When does Twitter Stock become cheap?

twitter-bird-white-on-blue-300pxI’m reading the book Sapiens: A Brief History of Humankind by Yuval Noah Harari. In a section on the Agricultural revolution, Harari reminds us that while farming allowed human populations to grow, the quality of life for the average farmer was worse than the average hunter-gatherer. Farmers worked longer hours, with worse health, and generally lived more repetitive (and possibly more boring) lives than their hunter-gatherer counterparts.

Still, living in cities with farms to work on meant more babies, which meant more people with more reason to cooperate, leading over the years to the complicated network of nations and societies we live in today. Similarly, are modern day humans are working harder than our ancestors worked. Are we living longer, but less fulfilling lives?

It’s unclear to me whether tools like Twitter, which are taking up more and more of our precious time, are making our lives better or worse. It does seem to me however, that Twitter and the Internet in general are bringing people together cognitively in the same way that farms brought people together physically. While sporting events, movie launches, wars and riots happen in different places all over the globe, everyone can share in these experiences in the same virtual space in real time scrolling through Twitter feeds 140 characters at a time.

What does this have to do with Twitter as a company and stock? I’m not sure, but hopefully we can come together here to figure out if Twitter is a good investment at $22.45 per share.

Twitter (TWTR) stock is trading at around $22.45 a share right now, putting it at a market cap of $15.7 Billion. They have about $4B in cash, revenues of $2-$B, and trailing 12 month earnings per share of -$0.86 (negative 86 cents). Twitter IPO’d around $45 per share, hit an all time high around $75 per share earlier this year, and has since tumbled to the current price.

Is Twitter stock cheap yet?

The answer to this depends on what metrics you are using for valuation. Technology companies like Twitter, which have ubiquitous use but indirect methods of making money, are especially hard to value. I’ll try my best.

For mature companies there are two benchmarks that I like to use when valuing a company. (1) A price to earnings ration (PE) of 15. (2) A market cap that is 2x revenue.

Why these numbers? I think that’s a good topic for another post or ten, but in short a PE of 15 is roughly the long term average PE for the entire stock market. Similarly 2x revenue is fairly average for companies across industries and maps pretty well to the 15 PE if you consider an operating margin around 10-20%.

These numbers are most definitely rules of thumb and shouldn’t be held sacred, however they are a good starting point for analyzing a stock. If a stock doesn’t trade at a 15 PE or 2x revenue, that is normal and expected, but you can learn a lot by asking WHY the stock is trading at a different PE or revenue number. Is there something structural about the company that makes it more or less profitable than others? Or, as we’ll find is the case with Twitter, do we need to wait around for revenue growth to justify the market cap.

Where does Twitter stand from a revenue and PE perspective? As of writing…

Stock Price: $22.45
Market Cap: $15.7B
PE: N/A (negative  86 cents per share earnings)
Revenue: 7x Revenue (estimated $2.2B in 2015)

Not looking good, but let’s ask why the PE is negative and why the revenue multiple is so high.

Why is the Twitter PE negative?

Twitter is spending more money than it makes. Obviously this can’t be sustained, but it makes sense for young companies that are transitioning from a user growth phase into a revenue growth phase.

Twitter earnings are also hard to figure out due to the large amount of stock options they use to compensate their employees which makes for a large difference between their GAAP (generally accepted accounting principles) and non-GAAP (shit we just made up) earnings numbers. This post is from 2014, but explains the difference in Twitter’s case pretty well.

As an aside, non-GAAP numbers are fine in principle and often help investors to understand special cases with regards to how a company is making money. More and more companies though are paying their employees in stock options, effectively moving that expense off the books by using non-GAAP numbers or diluting outstanding shares. It makes our job as investors harder.

The bottom line for Twitter’s PE is that negative earnings are obviously bad and if you invest in Twitter, you have to have some expectation that earnings will turn around at some point in the future. Hopefully sometimes soon before cash reserves run out. The good news is that Twitter’s earnings are trending up and future estimates are positive.

