BMO Capital Markets analysts Daniel Salmon, Nirav Modi and Ygal Arounian rate Twitter Inc (NYSE:TWTR) as market perform, as they gauge the opportunities and challenges around Twitter’s user growth.

Twitter

Opportunities and challenges for user growth

Vital to gauging valuation at these levels is framing the opportunities and challenges for user growth. Being able to pay 15x-25x forward revenues necessitates being able to envision a doubling, tripling, or quadrupling of a fast-growing user base. In the Investment Considerations section below, we walk through the myriad of factors that should power monetization. And normally, this is where we would cover user growth as well. But because Twitter Inc (NYSE:TWTR) valuation sits at these levels, we felt it appropriate to address user growth up front here in the Valuation analysis.

Twitter’s advantages over other companies

Relative to other internet companies’ user growth, we believe Twitter has two advantages:

1) An innate connection to television, and;

2) A platform geared around real-time activity and transparency.

On the first point, the connection to television – the most widely consumed form of media in Western markets, still – is an important differentiator relative other internet stocks. We cover this in more detail below, but Twitter Inc (NYSE:TWTR) is creating an opportunity for more communal TV viewing, even if that community forms in the digital space (which we recognize is not everyone’s idea of “community”). Certainly other social media and internet companies offer the ability to gather in virtual communities online; we simply believe that Twitter has an advantage when it comes to online communities geared around television (which has major implications for potential monetization and we cover those more in the section on Social TV).

On the second point, we believe real-time functionality and transparency are fundamental elements to youth culture today. The always-on mindset tends to get most of the attention, but we believe Twitter Inc (NYSE:TWTR)’s public nature appeals to modern youth culture too (for better or for worse) in allowing them to openly share their content with the whole world. Said another way, whereas Facebook Inc (NASDAQ:FB) upgraded many of the features of prior communications tools, like email (including keeping conversations private if one so chooses), Twitter’s public nature is capitalizing on sociological changes taking place in younger demographics where the consumers are “digital natives” rather than “digital immigrants.”

Twitter’s user growth

Unfortunately, this creates challenges to mainstream adoption as well. The result of a realtime, fully public community is that it is often perceived as chaotic or nonsensical to older “digital immigrants” and we believe Twitter Inc (NYSE:TWTR) faces a greater challenge than other social networks in keeping new users on the platform that are less accustomed to its unique nature. Twitter does not disclose its total registered users – only its monthly and daily active users – but we expect that the relative gap between those figures is likely higher than for Facebook Inc (NASDAQ:FB), as many older users join but don’t become regular users. Re-activating these users will be vital to achieving the bull-case scenario we lay out for Twitter user growth. The base case represents our actual user growth estimates through 2015 and then what we believe to be a reasonable scenario for growth out to 2010. And then it also includes a bull and bear case to help frame the potential for long-term user growth.

Just as we have written about for Facebook Inc (NASDAQ:FB), we also believe a “portfolio of social networks” framework is appropriate for gauging Twitter Inc (NYSE:TWTR)’s long-term user potential. While Twitter’s “portfolio” is very much in its early stages, the importance of “second bets” is fully on view today in the analysis of Facebook’s stock, where Instagram is top-of-mind for investors (this also goes for Google and YouTube, LinkedIn, and Slideshare, etc.). This is in fairly stark contrast to this past spring, when topic No. 1 with investors was about the teens potentially leaving Facebook. As we noted then, Facebook’s “second bet” in Instagram would be vital to answering those questions and that is exactly the case today.

Twitter’s recent bets

Twitter Inc (NYSE:TWTR) acquired Vine in October 2012 before the small start-up’s video-sharing app had publicly launched. Rather than fold it into the Twitter platform, it has remained an independent product, and is now Twitter’s “second bet.” Vine enables users to create and distribute short six-second looping videos on iOS, Android, and Windows; they can be shared with followers on Vine and also shared on Twitter and other social networks. Twitter also has a small “third bet” in its separate #Music platform as well. Both #Music and Vine currently do not display ads to its users and we don’t expect they will anytime soon. But a day may come when flipping on the “second or third bet” will likely be an important investment consideration for Twitter; today, it is vital only to help give context to this discussion of the company’s long term user growth potential.