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Twitter: Don't Expect a Dividend From This Growth Stock

Despite being one of the largest social media companies at a $25 billion market cap, Twitter (NYSE:TWTR) has recently underperformed Facebook (FB) as well as the broader S&P 500 Index. That being said, the company has experienced rapid user growth in recent years, which should lead to future profitability gains.

With an easily scalable business model, Twitter's growth could also very likely lead to rapid free cash flow growth, making it a strong candidate to pay out a growing stream of dividends. That being said, we believe that this is not the full story and hold to the view that Twitter will not pay a dividend any time soon. Here's why.

Business overview

Twitter boasts an international network of nearly 320 million users. Additionally, it has become the primary platform for political leaders, celebrities and other public figures to communicate publicly. With its short-form text, image and video content format, Twitter is ideally suited for the soundbites so frequently used by well-known figures.

Since users can access, react to and share a broad collection of real time information about any and all of their interests in a fairly quick and efficient manner, Twitter can gather a tremendous amount of detailed data. It can then turn around and monetize it as advertisers launch targeted ads.

Recent quarterly earnings

Twitter's third quarter missed on both revenue and earnings, and the dismal performance led management to also reduce its fourth quarter guidance. While average monetization DAU increased by 17% year-over-year, mDAU in the U.S. crushed estimates of 26 million with 30 million and international mDAU followed suit with 115 million against consensus estimates of 98 million, revenue product issues and greater than expected advertising platform issues proved to be insurmountable headwinds.

Growth prospects

Twitter's impressive user growth during the third quarter should continue its momentum thanks to the upcoming Summer Olympics and U.S. presidential election. That being said, the company must find more effective and efficient ways to monetize its user network if it is to ever warrant a higher valuation multiple. The good news is that user engagement is also growing, which should make it easier to monetize the network as more data is gathered on individual users.

Management continues to invest heavily in growing user engagement through content improvements. Recent moves include live-streaming more premium content, including Thursday night NFL games during 2016-2017 and PGA Tour tournaments.

A major challenge is the minimal switching costs for users and advertisers as their network is not as broad as Facebook and Instagram and the format is focused on followers, not on the friends or connections that are found on Facebook and LinkedIn.

Why not dividends?

The first important requirement for a company to become a dividend payer is the ability to generate consistent and abundant free cash flows. Twitter checks this block, as it has been free cash flow positive in every quarter over the past three years despite investing heavily in content improvements.

The second major requirement to become a stable dividend stock is to have a strong balance sheet that does not require deleveraging. At first glance, Twitter also checks this block thanks to its strong net cash position, as its business is not capital intensive and the company has over $3 billion more in cash and receivables than total debt. However, upon closer examination, we see that interest coverage is less than two-to-one when measured against operating income in the first three quarters of 2019. As a result, any material decline in earnings or rise in interest rates could put considerable pressure on free cash flows, thereby necessitating their strong cash position.

This leads us to the third requirement for a stable dividend stock: fat and sustainable profit margins. Unfortunately, Twitter fails on this requirement because its operating income is not protected by a switching cost moat and its free cash flows are highly sensitive to interest rates.

With its recent track record of consistent profitability and free cash flow generation and its sizable cash pile, Twitter could certainly begin paying out dividends to investors. However, given the less than safe status of its interest coverage, it would be foolish for management to deplete its cash pile. Therefore, any dividend it would initiate in the near term would be unlikely to survive any interest rate and/or earnings volatility.

Since dividends are typically viewed as a commitment from management to investors as a signal of the company's maturity and stability as a free cash flow generator, this would not be an appropriate step for management to take at this point as it could very likely lead to future shareholder disappointment. As a result, any capital returned to shareholders at this point would probably be better made via share repurchases.

Another reason that management should not initiate a dividend in the near future is because it is still in its growth phase. Twitter lacks a strong moat and continues to trail competitors like Facebook and Instagram on a wide array of metrics. Furthermore, its efforts at generating the content necessary to build a moat and improve engagement to drive increased monetization efficiencies will require considerably more capital investments than already laid out.

For example, the company was recently outbid by Amazon (AMZN) for Thursday Night NFL live streaming. Instead of paying out a potentially unsustainable dividend, Twitter should be pouring every spare dollar into winning content bids and/or creating its own improved content and platform.

While its recent streak of profitability and strong net cash position give hope that someday Twitter might pay a dividend, the underlying fundamentals of the business still leave much to be desired before investors can expect to receive any cash returned to them directly.

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This article first appeared on GuruFocus.