Specifically, to justify a $15B market cap at a 15 PE, Twitter would need to generate earnings of $1B per year. As we’ll see below, getting to the revenue and operating margin to bring in $1B in earnings should be very doable for Twitter a few years out.

Why is Twitter’s revenue multiple so high?

Twitter is currently trading at 7x revenue, which is above our 2x revenue benchmark. Why?

Again, Twitter is growing and investors know this. The 2x benchmark is for a mature company, i.e. one that is not growing or growing slowly. Twitter revenues are growing somewhere north of 50% quarter over quarter and year over year. At these rates, $2B in revenue in 2015 becomes $3B in revenue in 2016, $4.5B in 2017, etc.

The obvious next questions are if current growth rates can last (hint: they never do), how they will trend in the future, and if the company will be able to make a profit on those future revenues.

How big can Twitter revenue grow?

I’ll use a really simple method to calculate further revenues, which I’ll call “Twitter will make as much money as Facebook does”. More specifically, I suspect that Twitter will be able to make as much per user as Facebook is.

Anecdotally, Twitter’s new “put a sponsored tweet where you expect to see replies or click to reply” tactic is super annoying and probably making bank for them. I expect their revenue to beat in their next earnings report.

Facebook has about 4x the number of monthly active users (1.2B vs 300mm) but is making 8x the revenue ($17.4B vs $2.B). I believe that Twitter can close the gap and should be able to make at least $4.4B from their 300mm users. This would put their revenue multiple at a respectable 3x. If we expect their user numbers to grow as well, they can very reasonably reach a 2x revenue multiple in 2-4 years.

A 20-25% profit margin (reasonable for an Internet services company) on $4.4B in revenues leads to ~$1B in earnings or that 15 PE we’re looking for as well.

We’re just doing math here, so it’s important for everyone to do their own homework to see if they think that these numbers we end up with make sense. The particulars of each company, what I would call “Main Street Analysis”, will tell you in the numbers make sense. In practice that might look like a lot of reading of earnings reports, other analysis, or general knowledge of how the business works. In our case, we’re being lazy and just saying that Twitter will have a similar trajectory that Facebook has had since IPO.

So is Twitter cheap?

Based on this analysis and the expectation that Twitter can get to $4.5B in revenue and grow respectively from there, Twitter is about fairly valued and just starting to get cheap. So I personally am considering starting a position with the expectation to add more as the price drops. I’ll probably purchase shares in my children’s brokerage accounts. (Christmas money for the win.)

If you expect Twitter to grow into more than just a platform to show ads occasionally to 300m people, you can basically get all of that extra stuff for free. The current price is inline with the straight forward, low risk, advertising business Twitter has now. So any extra revenue from Periscope, premium services, digital ID fees, or spoils collected from the governments it overthrows is gravy.

In my opinion, Twitter is very much an integral part of our society. When news happens, it happens on Twitter first. Facebook is starting to work like Twitter in this way, but I don’t see it overtaking Twitter without losing all of the other stuff we like about Facebook. The hole quick, 140 character, nonchalant nature of Twitter is actually exactly what makes it work so well. And considering they are ingrained in every news organization, business, and with every celebrity, I don’t see another service overtaking them without warning.

Assuming the general market doesn’t suffer a pull back, Twitter should be free of any new “bad news” that could move the stock lower. Weak investors should be shaken out soon, and if Twitter continues to grow as I expect it to, I suspect a slow rise with each new earnings report. Look for the stock to trade a bit lower, but turn around soon, and then rise up steadily from there.

 

Apple. When are the fundamentals of the stock ever going to take charge of its price?

This post is inspired by a post by the user cyice on Stocktwits, who said: “when are the fundamentals of the stock ever going to take charge of its price“.

