A Tale of Two Earnings: Twitter, Inc. and Amazon.com

Last week, Amazon (AMZN -1.64%) and Twitter (TWTR) both reported earnings. Amazon's stock fell on the news, and Twitter's has seen a nice pop, but these market reactions don't align with the companies' long-term growth plans.

On this episode of Industry Focus: Tech, Dylan Lewis and Daniel Sparks go over the biggest numbers from both companies, why the market reacted how it did to the reports, and the polarizing differences between Twitter and Amazon's long-term plans. Listen in to find out what it likely means that Twitter hasn't been acquired, despite advertising its M&A interest a few months ago; how Amazon is working on beefing up their Prime offerings; and more.

A full transcript follows the video.

This podcast was recorded on Nov. 1, 2016.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, November 4th, and we're catching up on tech earnings from last week. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Daniel Sparks. Daniel, how's it going?

Daniel Sparks: Good, thanks for having me on the call!

Lewis: Always a pleasure. Pretty busy week last week in tech, so much so that we didn't get to hit everything we wanted to. We just focused on Apple's earnings last week, so we thought maybe it made sense to bring it back around, see what was going on with Twitter and Amazon, a lot of news coming out after they reported numbers.

Sparks: Yeah, Twitter and Amazon particularly interesting. Twitter stock went up a little bit, Amazon went down. But as we're going to talk about, we're not sure exactly if those moves make sense, but we'll check it out.

Lewis: Yeah, those reactions might be short-term blips, and not really indicative of a long-term trajectory of either of those businesses. Twitter, the big numbers: revenue came in at $616 million, which was ahead of estimates of $605 million. EPS (earnings per share) came in at $0.13 ahead of expectations of $0.09. I think those are the numbers that generally lead you to have a little pop after you report earnings, some good-looking numbers there. But, let's look back at what the company is trying to set out to do, and some of the commentary we got from them, how those align.

A little while back, they said they're looking to do three things: increase discipline, simplify the service, explain what Twitter is and why people should use it. And I think we saw a couple different moves that kind of got at that. One of them, not really touched upon in the conference call -- the decision of the company to move away from Vine and discontinued that app, which is something that had a lot of people scratching their heads.

Sparks: Yeah, the Vine move was interesting. It just really shows that getting rid of some of their stock-based compensation, which has really become bloated lately, is a huge emphasis as they strive toward GAAP profitability. Obviously, one way to do that is to take a segment of the company that's bleeding cash from paying employees and not making enough money, and just cut it all together. But there was a day when Vine was a big deal, with a lot of Vine stars. And a lot of the stars that are on the platform are still famous today, they've moved on to YouTube and Instagram. So it highlights some of Twitter's missteps since Vine came on board, and an overall product execution problem they have had across the board.

Lewis: Yeah, and I think that gets at the idea of simplifying the service a little bit, and narrowing focus, getting more at the core product and what people are engaging with all the time, and focusing a little bit more on some of the performing assets that Twitter has. Looking at increased discipline, some of the things that got it that, at least one thing that caught my eye, was the company talking about driving toward GAAP profitability in 2017. How exactly are they going to get there? It seems like it's going to be pretty much are primarily cost savings, huh?

Sparks: Yeah. Like we were talking about before, you see the stock move up when things like this happen. They beat earnings estimates. But you look at why, and even this quarter, it did, as they scaled back some stock-based compensation, reduced some R&D costs, a lot of it has to do with cost-cutting. And of course, revenue came in higher, too. Outsized revenue growth probably helped. But as we look forward and see their plans to drive toward GAAP profitability, it looks mostly focused on cost-cutting. They do emphasize that they want to grow their core platform. But these things aren't certain. The only certain path they have right now is cost-cutting. For any long-term shareholders, you might look at something like that, and it's sweet and sour. It's nice that they are moving toward GAAP profitability, but to see that that's the way it's achieved, it's hard to say that's a great thing, and that it's something that investors should be excited about.

