Trefis is launching coverage of Twitter (NYSE:TWTR) with a price estimate of $26. While our valuation may stand substantially below the market price of $43, it is still based on optimistic growth assumptions for Twitter’s user base, monetization and operating leverage.
Our valuation implies that Twitter will earn close to $1.4 billion in revenues in 2015 with adjusted EBITDA climbing to $186 million. Furthermore, it implies that the company will continue to grow its revenues at a compound annual growth rate of close to 30% over the next eight to nine years, while substantially increasing its margins. For a $43 price to be justified Twitter needs to grow even more than our optimistic growth forecasts while increasing its profit margins more than we expect it will be able to.
Important Note on Trefis Price Estimate for Twitter
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It must be noted that our $26 price estimate is based on a diluted share count of approximately 666 million for Twitter, which includes restricted stock units as well as outstanding stock options. This is an important distinction for high-growth technology companies like Twitter that can have significant amounts of options outstanding due to compensating employees with options. If our price estimate were calculated solely off the current outstanding basic share count, the Trefis price would be about $32. This $32 figure should be used when comparing the Trefis price on an apples to apples basis with the IPO price ($26), the current market price ($43) and price estimates from other research providers (ranging from $29 to $54).
How Twitter Makes Money
Twitter earns revenue through advertising and data licensing, with the advertising business accounting for a majority of its revenues. The company charges advertisers and marketers for promoting their tweets and Twitter accounts. Additionally, it charges data re-sellers for access to user tweets.
Advertisers leverage Twitter’s real-time data that reflects user interests, and target their tweets to the relevant audience. These promoted tweets appear in user timelines just like any other tweets, thus minimizing the negative impact on user experience. Additionally, these advertisers can pay to promote their accounts to increase their followers and community. The third element of Twitter’s advertising strategy is promoted trends. When a user clicks on promoted trends, the search results related to that trend are displayed on the timeline and a promoted tweet from an advertiser appears at the top of these results.
Most of the advertising revenue is generated on pay-for-performance basis, which implies that Twitter gets paid when users actually engage with the ads. The company has also launched self-serve ad platform and real-time bidding following its acquisition of MoPub.
Trefis Breakdown for Twitter’s Valuation
As you can see from the Trefis breakdown for Twitter’s valuation shown below, the bulk of Twitter’s value is attributable to advertising with slightly more value attributable to advertising in the U.S. versus outside the U.S.
3 Key Trefis Forecasts that Imply a $26 Price Estimate for Twitter
The $26 Trefis price estimate for Twitter as well as the breakdown of this value as shown above is attributable to a limited set of key forecasts that drive Twitter’s value. We’ve summarized these Trefis forecasts below:
(1) 600+ million Monthly Active Users In The Long Term
Twitter’s average monthly active users stood at 160 million in 2012.  We expect this figure to grow to 226 million for 2013, and forecast it to reach past 600 million globally over the course of next eight to nine years. Most of this growth will be driven by growing smartphone penetration, Twitter’s value proposition to users and marketers, and its integration with the third party sites resulting in wide distribution and visibility.
Twitter allows its users to tweet messages which are limited to 140 characters. As a result, the messages tend to be concise and relevant, thus eliminating some noise and making content sharing more meaningful. As tweets are primarily public, users can follow celebrities, media outlets, political leaders, think tanks, companies, brands and other content of their choice. This helps them stay abreast with latest news and events, and benefit from the ideas of others. We believe that this trend will continue to catch up globally, and bring more users to Twitter’s platform.
Additionally, the growing usage of smartphones and other mobile devices will encourage higher usage of interactive mobile applications including Twitter. Smartphone sales have picked up significantly in the U.S. over the past few years, thanks to innovation from Apple (NASDAQ:AAPL), Google (NASDA:GOOG) and Samsung and the subsidies offered by carriers such as AT&T (NYSE:T) and Verizon (NYSE:VZ). In addition, Internet usage is gradually shifting to mobile, which has encouraged brands and companies to focus on bringing their services to this platform. This trend plays right into Twitter’s hands as more than 75% of its monthly active users access the service from mobile devices, and over 70% of its advertising revenues come from mobile.  Around mid 2013, approximately 60% of the U.S. mobile users owned a smartphone, which suggests that there is still a lot of upside for smartphone penetration within the country. The opportunity overseas is even larger. We expect global annual smartphone sales to jump from 675 million in 2012 to 2 billion over the course of next six to seven years, accounting for 90% of the mobile phones sold at that point.
