Twitter: Improving Fundamentals And Attractive Valuation

Twitter's (TWTR) stock is on fire lately. Shares of the short-message social network have gained more than 40% in the past 12 months, fueled by accelerating user growth and better than expected financial performance.

Importantly, the stock is still offering attractive upside potential from current levels if management plays its cards well in the years ahead.

Improving Fundamentals

Twitter is implementing multiple initiatives to improve the user experience. The company is deeply focused on effectively tackling abuse, providing more video content, better news features, and revamping the app to make the language simpler and more conversational. The company is also improving its machine-learning to provide more relevant content in timelines and notifications based on what content users are finding more engaging in real time.

These initiatives are producing interesting results, and Twitter is outperforming expectations in terms of both financial performance and user growth. Total revenue during the second quarter of 2019 was $841 million, an increase of 18% and growing 20% on a constant currency basis. The number surpassed Wall Street expectations by $12.93 million.

Twitter ended the quarter with 139 million monetizable daily active users, an increase of 14% and representing acceleration in growth versus prior quarters. This is clearly one of the most positive factors to keep in mind, because accelerating user growth could do wonders for Twitter in terms of revenue growth and Wall Street perception going forward.

Source: Twitter

Total ad engagements increased by 20% during the quarter, and cost per ad engagement was flat year-over-year, reflecting a mix shift toward higher-value ad formats during the period.

The company is financially solid, with $6.7 billion in cash, cash equivalents, and marketable securities. Twitter has $935 million of convertible debt maturing on September 15, 2019, and the company is planning to settle the principal balance from cash on hand when due.

Net cash provided by operating activities in the quarter was $339 million, an increase from $321 million in the same period last year. Capital expenditures totaled $135 million versus $194 million in the same period last year. All in all, Twitter produced $204 million in adjusted free cash flow during the quarter, a significant increase versus $127 million in the same quarter last year.

Looking at the big picture, Twitter is producing accelerating user growth and strong engagement, and this is being reflected on better than expected revenue and cash flow numbers from the company.

Valuation Is Still Attractive

Twitter stock has appreciated substantially in recent months, but free cash flow has also expanded. When looking at valuation levels, the price to free cash flow ratio currently stands at 30, which is not excessive at all for a company producing accelerating momentum and with plenty of potential for sustained cash flow growth in the years ahead.

Data by YCharts

Moving forward, Wall Street analysts are on average expecting $1.95 in free cash flow per share for 2020 and $2.33 in 2021. Under these assumptions, the stock would be trading at forward price to free cash flow ratios of 21 and 17.5. Again, a very reasonable valuation for a social media company with plenty of room for sustained growth in the years ahead.

Importantly, valuation is a dynamic as opposed to a static concept. Stock prices reflect a particular set of expectations about the company's future, if the company can consistently outperform those expectations, then estimates will be adjusted upwards, and the stock price will need to increase in order for the valuation to remain constant.

Twitter is doing a great job in terms of delivering earnings numbers above expectations, the company has consistently exceeded expectations in each of the past 8 quarters, and the most recent earnings beat was by a particularly large margin.

Source: Seeking Alpha Essential

The chart below compares the stock price with earnings and sales estimates for Twitter in next fiscal year. Like usually happens, the stock price and fundamental expectations are moving in the same direction, and fundamental momentum is a vigorous tailwind for Twitter stock.

Data by YCharts

A rising bar is hard to beat, and earnings estimates for Twitter have considerably increased lately. On the other hand, winners tend to keep on winning, and companies that consistently deliver earnings numbers above expectations tend to continue doing so in the future more often than not.

This is an important consideration when analyzing valuation. A company with strong financial performance and accelerating momentum obviously deserves a higher valuation than a business producing mediocre financial performance and weakening momentum.

But sometimes it can be challenging to incorporate the multiple factors into the analysis in order to see the complete picture from a quantitative perspective. In that spirit, the PowerFactors system is a quantitative algorithm that ranks companies in a particular universe according to a combination of factors, including financial quality, valuation, fundamental momentum, and relative strength.

In simple terms, the PowerFactors system is looking to buy good businesses (quality) for a reasonable price (valuation) when the company is doing well (fundamental momentum) and the stock is outperforming (relative strength).

Data from S&P Global via Portfolio123

The backtested performance numbers show that companies with high PowerFactors rankings tend to deliver superior returns over the long term, and this bodes well for Twitter stock going forward.

Twitter has a PowerFactors ranking of 96.5 as of the time of this writing, meaning that the stock is well into the top 5% of companies in the US stock market based on financial quality, valuation, fundamental momentum, and relative strength combined. In other words, valuation levels are compelling when analyzed in the context of other quantitative return drivers.

Moving Forward

Twitter is clearly moving in the right direction, but the company is still minuscule in comparison to Facebook (FB) and its 2.1 billion users across its family of services. With 139 million users, Twitter is also smaller than Snap (SNAP), which has 203 million daily active users as of the most recent quarter.

This relatively small size is both an important risk factor from a competitive point of view and also a major opportunity for the company, because it should be relatively easy for Twitter to continue accelerating user growth if management makes the right moves going forward.

The key variable to watch is the company's ability to drive sustained gains in users and engagement with initiatives such as identifying and addressing malicious behavior, providing more relevant content, improved news features, and building a more conversational platform. Recent results in that area look encouraging, and Twitter has a lot of room for further improvement going forward.

Being a relatively small social media company that is also going through a transformation, Twitter is an investment proposition with above-average risk levels. However, the company is making material progress and valuation is still very reasonable, so the upside potential in Twitter stock could more than compensate for such a risk.

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