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Twilio: Undervalued With Some Risks

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About: Twilio Inc. (TWLO)
by: Stefan Ong
Summary

Twilio has fallen roughly 25% since its 52 weeks high.

However, Twilio has maintained high sales growth in recent quarters.

Twilio is slightly undervalued by 15% based on my estimates.

Twilio's (TWLO) stock price has fallen roughly 25% from its 52-week high, mostly due to multiple adjustments. Despite the big drop in share price, I believe that Twilio is a market leader in the Communications-Platform-as-a-Service (CPaaS) space with a growing brand name and switching costs. At $111, it is also reasonably priced with a potential upside of 15% based on my valuation estimates.

(Source: Google)

Twilio had another great quarter

Twilio celebrated a milestone in the recent quarter, crossing a $1B annualized run rate for the first time with total revenue of $275M and exceeding management's guidance of $265M. This growth was mainly fueled by SendGrid, which contributed $46M during the quarter. Twilio remains focused on growth, as seen from their transcript:

We remain focused on revenue growth in gaining market share as we have since going public.

(Source: Twilio Q2 Transcript)

The acquisition of SendGrid has improved Twilio's gross margin profile from 55% to 59%. Moreover, there is still a long runway for Twilio to invest in its business. Twilio puts its total addressable market at $66B after the SendGrid acquisition. At its current revenue run-rate of roughly ~$1B, it has penetrated only roughly 1.5% of its total addressable market.

(Source: Twilio Presentation)

Twilio has also been reducing its customer concentration. Twilio's 10 largest customers contributed 18% of revenue in 2018, compared to 30% in 2016. For WhatsApp, the revenue contribution decreased from 9% in 2016 to 7% in 2018. This reduces the risk of large customers switching away from its platform. It also highlights that Twilio's platform is capable of attracting broad-based usage from a wide customer base.

Twilio is growing its brand and switching costs

As stated in its prospectus, Twilio's main strength is developer mindshare. With the growth of software developers, they will potentially have more influence over IT budgets. Hence, Twilio's developer-first approach will likely provide some brand-name advantage against its competitors. Twilio's brand has enabled it to add over 7,000 customers this quarter. Total customer count is now roughly 161,000 compared to roughly 75,000 a year ago, with SendGrid contributing roughly 74,000. Net dollar expansion rate also came in at 140%, which has stayed above 130% since 2015. This highlights that developers are staying with Twilio, despite increasing competition.

(Source: Twilio 2017 Analyst Presentation)

Once companies use Twilio's services, it would become increasingly difficult for most to switch even if other companies compete on price. Most companies would not want to distract developers with new systems, which would lead to lost productivity. Furthermore, Twilio also uses its own markup language TwiML, which increases the difficulty of switching to other CPaaS platforms.

Twilio's super network also contributes to its switching costs. Twilio has almost ten years of data and monitors millions of data points per day to optimize its software to make the best routing decisions for customer calls. To enable this network, Twilio strategically built out its global infrastructure and operates 27 cloud data centers in nine geographically distinct regions. Despite the rise in competition, it would likely be difficult for other companies to replicate this super network globally.

Investment risks

Twilio's revenue is primarily usage-based. This puts Twilio at the mercy of network providers and future price increases. Twilio has been working hard to diversify away from this segment, with the introduction of Flex and Authy in its engagement cloud. This would allow Twilio to shift more toward higher-margin software and away from usage fees. However, it is still a relatively small component of revenue, and it remains to be seen if Twilio can grow this segment at scale.

(Source: Twilio 2017 Analyst Presentation)

Moreover, traditional voice and SMS messaging are declining as seen from the rise of WhatsApp, Messenger, and WeChat. In 2017, application services only make up 9% of total revenue. Twilio has to quickly diversify away from voice and SMS or it faces the risks of future declining revenues.

(Source: Twilio 2017 Analyst Presentation)

Twilio is slightly undervalued

To value Twilio, I used a DCF model with the following assumptions:

1) Revenue growth at 45% for the next five years, then dropping to 2% in perpetuity starting from the year 2025. The high growth rates in the first five years reflect Twilio's lead in the CPaaS space as well as its ability to cross-sell its solutions like SendGrid. Coupled with low penetration in its current TAM, Twilio should be able to execute high sales growth for at least the next five years. However, Twilio will likely face competition from companies like Bandwidth (BAND) and Nexmo to name a few. If Twilio is unable to differentiate itself and convince its developer-customers to stay with its platform, they might experience lower sales growth in the next few years.

2) Operating margin of 20% from 2025 onwards. This is in line with Twilio's long-term margin profile. Twilio actually expects 20%+, but to account for potential price competition, I will be using 20%. Twilio has been focusing on growth in recent quarters and will likely be able to optimize for higher gross margins from its current 59% in future years. However, if competitors are able to develop innovative communication solutions at a lower price, there would be some downward pressure on Twilio's long-term margins.

(Source: Twilio 2017 Analyst Presentation)

3) A sales-to-capital ratio of 2 is in line with its software peers. Developing software is not capital-intensive, so I estimate Twilio will be able to generate $2 of sales with every $1 in incremental capital.

4) Twilio has an initial weighted cost of capital of 9.13%, which drops to 8% in the terminal year. The higher cost of capital reflects the higher risk of Twilio having negative cash flows and losing money. However, once the company achieves profitability and higher free cash flows, the risk should be reduced as reflected in the lower cost of capital.

(Source: Author creation using Twilio financials)

The value I derived for Twilio is roughly $16.4B for the entire company. This represents a 15% upside from its current price. As with all DCFs for high growth and money-losing companies, my point estimate valuation of $127 is likely to have a large spread of possible outcomes. To overcome this shortcoming, I compare its pricing multiples against similar software companies.

Companies Price/Sales EV/Sales 3Y Sales Growth (%) Operating Margin (%)
Twilio 14.1 15.8 57 -28.4
Bandwidth 8.4 7.9 14 -6
Splunk 7.9 7.8 40 -12
ServiceNow 15.6 15.6 37 -1

(Source: Author creation from Gurufocus)

Compared to its direct peer Bandwidth, Twilio trades at much higher multiples. However, the higher multiples are justified, given that Twilio is growing at a much higher rate. Compared to other software companies, Twilio seems to be more expensive, given that it is losing much more money than Splunk (SPLK) and ServiceNow (NOW). Nevertheless, Twilio is growing faster than them, so the higher multiples may be justified if Twilio is able to keep up its high growth rates in the next few years.

Potential investors have to decide if they believe Twilio will be able to differentiate itself in the long term and steer away from competing solely on price. If so, Twilio's recent pullback makes it a good time to buy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TWLO over 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.