October 23, 2013 – Twitter: There’s Gold in Them Thar Tweets
TWTR is losing money today, but not for long. Stripping out stock compensation, TWTR’s COGS (35.5% of sales), R&D spending (34.5%), and SG&A (40.7%) currently yield (-9.7%) non-GAAP operating margins, compared to FB at 41%, GOOG at 32% and LNKD at 15%. A big piece of this is TWTR’s late start on monetization – it only began selling ads in mid 2010, 4 years after its launch and 6 years after FB’s first ad sales. With sales more than doubling YoY, TWTR’s structural cost advantages vs. its cloud-based peers should become more apparent – it does not have to support massive searchable archives containing hundreds of billions of image and video files like GOOG and FB, and it does not have to maintain an enterprise sales and support organization like LNKD. With stock compensation expenses also likely to ebb after the IPO, we expect GAAP earnings to turn positive before the end of 2014 and GAAP operating margins to top 35% by 2017, while non-GAAP margins approach a sustainable level north of 43%, better than GOOG, FB or LNKD.
TWTR margins are below water and comps, due to late start on monetization. TWTR is losing money, a condition once common for TMT IPO candidates, but less so in recent years. 58% of TWTR losses are related to stock compensation, which is likely at an unusual high point ahead of the IPO. Even stripping these out, operating margins of (-9.7%) are far below FB’s 41% and LNKD’s 14.7% calculated on the same basis. TWTR has only been ramping revenues for 3 years, since it began selling ads in 2010, while it has been building infrastructure and usage for more nearly 7 years. Arguably, it has established a cost basis that anticipates much larger future revenues.
Scale is an important driver of profitability. For online services like TWTR, COGS are almost entirely data center costs, which are responsive to usage volumes and subject to considerable economies of scale. Moreover, revenues are only partly driven by usage, with additional key drivers advertising density and pricing unrelated to volume. Operating expenses are more driven by ambition than current volume – investments in engineering new services or expanding markets – and should also decline as a percentage of sales with increasing scale. Given, its late start on monetization, we believe TWTR can and will grow its sales considerably faster than its infrastructure costs or its operating expenses, allowing a fairly quick path to profit and an asymptotic approach to sustainable margins to rival or surpass its obvious peers.
TWTR’s mature gross margins should be best in class. LNKD’s current GM (ex stock compensation) are 79%, FB’s are 75%, GOOG’s are 65% (ex MOT) and TWTR’s are 64%. For these companies, the predominant costs of revenue are the data processing infrastructure and related personnel, but contrasting business models dictate very different sustainable margins. GOOG and FB’s infrastructure costs will be the highest – indexing the entire web and maintaining a searchable archive of 100’s of billions of images both have extraordinary storage and processing implications. LNKD may have the least intensive infrastructure requirements, but carries significant non-tech costs in its COGS to support its enterprise HR business. TWTR’s near-real-time use case minimizes expensive search and storage costs, but creates a “need for speed” that could be greater than either GOOG or FB. Balancing these factors, we would expect TWTR’s margins at scale to be far closer to LNKD at the upper end, than to either FB or GOOG at the lower.
TWTR R&D/Sales should trend toward GOOG. GOOG’s R&D, which includes funding for “moon shots” and for computer science research that leads the industry, has run between 12 and 14% of sales for the past 6 years. FB runs even leaner at 9-11% over the past 2. LNKD product development costs have been 21-23% of sales over 3 years, a rate the company believes will decline in the future, and which may include product management activities to support its enterprise products which may not have an analog at FB or TWTR. While we expect TWTR to be aggressive in developing new business opportunities, we expect the same of FB, and see 10-12% (ex stock compensation) as a reasonable sustainable level in the future.
Media deals could help cut marketing expense. TWTR SG&A, at 40.7% of sales, is dramatically higher than GOOG (20%), or FB (24%), but slightly below LNKD (43.1). However, TWTR’s advertising-based business model is much more analogous to the first two than it is to LNKD, which must maintain a substantial sales force to sell its enterprise HR solutions. Over time, we would expect both FB and LNKD SG&A to trend toward GOOG’s levels, with TWTR, perhaps, having a slight advantage due to the prominence of its co-promotion activity with media partners.
Excessive stock compensation expense likely IPO related. We expect the current high level of stock option recognition to continue for several quarters, as the IPO, and the subsequent expiration of holding periods will trigger vesting and exercise. TWTR’s stock compensation expenses have nearly doubled YoY, averaging 18.7% of sales YTD. This is consistent with FB, which saw an even bigger jump – from 5.8% to 30.9% – around its IPO in 2012 and have since fallen back to 12.3%YTD. LNKD was less generous to its employees, with a modest IPO bump from 5.7% to 8.9% in 2011. While there are examples of mature companies with egregious employee option policies, GOOG, which has tempered stock compensation expense to 5-5.5% of sales over the past few years, could be an appropriate long term model.
Sustainable operating margins, including stock compensation, could top 35%. Assuming GM between 75-80%, R&D at 10-12%/sales, SG&A at 20-23%, and employee stock compensation at 6-10%, long term operating margins at the mid-point would be 36.5%, or 44.5% on a non-GAAP basis. At these levels, we would expect TWTR’s mature margins to be somewhat better than LNKD, GOOG or FB. We note that infrastructure investment, expenses, and compensation are subject to management discretion, and we believe that spending above these levels in the near term is justified in pursuit of the significant further opportunities that are available to TWTR. Still we believe revenue growth will be sufficient to bring TWTR to profitability before year end 2014, and to reach our target sustainable cost levels by 2018.
For our full research notes, please visit our published research site.