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Twilio Stock Is Ready to Top Out, but Keep Your Eyes Peeled for a Big Dip

In a best case scenario, Twilio stock ends the year at $90

By Luke Lango, InvestorPlace Contributor

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Twilio Stock Is Ready to Top Out, but Keep Your Eyes Peeled for a Big Dip

Source: Web Summit Via Flickr

Cloud communications app maker Twilio (NYSE:TWLO) has been one of the hottest stocks on Wall Street in 2018. Year-to-date, Twilio stock is up more than 250%, while the S&P 500 is up less than 8%.

What has driven the massive out-performance in Twilio stock? The market realized that Twilio was emerging as the uncontested leader in the rapidly growing and potentially huge Communication Platforms as a Service (CPaaS) market.

The CPaaS market, which comprises companies integrating real-time communication into their services, will be huge due to the secular shifts towards cloud-based communication, personalized customer experience, and digital engagement. Some peg this market as growing by five-fold over the next five years.

Twilio, with huge customer and revenue growth and a 95%-plus retention rate, has emerged as the leader of the CPaaS market. When you emerge as the leader in market that could grow by five-fold over the next several years, your stock naturally heads way higher.

But, at current levels, the valuation on Twilio is tough to justify. Even if you forecast Twilio to maintain market share and grow revenues by five-fold over the next five years, and assume that operating margins swell to management’s long-term targets, an $80 price tag for Twilio stock still seems pretty full.

Meanwhile, if you project much more reasonable growth, Twilio isn’t worth much more than $70 today.

As such, I’m concerned about valuation when it comes to Twilio stock.

Having said that, hyper-growth stocks like this tend to ignore valuation during their hyper-growth stages. Thus, so long as revenue growth remains robust, margins expand, and the long-term growth narrative is affirmed by the numbers, this stock will head higher.

Twilio Has Strong Long-Term Drivers

Twilio’s long-term growth narrative is very promising.

Cloud is one of the biggest growth stories in the market, and CPaaS promises to be on the biggest growth segments within the cloud market over the next five to ten years. There are four big drivers here:

One, engagement is only becoming more digital than ever, meaning consumers are increasingly interacting with businesses and their services through digital interfaces like websites and apps.

Two, because engagement is becoming more digital than ever, communication between consumers and businesses is becoming increasingly digital (think texts, notifications, so on and so forth).

Three, the consumer-facing business economy has become more crowded than ever, meaning companies increasingly need to differentiate their customer experiences in order to get ahead of the competition.

Four, enterprises are shifting all their infrastructure to the cloud, and that includes communication services.

Due to these four big drivers, the CPaaS market is set to boom over the next several years. Simply, more and more companies will turn to CPaaS to communicate effectively, dynamically, and digitally with their customers.

In 2018, Twilio has emerged as the leader of this market. The company has reinvigorated revenue and customer growth, and maintained a sky-high retention rate.

Also, the company has put to rest customer reliance concerns (the top 10 customers account for less than 20% of total revenue), while also easing concerns about companies in-sourcing CPaaS operations (robust customer growth and high retention directly refute that bear thesis).

Meanwhile, margins are soaring thanks to opex leverage, and the company is on the cusp of becoming profitable.

Put it all together, and it is no wonder why Twilio stock has run so far, so fast. If you ignore valuation for a moment, then the growth narrative appears strong enough to keep Twilio stock on a solid long-term uptrend.

Valuation Looks Rich

Even under aggressive growth assumptions, the current valuation on Twilio stock is tough to justify.

One of the more aggressive estimates for CPaaS market growth comes from IDC, who expects the market to grow by more than five-fold over the next five years from $2 billion to $10.9 billion.

According to those numbers, Twilio controlled 20% of the CPaaS market in 2017.

Let’s aggressively assume three things: 1) IDC estimates for five-fold growth over the next five years are accurate, 2) Twilio is able to maintain market share despite rising competition, and 3) Twilio hits its long-term 20%-plus operating margin target in five years.

Even under those aggressive modeling assumptions, Twilio stock is still worth only ~$90 today. Modeling those assumptions out, I arrive at over $2 billion in revenues in five years and earnings per share of ~$2.90.

At that time, Twilio will likely be a 20% grower much like current cloud giants Adobe (NASDAQ:ADBE) and Salesforce (NASDAQ:CRM). But, with margins likely maxed out in the 20’s, Twilio stock will look more like Adobe than Salesforce by 2022.

Adobe trades at 40X forward earnings. A 40X forward multiple on $2.90 implies a four-year forward price target of $116. Discounted back by 10% per year, that equates to a year-end price target of just under $90.

Thus, even in an “everything goes right” scenario, Twilio stock isn’t worth much more than $90 today.

Meanwhile, in a more realistic scenario calling for more tempered CPaaS market growth and slight market share erosion due to competition, I think Twilio stock is worth about $70 today. In that scenario, earnings should shake out to $2.25 per share in five years. Using the same 40X forward multiple and 10% discount rate, that leads to a price target of just under $70.

Stock Should Head Higher

There’s no hiding it. The valuation on Twilio stock is stretched.

But, hyper-growth stocks like Twilio that are emerging as leaders in a secular growth market tend to defy the laws of valuation for an extended period of time. These stocks tend to track revenue growth, because so long as revenue growth remains big, the numbers affirm the long-term bull thesis of huge CPaaS market potential.

From this perspective, Twilio should continue to grind higher. The CPaaS market is just beginning its transition from nascent and niche, to huge and mainstream. During that transition, Twilio’s top-line numbers will remain strong and its stock will head higher.

Bottom Line on Twilio Stock

Don’t short Twilio here. Shorting a hyper-growth stock with tremendous potential and momentum is a recipe for disaster, but don’t buy the stock in bulk either.

While the growth narrative lends itself to multi-year share price appreciation, the valuation today seems to fully account for big growth for many years to come.

As such, I think this is a “buy the dip” stock. Eventually, this stock will have a big dip, as all hyper-growth stocks eventually do. I think that will be a dip worth buying. Until then, I think valuation will cap upside potential.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities, but may initiate a long position in TWLO within the next 72 hours. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/09/twilio-stock-big-dip/.

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