Description

Twilio has fallen along with all the other hypergrowers and is now trading at a very attractive valuation. Investors have indiscriminately punished companies including Twilio that are currently unprofitable. However, management has indicated that they have achieved the desired level of scale and is working on reaching non-gaap profitability in 2023. Profits could quickly grow along with revenue as the economy of scale kicks in and we should see the stock price shoot meaningfully higher from the current level.  

Description of Business 

Back in the old days, getting business telephone services means that companies had to work with local telephone carriers in a slow process. Companies bought on-premise hardware and their IT departments had to do all the maitenance work. This process required not only heavy capex on the communication equipment such as phones and switches but also IT personnel on maintenance. Then came Twilio. It offered software-defined voice capabilities so companies could almost instantly start using voice without buying and managing its own hardware.Next, Twilio broadened its offering to include text so software developers could effortlessly offer text capabilities on a global scale in their application by accessing Twilio’s text API with only a few lines of code.

The growth has been amazing. Revenue grew from 277m in its IPO year 2016 to 2.8B in 2021. Its customer base has grown from 36K to 256K during the same period. Net-dollar retention is consistently over 120%. A well-known early-day customer of Twilio was Uber. Uber had heavily relied on Twilio’s capabilities to send messages between drivers and riders. Of course, we all know that Uber later stopped using Twilio and caused a big headache for Twilio’s share price. However, years of outstanding growth have proved that Twilio does not rely on one single client. Twilio’s top 10 customers combined only account for 11% of the total revenue in 2021. Among the top customers are Facebook messenger/WhatsApp that employ Twilio’s API to send text messages between its billions of users. Today, through its own R&D effort and acquisitions, Twilio has broadened its technical offerings to include the full spectrum of communication covering voice, text, e-mail, video, and live. Additionally, Twilio has moved up the ladder by offering solutions such as contact center and CDP(customer data platform) on top of its technical offerings.

Competitive advantages:

Twilio has worked with hundreds of carrier networks around the globe to built a layer of software called the Twilio Super Network. The Twilio Super Network empowers any developer to reach almost anyone and everyone in the world via voice or text with only a few lines of code and minimal effort. Newer offerings for email, video, live, and broadcasting has solidified Twilio as the go-to place and one-stop shop for software developers’ communication needs. With its easy-to-follow tutorials and well organized documentation, Twilio has built a strong reputation among devs as a trusted technology platform. Twilio is not for companies that want an out-of-the-box pre-packaged solution but the number one choice for companies that want to quickly build out their own customized digital experience for their customers. 

Recently, Twilio has expanded its offerings beyond the tactical communication solutions. Its latest acquisition of Segment, a leader in CDP, will enable Twilio to move further up the tech stack of its customers. Segment pipes all interactions between an organization and its customers across all communication channels into a single depository so businesses can have a holistic view of its customers. It helps companies own their first-party customer data in a centralized fashion, accurately create customer personas, and interact customers in a personalized way, resulting in increase in customer satisfaction and LTV. In a post-cookie and privacy conscious world, leveraging first party data has become a priority for many and I see the combination of Twilio and Segment will have tremendous synergies. If traditional Twilio products help solve the problem of delivering the message, then Segment will help with the problem of crafting the message.   

Competition

According to its 10-K, Twilio competes with 4 types of competitors: “legacy on-premises vendors, regional network service providers that offer limited developer functionality on top of their own physical infrastructure;smaller software companies that compete with portions of its product line; and,SaaS companies and cloud platform vendors that offer prepackaged applications and platforms.”

I believe as businesses move further into a software-defined and cloud-based world, legacy on-premise hardware vendors will continue to lose share. Another type of competitor, companies like Bandwidth(BAND), own its own infrastructure and offer a cheaper solution than Twilio.  However, the initial cost difference would be barely noticeable for small companies and start-ups because total cost, charged based on usage, is usually low upon sign-up. These small-scale companies would much prefer to pay a bit more for the easy-to-use and highly customizable features offered by Twilio to innovate faster. For big corporations, unless they are tech-savvy and committed to using their own software engineers to own this functionality, Twilio is almost always a much better choice. Neither am I worried about the competition from smaller software companies because Twilio has spent heavily on R&D to stay at the edge of innovation. Lastly, while some business buyers prefer pre-packaged SaaS solutions, other companies prefer highly customizable and flexible modules from Twilio to build out their own applications.  To reach out the buyers of off-the-shelve solutions, Twilio has also started working with IT consulting firms that will use Twilio's technology in turn-key solutions for companies.

Why does the opportunity exist today?

First, we have the broad tech sell-off that indiscriminately punishes high growth companies that have yet turned profitable. 

Variant opinion: Management has stated that they have reached the desired scale and now the goal is to leverage the scale to obtain non-GAAP profitability in 2023.

Second, highly regarded long-time COO Goerge Hu,who previously helped Salesforce scale, resigned. Investors worry this change could indicate Twilio’s future growth would slow down.

Variant opinion: CEO and founder Jeff Lawson clarified in an investor event later that Hu’s decision has nothing to do with the fundamentals of the company. Hu decides to resign because he wants to take a bigger role but Lawson is not ceding the CEO role. Twilio’s future growth is very likely intact as management sounded very confident about its growth over the next few years.

Third, gross margin declined in Q4. 

Variant opinion: a big portion of the decline was due to an increase in the A2P(application to person) 10DLC fees charged by its US carriers partners on its network. Although Twilio passed through the charges to its customers, mathematically these passthrough only revenue depressed its gross margin. As Twilio’s application services with gross margins in the 70-80% level, such as contact center, email, and Segment, start to make a more meaningful contribution to revenue, the company should be able to achieve its long-term 60%+ gross margin. 

Valuation:

The company at the end of 2021 has 174m diluted shares. Dilution from SBC has been running at about 5m or 3% per year in the last 3 years. It has about 4.35B net cash and over 1B of tax loss assets. Putting a conservative revenue growth estimate of 30% over 2021’s 2.84B, I get 2022 revenue of 3.69B. I believe this is highly achievable because of the company’s past performance and its own 2022  Q1 revenue growth forecast of 46% with 33% organic revenue growth. Although still unprofitable, the company had only 58m net cash outlay  and about 100m capex spend in 2021.

Twilio is not a newly IPOed software company with questionable growth in a post pandemic world. It is a category leader with consistent growth north of 30% since its IPO in 2016. If we believe management’s goal of achieving long-term non-gaap operating margin of 20-25%, at 5.4X 2022 P/S net cash of 4.35B, the valuation translates to about 22-27X non-GAAP operating income. I have chosen to use 2022 P/S instead of NTM P/S to be extra conservative. Tax assets are also not included in the calc. Twilio has rarely traded at such low valuation during its lifetime as a public company. While I have no idea how much lower it will go during the current downturn, I believe in the long term(3-5 years out) this stock will generate great returns for investors. 

Catalyst

Growth

Reaching profitability

Improvement in gross margin

Segment acquisition meaningfully contributes to revenue