Twitter is now profitable, practically speaking. To justify its inflated valuation, however, it must overcome a problem inherent in all advertising-driven businesses: inertia.
Officially, Twitter lost $144.6 million in the second quarter of this year. Normally, it wouldn't do to trust gimmicky measures like adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) or "adjusted net income" for a large public company. But Twitter is justified in touting these. The adjustments are not a gloss on the company's operational performance. They mainly concern Twitter's expenses for stock-based compensation, which reflects the care the company is taking to attract and retain top talent.
Had it not been for $158 million in stock-based compensation expenses in the last quarter, Twitter would have earned about $14 million, its biggest profit ever (although based on GAAP requirements, it has never had a profitable quarter). For a company that only started monetizing its user base in 2009, and has had to hire rapidly, that's not bad. It proves the platform can subsist on advertising and data licensing revenues even now.
Twitter's revenues are growing much faster than expenses. In the second quarter, revenues were up 124 percent year-on-year, while expenses increased 94 percent (mostly because of hiring). The company is no longer burning money: The adjusted net income has been positive for the past three quarters. The microblog network is also rapidly correcting its geographical imbalances. Twitter has only 22 percent of its audience in the U.S. but makes 64 percent of revenue there. However, international revenue increased 168 percent year-on-year in the second quarter, much faster than revenue for the company as a whole. The business model is viable and globally scalable: The service many of us have come to rely on for news will not wither on the vine.
For investors, the story is more complicated. Twitter's earnings to sales are a fraction of Facebook's. And according to data compiled by Bloomberg, Twitter had the highest predicted 2015 price-to-earnings ratio of its internet industry peers even before Twitter's share price rocketed an inexplicable 29 percent following the second-quarter results announcement. There's a lot of long-term faith priced into the the firm's valuation.
It's not clear what Twitter can do to justify that kind of faith. Facebook, with its 1.37 billion monthly active users, would need to make a lot of mistakes for Twitter, with 271 million, to catch it. That's not likely to happen, if only because scale is now favoring Facebook: In the last quarter, it spent $0.95 per user, compared with Twitter's $1.09.
It's tough to be so far behind a powerful rival. An April report by marketing company Resolution showed that ads on Twitter were more effective than on Facebook, generating more clicks, but big advertisers such as Pepsi, MacDonalds, Hertz and FedEx still spent 127 percent more money with Facebook because ads there reached more users. At the end of the day, it's the absolute numbers that count when valuations are calculated.
The phenomenon is known to anyone who has ever started a website or -- in olden days -- a print publication in a niche already populated by powerful competitors: Established leaders get a disproportionate share of the pie even if they are less effective vehicles for advertising than the runners-up. It's sheer psychological inertia and risk aversion.
Twitter still has a comparative advantage over Facebook in mobile ads: They make up 81 percent of its ad revenue, compared with 62 percent for Facebook. Advertisers, however, will not be impressed: Facebook only started selling mobile ads two years ago. Now, only Google can rival it in mobile.
"We do not see any structural reasons that the levels of monetization for our monthly active users can't reach or exceed that of our industry peers over time," Twitter's chief financial officer, Mika Gupta, said on the latest earnings call. Being a perpetual runner-up, however, is a structural reason, and Twitter is not doing anything to close the gap with Facebook. In absolute terms, Mark Zuckerberg's company added 41 million users in the last quarter; Twitter signed up 16 million, its highest tally in five quarters.
There is no reason, then, for investors to give Twitter higher valuation ratios than they grant Facebook. The company is no dud, but it makes sense to modify expectations about its place in the industry.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
Corrects first name of Twitter executive in 10th paragraph.
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