Twilio – A Future Essential, Or Overhyped & Just Unprofitable? (NYSE:TWLO)

Dear readers/followers,

My investments in growth stocks such as Twilio (NYSE:TWLO) have always been very moderate. Though I have a track record of providing actionable and profitable advice on such investments, such as my set of articles on Prosus (OTCPK:PROSY) and Adyen (OTCPK:ADYEY), I’ll be the first one to tell you that these stocks are not my focus.

Still, the view of a valuation-oriented dividend investor can be of value to some, if they’re on the fence about whether to invest in a business like TWLO.

This is my view on TWLO.

Twilio – The Business

I always try to simplify things as much as possible and will take the same tact here.

Twilio is a company in the business of offering so-called Cloud Communications as a Service, or CPaaS. As service-companies are growing, and Software-as-a-Service (SaaS) companies are just the beginning here.

The company offers solutions that customers can plug into their operations through so-called APIs, standing for Application Program Interface, a now-standardized way of transferring information.

The company connects traditional telco infrastructure (phone numbers, messaging, voice, connecting IoT to cell devices, email, video, live streaming) to the internet through the company’s so-called SuperNetwork, added by Channel APIs. These two areas are the essential foundation of all of Twilio’s products, with powerful APIs essentially on top of the foundational SuperNetwork infrastructure, consisting of over 1,500 carrier connections. Think of these two things as interconnected.

The company provides customers with a very modern and simple way to connect and communicate with their customers and within their own business. The company’s solutions are easily embeddable through the aforementioned APIs into both applications and websites as well as services such as SMS, emails, and chat functions.

Historically, Twilio started out prior to the financial crisis in 2008 as a VoiceCall company, allowing customers to make and receive cloud-based calls. Twilio SMS which was launched in 2009 became more successful, and since then the company has been on a mission to launch new products and services either through its own R&D or through M&As.

The company is global, with customers in over 180 countries. There is no company dividend. There is no S&P credit rating – though, at a high cash position and less than 10% debt/cap, it can be argued that TWLO has no need for something such as that at this point.

On a high level, you can view Twilio as a “cake” of service offerings. The base layer is the SuperNetwork, stacked on by Channel APIs that form the very core layers of the company.

Following these two, the company also offers the possibility to add Services. These services include things like verification/ID services, advanced messaging services, and other things.

As the top layer of the “cake”, the company offers very advanced higher-level solutions that sometimes act more as cloud-based software suites, such as Twilio Flex, which is a cloud center contact platform, allowing for cross-platform customer communication. It also offers integration with the most common CRMs. Aside from this, Twilio also wants to offer Marketing/Campaign management.

In addition to this, viewing the top layer, Twilio has done multiple interesting M&As over the past few years with capacities that have been inserted into the company’s capacities. The biggest is probably Segment, which allows Twilio to be used to create incredibly personal advertisement/marketing campaigns, thanks to class-leading individualized data collection across multiple devices and sources. This is what drove the creation of Twilio Engage, through which customers are able to be targeted with individualized engagement regardless of customer stage.

The ultimate target of this is, of course, to drive repeat purchases, increase conversion and drive engagement across different digital channels.

The company also has a couple of other things in the pipe – but given the beta status of most of these, I don’t view them as worth going into at this point.

So – that’s Twilio in around 600 words, as I view the company. It provides customizable communication tools and engagement/analytics for B2C engagement.

The Value Proposition For A Company Like Twilio

There is no doubt in my mind that the company has a very comprehensive and appealing set of offerings to customers. You don’t build a business and get customers such as Airbnb (ABNB), DoorDash (DASH), MercadoLibre (MELI), Glassdoor, Shopify (SHOP), Lyft (LYFT), and other massive businesses without having appealing products.

The people who say that Twilio has no business or no moat, I say that this is completely untrue. The company has a solid business proposition, and it has a form of a moat.

I don’t agree, though, that Twilio is “without peers”. There may not be many companies, or indeed any that do all that Twilio does, but there are certainly competitors that do part of what Twilio does, to one degree or another. Competitors to Twilio include things like Vonage (VG), MessageBird, Plum Voice, Vidyo, and others – though again, most of these are only partially in the same businesses and services that Twilio is active in.

The company specifies a TAM of $4.6B, growing to around $22.4B by 2028 for cloud communications, and their total TAM to $79B, thanks to customer data expansion.

