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Morningstar | Gap Between Twilio’s Competitive Positioning and Market Valuation Continues to Widen; Raising FVE

The start of a new year didn’t bring anything new for no-moat Twilio, as the firm continued its "beat-and-raise" cadence, exceeding our above-consensus expectations on both the top and bottom lines, and upping full-year guidance. Enterprises continue to embark on broad digital transformation journeys to modernize customer engagement and improve operational efficiency, and Twilio’s products are increasingly consistent with this zeitgeist. We are raising our fair value estimate to $89 per share from $83, stemming from the time value of money and modestly higher long-term growth assumptions. Still, shares continue to trade at an outlandish premium, in our view. Though we view Twilio’s competitive positioning as quite formidable, current levels have the stock trading at a forward sales multiple above 15 times. We have an incredibly hard time justifying that kind of multiple for a company that has structurally limited profitability prospects.

Revenue came in at $233 million, an 81% year-over-year increase. Organic growth rates for Twilio and Sendgrid were above 60% and 30%, respectively, indicating strong individual performance even as integration and cross-selling efforts are in the incipient stages. Margins were also a bright spot this quarter, with adjusted gross and operating margins widening 350 and 500 basis points, respectively, to 58.5% and 1.4%. Sendgrid, which has structurally higher gross margins, contributed roughly 300 basis points of the consolidated increase. Still, management reiterated that they are focused on maximizing growth in lieu of profitability, in order to expand their addressable market and fully penetrate opportunities within the enterprise.

Management conveyed some detail surrounding changes in Verizon’s fee structure for certain long-code application messages. The additional fees will dilute gross margins by roughly 1% annually. While this effect is purely mathematical (the fees will be passed through to customers and so there will be no impact on absolute gross margin dollars), in our view it is illustrative of a larger issue endemic to Twilio’s business model. The firm’s reliance on service providers for network capacity makes operating leverage relatively harder to achieve, and we believe this is exacerbated in the U.S. given the negotiating clout of the big four carriers.

Twilio continues to do an excellent job driving incremental usage within its existing customer base even as it adds accounts at a rampant pace. Though our calculated average revenue per account calculations will have to be reset due to the distortion from the Sendgrid acquisition, the firm’s reported dollar-based net expansion rate remained stellar in the fourth quarter at 146%, up from 132% a year ago. The high-margin Orchestration layer of Twilio’s platform, Engagement Cloud, continues to see strong traction anchored by Twilio Flex. Flex had its first quarter of full availability during the March quarter, and management views the product as the first meaningful foray up the application stack. Management indicated that the Flex pipeline is filled with enterprises currently utilizing legacy, on-premise contact center solutions. These types of solutions tend to be the most complex and require the highest degree of customization. The full programmability of Flex puts the product in good stead to take share, in our view, and management indicated that they are aggressively targeting these types of deployments.

Finally, we continue to see product synergies between Sendgrid and Twilio that will enhance the competitive positioning of the combined entity. Sendgrid offers a marketing campaign product that, similar to Flex, is more akin to a software-as-a-service (SaaS) application than it is to a platform-as-a-service (PaaS) offering. As the combined firm endeavors to bring programmability further up the application stack, we believe it will continue to expand the ambit of its customer engagement offering, from the contact center to marketing and much more. These capabilities should allow the firm to become more embedded in the enterprise workflow, as organizations deploy the tools at different points along the customer journey. These dynamics coming to fruition form the basis of our positive trend thesis for Twilio.