Cloud communications app maker Twilio (NYSE:TWLO) recently reported second-quarter numbers that easily topped expectations across the board, and featured a surprise profit due to a combination of robust revenue growth and a big drop in the spending rate. The third-quarter and full-year guides also came in well above Street expectations, and pointed to continued surprise profits in the near future.
In response, TWLO stock jumped — by a whole bunch. As of Wednesday morning, TWLO stock was up more than 20% to a new 52-week high of almost $77 before falling back to $74 at close.
In the big picture, I think this rally in TWLO stock is way, way overdone. The quarter was really good. The fundamentals are strengthening. And, the company has huge revenue growth and margin expansion potential over the next several years.
But, at $75, TWLO stock is trading at 2,500X this year’s guided earnings and 1,110X next year’s consensus earnings estimate. Those multiples just make no sense to me. Indeed, under aggressive modeling assumptions, I think that TWLO stock is fundamentally supported at $75… in five-plus years.
Thus, a $75 price tag on TWLO stock seems exceptionally premature. I fully expect investor euphoria to die down soon, and for that euphoria to be replaced by more enduring fundamentals. At that point, TWLO stock will fall back to levels that make more sense.
Here’s a deeper look.
Twilio’s Quarter Was Really Good
Twilio’s second-quarter earnings report was really good, and in tandem with its solid first-quarter report, Twilio’s operational results year-to-date point to strengthening long-term fundamentals.
The big concern at Twilio last year was that the company had a customer reliance and retention problem. In short, Twilio drew a bunch of its revenue from a select few customers, and one of those customers, Uber, boogied and decided to in-source the services they were getting from Twilio. The market freaked out that other big tech companies would follow suit, and that Twilio’s numbers would deteriorate.
But, that hasn’t happened. Actually, the opposite has happened. Customer growth remains strong (30%-plus growth in the customer base year-to-date in 2018, versus 45% growth per year from 2013 to 2017). All those customers are spending more — the average revenue per customer was up 17% in Q2, versus 16% average growth from 2013 to 2017. Customer retention rates are high, consistently above 95%.
Overall, key performance metrics are actually getting better, illustrating that Uber withdrawal concerns are overblown and that this company has a very healthy long-term growth trajectory through both new customer growth and old customer retention.
Alongside improved top-line performance, margins are expanding by a whole bunch. As management promised, big revenue growth is driving equally big operating expense leverage. In the second quarter, the operating expense rate dropped from 62% a year ago to under 54%, and that drop was big enough to support a surprise swing into operating profit territory.
In the big picture, then, Twilio’s quarter was really good. Customer growth remains strong. Revenue growth is accelerating and margins are expanding.
Twilio Stock Isn’t Worth $75
Given the strong quarter, it is easy to understand why investors are so excited to buy into the Twilio growth narrative.
But this near-term euphoria will eventually subside. It will inevitably be replaced by long-term fundamentals. At that time, TWLO stock could drop considerably.
Twilio’s customer base is growing at 30% and it’s slowing. Thus, my best guess is that over the next decade, Twilio will expand its customer base by roughly 15% per year, implying roughly 200,000 customers in 10 years, versus less than 50,000 in 2017.
As the customer base grows from 50,000 to 200,000, it will be tough for Twilio to maintain robust average revenue per customer growth. Naturally, a lot of new growth will come from smaller businesses, and those businesses will likely spend less on an annual basis. Thus, in a long-term window, I think average revenue per customer settles somewhere around $11,250 per year, versus about $8,000 last year.
During this stretch, gross margins should trend towards management’s long-term 60% target, while the opex rate should fall back to the 35-40% range. That implies operating margins in a decade of 20-25%.
Modeling out all the above assumptions, I think that a best-case scenario for earnings per share in a decade is $3.50, which would be a huge ramp from this year’s expected profits of $0.03 per share. Nonetheless, even $3.50 in earnings per share in a decade doesn’t justify today’s $75 price tag on TWLO stock.
A hyper-growth 25X forward multiple on $3.50 implies a nine-year forward price target of $87.50. Discounted back by 10% per year, that equates to a year-end price target for TWLO stock of about $40.
Bottom Line on TWLO Stock
Investor euphoria regarding this company’s robust top-line growth potential and a recent swing to non-GAAP profitability have shot TWLO stock to levels that are simply unsustainable.
Indeed, I think this stock is overvalued by nearly 50%. As such, when present euphoria inevitably fades, TWLO stock will likely drop in a big way.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.