Specifically, the company believes that it can grow based on ongoing digital transformation and technology adaption/Direct-To-Consumer sales models – trends that obviously have been accelerating significantly during the pandemic. Everything that’s been focusing on at-home and digital delivery has been experiencing significant growth – and so tools that support this, such as Twilio, are growing as well. The company sees benefits from the pandemic due to helping businesses communicate, including from remote spaces.

Secondly, the company sees changes in data privacy with increased requirements for first-party data. Twilio, again, solves this issue through its Engage platform and its Segment M&A. This shift from what’s known as third-party data to first-party data is of a net benefit to every company that works as Twilio does.

Twilio’s Revenue & Profits

Based on these two or three trends as drivers, we can move on from here. In terms of revenue, Twilio generates revenue in one of two ways.

• Usage-based Fee business
• Monthly Subscription fees

None of these is especially strange, and we, as investors, can assume that Twilio has priced these various services at pricing points where, eventually, the company will make a net profit from its operations.

That’s revenue – the company’s COGS/Cost of revenue primarily comes from fees paid to network service providers based on the respective volumes of calls, services, and other things used.

It’s, therefore, possible to simplify that the company earns a small margin on the difference between fees paid and fees earned.

Overall, the company has been able to grow revenues at a relatively impressive rate – though the revenue growth rate has been dropping from 80-85% to below 60% YoY in the last couple of quarters. There have also been one-time effects such as elections, pandemic-fuelled digital adoption/growth, and other things. Revenue, simply put, has been solid for several years, and customer growth has been solid as well – even if customer growth rates have dropped off from 20-24% to less than 17% as of the last quarter reported.

The company has fairly solid gross margins, coming in at 50-55% and dropping below 50% only during the last two quarters or so. The reason for the ongoing gross margin decline is higher fees by certain carriers and overall higher service provider fees, as well as international expansion, with international margins being lower than US-based margins.

As I mentioned, Twilio’s earnings are a product of the difference between fees paid and fees earned (grossly simplified) – and since the company doesn’t control the cost side of that equation, and might not have the pricing power to push prices upward all that far, this can potentially hurt margins.

I like numbers. Numbers don’t lie. We do need to understand them, but they don’t lie.

And unfortunately for Twilio, their numbers aren’t looking all that stellar.

While Revenue growth has been solid, and the company’s so-called Dollar Based Net Expansion Rate, or DBNER (measuring the percentage of increase in revenue on a per-customer YoY basis) has been strong, there are some things to understand here.

The first and most obvious problem is that Twilio is not a profitable business. By that, I mean that its net profit is negative, and these net profit/GAAP profit numbers have actually worsened for years, despite continued growth in revenues. From early 1Q19 to 4Q21, we’ve gone from close to negative $0.5 EPS to negative $1.5 – and less. The FY21 net profit came in at a negative $5.45. The company also does not expect this to materially change in 2022.

Even on a Non-GAAP/Adjusted basis, the company’s earnings are in negative territory. The company predicts to achieve continued revenue growth and some stellar, 60% non-GAAP GM levels, but given that all of the company forecasts are non-GAAP, they are of limited interest to me.

Right now, management expects to turn profitable (albeit on a non-GAAP basis) by 2023.

The company’s cash-rich position, pointed to by some investors and bulls, isn’t something I focus that much on since it’s mostly a result of debt and equity, not operational cash flow. While management is to be applauded for timing, I’m not one to applaud a rich balance sheet that’s being filled like this, even if it does mean they can pursue further M&As. A good point about TWLO is that they’re at least not burning through that cash from its operations – but are mostly “neutral” in terms of cash generation/usage.

So what exactly is the problem? Why is Twilio not making money, either GAAP or Non-GAAP?

The company has an easy explanation for this. Investing. Got to spend money to make money. You won’t find me arguing with this point. Spending on R&D, marketing, growing its workforce, and other areas, resulted in a negative $104 FCF. In terms of FCF, the company’s cash burn is worse than it has been for 3 years.

I like charts such as this.

It shows me how a company, regardless of sector, flows from one period, in this case, 2013, into more recent periods, such as 2021. What concerns me are the worsening rates of gross margins, and the small/no change in portions of COGS/SG&A, which suggests to me that the company’s business model, even when scaled up, is unable to produce a net profit.

This is another good charting exercise. See how the company, year after year, increases its expenses and its income goes lower and lower in tandem, with margins deteriorating further and further (though currently substantially higher than 2013)

I also want to show you another development – stock-based comp.

