Twitter - Grossly Overvalued by 41%

 Twitter (TWTR, Financial) released its 10K report for FY14 on March 2, 2015 and I took this opportunity to evaluate the company‘s stock to determine if its lofty valuations are warranted. Over the past five years, TWTR has become a household name with 288 million monthly active users (MAUs). Since its IPO in November 2013, the stock has underperformed the market, gaining 15.5% over the period compared to the 20% returns of the S&P500. Part of the problem lies with the massive gains reaped by the investors who participated in the IPO. TWTR was offered at $26 a share and spiked up by 75% on opening day of trading.

The company derives 89.5% of its revenues from advertising and 10.5% from data services. A look at the financials of the company indicates the obvious. TWTR is still in the nascent stages and trails Facebook (FB, Financial) by 5 years.

The revenue grew at an impressive 110% annual rate over the past 2 years; however, the OP loss widened from $77 million in FY12 to $539 million in FY14. However, this is on account of the outdated accounting rules which require a company to expense their R&D spend. Capitalizing R&D, TWTR returned a positive OP margin of 11% in FY14. The R&D spend increased significantly from $119 million to $690 million between FY12 and FY14 which is a positive in my opinion.

Next is the balance sheet: the company had $3.6 billion in cash and equivalents and a total debt of $1.6 billion. Accounting for the operating leases, the debt increases to $2.18 billion.

I started the valuation exercise by projecting the future revenues of TWTR. Estimating growth rates for TWTR is not an easy exercise. I employed several methods to estimate the growth rate for TWTR over the next 10 years.

The starting point in this exercise were TWTR’s own scenarios presented by their CFO Antony Nato last year at an analyst event. Assuming the company executes its strategies, Nato expects the company to generate revenues of $14 billion by FY2024, which translates into a growth rate of 26% per annum over the next 10 years.

Alternatively, we can analyze the advertising industry spends and estimate the market size in FY24 as a starting point. The tables below present the ad revenues shares of digital of major companies and the total market (in billions), as estimated by eMarketer.

Analysts at eMarketer estimate a total industry size of $559 billion at the end FY14 increasing to $710 billion by end of FY18. Growth will be driven primarily by mobile category. The conventional advertising areas are expected to decline at an annual rate of 5% over the next few years.

Google (GOOG, Financial) is the dominant player in the digital space and has held its position steady over the past 3 years. FB and TWTR are on the upward trajectory along with LinkedIn (LKDN) at the expense of AOL and Yahoo (YHOO, Financial). Going by the trends, I project the ad spends to reach $1 trillion by FY24 with digital and mobile together contributing $700 billion thus making up the substantial portion of the pie. TWTR is probably best placed compared to GOOG and FB to capitalize from the growth of the mobile ad market owing to its 140 character limit concise ad format which might be more suitable for the mobile space.

Based on the data above and the market share trajectories of TWTR and its peers, I project TWTR to increase its earnings to $16.1 billion by FY24 capturing 2.3% of the total digital + mobile ad market. This translates into an average growth rate of 45% per annum over the next 5 years, followed by a 13% average growth over the remaining years. I have modeled a terminal growth rate of 2% as part of my analysis.

Coming to margins, using GAAP accounting rules, the company currently delivers negative OP margins and will likely continue to do so in FY15. To estimate the profitability when the company reaches normal operating profit stage, I evaluated the profitability of similar companies in this space. GOOG and FB were the primary peers I selected for this analysis. I also looked at the average advertising industry margins in order to project my margins for the future.

GOOG currently operates at a 25% OP while FB has delivered margins in the 35-40% range. Admittedly, FB numbers might not be sustainable owing to the increase in R&D and capex which is required by the company to fuel its future growth. The industry overall operates at a 12% pre-tax operating margin. I project the TWTR to attain stable margins in the 25% range which is slightly optimistic in my opinion. Further, my model projects the company to attain these margins by end of FY19 with FY16 being the first non-negative year. Post FY24, I have modeled an OP of 20% into perpetuity which is a fairly aggressive assumption in my opinion.

The company currently operates at a poor sales to capital ratio of 0.87 compared to 1.4-1.5 average for the advertising industry. I also looked at the capex spend of TWTR and the company spends approximately 15% of sales in this category. To be aggressive in my valuation projections, I modeled a sales to capital ratio of 2 indicating that the company will generate double the revenue for every dollar invested in the business.

Finally, the cost of capital was estimated by using the bottom-up levered beta for TWTR and the calculations are shown below.

One last step in the valuation exercise was to include the carryforwards of Net Operating Loss of $2.6 billion to off-set the tax liability in future years.

The table below presents the summary results of the valuation exercise:

As shown above, in spite of an aggressive projections and assumptions made while discounted cash flow based valuation exercise, the stock is grossly overvalued and is ripe for correction. In fact, my revenue estimates are more aggressive than the numbers suggested by TWTR’s CFO by a margin of $2 billion. The company would have to spectacularly outperform my aggressive projections to justify its lofty valuation. I would recommend shorting TWTR at current levels.