Twitter, Inc.'s Next Growth Market: Video Ads?

Google's (NASDAQ: GOOGL  ) YouTube brings in billions of dollars in revenue for the company every year, most of which is derived from video ads -- and competitors are noticing. About four months ago, Facebook's Instagram introduced video ads. Even Facebook itself is planning to launch video ads on its own platform by this summer. Now Twitter (NYSE: TWTR  ) has hired former YouTube executive Baljeet Singh as a product director in its revenue organization, with one of his roles including helping the company push new video ads, according to The Verge. For Twitter investors, this is excellent news.

Twitter headquarters. Image source: Twitter. Photo by Aaron Durand (@everydaydude).

What's so great about video ads?
First, they are extremely lucrative. YouTube, for instance, contributed about $2 billion of net digital ad revenue to Google in 2013, eMarketer estimates. Impressively, that $2 billion in net ad revenue was on just $5.6 billion in gross ad revenues -- that's about a 35% margin.

Adding perspective, eMarketer said that YouTube's ad revenue alone accounts for about 1.7% of global digital ad revenues, "higher than the market shares of Twitter, AOL, Amazon.com, Pandora, LinkedIn, Millennial Media and other large players."

Second, the digital video ad market is growing rapidly. In 2011, YouTube's gross ad revenue amounted to just $2 billion, significantly below eMarketer's 2013 estimate for YouTube's gross ad revenue at $5.6 billion. Or here's another way to look at YouTube's impressive growth: Year-over-year gross revenue growth for YouTube in 2012 and 2013 was 85% and 51%, respectively. Further, eMarketer says that YouTube now accounts for a whopping 11.1% of Google's total ad revenues, up from 5.5% in 2011.

Why does Twitter need video ads?
For investors, video ads on Twitter are likely a key ingredient for helping the company live up to the enormous expectations baked into its stock price. The company's $32.6 billion market capitalization calls for some impressive growth.

With Q4 revenue up 116% from the year-ago quarter, the company is living up to those growth standards -- for now. But a small non-GAAP fourth-quarter EPS of just $0.02 is nothing compared to Twitter's $55.30 share price, so high levels of growth, both at the top and bottom line, will need to be sustained for a very long time.

Investors are also concerned revenue growth could decelerate if user growth deceleration persists. Per the company's annual report, the cost of advertising on Twitter fell 18% for the seventh straight quarter of sequential declines in the last three months of 2013. Though ad engagement was up 74% sequentially, Twitter's most recent 10-K filing says that that one of the primary factors driving engagement is monthly active user growth, which slowed considerably in the fourth quarter. Sequential growth in monthly active users was 3.9%, down from 6.4% growth in Q3.

Twitter warns investors of the perils of decelerating user growth in its 10-K:

In the event that cost per ad engagement continues to decline, and we are unable to continue to offset the impact of such decreases on advertising revenue by increasing the number of ad engagements, our advertising revenue would decline.

Video ads, however, may help Twitter dampen the effects of slowing user growth.

The takeaway for investors is that video ads could be a major boon for the company. While the valuation is still a bit too aggressive for me to justify, the hope of lucrative videos ads makes this growth stock worth holding.

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