Last week, Twilio (NYSE:TWLO) published its Q3 results and, despite revenue that exceeded expectations by more than 8.6%, a non-GAAP EPS which surpassed forecasts by more than 100%, and came positive when all analysts were expecting it negatively, the stock price dropped more than 16%.
Such a decrease can make investors wonder whether Twilio was a good investment idea, and those who bought shares prior to Q3 results might be puzzled now.
We also own Twilio shares, but we have to confess that we were not worried about Q3 results. We were even impressed with the strong demand for Twilio’s CPaaS (Communication Platform as a Service), and with the company’s new customer acquisition.
Q3 Highlights
- Revenue grew 65.2% YoY and stood at $740.2M vs a growth forecast of 52% for a $681.09M Revenue.
- A number of customers up 20% YoY.
- Non GAAP EPS of $0,1 versus -$0.14 consensus estimate.
- Q4 revenue guidance of $760M-$770M vs $750.7M previously forecast by analysts.
Investors may be wondering why the stock sold off.
First of all, traders are looking for short-term profits and almost any reason to sell a stock is a good reason. If there is any downward risk, then most traders will sell even before reflecting. This resembles confirmation bias, where traders are looking for reasons to sell, and they decide not to sell only if there are no reasons at all. The initial sell-off, combined with the automatic stop-losses, resulted in a severe drop.
The first news that fed this confirmation bias was the departure of the COO who was regarded as a pillar. He did an amazing job in scaling up the company to the size Twilio has become. We do value the skills and competencies of Mr. George Hu, but we would not sell Twilio because a talented employee leaves. There are other highly skilled people within Twilio that could take over his position, assume his responsibilities, and thrive. The COO is not the founder/CEO who built the company out of scratch with a mission and a vision.
Furthermore, Mr. Hu is leaving to rest. He is himself, an entrepreneur who launched a company in the past and sold it to Twitter (NYSE:TWTR). He has had very busy years and wishes to take some time with his family. He has been very positive since the announcement and seems to maintain strong ties with the company. So investors should not worry about his departure. He will remain in Twilio until his successor is ready to take over. What matters for us are the company’s fundamentals: its value proposition, growth prospect, profitability, liquidity, and financial health. The departure of the COO, as successful as he can be, cannot justify such a price decrease.
The second event that supported this confirmation bias was the GAAP EPS which fell short of expectations. The difference between GAAP and non-GAAP EPS is that GAAP EPS also includes one-time expenses. As their name indicates, they are exceptional expenses that do not occur every quarter. That is why we consider that non-GAAP EPS is more representative of a company's financial performance, and this decline in GAAP EPS should not worry investors.
The third information that nourished the confirmation bias was the organic revenue growth, which was strong at 38% YoY, however, it decreased compared to the previous quarter when it stood at 50%. First of all, growth rates fluctuate from quarter to quarter. For instance, in the second quarter of 2019, Twilio’s organic growth was 36%, preceded by 46% in Q1, and followed by 48% in Q3. So this quarter-over-quarter decrease should not worry investors. We believe that organic growth potential remains intact.
Twilio surpassed revenue and EPS forecasts 100% of the time since first analyst coverage in August 2016. The company beat non-GAAP EPS estimates by an average of 181% each quarter. YoY cash from operations has been growing at a rate of 104% since 2017. Liquidity and financial health are also strong, and the company has one of the lowest debt to equity ratios we have ever seen for a growth company still seeking profitability, at 9.7%.
Such outstanding performance is quite rare in the business world.
In addition, if investors’ benchmark is the third quarter of 2020, then we can understand the price drop. But, this comparison is wrong. In 2020, demand was boosted by two significant events:
- Pandemic contributed significantly to the strong demand for communication software. Life is going back to normal now, and the need for such platforms decreased slightly. However, this does not jeopardize the company’s growth prospect, which should remain intact the next decade.
- US elections resulted in strong organic growth for Twilio, as its communication software was used during the elections to avoid gatherings and to contain the pandemic.
