Twilio Seems Oversold

Thursday, Oct 31st 2019


Quick 101 on Twilio##

Twilio is considered to be the "Amazon of electronic communications." The company builds application programming interfaces (APIs) that software developers use to integrate all sorts of communications into their products.

For example, companies like Lyft use Twilio to send automated text messages, emails, and other communications to their users. Instead of having to build every communication tool from scratch, Lyft's software engineers write a few lines of code to connect to Twilio's APIs, and voila.

Seems like a great value proposition, right? With a $50B+ total addressable market for electronic communications spending, and a best-in-class API software product, Twilio has a lot of opportunity as a business.

So why's the stock down 10% today and down 35%+ over the past three months? Factors and near-term valuation, in our view.

Factors and Near-Term Valuation, not Fundamentals##

On factors -- the main factor driving Twilio has been momentum, and that factor has reverted downward in recent months:

  • There are many hedge funds whose strategies revolve around buying "momentum" stocks (i.e. betting that recent winners will continue to be winners).
  • Most cloud-based software-as-a-service (SaaS) stocks have been swept into the momentum basket in recent years.
  • In the short term, Twilio's stock is highly susceptible to these momentum swings and therefore sell-offs driven by those short-term oriented funds.
  • We don't invest your capital based on momentum, but it's an unavoidable consequence of quality growth investing, in our view.

On near-term valuation -- Twilio is often valued on an "EV/Sales" basis which has hurt the stock in recent months:

  • Twilio is a high-growth company with a massive $50B+ market opportunity, which is why management is investing all excess cash flow into growth efforts (e.g., marketing, hiring, etc.).
  • Given these investments, Twilio currently has very low profit margins and earnings, making its near-term P/E ratio look extremely high and expensive.
  • With a basically incomparable P/E ratio (given extremely low earnings, or "E"), investors instead look to its revenue as a basis for valuing the stock (EV/Sales).

Why Software Investors Use "EV/Sales" Valuations##

If you're not familiar why people use "EV/Sales" to value some stocks, here's the scoop:

  • EV = Enterprise Value, or the total value of the company
  • If you take the company's EV and divide by its next year's Sales estimates, you get the EV/Sales multiple.

The average EV/Sales valuation multiple in the SaaS industry had increased materially in the last few years to the 10x+ level, as a result of SaaS companies growing quickly. Investors have been willing to pay up for that solid growth until recently.

However, the last few months of macro uncertainty have led SaaS CEOs to be slightly more cautious in their near-term growth forecasts. As a result, Wall Street analysts cut their future sales estimates for SaaS companies, and the EV/Sales multiples that investors are willing to pay have also fallen massively.

So a factor reversal + near-term valuation decline = massive selloff for Twilio.

Why We Think Twilio's Stock is Oversold##

Simple: long-term fundamentals based on what we call "napkin math."

The company reported Q3 earnings yesterday, and we saw strong sales and earnings growth in the quarter, with only a slight cut to the company's Q4 estimates. One quarter doesn't change fundamentals, but the Q4 guidance cut was enough to send TWLO down 10%+.

Zooming out, let's do some quick napkin math to show why Twilio seems attractively valued today:

  • For every $1 of sales it generates, Twilio makes ~55% gross margin. That means after paying the communications networks it uses to help Lyft, Zendesk, etc. send messages, it keeps $0.55.
  • After paying its employees, marketing expense, rent, etc., Twilio only keeps $0.01 (!).

That's the bear case -- Twilio is expensive and unprofitable. But remember it's in hyper growth mode. What does this look like at scale once Twilio throttles back the sales/marketing, R&D, and admin expenses?

  • The average SaaS company at scale spends ~10% of revenue each on Sales/Marketing, R&D, and Admin costs, or ~30% total.
  • That's $0.55 gross profit - $0.30 fixed expenses = $0.25 operating profit for Twilio at scale. After taxes, that's $0.16 of earnings.
  • So for every $6 of sales, Twilio makes $1 of earnings (Sales / Earnings = 6x).

Twilio has sold off so much that it's now valued at ~4.5x EV/Sales based on sales estimates in three years. Convert that to its "at-scale earnings" by taking 4.5x EV/Sales x 6x Sales/Earnings = 27x EV/Earnings.

Putting it all together...

Twilio is basically valued at 27x P/E three years from now, even though it's expected to grow sales 30%+ for the next several years thereafter and earnings at least in line (if not above) that sales growth rate.

The average S&P 500 company is valued at ~13x P/E three years from now, but likely growing sales and earnings well below 10% at that point (we're in year 10 of a bull cycle with low single digit GDP growth, peakish corporate margins, etc).

On a P/E ratio vs. EPS growth basis (the "PEG" ratio), Twilio looks attractive at <1x PEG in three years vs. the S&P at >1.3x (on our estimates). It's sort of a bang-for-your-buck analysis, albeit a very rough estimate.

Remember the Napkin Math##

We like the long-term odds on Twilio here. This napkin math suggests the stock is baking in significant pessimism today. Bears are assuming Q4 sales guidance is representative of the next 3+ years for Twilio. We disagree.

When a stock's selling off, we'd encourage you to do this sort of long-term napkin math. You don't need to be a genius to spot when a high-quality company is being "thrown out with the bath water."

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