Lewis: Yeah, it seems like the company has decided to take a new focus on the cost structure of the business. They point specifically to sales and marketing, which used to be about 31% of revenue, and they are aiming for that to be somewhere between 22-26% in 2017. That is obviously going to be helped as Twitter reduces headcount by about 9%, as most of the jobs were in sales partnerships and marketing there. So, that's an easy way for them to scale back costs in that segment. They also pointed to cost of revenue, which was about 30% of revenue ex-tax. They're aiming for about 19-23% for 2017. They talked about exploring some different options with the owned and operated data centers they're using, and some of the infrastructure there, exploring some partnerships to help them bring down costs. Those are two major segments that they are looking at to help them get toward GAAP profitability consistently in 2017. But, again, what you're not seeing is them saying, "Outsized revenue growth, or boosting margins, or anything like that is what's going to get us there." So it's nice, they're cleaning up shop, they're trimming some of the fat. But it's not really the way that, as an investor, I would like to see them getting there.

Sparks: Yeah. Like I said, it's sweet and sour because, at the same time, they do need to cut some cost. When you actually look at the breakdown of their spending, you'll see that the sales and marketing, which, at the end of the day, ends up being, most of that sales and marketing expenses is employee compensation, stock-based compensation. When you look back to the second quarter of this year, before some of their cost-cutting, which was already under ways starting to take effect, which, some of that happened in the third quarter, ahead of this bigger cost-cutting, you'll see that the stock-based compensation was 28% of the company's second-quarter revenue. For comparison, a company like Facebook, which is known for paying quite a bit in stock-based compensation, is only 12.5% of their revenue. So they definitely were getting a little bloated. So yeah, it's tough to say. Obviously, cost-cutting can be good, but like you said, we're not seeing those positive indicators, expanding margin, outsized revenue, those really being the focus. It's interesting.

Lewis: Yeah. And stock-based compensation for Twitter is something that has long been controversial, and something that a lot of shareholders have been a little bit upset about. We talk about their GAAP profitability and their non-GAAP profitability, that EPS number I talked about before is a non-GAAP number. Under GAAP (generally accepted accounting principles) rules, stock-based compensation is an expense that you have to recognize. So that gets you to that about $100 million net loss on a GAAP basis. You can see them, in their reconciliations -- something that's available on their investor relations website -- going from that net loss number to the adjusted EBITDA number, which is a non-GAAP number, and something they like to point to in a lot of their results, stock-based compensation is a $160 million expense for the most recent quarter, and that's held pretty consistently over the last five quarters. It's been somewhere between $150-170 million. That alone swings you back around to a positive adjusted EBITDA. So, when you look at the GAAP/non-GAAP numbers with Twitter, that's something you have to keep in mind.

Sparks: Definitely.

Lewis: Some other stuff with Twitter, they talked briefly, I wish that we had gotten some more commentary on it, about the M&A stuff. In his introductory remarks, Jack Dorsey said, "Our board is committed to maximizing long-term shareholder value. I don't plan to comment any further on the topic." I know I was hoping for something. If we go back maybe a month, a month and a half, it seemed like they were banking on having a deal set by this conference call. They had kind of drawn a line in the sand of, "By the end of October, we want to come to our investors with something." Obviously, we famously saw Disney, Google, any major tech company, salesforce.com, decide to bow out and say formally they weren't interested. I think some Twitter shareholders are probably pretty happy about that, but it kind of speaks to management not really having full control of what's going on, and maybe not having a great read on the business sometimes.

Sparks: Yeah, I think the lack of commentary, as you said, seemed to confirm their lack of control. It was interesting watching all the offers, supposedly, come in. These were pretty major reports -- New York Times, Wall Street Journal -- so this probably really was happening. But to see Dorsey open up the call and give it such little commentary, just really leaves investors in the dark on whether they're really pressing for sale, and what's going on here. So I think shareholders are probably expecting -- I know I was definitely expecting more on that front.

