Twitter: Should You Buy It?

Some stocks just never allow you to gain an edge through fundamental research -- even by the most rigorous analytical minds.

These stocks become so popular that they become disconnected from any sort of fundamental valuation, and you can simply hold your nose and buy along with the crowd. Or you can be gutsy and look to sell shares short.

Score one for the fundamental analysts. Heading into quarterly results, Twitter (NYSE: TWTR) was a major focus for short sellers, as I noted three weeks ago. The short interest has risen further since that article was published, to 32.7 million shares by mid-January.

And these short sellers may be tempted to lock in gains after shares plunged more than 20% this week. But they shouldn't close out those short positions just yet -- Twitter has an additional 20% to 25% downside from here.

Twitter faces two challenges: It needs to sharply boost its audience, and it needs to figure out how to make much more money off of that audience. These are concerns I spelled out late last month on our sister site ProfitableTrading.com. Among the reasons why this stock may be headed to just $40 (or lower):

• Twitter has not been a popular choice among key potential advertisers, according to a survey conducted by Cowen Co.

• Twitter's ability to sharply boost revenue per user is still unproven.

• Twitter's price-to-sales and price-to-earnings ratios remain in nosebleed territory (even after this week's sell-off).

A closer look at just-released fourth-quarter results paints a picture of more troubles ahead.

At first blush, Twitter delivered a solid quarter. Sales rose 116% from a year ago, to $242 million. And the number of active users grew 30% from a year ago, to 241 million users. Trouble is, that represents just 4% sequential growth, which means that this company's rapid expansion phase may already be cooling off.

At first blush, Twitter delivered a solid quarter. But there are signs that the company's rapid expansion phase may already be cooling off.

Twitter's cost structure is also a key concern. Expenses grew from $117 million in the fourth quarter of 2012 to $747 million in the fourth quarter of 2013. While the 2015 consensus forecast for earnings per share (EPS) had been anticipating a profit of $0.15, look for analysts to revise the numbers down to flat or negative territory.

Solely on a price-to-sales-basis, this stock also remains in the stratosphere. Management expects sales of about $1.2 billion this year, up from $665 million in 2013. Yet the company is still valued at $28.4 billion, equating to a 2014 price-to-sales ratio of 24.

What about 2015 and 2016? Analysts are now targeting around $1.9 billion in revenue next year and $2.9 billion in 2016. And they think Twitter will earn $0.40 a share by 2016. That means TWTR is trading at 10 times 2016 projected sales and 130 times projected 2015 earnings.

In recent months, these valuations haven't mattered as much. But the fact that Twitter's user base has begun to grow at a much slower pace means these metrics will now hold a lot more weight. The only way to keep investors from focusing too closely on valuations is to deliver an acceleration in the growth of the user base (and user engagement and monetization).

UBS' Eric Sheridan, who rates shares as "underperform" with a $42 price target, explains the challenge: "Management must identify core uses around which to focus the product for Twitter to break into the mainstream." Sheridan adds an ominous note: He sees shares falling to just $21 if Twitter ends up delivering 2014 and 2015 sales that are below estimates.

Youssef Squali, who covers social media stocks for Cantor Fitzgerald, sets up an interesting analogy: "Twitter has all of a sudden become a 'show-me' story in the same way that Facebook (Nasdaq: FB) was challenged to prove its mobile credentials over a year ago."

Facebook met that challenge well, and it remains to be seen if Twitter's management team can also find ways to rapidly expand (and profit from) its user base. As profits are likely to be elusive in the near term, Squalli applies a discounted cash flow approach and figures shares are worth $45.

Analysts at Merrill Lynch see shares falling to just $36. That target price equates to 55 times 2015 EBITDA (earnings before interest, taxes, depreciation and amortization) on an enterprise value basis. Merrill's analysts have even looked out to 2028, at which time they think the company will have 800 million active users and generate $21 in revenue per user (up from $3 per user today). And still, that leads them to a $36 price target.

Risks to Consider: As an upside risk, Twitter is likely to radically tweak many of its approaches to address the concerns that analysts have raised. Facebook showed an ability to respond to such concerns, and if you see Twitter announcing plans to develop services and strategies that deliver better user base growth and monetization, then you can grow more comfortable owning this richly valued stock.

Action to Take -- If you were tempted to step in after shares have pulled back, here's another reason not to do so: Recall that Twitter came public with a very small float, which has created scarcity value for its shares. Well, insiders will be free to sell 9.9 million locked-up shares this month and another 465 million shares in May. That could create significant pressure on the stock as the supply/demand imbalance for shares reverses.

Clearly, Twitter is experiencing growing pains, but the fact that user base growth slowed sharply--on a sequential basis--should be grounds enough to steer clear of this high-flier.

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