Look – I know stock-based comp is very popular with loss-making, cash-flow positive tech companies. Usually, tech stocks like these aren’t profitable on GAAP, but are looked at through cash flow – but TWLO isn’t profitable on GAAP or non-GAAP cash flow either.

And their stock-based comp increased by 75% to over $630M in a single year.

You won’t find me as hostile towards stock-based comp as some value investors. It allows for cash preservation in the business, and it has a lot of other upsides.

The problem is that no matter how you slice it, SBC is an expense. Usually, companies have a tendency to cover this up a bit through buybacks (like putting lipstick on a pig if you ask me), but TWLO doesn’t do a whole lot of buybacks compared to others.

Before you dive down into the comments to defend stock-based comp, and that you intend to value TWLO on cash flow as opposed to earnings/profit, that’s fine – but then you’ll have to subtract out stock-based comps. And this significantly worsens the company’s cash flow numbers.

To those uninitiated about how SBC works – here’s a relevant example for you.

Google (GOOG) bought back $67B of stock between 2016 and 2020. Their shares outstanding (SO) only changed by 2%. Why? Because Google issued more than $47B of share-based compensation during that period.

Again – SBC isn’t a problem – nothing is a problem if we can understand and account for it. It becomes a problem when tech investors want to pretend it’s not an expense. It is. You can’t underpay/not pay employees in cash, and then pretend what you do pay in isn’t an expense.

I don’t want to harp on this too much further, so let me make my point with this chart.

TWLO has never been able to show consistent profitability, regardless of revenue growth. Not in terms of EPS, not in terms of EBITDA, Free Cash Flow – pick any metric you want, pick the company’s adjusted/non-GAAP metrics, it’s unprofitable.

This is a problem.

The Positive Catalysts

That was a fairly negative segment – so let’s switch it up with some upside. There are plenty of catalysts why Twilio would be able to see success in the future and continue to grow its revenue.

The company works with very high switching costs. Once Twilio solutions are installed and working, the likelihood for companies developing in-house solutions is very low. They’re likely to stay with Twilio unless they can make a compelling case for switching to a competitor being cheaper/easier.

Being the market leader in the entire segment is, of course, a huge upside as well. The company doesn’t just lead CPaaS, it also leads sub-segments like Customer Data through its M&A of Segment and similar historical, and future M&A.

Twilio’s size is not comparable to any other company on the market. Its customers include every single large company you can likely think of, with over 35% of the Global 2000, in every single industry and business size. There are massive advantages to being the company that Amazon (AMZN) or the American Red Cross or Uber (UBER) uses.

You won’t find me arguing that there are positive potential catalysts and fundamentals to this company.

That is not the problem I see with Twilio.

Some Expectation/Forecast Issues…

Twilio – and many other companies – like talking about TAM – or total addressable market.

As someone with extensive experience in the enterprise space, I’m more familiar than I’d like to be with the concept – and I don’t particularly like it. It comes back to a very simple fact – companies and individuals often have a very deep-rooted desire to put the best face on things. TAM is exactly this – fooling ourselves into essential confirmation bias that’s not only dangerous to ourselves but to the companies we work for. Overreliance on TAM can lead to trying to capture markets that aren’t technically within their reach, or building products that can never be sold to a consumer.

Instead of letting someone blather on about their supposed TAM, I like asking what their MVP/MVM is. That’s the Minimum viable market. A far more interesting concept, as I see it.

You can say that the market for hot sauces is nearly $2.75B as of 2021, and is expected to grow at a 7.1% CAGR until 2028 (Source: Fortune Business). Does this mean we should all be jumping to build the next hot sauce brand? Of course not.

I’m not claiming that Twilio’s space is as crowded as hot sauces – I’m arguing that the concept of TAM should be viewed with skepticism – at the very best.

TAM, to me, is not that interesting. Rather, I focus on MVM and Customer Acquisition Costs, or CAC. These to me are the bread and butter of a business. If you can convincingly show me that your CAC and your MVM work in tandem, and you’re able to generate a solid margin on your operation, then you have me hooked and I might invest even if your business is something unbelievably boring.

If you tell me that I have to “wait for things to become profitable”, wait for things to “percolate” and “mature”, and wait for “synergies” to materialize for a decade before I even see a dollar of GAAP profit, I’m probably sending you packing before you finish that sentence.

Before you speed down to the comment section to point out the flaw in this reasoning applied to a company with Twilio’s specifics, size, and customers, let me say that I’m fully aware this is in no way a perfect comparison.

