Is Twitter, Inc. a Buy?

Twitter (NYSE: TWTR) achieved its goal of turning a profit in the fourth quarter last year, and it followed it up with another profitable quarter to start off 2018. The company's success has led to a huge run-up in its stock price over the first half of 2018. Shares are up more than 85% so far this year as of mid-July.

Twitter certainly deserves some love. Not only is it turning a profit, it's showing strong (albeit opaque) daily user growth, its video strategy is attracting viewers and advertisers, and it seems to have spending (including stock-based compensation) under control.

But given the run-up in the company's stock price, investors should take a closer look at its valuation before buying shares.

Priced for growth

The share price investors currently have to pay for Twitter implies high expectations for earnings growth. Twitter's enterprise value-to-EBITDA ratio is much higher compared to larger competitors like Facebook (NASDAQ: FB) and Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL). Oddly, Twitter's valuation doesn't line up with EBITDA growth expectations.

While Twitter's growth expectations are well below Facebook and Alphabet's, its valuation is much higher. That makes no sense.

Perhaps analysts are missing something, and there's room to improve EBITDA at a rate that would justify a premium over Facebook and Alphabet. Let's take a closer look at how Twitter reached profitability and where it can go from here.

Where will profits come from?

Twitter's strategy in 2017 was to cut expenses as much as possible, and it did a pretty good job. Twitter saw declines across the board on its operating expenses, which dropped a total of 21.4% to $1.54 billion.

But CFO Ned Segal has noted several times that there's simply no more room to cut costs. Indeed, first-quarter operating expenses were practically flat compared to last year, with decreases in R&D and general and administrative expenses offset by an increase in sales and marketing spend. Segal expects operating expenses to start climbing again as the company laps some of its bigger expense cuts.

As such, the pressure is on Twitter to show significant revenue growth in order to drive profits. The company posted 21% year-over-year revenue growth in the first quarter, and it reiterated expectations that sequential revenue growth will look similar to last year. That implies investors can expect year-over-year revenue growth of around 21% for the full year as well. For reference, analysts expect Facebook's revenue to grow 39.5% and Alphabet's to grow 22.7%.

What's more, it's unclear whether Twitter can continue that revenue growth next year after it laps easier comps of 2017. Indeed, analysts expect revenue growth to slow to about 13% next year.

There's no indication Twitter will be able to overcome the challenges it still faces with revenue growth, as Facebook and Google continue to deliver better return on investment for marketers, leaving Twitter as a secondary option for many. And if it can't grow its top line, it won't grow earnings at a pace that justifies its current valuation. At this point, staying away from Twitter stock is a smart move.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy owns shares of Alphabet (C shares) and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, and Twitter. The Motley Fool has a disclosure policy.