Where Twitter Goes, Not Even Jack Dorsey Knows

To me, the most fascinating aspect of Twitter is the immense disconnect between the value it creates (or its users customers receive) and the value it captures or realizes. Since its founding in 2006, the service has become the most effective channel to disseminate ideas and information on the planet; played a critical role in at least four revolutions and now counts more than a billion customer touchpoints each day. Despite this, Twitter has yet to enjoy a single profitable quarter. Although revenues have been successfully scaled over recent quarters, costs have continuously outpaced this topline growth. In Q3 2013, Twitter lost more money than it did over the last three quarters of 2012 combined.

Sustained unprofitability is neither new nor insurmountable for web services companies. However, I can’t think of another product, service or solution that plays such an instrumental and active role in society and struggles more to achieve even nominal profitability. With this and Twitter’s vaunted initial public offering next week, I thought I’d do a quick summary of my thoughts on the company and its future – as well as how I believe management feels about those same topics.

Twitter’s Unknown Future

In reviewing Twitter’s IPO prospectus, most news outlets and analysts have focused on two things: the company’s slowed user growth and its ongoing unprofitability. What’s missing in this analysis is the significance of these happening concurrently. New products, services and companies tend to follow a largely foreseeable growth pattern. While the exact timeframe, scale and entropy of the curve will vary (most will experience continuous ‘spikes’ but ultimately revert to the mean), this lifecycle typically looks like this:

By graphing Twitter’s user growth rates, it’s clear that the company has exited the “growth” phase of its lifecycle – even if we chart raw user growth in order to compensate for the law-of-large-numbers.

Twitter’s user base was once expected to compete at or at least near the scale of Facebook. Today, however, reaching even half of Facebook’s present penetration (1.2 billion) seems unlikely. Twitter CEO Dick Costolo reportedly set a 2013 year-end target of 400M users, which would represent a 100% increase over its 2012 FYE count. But with only 232M by the end of Q3, it now looks as though Twitter will fall short of even 250M users –equivalent to only 25% of Costolo’s goal.

A plateau is, of course, inevitable. The problem is that Twitter appears to be entering the ‘mature’ stage of its growth cycle before having established a profitable business model. Were the company still in the ‘growth stage’, valuations (and eyes) would rightly be focused on the size of its social network (i.e. Monthly Active Users, or “MAU”), rather than earnings or margins. Now, however, the company should be proving its ability to derive value from this user base Twitter’s failure to do so either means management has yet to figure out how, or they were caught off guard by stalling growth rates (as Costolo’s shortfall suggests).

In either case, the outcome should be alarming to (would-be) investors. After all, how do you project the value of a maturing business that doesn’t actually have a functioning “business?”. This also contrasts significantly with the IPO of Facebook. Though the company was firmly in the mature stage of user-growth by the time of its listing, it was also enjoying the fourth consecutive year of profitability. Prospective IPO buyers were thus focused on the company’s ability to grow earnings and realize value from the desktop-to-mobile migration – not whether earnings might ever exist in the first place.

What does this mean for Twitter’s (current and future) valuation?

To enhance profitability or drive accelerated user growth (both of which would increase equity value), Twitter needs to do something new. Over the past year, management has made few attempts to expand from being a social communications platform to also acting as a content discovery gateway. In April and October, Twitter released #music and “See It”, which enables Twitter users to find and tune into streaming music or live TV from inside Twitter apps. The notion that Twitter could use its relational and real-time trending data to help its users find and enjoy new artists or television shows is promising – but it’s unclear that they could do so better than Google (which has 6x as many users and is the Internet’s primary discovery gateway), Apple (the leading digital content distributor ), Microsoft (whose Xbox dominates US living rooms) and so on. To that end, #music is expected to be shut down before the end of the year and “See It” has yet to pick up much attention or users (though it is currently limited to 22M Comcast video households).

What’s more, the core decision to pursue an IPO suggests that management sees limited opportunities for shareholders in the near future. To maximize pre-IPO shareholder returns, Facebook deferred its listing so long that it was beginning to violate securities laws. Not only is Twitter choosing to go public far earlier than it needs to, it could have waited at least two to three more quarters and still taken advantage of the JOBS act (which provides significantly fewer and less expensive regulatory requirements for listings of companies with under $1B in revenue). For Facebook, the three quarters leading up their IPO resulted in a 20%+ increase in market capitalization.

According to David Pakman, a venture capitalist at Venrock, “With Twitter, the public has the chance at seeing way more of the upside (of explosive growth).” To any capitalist, the premise that current shareholders would give away “explosive upside” to future shareholders should be treated with skepticism. Instead, I’d argue that management and/or current shareholders believe one or more of the following scenarios:
A. Key financial and operating metrics (namely MAU, ARPU, revenue growth, earnings growth) are likely to experience a material decline or slowing
B. Social media multiples are likely to compress at a rate faster than increases in Twitter’s intrinsic value
C. Twitter is unlikely to demonstrate a viable business model over the next few quarters (and be even deeper into its mature growth phase)
D. The company has an increasingly imbalanced risk-return ratio for shareholders going forward

IPOs are often compared to entering “adulthood” or “graduation”. The problem with Twitter is that it has yet to decide what it wants to be when it grows up. Even then, it will need to prove not only that it will be good at that profession, but that the market will pay a high salary for it. If Twitter were still in a period of hyper-growth (“puberty”), this uncertainly would be okay. As a company now in its 20s, proclaiming boundless potential is not enough.

Would-be investors should be careful Thursday – as with all teenagers, it will be impossible to predict and harder still to control.