These are the dog days of summer, at least astronomically. This is the time of the year in which many traders take holidays, volume shrivels, and investors wait for the many conferences that are held after Labor Day. Even modest changes in sentiment can result in outsize changes in share prices.
That said, however, for investors, the calendar is rarely empty. Indeed, this week is going to bring some significant tech earnings including those of Snowflake (SNOW), Salesforce (CRM), Workday (WDAY) and Palo Alto (PANW). I think most investors are prepared at this point to hear about a slowing growth narrative from both Snowflake and Salesforce, and they have already heard that Workday's demand picture has slackened. Even Bill.com (BILL), which wound up beating estimates substantially and providing guidance for the coming months of 50% growth spoke about seeing "signals of the macro environment impacting spend patterns."
I would be surprised if most companies reporting this week and beyond didn't talk about lags in consumption growth/or new project initiation for some of their users as a focus of cost mitigation. Whether or not the NBER has called a recession, the preponderance of economic macro indicators is clearly suggesting an economic slowdown that is already in progress. Twilio is a company with a revenue model based on usage, and during its most recent earnings report, it provided guidance based on expectations of a slowdown, even though most demand signals had not deteriorated. When Twilio announced its quarterly earnings on 8/4, CEO Jeff Lawson announced that the company is "taking proactive steps to prepare Twilio for a worsening macro environment." The company announced at that point that it had reduced its hiring plan and was closing several offices in order to optimize its cost structure.
The shares fell sharply in the wake of that announcement and the overall guidance provided in the latest earnings release. Unlike most IT shares, Twilio's have not seen any significant recovery from the low that was recorded in mid-June. I wrote in another article recently that my success in calling bottoms is minimal. It has happened; indeed a few years ago I published my initial recommendation on Twilio shares at what proved to be a bottom. But that is more happenstance than some kind of special methodology on bottom calling.
I am positive about the outlook for Twilio for 3 major reasons. One is the company's product portfolio, which I will highlight later in this article. Another is its developer first sales motion. And finally, the company is now addressing its most glaring investment issue, profitability, with a strategy designed to ensure that the company reaches non-GAAP profitability, and presumably positive free cash flow generation consistently in 2023.
Overall, Twillio shares have now lost 78% of their value from their high point over the last 12 months, and are down by no less than 81% since their all-time high in early 2021. Twillio shares were considered to be an excellent work-from-home investment which accounts for some of the implosion as the end of the pandemic has eliminated that demand driver. Along the way there have been controversies with regards to organic growth and investor angst about that metric, as well as concern about margins, and the company's path to profitability. I will discuss the company's business model later in this article, but the pressure on gross margins in the quarter that was reported at the start of this month is another factor weighing on the shares. In addition, the company's DBE ratio has been falling; it had been at 126% at the end of last year; in the latest quarter it was 123%.
At one time I was an enthusiastic protagonist of Twilio and its shares. But the last time I wrote about the company on the pages of SA was more than 10 months ago, far before recession clouds had become visible. It has been someone longer than that since I owned the shares personally or even in my managed accounts. Last November was at the start of the valuation implosion - but it was also at the beginning of articulated investor concerns about organic growth for Twilio. Three quarters have been reported since that point. All of quarters were ahead of prior guidance in terms of revenue performance; the latest two by about $20-$25 million while Q4-2021 was an even larger beat. And of course, in all of these quarters, organic growth remained above 30% - it was 33% this last quarter. Non-GAAP EPS has also been significantly better than forecast, which is not terribly surprising given the company's revenue overattainment.
I don't want to suggest here that I have some special knowledge as to the growth trajectory of Twilio in the next quarter or two. Lots of electrons have been expended on SA and by brokerage analysts as to what the company's organic growth rate might be-not for the next quarter or two but for the next 2-3 years. My view is that Twilio's organic CAGR will be better than feared, and I will discuss that in this article. But there are demand headwinds for this company from the macro environment as is the case for a substantial proportion of major IT vendors.