Nevertheless, we expect Twitter’s user base to remain substantially below that of Facebook (NASDAQ:FB) due to the platform’s limited features and usability. In this sense, Twitter will be more similar to LinkedIn (NASDAQ:LNKD) where the platform is designed for a more niche and specific purpose.
(2) Advertising Monetization Rate Growing By 2.7 Times In The U.S. And 9 times Internationally
We estimate that Twitter’s ad revenue per 1,000 timeline views for the U.S. business will jump almost 2.7 times in the next eight to nine years, amounting to $5.10 in ad revenue per 1,000 views. For the year 2013, we expect this figure to grow to $2.35. Given that the company is investing significantly in ramping up sales and marketing teams in international markets, we expect the international monetization to grow even faster. From about $0.17 in 2012, we expect Twitter’s ad revenue per 1,000 timeline views for the international segment to reach $1.54 in less than a decade, thereby growing nine-fold. These forecasts imply that the average revenue per monthly active user will go up from $1.7 in 2012 to almost $10, which is slightly below our forecast for Facebook.
While Twitter will benefit from the general shift of advertising dollars from traditional media to the Internet, its ability to effectively target advertisements to the right audience will be the primary factor contributing to monetization growth. Ninety-four out of the top 100 Ad Age advertisers marketed themselves on Twitter in 2013. These advertisers are getting an attractive return on investment as they can leverage Twitter’s data to improve the ad engagement. The benefit is not just limited to the initial targeting. Due to the ‘retweet’ feature and the viral nature of the platform, these ads or promoted tweets tend to get distributed to a much larger audience for no additional cost.
The data analytics to drive better returns for advertisers will continue to fuel the growth in the online advertisement market. According to Twitter, the global online advertising market (excluding mobile) is expected to grow from $91.1 billion in 2012 to $124.7 billion in 2017, reflecting a compounded annual growth rate of 6.5%.  During the same period, global mobile advertising market is projected to increase from $10 billion to $52.2 billion, which suggests that the proportion of mobile in the overall online advertising market will increase rapidly.  That’s good news given that Twitter is a mobile focused service. 
(3) EBITDA Margins Jumping from 7% To 45% In Less Than A Decade
For the year 2012, Twitter’s EBITDA margins (a measure of profitability) stood at a paltry 6.7%. However, we expect this figure to grow rapidly as the company gains significant operating leverage due to the expected increase in ad monetization. Sales and marketing expense is going to be the most significant cost component of Twitter’s operating expenses in the long run. Although we expect this cost to increase in the near term as a percentage of revenue, it is likely to come down in the long run. Additionally, many of the costs included in research and development expense and general and administrative expense are somewhat fixed in nature, which suggests that these expenses will go down as a percentage of revenue as Twitter’s advertising business picks up. Overall, we forecast the company’s adjusted EBITDA margins to hit 45% in the next eight to nine years.
What Needs to Happen for Twitter to be a $43 Stock
So far we’ve summarized our forecasts for Twitter that justify our $26 price estimate for Twitter. For the market valuation of $43 to be justified, Twitter will have to exceed our forecasts meaningfully. Specifically, the following would justify a $43 valuation:
- (+$6) U.S. Ad Revenue Per 1,000 Timeline Views reaching $7 instead of our forecast of about $5
- (+$4) International Ad Revenue Per 1,000 Timeline Views reaching $2 instead of our forecast of about $1.50
- (+$4) Sales & Marketing as a % of Revenue declining from about 29% today to 12% of revenues instead of the 16% we currently forecast
- (+$3) Research & Development as a % of Revenue declining from about 34% today to about 7.5% of revenues instead of the 10.5% that we currently forecast
You can click on the links to the forecast drivers above and make the changes yourself to see the impact on our price estimate. In total, these changes add about $17 in value to our current diluted price estimate of $26, implying a price estimate of $43.Notes: