After digesting Twitter's (NYSE: TWTR) impressive second-quarter results, investors may have a sense of deja vu.
Just a year earlier, Facebook (Nasdaq: FB) was staring down a wall of cynicism -- and delivered scorching results. Shares delivered huge upside on that second-quarter report a year ago, and went on to deliver even more impressive gains over the following year.
Facebook's problem back then was quite simple: It had a huge user base but wasn't making much money off of those users. That's no longer the case.
Those same concerns dogged Twitter, though as I noted last month, the drivers were in place to enable Twitter to deliver much stronger quarterly revenues than analysts had been anticipating. Frankly, Twitter only needed decent upside to see its shares move out of the doghouse.
As I wrote in June: "Analysts expect Twitter's second-quarter sales to rise more than 10% sequentially, which would be good enough to change the tone of conversation around this broken stock. A 'glass half full' perspective (instead of 'half empty') could push this stock right back to $40."[More from StreetAuthority.com: 5 Small-Cap Stocks On The Brink Of Being Great Bargains]
As it turns out, Twitter did a whole lot better than that. Twitter's second-quarter sales surged 25% sequentially (to $312 million, above the $283 million consensus), and shares rallied roughly 25% to around $48.
When you consider that Facebook went on to double, even after delivering its solid second-quarter report a year ago, it's fair to wonder: Is Twitter also headed a lot higher?
The short answer: higher, but not a lot higher.
First, let's discuss the negatives. While Twitter posted a 24% year-over-year gain in users, a fair bit of that growth was due to the World Cup. As a result, growth in the user base is likely to be less impressive in the current quarter. Also, even as Twitter delivered solid earnings before interest, taxes, depreciation and amortization (EBITDA) in the second quarter ($54 million, compared with the consensus forecast of $30 million), management concedes that internal spending will be so strong in the current quarter that EBITDA is likely to shrink sequentially.
One of the key investor concerns has always revolved around long-term profitability of this business model, and those concerns haven't gone away. Estimates of what kind of EBITDA Twitter can generate by 2016 are all over the map: Deutsche Bank pegs that figure at $541 million, Pacific Crest Securities pegs the figure at $900 million while Merrill Lynch anticipates $1 billion.[More from StreetAuthority.com: After Twitter's 20% Jump, Is More Upside Ahead? ]
But the company is now worth nearly $35 billion, and to justify that valuation, investors must be confident that EBITDA in 2017 and 2018 will be far higher.
Yet the positives in place for Twitter are quite impressive. They include:
• Roughly $5 in revenue per monthly average user (MAU), which is up sharply from prior quarters (but lags Facebook's $10 per MAU metric). Twitter is in the midst of delivering more ads per page, so that metric is likely to climb higher in coming quarters. "The 'MAU-Monkey' appears to be off Twitter's back," note analysts at Deutsche Bank, who just raised their price target from $52 to $60.
• Twitter is also aggressively pursuing other ad formats (as I noted in my second-quarter preview in June), "and we think these formats have the opportunity to maintain 100%+ revenue growth for several quarters," note analysts at Merrill Lynch, who just raised their target price from $40 to $60.[More from StreetAuthority.com: 5 Surprising Facts About This Bull Market]
• Even after adjusting for the strong second quarter, analysts may still be under-estimating Twitter's financial momentum: "Full-year revenue and EBITDA guidance, which looks easily beatable, was raised and is above consensus," note analysts at Topeka Capital Markets, who boosted their price target from $60 to $62. If analysts only boosted forecasts up to the level of management guidance, then these analysts are suggesting that a few more "beat-and-raise" quarters are in store for Twitter.
Though shares appear poised to keep rallying in coming weeks and months, investors shouldn't anticipate the same surge as Facebook delivered over the 12 months following its terrific second quarter. That's because Twitter is already pricey. Take BMO Capital's $48 target price as an example. That target reflects a 16 times multiple on 2016 revenues, "which compares with FB at 12.4x and LinkedIn (Nasdaq: LNKD) at 7.4x," according to BMO. As Twitter rises higher, that valuation gap will become even further stretched.
Risks to Consider: Twitter's shares surged so much this week simply because most analysts and investors were caught off guard. That element of surprise is now gone for future quarters, unless Twitter delivers third- and fourth-quarter results that are also far above the consensus. The current share price already reflects some upside relative to the newly revised sales and EBITDA forecasts, and any lack of upside would penalize this stock. To be sure, I thought that Facebook had lost the element of surprise after its great quarter a year ago, but shares have continued to power ever higher.
Action to Take --> Facebook and Twitter have delivered a clear lesson to investors: A young, newly public company is often hard-pressed to live up to the hype, and within a few quarters, can deliver tepid results and fall out of favor. But such stocks are worth renewed investigation at that point, as they may just be taking a little time to let their business model gel. That's an important lesson to heed right now as so many companies have gone public in recent quarters. Some of them will stumble in the early going, as Facebook and Twitter did, which often provides a nice second chance to buy appealing business models.
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