Twilio is often categorized as cloud yet its business model is truly unique in every sense of the word. It’s not only the company’s gross margin of 50% versus the typical 70% that separates the company, but conversely, it’s also the lower sales and marketing expenses and lower R&D that make this company unique.
Here’s how Twilio compares to Top 10 cloud valuations on sales and marketing at 32% of revenue for sales and marketing (S&M):
Here’s how Twilio compares with Top 10 cloud valuations with 16% spent on R&D:
When you combine the two line items, Twilio makes up for its lower gross margin with lower S&M and R&D. These line items have been range bound with the percentages seen above since 2014 with the company going public in 2016 and some financials from 2014 being available. Therefore, this is not due to scale or any type of customer mix from the pandemic or some kind of economic pressure.
I’ve made the argument that I believe Twilio has established a defensible moat when I covered the stock for MarketWatch in July of 2020. This elusive moat is why I believe those line items track much lower for Twilio as a platform compared to cloud software companies. Here’s what the article said from two years ago:
Twilio works with 1,000 mobile carriers in over 150 countries. The logistics around this are a nightmare for most developers and also for potential competitors. Uber developed this in-house but it was a rare situation where SMS and voice APIs are integral enough to warrant the investment […]
In 2017, Uber had a $60 million annual run rate with Twilio and decided to source different vendors. Even at this level, the company did not build the capability in-house and still remained with Twilio for high-performance messaging. Eventually, Uber migrated to Twilio’s main direct competitor — MessageBird.
Despite chipping away at Twilio since 2011, MessageBird has about 15,000 customers compared with Twilio’s 165,000. The company has been able to do this by serving the developer market and building out an extensive API library and documentation in which telecom features are integrated through a few simple lines of code.”
*Twilio now has 275,000 active customer accounts and MessageBird has 25,000 customer accounts. Some of Twilio’s growth is from the acquisitions.
Twilio raised the number of registered developer accounts from 5 million to 10 million at the 2020 Investor Day. This puts Twilio second to companies like Apple and Nvidia in terms of its popularity with developers. Point being, there are puts and takes with this company – gross margin is low but operating expenses are also low from strong management execution.
Rather than Twilio’s gross margin weigh on the company, I believe it could be the GAAP profitability first and foremost (which is a line item where we are not seeing improvementwe are not seeing improvement in the near term) and then it was the contracting adjusted profitability margin and contracting free cash flow margin second (adjusted OM and FCF are reversing course, which is why we entered).
We also entered the stock because the forward revenue growth is actually quite high and puts the company into a higher valuation bracket than where it currently participates – but this is only important if we see some improvement in bottom line numbers as the GAAP profitability is where Twilio ranks low as a category peer.
The improvement in FCF and adjusted operating margin was not as easy to see in the previous earnings call because the company had only announced plans to be remote first resulting in lower real estate costs. The 11% layoffs announced in September help to complete the picture.
I do believe the end result will be Twilio becoming (narrowly) free cash flow positive, which I expand on below. Management has already stated they will be profitable on an adjusted basis “by early 2023” and analyst consensus agrees with this. Twilio has not missed a top line estimate or a bottom line estimate for four years (as far back as the history allows) and so the probability the company meets this adjusted profitability expectation in early 2023 is high.
It was primarily valuation that caused us to enter as the company is priced for the worst case scenario. Yes, macro can force valuations lower yet I believe Twilio should be in the 5.5X NTM revenue bracket, and instead, the stock is trading at 3X NTM revenue. The 5.5X NTM cohort still has messy GAAP operating margins yet many are FCF positive.
With quarter or two of a return to FCF positive, Twilio can contend with 5.5X up to 7-9X NTM revenue given its growth rate. Technically, this is still at discount as the organic growth rate would put the company in the 11X NTM revenue bracket. However, GAAP profitability weighs on Twilio and must be discounted, which we discuss below.
Twilio Financials
The company reported revenue growth of 41% in Q2 and is expected to report growth of 31% next quarter. Last quarter, the company reported revenue growth of 48%. This is down from 70%-80% growth in 2019 and down from 60%-70% during 2020-2021. The management has stated their goal is 30% organic growth.
The company’s organic growth was 33% in Q2 with $37 million from acquisitions and $44 million from telecom fees. In Q1, the company reported 35% organic growth.
Twilio’s organic growth is broken out because the company collects and then pays 10DLC A2P telecom fees and the company has also had a string of acquisitions (SendGrid, Segment, Zipwhip and Syniverse, for example).
Next quarter is key because the company will only break out A2P telecom fees for total vs organic as the acquisitions will have lapped one year. For comparison purposes, had this change occurred last quarter, then Q2 revenue growth would have been reported as organic growth of 38.5%.