I will, however, make the staunch point to you that I do not like chronically unprofitable companies.

Neither should you.

Even if Twilio says they might become profitable on a non-GAAP basis by 2023, I’m not really interested in owning shares of negative GAAP profit at 10X+ multiples. People doing the valuation work and the bullish articles on TWLO spend a whole lot of time arguing for revenue growth, peer-based valuation comparing TWLO to businesses like Microsoft (MSFT) – a comparison that’s absurd on several levels, but the largest of which being that Microsoft has been a profitable business virtually since its founding.

We often read things like, compared to its “peers”, TWLO is attractively valued, and that the company has a growth rate above that of a company like MSFT. That’s just it.

Growth without profit is, in the end, meaningless.

Anyone can sell a product or a service at a loss – it only becomes interesting if you can do so while actually keeping some money in your pocket, instead of giving it all away in the work of making your sale. If you need to spend $100 dollars in COGS, SG&A, R&D/other expenses to sell a product with a $50 price tag, you won’t be convincing investors in the long run.

…First Mover Disadvantages…

Being the “first mover”, isn’t necessarily a good thing in a market – even though many investors believe it to be. Why?

Everyone goes after first movers, first of all. Google Glass started and had to shoulder cost burdens, privacy rights, and concerns to a point where they canceled it in 2015. Now Snapchat (SNAP) Spectacles exist.

Being first is also expensive, as we’re seeing for Twilio. Educating the market is expensive. CAC is expensive. R&D is very expensive. Navigating privacy laws is expensive. Consider that a company like Gillette spent $750M dollars to develop the Mach3 razor. Now, 20 years later, the Dollar Shave Club offers a copy that you can bet anything on that did not cost $750M to develop.

You have no prior experience exists to fall back on. You’re making it up as you go, and you are making the mistakes. Apple (AAPL) is a good example of this. Macintosh1 was a success. Their next products? Massive mistakes, led to Microsoft’s Dominance because they learned from Apple’s mistakes.

There’s plenty more to mention – I’ve made a study of this, with price of educating customers, fatigue due to everyone coming after you from your first success, corporate complacency, and someone having to foot the up-front bill, which is what Twilio is facing here.

People seem to be treating the company as though, because of their customer base, they are immune to being targeted by competition or any of these things. I believe this assumption to be false.

…Rate Risks That Will Worsen The Unprofitability…

The current market environment will not make it easier for TWLO to become a profitable business.

The company failed to become profitable during an extensive, years-long zero interest rate market with essentially “free money for days”.

What, exactly, would point to the fact that TWLO manages to become this profitable giant some people seem to guide, in an environment where they will have to handle 2-7% interest?

These new trends will make the company’s work much harder – not easier. That is yet another problem.

…And Introspection

I also have a question for you, the TWLO investor/interested person in TWLO.

What do you want out of an investment?

It’s a serious question that most people don’t ask themselves often enough. And I’m not talking specifically of TWLO, but of any investment in your portfolio.

You see, many investors go through their days picking stocks that people recommend with no cogent strategy in mind. This is a mistake.

I know what I want, and what I expect out of my investments. I’m looking for market outperformance while staying safe and earning 2-5% dividends on an annual basis. This is also what I have consistently achieved going on for 5 years now.

Investors who pick TWLO or similar companies as their investment seem to expect or hope for the company to deliver 100-600% returns over the coming few years.

That’s fine – and it’s an entirely valid thesis for a company like this if you’re a growth investor.

Of course, such an assumption also comes with a substantial amount of risk. What if the company does what most companies do – simply perform similar to how they have been performing? Remain loss-making? Drive revenue but not profits? In the long term, such a business model isn’t sustainable.

We’ve already seen the fall of many favorite growth stocks that were hyped 1-2 years ago. I believe we’ll see a continuation of this trend, in particular when it comes to some of the less profitable names out there.

As long as you know what you want, and are fine with the expectations and risks that come along with it, you’re doing very well.

The only problem is people characterizing TWLO as some sort of “blue chip” stock.

TWLO is not a blue-chip stock. It’s an unprofitable growth stock, and not a particularly new one at that, with a history going back 14 years.

Let’s look at the valuation

Twilio Valuation

Most analysts value Twilio based on peer valuations.

When doing this, we see that the company currently trades at a substantially lower valuation than its competitors. It’s also lost 55% of its value in less than 5 months.

