with 10-year projections. I used a revenue growth rate of 50% for the first year and then scaled down 5% each year down to 10% for the last 2 years. After that, I used a terminal growth rate of 6% and a discount rate of 12%. The most difficult part is trying to project when they will generate positive free cash flow, which my model projects will be in 2019.
As you can see, I feel a valuation of $9.8 billion is the fair value of Twitter’s equity, which implies there is still room for a 9% drop in market capitalization for the Twitter stock. An important note about the valuation is that the revenue projection I used for the year 2025 ends at $24.7 billion, which is about 37% higher than Facebook’s current revenue, but the operating margin stands at just 13%. There can be a lot of give and take on both the revenue and operating margin projections, however, I feel the balance between them was fair enough given the company’s current growth and operating margins.
Twitter is testing investors’ patience, but I think investors might be finally getting fed up. It is time for Twitter to post some serious results which can move the stock. Now it seems to move just on M&A speculation. I will wait for Twitter to prove that it has a sustainable business, like Facebook. Otherwise, it could be headed towards being the next Yahoo (NASDAQ:YHOO). In order to do so, they will need to diversify their products, increase their user base, and improve their topline and advertising revenue. Now that’s a tall order for Twitter. To sum up, I will most likely remain bearish on the Twitter stock unless I see the company beating my top-line and bottom-line estimates, in which case I would revisit the valuation.