With an organic growth rate of 47% in 2019, Twilio Inc. (NYSE:TWLO) is one of the few investment opportunities that investors can buy into at a reasonable price. Twilio provides cloud-based communications APIs, often referred to as Communications-Platform-as-a-Service (CPaaS). This market segment is a gold rush as enterprises warm up to digital transformation.
In addition to strong revenue growth, the company has a strong dollar-based net expansion of 135% for FY'19, fairly consistent with the past.
I believe that Twilio is fairly valued based on relative valuation to its peers. This company also fulfills the software Rule of 40 which puts it in the upper level of companies for financial health. All in all, I believe that Twilio warrants a bullish rating. There are some investment risks that I will highlight later on that prevent me from awarding a very bullish rating.
I determine stock valuation on a relative basis by comparing sales multiples and sales growth to the company's peers. I believe that high-growth companies should be more highly valued than slow-growth companies. After all, growth is a prime factor in valuation models such as DCF. Higher future growth results in higher valuation and, therefore, higher EV/sales multiple.
To illustrate this point, I created a scatter plot of enterprise value/forward sales versus estimated Y-o-Y sales growth for the 152 stocks in my digital transformation stock universe.
(Source: Portfolio123/private software)
The sales multiple in the vertical direction is calculated using the EV and "next year's sales estimate" mean value based on all analysts from the Portfolio123 database. The estimated Y-o-Y sales growth is calculated using "current year's sales estimate" and "next year's sales estimate," also provided by Portfolio123.
As can be seen from this scatter plot, Twilio is well below the best-fit line, suggesting that its forward sales multiple is undervalued relative to its peers, given its estimated future revenue growth rate.
The Sales/EV multiple tells me that the stock is undervalued, but my value assessment changes when I substitute next year's gross profit estimates for forward sales.
(Source: Portfolio123/private software)
The results shown on this second scatter plot suggest that Twilio is fairly valued based on next year's profit estimates. This is due to the fact that Twilio has a lower gross profit margin of 61% than many of its peers.
When it comes to software companies, I don't rely on traditional value factors; instead, I focus on other measures, such as the software company "Rule of 40" and relative valuation, a concept that I recently developed that compares forward sales multiple versus estimated sales growth.
Twilio's annual revenue growth is ~75%, but this includes the acquisition of SendGrid.
For the purposes of calculating the Rule of 40, I am going to use the organic revenue growth for 2019 of 47%.
Twilio's free cash flow margin TTM is approximately -5% and has been negative since the company went public.
One industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40 - some analysts use EBITDA and others use free cash flow margin. I use the free cash flow margin TTM.
The Rule of 40 is interpreted as follows - If a company's growth rate plus free cash flow margin adds up to 40% or more, then the software company has growth and cash flow in balance and is considered financially healthy. In Twilio's case:
Revenue Growth + FCF margin = 47% +- 5% = 42%
The calculation comes out well above 40%, indicating that Twilio has a healthy balance between growth and profits.
Software stock valuations are high on a historical basis. Uncertainties, such as the rising tension in the Middle East, trade disputes, and the coronavirus, could cause a market downturn. Software stocks tend to get hit hard during any market turbulence.
80% of Twilio's cost of goods sold are network fees which limit the gross margin to the low 60%. Twilio has approximately 3,000 network carrier provider relationships in its infrastructure. Carriers could increase fees, and if Twilio is unable to pass the fee increases on to its customers, then there would be an impact on gross margin.
Twilio has historically had a significant concentration of revenue amongst the top ten customers. In the past, large customers such as Uber (UBER) and WhatsApp have announced a reduction of usage of Twilio's platform. While both of these customers have reduced their dependence on Twilio, they still use the platform. In any case, as customers get larger, they tend to stray from the fold.
Twilio has announced an increase in investment spending, which will cause losses for Q1 and Q2. The cash burn is already fairly high and rising. The SG&A expense margin (including R&D) is already 82% of revenue.
The cash burn and negative free cash flow margin are two parameters that investors need to keep an eye on.
Twilio's annual revenue growth was approximately 75%, with 47% organic growth, one of the highest revenue growers in my digital transformation stock universe. In my opinion, the stock price is fairly valued based on the forward gross profit multiple. The company fulfills the software Rule of 40, despite having negative free cash flow. I believe that this company represents a good investment opportunity and I am giving Twilio a bullish rating.
There are some issues that investors should be wary of, however. One issue is the high concentration of large customers. The loss of a large customer could result in a significant reduction in revenue. Another issue is that 80% of the cost of goods sold consists of network fees. Rising network fees would have to be passed on to customers or else gross margins would suffer. Finally, Twilio is increasing its cash burn on investments for the future. This may cause a reduction in margins in 2020.
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This article was written by
I have been trading stocks, commodities, and options for more than 25 years. I have honed my skills in quantitative analysis and various stock investment tools for 15 years at Portfolio123 and offer services as a consultant in stock portfolios. I also own the financial data service Equity Analytx which provides aggregated fundamentals for a wide range of industries.
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.