The company provided guidance for revenue this current quarter of $970 million at the mid-point of the guidance range as opposed to the $976 million consensus. The more significant issue was that of earnings which are projected to be a non-GAAP loss of $.35 compared to a prior analyst projection of $.11. That said, almost all of the difference between the consensus and the current forecast relates to a one-time charge for an employee sabbatical program. This is a non-cash charge, and is one time, but it is being recorded in non-GAAP earnings.
Management said that while it had seen nothing more than a few pockets of demand softness, it had been particularly cautious in providing an outlook. It might be notable that while analysts focused on what was perceived as a guidance cut, the company's Q2 results had revenues about 3% greater than forecast with a loss almost half what had been expected. It is also worth noting, I believe, to mention that this past quarter included booking an 8 figure deal for the company's Flex software, the largest ever for that solution, and a significant reference win.
This is not an article that is trying to discuss how the next couple of quarters play out. I can't imagine that with shares down by 80% anyone might be expecting quarters with great upside. The fact is that on some measures, Twilio shares have fallen so much that they no longer reflect expectations for growth and profitability.
The purpose of the article is to highlight the company's longer-term outlook and to suggest that this is a reasonable entry point for longer-term investors. The shares are not going to perform in the absence of a constructive view toward tech equities on the part of investors. During days or weeks of risk-off sentiment, the shares will be pressured. But I don't think it is likely either, that they continue to underperform the high-growth IT group as has been the case for the last several months.
Over the course of the last 18 months much has been written about a tech bubble, valuations and comparisons to past bear markets. Having suffered through the last two mega-bear markets, I think I have some ground to comment on how this cycle compares to past cycles. In the dot.com crash in 2000-2001, many companies in the tech space were chimeras-they had no revenues, and free cash flow was a concept for historians. I almost got fired for refusing to endorse an IPO of the brokerage at which I was working because…well it had no revenues. Even legitimate companies undertook egregious business practices such as barter transactions, and booking sales to entities who could never pay for the products that were "bought."
The great financial crisis of 2007-9 brought an existential threat to the world's financial system. There was no access to credit both for businesses and consumers. Large swathes of the market for IT offerings essentially fell to zero-no way banks or FI's with risky balance sheets could buy anything from IT vendors. And back then, there was little recurring revenue to buffer the shocks of a demand implosion. Even companies like NetApp (NTAP) came close to financial catastrophe.
What does all this have to do with Twilio and its outlook as a company and as an investment? The economy is poised to enter a recession according to the preponderance of evidence. The fall in the Empire State Manufacturing index was certainly disheartening to the view that some recent economic macros meant the economy could handle additional Fed rate shocks. And while the Philly Fed index was better than feared, its new orders component continued to show contraction. And bringing an end to inflation is not the product of 1 or two cool inflation reports. Whether the Fed raises rates by 50bps or 75bps is an interesting debate, but substantial additional Fed tightening is inevitable.
But not all recessions are the same, and not all Fed tightening cycles emasculate economic activity. Twilio has built a significant business that has seen rapid growth. At this point, the company's revenue run rate has reached $4 billion. The company is still not profitable, even on a non-GAAP basis, but it is nearing that point, and it is not burning cash. And for what it is worth, the company has put a stick in the sand about achieving non-GAAP profitability in 2023. That is not such a farfetched objective so long as organic growth remains near the company's target of greater than 30%. But I think the company's CFO made it clear that even in a variety of different scenarios, the company's plan to achieve non-GAAP profitability remains in 2023 remains.
Okay. All right. We'll go to our next question. Next, we'll go to Nick Altman with Scotia Bank.
Great. Yes. Good to hear that you reaffirmed your commitment to profitability in 2023. But just given there's a handful of onetime costs related to the office closures and the sabbatical program that are sort of pressuring 3Q, how should we be thinking about EBIT margins as we sort of exit this year and then kind of going into 2023?
Yes. That's a fair question. So thanks for asking it. I think the way that we're thinking about it is, is that irrespective of kind of the macro environment that we intend to be profitable in 2023. And we've thought through a number of different scenarios that could play out that even if there were growth impacts, we still intend to be profitable in the coming year. And in addition to that, we continue to see this massive opportunity, as Elena has been talking about, with respect to the software aspects of our business, in particular Segment and Flex.
