Twitter IPO Reveals the Company Has a Lot of Work To Do

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Twitter’s IPO filing contains a lot of bad news for people who might be interested in buying the stock when it goes public.

User growth is slowing.

Revenue growth will slow in the future, the company warns.

And employee costs are out of control.

Clearly, the company is going public despite its problems, not because it has overcome them.

Management at Facebook (FB), Twitter’s main competitor, are likely to read this S-1 and breathe a sigh of relief.

I’m not saying the company is screwed, or that the IPO will fail. Twitter has likely learned a lesson from the Facebook IPO, which was priced to high, and saw its stock value halved in the months after the launch.

CEO Dick Costolo has in fact built a robust and growing business. Hats off to him and his team. Twitter is on course for greater than $500 million in revenues this year.

That’s huge. Building a business like that is not easy.

But … the books are kinda ragged-looking and contain a number of ringing alarm bells.

These are the fires that Twitter will have to fix if it wants to mature, the way Facebook did, into a growing company with a rising stock.

Twitter has 218 million active users, and already user growth is slowing. In the last quarter, Twitter added only 1 million monthly active users in the U.S. All its remaining growth was abroad. Among Americans, Twitter looks like it has fully tapped out the market, or close to.

To put that in perspective, Facebook has more than 1 billion users and is still growing. It’s adding way more than 1 million users per quarter in the U.S., too.

So the first takeaway is that Twitter is much smaller than Facebook — not a surprise — but already has a growth problem, which is a surprise.

Twitter is basically a competitor to Instagram in size, not Facebook.

That’s not too worrying, because as Facebook has demonstrated its not user growth that counts its revenue growth — the two are not linked, as investors once feared. Yet Twitter warns its revenue growth may also be limited:

Although our revenue has grown rapidly, increasing from $28.3 million in 2010 to $316.9 million in 2012, we expect that our revenue growth rate will slow in the future as a result of a variety of factors, including the gradual slow down in the growth rate of our user base.

Hmm.

Twitter must make these warnings for legal reasons, as a caution to investors. But still. The optics are bad, as they say.

On top of that, Twitter is not profitable. This chart shows you all you need to know — revenues keep rising, but Twitter’s costs are such that it doesn’t make money. It lost $69 million on $254 million in revenue through the first six months of the year.

Again, that’s not a problem — the losses are proportionately much smaller than the revenue as time goes by, strongly suggesting that Twitter can pull back on its costs anytime it wants and become profitable. Right now, it’s growing its user base and paying for that.

But the largest portion of Twitter’s costs is R&D, which it defines in large part as salaries for engineers. Twitter has 2,000 employees — a massive number for such a simple-looking product. Twitter says, “From January 1, 2010 to June 30, 2013, we increased the size of our workforce by more than 1,800 employees.”

Eighteen hundred! For a device that publishes 140 characters at a time. What are they all doing?

They’re not all engineers, but R&D/engineering costs are the major reason Twitter loses money every quarter.

So getting staff costs under control will have to be a long-term strategic priority if Twitter is to ever actually make money.

The next issue is Twitter’s vulnerability to Facebook, and other apps and social media, which it warns about specifically in the S-1:

… following Facebook's acquisition of Instagram, Facebook disabled Instagram's photo integration with Twitter such that Instagram photos are no longer viewable within Tweets and users are now re-directed to Instagram to view Instagram photos through a link within a Tweet. As a result, our users may be less likely to click on links to Instagram photos in Tweets, and Instagram users may be less likely to tweet or remain active users of Twitter. Any similar elimination of integration with Twitter in the future, whether by Facebook or others, may adversely impact our business and operating results.

It is not likely that Apple or Google (via Android) will suddenly switch off Twitter integrations in their products. But again, they might. Twitter depends on its partners, not the other way around.

The bottom line is this: Twitter is a growing company with robust revenues. It may yet still have a ways to go.

But its opening financials and metrics are messy, and they compare poorly to Facebook’s S-1 a year ago, which showed a wildly profitable company with no major problems in front of it.

Good luck, Mr. Costolo. You probably won’t need it. But putting a price on your new stock while warning that growth is limited is a challenge I don’t envy.

Disclosure: The author owns Facebook stock.

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