At $110 a share, Apple ($AAPL) is down around $20 or 16% from it’s highs just over $132. The stock trades at a PE ratio of 13. Minus the $200B in cash Apple has, that’s a PE of about 9. Meanwhile, companies like Google and Microsoft trade at PEs of 20 and 32 respectively.

I won’t go into why the market thinks Apple deserves a PE 1/2 of other tech companies (I wrote it up and decided to scratch it — the market is crazy and crazy hard to understand). If we just assume that the market has different rules for Apple, we can try to figure out what those rules are.

A chart…

aapl_5years

In July 2013, Apple traded at $60 with a PE around 10. It touched $130 this year and a PE around 15 and now trades at $110 with a PE around 13. Also notice how the price bounced off the 200 day moving average in July 2013.

So one answer to the “when are the fundamentals of the stock ever going to take charge of its price” would be around a 10 PE, which would correspond to a price of about $90 and also come close to that 200DMA. I’m long Apple in a retirement account and would back the truck up if it dips down around this area.

ZNGA Update and Options vs Common Stock

zynga_logo

Last week, I made the case to purchase Zynga stock in anticipation of their August 6th Q3 report. (BTW, you’ll be able to find the Q3 earnings report and conference call link on the Zynga Investor Relations site.) At the time, ZNGA was trading around $2.85 per share. Since then, the stock has dropped to around $2.60, recovering to around $2.70 at the time of writing this post.

My apologies to anyone who purchased on my recommendation last week and is now down about 5%. The thesis was to hold through earnings though, so hopefully you didn’t get scared out. It’s important to know both your exit from a trade and your tolerance for pain while holding through the trade. If you’re really following me, you are still holding. If you end up losing money after earnings, I apologize again, but I am not a financial adviser… this is not financial advice… please don’t sue… etc etc.

In my case, I’m bullish on Zynga as a company long term and looking to purchase as many shares as possible as cheaply as possible. I feel that $2.50 and definitely $2.00 are very strong support for the stock price and so barring any big screw ups in the company, it’s unlikely to go much lower than it is now. I think the current quarter’s earnings are likely to be good because the company has been turning around in general and also because their games have maintained high ranks in the app store “top grossing” charts while new games have come out. Existing games have had their video ad systems updated, and there is growth in general in both smartphone use and ads on smartphones. So things should be good. If they are, this might be my last chance to load up on Zynga stock before it starts to get expensive.

My Zynga holdings are about 8% of my retirement fund, which is on the mid to high side. I’m hesitant to add more, but I’ve also been hesitant to add more to other companies I had hunches about like this, and I’m trying to trust my gut more… especially when stocks are trading in value territory with lots of support. It would have been nice of me to have bought more Tesla, Amazon, and Activision at their recent lows. So I wouldn’t mind adding here even more before earnings.

Then the question becomes, what is the best way to add to my position? Should I buy more stock? Or purchase out of the money call options?

1. Just Buying Shares

This case is easy to analyze. I can buy about 300 shares at $2.7 each for a total of $810. If the stock moves to $3.10, I’ll make $0.40 on each share or $120. I’ll also have 300 shares in Zynga stock going forward. For my long term focused fund, it’s almost more important to track how many shares of a company you have (the assumption being you’ve picked great companies that will be valuable in the future) vs how much the stock price is up from your basis.

If earnings are poor or just not good enough and ZNGA shares trend lower, I’ll obviously lose X cents per share on 300 shares. Here is where things would stand at various price points:

$2.30: -$120
$2.60: -$30
$3: $90
$3.10: $120
$3.25: $165
$3.50: $240

2. Purchasing Call Options

When you consider buying options, things can get complicated. When purchasing stock, there’s basically two things you can do: purchase stock at the market price or wait. With options, you have to figure out not only when to buy but at which strike price and on which strike date. Here’s a view of the Zynga options chains in Etrade.

znga_options_2015-07-24

 

Figuring out which options to buy can be confusing and is the topic for another post (maybe there is one in our archive), but for now let’s assume I choose the options striking on August 7th (one day after the earnings call) at $3.00 (a good balance of risk reward).

