3 Reasons Twitter's Stock Rally Could Come to an End

Since the middle of March, Twitter's (TWTR +0.00%) stock has been on quite the run. Shareholders have been waiting for the company to report faster user growth, and it seems they're getting what they've been asking for. However, if we look beyond Twitter's user count, we find problems that don't seem to have easy solutions. The company is growing users, but until it can turn them into profitable relationships, long-term investors should avoid Twitter's shares.

Pandemic-driven growth

The pandemic has unmistakably fueled two activities. First, people are constantly looking for information, which has increased social network user growth. Second, video usage has climbed as everyone looks to fill their time at home. In Twitter's Q2 2020 conference call, CFO Ned Segal said much of the company's user growth was driven by "the events around the world." 

Image source: Getty Images.

Twitter and Snapchat (SNAP +2.52%) have both seen their user growth rates jump recently. Twitter reported that monetizable daily active users increased by nearly 34% year over year, which was the fastest increase of the last several quarters. Snapchat reported an annual increase in daily active users (DAU) of 17%. Some investors may assume all users are looking for the same thing. However, there is a tremendous difference between how Twitter and Snapchat users interact with these services.

Source: Hootsuite. Table by author.

Though Twitter is considered a social media site, based on activity, it's actually more of a news destination. One of the biggest differences between Twitter and other sites is the lack of interaction by Twitter's average user. According to the Pew Research Center, the median user only tweets about twice a month. whereas the top 10% of users tweet more than 130 times per month. This brings us to the first reason Twitter's stock rally could come to an end. Twitter users look for news, view photos, and watch videos, but participation is limited.

Snapchat users seem far more comfortable sharing content. This could be a key difference in the sustainability of user growth at each site in the future. Snapchat is growing users who want to interact, while more Twitter users seem comfortable passively consuming content. Once the pandemic passes, Twitter's users may find their need for distraction and immediate news less pressing. In short, Snapchat seems like it may retain its newfound users, whereas Twitter could become just another news source.

Imitation: flattering, but not always profitable

It's somewhat ironic that Twitter and Snapchat are seeing such usage growth. Snapchat essentially invented the disappearing post, and Twitter is the latest to the party. Snapchat says its default setting is to delete "Snaps" automatically. In addition, posts added to "My Story" disappear 24 hours after they're added.

Facebook (FB +2.33%) began offering Stories in response to this option on Snapchat and Instagram. In late 2019, CFO Dave Wehner said the company's "decline in average price per ad was primarily driven by the ongoing mix shift toward Stories ads, which monetize at lower rates." At the beginning of this year, the CFO again mentioned the average price per ad was down partly because of advertising on Stories.

Twitter wants to introduce its own version of Stories, which it will call Fleets. The concept is being tested internationally, but CEO Jack Dorsey said, "we hope to roll it out as quickly as possible all around the world." Fleets won't be able to receive likes, replies, or retweets, and they will disappear after 24 hours. The theory is that Fleets will address the issue that people don't feel comfortable putting their own posts on the site. However, as we've seen from usage, it may not be that users aren't comfortable -- it's more likely that many of them just don't see Twitter as a place to share their own information.

Fleets are the second reason Twitter's stock rally could come to an end. The company is rolling out a product that monetizes at a lower rate than other advertising. In its most recent quarter, Twitter reported that its operating cash flow declined by almost 41% annually. The addition of Fleets suggests these struggles may only get worse.

Spending more while making less

The third reason Twitter's stock rally could be in trouble: Management doesn't seem to fully understand how bad things are at present. A quick comparison of a few key numbers from Twitter and Snapchat's most recent quarterly earnings shows just how differently these companies are performing year over year. 

Source: Snapchat and Twitter. Table by author. All numbers are annual change.
*Snapchat posted negative operating cash flow for the period in question, but the amount it lost shrank by this percentage.

While revenue and cash flow decline, most companies would cut expenses to preserve cash flow. More users should bring the potential for more revenue for Twitter in the future. Unfortunately, the company suggested that it doesn't currently possess the capabilities to serve its advertising customers as effectively as it would like. While Snapchat is trumpeting success stories where the site drove better sales for its customers, Twitter is still working on improving its offerings.

Management made a few comments on Twitter's most recent conference call that sound particularly worrisome. CEO Dorsey said, of the company's small business capabilities, "Our self-serve channel for small and midsized businesses is relatively small right now."

CFO Segal said that Twitter's direct response advertising doesn't offer the measurements that advertisers expect: "Can we get where we need to be from a measurement perspective? We think we can."

Twitter generated more than 80% of its revenue from advertising in the last quarter. The company has improved its front-end product, and users have flocked to the site for news. But while Twitter may end up working though its advertising challenges, this is a "strike while the iron is hot" moment for the company. Though Twitter has more users, if it can't figure out how to make more money from the situation, the stock's rally could come to an end. Twitter investors who have held on during the stock's rise over the last few months might want to consider taking their profits now.