Lewis: And you look at how that played out, some of the most successful open-and-shut acquisitions that have happened in 2016 have been ones that came out of nowhere, were announced, they went through the standard regulatory rigmarole, but they had their suitor, they had already agreed to terms, and then it was announced. When you see you company saying, "We're exploring this, we're interested in this, and we're kind of open to accepting anything," that's not nearly as firm. They're trying to get the market excited and stir up some more interest, perhaps. So, as you're watching from the sidelines, I think this Twitter example in particular is a great case study on when maybe you should not bank on a deal happening, because shares just flew all over the place on that speculation, and I'm sure some people were buying and selling hoping to get a nice little premium on top of where shares currently were.

Sparks: Oh yeah, for sure. Investors should definitely wait until there's a firm word of something. This was the ultimate scenario where it probably did not work out for investors banking either way, because the stock just moved everywhere.

Lewis: Right. Two other things I wanted to touch on that we got some insight and updates on in their quarterly report. One of them was quarterly advertising revenue by geography. Year-over-year, this metric was up 6%. But you look at the growth there, 21% growth in international, and -2% growth in the U.S. I was kind of surprised to see that. Obviously, you're happy to see that international segment continuing to grow. But, the U.S. is the most valuable advertising market, so seeing a decline there was a little concerning for me.

Sparks: Yeah, the decline in the U.S. is a big deal, it makes you wonder how sustainable Twitter's revenue growth is. That's a tough concern as right now, their overall revenue growth is decelerating pretty significantly. Let's see ... in the second quarter, revenue growth was 20% year-over-year. Then, it comes in at 8% year-over-year in Q3. So we're seeing a significant deceleration. When you look at a core market like the United States, down in this quarter, amid this bigger decline of year-over-year deceleration in total revenue, it is concerning, and it makes investors wonder whether revenue growth can continue from here.

Lewis: On the positive side, data licensing, which is the other main element of their revenue mix, grew 27%. But it is a much smaller part of their overall business. So you're working with a smaller denominator, and you're earlier on in the runway there, so that's not terribly surprising. I think another point of optimism, though, for Twitter shareholders is, it seems like the floor for monthly active users has been found. And it looks like somewhere around Q4 2015. Since then, we've seen nice year-over-year and nice sequential growth on the MAU front. I think the concern here -- and this is something that analysts brought up -- is, you had major events like the Olympics and the presidential election over the last couple months and quarters when we've seen this nice return to growth. Most recently, it was 3% year-over-year for Q3 2016. Is there any possibility that once you lose those huge catalysts, we might return to flat or even declines on a sequential or year-over-year basis? Management seemed to downplay the impact of those types of events. But I think it's something you have to be mindful of. 

Sparks: Yeah, especially given the way Twitter works. It's a news-based platform. That's definitely a question I have, how sustainable this is. I was really disappointed and how much they downplayed it. But we'll see as it goes on.

Lewis: And that isn't necessarily something that's going to prove out in next quarter's numbers. As a looming risk, you have to remember the election and all the post-election coverage will take us well through calendar Q4. So, if you're looking for this risk to materialize at some point, it probably won't happen until Q1 or Q2 of 2017.

Daniel, turning our focus over to Amazon. Numbers, debatably good, debatably bad. The top line was fine, revenue came in at $32.7 billion, which was slightly up on estimates. EPS clocked in at $0.52, well below analysts expectations of $0.82 per share. These results kind of surprised the market, and the stock sold off 3-4%, and it's held there since then. I think that people have gotten used to seeing solid earnings come in for Amazon, and were taken aback because it seemed like they decided to outlay a lot of internal investments this quarter, and that wound up coming down and hurting them on the bottom line.

Sparks: Yeah, is kind of the opposite scenario from Twitter. We see higher costs, but a really long-term focus toward expanding margins, because these are the types of investments that, as they're really investing in the fulfillment centers and the different areas of the business, Amazon very much so has a long-term focus on expanding margins. We've seen that play out in the past. I think, as these costs ramp up a little bit, investors remember the days of the past, when Amazon was never reporting consistent earnings. That could bring up some memories of that. That could be why, some of the bear sentiment toward the stock, after seeing these lower-than-expected earnings.