Such exceptional events, which generated strong growth do not occur every year. We’d rather see the glass half full, and consider that despite those events and the comparison base with Q3 2020, Twilio’s growth has been vigorous.
As tech long-term investors, we give a lot of importance to strong organic growth. This is even our most important requirement. But organic growth is limited in time, and after a period of strong organic growth, the latter decreases until it stabilizes, and becomes comparable to the GDP growth rate. So organic growth alone is not a good indicator for long-term investors.
We believe that outstanding growth companies have five engines that rotate with time. Those are:
- They operate in a very promising sector with a large Total Addressable Market (TAM): Twilio’s management estimates its TAM at $66 billion and TAM is expected to increase at a 14,9% CAGR in the next 5 years.
- They are still in their early innings with regards to organic growth prospects: Twilio organic revenue climbed 38% YoY in Q3 2021 and is forecast to grow at a double-digit CAGR for the next decade. With only $1.7 billion in revenue in 2020, for an expected TAM of over $132 billion in 2027, Twilio has captured only a tiny fraction of its market, and has significant space to develop. The company could grow to a $10 billion revenue company within 2029, from $1.7 billion today.
- They are market leaders and offer state-of-the-art products/services: Twilio is the CPaaS market leader. The company works with very famous names such as Lyft (NASDAQ:LYFT), Uber (NYSE:UBER), and Airbnb (NASDAQ:ABNB), and its technology adds value to its partners as it allows a better customer experience. The company also offers developers, built-in models, to start creating mobile applications on a ready-to-use basis, instead of purchasing an app with the required features, or starting it from scratch. This part of Twilio’s activity should continue to rise at a double-digit growth rate for the next decade.
- They have the ability and the art to grow externally, absorb other companies efficiently, and create new revenue streams: Twilio recently acquired a company named Segment which operates in Customer Relation Management (CRM). The company made this acquisition with the objective to penetrate the marketing sector. Engage is a CPaaS equipped with Artificial Intelligence to predict which automatic message is the best fit for customers. The algorithm used is similar to the ones we find in tech-AD companies, which allow very accurate targeted AD campaigns.
- They are disruptive innovators that continuously research and develop new products and features: Twilio recently launched Twilio Engage in an effort to renew the company. Management even mentioned the name Twilio 2.0 and changed their mission to: “Unlock the imagination of builders”. In March, Twilio was named one of the most innovative companies of 2021 by Fast Company. Its CPSaaS were very useful during the pandemic and their adoption created sustained demand for communication software.
Twilio's Valuation
According to the Discounted Cash Flow Perpetuity Exit Model, Twilio is quite overvalued if we look at the consensus free cash flow forecasts until 2031. Based on those estimates, we put the share intrinsic value at $208.3, implying that the market values Twilio 44.75% more than its fair value.
Nevertheless, history has shown that Twilio constantly beat analysts’ forecasts, with a strong beat on EPS, at an average of 181% since first analyst coverage. Furthermore, external growth cannot be estimated in the company’s valuation. Based on our own Free Cash Flow to Equity estimates, we consider Twilio’s intrinsic value to be roughly $306, implying the stock is currently fairly valued.
However, if we look at Enterprise value/sales, Twilio has a lower ratio than the SaaS industry average, 31.41 for Twilio versus 39.62. Even more astonishing, Twilio’s price to book value amounts to 4.99 vs a sector average of 27.66. The stock looks undervalued now.
Conclusion
Investors should consider adding Twilio to their portfolio. The company operates in a very buoyant sector with a TAM estimated at $66 billion, and a sector CAGR of 14.9% until 2027. The company was successful in creating new revenue streams through acquisitions and its TAM should continue to grow both organically and externally.
The company has five strong growth engines which should rotate with time to ensure sustained growth to shareholders. The current drop is what we consider a misconception and stems from what can be interpreted as a confirmation bias. We are very bullish on Twilio.