The company’s net retention rate has slowly eroded over time, currently at 123% down from 127% in the previous quarter and down from 131% in the year ago quarter.
The company reported a GAAP gross margin of 47% and an adjusted gross margin excluding A2P fees of 54.3%. The GAAP GM was 48% last quarter and 47% two quarters ago yet the company previously had gross margins at or above 50%. Any slippage here is penalized.
Management stated the gross margin is lower because international is increasing in percentage of revenue at 35% compared to 33% in the year ago quarter. Here is what was said:
“This decline was primarily driven by the strength of our international messaging business. U.S. 10DLC carrier fees reduced gross margin by approximately 330 basis points in Q2. The continued success of our messaging business often serves as a critical foot in the door with our customers, opening up opportunities to add more value with our higher margin software products over time. We believe this will ultimately drive higher gross margins, allowing us to achieve our long-term non-GAAP gross margin target of 60%+.”
This quarter stood out for having less growth YoY in the company’s total gross profit at 34.5% YoY growth to $445M in gross profits compared to 59% YoY growth last year for $331M in gross profits in the year ago quarter.
Twilio stated goal is to reach 60% GAAP gross margin from a mix of the software product and the core product. Although this may take a couple of years to reach 60% GM, I believe with early signs of GM expansion, the stock will be rewarded.
The adjusted operating loss for the quarter was ($7M). For Q3, the company is guiding for adjusted losses of ($65M) at the midpoint which includes a one-time expense for employee sabbaticals of $35M. As stated, Q3 is expected to be the bottom for Twilio’s adjusted operating losses. Let’s hope it’s also the bottom for Twilio’s gross margin although international mix creates some uncertainty on where this could bottom.
The company reported adjusted EPS of ($0.11) compared to ($0.05) in the previous quarter and is flat from the year ago quarter. The adjusted EPS for Q3 is expected to be ($0.35) and will be ($0.13) EPS in Q4. As stated, by 2023, Twilio will be profitable on an adjusted basis.
Per the CFO on the Q2 earnings call:
“And you probably noted that we've taken some actions with respect to slowing down hiring except for some key areas. We're taking — we guided based on having a real estate charge, which I think reflects our kind of remote-first approach to the way that we're going to work going forward. And I think both of those things will drive profitability into next year. And I think irrespective of the macro environment, we're intending to be profitable next year no matter whether it has an impact on growth or not.”
Ultimately, Twilio’s Q2 earnings report weighed on the company due to a slipping bottom line. GAAP EPS was ($1.71) versus ($1.31) a year ago. Stock based compensation was at 25% of revenue for $242M, up from 18% of revenue last quarter.
Looking forward on GAAP EPS, there are one-time items that will weigh on Q3’s GAAP EPS. The first is a $100 million expense due to real estate closures as Twilio is moving toward being remote-first. This this was discussed in the prepared remarks: “We also announced our decision to become a “remote-first company” and made a significant reduction in our real estate footprint. We’ll continue to closely monitor the returns on our investments, and make adjustments as needed, in an effort to recognize further efficiencies as we scale.”
The company also recently announced layoffs, which will result in expenses of $70 million to $90 million. This one-time expense will also be primarily recognized in Q3 – so Q3 setting up to have a couple hundred million dollars of extra one-time expenses in the GAAP operating losses.
Twilio had negative free cash flow of ($78.5M) in the most recent quarter with a FCF margin of (8.3%) this is down from (4%) in the previous quarter although a slight improvement from the (11%) in the year ago quarter.
I believe what the market will be looking for is comments on free cash flow as the company LTM FCF was ($253 million) but with the two reductions — real estate from remote work and 11% headcount reduction, Twilio has to ability to become FCF positive very soon – in the next two quarters (Q4 and Q1) once the expenses pass and the reductions start to take effect.
Due to the market being forward looking, this is likely the line item that will help the stock’s price if management can appease The Street. I believe that’s the goal as Twilio has a median salary of $150,000 and at 11% reduction results in $150 million for the year that follows Q3. If Twilio targets a small percentage higher than its median, the company can get this number to $170 million on headcount alone. It’s also reasonable to assume Twilio will see $75 million reduction in real estate expenses. Twilio's lease ends in 2025 so the $100 million fee has to be able to offset three years left in a lease. Maybe it's closer to $50 million but somewhere in that area to justify the $35 million termination fee per year averaged over three years (is my thinking).
Regarding the headcount reduction, Twilio did state that it would come from the core product where they will push customers to be more self-serve. Due to the developer friendly documentation the company provides, they do not believe there will be any additional churn from this transition. From there, they will focus on new hires for the software team.
