Twilio (NYSE: TWLO) isn’t a household name, but many of us unknowingly use it every day. The software company provides developers with an in-app communication solution. By integrating phone numbers and messaging communications, Twilio offers communication channels including voice, SMS, Messenger, WhatsApp, and even video.
When your Uber arrives and you receive a text, that’s Twilio. Airbnb uses Twilio to automate messages to hosts to alert them of a booking. eBay, Twitter, Netflix, Wix, Mecardo Libre each use Twilio in some form or other.
With in-app communications set to boom and Twilio the top dog in this space, is Twilio worth investing in? To answer this, I will use my blogging partner’s six-point investment framework to dissect Twilio’s growth potential.
1. Is Twilio’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Twilio recently surpassed US$1 billion in annualised revenue run rate in the third quarter of 2019. That’s tiny compared to its market opportunity. The CPaas (communications platform as a service) segment is forecast to grow from US$3.3 billion in 2018 to US$17.2 billion in 2023- a 39% annualised growth rate.
International Data Corporation said in a report that CPaaS companies are driving this growth by “integrating new segments, churning out new use cases, and piquing the interest of enterprise developers with innovative digital solutions for customer engagement.”
With the acquisition of SendGrid last year, through an all-shares purchase, Twilio added email communication into its array of products. SendGrid also brought with it 84,000 customers, giving Twilio a new base of developers to cross-sell existing products to.
2. Does Twilio have a strong balance sheet with minimal or a reasonable amount of debt?
Twilio is financially sound. As of 30 September 2019, it had US$1.9 billion in cash and marketable securities and around US$450 million in debt (in the form of convertible senior notes). That translates to a net cash position of around US$1.5 billion.
That said, Twilio’s cash flow from operations has been lumpy over the past few years as it chased growth over profitability or cash flow.
While its relatively large cash position should provide it with a buffer to last a few years, investors should continue to monitor how Twilio is using its capital.
Twilio already ended up having to issue new shares in a secondary offering in 2019 to raise money. This diluted existing shareholders, and current shareholders of Twilio should not rule out further dilution in the future.
The table below shows Twilio’s cash flow over the past four years.
3. Does Twilio’s management team have integrity, capability, and an innovative mindset?
Twilio’s founder Jeff Lawson has overseen the company from the start (the company was founded in 2008). As mentioned earlier, Twilio has a US$1 billion revenue run rate. That’s an impressive achievement, and a testament to Lawson and the rest of the management team’s ability to scale the company.
I also believe Twilio’s executive compensation structure promotes long-term growth in the company.
Lawson’s base salary in 2018 was only 2% of his target pay mix. 51% was in restricted stock units and the other 47% was in stock options. As the stock options vest over a few years, it encourages planning towards increasing shareholder value over the long term.
Lawson’s base salary of just US$133,700 in 2018 is also low in comparison to what other CEOs are getting.
So far, Twilio’s management has also been able to strategically acquire companies to expand its product offering and customer base. Its purchase of SendGrid brought with it email communication capabilities and more than doubled Twilio’s existing active users.
Twilio’s management has also taken the opportunity to raise more capital as its shares trade at relatively high multiples. This, to me, seems like a prudent move, considering that Twilio needs some cash buffer as it looks to grow its business.
Twilio is also proving to be led by innovative leaders as the company has consistently introduced new products. In 2018, Twilio introduced Twilio Flex, a programmable contact centre that integrates multiple tasks into a single user interface. Twilio Flex opened a new door of opportunity to tap into.
4. Are Twilio’s revenue streams recurring in nature?
Twilio’s enjoys a sticky customer base. Its existing customers have a history of becoming increasingly dependent on Twilio’s services over the years.
The communication software company’s net dollar base expansion rate, a metric measuring net spend by existing customers, was 132% in the quarter ended 30 September 2019. What that means is that existing customers spent 32% more on Twilio’s services in the last 12 months compared to a year prior.
More importantly, Twilio’s net dollar expansion rate has been consistently north of 100% for years. Its net dollar expansion rate was 140%, 128%, 161%, and 155% for 2018, 2017, 2016 and 2015.
The beauty of Twilio’s business model is that there are no built-in contracts. Customers simply pay as they use the company’s software. The more messages they send using Twilio’s API, the more Twilio charges them.