Buying 140 contracts at $0.06, conveniently comes to $810. That would be $0.06 x 100 (100 options per contract) x 140 contracts. This purchase would give me the “option” to purchase 14000 shares of ZNGA stock at $3 per share. If the stock never gets to $3/share on August 7th, the options would expire worthless and I’d be out $810. If they got to $3.06 per share, I would just about break even. I’d be able to buy 14000 shares at $3 for $42k and then sell them at $3.06 for $42.8k. He’s what I would make or lose at different prices on August 7th:

$3 and below: -$810
$3.06: $0 (breakeven)
$3.07: $140 (about same as buying 300 shares)
$3.25: $3500
$3.50: $7000

As you can see the potential rewards are higher, but there is a bit more risk since I could lose all $810 invested. On the other hand, there is very little chance I would lose the total $810 invested in the “just buy stock” option. So let’s make a buy stock scenario that has a similar amount of risk.

3. Buying Shares with a Stop Loss

What is instead of buying 300 shares of ZNGA stock worth $810, we bought a higher number of shares and used a stop loss to limit our downside risk to $810. What might this look like? The first step would be to figure out a good place for that stop loss. Recently ZNGA got down to $2.60, but didn’t go lower. The current 200 day moving average is also hovering right around that number providing support. There is support at $2.60, so let’s place our stop loss there… 10 cents below the current $2.70 price.

If we bought 8100 shares at $2.70, we could set a stop loss at $2.60. Assuming no slippage (i.e. our stop loss actually fires at $2.60 when the stock gets that low), we would only lose $810 on those shares if the stock price went lower. Here’s what we would earn at the same price levels as in the options scenario:

$2.60: -$810
$3: $2430
$3.06: $2916
$3.07: $2997
$3.25: $4455
$3.50: $6480

In this scenario, we would risk the same $810, but stand to make even more than purchasing $3 options would. In some ways there is less risk in this scenario, since we still make money (a lot actually) if the stock doesn’t trade above $3. We also have the option of holding the shares past August 7th if we want to.

In some other ways, there is a lot more risk though. If ZNGA is trading at $2.65 before earnings, then reports terrible earnings and opens the next day at $2.30. There is a chance my stop loss would sell below my target and we could lose something like $3000 or more selling those shares for a loss. Oops.

The other thing to note in this scenario is that you would need to come up with $21.8k to purchase those shares, which is more than my current holdings. One option would be to go on margin to get that money. Generally, that’s a bad thing to do without knowing what you are doing. Purchasing options is actually one way to effectively trade on margin, but with fixed costs.

What am I going to Do?

I’m not sure yet. The options option looks nice as a way to gamble an extra $810 on this next earnings with a fixed amount of downside risk. Buying shares could be good as well, but I would do something between Option #1 and #3 above. For example, instead of buying them all at once, I could buy 3000 or so and then buy 3000 more if earnings were bad (and I still believed in the company). I’d have lost money, but would have even more invested in the company ready for the turn around. This is basically the strategy of my portfolio. It’s worked well for me with Netflix, Tesla, Activision, and currently Nintendo. Of course, I could get unlucky and average down on a company like this that drops to $0. The idea is I would hopefully make up for it with my winners… or basically be able to make good judgements to cut my losses when I really need to.

If I figure out what I’m going to do. I’ll post an update. Good luck everyone!

The Long Case for Zynga $ZNGA

ea_hero_imageAside: I’m going to try to blog here when I do research for stocks I’m investing in and in particular when I am sharing ideas with my mother. Explaining an investment to my mother and to the blog here are remarkably similar processes… so two birds with one stone and all.

Next up: Zynga (ZNGA).

Zynga makes games for mobile phones and tablets and also for sites like Facebook. They famously made their fortunes on the back of games like Farmville and Mafia Wars before going public. Since then, they have done a number of acquisitions and spent a bunch of money, but generally failed to create hits as big as Farmville was at the time. Their stock has tanked from $10/share at IPO to ~$2.85/share right now.