In addition, Twilio raised equity in February of 2021 and debt in March of 2021. The company currently has debt of $986M and cash and marketable securities of $4.4B down from $5.4B last year due to a $750 million equity investment in Syniverse. Syniverse was valued at $2.85 billion at the time of that Twilio became a large shareholder. Of this, the company has cash of $800 million down from $1.49 billion in the year ago quarter.
Modeling Twilio’s GAAP Profitability
I thought it would be interesting to see a financial model for Twilio’s GAAP profitability given how many moving pieces there are — primarily, operating cost reductions yet an intention to ultimately increase headcount on the software side. Also, I thought it would be interesting to see the impact a 62% gross margin would have if/when Twilio gets there. You can see below this would result in GAAP EPS of ($0.84). This is an improvement but the company will not be GAAP profitable (by this estimate) until the company scales to much higher revenue. The gross margin will not be enough.
You can see the entire model on this Google Doc here. It was prepared by Arun Gopalakrishnan, a Financial Analyst that we are contracted with.
The following information was used for the model:
Expect sales & marketing expense to continue expanding albeit slowly "as we continue to expand our sales efforts globally" coupled with hiring freeze (Source: Q2 2022 page 31 Financials)
Expect R&D to increase as company continues to hire in growth areas and "focus on enhancing Twilio Segment and Flex products and strengthening platform infrastructure". R&D will house most of the increase in personnel costs (Source: Q2 2022 page 31 Financials)
We're focusing our hiring efforts on areas that we believe will unlock significant value and present strong opportunities for continued growth such as Segment, Engage and Flex, and we’ve frozen the vast majority of new hires and backfills outside of these areas. (Source: Khozema Shipchandler – Q2 2022 Earnings Call Page 9)
We also announced our decision to become a “remote-first company” and made a significant reduction in our real estate footprint. (Source: Khozema Shipchandler – Q2 2022 Earnings Call Page 9)
One-Time Expense of $35M in Q3 2022 for new sabbatical program for tenured employees & non cash impairment charge associated with the closure of several offices (Source: Khozema Shipchandler – Q2 2022 Earnings Call page 10)
Excludes One-Time Expenses, Non-Cash Charges, Capitalizes majority of R&D expense. Management is moving salaries to performance based salaries (non-cash) so not included in Non-GAAP.
Source: TWLO Profitability Analysis Google Doc Link Here
What is Twilio’s Thesis?
For Members who have been with our site for a few years, you’ll recall that I’m quite bullish long-term on Twilio. This has not changed, rather macro forced us to step aside and see how management weathers the new FCF-forward reality. My product thesis is best described in a 1-hour webinar from April 2021 but I’d like to take the opportunity to reiterate a few points.
An important catalyst to look for is when Google eliminates third-party data from Android and Chrome when the company officially launches Privacy Sandbox. This was expected to occur in 2023 yet has been delayed to 2024 although is being beta tested right now.
We want to watch Twilio closely around this time as its customer data platform is based off the importance of first-party data, yet the transition that Apple began with deprecating the IDFA and introducing App Tracking Transparency (ATT) will not be complete until Android and Chrome participate.
The results will be mobile identifiers and third-party cookies become obsolete by 2024 (note: I do wonder if this timeline will be moved up to end of 2023/very early 2024 if Google continues to see macro headwinds to its ad business).
Similar to how Twilio was a few years ahead of the mobile app economy, the management is very early is very early to the shift toward leveraging first-party data. Phone numbers and email addresses make up the most valuable first-party data available on the internet called personally identifiable information (PII). I believe the Twilio management team has been planning for this for 6 years since the 2018 SendGrid acquisition which combines their core product’s access to phone numbers with a trove of email data. This was a very smart strategic move that is not fully recognized yet until access to third-party data is eliminated, which will put immense pressure on companies to make the most of their first-party data. The caveat is the management team must execute.
My understanding is that very few companies will be able to help unlock the enormous value of first-party data as Twilio has a natural path to collecting phone numbers and emails on behalf of B2C companies.
Previously, I had written the following which I still believe to be true yet will take time to fully recognize (Google’s move being a lynchpin for Twilio competitors):
“Keep in mind, the power of data exponentially increases so each signal Twilio adds is not a linear increase in ROI from a marketer’s perspective – it compounds. In other words, by having four signals, Twilio can beat a competitor like Mailchimp with SendGrid because of the cross-channel data and touchpoints they offer*. The same could be said for Zendesk versus Twilio Flex as to why Flex might be stronger (cross-channel data points).
This is why, on a product-level, I see Twilio increasing its market share against competitors.”
Note: Twilio is not the marketer, the customer remains the marketer (Nordstrom’s, Kroeger’s, Chevrolet, Proctor & Gamble, etcetera) remain being the marketer. Instead, Twilio helps those companies’ market more their databases more effectively. This is not the same asnot the same as third-party datathird-party data where Nordstrom’s (for example) mixes data that is not their own to market customers. This is done through third-party platforms with access to third-party data – which is a marketplace entirely enabled through mobile IDs and cookies.
