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By Jason Stipp and Rick Summer, CFA, CPA | 11-01-2013 01:00 PM

Bear, Base, and Bull Case for Twitter

Morningstar analyst Rick Summer estimates a floor on the shares at $15, upside potential of $50, and a current scenario-weighted fair value of $26.

Jason Stipp: I'm Jason Stipp for Morningstar. Investors are abuzz about the Twitter IPO. But behind the hype of a big company going public, what do the fundamentals say?

Rick Summer, who will be covering Twitter for Morningstar, is here to offer his insights.

Thanks for joining me, Rick.

Rick Summer: Sure thing.

Stipp: You've had a chance to look at some of Twitter's financials, released … ahead of the IPO. What are their plans for monetizing their user base? Can you give us a little bit of color around how they will actually be making money?

Summer: Today, about 90% of revenues come from advertising, so it's very traditional. We look at companies like Facebook, like Google, traditional advertising. That's the tradition in one sense of the word.

I think in the other sense of the word, we've actually seen the type of advertising they have put forth. Five years ago, Twitter was around, but not making money, not really generating a lot of revenue. They have created three different advertising products that they put in front of users today: Promoted Trends, Promoted Tweets, and Promoted Accounts, and each of those have different pricing dynamics.

Most of their revenue comes from Promoted Tweets, so users can pay to actually promote an individual tweet into your tweet stream. It's just a way of paying for placement, and that has … generated significant revenue for them.

It's important to think about what's next. They will clearly have new advertising products. We need to remember, through the lens of Facebook, Facebook has been very successful in launching new advertising products, such as Mobile Application Installs or Mobile Newsfeed. We would expect someone that has a captive audience, and knows something about the audience, to continue to be able to innovate and offer new ad products.

Stipp: Would you say that they are just scratching the surface of what their revenue potential could be, given that we could see innovation in the kinds of ads that they are able to serve?

Summer: Absolutely. And I think this is a bit of an industry thesis as well. We have the same sort of modeling with Facebook, [with respect to] thinking about their ability to grow the advertising revenue per user.

It takes a lot of different forms. You could be pushing content out to other websites and embedding advertising there. New advertising formats, like video advertising. So it's not all just about more advertising. It should be more consumption, and … new ad products come along with that.

Stipp: And of course, the other piece of having more advertising is having more users or more eyeballs, pageviews, or uniques. How is the growth of Twitter's user base looking?

Summer: We're seeing growth slow, and it's slowing across most major social networks at the same time. And I think the question is, is this slowdown permanent, or is this something that they really recover from? They are still really growing at very healthy rates, but slowdowns are always concerning.

You are asking the right question, which is, the most important aspect of Twitter is how big is this network going to be? The way that we've constructed our evaluation, we believe in our base case that they can actually grow to about 1 billion users over 10 years. So, roughly about half the size of what we believe Facebook will be at that time period.

The biggest challenge is, right now, it's arguably early adopters--people that understand the platform. [Twitter] users … are pretty avid. About half the users are going there on a daily basis. But the biggest challenge you always hear is, it's very complicated, I don't understand it, I don't know how to do digest that content. [Twitter] has to be able to get over that hurdle--we think that they will--but they have to be able to get over that hurdle to continue this stratospheric growth.

Stipp: If we do see revenue growth from more users in different types of ads, what about profitability? Are they profitable now? And if not, when do you think they will be profitable?

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