Twitter's Narrow Economic Moat Looks Promising

Key Takeaways

•  Twitter's narrow economic moat shows promise and may be widening. We have awarded Twitter a narrow moat rating and believe the firm could eventually earn a wide economic moat. While the social network has yet to achieve the reach of Google or Facebook, its network effects and proprietary customer dataset provide formidable competitive advantages.
• Twitter's revenue growth depends on its success in advertising. Twitter has increased its quarterly ad revenue per user to $0.66 in the third quarter from $0.41 in the third quarter of 2012. Still, this metric trails  Facebook (FB) ($1.38 in the second quarter) by a significant amount.
• Growth and improved competitive positioning depend on increased engagement and user growth. User growth will help expand the company's reach and, we believe, provide the critical mass necessary to capture new advertising budgets that depend on reaching a minimum number of users. Furthermore, engaged users will highlight the platform's differentiation, strengthening the network effects and increasing advertising spending.

 

A Future Wide-Moat Firm?
Twitter's narrow economic moat is built on several important characteristics: Network effects, reach, and unique customer data. Twitter and its users benefit from the network effects typical of a broad content distribution platform. The company counts 232 million monthly active users, an impressive number for a media platform that has gained both attention and budgets from advertisers.

During the second quarter of 2013, Twitter also reported more than 150 billion timeline views, growing 69% versus the prior year. Timeline views are Twitter's metric for reporting engagement, a measure of the frequency that users are reading tweets (messages). This level of engagement is likely to be misunderstood, in our view, as competitors are frequently reporting other measures of engagement.

For comparison, we've included comScore data for U.S. desktop and mobile traffic below. Taken at face value, we don't believe Twitter's reach alone today is sufficient to create the massive competitive advantages that would support a wide moat. For example, in the United States, companies such as  Yahoo (narrow moat),  Google (GOOG) (wide moat), and Facebook (wide moat) have much greater reach, both for desktop and mobile users, as shown in Exhibits 1 and 2.

Twitter's interest graph forms a unique and proprietary database of user data, supporting the company's moat. While Facebook claims to own the social graph, Twitter's social network is forming the interest graph of its users. Twitter provides unique connections to celebrities (Katy Perry has more than 44 million followers), politicians (President Obama has more than 38 million followers), brands (comedy website Funny or Die has more than 6 million followers), sports (the NFL has more than 5 million followers), and pundits (venture capitalist Fred Wilson has more than 250,000 followers).

Users can tailor their timeline and create lists based on their interests. Individuals can also interact with tweets, including through replies, retweets, favorites, following, or forwarding onto an individual by email, outside the Twitter ecosystem (see Exhibit 3). Each of these actions represents a different level of engagement, generating additional data for the Twitter customer database. We believe advertisers will be able to successfully target branding and direct response campaigns on Twitter better than most competitive platforms.

The engagement with the Twitter platform is naturally social, reinforcing the desire to share and react to information in real time. The company argues that it is the largest real-time social network in the world; we agree.

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There are many self-selected groups within Twitter, connected by interests. For example, users may follow celebrities (One Direction and LeBron James), work interests (human capital), and local interests (Chicago events or breaking news). Each user's experience is highly personalized, based on how users create and manage their networks, how they interact with the content, and how they post their own content. Because this activity is unique to Twitter, the company is building a highly unique (and proprietary) customer dataset.

Also, because of the social network's real-time reach and unique targeting capabilities, certain advertisers will use Twitter for specific advertising campaigns, typically augmenting other digital campaigns (for example, search engine marketing). This network is extremely difficult to replicate. Furthermore, the real-time nature of the content is also unique.

We are not yet comfortable assigning a wide moat, however. We differentiate a narrow and wide moat rating by our degree of certainty that the company will continue earning excess returns beyond 10 years. With only 232 million users and a general slowdown in growth, we are more comfortable assigning a narrow moat, as our confidence level is tempered by the fact that Twitter is used by less than 5% of the global population. If growth accelerates, we will probably revisit our moat rating.

Twitter's Revenue Growth Depends on Its Success in Advertising: Turning Tweets Into Dollars
Twitter earns revenue from only two sources today: advertising and data licensing. Although both sources have grown rapidly, advertising represented more than 90% of total revenue in the most recent quarter, and we see the most long-term upside from this segment. ZenithOptimedia estimates the global digital advertising market is approximately $100 billion, an indication that Twitter may have just scratched the surface of the addressable market.

