The Three Key Risks of Buying Twilio Stock

TWLO continues to soar, but there are at least three reasons to think the run may be nearing an end

Twilio (NYSE:TWLO) continues to soar. Twilio stock has risen 64% so far this year. That comes on top of an even better 2018, when TWLO stock gained some 278%.

As far as the gains go, I’ve been half-right. I recommended TWLO stock in late 2017 as one of ten stocks to buy. But I also argued at the beginning of this year that Twilio stock seemed to have run too far.

That caution in January looks foolish at this point,  but so does the continued run of Twilio stock. With the stock again nearing all-time highs, it’s posing risks now. And while those who have been skeptical of Twilio stock so far have been proven wrong, there are three reasons to believe that, finally, TWLO stock is set to run out of gas.

The Valuation of TWLO Stock

On its face, Twilio stock looks overvalued. It trades at over 17 times  analysts’ average 2019 revenue estimate. Based on the average 2020 profit estimate, its forward price-earnings ratio  is a staggering 490.

That said, valuation based on two near-term metrics is not a reason to short Twilio stock or even sell it. Twilio has a huge opportunity with its CPaaS (Communications Platform as a Service) offering. In this market, good companies — and particularly good software companies — are prized and, thus, have expensive valuations. Salesforce.com (NYSE:CRM), for instance, has driven years of impressive returns, yet that stock has never been “cheap” and in fact still isn’t.

In fact, for the entirety of this decade-long bull run, investors avoiding stocks that look expensive on near-term metrics have missed out on big gains. Growth stocks like TWLO have sharply outperformed value stocks, reversing a long-term trend. And there are  software plays other than Twilio stock with similar revenue-based valuations. Among them are Veeva Systems (NYSE:VEEV), Paycom Software (NYSE:PAYC) and Shopify (NYSE:SHOP).

So an investor can’t dismiss TWLO stock out of hand simply because it looks expensive. It should look expensive, at least judging by the valuation of other stocks in its sector. There may simply be a bubble in all the “-aaS stocks,” as some investors might argue at this point. Still, the valuation of TWLO stock isn’t that far out of line with its peers.

Risk #1: Does Growth Match the Price?

That said, the issue with Twilio stock is that it’s valued higher than almost every other software play out there,  yet its growth isn’t that spectacular versus its peers. Its revenue is expected to grow 70% this year, but a good chunk of that is coming from its acquisition of SendGrid, which closed at the beginning of February.

TWLO’s 2020 sales are expected to rise 33%. That’s solid,  but not spectacular for the software space. Shopify and Square (NYSE:SQ) should have similar growth rates. MongoDB (NASDAQ:MDB) — whose price-sales ratio is admittedly even higher than Twilio stock’s — and The Trade Desk (NASDAQ:TTD) are in the same ballpark as well.

Even in the context of the huge valuations of software stocks, TWLO stock appears to be trading at  a premium. Investors are treating this like one of the best growth stories out there — and, from a revenue standpoint, it’s close to that at the moment. But revenue alone can’t drive long-term returns, and there’s a key reason to believe that Twilio stock actually merits some sort of discount to other growth stocks in the sector.

Risk #2: Gross Margins

The key fundamental issue for Twilio stock is gross margins. In 2018, its adjusted gross margins were flat year-over-year at just 55%. The addition of SendGrid will boost that figure, but TWLO’s gross margin still rose to just 58% in Q1.

That’s a very low figure for the space. Salesforce’s non-GAAP gross margins were 77% in its most recent year. For Veeva, the figure was 73%, and Paycom ‘s was 85%.

And the problem is, particularly once the one-year-anniversary of the SendGrid deal passes, those gross margins aren’t likely to rise. There simply isn’t a lot of leverage in the Twilio model; more revenue simply means more payments to network-service providers. With margins 15 points or more below a number of its software peers, Twilio is likely to be less profitable than they will be over the long-term.

Yet, the buyers of Twilio stock are paying as much or more per dollar of revenue than they are for almost any other software play out there. If TWLO’s revenue doesn’t  lead to as much profit as that of its peers, TWLO’s valuation starts to look too high. Indeed, even Wall Street analysts appear to be taking that into account: the average target price on TWLO now is less than $2 above the current price of TWLO stock.

Risk #3: Competition

The last concern is competition. TWLO stock took a big hit in 2017 after two key customers reduced their spending on TWLO’s solutions. Both Uber (NYSE:UBER) and Facebook (NASDAQ:FB) unit WhatsApp diversified their CPaaS spending, with Uber bringing some functions in-house. Those moves were a key reason Twilio stock plunged in 2017; investors were worried that TWLO wouldn’t be able to hold onto its most lucrative customers.

Those worries clearly have been assuaged to some degree. But competition remains a concern. VoIP providers like Vonage (NYSE:VG) offer similar services. (Vonage’s Nexmo unit is a direct competitor.) And TWLO’s largest customers can develop internal solutions, as Uber did.

The dilemma, at this price, is whether or not Twilio can remain the market leader and still  report declining revenue growth. There’s a real question as to whether TWLO truly has a moat, i.e. a difficult-to-surmount advantage over its competitors and potential future competitors.  More importantly, given its lower gross margin, Twilio may not have as much pricing power as Twilio stock bulls hope. If that’s the case, its margins won’t rise, and its earnings won’t grow to the extent that’s currently priced into Twilio stock.

The Case for Twilio Stock

To be fair, there’s an easy retort to these risks. They’ve been cited before, when TWLO stock traded at $25, and $55, and (as was the case when I recommended caution earlier this year) $93. The stock now is at $143. The bulls were clearly right then. They may well be right again.

And Twilio is a tough company to bet against. CEO Jeff Lawson has a strong track record, having driven the growth of both Amazon.com (NASDAQ:AMZN) Web Services and StubHub (which is now a part of eBay (NASDAQ:EBAY)). The CPaaS market on the whole is going to grow. Investors like the sector: smaller CPaaS players like 8×8 (NYSE:EGHT) and RingCentral (NYSE:RNG) trade at huge multiples as well.

I am concerned about the valuation of TWLO. However, there have been valuation questions about every SaaS stock in recent years; many of them have doubled or better during that period. I do think Twilio’s run is doomed to stall out, but I’m not the only person to have made that case. So far, pretty much all of us have been wrong.

As of this writing, Vince Martin has no positions in any securities mentioned.

 


Article printed from InvestorPlace Media, https://investorplace.com/2019/06/three-key-risks-twilio-stock/.

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