Sounds glum, so why am I bullish now? I’ll try to bullet point the case here, dive into some of the numbers, and then post the risks.

The Case

1. Downside is limited by cash and assets.

At $2.85, Zynga’s market cap is about $2.62 Billion. In 2014, they had about $1.8 B in shareholder equity, including about $1B in cash and equivalents and a $300m office. This puts a floor of about $2/share on the stock, with technical support at $2.50.

2. Revenue is turning around.

Revenue numbers were up year over year the past 3 quarters. Zynga is already set to post their first annual YoY gain in revenue since the IPO and a surprise this quarter topping $175m (which is above most estimates) would mean 4 quarters in a row of YoY revenue growth.

It appears that Zynga is turning the corner on revenues, and while up from all time lows, the stock price still seems to reflect a company that is shrinking and not growing.

3. Mobile games industry is still growing.

By one account, the mobile games market grew from $21.7B to $25 from 2013 to 2014. That 15% per year growth is going to be a nice tailwind for the mobile games market. So even though Zynga is not the only game in town, the pie is getting bigger.

Many traders are watching the iOS and Android store “top grossing” charts and trading parent companies as games move up and down the list. The position of games on this list is a great indicator of revenues for the parent companies, but it seems people are being harsh as games move down the list. A top 10 spot on the list today is worth as much as the top 1 spot a few years ago. And so Zynga with 2 top 20 games in Hit it Rich and Wizard of Oz Slots is making decent revenue despite sliding down the list a bit.

4. Games pipeline is strong.

Zynga released Empires and Allies this quarter, which has done well on the charts. It’s recently jumped up the free downloads chart (as high as #1) while simultaneously sliding down the grossing charts. This is really odd, and some have accused Zynga of manipulating the free downloads charts. There have been bugs forcing people to reinstalls (probably not adding bugs on purpose) and Zynga has been advertising Empires and Allies on Twitter and other places, both of which would inflate download numbers.

Historically, Zynga has done much advertising promotion for their games. Instead they relied on their social integration to get gamers to bug their Facebook friends for virtual wood to build their farms. In my opinion, the fact that Zynga is starting to advertise Empires and Allies is more a sign that they believe they have a good pipeline to convert ads into real customers than a sign of desperation to inflate unimportant numbers.

Besides Empires and Allies, Zynga will be releasing a couple games from Natural Motion which they acquired last year: CSR2 Mobile Racing and Dawn of Titans. Both games are visually heads and shoulders above other mobile games and could be very popular as customers look for something to take advantage of the beefier tablets coming out.

5. Ad revenue should increase.

There is more demand for ads on mobile devices and game developers are getting better at integrating ads into their games in ways that are not intrusive and actually encourage users to watch video ads. In particular, users can watch video ads in Zynga slot games to earn money to spend on the slots. Similar features are being added to exiting Zynga games and will surely be included in all future games.

Ad revenues are not incorporated into iOS and Android “Top Grossing” and so can be missed by traders and investors focusing on those numbers.

Higher revenue from smarter ads means that Zynga can earn higher revenue even with lower daily active users.

6. Real Money Gaming could be huge.

Real money gaming hasn’t taken off on mobile yet, but as regulations loosen up or companies get bolder things could start moving fast. Gambling via fantasy sports is a booming industry, which is an indicator of demand for fantasy sports but also for gambling.

Zynga is in a good position here with top casino games, the top free poker game, and lots of real money gaming patents.

Future Stock Price Estimates

The general thesis here is that revenues are turning around, existing cash cows and cash chickens will support current levels of revenue while new games and eventually real money games will support growth in revenue.