The company's SBC expense is about 15% of revenues. That is about average for IT vendors, although no doubt, it will raise some eyebrows. The share price implosion has brought the EV/S ratio down to around 2.2X. That is less than half the average valuation for the company's growth cohort. Even after considering the lack of free cash flow, the shares are still at a 40% discount from average based on its growth prospects.
The reality is that Twilio's business is actually thriving. Presumably an 80% share price contraction is, at least in part, a function of investor expectations for lower growth and a bumpy margin pattern in the midst of a coming recession. But this is still a growth company with a defined path to profitability whose shares no longer reflect that kind of reality.
As mentioned earlier, there are three key reasons that I am optimistic about Twilio's future. One reason is the company's product portfolio. Twilio started out as a company offering API's to developers who then built applications that incorporated those interfaces. It is the leader in the cloud messaging space. But the company's offerings are considerably more complex than just cloud messaging, and these days, as part of the company's strategy to achieve consistent profitability, it is driving its business beyond messaging into software, with its significantly greater gross margins.
Twilio's product portfolio is considered as a Customer Engagement Platform by industry analysts and commentators. The company's strategic vision is to offer not just cloud-based SMS messaging but a potentially integrated set of solutions that can be considered as a Customer Engagement Platform.
For those unfamiliar with the company, its co-founder and CEO, Jeff Lawson has a background in computer science and entrepreneurship. The concept of the company has been to focus on a sales motion catering to developers and most of its sales effort has been focused on promoting its tools for the software development community. It is, in that regard, the quintessential pick and shovel company in terms of providing tools to developers who need to build applications that run in the cloud and which are based on messaging.
Twilio groups its products into 3 categories, Channels, Applications and Connectivity. Channels is the messaging component of the company's offering. These days, besides the core offering of messaging API's, the company has products that allow developers to build applications for voice, video and e-mail applications. Over the years it has developed API's to facilitate account security which has seen increased traction. While there are numerous competitors in this space - the link here shows a few of them - Twilio's biggest advantage is its cross-functional set of offerings. Many developers want APIs for more than just text messaging, and in that regard, Twilio has a more comprehensive set of solutions than its competitors. As can be seen, Twilio competitors, for the most part, are not household names; often Twilio wins because of its name recognition.
Video is a relatively new offering for Twilio. The company now provides APIs that can be used to build applications for small and large conferences and its latest offering has been Twilio Live, which as the name implies, is designed for live interactive streaming experiences. Video still represents just a very small component of messaging revenues for Twilio but probably has the greatest percentage growth potential.
The market for SMS marketing software continues to grow significantly, with this linked study suggesting a CAGR of 23% through 2030. That is really the base of Twilio's growth. More and more brands choose to market through text messaging because the statistics suggest that it works. I guess I am the outlier in that I haven't joined the cohort of buyers motivated by SMS messages. I have linked here to what are called 44 mind-blowing SMS marketing and texting statistics. Some of them do show why this space continues to grow at rapid rates.
Twilio has never been the cheapest offering in the space. It recently increased its usage pricing for messaging which should presumably be a factor in buoying gross margins going forward. Applications built on 3rd party API's are exceptionally sticky; the cost of switching is far greater than what can be potentially saved through switching to a lower cost messaging vendor.
Twilio's second major segment is what it calls Applications. Within Applications, the two most prominent offerings are Flex and Segment. Flex was introduced by the company 4 years ago. I believe that its growth trajectory has disappointed some investors, and it hasn't achieved the revenue levels of messaging. That said, selling Flex is an enterprise sale so sales cycles are far longer than is the case for messaging, which can be downloaded and purchased by developers. Growing Flex at faster than the corporate average is a significant component of Twilio strategy to grow margins. Flex basically is software that allows users to build their own contact center platform. Many users are using their contact call centers as a piece of a digital transformation strategy, and Flex, which was purpose built for the cloud, resonates with those customers. As mentioned, last quarter Twilio booked its largest single order for Flex, an 8 figure deal with a Fortune 200 retailer. The customer already had a relationship with Twilio that included video, chat and messaging. The ability Twilio has to offer a customer multiple solutions in the communications space is one of its principle competitive advantages.
