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Morningstar | Twitter Reports Strong 1Q; Further Growth and Margin Expansion Now Priced In; Shares Overvalued

Twitter started 2019 with a bang as the firm’s first-quarter revenue exceeded expectations. We were impressed with further strength in U.S. advertising revenue as the firm displayed growth in both the U.S. monetizable daily average user count and average revenue generated per those users. We were also pleased with improvement in user engagement, which we think could help Twitter attract more direct response and target-marketing dollars. However, we estimate that the firm’s user engagement remains far behind that of Facebook. Regarding the bottom line, while the firm’s operating margin came in above consensus, it was slightly below our internal projection as higher than expected cost of content prevented year-over-year gross margin expansion. Management provided second quarter and full-year guidance in line with our estimates. We note that our second quarter internal revenue projection is at the high-end of the firm’s guidance.

After making only slight adjustments to our model, we are maintaining our $30 fair value estimate on no-moat Twitter. In reaction to impressive first quarter results, this very high uncertainty name is up 15% and is now trading in 2-star territory. While we continue to expect strong top-line growth and margin expansion through our 10-year model, we believe they are now priced in. At current levels, the stock is trading at 8 times and 21 times our 2019 sales and adjusted EBITDA estimates. We think the stock is now overvalued.

Twitter reported total first-quarter revenue of $787 million, up 18% from last year. Advertising revenue increased 18% year over year, with strength in user monetization within both the U.S. and international markets. This was the fifth straight quarter and double-digit ad revenue growth for the company, indicative of additional ad dollars being allocated more consistently for ad buys on the Twitter platform. Total monetizable daily average users (mDAU) of 134 million was up 12% from last year. U.S. mDAU count grew 8% from last year to 28 million. Such mere single-digit growth was more than offset by our estimate of an impressive 17% growth in average revenue per user. International mDAUs grew 12% to 105 million, accommodated by a 31% increase in average revenue per user.

After taking one last look at Twitter’s monthly average users, or MAUs, as the firm will no longer report that metric, we noticed that user engagement, which we believe is the ratio of mDAU/MAU, improved more than 500 basis points year over year to 41% (based on our estimates). In our view, improvement in user engagement is attracting not only more, but also different, advertisers to Twitter. We expect higher user engagement to improve ad ROIs and bring in more direct response and target marketing campaigns, in addition to the mass marketing which account for most of the firm’s ad revenue. We estimate that while growth in user engagement has been ongoing since 2016 when that figure stood at 33%, mDAU growth has easily outpaced growth in MAUs. However, we note that Twitter’s user engagement remains significantly below Facebook’s 65%-66%.

As we mentioned in our prior notes, there are indications of price stability, and that was supported by the mere 4% decline in Twitter’s cost per engagement during first quarter, compared with negative 28% in first quarter 2018, negative 7% last quarter, and negative 52%, and negative 56% in 2017 and 2016, respectively. Growth in mDAUs and ad engagements, combined with steadiness in ad prices in the future, support our assumption of a 15% annual revenue growth during the next five years.

Twitter’s healthy top-line growth, especially the 20% growth in the higher-margin data licensing revenue, drove year-over-year operating margin expansion of 60 basis points to nearly 12%. While the firm’s operating margin could have been more impressive, Twitter’s continuing investments in improving its user type and overall data security, plus higher cost associated with streaming video content, limited margin expansion. According to the company, those and other investments are ongoing for this year. For example, Twitter is testing various changes to its app as efforts to make it easier to use and engage with other users continue. The company has also developed its own camera feature which is now fully integrated into the app and may make it easier for users to create additional content. We expect the firm to spend more on R&D to further test and possibly implement innovative features which may help retain and/or increase users. Twitter’s investments in creating a self-service and automated ad buying platform, along with an ad measurement dashboard is also ongoing. Per the company’s guidance, we have modeled a 300-basis-point lower operating margin this year. We remain confident that the firm will benefit from those investments in the long run as more user content could push user engagement higher, and the ease of use for ad buyers may not only attract more small and medium-size businesses to advertise but may also help lower growth in sales and marketing expenses.

We remain confident in Twitter’s ability to generate double-digit top-line growth and expand margins during the next 10 years. We have modeled a 10-year, 12% CAGR for total revenue and we expect operating margin to widen to nearly 31% in 2028 from 15% in 2018. However, in our view, those improvements currently are priced into the stock.