What to look for in Twitter’s S-1

By Pascal-Emmanuel Gobry on September 13th, 2013

Late last night, Twitter used a little-known provision of the recent JOBS Act to file papers for an IPO. What this means is that while we can’t look at Twitter’s financials just yet, we will soon be able to. Its S-1, or filing for the public offering of securities, will be public just as Twitter gets ready to actually sell its stock on the market. Since we know it’s coming, but we can’t sink our teeth into it yet, we can at least prepare.

You will see plenty of stories telling you how much each investor is going to make, how much Jack Dorsey will be worth, how many employees Twitter has, and so forth, but if you want to actually be really informed, you have to look at relevant and important metrics.

Thankfully, since Twitter’s business model is straight selling of advertising, there should be none of the weird shenanigans you sometimes see, such as Groupon’s non-standard metrics or Zynga’s bizarre revenue recognition practices.

The first thing to know about analysing financial statements is that you’re trying to get an idea of the future. The worth of an investment is determined by what’s going to happen in the future[1]. If you’re trying to buy a hotel, if it’s very profitable but if it’s in an area people aren’t going to visit in the future, your investment is not worth a lot of money; if it’s not profitable but it’s in an area that’s going to be very popular, it’s worth more money.

What matters is what your investment is going to do in the future, and what it did in the past is relevant only insofar as it helps you understand the future. For that same reason, what you are looking for is less what the state of the company is at any point in time than the trend: in short, is it growing or not?

With that in mind, here are the key things to look for in Twitter’s S-1:

  • Profits! This is actually the least important of all the metrics, but it’s one which people will inevitably focus on, and it’s an inevitable one. Is Twitter profitable, or not? That’s important.
  • Cash flows. If Twitter is not profitable, or just very slightly profitable (and those two are the most likely), it can be for either of two reasons: either it is investing very heavily, or its business just costs so much to operate that it is hard to generate profits. Obviously, between the two you want the former rather than the latter. The way you can tell which it is is by looking at metrics such as operating cash flow and EBITDA[2].
  • Revenue growth. This is really important. How fast is Twitter’s revenue growing? (One hopes it is growing.) Here, you want fast (anything less than double-digit would be a real concern). An even more important question is: is the growth accelerating, or decelerating? This was one key reason why investors reacted so negatively to Facebook’s financials: even though the company’s revenue is growing really fast, that growth is decelerating, which suggests it will peak (or at least slow to a crawl) soon if Facebook doesn’t find some new business line.
  • Operating leverage. The over-used world “leverage” can refer in finance to two things: financial leverage, i.e. debt, or operating leverage. What operating leverage means is that your revenues are growing faster than your (operating) costs. This means that for each incremental dollar of revenue, you need to spend less to generate it, which in turn means you will earn more profits. For intuitive reasons, operating leverage is really powerful, because it means the more you grow, the more profitable you are. It’s the stuff great business models are made of. All else equal, you should rather invest in a company that has no profits but has operating leverage rather than one that’s profitable but doesn’t have leverage. Since Twitter is in the technology business and most technology companies have strong operating leverage, if Twitter doesn’t have it it’s a huge red flag. If it has a lot of it, it is a really good sign.
  • CPMs. In advertising, the CPM (Cost Per Mille) is the dollar rate of a thousand ad impressions. It is the standard unit of account in the online advertising world. Twitter doesn’t actually charge CPMs, but it will probably disclose it, because it’s the standard metric. Here, you’re looking for two things. One: how do Twitter’s CPMs compare to that of its competitors? If it’s high, that’s obviously a good sign-it means Twitter’s advertisers love its products and are willing to pay for them. If they’re low, it can be either a good thing or a bad thing: it can mean Twitter’s advertising products stink, or it can mean it still has a lot of room to grow.Which is why you’re looking for the second thing, which is the trend: are CPMs growing or not? If you’re selling oranges, the way to earn more money is either to sell more oranges, or to charge more per orange. Ideally you want to do both, but the most profitable by far is to charge more per orange, because your costs don’t grow nearly as much (you have operating leverage). If Twitter’s CPMs are growing, it means it’s charging more per orange, which is very good. If Twitter’s CPMs are shrinking, it’s a very very bad sign: it means advertisers have tried Twitter’s oranges and they taste sour, so it has to sell them at a discount.
  • Mobile. Mobile is obviously transforming the internet, and the question for all pre-mobile companies is how they manage the transition. Twitter has set a high bar for itself there, since the Twitter product was clearly made for mobile. What percentage of Twitter’s usage is on mobile, and what’s the trend? What percentage of revenue, and what’s the trend?
  • User growth and stickiness. Obviously, you want Twitter’s user numbers to grow, since that means more revenue and more profits down the line. But more importantly, you want to see stickiness. Twitter’s perennial problem is that with all its media attention and celebrity endorsers, it has no problems attracting users, but it has had a lot of problems retaining users, because Twitter can be hard to understand for non-techie folks. If Twitter gets lots of new users but they don’t actually use the product, it can’t show them ads and it can’t make money.The obvious number to look at here is churn, meaning the percentage of users who stop using the product each period. Another important number is the ratio between MAUs (Monthly Active Users) and DAUs (Daily Active Users). Since Twitter has spent most of its energies for the past two years refashioning its product to make it more palatable for casual users, the trend here is important: if it’s not headed in the right direction, it means all of Twitter’s product changes haven’t had an impact, and that’s a big red flag.
  • MD&A and footnotes. MD&A is financial analyst-speak for a section of financial filings called “Management’s Discussion and Analysis”, which is where the company’s management explains the financial statements and tries to put its best spin on it. That’s usually the part with the most information, and so you should read it closely.Another thing that is well known to financial analysts is that the most important information is almost always buried in the footnotes, because it’s what the company wants to hide. There’s no good rule of thumb here, because every company is different. In particular, a very important thing is to compare footnotes between filings, since if a company chooses to report or disclose something differently and hides it in a footnote, it usually means it’s hiding something. But with an IPO you only get one filing so you can’t do that.

And finally, here’s the one thing NOT to look for in Twitter’s S-1: the so-called “risk factors.” Since the US SEC thinks the investing public are basically children, it makes every company that goes public add a section to its S-1 called “risk factors” where it details everything that could go wrong. And since US companies have highly-compensated risk-averse lawyers, those lawyers make them put as many, as grim risk factors as possible in the filings.

Whenever a high-profile S-1 comes out, journalists jump onto that section, because headlines like “10 Ways Twitter Says Its Business Could Implode” are irresistible. But the “risk factors” section is essentially a formal legal requirement. We all know that if hackers wreck Twitter’s systems or if users stop visiting the site, Twitter’s business will be negatively affected. The fact that Twitter will tell us that in its S-1 is not in itself relevant.

[1] This is reflected by the finance paradigm that the value of an asset is the net present value of its future cash flows. (Net present value is the consequence of another finance paradigm, the “time value of money”, meaning that a dollar today is worth more than a dollar tomorrow, and so you should “discount” future dollars to get their “present value.”)

[2] Earnings Before Interest, Taxes, Depreciation and Amortisation.