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Twitter stock fell after weak third-quarter results. Here's why the company is struggling.

Twitter co-founder and CEO Jack Dorsey.
Twitter co-founder and CEO Jack Dorsey.
Kimberly White/Getty Images

Twitter stock plunged 11 percent in after-hours trading after the company released disappointing third-quarter results on Tuesday. While Twitter met its revenue target for the quarter, user growth has slowed to a crawl, and the company revised its fourth-quarter financial results downward. The news comes a couple of weeks after CEO Jack Dorsey announced layoffs of 8 percent of the company's workforce.

Dorsey is trying to turn Twitter around after a year of poor performance. "We do not expect to see sustained, meaningful growth in monthly active users until we start to reach the mass market," chief financial officer Anthony Noto said at the last earnings call in July. "We expect that will take a considerable period of time."

Twitter's dismal performance prompted one of the company's biggest investors, venture capitalist Chris Sacca, to pen a widely read memo earlier this year discussing Twitter's problems and suggesting some solutions. "Twitter has failed to meet its own stated user growth expectations and has not been able to take advantage of the massive number of users who have signed up for accounts and then not come back," Sacca wrote.

Twitter's basic problem is that it doesn't enjoy the same mass-market appeal of Facebook, which has more than four times as many users. But there's no obvious reason — save maybe the company's valuation — that that should be a problem. Twitter could arguably build a strong business by focusing on its current user base. What it's failing to do is show Facebook-like numbers, which is what Wall Street really wants from Twitter. So Twitter faces pressure to change the core service in ways that could drive off its most loyal fans.

Twitter suffered yet another quarter of losses

Twitter is one of the internet's most popular sites, with more than 320 million users. But the company has fallen far behind Facebook, and user growth has been stalling recently. Twitter said that it gained just 4 million users, growing from 316 million to 320 million users. For comparison, Facebook has around 1.5 billion users.

And despite large and growing revenues, the company has struggled to turn a profit. Twitter lost $578 million in 2014. In the first six months of 2015, Twitter's revenues were an impressive $938 million, but the company lost $299 million.

On Tuesday, Twitter revealed that the third quarter has brought more of the same. Revenues were $569 million — a significant increase from last year's third-quarter revenues. But the company lost $132 million dollars for the quarter — less than they lost in Q3 2014, but still troubling for a company whose user growth has nearly stopped.

Twitter is optimized for power users

(DAMIEN MEYER/AFP/Getty Images)

Many of Twitter's strengths — and also its weaknesses — come from the fact that tweets in a user's timeline are displayed in strictly chronological order. Any time you log in to Twitter, you see the most recent tweets from people you follow.

This focus on recency makes Twitter indispensable for certain kinds of users. If you're a journalist following a breaking news story, for example, Twitter is by far the best source of information. And for people who sit in front of a computer all day, Twitter is a great way to always stay on top of the latest conversations.

But presenting tweets in a strict reverse chronological order can make the service less useful to casual users. People whose jobs don't involve sitting in front of a computer might only check in once or twice a day. They care more about seeing the most important information than the most recent. Facebook's newsfeed is designed for these users. It uses a proprietary algorithm to predict which posts users are most likely to care about, ensuring that you see your friends' wedding and pregnancy announcements.

Until recently, Twitter didn't do this. Because Twitter made little effort to prioritize tweets, users have had to do more work to make it useful. Power users carefully curated the list of people they follow to optimize their Twitter experience. A lot of casual users didn't have time for this, and as a result Twitter felt chaotic and overwhelming to them.

These different schemes for ordering posts have led the two sites to be used in different ways. Facebook has become the most popular way for ordinary users to share personal content with friends and family. Twitter, by contrast, is used in more impersonal ways. People use Twitter to see tweets from their favorite celebrities, journalists, and other public figures, to stay up to date on the news, and to share snarky insights into the news of the day.

This difference has had huge business consequences because the number of people who want to stay in touch with friends and family is vastly larger than the number of people who want to keep up with current events. Facebook had 1.49 billion monthly active users in June 2015 — more than four times Twitter's 320 million active users.

And while Facebook's audience is about four and a half times the size of Twitter's, Facebook's revenues are nearly eight times as large.

Twitter recognizes that this is an issue and has begun experimenting with new features to help casual users get value from the service. Earlier this year, the company added a "while you were away" feature to show a handful of popular tweets that were posted since your last login. A few weeks ago, Twitter introduced Twitter Moments, which presents curated collections of tweets about breaking news stories. Twitter is hoping features like this will jump-start the company's growth, but it's too soon to say if the strategy is working.

Twitter is falling behind other social media sites

By most standards, a company with 320 million users and more than a billion dollars in annual revenue is a big success. But Twitter became a publicly traded company in 2013, and so it faces pressure from Wall Street for continued growth.

Twitter hasn't delivered:

(Statista)

In 2012, Twitter added 66 million users for a growth rate of nearly 50 percent. In 2013, the company added 51 million users for a growth rate of 25 percent. In 2014, the company added 47 million users for a growth rate of 18 percent. Between March and June 2015, the company added a paltry 2 million users. Between June and September, Twitter only added 3 million additional users. (All of these figures ignore SMS-only users, which have been growing faster in recent quarters — but not that fast.)

Meanwhile, other social networks are passing Twitter in audience size. Instagram (which was acquired by Facebook in 2012) became larger than Twitter in late 2014. Snapchat is growing quickly and could surpass Twitter this year.

