Tuesday, 14 March 2017

Why can Twitter Inc (TWTR) not make a profit?

This seems bizarre. Twitter have a good quality, highly scalable platform. All they need to do it seems is sell advertising on the platform to monetize it, sit back, and collect the cheques. A layman friend of mine asked me this just the other day - how can they not make money? 

The answer on the surface is; stock based compensation. Twitter have been handing out > $600m per year since 2013 in share based remuneration for staff. The majority of this expense is recorded as R&D. R&D? What do they have to research and develop? They dreamed up Twitter. Now it is here!

R&D should be the smallest line in the total expenses line-up rather than one of the major ones. Twitter need to get a handle on their expenses and stop paying staff millions in stock and cash in order to develop what is already a mature business. Just like Google's self driving cars these tech companies love to try and use their revenues as a slush fund for new bizarre projects.

If we imagine for a second that the R&D is capital expenditure then Twitter spending $713m in 2016 against $2,529m in revenues is a ratio of 28%. Even mining companies would be hard pressed to spend that much on capital expenditure - and a tech business is meant to have low investment with highly scaleable returns!

All this would dilute away and be forgivable if revenue growth hadn't stalled. When Twitter came to the market in 2013 revenue growth was up 110%. The same again in 2014. But since then it has slowed rapidly and now keenly lags Facebook or Google. Twitter may have just reached its market share of advertising revenues. I myself have used both Facebook advertising and Twitter on one of my other ventures and have found the Facebook advertising achieves much better results. This may well be due to the way people use Twitter. When I use Twitter it is usually mobile and I scroll rapidly through tweets often to get to the top and feel 'up to date.' Maybe it is just me but the advertising has limited appeal as the attention span for Twitter is particularly short.

Now, given the fall in the share price is it good value?

Presently in FY2016 Twitter has handed out $615m per annum in stock options in a company which is showing stunted growth and now a declining share price. It is not clear if this death spiral will end first in either a hyperinflation of stock certificates or an exodus of employees with worthless RSUs. The dilution they are creating is hardly going to motivate staff - in effect the stock based comp only works on the way up - a bit like a...bubble?

What should Twitter do? In my opinion - stick to being Twitter, stop researching being a better Twitter and let the stockholders decide what to do with the cash it could potentially throw off. That means slash R&D expenses and get marketing expenses under control and become profitable. I estimate with a quick model driven off the 2016 20F Report that they could become profitable this year and generate a meaningful 0.34c EPS in 2018. Which at a generous 20x P/E (Facebook consensus 2018E multiple) would give a valuation of $6.75. Still a >50% downside from the current value but at least shareholders could draw a line under that value and management could start looking for ways to become increasingly profitable instead of just larger and more stubbornly unprofitable.

[My assumptions were revenue growth slows to a flat 10%. R&D and S&M are capped for 2 years at lower levels. A one off $250m in 2017 for restructuring costs (just a guess). Share based payments drop to a minor $15m p.a. Dilution peaks in 2017 with some further in 2018-2019.]

But I doubt this will happen as the management seem contented so far with simply 'adjusting' their earnings in quite stupefying fashion with a series of adjustments to strip out the stock based compensation as it is a 'non cash' expense.

The only reason this share should trade above even a generous $6.75 is the potential takeover premium - I guess fools buying this imagine a greater fool buying out Twitter (as has been rumoured) being one of the other tech majors. However given this has yet to happen one can assume the other tech majors don't fancy it is good value - they may even have been inside the books for some due diligence too.

Not one for the value conscious investor.

Disclosure: I have no interest in Twitter Inc.

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