Twitter Hq

Source: Twitter.

A couple of months ago, Twitter (NYSE:TWTR) started offering objective-based ads to all of its advertisers. It had tested the new format -- where advertisers only pay for specific actions from users -- for about a year before opening it up to the general public. During the company's first quarter, it blamed a shortfall in those direct response ads as a reason why the company's revenue fell short of expectations.

Twitter's second-quarter revenue came back above expectations, but average price per ad engagement grew just 6% year over year compared to 30% during the previous quarter. The struggles with direct response ads are fairly evident and stem largely from Twitter's poor targeting abilities.

Those targeting abilities were the subject of a recent survey by Cowen and Company, which found that more than half of Twitter users find ads on Twitter "a poor fit," or not really relevant.

Why am I seeing this?
The survey found that just 3.1% of U.S. Twitter users surveyed found the ads they saw on the social network relevant and insightful. Another 26% described the ads as "OK." But 58.7% said the ads were either not really relevant or a poor fit.

The lack of relevancy is quite astonishing considering that Twitter should theoretically have a strong signal about its users' interests. Users follow other users based on their interests and passions on Twitter, compared to the social graph on Facebook (NASDAQ:FB), where users follow other users based on whom they know.

Still, Facebook doesn't seem to be suffering from an inability to convert advertisements, and it's attracted hundreds of thousands of small businesses to its platform. The sheer size of Facebook's ad pool may be a reason why it's able to target ads better than Twitter. Twitter is just approaching 100,000 advertisers, whereas Facebook has over 2 million.

With most ads missing the mark, it's no surprise that Twitter's results in the first quarter fell short of expectations, or that it's having a hard time increasing average ad prices. Twitter continues to cap ad load -- the percentage of ads relative to non-advertising content -- which currently stands at one-third of its long-term goal of 5%.

The Cowen survey found the average ad load among those surveyed was around 5% already, indicating that Twitter needs to increase ad rates in the U.S. to continue growing in the market. The best way to do that is to increase conversion rates.

So, what's Twitter doing to improve?
Twitter acquired TellApart in May to help improve its targeting capabilities. TellApart specializes in cross-device retargeting for online retail. Retail is by far the most popular ad type on Twitter in the U.S., with 55.5% of respondents seeing retail ads in their timelines. With TellApart's technology, a user who viewed a product on his desktop or tablet could see an ad for it in his timeline in the Twitter smartphone app. That increases the likelihood the ad will convert.

The second most popular ad format is app-install ads (42.1%). Twitter is doing a couple of things to improve the value of those ads. First, it has introduced targeting based on the kind of apps users already have installed on their phones. Twitter started collecting those data last winter, but it finally allowed advertisers to use the data starting in June. Second, it introduced autoplay video ads for app-install ads. Management attributed growth in price per ad engagement to autoplay video ads.

Aside from improvements on its own platform, Twitter also partnered with Google last quarter to open its inventory to the latter's DoubleClick Bid Manager. DoubleClick provides advertisers with the ability to track how well ads on Twitter convert into purchases by attributing them across platforms. So, if a user sees an ad on mobile and makes a purchase on desktop, Twitter will get some credit. That may compel advertisers to spend more on ads if Twitter is actually producing results.

Overall, Twitter's health relies on growing its average price per ad as management expects user growth to remain stagnant in the short term. Improving its ad relevancy is the best way to improve revenue, as Twitter now gets paid only when an ad converts.

Adam Levy has no position in any stocks mentioned. The Motley Fool both recommends and owns shares of Facebook, Google (A and C shares), and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.