If we ignore peer multiples for a moment and let me be clear – comparing TWLO to profitable companies should be done only with full knowledge of the shortfalls of such attempts – we can look at analyst price targets based on the company’s path to eventual profitability in 2023E and beyond.

The valuation range from analysts illustrates how little certainty and how little we really should trust some of these targets, given that they range from as low as $170 to as high as almost $600/share. (Source: S&P Global) This is one of the largest PT spreads I’ve ever seen.

It comes to an average of $303/share with 21 out of 28 analysts recommending a “BUY” here. In fact, you don’t need me to justify your “BUY” here. The company is considered a “BUY” on the background of its growth plan, fundamentals, and set of technologies and assets. The upside potential in the case of reversal to such multiples is massive – well above 100%.

Looking at P/E multiples and similar things is obviously a somewhat pointless exercise.

The P/E on an adjusted basis is negative 363X, showcasing just how useless this metric is here. Instead, what we can do is look at revenue or sales multiples, all of which show us a different story.

These numbers would imply, that if you wanted to buy TWLO, now or lower would be the right time, given the lows we’re currently seeing.

However, truly forecasting this company and expecting when it becomes profitable is, as I see it, a too risky exercise to venture into. Your stance when investing in the company needs to be allowing for this business to remain unprofitable until either trends push the valuation up again, and you can sell at a targeted profit, or until we can realistically say that we can see the company become profitable and “becomes the next Amazon/Google”.

As things currently stand, I don’t see the visibility for this being in any way realistic or forecastable.

I will argue that it’s near-impossible to say when exactly a loss-making company with this amount of SBC and proven history of growing expenses at a rate with, or above its revenue growth. Worsening margins won’t easily change as we’re moving into a higher interest rate environment.

I’m not saying the company is headed into fundamental trouble. TWLO lacks the recurring cash burn for this to be an issue, especially considering how cash-heavy it is and how good its current ratio is. Remember though, that the company’s cash-rich position isn’t a result of good operational performance or cash flow, but rather issuing equity and debt. It’s like telling your friend who took out a $100K loan that “wow, you’re rich now!”.

In the end, and to me, an investment is really only as good as its conservatively-adjusted upside and dividend.

TWLO doesn’t have one and isn’t a profitable business.

I’m unwilling to bet money on when, if at all, the company ends up becoming profitable. TWLO offers revenue growth and guides for revenue growth. I understand the logic behind investing in TWLO.

It just doesn’t have a place in my portfolio at this time – and I question if they should be in yours.

How deeply discounted the company should really depend on your views. Me, I don’t engage in discounting unprofitable businesses to any optimistic degree. I understand the logic behind investing here with a very long-term timeframe and for a potential profit in the several hundred percent.

But to me, this is too speculative to consider.

I’d call TWLO a “HOLD” or what some might call a “spec buy” (but I prefer the simple buy/hold/sell), with a PT of $85/share representing a lower sales multiple, closer to 4.5-5X.

I want to clarify that even at a double-digit price, I’d still be careful with this company – at least until I see some indication of profitability improvement, and not just on non-GAAP.

Thesis

I realize this might be an unpopular article and stance, given the company’s seeming love from contributors and readers alike, going by the number of bullish articles and the relative quant ratings here.

I fully expect a decent amount of vitriol for this stance, which as far as I can tell, is the first neutral stance on TWLO in a long time.

I understand the liking for the company as a potentially massive growth stock in the case of appreciation – but I also think the risk here is higher than investors might want to believe.

I’ve yet to see a compelling argument on how the company will turn around its operations and become profitable. The most common thing here is “More growth” – but that just seems more of the same to me, and history has proven to us that all this does is increase costs – not turn profits.

Still, I’m open to being proven wrong and I will follow Twilio from now on.

So, to the question I pose in my article title – I believe that the last word has yet to be said on Twilio, and it could go either way.

While the market has been in a growth frenzy the past few years, with unprofitable companies being loved by investors, I believe this is about to change.

I would, however, be willing to pick this company up on the cheap once we see some proper indication of more profitability. But until then, I’m at a “HOLD”, and I’m cautioning investors here.

I suppose the easiest way to put it would be to ask if you’re okay with a company that spends 10-25 years growing revenues with unprofitable results, and then “might” turn positive, or, if you hold the stance that unless they’re profitable before they scale over $20B market cap, they won’t necessarily easily be profitable after that $20B.

I obviously hold the latter stance.

Thank you for reading!