The contact center software market is substantial with a CAGR that is estimated to be greater than 20% in the report linked here. There are many competitors in the space; the list linked here is certainly not exhaustive. In particular, AWS has a competitive offering in the space as does Ring Central. I thought the following thread on Reddit was worth sharing, given the comments by a buyer/developer within the industry.
Also included in Applications is Segment, which Twilio acquired near the end of 2020 for $3.2 billion in a stock transaction. While Twilio doesn't report revenues from its different products on a consistent basis, it did report that Segment revenue was about $57 million in Q4, or nearly 7% of the company's total. Segment is what is called a customer data platform. The software collects user data from every interaction with customer interaction with user websites, mobile apps and digital adds. This data is then assimilated, categorized and becomes a single source of truth for customer data. In turn, this can be used to optimize the campaigns that brands send to their customers on a cross channel basis. In some ways, this offering is similar to that of Braze (BRZE) although they are not direct competitors.
Segment obviously integrates well with Twilio's messaging apps and with Flex. Segment growth is almost certainly being aided by its now being a part of Twilio's stack; many users want to consolidate vendors and using Twilio messaging and Segment together enables that. The market for customer data platforms is growing very rapidly, with this linked analysis suggesting that its CAGR will be 34.5% through 2026.
The third major bucket in which Twilio groups its offerings is that of Connectivity. Within connectivity there are a number of offerings that are of importance to developers of apps that also use SMS. These include offerings such as SIP tracking, short codes and phone numbers.
These offerings are essentially add-on features to Twilio messaging, providing functionality customers want to build into their communications apps.
Obviously, Twilio offers a wide range of solutions that encompass many of the use cases that have been imagined in terms of creating communications for cloud applications. While there are a number of significant competitors that can provide somewhat comparable functionality, and competitors with lower prices in the SMS space. Twilio's overall set of solutions on a single platform cannot be matched by any single competitor. The company's strategic focus is to leverage that differentiation, particularly by focusing its direct sales efforts on both Flex and Segment. That is a key part of the strategy the company has embraced to bring it to profitability over the next several quarters.
From an investment perspective, the inability of Twilio to consistently report profits and generate cash has been a significant hindrance to its share price performance. Even though last quarter's results were a beat compared to prior guidance and consensus expectations for both revenues and earnings, investors obviously were unhappy with the details. The single biggest concern analysts and investors have expressed relates to the company's gross margin performance. Last quarter, non-GAAP gross margins were 51%, which was down from 54% in the year earlier period and was down from 53% in the first quarter. The reason for this decline relates to the mix of business; in Q2, particularly, the company's gross margins were compressed because of a greater mix of international messaging business which has lower gross margins, but which is typically part of a process in which users wind up buying a significant amount of software, as I tried to describe earlier. While it may take more than a couple of years for the company to reach its gross margin goal of 60%+, the focus on Applications, a change in the selling motion for Messaging, coupled with the recent price increase for Messaging should enable the company's gross margins to rise in the last two quarters of 2022.
The company started to position itself for potential demand headwinds during the quarter that was reported on August 4th. Hiring has been constrained, and the company reduced its real estate footprint significantly. The company's opex in Q2 doesn't reflect any of the impact of the company's cost containment strategies. The non-GAAP research and development spend ratio was flat year on year as was the sales and marketing spend ratio. The non-GAAP general and administrative cost ratio fell by 100 bps. Overall, non-GAAP operating margins were at a loss of 1% compared to a year earlier profit of 1% and a non-GAAP operating margin of 1% in the prior quarter.
