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1 Factor That Could Expand Profit Margin at Twitter

By Adam Levy - Feb 18, 2016 at 10:45AM

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Self-serve ads could be the key to making Twitter profitable.

The number of businesses advertising on Twitter (NYSE: TWTR) nearly doubled in 2015. Last quarter, 130,000 advertisers bought ads on the social network, up 90% year over year, according to CFO Anthony Noto. A big reason for that growth was the expansion of its self-serve platform from about 20 countries to over 200 countries in September.

As Twitter's self-serve advertising business continues to expand, Twitter could see margin expansion. Self-serve ads don't require the same overhead as direct sales to brand advertisers. In fact, the marginal cost of gaining a new self-serve advertiser is almost nothing. Without user growth, Twitter may have trouble attracting additional ad dollars from big brand advertisers, but its self-serve ads are still growing strong.

Getting to the bottom line
Twitter's operating margin improved substantially last quarter. Operating loss fell to just 9% of revenue from 20% last year. Still, Twitter is struggling to turn a profit with just a small number of self-serve advertisers. Facebook (META -0.76%) boasts 2.5 million advertisers -- most of which are small and medium-sized businesses -- on its platform. Last quarter, its operating margin climbed to 44%.

Growing its number of self-serve advertisers is the key to Twitter becoming profitable. "The self-serve business has much higher margins. We love the margins of that business," said Noto on the company's fourth-quarter earnings call.

As the number of advertisers on Twitter grows, Twitter can also increase its ad load. Ad load increased sequentially and year-over-year last quarter, which Noto attributes to the higher demand. Moreover, he still sees room to expand ad load. As such, self-serve could drive revenue growth going forward along with margin expansion.

Another benefit to margins from self-serve advertising is that more varied businesses will allow Twitter to show more targeted ads. One reason Facebook targeting is so good is because it has 2.5 million different businesses to show its users. With more options, it's easier to get a better match. Twitter's user data is arguably just as good as Facebook's, if not better, since users follow their interests, not their friends. With more advertisers, Twitter could see an increase in ad engagements due to better targeting, thus increasing margins further.

Growing competition makes revenue growth tough
The majority of Twitter's ad revenue still comes from direct sales to big brands. But with its lack of user growth, Twitter faces a tough challenge in attracting a larger share of those brand advertisers' budgets. Competing platforms like Instagram and Snapchat are still rapidly growing their audiences and they skew toward the younger demographics that brand advertisers prize.

On Twitter's fourth-quarter earnings call, COO Adam Bain noted, "We're covering many of those [branded] advertisers now, and have been for a while. Since it's our most mature business, the growth in revenue is going to come primarily in growing budgets themselves." He believes the addition of video advertisements will help drive more advertisers to Twitter's platform from traiditonal sources like television. Facebook is also heavily investing in ad products to attract brands used to television advertising to its platforms.

There is a secular trend toward social and mobile advertising, according to research from Magna Global. Social advertising grew 44% last year, while digital advertising as a whole grew just 17%.

Twitter is certainly in the right market to capitalize on the trend, but its lack of user growth is holding it back. That much is evident from the company's first quarter outlook. It expects to bring in between $595 million and $610 million in revenue. That came in well below analysts estimates and represents just 38% revenue growth at its midpoint. While that revenue may be higher margin, it's still lagging the growth of competitors like Facebook.

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