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Once trading at more than $430, Twilio (NYSE:TWLO) shares are trading at roughly $43 now - call it a reverse-ten-bagger. Shares just dropped 35% following disappointing earnings, guidance, and troubling comments by management in the conference call. Is this a buying opportunity as shares are now trading at an EV/S of 1.36?
The malaise starts with revenue growth of 33% in Q3 2022, down from 41% in the previous quarter and down from 65% a year ago. Q4 guidance calls for only 19% growth, and the company also slashed its longer-term 30% growth target, down to 15-25%; that is only approximately 90 days after this growth goal was announced with confidence. It's an appalling deceleration of growth, that justifiably rocked shareholders' confidence.
While some of the deceleration was blamed on the macro environment (Twilio for the most part is a usage-based business, so it is more sensitive to macro than traditional SaaS), management opened up on some operational issues, especially concerning its recent acquisitions. It turns out that the company had these issues for some time, especially regarding its acquisition of Segment, the market-leading customer data platform (CDP). Twilio admitted to experiencing "elevated attrition across our sellers" which was important "because those sellers were the ones that were most knowledgeable about the segment product, about the segment market, competitive landscape and the customer". Considering that CEO Jeff Lawson likes to talk about his vision of a customer engagement platform and that Segment is a key piece of that puzzle, this news is very concerning.
Another disappointing fact from the call was that Twilio Flex, their cloud contact center solution, which has been a key product for Twilio over the last four years has only scaled to $100 million in ARR as of now. Analysts were expecting much more progress by now.
On top of that management also mentioned in passing that they, decided to refuse additional business from political election cycles as "that traffic was from customers who did not intend to honor our acceptable use policy with regards to consumer opt-ins" and those short-term revenue bumps are "immaterial to the general story of Twilio". This is - to put it lightly - a bold move considering all the problems the company has already.
While management tried to highlight the still exciting long-term story for the business, one key takeaway from the call is an increased focus on profitability: Twilio will reduce its workforce by 11% (-$200 million OpEx annually), will slow down hiring (-$100 million OpEx annually), and reduce its real estate footprint (-$30 million OpEx annually), for a total of $330 million annual cost reduction.
At the same time management has seemingly given up on its long-standing goal of achieving +60% gross margins. Now, management is not focussed on gross margins anymore, but rather on gross profit dollar growth. This is an important acknowledgment from management and a quite concerning one for shareholders: It shows how dependent the company is on carrier fees set by telecoms in its messaging business, which is still the most important and fastest-growing part of the business. Twilio seems to have limited pricing power in its key market. This probably explains why the company made big efforts to go into software businesses with higher margins like Flex and Segment but makes the execution difficulties in these new growth areas even more problematic for the business as a whole.
Another problem is that management's idea to deemphasize the importance of gross margins is difficult to connect with their goal to become profitable from now on. They want to achieve a 20%+ non-GAAP operating margin in the long term but considering the ongoing gross margin contraction and, so far, a company culture of lavish spending, it is hard to see that kind of profitability any time soon. And indeed management demands patience from investors on their profitability goal: They expect to become non-GAAP operating positive in 2023 and then increase margins by 1-3% yearly until their goal is reached. They would not specify at which level margins will start off in 2023. In other words, it will take them years - if ever - to get to 20% non-GAAP operating margins.
The question investors should ask themselves is how can you trust management that just reduced its long-term revenue guidance from approximately 90 days ago from 30% to 15%-25%? How can you trust a management team that lets investors believe all year that Q4 will see incremental revenue from the election cycle, and pulls the rug out from under their feet days before the election? How can you trust a management team that pounds the table to become more disciplined about spending, getting to 20% non-GAAP margins, but in the next second mentions that stock-based compensation, which was at 22% of revenue in 2022, should only decrease to 15%-20% in the medium term?
Essentially, this means that the long-term non-GAAP operating profit will be almost entirely eliminated by SBC. High SBC can be excused for a high-growth company with strong unit economics. But Twilio, at projected 15%-25% revenue growth and (declining) non-GAAP gross margins in the low 50s, is neither.
To summarize, the company looks very beaten down at the moment. What does that mean for the stock? It is safe to say that it has de-risked considerably from an EV/S of more than 36 to now 1.3 -- yes, that is one point three. From a valuation standpoint, shares look like a complete bargain.
Pessimism seems to be at its peak at the moment, and Twilio is the victim of both a very tough stock market and deteriorating fundamentals at the same time. There could be huge upside in the stock if they do turn the business around, though. It is important to remember that Twilio is still a leading cloud software company in secular growth markets. If their high-margin software businesses (Flex and Segment/Engage) take off and if management becomes more disciplined about spending (also on SBC), they could become profitable in the future.
However, investors need to be careful here: At the moment those are big IF's, especially considering the unambitious profitability goals that will take years to complete, and even if achieved are far from satisfying for prudent investors. In the current environment where inflation is at 8% and the risk-free rate is at 4-5%, it is difficult to make the case for a company that is not looking to achieve meaningful profitability any time soon.
In addition - and this is in my view the most important takeaway - you are looking at a management team that has lost the trust of investors. It has not been sufficiently transparent with shareholders and made it a habit recently to over-promise and under-deliver. Investors have voted with their feet that this is not acceptable. It remains to be seen if management has finally received the message.
For my own portfolio, I have decided to trim the position, even though it is admittedly very disappointing, and not easy, to do so at this time. But I simply feel there are much more attractive, better-run companies that have also been punished by the market recently, and have a better chance to rise again once the investment environment becomes more favorable for growth stocks again. I may keep a small amount of Twilio shares to follow the story but I am not considering adding at this time.
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Disclosure: I/we have a beneficial long position in the shares of TWLO either through stock ownership, options, or other derivatives. 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.