Lewis: And in fairness, Q3 2015, the company posted $0.17 in GAAP earnings, they posted $0.52 this quarter. That's over 200% growth. This is moving in the right direction. I think there were just some decisions that the company made to invest in itself and build out some of its strengths a little bit more, and that caused things to not look quite as rosy on the bottom line this quarter. 

So, that investment came, it looked like, from about three different parts. We had digital content, and that's the Prime video, and strengthening the ecosystem there, building out their original offerings. Right now, they're in four countries: the U.S., the U.K., Germany and Japan. It seems like they might be entering India with Prime video sometime soon. This strategy there, and I think where you're seeing a lot of the spending, is in content creation. That's in their Amazon Studios segment. The idea there is, they're going to hold the worldwide rights to that content, and be able to freely repurpose it or distribute it in other countries, as opposed to licensing content and being in a third-party relationship and having limited rights. That's a good strategy. It winds up being more expensive to create content yourself, naturally. But having the flexibility to do what you want with it, especially as you're looking to grow your global footprint, is pretty important, I think.

Sparks: Yeah. These investments, you see this in their guidance going into the 4th quarter, they're estimating between $0-1.25 billion in operating income, which is down from $2.2 billion in the same quarter in 2015. Again, it's not just this quarter going into Q4, these investments play out. They're going to cost a lot of money, and I think that's why investors are a little bit concerned, but investors should really keep in mind how Amazon has done historically with these investments. We all know, these fulfillment centers are necessary. Every winter, we hear about these issues with getting shipments to customers, this huge influx of Amazon orders comes in for the holidays.

Lewis: Yeah, the company added 18 fulfillment centers in Q3. Looks like they're going to add five more in October. For 2016, they're planning to add 26. These are the types of things that cost you a decent amount of money up front, but are necessary for strengthening the business and making sure your core competencies and competitive advantages stay that way. Right?

Sparks: Correct.

Lewis: And one of the other areas that we saw some upfront investment going was in Prime benefits. Looking at things like Amazon Fresh, which is their produce in grocery delivery, and Prime Now, some of the same-day delivery service stuff they're looking to roll out. Again, these are things that strengthen their ecosystem, make the Prime membership seem even more valuable, and keep people loyal to the Amazon brand. I'm not too worried about that. Obviously, the numbers were jolting, and I think it might have been better for management to telegraph this a little so it didn't seem quite as lumpy. I think they said the conference call like four times, "Results were very lumpy." I think that's why we saw this market reaction, because a lot of people were a little bit surprised that things weren't smoother.

Sparks: Yeah, definitely. As far as Amazon Web Services, that was another interesting area during the call, of course, it always is. Amazon Web Services, I think investors think of Amazon as this eCommerce company. At the end of the day, a huge chunk of their operating profits comes from Amazon Web Services, even though it's only about 10% of revenue. This was an area that investors should always make sure and turn to, even though they might not have experience with Amazon Web Services. The fact is, Amazon Web Services is a big deal. We can call it AWS for short.

Lewis: Yeah. That is really a cash cow for the business. I love the statistic. The division's $861 million operating profit was more than 3X larger than the North America retailing profits. Which is bananas, and gives you an idea of how crucial it is to the business, despite only being 10% of the top line. Certainly something to be mindful of. That segment in particular had 55% year-over-year sales growth, and 101% higher operating profits. Those are two things that are trending very nicely for them. Anything else on the Amazon side, Daniel?

Sparks: It's worth highlighting that even though they're predicting these higher costs, Amazon is doing great. Their guidance for revenue growth in the fourth quarter was between 17% and 27%, which puts them at a min range that's about in line with their year-over-year growth in the year-ago quarter, the holiday quarter of 22%. Amazon is firing on all cylinders. They're making some big investments here, which at the end of the day, shareholders should be excited about. I think they're going to play out great and expand margins over the long-haul, boost the value propositions for Prime.

Lewis: I think our takeaway here is, both for Twitter and Amazon, the immediate reactions were not necessarily the best long-term reactions, and the directions that we feel like these businesses are going.

Sparks: Yeah, I'd agree.

Lewis: Well, listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say hey, you can shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Daniel Sparks, I'm Dylan Lewis, thanks for listening and Fool on!