After six straight quarters of double-digit revenue growth, Twitter (NYSE:TWTR) grew its top line just 9% in the third quarter. Management blamed unexpected seasonality in July and August, as well as data collection bugs in its software that negatively impacted its Mobile Application Promotion (MAP) ads.
Twitter is working to remediate the problems with its data collection, which affected both targeting and measurement. Still, management's outlook for the quarter suggests revenue growth of less than 7% at the midpoint.
Twitter may continue to struggle to grow revenue next year as well. Citigroup analyst Hao Yan reduced his price target on the stock this week citing concerns over revenue growth tied to the MAP challenges. The problem isn't so easily remedied and it could impact growth until it laps the data collection and sharing problem in the third quarter next year.
The company could have a long-term challenge as well, after underinvesting in research and development (R&D) by chasing profitability. It got there by mercilessly slashing expenses. Evercore ISI analyst Kevin Rippey says Twitter has built up a significant "tech debt" compared to competing social media companies like Snap (NYSE:SNAP) or Facebook (NASDAQ:FB).
Why the MAP problem isn't going away
It's important to understand what caused Twitter's problems in the third quarter. Long story short: Twitter was collecting and sharing unique user data it wasn't supposed to.
The company asked users to opt into sharing data to improve ad targeting, but even when a user refused, it was still collecting data. Those data include things like device operating system and other device settings. Separately, Twitter would be able to see if a user installed an application after seeing an ad for it. Both have the most impact on its MAP ads.
When the company discovered it was collecting and using data it shouldn't, it promptly fixed the issue. But that means Twitter no longer has the ability to target ads for iOS-specific apps to iOS users that don't opt into sharing data, for example.
Meanwhile, Twitter isn't able to share feedback from those users about whether or not they installed the app that was promoted. That makes MAP ads look less effective than they actually are because marketers see fewer installs per ad impression or click.
Twitter will be able to use some substitutions for the data it was using previously, but it won't be able to fully replace the targeting and measurement capabilities. That means greater uncertainty for advertisers, which will negatively impact how much they're willing to spend on advertisements. That problem will persist, and Twitter won't return to a stable comparable quarter until Q4 of next year.
A long period of underinvestment
2018 was a great year for Twitter's bottom line. Operating margin expanded from 2% in 2017 to 15% last year. That margin expansion came on the back of 25% revenue growth.
But that margin expansion may be the result of underinvesting in R&D in 2017 and 2018, as Kevin Rippey points out. Twitter invested $542 million in R&D in 2017 and that increased only slightly to $554 million last year. Both years are a substantial decline from the $713 million it invested in 2016.
R&D expense totaled $484 million through the first nine months of 2019, up 17% from the same period last year. Still, Twitter is investing less than Snap in R&D, and Snap generates less than half the revenue of Twitter.
On a percentage basis, Twitter is investing about the same amount of revenue in R&D as Facebook, but Facebook's revenue is about 20 times Twitter's. Importantly, Facebook is increasing its R&D spend at a faster rate than Twitter, up an impressive 41% in the first nine months of 2019.
It's going to be hard for Twitter to grow revenue when the competition is producing more innovative and lucrative ad products for marketers and new consumer products to keep their audiences engaged.
To that end, CFO Ned Segal said he expects R&D as a percentage of revenue won't look very different from its competitors over the long run. Hopefully for investors he means Snap and not Facebook. He said the 20% increase in head count this year is disproportionately weighted toward engineering, but that may not be fully reflected on the company's income statement.
Still, Twitter has a lot of catching up to do in that department in order to start producing more sustainable revenue growth.