2 Crucial Questions That Twitter Must Answer on July 29

Before you pay a high premium to invest in Twitter, the company needs to answer these two questions, and prove that neither are an issue on July 29.

Jul 20, 2014 at 11:00AM

Twitter's (NYSE:TWTR) earnings will be among the most highly anticipated of the season on July 29 after seven different firms have upgraded the stock following its lockup expiration. While analysts have remained bullish, Twitter's eventual upside lies in its ability to improve engagement and drive user growth, like Facebook (NASDAQ:FB). However, will it be successful?

A lot of questions ahead of earnings
Ultimately, for social media companies to experience long-term success they must have strong user growth and engagement in order to attract video and display advertisers in a competitive market. These two areas have been concerns for Twitter investors in recent quarters. Specifically, Twitter had guided for 400 million monthly active users to end 2013, but fell well short, currently having just 255 million to end the first quarter of 2014.

With that said, Evercore reiterated its Overweight rating last month after saying that Twitter's user base may be 20% higher year-over-year in the second quarter. However, data on Twitter's user growth has been volatile, giving investors a lack of clarity as to what should be expected.

Specifically, two independent sources recently told Business Insider that Twitter's user growth remains challenged. Reportedly, if not for the World Cup, Twitter's monthly active users would have actually fallen into negative territory quarter-over-quarter, and that Twitter will finish the quarter in the very low 260 million range.

If accurate, this would prove that recent initiatives to improve the user experience and boost engagement is not working. Not to mention, it would represent a decline from Twitter's quarter-over-quarter user growth during the fourth and first quarter of 4% and 6%, respectively.

A deep connection with user engagement and growth
Given Twitter's $21 billion market capitalization and the high expectations that naturally come with a stock that trades at 27 times sales, controversy is always high surrounding the company. However, some of the more reliable data points we've seen to explain Twitter's user growth woes are most certainly in connection to its poor user engagement statistics.

For example, Deutsche Bank conducted a survey earlier this year on ex-Twitter users. What Deutsche found was that nearly 60% of ex-users had less than 10 followers, implying little engagement, and that 66% sought more sharing of posts like videos.

Twitter Users Who Left Say

Source: Deutsche Bank analysis on Twitter ex-users

In adding to this analysis, Hillside Partners found that Twitter sharing had fallen 5% year-over-year during the first quarter. Meanwhile, Facebook's likes and shares grew 31% and 14%, respectively.

User engagement's role with revenue growth
Notably, there are much fewer questions surrounding Facebook's fundamental outlook these days, as advertising revenue has soared across both mobile and PC platforms. Facebook has implemented new products to become more friendly to advertisers, and its improving user engagement has aided in this effort as a way for promoted posts to become more beneficial for the advertiser.

Furthermore, Facebook's advertising software provider Nanigan recently reported that its clients experienced a 146% increase in click rates on the Facebook platform during the second quarter. Meanwhile, Nanigans claims that its clients' cost per 1,000 impressions have soared 218% year-over-year, and 57% quarter-over-quarter.

In other words, this is a direct tie that improved click and engagement rates is having an effect on Facebook's ability to monetize advertisers at a higher rate; implying there is more value in Facebook's platform. Hence, when users are engaged with advertisements, this data proves that advertisers are willing to pay higher prices.

Foolish thoughts
As you can see with Facebook's data, engagement is crucial for Twitter during the second quarter following its new initiatives to improve the user experience. However, growing users is equally important in boosting engagement. These two metrics will be important for Twitter investors to monitor in the second quarter following back-to-back lackluster quarters in user growth.

Ultimately, Twitter's valuation is tied to its long-term performance, and expectations that it will grow larger. However, Twitter must answer questions regarding user growth and engagement with data being so fickle. Until it proves that neither are a fundamental problem, it would be hard to get long Twitter when trading at 27 times sales.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Facebook and Twitter. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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