Twitter’s (NYSE:TWTR) stock has gone up significantly in December on new ad products and some positive reports around the adoption of the company’s ad platform among advertising professionals. According to a survey conducted by RBC Capital Markets, the ROI (return on investment) for advertisers on Twitter seems to have increased over the past six months and 59% of the survey respondents plan to increase their ad spend on the platform over the course of next year. 
While that is encouraging and the business is poised for strong growth, the market valuation continues to be steep. Our price estimate for the company stands at $26, which is a discount of about 50%-55% to the market. Unlike the market price, our estimate is based on a diluted share count of approximately 666 million for Twitter, which includes restricted stock units and outstanding stock options. Investors must note that Twitter’s cash flows are still negative and may continue to be so for the next couple of years. In addition, limited functionality, competition from other platforms and possibility of ad monetization peaking are some factors that can slow down growth in the future. As the overall revenue growth moderates, margins will be impacted too.
User Base Growth Could Suffer Due To Limited Functionality & Competition From Other Platforms
Twitter’s average monthly active users stood at 160 million in 2012.  We expect this figure to grow to 226 million for 2013, and reach past 600 million globally over the next nine years. Most of this growth will be driven by: 1) growing smartphone penetration; 2) Twitter’s compelling value proposition to users and marketers; and, 3) its integration with third-party sites resulting in wide distribution and visibility. However, there could be downside of about 20% to our price estimate if this figure was to reach just 450 million during the same time frame. This downside scenario is based on the assumption that the U.S. active user base will reach 95 million with international markets contributing another 355 million. Competition from Facebook (NASDAQ:FB), LinkedIn (NASDAQ:LNKD) and other platforms, as well as the platform’s limited features, could hamper Twitter’s active user base growth.
Twitter May Face Bans In Certain Countries
We have previously stated that one of the catalysts for Twitter’s growth is its potential role in shaping political and economic systems of emerging nations. It can be a powerful tool for sharing thoughts and opinions among political leaders and general masses, as well as creating greater awareness for information transparency. However, this is a double edged sword and could potentially encourage governments to block certain Twitter accounts, or completely block the service. Governments may take this as a precautionary step, both to prevent the spread of hate speech and to curb potential uprisings. We have seen this happen in Egypt and Iran in recent years. In China, Twitter is completely blocked.
Ad Monetization Could Hit A Ceiling
Twitter plans to increase the size of its sales and marketing support teams and extend its self-serve advertising platform to countries other than the U.S. We believe that these efforts will help the company sell more of its ad inventory over time, which will support growth in its monetization levels in the international segment. We currently forecast Twitter’s international ad revenue per 1000 timeline views to increase from $0.17 in 2012 to $1.54 in less than a decade. We also forecast the same figure for the U.S. to grow past $5.00 during the same time frame. However, the ad monetization level could hit a ceiling, depending upon the optimal ad density and pricing that Twitter eventually decides upon. This could result in meaningful downside to our price estimate. Facebook recently stated during its Q3 earnings announcement that it is satisfied with the level of ad density on mobile and has no plans of increasing it further. We are currently unaware of what Twitter thinks would be the right balance between user experience and the density of promoted tweets. This poses some risk due to the possibility of the ceiling being hit sooner than we think.
Additionally, the emerging markets of Latin America and Asia are likely to have lower revenue per 1,000 timeline views compared to developed markets of Europe. This could negatively impact the figure going forward if most of the growth comes from these markets. Competition from Facebook and other platforms could also diminish the growth in ad pricing, putting further pressure on monetization growth.
Marketing Expenses May Remain High
While research and development expenses form the biggest cost bucket for Twitter right now, they are likely to be significantly outstripped by sales and marketing expenses over the long run. In order to continue selling ads amid growing competition and international expansion, Twitter will need a much larger sales force. We currently forecast these expenses as a percentage of revenue to increase for the next couple of years before declining to about 16% in the long term. Our forecast is based on the assumption that Twitter will derive significant operating leverage as it grows its advertising business. However, in a scenario where these expenses stay above 20%, there could be 10% downside to our price estimate.
Our price estimate for Twitter stands at $26, implying a discount of 50%-55% to the market price.Notes:
- Twitter: RBC Ups Target to $60, Topeka Toots Own Horn, As Stock Surge Continues, Barron’s, Dec 13 2013 [↩]
- Twitter’s SEC filings [↩]