In recent articles, I’ve detailed the sorry state of the IPO market this year, and the hope that cloud communications provider Twilio (proposed ticker TWLO) could jumpstart activity.
Expectations couldn’t be running hotter, either.
Days after filing official IPO documents with the SEC, Quartz dubbed the company, “The most interesting tech IPO of the year.”
Is this just click bait? I wouldn’t go that far.
Twilio does boast several hallmarks of a hot IPO.
Namely, a growing, multi-billion-dollar addressable market and rapid sales growth (up 88% in 2015).
After fully reviewing Twilio’s IPO prospectus, though, I’m afraid a runaway and lasting success is hardly guaranteed. Here’s why…
Cash Grab?
While other tech unicorns insist on staying private for as long as humanly possible (Uber, anyone?), the first thing that comes to mind is that Twilio must be desperate for cash.
But that’s not so.
The company is flush with $103 million – enough to fund operations for at least three years, based on its historical burn rate.
So if the IPO isn’t a cash grab, then it must be because Twilio genuinely believes that now is an attractive time to go public.
And after a quick review of the fundamentals, I can understand why.
Two Significant Markers of Success
The company is in the enviable position of expanding rapidly in a massive market.
Specifically, Twilio’s base revenue is increasing at a compound average growth rate of 81%. Yet, in dollar terms, it’s barely scratching the surface, with $166 million in sales in an estimated $47 billion market, according to IDC.
That $166 million figure is significant, too – and a positive indicator of IPO success.
Research by University of Florida professor Jay Ritter shows that companies with more than $50 million in sales before they go public perform best, rising by an average of almost 40% over three years. That compares to a lowly 5% rise for companies with less than $50 million in sales at the time of their IPOs.
And that’s not all Twilio’s IPO has going for it.
A few weeks ago, I noted that “timing is everything” for IPOs.
Companies that go public when they’re between 6.5 and 10.5 years of age create the most shareholder value. Sure enough, Twilio is in the “IPO sweet spot,” since it was founded in 2008.
Don’t Underestimate the Risks
As you know by now (or should do, since we repeat it so often!) share prices ultimately follow earnings.
And that’s the biggest black mark against Twilio.
The company has never earned a penny. (Actually, Twilio lost $38.9 million last year.)
And it might never make anything.
I say that because rapid sales growth doesn’t guarantee profits. Especially when each incremental dollar in sales comes at a greater cost. And that’s a real risk for Twilio.
The company is hell-bent on expanding via international and enterprise sales. In fact, the IPO prospectus lists both as top growth priorities.
But neither of these is going to come easy or cheap.
- International Sales: To expand international sales from current levels of about 15% of revenue, Twilio plans to rely on “collaborating with international strategic partners.” But introducing middlemen into the equation always increases costs. Not to mention, the higher Twilio’s international sales exposure goes, the higher the company’s foreign currency exchange risk goes, too. And, at present, the company isn’t hedging exposures in foreign currencies, either.
- Enterprise Sales: As far as enterprise sales go, Twilio only generates “a small portion” of its revenue from such customers. By its own admission, expanding into this market will mean incurring “higher costs and longer sales cycles.” At the same time, enterprise customers know that size comes with advantages, including the ability to demand “volume discounts.” So we’re talking about a double-whammy of higher costs to acquire enterprise customers at reduced product prices. That’s going to make turning a profit harder, not easier.
But Wait, There’s More!
As if there weren’t enough, there are five more legitimate risks in Twilio’s IPO:
- Too Many Freeloaders: As of March 31, 2016, over 900,000 developer accounts had been registered on Twilio’s platform. But only 10% of them are paying customers. And only 3% are what Twilio refers to as “Active Customer Accounts” – ones that generated at least $5 in revenue during the last month of the quarter.
2. Clients With No Commitments: Twilio’s software is used by a long list of Silicon Valley high-fliers, including Zendesk Inc (NYSE:ZEN), Uber, Box Inc (NYSE:BOX), HubSpot Inc (NYSE:HUBS), OpenTable, and WhatsApp. Many of these companies are Twilio’s largest customers. For instance, WhatsApp accounted for 15% of Twilio’s total sales last year. Amazingly, though, WhatsApp doesn’t have a long-term contract with Twilio. Heck, three of Twilio’s top 10 customers don’t. Such high concentrations and a lack of customer commitments pose real risks to the business if hard times hit Silicon Valley.
3. New-Fangled Metrics: Sales? Profits? Don’t be concerned with such snooze-worthy fundamentals. Twilio argues in its IPO prospectus why its business should instead be evaluated on “dollar-based net expansion rate,” “base revenue,” and “active customer account” growth. Uh-oh. Whether it’s Groupon Inc (NASDAQ:GRPN) or Twitter Inc (NYSE:TWTR), I’ve seen my fair share of “hot” startups trying to tell investors why tried-and-tested fundamental metrics don’t apply to them. But guess what? Eventually, they do. The new terms are nothing more than a company’s attempt to cast the business in the most favorable light. And as we’ve seen with Twitter, such companies are quick to create new metrics to suit such purposes. Be afraid. Be very afraid of companies employing these financial sleights of hand.
4. Who’s Got the Power? Not Us! Just like the insiders at Facebook Inc (NASDAQ:FB), Alphabet (NASDAQ:GOOGL), and countless other Silicon Valley tech companies, Twilio is concentrating its power in the hands of a few shareholders, with a dual-class structure of common stock. That means the commoners like us get one vote per share, whereas the higher-ups and holders of Class B common stock get 10 votes per share. It leaves little room for ordinary shareholders to affect change.
5. Patent and Privacy Problems: Twilio is currently subject to two lawsuits. One involves a patent infringement case, while the other involves privacy invasions. Neither is good for business or PR. Adverse outcomes in either case threaten the core features of Twilio’s products, so investors shouldn’t take these risks lightly.
Will Twilio Thaw the IPO Freeze?
Whereas real estate is all about “location, location, location,” IPOs ultimately come down to “price, price, price.”
Investors hate to overpay, so Twilio’s IPO success will ultimately hinge on its valuation.
As a frame of reference, Fidelity recently valued its 6% stake in Twilio at a market cap equivalent of $1.3 billion. That translates into a price-to-sales ratio of 7.8, which is right in line with other publicly traded Software-as-a-Service juggernauts like Salesforce.com Inc (NYSE:CRM).
In other words, there’s no way Twilio’s IPO is going to be a screaming bargain. Especially since the underwriters will try to ratchet up the valuation on the IPO.
If they get too greedy, look out below!
Once shares are trading on the public markets, they’ll adjust quickly to take into account all of the risk factors above.
As for the winter of IPO discontent officially coming to an end? That will take a lot longer and more than just one successful IPO.