Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Twitter (NYSE:TWTR) stock exploded 15.5% higher after reporting Q3 earnings Thursday, making it the best performer on the S&P 500 (according to The Wall Street Journal). One day later, Twitter stock is climbing again -- up 2% around 10 a.m. EDT -- and part of the reason for that is the new upgrade Twitter just received in response to earnings.
Here's what you need to know.
What Twitter reported
For the fourth time in a row, Twitter reported positive GAAP earnings results. Revenue rose 29% year over year in Q3 -- more than twice the pace of cost growth. Gross margin expanded by 4 full percentage points. Operating profits turned positive, and as a result, Twitter has now reported more than $1 billion in profits over the past 12 months.
And Twitter did all this despite shrinking its number of monthly active users (MAU) by 9 million, a consequence of the company's ongoing mission to purge itself of malicious bots.
Look who's (not) upgrading Twitter now
Twitter's news was met with a round of applause on Wall Street -- but so far, few upgrades. According to a running tally on StreetInsider.com (subscription required), a total of eight separate analysts have raised their price targets on Twitter in response to yesterday's news, with three price target hikes coming yesterday, and five more today. Analysts are singing the company's praises:
- "[S]trong U.S. ad growth overshadows the user decline," is how StreetInsider summarizes Barclays' take.
- "Int'l ad revenue growth remains solid +26% y/y while US ad revenue acceleration to +32% y/y shows a healthier more broad-based momentum into 4Q," says Deutsche Bank.
- "Overall, the results represented another quarter with ongoing progress which was consistent with our longer-term expectations for Twitter as a durable, if niche-y (but highly differentiated), platform for digital advertising," Pivotal Research says.
And yet, with these new price targets ranging from a low of $27 to a high of $35 (less than 10% above Twitter's current share price of $32 and change), most analysts appear to remain skeptical of Twitter's attractiveness as an investment. So far, only one banker has stepped forward to actually upgrade the shares: Oppenheimer.
Finally, a fan
The closest thing to an unabashed fan of Twitter we've seen so far, Oppenheimer is leading the price targeting pack with a prediction that Twitter stock will shoot to $37 within a year. "[Management] has stabilized pricing and expenses, and DAUs can post small gains," argues the analyst. Moreover, now that Twitter has "nicely exceeded expectations" on "3Q revenue and profit," there's "reduced execution risk" that the company will similarly succeed in hitting Q4 revenue guidance that is "in line" with Wall Street's expectations -- and maybe even deliver the improved profit margins that it's promised, and that exceed Wall Street's expectations.
If Twitter succeeds with this, Oppenheimer believes it will set the stage for the company to grow earnings before interest, taxes, depreciation, and amortization (EBITDA) as fast as 28% annually through 2019, versus closer to 18% EBITDA growth at the company's peers. And if that happens, then Oppenheimer argues Twitter stock will deserve a premium multiple relative to peers such as Alphabet, Facebook, and Yelp.
Hence the higher price target, and the upgrade today.
A few words on valuation
Is Oppenheimer right about all this? I have to admit that there appear to be a few too many "ifs" in the analyst's analysis for my taste -- even if Twitter stock does appear more modestly priced after putting four consecutive quarters of GAAP profitability on its books. So how does Twitter's valuation look today?
With $1 billion in trailing profit, and a market capitalization of almost exactly $24 billion, the math on this one isn't frightfully hard: Twitter stock is trading for 24 times earnings, which seems reasonable, if not particularly cheap, in a stock market where the average S&P 500 equity is selling for a bit less than 22 times earnings.
Before rushing out to buy Twitter stock on Oppenheimer's say-so, however, you should know that a review of Twitter's cash flow statement suggests that the quality of Twitter's earnings may be waning: After several quarters of strong free cash flow, Twitter's Q3 results showed a sudden weakening in cash production resulting from higher capital spending at the social media company. In a quarter in which Twitter reported earning a record $789 million in profit, data from S&P Global Market Intelligence show that actual free cash flow at the company was only $323.5 million -- just $0.41 in real cash profits for every $1 in claimed net income.
This gives Twitter a price-to-free-cash-flow ratio of nearly 32, which is quite a bit more expensive than the 24 P/E you get when valuing Twitter on GAAP earnings alone. With most analysts on Wall Street still predicting a long-term growth rate of only 14% for Twitter, there may be a reason that right now, only Oppenheimer is willing to step up and call Twitter a buy.
Simply put: There's more risk here than meets the eye.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Rich Smith owns shares of GOOG. The Motley Fool owns shares of and recommends GOOGL, GOOG, FB, and TWTR. The Motley Fool recommends YELP. The Motley Fool has a disclosure policy.