Twitter Is Finally Accepting What It Is -- and What It Isn't

Twitter (TWTR) is impressing investors today with its prediction that it could post its first profitable quarter ever in Q4. While the company posted record profitability in the third quarter on a non-GAAP basis, Twitter might just be able to squeeze out some black ink on a GAAP basis in the coming quarter.

Outlook for the fourth quarter calls for adjusted EBITDA in the range of $220 million to $240 million. At the high end of that range, Twitter says it "will likely be GAAP profitable." That's despite a top line that's been shrinking all year. A big part of the company's improving financial condition is due to coming to terms with what Twitter is -- and, more importantly -- what it isn't.

Image source: Twitter.

Twitter can survive

Given Twitter's long history of losses, there has been speculation over the years regarding whether or not Twitter can survive as a stand-alone company, which was only stoked by Twitter trying to sell itself last year. I've argued that Twitter can indeed survive, as long as it ramps down growth investments while investors simultaneously lower their own expectations. Twitter has carved out a unique place for itself within social media, and still enjoys solid operating cash flow ($240 million last quarter) with a respectable top line.

The good news for Twitter shareholders is this is precisely what the company is doing. The improvements in non-GAAP profitability are largely thanks to cost discipline. "This profitability reflects our improved prioritization and disciplined execution across all of our strategic priorities," CEO Jack Dorsey said on the earnings call this morning.

Despite the fact that revenue fell 4% to $589.6 million in the third quarter, total costs and expenses fell by 16%. That helped Twitter swing from an operating loss of $78.1 million a year ago to positive operating income of $7.3 million. Twitter's GAAP net loss narrowed from $102.9 million a year ago to $21.1 million. The biggest cost reductions came from R&D and sales and marketing.

Data source: Twitter Q3 shareholder letter. YOY = year over year.

Twitter has been working hard in recent quarters to bring down expenses, but CFO Ned Segal emphasized that Twitter's expenses may still rise going forward as the company continues to invest in specific areas. Future margin expansion will likely come from revenue growth. Segal stated on the call:

We are at the point, though, where after a lot of hard decisions made over the last couple of years, and an expense base that's come down quite a bit, where the expense base will selectively grow as we invest against our priorities. So to the extent you see margin improvement, it's more likely to come from revenue growth than it is from cutting the expense base. As you said, we want to make sure that we're investing appropriately against the opportunities that we see.

The issue is, and has always been, Twitter's ability to monetize strong user engagement. The disconnect between daily active user (DAU) growth and ad revenue growth remains: DAUs jumped 14% in the third quarter while ad revenue fell 8%. Twitter will never be one of the top dogs in online advertising, but that's OK. As long as Twitter accepts that it will always be a relatively smaller player compared to the advertising duopoly of Alphabet subsidiary Google and Facebook -- and sizes its cost structure accordingly -- it can build a sustainable business.