Twilio: Growth Isn't Everything Anymore

About: Twilio (TWLO)
by: Gary Alexander

Twilio's shares skidded ~5% after reporting Q4 results. Though growth smashed Wall Street's estimates, earnings were only in line.

A robust January/February rally has ballooned Twilio's market cap to nearly $12 billion. In the year-to-date alone, Twilio is up 32%.

Twilio trades at a ~10.5x forward revenue multiple, which is steep for a company with relatively poorer gross margins compared to the rest of the SaaS sector.

While Twilio's growth trajectory is certainly rapid (especially with the tuck-in of SendGrid), investors will need more FCF/bottom-line justification for the stock to continue rallying.

After rallying sharply throughout the beginning of 2019, PaaS software titan Twilio (TWLO) is finally taking a small breather. The company reported a mixed Q4 (with incredible growth soaring past Wall Street's estimates, but EPS results that were only in-line), but shares fell more than 5% in after-hours trading, breaking the company's recent earnings streak.

Chart Data by YCharts

Investors may be wondering: what's going on with Twilio? For the past several months, the discussion has been all about growth: Twilio dominates the CPaaS market and despite losing "anchor" clients like Uber and WhatsApp, Twilio has been able to achieve stellar top-line acceleration thanks to the addition of new products like Twilio Flex, a build-your-own customer contact center. There's no doubting that Twilio is one of the best growth stories in the SaaS sector - this quarter, revenue growth improved nearly ten points sequentially.

Twilio's massive growth, however, seems to no longer support its ballooning stock price. Increasingly the margin discussion comes back to the fore: since its inception, Twilio has always performed at a gross margin in the mid-50s (below that of its peers; most SaaS companies operate at 70-80% gross margins). Yet Twilio has always enjoyed a premium valuation. Without bottom-line and free cash flow support, it seems that Twilio's valuation has reached a near-term ceiling.

A quick update on where Twilio is currently trading: at the company's current share price of ~$111, Twilio has a market cap of $11.53 billion. After netting off $748.3 million of balance sheet cash and $434.5 million of convertible debt, Twilio has an enterprise value of $11.21 billion. Here's how that stacks up to the company's latest guidance outlook for FY19:

Figure 1. Twilio FY19 guidance Source: Twilio Q4 earnings release

Against this revenue outlook, Twilio trades at a steep 10.5x EV/FTM expected revenues, which is incredibly elevated considering Twilio's gross margin deficiency relative to peers. In addition, note that next year's forecast calls for barely any operating profits.

Twilio has a lot of positives going on for it - it has still virtually cornered the CPaaS market, and the use cases for Twilio's flagship product are so broad that the risk of meaningful near-term deceleration is low. However, the company seems to have run up against its valuation limits. Unless the profitability story improves, Twilio stock will continue to trade sideways.

At best, Twilio is a hold. I'd prefer to stay on the sidelines until a more attractive entry point avails itself.

Q4 download

Here's a look at Twilio's latest fourth-quarter results:

Figure 2. Twilio 4Q19 results

Source: Twilio Q4 earnings release

The standout result of this quarter, as always, was revenue growth. Revenues jumped 77% y/y to $204.3 million, absolutely crushing Wall Street's estimates of $184.5 million (+60% y/y) by a double-digit margin. Note that the SendGrid acquisition closed in Q1, so this growth was purely organic - beginning next quarter, SendGrid's revenues will be folded into the total.

It's worth noting that Twilio outperformed substantially on base revenues as well. Base revenues saw the same 77% y/y growth to $186.2 million, again far surpassing Wall Street's target of $174.4 million. As can be seen in the chart below, base revenue growth has seen multiple quarters of strong acceleration:

Figure 3. Twilio key metrics

Source: Twilio Q4 earnings release

For Twilio, the mix of base revenues is of critical importance, due to base revenues having a locked-in contractual minimum (whereas the large legacy accounts like Uber had no such minimums, making their revenue contributions more unpredictable).

Another standout result was on dollar-based net retention, which clocked in at an impressive 147% this quarter (from 118% in the year-ago quarter). Recall that many software companies, notably Cloudera (CLDR), struggled with retention last year due to sales org reshuffles, and investors have paid great attention to retention as returning customers are far more profitable than new customers. What Twilio's vastly expanded retention rate is telling us is that new products, such as Flex, are having strong attach rates to the existing installed base. Twilio's ability to innovate in new product lines has been instrumental in widening its TAM and contributing to its ever-expanding top-line growth.

Unfortunately, however, Twilio's standout top-line results have only trickled slightly into bottom-line strengths. Take a look at the chart below:

Figure 4. Twilio margin trends

Source: Twilio Q4 earnings release

As can be seen in the chart above, Twilio's pro forma gross margins saw barely any expansion from the year-ago quarter, stuck firmly in the mid-50s. Twilio did manage to achieve operating margin growth, but primarily by sacrificing research and development spending. As a percentage of revenues, R&D dipped five points to 18%.

Slimming down Twilio's cost structure is always a positive no matter which bucket it falls into, but we'd prefer to see the reduction in sales and marketing. Offsetting the benefits seen from the R&D reduction is a three-point increase in sales and marketing as a percentage of revenues, which tells us that sales efficiency is getting worse. Twilio's growth rates have been astounding, but the company has been pushing the gas pedal on sales in order to achieve it. As a result, Twilio's operating margins are still roughly flat.

As previously mentioned, pro forma EPS of $0.04 came in-line against Wall Street's expectations, which investors balked at. The fact that Twilio managed to beat revenue by such a large spread, but only come in-line on EPS, suggests that operating margins came in much lower than expected. Note also as well that for the full year FY18, Twilio only saw minimal improvements in operating cash flows:

Figure 5. Twilio cash flows

Source: Twilio Q4 earnings release

Key takeaways

There's no doubt that Twilio's place as a leader within the CPaaS niche is secure. In recent quarters, Twilio has extended its dominance by offering its developer tools in tertiary areas like Flex, a success that is clearly marked in Twilio's incredible revenue retention rates and top-line growth. However, with Twilio stock trading at a double-digit forward revenue multiple, the company is essentially priced for perfection. At a >$1 billion revenue run rate for next year, Twilio is still unprofitable on a GAAP basis and generating barely any free cash flow - which will make investors think twice about investing in this stock at a sky-high valuation multiple.

In my view, investors are better off staying on the sidelines until Twilio's stock sees a more pronounced drop.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.