Why Twitter Inc Should Be Avoided

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A version of this article originally appeared on Fool.com

WASHINGTON, DC -- Few companies have demonstrated the ability to grow more rapidly than Twitter (NYSE: TWTR.US) . In the most recent three years, monthly active users of Twitter increased by 473.5%, more than double Facebook's figure of 216.2% over the same period. Granted, Twitter started from a much smaller base, but that is incredible growth nonetheless. From 2010-2012, Twitter expanded its top line by 1,120%,outpacing all members of the S&P 500 during that stretch. Yet, Twitter still seems like a bad investment for one simple reason: Companies with similar market caps offer investors far more value.

Two prime examples: Food and satellite television

Since its IPO less than two months ago, shares of Twitter have more than doubled. The company's current market cap is $32.7 billion. That places it in the same ballpark as Kraft Foods which has a slightly smaller price tag, and DirecTV which has a slightly higher price tag. Let's start by taking a look at some figures regarding revenue for each of these companies.

KraftTwitterDirecTV
Market Capitalization:$32.3 billion

$32.7 billion

$34.8 billion
Generating Revenue Since:1903* 20091994**
Revenue (9 months ended Sep. 30, 2013) $13.62 billion $422.2 million $21.7 billion
Revenue Relative to Twitter 32.3

1

51.4

*Including predecessor companies
**First year of revenues from DirecTV programming services

Twitter generates less than 1/30 and 1/50 the revenue of Kraft and DirecTV, respectively. Even if Twitter could replicate its 2010-2012 revenue growth over the next three years, something even management thinks is impossible, it would still have much lower revenue than both Kraft and DirecTV.

Enriching insiders over shareholders

As a result of its IPO, Twitter sold 70 million shares to the public, representing approximately a 12.9% stake in the company. In conjunction with its IPO, Twitter's prospectus revealed that 63.5% of the total amount the company has received from selling shares came from IPO participants. In other words, those who participated in Twitter's IPO contributed nearly two-thirds of the money the company received from selling shares in exchange for slightly over one-eighth of the company. To me, that seems blatantly unfair.

Holders of the other 7/8 of the company are restricted from selling until early May, and what they do with their shares at that point will be telling indeed. Twitter will almost certainly have to issue 42.7 million additional shares in connection with outstanding options that have a weighted-average excise price of $1.84 per share. The company has also reserved 80.3 million shares for future issuance in connection with its equity compensation plans. Twitter's shareholders should prepare to experience massive dilution.

On the other hand, owners of DirecTV and Kraft can expect a boost to their proportional ownership, courtesy of share repurchase programs. DirecTV has bought back over $2.4 billion of its own stock since February, and has authorized purchases of an additional $1.59 billion worth of shares. Kraft has actually increased its number of outstanding shares by roughly 0.6% so far this year. But, don't expect that dilution to continue, as the company recently authorized a $3 billion dollar buyback program.

Positive adjusted EBITDA doesn't count as profitability

Twitter has not had one quarter of profitability, but that hasn't stopped the company from projecting financial success. It reported positive adjusted EBITDA during 2012 and the first nine months of 2013. To arrive at its adjusted EBITDA figure, Twitter ignores its significant stock-based compensation expense and violates several other accounting rules. To the intelligent investor, adjusted-EBITDA is an entirely useless figure.

Earnings on the income statement, and figures derived therefrom, are subject to managerial manipulation, meaning they don't always provide an accurate picture of a company's financial performance. Many investors consider free cash flow to be a more reliable metric. DirecTV has generated over $2 billion in free cash flow in each of the past five years. Kraft has generated $853 million in free cash flow in the initial three quarters of its first fiscal year after spinning off Mondelez International. Post-spin off, Kraft will likely generate less free cash flow than DirecTV, but dividend lovers can appreciate Kraft's juicy 3.9% yield.

Foolish final thoughts

Twitter is an unattractive investment for multiple reasons. Two-thirds of the money Twitter received from selling shares came from public shareholders, who in exchange received little more than an eighth of the company. Overly generous equity-based compensation will almost certainly cause the holdings of Twitter shareholders to be massively diluted. Plus, there's the company's lack of profitability. Twitter's one bright spot has been phenomenal revenue growth.

But, even after such phenomenal growth, Twitter's revenue is still completely dwarfed by those of DirecTV and Kraft. The latter two companies are solidly profitable and are increasing, rather than diluting, the proportional ownership of current shareholders through generous buyback programs. DirecTV and Kraft are both quality investments, but Twitter is pure speculation. Investors who pass up DirecTV or Kraft in favor of buying Twitter will likely regret it.

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