Why Twitter Investors Were Just Duped

Last week, I got put on the proverbial hot seat when I was asked to analyze Twitter’s (TWTR) second-quarter earnings report on CNBC.

Our discussion was in real time – after investors had just bid up shares nearly 30% in after-hours trading.

Big mistake!

Sure, the company crushed expectations. Twitter reported a 124% increase in revenue. It added 16 million new users to the network. And it actually turned a profit (on a non-GAAP basis).

But an insidious trend is gaining momentum. One that threatens to undermine shares in a hurry, too.

Bigger is Better

Everyone agrees that social media investments are all about the network.

The bigger, the better, as it means there’s more potential to generate advertising revenue – and, in turn, profits.

However, “The question investors need to ask,” says Richard Greenfield of BTIG, “is how big is Twitter’s monetizable universe?”

Precisely!

On the surface, Twitter’s increase in monthly active users to 271 million bodes well for its future. That’s obviously what prompted such a bullish reaction to the company’s quarterly report.

Upon closer examination, though, it turns out that 14% (or 38 million) of those 271 million users don’t ever see any advertisements. That’s because they access Twitter through various third-party applications. And Twitter can’t serve ads in those applications.

The trend isn’t moving in the right direction, either.

In fact, the number of users accessing Twitter via third-party apps increased by 24% during the quarter, even though Twitter plainly stated in its S-1 filing that it expected these figures to decline over time.

Meanwhile, the number of users accessing Twitter via its website or mobile app only increased by 3.9%.

Put more simply, Twitter is unable to monetize the bulk of its user growth.

Sure, Twitter might one day figure out a way to monetize users of third-party apps. But do you want to risk your hard-earned capital on a possibility?

Not me! Especially when shares are already trading at a steep valuation.

Consider:

Twitter’s monthly active user base is one-fifth the size ofFacebook’s (FB). And its revenue per user is 50% lower.

Yet Twitter trades at a 44% higher price-to-sales (P/S) ratio.

At current prices, Twitter sports a P/S ratio of 27.0, versus Facebook’s 18.8.

Now, for those of you who want to cry foul for comparing the two social media networks side-by-side, spare me!

When Twitter’s CEO, Dick Costolo, repeatedly says he wants to reach everyone on the planet, it’s clear that he expects to achieve the same scale. And he’s far, far from it.

If Twitter can’t show a clear path to one billion users, it’s destined to be a niche service. And a niche service is completely undeserving of the premium valuation that shares currently sport.

Remember Rule #1: Stocks Ultimately Follow Earnings

Did I mention that Twitter isn’t even really profitable, either? Well, it’s not.

Sure, the headlines trumpeted the fact that Twitter reported a profit of $ 0.02 per share for the quarter. Giddy Wall Street analysts even tripped over each other to raise their respective price targets on the news. But that was on a non-GAAP basis.

On a GAAP basis, the company actually reported a loss of $ 0.24 per share, thanks to an unbelievably high amount of stock-based compensation expenses (close to 50% of revenue).

In the long run, profits matter above all else. They’re what ultimately drive stock prices. And it’s going to be years until Twitter reports any legitimate profits.

Not until 2017, according to JP Morgan (JPM) analyst, Doug Anmuth.

And if the growth in users who don’t see any advertisements continues to accelerate, like I expect, it could take much longer. Caveat emptor!

Ahead of the tape,

Louis Basenese