|Shares Out. (in M):||69||P/E||0||0|
|Market Cap (in $M):||2,999||P/FCF||0||0|
|Net Debt (in $M):||200||EBIT||0||0|
|TEV (in $M):||2,799||TEV/EBIT||0||0|
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Sorry wrote this before the jump, but thesis has not really changed.
On the surface Twilio doesn’t look like a regular “value” stock in our portfolios. We may even get accused of abandoning our value investing discipline with this purchase. Twilio is only ten years old. It went public just a few years ago. It has been losing money and is expected to only break even in 2018. Due to a lack of 2018 earnings, it trades at the dear valuation of price to infinity.
We were studying and thinking about this company for seven months before we pulled the trigger on the purchase. Vitaliy traveled to San Francisco for the company’s investor-day presentation in October and met with Twilio’s management.
Twilio is both a software and a communications company. Its founder, Jeff Lawson, is a serial entrepreneur. In his last two adventures he was chief technology officer at StubHub – the eBay of concert tickets (later actually purchased by eBay), and then he was employee number two at Amazon Web Services.
What Twilio has done is truly incredible. It created switching software, put that software into the Amazon Web Services cloud, then built a global telecommunications network in 100 countries that it connected via its software switches. Then it went to software developers and offered the ability to integrate calling or texting into their applications. This doesn’t sound like a big deal, except that in the past, companies wanting to do this had to spend hundreds of thousands if not several million dollars on expensive switching equipment. Twilio provides developers with an API (application programming interface) for various phone and texting functions, and voila, a developer can integrate call and text functionality into an app, and their initial cost is … nothing. Once their application is rolled out and the calling and texting functionality is used, Twilio is paid per minute of talk time or per text sent/received.
This very unorthodox strategy for bringing its product to market, created a loyal following of almost two million software developers (up from a million developers a year ago) who are finding new ways to integrate Twilio’s functionality into applications they are building.
Even if you have never heard of Twilio you have probably used their technology. If you have taken Uber or Lyft, the call you made to the driver went through Twilio. Neither Uber nor Lyft wants the driver or the customer to know each other’s phone number. Therefore, when you click the call button within the app, you call TWLO’s (software) switchboard, which instantaneously masks your, and the driver’s, phone numbers with temporary phone numbers. That little masking trick, which would be almost impossible to do on a non-cloud platform, allows the driver-client relationship to be limited to only the duration of the trip.
Twilio's combination of a global network and the software switching in the cloud allows developers do things with voice communication that were unimaginable before.
Phone communication has changed a lot since Alexander Graham Bell made the first call in 1876 to his assistant. Switchboard operators were replaced by digital switches. Analog calls were digitalized and turned into packets that travel through fiber optic lines. You are no longer tied to a ten-foot-long phone cord; today you can make phone calls in your car traveling 80 miles an hour.
Despite all these incredible transformations, one thing has changed very little: When you dial a phone number there is little or no context associated to your dialing intent. If you are calling your mother there is no context needed – love is the context. However, if you call an airline or local utility company, this call carries very little context with it. These companies usually don’t know who you are, and even if they recognize your caller ID, they have no idea why you are calling. You have to navigate a myriad of menu options, which is very time-consuming and unpleasant experience. Every time we call a large company we experience the anxiety of not knowing how long it will take to get to the right person – or whether we’ll connect with a person at all.
A bank can embed the Twilio calling feature into its mobile app or its website. Then when a call is made, the customer is automatically forwarded to the right department based on their specific information (language preference, importance to the bank, location, etc.); and since each screen of the app has a call button, the bank knows what issue (which screen) triggered the call. There is no need to provide account information – the bank has all this information because the call is made from the app. The customer service experience is exponentially better – no menus.
In addition to making customers happy, Twilio saves the bank a lot of money because it’s able to provide better customer service with fewer people. No need to spend person hours just to connect customers to the right person at the company. Also, the few minutes it takes to authenticate the call (“Please give us your account information and your mother’s maiden name”) are not needed. These few minutes of savings per call event … you get the point. The savings are enormous.
