Is the Offer from Elon Musk Fair?| Twitter Analysis and Valuation

Twitter's share price from the 1st day of trading (back in November 2013) until today increased by only 8%. The long-term shareholders have every right to be unhappy with the performance as well as the way the company has been managed. This post is my attempt to value the company based on the current management as well as to assess whether Elon Musk's offer of $54.2/share is fair.

As always, the post will start by focusing on the company's fundamentals.

Link to the video for those who prefer to watch:

What is Twitter and how does it make money?

Twitter is a global social media platform that allows users to share content ("Tweets") in the form of text, video, and audio. The company in its annual report is described as "Twitter is what's happening in the world and what people are talking about right now".

Currently, it has two revenue sources:

1. Advertising revenue - accounting for 90% of the revenue ($4.5b in 2021). If this segment is to grow, the equation is relatively simple. The company needs to increase the number of users and/or the average revenue per user.
2. Data licensing and other - accounting for the remaining 10% of the revenue ($0.6b in 2021). This is an attempt to diversify the revenue and allow the use of their data through API.

The advertising revenue - The key segment

It is important to understand both the user base and the revenue per user in order to understand Twitter's main segment.

mDAU stands for monetizable daily active users

For that purpose, we need to divide the users into two categories:

1. The US users - The number has increased from 25m in 2017 to 38m in 2021 (11% annual growth), with the average revenue per user growing from $57 to $75. This growth came only in 2021, the average revenue per user up until 2020 was $56, almost at the same level as 2017.
2. The international users - The number has increased from 115m in 2017 to 217m in 2021 (19% annual growth) and it is clear that the majority of the user growth comes from users outside of the US. However, the average revenue per user has grown from $11 in 2017 to $13 in 2021, which is not that impressive.

The management is targeting 40% user growth in the next 2 years. Taking into account that the majority of these new users will not be from the US, it is quite clear that the revenue growth over the next 2 years compounded cannot get anywhere close to 40% (Although, the most optimistic analysts are projecting revenue growth way above that).

The historical performance

Although the revenue grew from $2.4b in 2017 to $5.1b in 2021 (20% annual growth), the operating margin wasn't stable at all:

in $m

It seems a bit strange that the margin improved and then declined to this level. Well, there are 3 main reasons for that:

1. Sales and marketing expense growth - To some extent, this can be justified as the user base did grow. Although, over time, this will decrease as % of revenue
2. R&D expenditure growth - This is difficult to justify at the moment. The company spent almost $4b in R&D in the last 5 years ($1.2b being only in 2021 - 25% of the revenue).
3. Litigation settlement (only in 2021) - $766m for misleading investors over the company's growth prospects.

The R&D and Twitter Blue

If a company spends close to $1b/year on R&D, expectations are set high, and Twitter, so far, has disappointed. They introduced Twitter Blue recently, another attempt to diversify the revenue streams and their first-ever customer subscription offering, costing around $3-4/month (depending on the region) and is currently available only in the US, Canada, Australia & New Zealand.

However, the question is, is this a subscription that will attract the average user of Twitter? Here are the main points of this offering:

1. It offers ad-free articles from certain publishers (but isn't ads-free)
2. It doesn't have a free trial.
3. It doesn't offer priority for customer support.
4. It offers to ability to undo tweets.
5. It offers bookmark folders.
6. It offers various themes and custom app icons.
7. it offers reader mode.

The answer to whether this is worth it is, of course, subjective. My personal opinion is that all of these features should be available to every single Twitter user. I don't think there's anything premium related to that and definitely doesn't justify the R&D expenditure. Yes, of course, part of the R&D goes to the further development/enhancement of their algorithms, and part of the increase is due to the general salary wages of the engineers. However, I would've expected more new products/solutions.

The financial position

The company has a healthy balance sheet with cash and short-term investments ($6.4b) exceeding their debt and leases ($5.5b). The property, plant, and equipment have been growing over time to accommodate the user growth.

The key assumptions about the future

Revenue - There's a large gap between the expectations from the analysts about the future revenue. The management is expecting a 40% growth in the number of users in the next 2 years and the analysts forecast revenue growth between 33% and 56% over the same period of time. My assumptions are a bit closer to the more pessimistic forecasts. I'm forecasting 18% growth in 2022, followed by 15% growth up until 2026, and then the growth to decline to the risk-free rate. By year 10, the company's revenue would've grown to $15.1b.

Of course, the company has the potential to grow much faster and develop new products. But they had the potential every single year and they didn't deliver on it.

Operating margin - There's no doubt that both the Sales & Marketing and the R&D expenditure will decrease over time as a % of revenue. My forecast for the operating margin is 20% and it will take Twitter 8 years to get there.

Discount rate - 7.05% (Based on WACC)

The outcome

After adjusting for cash, debt, and equity options:

What if my assumptions are significantly wrong?

Let's take a look at how the valuation of the company (per share) changes based on different assumptions related to the revenue 10 years from now and the operating margin:

In order for Twitter to grow to $30.5b in revenue, it has to grow 20% every year in the next 10 years. Is it possible? Of course. Do I trust that the current management can deliver? Absolutely not. On top of that, to get to a value of $50/share, they need to expand the operating margin to 24%.

Based on this analysis, it seems that Elon Musk is offering a significant premium over the intrinsic value of the company with the current management.