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Morningstar | Twilio to Acquire Sendgrid in All-Stock Deal; High-Margin Engagement Cloud Stands to Benefit

On Oct. 15, Twilio announced it had entered into a definitive agreement to acquire Sendgrid, a provider of email API products for transactional as well as promotional use-cases. In our view, although Twilio is paying a high price for SendGrid in terms of an enterprise value to sales ratio of roughly 18 times, we like the strategic fit of the deal and believe that Twilio is using overvalued stock to fund the deal. We will raise our fair value estimate for Twilio to $63 per share from $46, not because of the Sendgrid deal (which we view as value-neutral at the moment), but rather a more constructive medium- to long-term outlook surrounding the firm’s competitive positioning within the Communications Platform-as-a-Service, or cPaaS, industry, which is expected to see torrid growth over the next few years. We will maintain our no-moat and positive trend ratings for Twilio.

The all-stock deal values Sendgrid at approximately $2 billion, which represents a roughly 14% premium to the firm’s stock price prior to the announcement. Twilio’s shares tumbled as much as 12% in early trading before recouping some of its losses, which we suspect stems from concerns about the price paid and dilution. The dilution issues are exacerbated by a generous employee stock-based compensation plan, and the fact that the firm is bereft of a meaningful buyback program. We think the dilution will ultimately be offset however by various growth synergies that will materialize.

We raise our fair value estimate for Twilio as we foresee stronger revenue growth, predicated on increasing digital adoption amongst traditional enterprises as well as digital native businesses. We also see slight upside on the margin front, as the firm continues to innovate at the orchestration layer of their platform, known as the Engagement Cloud. In short, APIs in the Engagement Cloud are higher margin because most the costs associated with providing these services are embedded within the lower foundational layers.

Using Sendgrid’s reported fiscal 2017 revenue, the deal price implies a fairly rich enterprise value to sales multiple of roughly 18 times. However, if we annualize the firm’s revenue from the first 6 months of fiscal 2018 and normalize for historical seasonality trends, the implied multiple ends up between 13 and 14 times, which we deem as reasonable given the strategic fit. In terms of post-close logistics, Sendgrid will continue to operate independently as a wholly-owned subsidiary of Twilio, and the deal is expected to close in the first half of 2019. There are several reasons why we think Sendgrid enhances Twilio’s competitive position.

First, in addition to allowing developers to embed email communication functionality into the applications they build, Sendgrid has also spent years refining their software so that it optimizes efficiency and delivery across a broad swath of inbox service providers, each of which uses different mechanisms to identify and block spam. While one could argue that Twilio has the resources to incorporate email API functionality on their own, engineering the supporting apparatus across the various stakeholders to ensure agility and reliable performance, would be much more difficult and time consuming.

Sendgrid’s technology should allow Twilio to embed email API products within their platform that meet the same standard, in terms of performance, reliability and flexibility, as their core Voice, SMS and Video API products. Within the cPaaS space, Twilio’s platform is regarded by practitioners as superior to lower-priced peers, given its reliability, performance and depth of functionality. Sendgrid’s ability to manage, monitor and report on the delivery of emails sent through its platform will allow Twilio to maintain an aura of product superiority, along with the pricing power that this has facilitated.

Second, while Sendgrid’s business is even further from maturity than Twilio’s, there is evidence that they enjoy a fairly healthy competitive position. For example, calculated average revenue per customer account for Sendgrid has been flat to slightly up for the past 3 years. This implies that either Sendgrid has been able to maintain pricing power or deepen and expand relationships with customers by increasing usage. Either of these realities would be accretive to Twilio’s competitive positioning longer term as the two businesses combine resources and go-to-market models, in our view.

Third, Twilio CEO Jeff Lawson stated that third-party preliminary analysis indicated that the customer overlap between the two firms is “relatively small”, which would facilitate tremendous cross-selling opportunities across both customer bases. While the veracity of this proclamation certainly demands healthy skepticism, our view is that even with an appreciable amount of customer overlap, there should still be myriad opportunities to upsell increased usage of Twilio’s platform, particularly further up the stack in the Engagement Cloud as email API functionality becomes one of the building blocks that Twilio customers can utilize.

Finally, Sendgrid currently spends an inordinate percentage of revenue (27%) on general and administrative expenses. This is indicative of a relatively young business model that has not achieved enough growth and scale to bring operating leverage to a line that is typically easiest to lever. Both management teams explicitly stated that, from an operational perspective, the goal will be revenue and not expense synergies, and that any expense savings will be reinvested in the business. However, we think the similarity of both businesses will allow the combined entity to significantly reduce G&A expenses, accelerating the path to profitability and margin expansion over the longer term.