Twitter Has a Tough Row to Hoe

The tweet's out of the bag, folks. Twitter's S-1 has recently become public domain, adding fuel to the anticipatory fire of its upcoming IPO. However, with heightened buzz comes greater responsibility. Now we have a clear picture of Twitter's financial innards. Here's what could rain on Twitter's parade when it becomes public.

S-1's minuses
One big warning sign found in Twitter's S-1: The company's margins have been squarely in the negative since 2010. Not just a slight dip into the red, either -- in 2012, the company's operating margin was negative 24%, and that's up from negative 38% the previous year.

I wrote back in September about how, on the grand scale of social media public offerings, Twitter has more in common with pre-IPO LinkedIn (NYSE: LNKD  ) , in terms of size and revenue (especially compared to Facebook's (NASDAQ: FB  ) gigantic pre-IPO financials). However, Twitter's S-1 now puts the company in a unique position compared to LinkedIn. The microblogger brought in 1.3 times more revenue than LinkedIn during the latter's last full year before going public, but still has significantly smaller margins -- its net profit margin was negative 25%, compared to LinkedIn's 3%. LinkedIn might not have made the same kind of money as Twitter at first, but at least it was smarter about saving it.

So why all the negatives? Because last year, Twitter spent $128.7 million on its "cost of revenue," which the S-1 explains as leasing, hosting, support, and maintenance costs for its data centers, as well as salaries and benefits for employees. Throw in $119 million for research and development (which also included salaries for engineers and researchers) and you're already 78% of the way to maxing out Twitter's $316.9 million 2012 revenue. The $86.5 million the company spent on sales and marketing last year is more than enough to take that total over the edge. Sure, it's possible to spend more when you're making more, but Twitter is punching well above its weight class in this regard.

Still no sign of diversification
While years of negative numbers aren't a good sign, they don't necessarily mean a company is done for. Even with several bad profit margins, Twitter had $203.3 million in cash last year, more than twice the $92.9 million that LinkedIn had on its pre-IPO books. That wasn't a one-time fluke either -- the microblogger has had over $130 million on the books since 2010.

That's all fine and good, but investors should consider something else before diving into this stock: It generates almost all of its revenue from advertising (85% in 2012, to be exact). Not that that's bad, or not lucrative -- Facebook made a spectacular 98% of its 2009 revenue from ads -- but while Facebook eventually expanded its revenue streams to include dues paid by application developers, Twitter has no such outlets for further diversification just yet, and lists its dependency on ad dollars as a risk on its S-1.

The final countdown
There's still some time before we see how Twitter's IPO pans out, but it's always good to get as clear a picture as possible of a company before diving into it headfirst. If you're looking for a dependable stock for the long term, Twitter's inability to retain its revenue should come as a gigantic red flag, and this lack of retaining funds could make spending to diversify more difficult in the long term.

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