Twitter Stock Is a Disaster Waiting to Happen

Twitter (TWTR) is growing at an incredible rate. In 2014, revenue rose by an astounding 111% to $1.4 billion, and the company expects revenue to grow a further 66% in 2015. This growth is faster than Facebook (META 1.54%) is currently growing, and it's reminiscent of Google's (GOOG 0.37%) (GOOGL 0.35%) rapid growth during its early days.

While fast revenue growth seems to be what the market cares about these days, with Twitter being valued at a cool $33 billion, the company is wildly unprofitable. In 2014, Twitter posted a net loss of $578 million, driven by exploding operating costs. Profits matter, and Twitter has yet to prove to investors that its business model actually works. The stock is grossly overvalued. Here's why.

Image source: Getty Images.

Costs are out of control
Twitter is spending big in order to drive revenue growth, and its monetization has been improving. During the fourth quarter, advertising revenue per thousand timeline views rose 49% year-over-year in the U.S. and 94% year-over-year in international markets. It's clear that this heavy spending is producing results.

In 2014, Twitter spent $692 million, or 49.3% of revenue, on research and development. Selling, general, and administrative expenses ate up 57.3% of revenue, leaving Twitter with a massive loss for the year. The bull argument is that this spending is necessary to drive the growth that Twitter is experiencing, and as monetization improves, profits will eventually arrive.

But here's something that Twitter probably doesn't want investors to know:

Google numbers include stock-based compensation, which was a separate item on the income statement at the time. Sources: Twitter, Google, Facebook.

That table shows how Twitter stacks up against Facebook and Google when those companies were roughly the same size in terms of revenue as Twitter is today. Both Google and Facebook managed growth well above Twitter's guidance for 2015, but they spent far less on both R&D and SG&A as a percentage of revenue.

The argument that Twitter is losing boatloads of money in order to grow is necessary goes out the window under scrutiny. Both Google and Facebook managed to grow faster than Twitter is growing today while generating substantial profits. In 2003, Google's operating margin was 22%. In 2010, Facebook's operating margin was an incredible 52%. Twitter, on the other hand, had an operating loss equivalent to 38% of its revenue in 2014.

The valuation makes no sense
Twitter is currently being valued at around 22 times sales. When Google had its IPO, the stock traded at similar levels. The difference, of course, is that Google had already proved that its business model worked. It was already generating huge profits, and it was growing extremely quickly.

Facebook traded at a lower price-to-sales ratio when it first went public, even though the company had already generated massive profits. Twitter clearly doesn't deserve its current valuation in light of these comparisons. It has yet to prove that it's really a business, instead of a popular service that's burning cash quarter after quarter, as it desperately tries to find a business model that works.

Last year, Twitter raised $1.8 billion in a debt offering, and Standard & Poor's Rating Services rated that debt as junk. Twenty-two times sales for an unprofitable company with junk-rated debt? I think I'll pass.

Twitter certainly has the ability to further improve its monetization, but the company's heavy spending stands in stark contrast to its peers. Neither Facebook nor Google needed to lose so much money, or any money at all, at this stage to grow fast. Why does Twitter? If you can't answer that question, then you probably shouldn't be buying the stock.