How To Earn 28% On This Once-Broken Social Media Stock

David Sterman's picture

Wednesday, September 17, 2014 - 5:45pm

by David Sterman

In the brief history of social media stocks, history is repeating itself. Both Facebook (NASDAQ: FB) and Twitter (NASDAQ: TWTR) stumbled badly after much-hyped IPOs. And both are now gaining meaningful traction, cementing their roles as powerful platforms for the global ad market.

Of course, we now know how wrong many investors were about Facebook. A little more than a year ago, it appeared as if the company's management was ill-suited to the task of converting a massive user base into a profit machine -- what's known in the tech industry as "monetizing the base" -- and shares languished below $25.

Investor cynicism toward Facebook surely proved short-sighted. 2015 sales will likely exceed $16 billion, more than double the company's 2013 sales base, and shares now trade above $75.

Twitter's trajectory has uncanny similarities. By the time I profiled the company in June on our sister site, StreetAuthority.com, shares had fallen by more than half from their post-IPO high near $75, which was set in December 2013.

Since then, Twitter delivered a rock-solid second quarter and shares have rebounded to the $50 mark. The way I see it, Twitter is following Facebook's game plan and roughly 30% upside still lies ahead for shareholders.

TWTR Stock Chart

As I noted back in June, Twitter had been seen as taking a fairly casual approach to revenue growth. Management was convinced (as was Facebook's management) that building a large customer base was a crucial first step toward eventual revenue and profit growth.

Of course, Wall Street wants to see real revenue traction. And looking at first-quarter numbers, many became convinced that Twitter's growth trajectory was already petering out. Q2 results put those concerns to bed.

Twitter's customer base (known as monthly active users or MAU) grew a respectable 6% sequentially in the second quarter to 271 million, while another key metric, average revenue per user (ARPU), rose nearly 15% to $1.02 in just three months' time.

A deeper look into ARPU shows why this number should increase sharply in coming quarters and years.

In the United States, ARPU stood at $3.07 in the second quarter. Outside of the United States, that figure was just $0.44. The key difference can be explained by the fact that Twitter's U.S. operations were established before the company began its international expansion.

Twitter's foreign ARPU may never fully catch up, but if history is any guide, it will grow substantially from figures seen in the second quarter. That's because Twitter is only now getting around to monetizing that international base with the same programs that were first tested in the U.S.

And there's more reason to expect growth in overall ARPU. Analysts at Canaccord Genuity note: "Twitter monetizes at less than half the level of Facebook, but newer ad products should help it catch up fast."

To get there, Twitter has a number of arrows in its quiver:

-- The company is gaining solid traction with what are known as objective-based campaigns, also known as pay-for-performance campaign formats.

-- It is making a big push into promoted video ads, which carry much higher ad rates than text-based ads.

-- The introduction of a "Buy Now" button holds promise to help Twitter become a robust e-commerce platform. 

-- The company is accelerating a self-serve ad rollout technology to nearly a dozen new foreign markets.

I touched on some of those initiatives in my June profile of the stock, and the company's comments at a recent investment conference will give you a better sense of its growth strategies.

Companies are beginning to understand that Twitter is no mere time-wasting plaything for web surfers.

In fact, "50% of respondents [in a recent survey] include 'following brands' as a main reason they are active on Twitter," according to analysts at MKM Partners, who maintain a $64 price target on the stock. "Major ad agencies report better performance of ads on TWTR than on FB," they added.

The key charm of catching a business model at this point in its life cycle is the potential for robust profit margin gains as a higher amount of revenues are spread over a fixed revenue base. Twitter's EBIT (earnings before interest and taxes) margin was actually negative until this year, but it may approach 15% next year and 27% by 2018, according to UBS analyst Eric Sheridan, who has a $65 price target on shares.

Of course, in the near-term, Twitter's shares will seem expensive in the context of net profits as the company spends heavily to build out its platform. 

The parallels with Facebook continue. Once that company proved its mettle in the second quarter of 2013, it used its operating momentum to deliver ongoing upside. Even as analysts continually ratcheted up their estimates, Facebook has gone on to exceed profit forecasts by 15% to 40% in each of the subsequent quarters. Wall Street analysts are notoriously slow in modeling for accelerating growth, and as a result, must keep playing catch up.

Although analysts are formally modeling for 12% sequential sales growth to $350 million for Twitter's third quarter, it's notable that sequential sales growth has actually exceeded 20% in four of the past five quarters.

To be sure, Twitter's U.S. audience is now quite large, and growth is likely to come from rising ARPU more than from rapid growth in the user base. Yet outside the U.S., Twitter is just getting going.

On the company's third-quarter conference call, look for management to discuss the myriad ways that U.S. monetization efforts are now being replicated across the globe. That should set the stage for an estimated 67% jump in revenues in 2015 to around $2.25 billion.

For comparison's sake, that's a fraction of Facebook's projected $16.5 billion 2015 revenue estimate. That gap may never fully close, but as Twitter works off of the Facebook monetization strategy, look for its sales trajectory to remain robust.

And just like Facebook, which soared from $25 to $75 once the long-term growth platform came into focus, look for TWTR's recent move from $33 to $50 to extend into 2015.

Recommended Trade Setup:

-- Buy TWTR at the market price
-- Set stop-loss at $42
-- Set initial price target at $65 for a potential 28% gain in six months

Note: In just six months, the Alpha Score has tagged 71 stocks right before they jumped 10% in two weeks. And it's tagged 21 stocks right before they jumped 20%. To see how it does it -- and to get the name of a stock flashing "buy" right now -- click here.

This article originally appeared on ProfitableTrading.com: This Once-Broken Social Media Stock is Back on the Warpath​

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.