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Why Is Everyone Ignoring This Problem With Twitter?

By Adam Levy - Updated Oct 31, 2017 at 2:46PM

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The company may be profitable next quarter, but how much can it grow those profits long term?

Twitter (TWTR -1.08%) reported third-quarter earnings results that weren't as bad as analysts expected. Revenue and non-GAAP profits beat the consensus, and monthly active users increased modestly. But what really caused the stock to jump was Twitter providing an outlook for GAAP profitability in the fourth quarter.

To be clear, Twitter has said its goal is to become profitable on a GAAP basis in 2017 since last year. But now it looks like it's actually going to happen -- at least temporarily.

The market sent shares higher following Twitter's earnings, but everyone seems to be ignoring this key caveat to Twitter's soon-to-be profitability. The company got there by cutting costs, and revenue growth will be hard to come by in a world where Facebook and Google dominate digital advertising.

Clockwise from top left: 1. an @ carved in wood 2. a twitter bird made of CA license plates 3. A # carved in wood 4. A twitter bird made of CA license plates

Image source: Twitter, Copyright Troy Holden (@troy) for Twitter, Inc.

There are no more cost cuts left to make

Twitter has done a great job of cutting its R&D and sales & marketing expenses over the last couple years. For the nine months ended September 30, R&D expenses totaled just $408 million. That compares to $597 million two years ago. Likewise, marketing expenses fell to $528 million for the same period, down from $697 million the prior year.

But there may not be any more room to cut costs. "We are at the point, though, where after a lot of hard decisions made over the last couple of years and an expense base has come down quite a bit where the expense base will selectively grow as we invest against our priorities," CFO Ned Segal told analysts on the earnings call.

While Twitter will be careful in how it invests in the future, its path to profitability relied on cost cutting. Going forward, increased profitability will rely on revenue growth. As Segal said, "To the extent you see margin improvement, it's more likely to come from revenue growth than it is from cutting the expense base."

But when will Twitter show significant revenue growth?

Twitter really likes to boast about the growth it's seeing in daily users and ad impressions, but at the same time, the company's ad revenue growth is still declining. Ad revenue declined 8% year over year, and it was down 18% in the United States. Some of that has to do with Twitter ditching some ad products at the beginning of the year to focus on profitability. Still, Twitter is struggling to win over advertisers.

When asked when revenue growth might become more in line with daily user growth, COO Anthony Noto dodged the question. He did let loose a little tidbit that like-for-like ad prices are actually declining on the platform, trying to spin it as a positive (indicating potential for that trend to reverse). That trend is in line with marketer surveys that say a significant portion of advertisers are planning to spend less on Twitter, indicating poor return on investment.

Despite improving DAU and ad impression trends, it's going to be hard to grow revenue if advertisers are disenchanted by Twitter's ad product. Even with rising ad prices on Facebook, advertisers are getting a better return on investment and have been particularly attracted to Instagram. Google's YouTube is still a prime destination for TV ad dollars to flow as video viewing shifts online. Even Snapchat presents a challenge to Twitter as it offers similar use cases, but in a much more fun and engaging format. Not to mention, Snap is spending heavily on sales and marketing to attract advertisers while Twitter slashes its marketing team.

The analysts consensus estimate for Twitter's revenue growth next year is just 5.7% following an estimated 5.2% decline this year. By comparison, Google parent company Alphabet is expected to grow sales nearly 18%. Not to mention, it's already extremely profitable.

Twitter is up over 25% since reporting earnings, and the hype around its potential profitability has taken the stock too far.

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