Will 2018 Be Twitter’s Best Year Ever?

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You can't blame Twitter (NYSE: TWTR) investors for not wanting 2017 to end. Shares of the social media giant advanced 47%, while the tech-focused Nasdaq returned just 28%. It appears Twitter's stock finally turned the corner after years of languishing returns and continued turnover in the executive ranks.

However, Twitter's run was mostly due to investors no longer pricing in a worst-case scenario. To continue upon 2017's success, Twitter will need to do better than simply proving itself as a going concern and finally produce strong financial results.

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The bad: CPE continues to fall

The analysis on Twitter tends to narrowly focus on monthly active users (MAU). This is an important metric, but more important for investors are traditional metrics like revenue, profit, and free cash flow. Although Twitter reported year-over-year MAU growth of 5% for the first quarter of 2017 and 4% in both the second and third quarters, year-over-year revenue decreased 8%, 5%, and 4%, respectively, over the same period.

The discrepancy between these two sets of numbers isn't a result of fewer ads. In fact, ad engagements have increased more than 90% each quarter over the prior year. The difference is the cost per engagement (CPE), or the revenue Twitter can charge advertisers per click, retweet, reply, etc. CPE has plummeted more than 50% each quarter on the back of a 55% decrease the prior year.

The short answer is that Twitter is barely growing users but feeding them ads at a higher clip, and advertisers are responding by paying less for them. Twitter CPE rates need to find a floor or at least decline at a less rapid rate.

The good: Revenue should grow this year

Still, there are reasons to think Twitter can grow its top line despite plummeting CPE: First, the latter part of this year was negatively affected by the company's shuttering less-popular ad products, most notably TellApart early in 2017, making year-over-year comparisons difficult. While these headwinds will continue in the first half of 2018, the revenue-heavy fourth quarter will not face negative comparisons. Second, last year's revenue was dragged down by marketing costs from the company's Thursday night NFL streaming-rights deal. Next year Twitter will benefit from more-favorable comps as both will run off.

Third, the company's data licensing business should boost revenue. As of last quarter, data licensing was 14% of total revenue; look for that to rise as the division is growing at an approximate 20% annualized clip. It's likely investors will respond positively to the company once it returns to growth.

The ugly: Share dilution

Twitter has been faulted for being unprofitable. A large reason for Twitter's unprofitability: its stock-based compensation expenses. Twitter provides a non-GAAP net-income metric without stock-based compensation that shows the company is profitable without this specific expense.

Most analysts, myself included, prefer to look at cash flow metrics because, in the long run, cash flow is a better predictor of a stock's return. While still unprofitable, Twitter is increasing its free cash flow (operating income minus capital expenditures), which shows improvement in its overall operations.

However, the reason stock-based compensation expenses are important is they result in dilution among shareholders. In the last two years, Twitter has grown its weighted outstanding shares by approximately 10%. Though, the company notes that stock-based compensation decreased by approximately 40% year over year during the last quarter, and I expect this figure to continue to decline.

The verdict: A good year is in store

This year should see Twitter continue to strengthen its business, lowering expenses and reversing its revenue decreases. Additionally, I expect CPE decreases to slow. Twitter's management has announced they hope to be GAAP profitable (including stock-based compensation expense) in the fourth quarter as the company is working to lower its total expenses, including stock-based compensation. While I don't expect Twitter to match 2017's stock performance, I do expect continued improvement.

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Jamal Carnette, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Twitter. The Motley Fool has a disclosure policy.