Twilio is building the antithesis of a third-party ad exchange or marketing platform — and doing so well in advance of the first-party data era which officially began last year with Apple.
This was discussed on the Q2 earnings call:
Q: This is Abhinav on for Siti. I guess the first kind of question would be just with Google delaying recently their application of third-party cookies now, again, from 2023 to 2024, have you seen or do you expect this to change the demand environment a little bit around CDP's customer engagement more broadly and maybe that transition away from third party? And do you see some of the urgency kind of diminish for some of your customers that are coming in?
A (CEO, Jeff Lawson): Thanks for the question. Yes, I think what we see is the — it's taking a little bit of pressure off of companies. I mean, if you think about it, like 2023 is not that far away. So in some ways, it's actually pretty reasonable to give a little more time for such a big change in the Internet ecosystem to roll through.
That said, I mean we did a survey, and it was like — I think it was 70%, some number like that, of companies were not ready for this change. Now that creates demand for our products. But you also can't imagine that, that number of companies are going to magically like put the switch and completely flip their technology stack in just a month's time. And so I think it's giving a little bit of pressure release now.
But it still is a great environment for the CDP given that customers actually do have a lot more time to actually make these thoughtful changes, and we are already seeing some fantastic stories from the customer base emerge that really is giving our customers confidence that this first-party data approach is not just going to be tenable, like it's a big change for folks. But actually, it's going to be tremendously beneficial.”
Twilio also frequently discusses the higher ROI they are proving through case studies from using first-party data instead of only relying on third-party data for marketing purposes. Per the Q2 earnings call:
“A couple of the stories that we've shared publicly is Allergan using Segment was able to get a 41% reduction in their cost of customer acquisition, which is — those are amazing numbers. Another great customer story is from Domino's, who in Mexico was using Segment to build smarter customer audiences. And as a result of that, doing better ad buying, and they saw their return on ad spend increased 700%.”
In 2021, we had also discussed Twilio moving from being developer-centric to now also becoming sales/marketing-centric: “This also means Twilio is going through a pivot, not only on the product level but the customer level. Although Twilio will remain a developer-centric company, they will also need to appeal to the marketing and sales departments […] Developers will, of course, be the ones to implement Twilio’s APIs and products but there’s evidence that Twilio’s target customer is expanding to also include “marketing, sales and service leaders.”
This piece of the pivot (the new customer base being enterprises rather than developers) can be seen as either an obstacle or an opportunity. Twilio has certainly increased its serviceable addressable market and any success here will be seen in the gross margin long-term due to software sales.
5G is also a catalyst for Twilio. The company is quietly building more IoT products and will be able to tap into this market when adoption rises. I’ll leave that for a future deep dive when we revisit 5G from the consumer and enterprise standpoint. Marvell would give us the first signal this market is picking up since they are equipment related.
Risks:
A risk to consider is that Twilio’s gross margin could continue to soften from a higher international mix. Political ads will take effect in Q3 with the majority of spend recognized in Q4, which should bump up domestic spend. In Q4 of 2020, political spend was $23 million. The breakdown was not available for Q3 of 2020. Here is what was discussed in the Q4 earnings call:
“Fourth quarter non-GAAP gross margin was approximately 56% and was negatively impacted by 150 basis points from A2P fees. Twilio's gross margin, ex-Segment, was approximately flat quarter-over-quarter, aided by political traffic in the United States.”
If GM continues to soften, then we will look at how this affects the bottom line and make our decision based on both top line and bottom line margins.
Another risk to consider is Twilio’s revenue estimates are quite high in the current environment considering most ad/marketing companies are seeing reduced spend. However, with the current information we have, it seems B2C companies in some industries are less reluctant to switch off SMS compared to ads. Twilio said the following about their current trends:
“Now we did call out a couple of pockets of softness in Elena's section of the prepared remarks, where we commented that, for example, in crypto or social or on-demand related activities that we're seeing a little bit of slowdown. But on the flip, we are seeing some strength as well in financial services and IT-related spending.”
If Twilio misses on revenue, we will be forced to step aside as every management team needs to build trust right now with Wall Street given the bearish market. This is true for most of our stocks.
The third risk to consider is further acquisitions. We will close our position and step aside if this happens as the company has tested the upper limit of our appetite for M&A activity.
Additional Resources:
Earlier this week, we published a forum post about our entry in Twilio. There are additional posts from Members on Twilio that also articulate the pros/cons of this particular company and are well worth the read.
I wrote about Twilio’s gross margin in Q2 2022 here.