MorningWord 5/28/14: TWTR – The Bird is the Word

by Dan May 28, 2014 9:27 am • Commentary

Sentiment towards Twitter as a stock and a company is downright horrible. On the stock front the overhang from the 6 month IPO lockup (early May) proved too much to bear, causing a 20% drop in the shares, but still placing a sky high price to sales multiple of almost 15x expected 2014 sales!  As it relates to the company and its business model, investors remain challenged to look past what appears to be anemic user growth and engagement, questioning the broad based appeal of the platform.  It is our belief that Twitter is and will remain for a very long time a unique and sought after social media property, and that if was still a private company would likely sport a higher valuation than it is currently receiving in the public market (currently has a lower market capitalization than what Facebook agreed to pay for WhatsApp in cash and stock).

As we discussed on Friday in a post titled Catching a Failing Whalewe think there is likely to be an AH-HA moment for TWTR investors in the near fuutre and leaves us…..

looking for a relatively low risk way to play for an outsized move to the upside if in fact the company is able to tweak their existing business model and display better ways to monetize their user base, grow said user base and increase engagement. If the company is able to not only beat on most financial metrics, which they have done in both of their two reported quarters since going public back in November 2013, but also demonstrate how they will grow and monetize their user base, then the stock could see considerable gains from current levels, despite valuation concerns.

The obvious analogy is Facebook post IPO. As many painfully remember, FB got cut in half in the 6 months following its May 2012 IPO, as the company had not clearly articulated how they planned to monetize users who were quickly migrating to their mobile offering, away from desktop, which would be much harder to sell ads on. The stock had similar issues to TWTR leading up to its 6 month IPO lockup, as the hundreds of million shares were an overhang and hurting sentiment. However, once the lockup was out of the way, with many insiders saying they were holding, the stock started to work, rising 50% 3 months after lockup, and then 100% another three months later once they were able to demonstrate mobile ad sales.

Obviously we have no idea where TWTR bottoms out, but suspect that in the near term the $26 ipo price should serve as decent support.  We also think that investors and analysts alike face the potential to be caught off sides on the name as there is currently 8 buys, 18 holds and 8 sells.  One prior naysayer, Nomura’s Anthony DiClemente raised his rating from hold to buy this morning, suggesting:

We believe that the market has now priced in the expectation that Twitter remains a niche social media product. We believe risk / reward is much more favorable now, given the possibility that product enhancements rejuvenate user growth; we think ARPU will beat estimates given strength in ad demand, and we believe that incremental margins should be higher than the Street expects

DiClemente cites four reasons for the stock’s relative value, from

1) The stock is assuming Twitter as a niche product only. With Twitter down over 50% YTD and ~28% since 1Q results, we believe the market has priced in the notion that Twitter is unlikely to achieve mainstream status. The Street expects Twitter to be less than 20% of the size of Facebook in three years, but if there is any traction for recent product initiatives to boost user growth, there may be upside to Street estimates.

2) Velocity of monetization per user growth fastest in sector, by far. Our checks indicate that ad budgets continue to steadily shift to Twitter, driving robust velocity in monetization per user. Our model implies that Twitter can reach the ARPU that Facebook posted in 2013, driving an incremental $130mn in 2015E advertising revenue. Also, we believe there is upside from “off-platform” monetization via Twitter’s MoPub exchange; one example is the $230mn Omnicom-MoPub deal announced yesterday.

3) International is just scratching the surface. International usage on Twitter approaches 80% of the total, but accounted for only 28% of revenues in 1Q. We raise our 2015E international ARPU estimate to $3.01 from $2.81, but believe there is material upside here as this is only 20% of domestic ARPU.

4) Incremental margins will be higher than Street is modeling. Given Twitter’s relatively fixed operating cost structure, Twitter should benefit from the high levels of incremental operating margins that Facebook possesses; yet the Street is modeling Facebook’s incremental margins in the mid-60s over the next few years, versus Twitter in the high 30s. We are now modeling 70% incremental margins for Twitter over the next 3 years.

Friday we placed a trade that helps finance owning longer dated calls to play for a move higher after August’s Q2 results (here) while also outlining a trade that could be a very attractive long stock alternative in the event of a break of the prior lows that offers significant potential upside leverage while offering a healthy cushion to the downside.

I want to make one last point, the poor sentiment, despite still high valuation for TWTR reminds us very much of the situation in FB, and the stock’s 260% gains off of the 2012 lows, and the 170% gains off of the 52 week lows should server as a reminder just how quickly investor sentiment can change on the slightest change in outlook for a controversial story such as TWTR. It is also important to note that TWTR’s 14.5x multiple of expected 2014 sales is only a tad higher than Facebook’s at almost 13x, and if Twitter took some bold steps it has much higher potential for growth over the next couple of years.

With all that being said, we think TWTR should be a very attractive property to Google, who for all intents and purposes has faltered in their desire to be a player in social media, and that TWTR’s killer app of real time search would be an obvious addition to Google’s existing search dominance.  This is a property that Google should own and not waste time trying to build a better mouse trap.  We have been hoping that the stock would break the post ipo lockup lows and we would look to put some stock away for the long term, and also look for levered ways to play for a sharp reversal over the coming months.