Twitter Shares Overvalued, Despite Increase in Fair Value

 Twitter's second-quarter results came in above our near-term forecast across three metrics: revenue, users, and revenue per user. The robust user growth numbers coupled with continued strength in advertising revenue have a meaningful impact on our near-term forecast and also provide us with more optimism that Twitter can come closer to approaching a mass-market advertising platform alongside competitors like  Google (GOOG) and  Facebook (FB). As a result, we are increasing our fair value estimate more than 25%; we are also reiterating our narrow moat rating. However, we believe the current stock market euphoria may prove overly optimistic, and the shares are unlikely to earn appropriate returns.

Quarterly revenue grew 124% versus 2013 to $312 million, led by advertising revenue (89% of the total) posting 129% annual growth. Monthly active users also grew a healthy 24%, leading us to increase our expectations for MAUs to approximately 300 million by the end of 2014. Additionally, we have increased our revenue forecast to account for the company's success in rolling out new ad formats, increasing ad revenue per user 84% to $1.02 for the quarter. The disparity between U.S. and non-U.S. markets remains wide (roughly 5 times higher as measured by revenue per timeline view), although management said it expects this gap to converge as smartphone penetration continues to grow outside the more developed markets. We agree with this assertion, and we are becoming more positive (although not certain) that Twitter will become an effective mass-market advertising platform. We are increasing our base-case and bull-case forecasts to reflect this increased likelihood.

Despite our more optimistic view, we believe the shares are overvalued at this these levels. Although we believe the real-time nature of the Twitter experience provides a unique advertising opportunity, it does not approach the effectiveness in reach or customer conversion that companies such as Google and Facebook provide. While we believe Twitter is integral to many advertising budgets, we do not expect the firm to disrupt companies that can provide deeper targeting and broader reach. Ultimately, we believe the growth in ad revenue per user and total revenue opportunity will slow and will be unlikely to reach similar levels to the category leaders in the Internet sector.

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