The company is projecting sequential revenue growth of about 3% for this current quarter and projecting a non-GAAP operating margin loss of about 6.5%. Excluding the one-time charge for a sabbatical program for tenured employees, the projected non-GAAP loss margin would be about 2.5%. The current consensus is projecting a Q4 operating loss margin of about 2% coupled with revenue growth of about 27% year on year, or 4% sequentially. Both of those estimates would appear to be hyper-conservative, reflecting the current environment. Twilio's business has always benefitted significantly from messaging traffic due to election cycles and I doubt that this year will be different than that. Of course this is an off-year election, and it may be that results in Q4 2020 were enhanced because of a variant of the Covid virus leading to the absence of live election events, but I think that there will be more of a bump than reflected in the consensus revenues forecast And the company's restricted hiring should result in sequential opex growth declining noticeably in Q4.
As mentioned, the company has reaffirmed its expectation to reach profitability next year, and the consensus reflects that forecast. The consensus is calling for revenue growth in 2023 of 27%, below the projection of Twilio to sustain organic growth of 30%+, but probably reasonable in evaluating how macro headwinds might impact the company's growth.
Based on the steps that the company has taken, I believe Twilio will achieve EPS and free cash flow margins greater than the consensus. If a less difficult macro pattern emerges later in 2023, then the current EPS forecast should be exceeded by 2X-3X and free cash flow could reach $100 million. Still, no one is buying the shares because of that potential; getting to a level of profitability that will be pleasing to investors is a multi-year project, although with revenues that are likely to reach close to $5 billion next year, and with gross margins of $2.6 billion or more, there should be plenty of opportunity to achieve substantial cost optimization.
Twilio shares, down by 71% just this year, and by more than 80% since their peak valuations, are amongst the poorest performing shares in the IT space. There are, of course, some reasons for this performance, including the hype about the company as a work-from-home investment, as well as concerns about the true sustainable level of organic growth. In addition, the company hasn't been profitable, even on a non-GAAP basis, nor has it generated any significant level of free cash flow. Further, its gross margins, last reported at 51%, have been trending downward. Some growth last quarter was a function of European messaging, which has pressured margins.
Despite all of the above negatives, the fact remains that Twilio, considered holistically, is thriving. The company's organic growth remains at greater than 30%. It continues to beat its estimates quarter after quarter, even its earnings estimates. And the company has never had a more compelling solution portfolio. Even the company's Flex product, seen by some as a disappointment, recorded its largest single order to date with a Fortune 100 retailer needing to modernize its contact call center. Element, an acquisition from 18 months ago, continues to achieve accelerating growth; customer data platforms appear to be a user priority even in a constrained IT spending environment. As these are software solutions, they will help to buoy the company's gross margins. The company, anticipating that a recession could pressure revenue growth, has already taken steps to manage down its costs. It has exited some real estate leases, and it has drastically curtailed hiring.
The shares, after falling steadily last week, have reached an EV/S ratio of just greater than 2X. That is a remarkable level for a company that hasn't missed quarterly projections, and has maintained its expectations for 30% organic growth. Of course, there are many compressed valuations at this point, but most of those are a product of company's which have seen poor results, and worse guidance. The company's current EV/S ratio is more than 50% below average for its growth cohort in the low 30% range.
To recapitulate my investment thesis, it rests on three legs. One of Twilio's product portfolio is the most comprehensive in its space, with a clearly defined marketing strategy that is resonating with users. Another of these is a more focused sales motion that prioritizes company resources on software sales, and enhances the company's self-service sales motion for messaging, and finally, the company's new found focus on achieving profitability and free cash flow generation.
It is, I imagine, almost inevitable, that the Twilio's organic growth over the next 4 quarters will be less than 30%. Macro issues are going to be seen across the universe of software vendors and almost everyone else. But that said, I believe its percentage growth will stand out in an environment in which many companies are unable to find any. And, given its portfolio, and the integrated nature of this offering, I am quite comfortable with the company's forecast of profitability, and also believe it will see a substantial growth recovery when macro headwinds abate. Twilio shares are on sale at this level, and I think will generate significant alpha over the next year.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Short position through short-selling of the stock, or purchase of put options or similar derivatives 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.