BSIC Special Report: Twitter IPO

Months of rumours have finally come to an end: Twitter is joining the ranks of listed internet companies with an IPO in Q4 2013. The market is hyped up and ready to go, but is this offering destined for ridicule as Facebook’s was?

Correctly valuing Twitter is of paramount importance if we want to shed some clarity on all the excitement around its IPO. This BSIC special report comes to the rescue with an in-depth market analysis and full DCF and multiples valuation.

The Industry

With a promising user base reaching in Q3 ‘13 approximately 230M monthly active users (approximately 4x smaller than Facebook’s, its main rival in the social media advertising business,) its business model heavily relies on the competitive advertising business (89% of overall sales). This business model coupled with other factors tied to Twitter or to the industry affect market sentiment in different ways in this IPO.

First, Twitter has always been focused on mobile advertising. In the last quarter, the portion of advertising revenues generated from mobile devices rose to 70 per cent, from 65 per cent in the previous quarter. This is a high-growth market which from 2012 to 2017 is projected to increase from $10.0 billion to $52.2 billion, representing a 39.2% compounded annual growth rate, according to industry sources. The growth rate is substantially greater than the growth rate of online advertising which is expected to have a CAGR of 6.5% in the same period. This strategic positioning in a high-growth market as compared to competitors (i.e. Facebook’s estimated sales from mobile advertising will reach 45% of advertising sales in 2013) is a promising signal that Twitter will be able to grow faster.

Second, Twitter operates in a competitive industry. The environment is dominated by companies which have greater financial resources and substantially larger user bases, such as Facebook, Google, LinkedIn, Microsoft and Yahoo! which offer a variety of Internet and mobile device-based products, services and content. For example, Google could use its large user reach to implement a social network advertising strategy. In addition, there is a consolidation trend in the industry with Google, Facebook and Microsoft being aggressive in acquiring companies which increase their presence in the mobile advertising business (i.e. Microsoft’s acquisition of Nokia and Facebook’s acquisition of Instagram). Their cash firepower allows them to enter new markets swiftly often bringing about reduced functionality of Twitter’s products and services, as is the case with Instagram (pictures were no longer visible on Twitter after Facebook’s acquisition of Instagram). Lastly, Twitter’s growth depends on operating systems, networks, devices, web browsers and standards which quite often are within the reach of its direct competitors. Such an example is Google’s Chrome web browser or the Android operating system. Strategic alliances within the industry can affect user reach through other channels too (e.g. MAC OS, iOS, Firefox, Windows etc.).

Third, it is true that as user growth is expected to flatten out in the US (currently generating 74% of revenues) Twitter has to look for growth internationally. This implies that it would have to compete against smaller companies, such as Sina Weibo, LINE and Kakao, each of which is based in Asia. These companies often offer very similar features to Twitter’s (in South Korea the messaging service offered by Kakao is such an example). In addition, Twitter does not have a proven record of solid monetization outside the US. Advertising practices through online platforms are not as popular in non-US countries which is also proved by monetization levels equal to $2.58/user in the US as compared to 36c in the rest of the world in Q3 ’13. Even though the company is heavily investing in R&D, trying to increase effectiveness and its appeal for online advertisers (monetization increased in the US to $2.58 in the third quarter from $2.17 in 2012), the inherent risks related to a pure advertising company are tied to the loss of the perceived effectiveness of the platform.

Retail interest on the Twitter IPO has been high as proved by an incident on Friday the 12^th of October. Tweeter Home Entertainment Group, whose ticker was TWTRQ is a bankrupt consumer electronics company. It was mistaken by retail investors as being Twitter. Tweeter Home’s share price shot off the rooftop leading to a 1500% jump with a volume of more than 11.7 million shares traded by midday from the average 1000 shares/day volume clearly showing that the stock is going to generate high demand. During the valuation, one of our concerns was the fact that Twitter’s main shareholders include venture capitalists that have been increasingly pushing for the IPO. Currently, the largest shareholder is not a founder but actually is Rivzi Traverse, an investment firm founded by Suhail Rivzi. With a 17.5 per cent stake, a large exit from Rivzi Traverse together with other VCs would put downward pressure on the price. We looked however at the other comparable companies post-IPO and noticed that VCs did not sell their stakes for at least 6 months (a so-called lock-up period) which will be good news for the share price on IPO.

