Will Twitter Follow Zynga to an 85% Drop?

Behind every new technology is an innovative thinker… someone who creates a product or service unimaginable to those who came before them.

And naturally, the masses are typically skeptical of such new technologies. We’re often slower to see what the innovator sees.

Social media start-ups were no exception when they came online back in the early 2000s.

In those days, chat rooms and message boards populated the Internrnet. They provided easy communication across distances, but they did little to truly connect webs of people, as Facebook does today.

Today, social media is big business… albeit a business model that is still viewed with a skeptical eye by the folks who analyze traditional performance metrics, like same-store sales growth or profit margins.

When it comes to social media, the conversation regarding a technology’s ability to generate steady profits can be a weird one. It often goes like this:

Social media start-up: “We grew our user base by nine million last quarter!” (true of Twitter.)

Investors: “Great. How much revenue does each user generate?”

Social media start-up: “Huh? Revenue?”

Simply put, it’s often easier to introduce a product that goes viral, attracting many millions of free users, than it is to convert those same users into profits.

Still, that challenge doesn’t prevent social-media titans from taking their technologies to Wall Street. Going public gives them a chance to cash out, turnrning potential revenue into real cash in their pockets.

While initial public offerings (IPOs) almost always put a smile on the innovator’s face, investors aren’t always as happy with post-IPO results. For example, shares of Facebook (Nasdaq: FB) now trade for 62% more than their IPO price, early investors suffered through losses of more than 50% during the first three months.

For Zynga (Nasdaq: ZNGA), the online social games developer that garnrnered the attention of millions of Facebook’s users, IPO investors are hating life!

Initially, Zynga’s stock surged 54% higher in the three months following its December 2011 IPO. Then shares plunged 85% over the next eight months. Investors who bought on Day One are still down 53%. Ouch!

This patternrn — a big pop, followed by a big drop — is tell-tale of investors’ initial blind euphoria, followed quickly by a returnrn to reality regarding the company’s true prospects. Often, it takes only one quarterly earnrnings report to wipe the blush off the rose.

This week, Twitter (NYSE: TWTR) made headlines for delivering a disappointing quarterly earnrnings statement that showed new user growth was lackluster. The company generated earnrnings of just 2 cents a share, or roughly $1.01 for each of its 241 million active users.

Interestingly, Twitter’s stock has followed the same trajectory as Zynga’s did through the first 60 days following the IPO. Take a look…

See larger image

Twitter and Zynga may ultimately suffer from a business model that is too specific, being focused solely on real-time conversation (Twitter) and online social games (Zynga).

Facebook, on the other hand, has worked to transform itself into a broader social ecosystem, complete with photo-sharing (after its purchase of Instagram) and news feed. A diversified product line gives Facebook the opportunity to attract a larger and more diverse set of users, as well as the potential for multiple revenue streams.

Despite the hecklers, Facebook is now a 10-year-old company, worth more than all but 19 of the S&P’s 500 largest companies.

It’s hard to stomach Facebook’s whopping price-to-earnrnings ratio (P/E) — now 105, or six times the S&P 500 average — and that’s likely keeping value investors on the sidelines.

But the company is still worth the investment, and one you should look to make.

One way to buy Facebook’s stock, while hedging the frothy price and the possibility of a weak stock market in 2014, is to pair it with a bearish trade on Twitter. Here’s what you do…

  1. Buy Facebook (Nasdaq: FB).
  2. Sell short an equal dollar amount of Twitter (NYSE: TWTR).

This pairs trade should work to mitigate any wild swings — up or down — in the broad stock market. Instead, you’ll be betting that Facebook will outperform Twitter, whether the broad market is up or down.

If Twitter’s stock continues to follow Zynga’s trajectory… this could be a very profitable trade.