Twitter Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses." -- Charles Munger 

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. These include companies with the strongest competitive advantages, largest growth opportunities, and best management. I call these businesses Tier 1 enterprises, and Twitter (NYSE: TWTR  ) has earned its place among the elite.

A deep and widening moat
Twitter's primary competitive advantage is its fast-growing user base, which now stands at more than 230 million monthly active users. Even more impressive, more than 500 million tweets -- small messages no longer than 140 characters -- are sent every day. The growing size of Twitter's network has made gaining access to its platform increasingly important to advertisers around the world. But what makes Twitter's user base even more valuable is the data the company collects from its users. My esteemed colleague David Meier had this to say on the topic:

[E]very time you tweet, retweet, or indicate that you like someone else's tweet, the company populates your Interest Graph, a display of your interests based on your conversations on Twitter.

Now put yourself in an advertiser's shoes. Say you want to craft an effective message about a company's brand or send out a promotion that will have a big impact. It would help if you knew how to target the right people with the right message at the right time. That's called content marketing, and Twitter's Interest Graph is chock-full of the data that advertisers need to be more effective with their brand building, lead generation, direct-response marketing, and promotions.

The more people join Twitter's network, the more data it collects. The more data it collects, the more valuable Twitter's platform becomes for advertisers. And the more cash Twitter earns, the more it has to invest in new products and services that help to increase user engagement and entice new users to join. It's a classic network effect, and this virtuous cycle should continue to serve shareholders well in the future.

Tremendous growth opportunities
The global advertising market is expected to approach $600 billion by 2015. Twitter currently commands less than 0.1% of that total. But the trend is certainly working in Twitter's favor, as more dollars migrate from traditional advertising to the Internet, where people around the globe are spending an ever increasing amount of their time. In fact, experts project the mobile ad market will increase from $16.7 billion in 2013 to about $62 billion in 2017.

That plays right into Twitter's wheelhouse: The company is excelling in the mobile space, with 76% of its active users coming via mobile devices. That's one of the reasons analysts expect Twitter to experience exponential growth in the years ahead, with its revenue of $534 million in the last year projected to grow to $5.2 billion in 2018. I believe the move toward mobility will be a long-term global trend, and with its mobile business leading the way, I expect Twitter's revenue growth to exceed Wall Street's expectations. And thanks to economies of scale, that surging revenue growth should lead to even faster-rising profit growth. But attempting to forecast Twitter's earnings and cash flows five years out is likely to be an effort in futility, considering the little amount of financial data we have to date and the tremendous amount of optionality in Twitter's business model. But if you believe, as I do, that Twitter could continue to command a 10 times multiple on its sales, Twitter's market cap could exceed $50 billion in five years' time.

Exceptional management
Since Dick Costolo became CEO in 2010, Twitter's global active user base has quadrupled and the company has tripled in size. Prior to joining Twitter, Costolo was co-founder and CEO of FeedBurner, a digital content syndication platform that was acquired by Google in 2007. Prior to that, he founded two digital-media companies: SpyOnIt, a webpage monitoring service, and Burning Door Networked Media, a Web design and development consulting company. It's clear that entrepreneurship is a passion for Costolo, and that should serve Twitter well as the company is still very early in its growth cycle.

Another serial entrepreneur, Twitter co-founder Jack Dorsey, serves as chairman. Dorsey also co-founded mobile payments company Square, and currently serves as its CEO. Interestingly, Dorsey was recently elected to Disney's board of directors. Could this lead to further integration between Disney and Twitter in the future? It's certainly possible. Regardless, I view founder involvement as a positive, and I'm pleased Dorsey remains a member of Twitter's board.

Also impressive to note is that Costolo has a 97% approval rating on Glassdoor.com, and the company-review site states that 86% of employees would recommend Twitter to a friend. This strong level of employee engagement should further boost Twitter's prospects in the years ahead.

Risks and why I'd sell
Twitter's success is highly dependent on the network effect. If we see signs of slowing -- or far worse, declining -- user numbers, Twitter's value proposition to advertisers could evaporate quickly. User engagement numbers should also be closely monitored, because declining engagement metrics would likely be a sign that Twitter is losing share to competitors. Currently, Twitter is not only growing its user base, it's also seeing those users engage with its service more often. That's a powerful combination that should help drive the value of its business higher.

Valuation
Twitter's stock has more than doubled from its IPO price of $26, stretching its valuation in the process. As it's now trading at more than 30 times analysts' 2014 sales estimates, I certainly understand why many investors consider Twitter's shares far too expensive today.

But rather than waiting and hoping to get the opportunity to buy shares at a more attractive valuation, I will be selling puts on Twitter. With this option strategy, I will be paid a premium to enter a contract to buy 100 shares of Twitter at a specified time and price. Specifically, I will be selling the Twitter January 2015 $50 puts, currently trading at about $10 per share. If Twitter is trading at or above $50 on the Jan. 17, 2015, expiration date, the puts will expire worthless. And the $1,000 I receive in premium ($10 per share times 100 shares) will amount to an approximately 20% gain on the $5,000 at risk ($50 per share times 100 shares).

If Twitter is trading below $50, I will be obligated to purchase shares at an adjusted price of $40 ($50 strike price minus the $10 per share in premium), or about 38% lower than today's $64 price. I think it's also important to note that I would be buying Twitter in January 2015, after the company will have had time to grow its revenue and cash flows significantly. So, in effect, I would be buying shares of a very promising business at a far better valuation than is possible by simply buying shares today. And, importantly, I'd be very happy to purchase Twitter shares at that adjusted $40 price.

Finally, between the time I sell the puts and the expiration date, I will have the option of buying back my puts or rolling them to other strike prices and/or expiration dates. And so, with this put writing strategy, there will be many ways to earn a profit.

The Foolish bottom line
I like to invest in companies that lead the world forward. And Twitter, with its mission "to give everyone the power to create and share ideas and information instantly, without barriers," is one such company. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be writing Jan. 17, 2015, $50 puts on Twitter in the Tier 1 Portfolio in hopes of profiting from the success of this revolutionary business.


Read/Post Comments (3) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 02, 2014, at 12:19 PM, VieuxCarre wrote:

    Great article. I especially liked the specifics given of the strategy. Always good to hear how someone translates their stock strategy into an options transaction.

  • Report this Comment On January 03, 2014, at 4:00 PM, rustianowski wrote:

    I must disagree with your view on Twitter. The stock is still new and riding on the hype of the social media bubble. How can you already call this a tier 1 business, when they have barely done any business. Seriously how do they intend on making money? Selling ads, because that doesn't annoy and drive consumers with short attention spans away.

    Facebook is already becoming old news and the populations discontent over twitter blathering is only growing. The internet bubble is going to burst as the "trendy" consumers will move on to the next big thing. I expect this company to be filing for bankruptcy or selling within 4 years. This company is nothing more than an overvalued fad.

  • Report this Comment On May 19, 2014, at 10:46 AM, mjmny wrote:

    Hi Joe,

    I am invested in Twitter but recent fall scares me a bit.

    Do you still maintain your opinion Twitter is a Tier 1 stock?

    Regards,

    Marius

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