In one of our previous notes we compared some of the key engagement and growth metrics for Twitter (NYSE:TWTR) against those for Facebook (NASDAQ:FB) and LinkedIn (NASDAQ:LNKD) (read How Twitter Stacks Up Against Facebook And LinkedIn). In this analysis, we break down the cost components and look at two key line items – research and development cost, and sales and marketing cost. These two constitute the majority of Twitter’s operating expenses and stood at a combined 62.5% of revenue in 2013. The broader assertion that we make is that given the current high magnitude of these expenses and uncertainty regarding Twitter’s future, the company’s stock is very sensitive to the change in their forecasted levels. Our price estimate for Twitter stands at $29, implying a discount of about 40-45% to the market price. Unlike the market, we are valuing Twitter on the basis of diluted share count of close to 666 million.
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Research And Development Costs
Twitter’s research and development (R&D) cost as a percentage of revenue has come down from a massive 91.7% in 2010 to about 32.2% in 2013. However, the figure stood way above Facebook’s 9.6% which suggests that the company has a long way to go in terms of improving monetization and reducing the cost burden. We expect Twitter’s R&D cost as a percentage of revenue to approach 10% by 2020 as the company ramps up its ad sales, grows ad pricing and benefits from economies of scale. This is much more aggressive that its target model of 19%-21% which, in our opinion, does not even remotely justify its steep market valuation. Reaching a figure that is more akin to Facebook will require a lot of effort on part of Twitter in terms of improving its ad revenue per 1,000 timeline views. In the event where the company is only able to achieve a figure of 19%, there could be 20% downside to our price estimate.
Sales & Marketing Costs
Twitter’s sales and marketing cost as a percentage of revenue increased from 21.4% in 2010 to about 30.3% in 2013 as it ramped up its sales force to sell ad inventory slots and acquire customers. In comparison, the figure for Facebook stood at around 10.5% during the same year. We believe that while Facebook can potentially sustain the current levels and bring the cost down subsequently, Twitter is likely to continue to invest heavily in its sales department. As a result, its sales and marketing cost as a percentage of revenue can go up in the next 1-2 years. However, we expect it come down subsequently due to operating leverage gain. In the long run, we expect the figure to approach between 20% and 21%, which is similar to the company’s long-term target. However, if the figure was to come down to 10%-11%, which is what we expect for Facebook eventually, there could be 15% upside to our price estimate.