The precedents

No analysis of Twitter’s IPO could avoid the elephant in the room represented by Facebook’s 2012 IPO embarrassment, which saw the markets punishing an over-optimistic valuation by lead underwriter Morgan Stanley with an impressive drop in price immediately after the offering. Facebook’s price has since recovered, and a bull run in the last 6 months has brought it comfortably above IPO levels, but the fear of a rerun of its initial price tumble is still there for internet companies considering a flotation.

The last decade saw a score of internet firms coming of age with an IPO. Despite all the hype, only some lived up to their promises, while others have ended up in sub-unitary P/BV territory. Google’s IPO in 2004 arguably ushered in a new golden age for internet companies. It also represents one of the best long term success stories in the industry: its share price more than tripled in one year from its $85 at issue, and on Friday 18 October 2013 it broke the $1,000 barrier. Google has since become an irreplaceable part of the internet as we know it, and a textbook example of great online advertising monetization.

Seven years later professional social network LinkedIn followed Google’s successful path by convincing investors of the soundness of its business model, so much that its stock doubled in price on the IPO date itself. The company has kept delivering on its promises, and investors have rewarded it with impressive stock performance. LinkedIn’s well executed IPO on the NYSE marked the beginning of the era of social networks’ flotations, and has been quoted as one of the reasons of Twitter’s choice of that exchange. The choice of the NYSE is also related to Facebook’s fiasco on Nasdaq and to the depth of the NYSE which has a daily trading volume approximately twice as big as Nasdaq’s.

Few months later, online coupon website, Groupon IPOed amidst rumors concerning the sustainability of its perennially loss-making business model. Investors didn’t buy the story, and the stock was down more than 75% from $20 at issue twelve months later. Groupon’s botched offering temporarily cooled optimistic animal instincts towards internet start-ups: spring 2012 saw the most hyped IPO in years, ending up in ridicule both for Facebook and its advisors.

We believe that the different fates of these companies have much more to do with fundamentals than with varying market sentiment, and a solid valuation needs to be based on operating multiples. We analysed the companies above at IPO, six months post-IPO and one year post-IPO, and compared the results with our forecasts for Twitter. We concentrated on sector-specific operating multiples, since profitability at IPO is negative for some of the comparables and for Twitter itself. Revenue-per-user (RPU) and revenue-per-share were computed to analyse revenue generation potential, and then compared to price-per-user (market cap divided by total users) to measure the valuation attached to each user by investors (implying a mini-DCF model valuation for each user). EV/Revenue was used to gauge the future growth potential embedded in the stock price.

Twitter’s revenue per user at IPO will be $1.93 and $2.5 after twelve months, compared to Facebook’s higher but stable $4.78 and $4.95. LinkedIn’s numbers came in between ($2.88 and $3.84). The difference in amount and growth rates between the first two is to be attributed to Twitter’s earlier life stage, and we believe the measure will get closer over time.

This dynamic is also reflected in the price per user metric: Twitter’s is $61.7 or 30x RPU at IPO and $48.1 or 20x after 12 months. Facebook, which has a higher RPU, has a correspondingly higher price per user, $109.7 or 21x RPU at IPO and $56.2 or 11x after a year. It is interesting to note that the metric, as a multiple of RPU, is decreasing for all companies (as growth takes place and slows down year after year) but also higher for Twitter than for Facebook: investors believe that the former is younger and has comparatively more growth ahead. The EV/Revenue calculation confirms this expectation. Twitter’s multiple is 32.4x at IPO and 19.5x after twelve months, while Facebook’s is lower at 22.9x and 11.6x. If we account for LinkedIn’s IPO day price surge, its numbers again fall in between, at 30x and 18.5x respectively.