This is particularly problematic for Twitter because there are economies of scale in the advertising business. The largest internet companies — currently Google in search and Facebook in social media — can offer advertisers one-stop shopping and extremely accurate ad targeting, generating more revenue per user than a smaller service. Right now, 320 million users might seem like a lot, but in a few years it might not be enough to reach the top tier of social media sites.

Twitter is losing a lot of money

Twitter's stock price is below the level of its 2013 IPO. (MSN Money)

The pressure on Twitter to accelerate growth helps to explain an otherwise puzzling fact about the company: It's losing a lot of money. In 2014, Twitter lost $578 million, only a little less than the $645 million the company lost in 2013.

It shouldn't be difficult for a company with 320 million users to turn a profit. And indeed, Twitter took in $1.4 billion revenues in 2014, more than double 2013 revenues of $665 million. But the company's costs grew almost as fast. Twitter spent $692 million on research and development and $614 million on sales and marketing in 2014.

Twitter lost another $430 million in the first nine months of 2015 — almost as much as the $452 million the company lost in the same period in 2014.

Losses aren't necessarily a cause for concern if they reflect investments that will produce more rapid growth in the future. Twitter's problem is that it appears to be spending a lot of money on engineering and marketing initiatives that don't seem to be producing much growth.

Twitter is trying to improve its reputation among third-party developers

One of Twitter's strengths in its early years was a vibrant ecosystem of third-party developers. For example, when the iPhone ushered in the modern smartphone era in 2007, Twitter was relatively slow to introduce a mobile Twitter app. But luckily, Twitter was an open platform, and third parties stepped in to provide the mobile app customers demanded.

But everything changed in 2012, when Twitter effectively killed off third-party Twitter apps. It did this because the fragmentation of Twitter users across multiple apps made it harder for Twitter to provide a consistent user experience. Also, the popularity of third-party apps made it harder for Twitter to generate ad revenue.

But killing third-party clients had long-run costs. By souring third-party developers on the platform, Twitter deprived itself of an important source of new ideas for expanding the Twitter ecosystem. Now ideas for expanding Twitter have to come from Twitter itself. And in the past couple of years, these ideas have been few and far between.

Twitter's new CEO, Jack Dorsey, recognizes that this is a problem, and he's been working hard to win back developers' support. Last week, he publicly apologized for Twitter's previous behavior and asked developers to give him another chance.

People have a lot of ideas for fixing Twitter

As Twitter has posted quarter after quarter of poor financial results, a wide variety of people have weighed in with ideas for how the social media company can pull out of its current slump.

Focus on becoming more accessible. This is probably the most common suggestion, and it's the direction Twitter appears to be headed in. The basic idea is that ordinary users find today's Twitter confusing and overwhelming, and Twitter should work on ways to make the wealth of information it presents more accessible to casual users. For example, earlier this year investor Chris Sacca wrote a memo suggesting  that Twitter build a series of channels that allow people to quickly find information about particular topics, like a sports team, TV show, or election. Dorsey appears to have taken this suggestion to heart, as the recently introduced Moments feature does this.

Sacca also encourages Twitter to relax the assumption that tweets should appear in strictly reverse chronological order. Instead, when a user logs in, the platform should show a selection of the most interesting and insightful tweets that would have appeared on the user's timeline since the last check-in. Twitter took a small step in this direction earlier this year with its "while you were away" feature, but Twitter's interface is still fundamentally based on showing the most recent tweets.

The counterargument, which I made here, is that a more accessible version of Twitter already exists. It's called Facebook, and it's wildly popular. The danger is that aping Facebook might alienate existing users more quickly than it attracts new ones.

Refocus on third-party apps. Another option, promoted by analyst Ben Thompson, would be to build lots of different apps that allow people to interact with the Twitter platform in different ways. Different apps could target different types of users, with some offering advanced features to power users, while others provide casual users with simplified ways to extract value from Twitter's firehose of information.

The best way to do this would be to encourage third parties to build Twitter apps. But that's tricky because Twitter has burned a lot of bridges with developers since 2012. Dorsey's recent public apology to developers is an effort to repair these relationships and encourage more people to build for Twitter's platform.

Sell to Google. One of Twitter's most valuable assets is an unrivaled view into what's happening at this very instant. That knowledge could prove very useful to Google, whose mission is to "organize the world's information." Earlier this year Google and Twitter signed a deal to make it easier for Google to index tweets in real time. But if Twitter were a Google subsidiary, the search giant might find even more ways to extract value from this data — without requiring significant changes to the primary Twitter app.

The big problem here is that Twitter is probably too expensive. Twitter is currently worth about $20 billion, which is a lot of money even for a behemoth like Google. And Google may be able to accomplish many of the same goals at a small fraction of the price with the kind of strategic partnership the company signed earlier this year.

Just focus on power users. A final option, advocated by Vox's Matt Yglesias, is to simply accept that Twitter is never going to be a mass-market product on the scale of Facebook, and focus on serving the 320 million passionate users it has now as well as possible. This option would entail cutting back dramatically on research and marketing spending so that Twitter could earn a profit with limited revenue. The company might also focus more on selling premium ads targeted at its highly influential user base.

The problem with this option is that Wall Street would hate it. The company's current valuation of $20 billion is based on an assumption that the company will continue growing. Dorsey will face a lot of pressure to deliver on that expectation.


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