john@johnducas.com

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Twitter: A Little Overvalued?

Ever since going public, Twitter ($TWTR) has generated a lot of buzz in the investing community. Before the Initial Public offering, it was the most loved company by investors, who were speculating that a repeat of the Facebook ($FB) fiasco was highly unlikely. This is one of the reasons why Twitter actually opened on the NYSE instead of the Nasdaq, to avoid a similar botched IPO carried out by Facebook roughly a year ago when share prices slumped a few days after opening to the stock market. After the 7th of November, when the stock went public, sentiment reversed and investors turned on the stock, comparing it to Facebook.

Screen Shot 2013-12-20 at 10.17.47 PM

In this article, I will be exploring the different facets of Twitter such as how the company actually produces revenue, as well as giving my thoughts on the future of the company.

 

 

Twitter

 

Twitter is ‘an online social networking and micro blogging service that enables users to send and read tweets -text messages limited to 140 characters (Wikipedia).’ There is no need for an explanation though, we all know what it is, and some of us even use it. But here is something many people don’t know- how it makes money. Most of Twitter’s revenue is made through ads on their site. About 85% of the revenue comes from advertisement sales and ‘promoted tweets’. Promoted tweets are a way for advertisers to expand their reach. They pay to have messages pop up in users’ stream of tweets. Twitter also make money from licensing its data. Over 63% of ad revenue comes from mobile devices and more than three quarters of users on Twitter access it from their phones.

 

 

monthly active users twitter

 

 

The chart on the left illustrates the number of monthly active users both in the US and Internationally. The number of users is increasing at an average rate of 15 million per quarter. That is very impressive but unfortunately soon enough, Twitter will not be able to sustain this growth.

 

 

 

 

 

 

 

 

Looking at the Financial Filings-

 

  • Revenue

 

As of the closing price on the 15th November 2013, Twitter’s stock price is at 43.98 and has 544.70M shares outstanding which means that it has an enterprise value of $22bn.

Top line growth for Twitter has been extraordinary so far:

 

2012 Revenue- $316 million (198% increase)

2011 Revenue- $106 million (278% increase)

2010 Revenue- $28 million

 

This growth has continued in 2013, during the first 9 months of the year, Twitter booked $422 million of revenue. This would mean that if the company reached the $600 million mark by the end of the year, their revenue would have grown 100% from the previous year. In terms of growth, Twitter seems to be all set.

The company is currently trading at 36 times revenue= Enterprise value $22bn / Expected Full Year Revenue $600 million.

If all revenue were to be given out this year, investors would receive a meager 2.7%. You can calculate that by doing the inverse of the Price-To-Sales ratio- Expected Revenue $600 million / Enterprise value $22bn= 2.7%.

 

  • Earnings

 

 

Earnings on the other hand, don’t look all that impressive:

 

2012 Earnings-  -$79.4 million

2011 Earnings-  -$128.3 million

2010 Earnings-  -$67.3 million

 

Through the last three years, Twitter hasn’t managed to record a single year of profit. They have already lost $134 million in the nine months of 2013. I have a feeling that most of the investors that bought on the way up after the IPO have yet to see these figures.

 

Cash flow

 

Cash flow is most probably the most important thing to investors. It pays the bills and the dividends. From looking at its earnings you can already predict they won’t be pretty.

 

2012 Cash Flow-  -$28 million

2011 Cash Flow-  -$71 million

2010 Cash Flow-  -$49 million

 

This year things have changed, during the first nine months of 2013, Twitter registered a positive $4 million from its operations.

It is important to note that Twitter has hard large capital expenditures in the prior 2 years- $50 million last year and $46 million this year.

At this point, Twitter is basically spending cash and not receiving much in return. This is obviously intentional as they are spending a large amount of capital to grow the revenues for the long term. If not, they could’ve just cut the spending and become profitable.

 

 

Valuation Conundrum

 

Twitter’s current valuation is rather extreme to put it bluntly. To be valued at $22bn, Twitter really needs to do some big things to just keep the stock price where it is. This means that if Twitter keeps increasing their user base, ad revenue at the same enormous growth rates as in the past, imagine what it needs to do to just entertain a higher stock price? There’s not much room to go than lower from here.

 

Screen Shot 2013-11-17 at 1.15.24 PMI find that a high growth large cap company should have a valuation of about 20 times earnings. This is the case with Twitter’s rivals, which include Facebook and LinkedIn. As you can see from the spreadsheet, even though Twitter still isn’t making any profit, its Price-To-Sales is unjustifiable higher.

 

At its current $22bn valuation, in order to have a 20 multiple, Twitter would need to produce $1.1bn in earnings- 22bn / 20. The comical part is that it doesn’t even produce $1.1bn in revenue! It is going to be just under half of that in 2013.

What is the amount of revenue needed to justify Twitter’s current value?

If you look at Google’s ($GOOG) report, you can see that in the $50bn of revenue, $10bn was earnings. If you were then to translate that into Twitter, it would need $5bn in revenue to have the $1.1bn in earnings, which is necessary to uphold the current value. That is 10x revenue of what the company currently makes.

 

 

 

Conclusion

 

At some point I believe Twitter will be profitable, and very. Its investments towards the future are a good idea but if they prove to be effective, will take a long time to reflect in its stock price. And you never even know, by then Twitter might not even be one of the top social media sites anymore.

But saying that Twitter currently is a little overvalued is a huge understatement. Looking at the numbers, it would be surprising to see the company manage to increase their revenue by ten times. Buying and holding the company could in the end, result in multiple compression.

The only way Twitter could attract my attention would be after a disappointing quarter, until then Twitter is the wrong place to be, both for the bulls and the bears. From here Twitter could either decline at a steady pace or pick up momentum and reach the high $60s. This uncertainty is what has me skeptical. Furthermore, it is important to realize that Twitter is a rather complex company and even though most of the ways it generates revenue were uncovered in this article, there is still more that people do not know. In conclusion, because of the uncertainty over its future coupled with the perplexing nature of its revenue generation make Twitter the best stock to be left untouched.

 

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