Instagram's Ad Revenue Could Soon Surpass Twitter's

Mockups of Instagram's new direct-response ad units. Source: Instagram

Instagram is set to supercharge its advertising business. After introducing new ad formats and better targeting capabilities earlier this month, RBC Capital analyst Mark Mahaney believes Instagram could generate more than $2 billion in ad revenue next year. Comparatively, analysts currently expect Twitter (TWTR) to produce $3.3 billion in revenue next year.

Sure, those numbers seem far apart, but there are many reasons to believe Instagram will be able to rapidly ramp up its advertising business and quickly overtake Twitter's share of digital ad spend. Whether that's next year or in the next three years, Instagram is about to prove that it's worth much more than the $1 billion Facebook (META 0.24%) paid for it.

Attracting brand advertising with a larger user base
Last December, Instagram announced that it had surpassed 300 million monthly active users. The platform is growing rapidly, and after adding 100 million new users in less than nine months last year, it will likely surpass 400 million in the very near future.

Comparatively, growth has been slow at Twitter. The company just surpassed 300 million users last quarter. It took the company more than two years to go from 200 million to 300 million, significantly longer than Instagram or Facebook -- which did it in less than six months back in 2009.

Instagram's continued growth is a significant threat to Twitter's ability to attract brand advertising. Brand advertising still makes up the majority of Twitter's ad revenue, but there are some indications that average ad spend among brand advertisers is declining, as they spread out their purchases among several platforms with large audiences.

Integration with Facebook's ad purchasing platform
Later this year, Instagram will integrate its ad inventory with Facebook's ad-buying interface. As a result, Facebook's 2 million advertisers will soon have the ability to easily buy ads on Instagram. It's also developing an API to allow businesses to customize or automate the ad buying process for Instagram.

Twitter announced a partnership with Google's DoubleClick Bid Manager when it released its first quarter earnings results. The partnership will -- similarly to Instagram's deal with Facebook -- put Twitter ads in front of a whole slew of Google advertisers.

However, Twitter's ad units aren't closely related to the rest of DoubleClick's ad inventory. Twitter's ad units are unique to Twitter in that they're simply tweets. As a result, most businesses interested in advertising on Twitter are likely already on the platform, and any businesses buying ads through DoubleClick are likely providing low quality ads.

Comparatively, Instagram's ad units can be quite similar to ads on Facebook, which mostly consist of an eye-catching picture or video and some call to action. The overlap between Facebook and Instagram users will enable easy retargeting efforts as well, which leads me to my final point.

Instagram will benefit from superior targeting
The percentage of Instagram users in the United States that don't use Facebook has fallen to just 3%, according to ComScore. As a result, Instagram is able to tap Facebook's currently superior targeting capabilities for its advertisements. Theoretically, that will lead to higher conversions and therefore higher average ad prices than Twitter.

Ultimately, Instagram benefits from the nature of its social network providing an interest graph -- where users follow their passions -- as opposed to the social graph -- where users follow their friends -- of Facebook. Additionally, the tight integration with Facebook will allow Instagram to better filter out which connections on its platform are simply friends and which are interests.

Twitter, meanwhile, has suffered from poor targeting despite owning an interest graph like Instagram. Last quarter, the company blamed its underperformance on direct response advertisements. Those ads rely heavily on targeting to produce conversions, and unless Twitter improves its ability to produce results for advertisers, it's bound to see lower than expected ad revenue for the foreseeable future.

Instagram's value
Mahaney's estimate of $2 billion in 2016 Instagram revenue may actually be conservative. In 2010, when Facebook had roughly 500 million users, it generated about $2 billion in revenue. The reasons I've outlined above indicate that Instagram ought to be able to monetize its users even better than Facebook did with a similar audience.

With a larger and faster-growing user base and the strong potential to produce more ad revenue than Twitter within a couple of years, Instagram ought to be worth more than Twitter at this point. Twitter currently trades with a market cap between $23 billion and $24 billion -- about 10% of Facebook's market cap.

If Mahaney's estimate of $2 billion in ad revenue for Instagram next year is correct, that's about 9% of the average analyst estimate for Facebook's total 2016 revenue. However, it's very likely that Instagram will eventually account for much more than 9% of Facebook's revenue, which means that its value should be significantly higher than 9% of the company. That would put it well above Twitter's current market value.