A 'Hated' Web Stock Is Showing A Classic Setup

David Sterman's picture

Wednesday, June 4, 2014 - 9:45am

by David Sterman

A surging stock price suggests a healthy company, and a flagging price portends even worse days ahead.

Or so you'd think.

In fact, the converse may be true. Out-of-favor stocks often represent the best upside simply because they have few fans, many of which may eventually become converts.

That as surely the case a year ago, when Facebook (Nasdaq: FB) was becoming one of the most hated stocks on Wall Street. Fund managers that bought into this once-hot IPO began heading for the exits.

Yet as I noted at the time, soon-to-be-released quarterly results should lead "many investors to give this moribund stock a fresh look." Like clockwork, Facebook delivered solid quarterly results in July, and the once-hated stock has never looked back, climbing 160% since then.

Why was upside for Facebook, in hindsight, so obvious? Because it was very easy to find fault with the company's recent financial performance, and even easier to overlook the positive attributes that were beginning to bubble up.

A year later, a very similar setup is in place for a once-hot social media IPO. Since Dec. 26, shares of Twitter (NYSE: TWTR) have fallen 56% while the Nasdaq has been roughly flat. And the sell-off has lured few buyers: According to GuruFocus.com, just one fund manager -- the notorious Steven A. Cohen -- felt the need to buy shares in the first quarter of 2014. Cohen now owns 370,000 shares.

Twitter is now hated by investors. And that often spells opportunity.

To be sure, this stock likely never deserved to trade in the $70s. By the time I looked at this stock in January, for our sister site ProfitableTrading.com shares had already fallen to $57 as it had become apparent that the company had not yet articulated a clear monetization strategy.

Yet with shares now at $32, here's why you should revisit this broken stock.

1. Advertisers are warming up

Twitter's sales grew just 4% sequentially in the first quarter of 2014, to $250 million, which is pretty lame for a pricey tech stock.

But traction with advertisers is growing as the year progresses. "Our checks indicate that ad budgets continue to steadily shift to Twitter, driving robust velocity in monetization per user," notes Nomura Securities' analysts, who recently raised their rating to "buy" with a $43 price target. ​

 

2. MoPub is gaining traction

Twitter acquired MoPub last year to help bolster its ad sales in the mobile device category. MoPub now delivers ads to more than 1 billion mobile devices, according to the company. And that sizable base is starting to reap solid rewards. 

Advertising giant Omnicom (NYSE: OMC), for example, recently inked a $250 million two-year deal with MoPub. Mobile advertising is the fastest-growing online category, and Twitter's purchase of MoPub shows that it's becoming more serious about revenue generation beyond the core tweeting platform.

 

3. International follows domestic​

Prior to its IPO, Twitter was a lot more interested in building a large user base than making money. Yet efforts to generate greater average revenue per user (ARPU) are starting to take shape: ARPU is rising at a 50% pace, helping fuel projected 90% revenue growth this year (to $1.3 billion) and an expected 60% growth in sales next year (to $2 billion).

The international playbook is shaping up in a similar fashion. Twitter's non-U.S. base is 80% of the size of its U.S. base, but generates just 25% as much ARPU as the domestic base. Management is now in the process of applying the same monetization to its international customers, and ARPU should rise quickly to catch up with the domestic performance. 

 

4. At an inflection point​

Twitter's revenue base only modestly exceeds its expense base, but with expenses now mostly fixed, future incremental revenue growth should flow straight to the bottom line.

In round numbers, Twitter had roughly $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) last year, is on track for $200 in EBITDA this year, $750 million next year, and $1.5 billion by 2016. That will help transition Twitter from a "show-me" stock into a true growth stock. 

 

5. The lock-up expiration fades​

Twitter became a "don't touch" stock as it moved ever closer to the May 6 share price lock-up expiration date. Insiders and employees likely spent the rest of the month selling shares as well in order to get at least some money out of their quickly-falling stock option packages. There's no way to confirm it, but the massive employee-led selling has likely exhausted itself.

Risks to Consider: No one would call this stock cheap, so a further retrenchment in dot-com and social media stocks leaves Twitter vulnerable to more downside.

Action to Take --> Twitter is not Facebook. It will never generate the same ARPU simply because its social media platform isn't as vast. That helps explain why Facebook is now worth $162 billion, while Twitter is worth $20 billion. But Twitter is shaping up to be a very respectable second-tier social media platform and now simply needs to prove that it is becoming a trusted platform for advertisers. 

To be sure, Twitter must better articulate its business model to the investment community, as Facebook finally did in its second-quarter conference call last year. Analysts expect Twitter's second-quarter sales to rise more than 10% sequentially, which would be good enough to change the tone of conversation around this broken stock. A "glass half full" perspective (instead of "half empty") could push this stock right back to $40.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.