If Zynga can grow back to $1.2B/year in revenue and and make $360m/year on 30% gross margins, their stock price could be:

  • $4.02 based on 2x revenue + cash value ($3.7B Market Cap).
  • $6.03 based on 15 PE ($5.55B Market Cap)

Again, this would be based on the assumption that Zynga can double revenues and achieve a decent profit margin. Considering they’ve hit these revenue numbers before, it’s not unreasonable to think a more mature Zynga might “get lucky” again.

It took Zynga 3 years to shrink from $1.2B/year revenue to $680m/year. If it takes 3 years to grow back to that level, the estimates prices above would represent total gains of 40% and 111% respectively, or annualized returns of 12% and 28% respectively.

 

Still, there are risks…

Risks

The main risk to this thesis is that existing Zynga games drop off in users and revenue while new games coming out fail to gain users.

Also there isn’t a great explanation why Empires and Allies can have so many downloads without a similarly high placement on the top grossing lists. It could be that Zynga is wasting money advertising Empires and Allies without a proper return.

If the turn around in Zynga’s revenue is not accompanied by a turn around in earnings this year, then they will continue to lose cash pushing the $2 price floor lower.

Summary

I have a position in Zynga shares averaged around $2.90 a share and added an amount equal to 50% of my old position recently in anticipation of Zynga beating Q2 revenue and earnings estimates in their August 8th earnings call.

If the earnings goes well, Zynga should climb to $3.50 or higher. If not, there could be a pull back with technical support at $2.50 and fundamental support at $2.00.

ZNGA: Long-term Trend Has Changed

The closing price for ZNGA has risen above its 200-day moving average, indicating a long-term upward trend.

Trend for ZNGA as of Wednesday April 9th, 2014

Long-term: Up

Intermediate: Down

Short-Term: Up

This post was generated by our Market Trends tool. The trends are simply based on the 10, 50, and 200-day moving averages. View the current market trends or analyze your own stocks.

TSLA: Long-term Trend Has Changed

The closing price for TSLA has risen above its 200-day moving average, indicating a long-term upward trend.

Trend for TSLA as of Wednesday April 9th, 2014

Long-term: Up

Intermediate: Up

Short-Term: Up

Chart for TSLA

Stock Chart

This post was generated by our Market Trends tool. The trends are simply based on the 10, 50, and 200-day moving averages. View the current market trends or analyze your own stocks.

MSFT: Trend Has Changed

The closing price for MSFT has risen above its 50-day moving average, indicating an intermediate-term upward trend.

The closing price for MSFT has risen above its 10-day moving average, indicating a short-term upward trend.

Trend for MSFT as of Wednesday April 9th, 2014

Long-term: Up

Intermediate: Up

Short-Term: Up

Chart for MSFT

Stock Chart

This post was generated by our Market Trends tool. The trends are simply based on the 10, 50, and 200-day moving averages. View the current market trends or analyze your own stocks.

AAPL: Trend Has Changed

The closing price for AAPL has risen above its 200-day moving average, indicating a long-term upward trend.

The closing price for AAPL has risen above its 50-day moving average, indicating an intermediate-term upward trend.

The closing price for AAPL has fallen below its 10-day moving average, indicating a short-term downward trend.

Trend for AAPL as of Wednesday April 9th, 2014

Long-term: Up

Intermediate: Up

Short-Term: Down

Chart for AAPL

Stock Chart

This post was generated by our Market Trends tool. The trends are simply based on the 10, 50, and 200-day moving averages. View the current market trends or analyze your own stocks.

TSLA: Trend Has Changed

The closing price for TSLA has risen above its 200-day moving average, indicating a long-term upward trend.

The closing price for TSLA has fallen below its 50-day moving average, indicating an intermediate-term downward trend.

Trend for TSLA as of Tuesday April 8th, 2014

Long-term: Up

Intermediate: Down

Short-Term: Up

Chart for TSLA

Stock Chart

This post was generated by our Market Trends tool. The trends are simply based on the 10, 50, and 200-day moving averages. View the current market trends or analyze your own stocks.