As customers such as Uber, Lyft, Airbnb grow their own customer base, the need for in-app messaging increases, and Twilio grows along with its clients. The model also allows small enterprises to start using Twilio at the get-go due to the pay-as-you-go model.
It is also heartening to see that there is little concentration risk as the top 10 accounts contributed around 13% of Twilio’s total revenue in the most recent quarter.
5. Does Twilio have a proven ability to grow?
With a steady base or recurring revenue, Twilio has been able to focus its efforts on expanding its services and winning over new customers. Its customer account has risen more than six-fold from 2013 to 2018.
The growth in customer accounts is also reflected in its financial statements. Revenue increased from below US$100 million in 2013 to more than US$600 million in 2018.
That growth still has legs to run with base revenue (excluding the impact of its acquisition of SendGrid) in the first three quarters of 2019 increasing by 47% year-on-year.
6. Does Twilio have a high likelihood of generating a strong and growing stream of free cash flow in the future?
While Twilio’s topline has shown impressive growth, it has neither been able to generate consistent profit nor free cash flow.
Twilio has been spending heavily on research and development and marketing. In fact, the company has consistently spent around a quarter of its revenue of research and development.
However, I believe that there is a clear path towards profitability and free cash flow generation, as Twilio can eventually cut back its R&D and marketing expenses.
That being said, the company is still laser-focused on top-line growth at the moment and consistent profitability and free cash flow generation may take years.
Risks
One of the big risks I see in Twilio is succession risk. Lawson is the biggest reason for Twilio’s success so far. He is the founder and has led Twilio every step of the way.
That said, Lawson is only 42 this year and is likely to continue at the helm for the foreseeable future.
I also believe that the high cash burn rate is still a concern. Investors should keep a close watch on Twilio’s free cash flow levels and hopefully, we can see it turn positive in the coming years.
Twilio also faces competition that could eat into its market share. Its competitors such as Nexmo, MessageBird, and PLivo are also growing quickly. Twilio will need to consistently upgrade its APIs to ensure that it defends its competitive edge. For now, Twilio’s competitive moat includes the high switching cost to a competitor.
Twilio also enjoys a network effect. In its 2018 annual report, Twilio said:
“With every new message and call, our Super Network becomes more robust, intelligent and efficient…Our Super Network’s sophistication becomes increasingly difficult for others to replicate over time as it is continually learning, improving and scaling.”
Valuation
Valuing a company is always tricky- especially so for a company that has no profits or consistent free cash flow.
As such, we will need to estimate what is the company’s long term growth potential and mature-state profit margins.
While some best-in-class SaaS companies enjoy profit and free cash flow margins of around 30%, that does not seem feasible for Twilio.
Twilio’s gross profit margin is only around 54%, much lower than other software companies such as Adobe which has a gross margin north of 80%. As such, I think that Twilio’s steady-state profit margin could potentially be closer to 10%.
Given the total addressable market of US$17 billion, and assuming Twilio can achieve a market share of around 50%, revenue can increase to around US$8 billion. Using my 10% net profit assumption, net profit will be around US$800 million. If growth can sustain at current rates of around 35%, Twilio will take around seven years to hit this size.
We also have to estimate a reasonable multiple to attach to its earnings. Adobe has a price-to-earnings (P/E) ratio of 58 but it is still growing. Let’s assume a discount to that multiple and assume Twilio can command a P/E ratio of 40. That translates to a US$32 billion market. Given all these assumptions, Twilio will have a market cap that is twice its current market cap in seven years, which translates to a decent 10% annualised return for existing shareholders.
The Good Investors’ conclusion
There are certainly compelling reasons to like Twilio as a company. Its 40%-plus top-line growth, huge market opportunity, dominant position in the CPaaS industry, and capable management team, are just some of the reasons why I think Twilio has a bright future ahead.
However, its stock is richly priced, trading at more than 16 times revenue. It has yet to record a profit and has been burning cash. There is a lot of optimism baked into the stock already and the company needs to live up to the high expectations if investors are to make a decent annualised profit from the stock.
While my valuation assumptions predict a decent return, there are certainly risks involved. Any stumble in those growth projections or an earnings multiple compression will result in mediocre returns to investors. I suggest that investors who want to take a nibble off of Twilio’s growth should size their position to reflect the risk involved.
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