Twitter's unique media distribution platform and social network represent a powerful advertising platform, in our view. We believe advertising revenue represents the bulk of the top-line opportunity, which will require growth in the number of Twitter platform users, as well as growth in advertising revenues per user.

Currently, Twitter offers three advertising products: promoted tweets, promoted accounts, and promoted trends. Today, individuals and brands can highlight (and insert) a tweet into their followers' timelines, similar to the Facebook newsfeed ad, which has proved so successful. Advertisers may pay different amounts, depending on how users interact on that tweet, including a reply, retweet, follow, or favorite. In some ways, these actions are analogous to the pay-per-click model that is commonplace on the Web.

When looking at advertising revenue generated on a per-user basis, Twitter has continued to improve its standing and has surpassed  LinkedIn , though it continues to lag Facebook. We believe that Twitter's monetization started at a very low rate because the company has to sell nontraditional ad units, and advertisers found them difficult to price and measure their return on investment. Although this has been a short-term challenge, we believe this uniqueness should help sustain advertising relationships and pricing over the long run, and we would expect ad revenue per user to continue to grow.

Furthermore, as analytics become more robust and the technology improves, we expect advertisers will become more comfortable measuring their social networking ROI. Of course, this opportunity is also a key investment risk for Twitter, particularly if the company's ad platform is actually not very effective, which is yet to be determined.

We also expect new advertising products to find newly effective ways to engage users, similar to our thesis for Facebook. We believe investors should be even more concerned about Twitter's ability to expand its user base, particularly as user growth is slowing. Twitter's sequential growth in MAUs slowed to 6% in the third quarter, compared with 11% growth in 2012 and 19% in 2011. For comparison, other social networks have experienced similar slowdown in MAUs (see Exhibit 6), but we don't think Twitter's growth has stalled. Unless growth reaccelerates, Twitter will not reach 1 billion users for more than six years. We expect the company to invest heavily in simplifying the user experience in an effort to pull more users into the platform. While we project growth to reaccelerate, that ultimate growth rate will be a key input to our valuation of the firm.

Because of its inferior scale compared with Facebook (see Exhibit 8) and Google, we believe Twitter will largely be a complement to the advertising platforms of these wide-moat firms. This view is likely to limit Twitter's market opportunity.

The most important growth levers for Twitter are growth in market share, users, and time spent, in our view (Exhibit 9). Perhaps the most important aspect supporting our positive view on growth is the complementary nature of Twitter to traditional content and media. For example, the company recently agreed to a commercial deal with the National Football League to distribute proprietary content (short replays) to Twitter users. This complementary stance will allow Twitter to more cheaply acquire content that flows through its media platform.

Key Growth Levers

• Growth in market share (high growth). We believe the marketing data that Twitter is gathering through the proprietary interest graph will piggyback on the momentum created by Facebook. As advertisers have continued shifting spending to online media, large tranches have remained offline (particularly in television advertising, as evidenced by Exhibit 10) because of traditional considerations including brand-building objectives and broad reach. We believe Twitter will take market share from companies selling offline advertising as advertisers flock to where the users are. Furthermore, given the complementary stance relative to offline media and content as well as the real-time nature of the social network, we believe there is a high growth opportunity.

• New revenue streams (medium growth). Generally, we expect new ad products to drive the bulk of revenue growth. Although the data licensing segment has generated more than 10% of overall revenue, we expect new advertising products that provide unique formats and user interactions are the most likely to generate new revenue.
• Increase in Twitter users (high growth). Twitter has only 232 million registered users representing approximately 10% of the global population of Internet users. A wild card for Twitter is China. Currently, Twitter is blocked in China, and it's unclear that the company will be able to successfully launch there. If Twitter is successful at reaching similar penetration levels to Facebook, its growth opportunity is tremendous.
• Growth in time spent (high growth). Although the company has reported reasonably high engagement with more than 40% of users accessing Twitter on a daily basis, it is not clear that users are spending a great deal of time on the platform. Sources have reported that users spend as much as 20 times the amount of time on Facebook versus Twitter.
• Increase in ad unit pricing (low/medium growth). Ad pricing has decreased over the course of the past year. Generally, we do not model specific ad unit pricing or expect pricing to improve. We believe advertisers are much more likely to run integrated campaigns, and we expect their spending to increase, even if individual ad unit pricing continues to decline.

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