IMD's Nuno Fernandes: Why the Twitter IPO Isn't Worth Tweeting About

Monday, 07 Oct 2013 12:12 PM

By Prof. Nuno Fernandes

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Optimistic assumptions pave the way for an expensive investment.

So how much is Twitter worth?

In announcing plans to go public, Twitter filed with the SEC for a $1 billion initial public offering. Given the small number of shares offered, this puts an overall valuation of Twitter close to $15 billion. Twitter reports having 215 million users and revenues of $317 million in 2012. But what is Twitter’s real value?

Twitter is a company with two key drivers of value: a good user base and information about the tastes of these users. The question is whether and how they can convert this information into profits — and how quickly.

Without detailed financial statements, analysts are using rudimentary valuation estimates based on revenue multiples, the easiest financial metric to estimate.

Twitter is expected to have revenue of about $600 million this year and a projected $1 billion next year, according to e-commerce marketing firms. Facebook trades at about 15 times its estimated 2013 sales, and LinkedIn trades at 17 times sales. Thus, for Twitter, which next year will be a $1 billion revenue company, a $15 billion valuation seems appropriate.

But there is just one problem. These calculations, using sales multiples, assume that by some kind of magic, revenues will be converted into profits, and eventually even to shareholder value.

However, the reality is that Twitter isn’t profitable and never has been.

The company reported net losses of $79 million last year and $69 million for the first half of this year (its losses widened during the first half of this year to $69 million, up from $49 million in the first semester of 2012). More complex models of valuation would imply a negative value for Twitter.

The company’s growth forecasts for the end of 2013 suggest revenues of $633 million, and $1 billion in 2014. Clearly, Twitter is on a high-growth path, with growth of 190 percent in 2012, 100 percent in 2013 and 55 percent forecasted in 2014.

The question is how that growth rate will evolve as the firm becomes larger. As acknowledged in the SEC prospectus, "We anticipate that our user growth rate will slow over time as the size of our user base increases."

Now, let’s make an evaluation that assumes a compounded revenue growth rate of 55 percent for the next five years (that is, assume it will be able to grow from 2014 to 2019 at the same rate as in 2014), and then a scaling down of that growth rate to the nominal growth rate in the economy over a 10-year period (that is, a gradual reduction of growth by approximately 5 percent per year over the 2018-27 period).

In this scenario, we also assume Twitter would be able to generate operating margins of 30 percent (that is higher than Google and Facebook), and would require only moderate investment to sustain its growth (10 percent of revenues, whereas Facebook and Google have required more than 25 percent over the past years).

This effectively means Twitter would be able to generate about $10 million in revenues for every million in additional capital investment.

It’s also good to have a reality check on the numbers. The above assumptions imply that in 2025, Twitter would have revenues of approximately $27 billion.

Assuming half of the world’s population will be on Twitter (4 billion people) leads to an estimated value per user of about $7. In 2012, there were 2.4 billion Internet users worldwide, and Twitter revenue per user was less than $2.

While the assumptions here may strike you as extremely optimistic, the full Twitter valuation, according to them, is close to $10 billion (the IPO is planned at a value of $15 billion).

In reality, Twitter’s margins will come under pressure as it actively seeks out more revenues. Also, growth is likely to require more investment than the ones assumed above.

Of course, one could have more optimistic assumptions, that more than 50 percent of the world population is going to use Twitter, and that they are going to be generating even higher revenues per user. If that is the case, the $10 billion I estimated, would be revised upward.

However, it is also possible that a less optimistic scenario happens . . .

As we move beyond tweets and to a real business model, such optimistic assumptions on Twitter’s future have some strong implications on how Twitter does things.

Charging for corporate pages, a model typically used by phone companies with directories, is key for Twitter. Twitter would be free to individual users, but subsidized by businesses.

But this can prove challenging as Twitter has to be careful about making its focused advertising too obvious to users. To make more money, Twitter would need to show many more ads, which runs the risk of alienating users accustomed to seeing relatively few ads in their tweet feeds.

And there are additional challenges to Twitter’s business model, and its ability to grow at fast rates:

• less than 5 percent of users account for 75 percent of all activity on Twitter;

• more than 60 percent users did not login over the past 30 days;

• Twitter is being accessed more often on mobile devices, rather than fixed PCs, and the
propensity for advertising on mobile devices is lower.

In addition to these challenges, we are likely to see a more competitive landscape in the online advertising world. The competition for user-linked dollars is high and it is starting to impact margins.

Almost all social media sites show lower profit margins in 2013, when compared with 2012 and prior years (Google’s margin in the first semester of 2012 is down to 22 percent, from 28 percent in 2012).

As much as Twitter proves to be a great innovation for communication, it may prove to be an expensive investment for those buying the IPO. The IPO valuation reflects assumptions that Twitter will become a phenomenal success and show amazing growth.

Assumptions are optimistically high, and anything less than that will be seen as a failure.

The biggest problem with Twitter’s IPO is simply the potentially overvalued price given the company’s financial future as it can currently be forecasted.

IMD Professor Nuno Fernandes is director of IMD’s program Strategic Finance, which focuses on creating shareholder value.

© 2014 Moneynews. All rights reserved.

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