The number of use cases of Twilio’s smart communications is limited only by our imagination. Morgan Stanley uses Twilio to allow 16,000 advisers to communicate (mainly by texting) with their clients from the Morgan Stanley app while keeping a record of their communications for compliance purposes. Companies that write software for doctor or dentist CRMs integrate Twilio texting capability to automatically text clients to remind them of their appointments. Coca Cola in Europe uses Twilio to alert its drivers when vending machines are running low on its products. The internet of things is another huge potential market for Twilio.
Twilio basically invented the smart cloud communications market. In the beginning, Twilio’s competitive advantage was its network. Twilio named its network "Super Network", and quite deservedly so: It uses software to route traffic through hundreds of telecom providers globally. If a telecom provider experiences a technical problem (a line gets accidently cut), Twilio software automatically reroutes traffic through another provider’s network. Twilio’s network is more reliable than the networks of individual telecom providers it uses. Thus Super Network!
As the company grew larger its success attracted competition. Though Super Network is an important asset, it is not enough to protect Twilio from current and future competition. Twilio is using its first-mover advantage to increase its moat by outspending the competition on R&D. In 2017 Twilio spent about $100 million on R&D, which is 50-100 times more than its largest competitors spent. Twilio’s R&D adds additional functionality, making its communication cloud smarter and its moat wider. Once customers start using Twilio they rarely switch. Twilio’s annual customer retention numbers are astounding: 97% (they lose only 3% of their customers a year).
Twilio’s unorthodox strategy of marketing to developers (not chief technology officers) allows Twilio to spend a fraction of what other software companies spend on marketing and customer acquisition.
We really like Twilio’s management. Jeff Lawson, the company’s co-founder and CEO, reminds us of Amazon’s Jeff Bezos. This is not just because his name is Jeff and he is bold, but because he has instituted a frugal culture at Twilio (uncommon for San Francisco startups) and he is focusing on building for the long term at the expense of current profitability. We are not concerned about Twilio’s lack of earnings. It is going to break even in 2018, and it has no debt and $200 million of cash on its balance sheet.
An opportunity to buy Twilio stock came thanks to Uber. At the end of 2016 Uber was Twilio’s largest customer, representing close to 17% of Twilio’s sales – Uber was spending close to $50 million with Twilio. Then Uber diversified its spending across Twilio’s competitors, and its spending with Twilio dropped to around $20 million (or about 5% of Twilio’s revenue). This development unnerved Wall Street, and Twilio’s stock fell to half of its post-IPO high. We are not overly worried about this: Uber is very sophisticated software company, and thus it had the unique knowhow to pull this switch. We were impressed that despite Twilio’s largest customer going from 17% of revenue to 5% within a year, Twilio was still able to maintain revenue growth of over 50% (excluding Uber, revenue growth was 63% in the last quarter).
Twilio exemplifies the expression “There is value in growth.”
The value in Twilio lies in its ability to grow at a high rate. What gives us the confidence that Twilio will be able to sustain its high growth rate? Smart communication looks to us like an unavoidable, highly useful and desirable future, just as search was the future of advertising 15 years ago. We don’t think Twilio will be the only player in the smart communications arena that will carve out a meaningful chunk from the half a trillion dollars spent on (dumb) communications globally, but it will be a very large player. The beauty of Twilio’s business model is that it has an incredibly high recurrence of revenues. For instance, Morgan Stanley advisors will be using it for a long period of time, and as their usage of Twilio functionality increases, so will Twilio’s revenues. Also, other financial firms will look at what Morgan Stanley did and they’ll copy it – new customers for Twilio.
In our analysis we look at Twilio at least five years out. As revenue continues to march higher, costs will also grow, but the growth rate of expenses will start to lag revenue growth. R&D, sales, and administrative expenses will turn from variable costs into semi-fixed costs, and thus Twilio’s profit margins will start to expand; and then, suddenly, Twilio’s earnings will follow a hockey-stick trajectory. (This is why there is value in growth). We ran multiple scenarios, and we get 2022 earnings from $3-$5 a share– our value for Twilio five years out is somewhere between $60 and $150.
So where is the margin of safety in Twilio? If we grow Twilio’s revenue 50% (remember, excluding Uber the latest growth rate was 63%) and then 20% for four years, we get revenue of $1.1 billion. Software companies rarely trade at less than two times revenue, or about $2.2 billion dollars – which is Twilio’s current valuation. Voila – our margin of safety.
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