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Twitter's Lack of Diversification Looms as a Key IPO Risk

Stocks in this article: FB GS

NEW YORK ( TheStreet) -- The power of Twitter's platform and its value to users may be unimpeachable; the company's business model isn't.

As Twitter braces for an initial public offering of its stock, the company has built an impressive and fast-growing stable of users on the micro-blogging site. However, Twitter's highly concentrated advertising-based earnings loom as the crucial risk for investors to weigh.

Meanwhile, investors might want to consider the fast growth that Twitter reported in its Thursday S-1 filing with the Securities and Exchange Commission as more of a risk than a positive for the company. Much of Twitter's business model and earnings streams remain unproven, even as revenue at the company is set to exceed $500 million this year.

Investors should think carefully about whether Twitter will be able to generate sustainable earnings from its near-quarter billion member social network as the company's stock listing looms.

Virtually all of Twitter's revenue comes from advertisers and in the form of three sources: Promoted Tweets, Promoted Accounts and Promoted Trends. If those forms of advertising prove ineffective or are overtaken by competitors, Twitter may find itself at a loss to maintain or grow its business.

Worse yet, the company has few long-term revenue streams to cushion itself from an economic downturn or changes to the online advertising market.

"As is common in the industry, our advertisers do not have long-term advertising commitments with us," Twitter said in its IPO filing.

"If we experience a decline in the number of users or a decline in user engagement, including as a result of the loss of world leaders, government officials, celebrities, athletes, journalists, sports teams, media outlets and brands who generate content on Twitter, advertisers may not view our products and services as attractive for their marketing expenditures, and may reduce their spending with us which would harm our business and operating results," the company added.

To maintain or grow its ad dollars, Twitter may also have to prove the relevance of its advertising product. Are firms getting their bang for the buck by spending their ad budgets on Promoted Tweets? How will Twitter explain firms' return on investment as a means of locking up long-term business? Those issues remain open.

Consider Twitter's accelerating revenue growth. On one hand, that may signal to potential investors in Twitter that the company will soon be able to scale its business profitably. Taken another way, however, may raise new question marks.

Twitter's revenue was a mere $28 million in 2010 and it was just over $100 million in 2011. Last year revenue tripled to over $300 million, and those sales are poised to double in 2013.

Most of Twitter's revenue growth has come from the launch of its advertising products.

Twitter released its Promoted Tweet product in 2010 and moved those into user timelines in 2011. Last year, Promoted Tweets were released on Apple (AAPL) and Google (GOOG) Android mobile products. This year the company launched keyword targeting, a search product, and Twitter Amplify to timelines. As a result, Twitter's advertising revenue has grown from a mere $7.3 million in 2010, or about a quarter of overall sales, to $221 million, or nearly 90% of sales, in the first six months of 2013.

Those kinds of growth figures are tempting, until one considers the reach of Twitter's platform.

Currently, Twitter advertises that it has over 215 million monthly active users (MAUs) and its stable of users send out over 500 million tweets a day. That means nearly 200 billion Tweets are sent out a year.

Do Twitter's current revenue figures reflect a proven return on advertising dollars, or do they reflect experimental use by corporations around the world who are are interested in the site as a new part of their advertising budgets?

It remains unclear whether Promoted Tweets and the like will have any lasting traction with advertisers. The vast majority of Twitter's sales also come from U.S. markets. Can the company grow internationally?

Twitter as a media, communications and networking platform appears to have strong prospects in growing its overall users and engagement. The company had 218.3 million average MAUs in the three months ended June 30, a 44% increase from year-ago levels. As Twitter expands internationally and Internet connectivity and smartphone usage grows around the world, it is easy to see the company's platform continue to grow.

But Twitter generates virtually no revenue from its users. Eighty-seven percent of the company's revenue comes from advertisers who have total discretion over their spending on any given day. Twitter's blue bird is an increasingly iconic brand, however, it also may be indicative of the flightiness of the company's business model.

As investors study Twitter's IPO filing and consider the pricing terms that underwriter Goldman Sachs eventually discloses, they should think of Twitter in the terms of the wider advertising market where publicly traded firms such as Facebook (FB), Pandora (P) and LinkedIn (LNKD) also have a large presence.

Twitter very well could be a far more powerful media and communications platform than Facebook or LinkedIn and still see its business model fail to achieve the financial success that some might imagine.

Before investing in Twitter, investors should make sure they understand and believe in Twitter's advertising model. As Twitter goes public, it's no longer just about the power of the company's platform.

-- Written by Antoine Gara in New York.

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