Wells Fargo Hits Twitter with the Downgrade Stick

Twitter

Source: http://www.flickr.com/photos/trekkyandy/

Shares of Twitter (NYSE:TWTR) fell as much as 4 percent on Monday afternoon following news that Wells Fargo cut its rating on the stock from Market Perform to Underperform with a price target in a range between $36 and $39. Echoing the concerns of other analysts with a bearish outlook on the stock, analyst Peter Stabler cited high valuation, over-inflated investor expectations, and underlying risks as reasons for the downgrade.

“Though we believe Twitter has emerged as a leading social communication channel, and is likely to continue a rapid release of improved advertising products and measurement capabilities, we believe investors underestimate some challenges facing the company and advertisers seeking to employ the platform,” Stabler wrote in a note seen by Street Insider.

Stabler cites several specific challenges. First, he highlights the issue of engagement, which is pretty much the lifeblood of Twitter’s business. A user is only truly valuable to the platform if that person is engaged. Twitter only really makes money from users who see or click on advertisements, though it does pull in some revenue from data licensing — about 11.2 percent of its total in the nine months ended September 30 — but this share is expected to decrease in the future.

As it stands, Twitter’s engagement, as measured by timeline views, is pretty strong. Timeline views increased about 53 percent on the year to 158.7 billion for the quarter ended September 30, and the company reported a 21 percent increase in the engagement level of its monthly active users for the nine months ended September 30. At the same time, there was a 271 percent increase in ad engagements per timeline view — all told, a good sign for the platform.

But risks abound, and Twitter articulates them in detail in its filings with the Securities and Exchange Commission. Engagement is all important, making any threat to it potentially lethal. “The size of our user base and our users’ level of engagement are critical to our success,” the company reports. “A number of consumer-oriented websites that achieved early popularity have since seen their user bases or levels of engagement decline, in some cases precipitously. There is no guarantee that we will not experience a similar erosion of our user base or engagement levels.”

The second challenge that Stabler cites for Twitter is “discounting of engagement metrics/high costs.” Stabler is getting at the idea that measuring engagement is kind of a dubious process. Timeline views don’t necessarily capture the whole picture, and Twitter could spend too much time focusing on increasing ultimately superficial metrics at the cost of more important things.

Twitter articulates the concern in its own filing, reporting, “We focus on product innovation and user engagement rather than short-term operating results.” This focus sometimes comes at the cost of things investors care about, such as positive earnings. Twitter recorded a net loss of $133.9 million for the nine months ended September 30 and is not expected to turn a profit until 2015.

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