There’s seemingly a nice case for Twilio (NYSE:TWLO) stock at the moment. The cloud communications company has embedded itself in the app ecosystem. Revenue is growing at an impressive clip. Wall Street remains firmly behind the name. And while Twilio stock might not be cheap, it’s at least cheaper after a 35% decline from July highs.
After that pullback, TWLO stock admittedly does look more intriguing. I was a bull on Twilio stock heading into 2018, and reversed field at the beginning of 2019. With software sector multiples higher than they were 11 months ago, and TWLO stock up just 10% year to date despite solid performance, I’m tempted to flip again.
But there’s one significant concern about the Twilio operating model that still gives me pause, even with Twilio stock below $100. That concern suggests that the discount to peers is well-deserved — and should persist.
Case for TWLO Stock
Again, there’s a nice case for TWLO stock at the moment. Growth this year has been impressive, with revenue up 80%. The acquisition of SendGrid has contributed, but Twilio’s legacy business still increased sales 47% year-over-year in the third quarter.
Wall Street expects a deceleration to 32% growth in 2020, but that figure may be conservative. Twilio has never missed a quarterly revenue estimate since its initial public offering in 2016. And a Bank of America analyst argued this week that top-line growth of 40% could be achievable.
Yet Twilio stock isn’t valued as dearly as other companies posting similar revenue performances. Backing out net cash, TWLO trades at almost exactly 10x the 2019 consensus revenue estimate. Shopify (NYSE:SHOP) is valued at 26x this year’s revenue with 2020 growth projected at 35.5%, barely above that of Twilio. MongoDB (NASDAQ:MDB) trades above 20x sales. So does Roku (NASDAQ:ROKU), excluding its unprofitable player revenue.
Even assuming TWLO stock shouldn’t necessarily receive a premium multiple, there’s still upside to the stock on a price-to-revenue basis. Indeed, the shares historically traded closer to 15x on several occasions, including this summer.
Turning to 2020, then, there seems to be a case for enormous upside in Twilio stock. Revenue next year should near $1.5 billion. Put a seemingly reasonable 12x multiple on that figure, add the nearly $2 billion in cash and investments on the balance sheet, and TWLO stock gains almost 50% from current levels to north of $140. Wall Street isn’t quite that optimistic, but the average price target of $132 still implies 35% upside over the next 12 months.
Twilio’s Gross Margin Problem
All that said, it’s important to put revenue-based valuations in context. They’re used in cases with a company is thinly profitable — as Twilio is — or unprofitable. More broadly, they’re used as a measure of estimating potential future profits. Those future profits, after all, are the theoretical basis of valuation.
And Twilio’s revenue simply isn’t as profitable as that of other high-growth companies. Its gross margin so far this year, backing out non-cash amortization of intangible assets acquired in the SendGrid deal, is just 58%. That’s well below most software companies (though to be fair, Shopify’s gross margin is just 56% over the same period).
More importantly, that figure is not likely to increase. Adjusted gross margins have risen about 4 points so far this year — but almost entirely due to SendGrid. Going forward, expansion is going to be limited due to the very nature of Twilio’s model.
When Twilio picks up incremental revenue by providing text messaging or calling services, its gross margin stays roughly the same. It still pays network service providers to actually carry that data. Its cloud fees paid to Amazon (NASDAQ:AMZN) go up as well. Looking at 2018 results, before the SendGrid deal closed, revenue increased 62%. Cost of revenue rose 64%. The 10-K cited network service costs as the primary factor.
Valuation Issue for Twilio Stock
The reason that high-growth software and platform stocks get huge price to revenue multiples is that revenue growth is hugely profitable. For a company like Uber (NYSE:UBER) or Facebook (NASDAQ:FB), both of which are Twilio customers, each additional revenue dollar is enormously profitable. The platforms already are built. Similar costs wind up being spread across a larger revenue base, boosting margins.
Twilio’s model doesn’t work that way. Due to network costs, each additional revenue dollar is about as profitable as the one before it. So-called incremental margins simply aren’t that impressive.
The gross margin problem creates two issues for Twilio stock. First, the company simply isn’t likely to be as profitable at maturity. A software company driving gross margins of 75% or higher is going to have higher overall profit margins than Twilio at 58% or even 60%. That alone suggests that Twilio’s revenue will be less valuable. That in turn means TWLO stock should receive a lower multiple.
The second problem is that the lack of incremental margins creates a headwind to earnings growth. 2020 Street consensus sees 2020 adjusted EPS at 25 cents, nearly double the expected 13 cents in 2019. But that growth is only impressive because margins now are so narrow. Consensus suggests that net income will increase $15 million next year — roughly 1% of revenue.
The only way for margin expansion to accelerate is for Twilio’s revenue growth to be significantly higher than its operating expenses. But operating expense growth is going to be high for the foreseeable future. Twilio faces competition from privately held Plivo as well as Vonage Holdings (NYSE:VG) unit Nexmo. It can’t rest on its laurels.
Is The Sell-Off Justified?
This all is a long-winded way of saying that Twilio lacks operating leverage. As a result, its margin expansion likely will be slower, and result in a lower peak, than other high-growth names. And so its price-to-revenue multiple probably should be lower than that of other widely owned growth stocks.
Of course, that doesn’t mean Twilio never will be consistently profitable. It doesn’t mean Twilio stock is a short. And, in fact, it doesn’t mean TWLO stock remains too expensive.
It’s certainly fair to argue, as bulls and many analysts do, that the sell-off has gone too far. With the likes of SHOP and ROKU rebounding, TWLO probably looks like a value play among growth stocks. There’s still a big addressable market here, and a market that should continue to grow for years to come.
Twilio’s revenue growth still will leverage SG&A (selling, general, and administrative) expenses over time. A takeover remains possible: Cisco Systems (NASDAQ:CSCO) is among the tech giants floated as a possible acquirer.
But there are real concerns here, even with TWLO back below $100. Twilio infamously lost a chunk of its business with Uber back in 2017, and now Facebook’s WhatsApp reportedly is pulling back. In SEC filings, Twilio has disclosed pricing reductions, and that could continue in the highly competitive space. Valuation is cheaper, but hardly cheap even assuming margins expand over the next decade.
More broadly, investors have to look beyond Twilio’s revenue to its margins. That’s where the concern lies, and that’s what justifies both the recent sell-off and the fact that Twilio seems so ‘cheap’ given its top-line performance.
As of this writing, Vince Martin has no positions in any securities mentioned.