Twitter’s valuation

Now, let’s get down to the number crunching exercise we have done to come up with the “right” price for Twitter. The valuation is based on a 10-year Discounted Cash Flow analysis, while the Weighted Average Cost of Capital (‘WACC ‘) and operating factors have been obtained by selecting a comparable universe based on Twitter’s main source of revenue, i.e. online advertising with particular emphasis on mobile. We thus decided that the best candidates are Google, Linkedin, Facebook and Microsoft (in light of the recent acquisition of Nokia’s mobile business).

One of the difficulties stemming from the valuation resided in the company still being at a relatively early stage, in a way it could be defined as a “mature” start-up given the growth rate that it still has, much higher than the one shown by either Facebook or Linkedin pre-IPO. Given this peculiarity, we decided that the best (and safest) way to model topline growth required us to model the underlying market of mobile advertising services. Using a 5.4% compounded annual growth rate (i.e. GDP/inflation +3%, very reasonable for a relatively young tech sector), we estimated the market to reach $198bn by 2023. Assuming that the comparable companies will increase their market share benefiting from a position of strength, going from 40.7 % to almost 60%, and that Twitter will scale back a bit in its sources of revenue, going from 86/14 to 70/30 split between online advertising and data licensing, we were able to backcalculate topline growth in the two lines of business. We therefore obtain a 34% compounded annual growth rate (‘CAGR’) over the period in online ads, 48% CAGR in data licensing, which together imply a 36% CAGR for the overall company.

We decided to rely on the comparables for Gross Margin estimations, which is fixed at 60% in steady state after reaching a peak of 68% in 2016. A fundamental adjustment that had to be made to the statements filed by Twitter consisted in the capitalization of R&D for valuation purposes. This item is usually expensed following accounting standards, resulting in a distorted picture for investors given the importance of research and development for tech firms, even more so in the case of young ones as Twitter. The capitalized R&D has then been amortized for 2 years, an “expiration date” set by the company itself in recognition of the fast-paced business Twitter is in. We capitalized and amortized operating leases as well.

In order to sustain such a high growth, we assumed a fixed Sales-to-Capital ratio of 1.3, from which we calculated required reinvestment. Given the level of capital, the model spits out a Return on Invested Capital (‘ROIC’) of 20%, revised downward in perpetuity to 12%.

According the S-1 filings, Twitter expects to start paying taxes after 2017 (also benefiting from the JOBS Act) and our above mentioned assumptions suggest that the company will become Free Cash Flow positive from 2020.

Coming to the WACC calculation, we started by looking at the sales in each country to get the Equity Risk Premium while the unlevered Beta comes from our set of comparables, which is equal to 0.98. The company is almost entirely financed with equity (as can be expected from a start-up) and its current cost of debt is 8%. Putting together the after-tax cost of debt and the cost of equity we were able to reach an 11.2% cost of capital that is forecast to progressively decrease as the steady state is approached and the capital structure adjusts to reflect a more mature business. Although such a drop may be seen as a drastic imposition, it is indeed consistent with expectations of Twitter becoming closer to a blue-chip status in the future.

An important part of the valuation is made of the options, which have been evaluated using the classic Black and Scholes formula for option pricing. We used the target price for the IPO ($20 at the time this article was written) as the current stock price, and took the average strike price and maturity from the S-1 filing itself. This pricing exercise suggests a value of the options of ca. $800mln.

Putting all these assumptions together finally brings us to the estimation of the Equity Value and ultimately to a share price of $24.9, not far from the rumored issue price.

Conclusion

The valuation is very conservative in its assumptions and those are clearly reflected into the final share price. As it can be expected, the model is extremely sensitive to the WACC and the terminal growth rates but at the end of the day the purpose of evaluating Twitter was not only to come up with a listing price but also to understand market’s expectations towards the company. Twitter is still at a very delicate stage of its life cycle and we believe that given the general positive market sentiment and Twitter’s expected high-growth, the target share price will be approximately $25.