Twilio(NYSE: TWLO) has seen amazing growth since its initial public offering earlier this year. In this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann explain what exactly the company does, and what all the hype is about.
Listen in to find out why companies like Uber and WhatsApp are signing on to work with Twilio, and why investor interest around the company is so high. Also, the hosts look at the flip side -- some problems that Twilio might face in the near future that would put a damper on their growth, and what long-term investors should make of the company's intimidatingly high P/S multiple.
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A full transcript follows the video.
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This podcast was recorded on Sept. 30, 2016.
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Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It'sFriday, Sept. 30, and we'refinally getting around to our discussionon tech companyTwilio. I'myour host, Dylan Lewis, and I'm joined in the studio by Motley Foolpremium analyst, David Kretzmann. David,how's it going?
David Kretzmann: I'mdoing well, thanks for having me, Dylan.
Lewis: We teased this show like threeweeks ago, we almost did it last week,we are finally doing it. I think we might be more excitedthan anyone elseto finally make it happen.
Kretzmann: This'd better be a good one, we had a lot of time to prepare.
Lewis: A lot of buildup I think we need to deliver. Twilio is one of the big IPO names this year. It's one of those names that a lot ofpeople may have heard of, but they probably have no idea what they actually do.
Kretzmann: Yeah. This has been,I think it's pretty easy to say, the hottest tech IPO so far this year.I think they went public in June, and the stock hasdefinitely been on a tear.I'm excited to dig a little bit deeper. But,taking a high-level view of Twilio,this is a company that describes itself as "communications as a service." Think of it as anAmazon Web Services [AWS], butfor developers working with communicationstuff with different apps. I think we'll talk about some use casesthat give a very high level of you that will dig a bit deeper into.
Lewis: Yeah, they really like that AWScomparison. They bring it upa couple different times in conference calls, prospectuses. They're thiscloud communication platform, and they're notoffering up this single software application. What they're doing instead isbuilding a platform of building blocks thatallow developers to add communicationfunctionality into different software applications, which is aroundabout way of saying, cloud communications.(laughs) But, if it sounds like an in-the-weeds tech company,that's because it is. They describe themselves as "acompany founded by developers for developers,"and I think that shines throughin the solutions that they offer. As we hinted at,since going public in June, the company has been on a tear. Theoriginal offering price of $15 per share,first day trading sent it up to the mid $20s andthey have not lost steam. I think shares are currently in the high $60s.
Kretzmann: Itkeeps going up.
Lewis: So,a lot of interest there. To get a better sense of what they do, and use anillustrated example here, we'regoing to touch a little bit on howLyft andUber do very similar things, integratingTwilio into their services. Lyft has this on-demand service where you are able to hail rides andhave them show up at your doorand you're ready to go. Of course, in order to do that,they need real-time communicationbetween passengers and drivers. So, they've integrated Twilio's software-powered communications,and they have this custom solutionthat basically allows for real time SMS, oras we most commonly know it, textupdates from drivers to passengers to let them know aboutwhere they're going to be.
Kretzmann: Thebenefit for Twilio, it makes it a much more scalableand secure solution for Uber or Lyft,because you're not actually a passengercontacting the actual number ofthe driver. It's basically a virtualphone number that's owned by Twilio,in this case. So you're calling that number,but it's still connects you to the driver. So it's a moresecure way. That way, if you're a passenger,you're not giving up your phone number to someone you don't know,and vice versa with the driver. That's part of the appealwith the platform.
Lewis: Yeah, they use the masked phone numbers product that Twilio offers. Basically, like you said, it letsindividuals use their phone numberwithout actually sharing theirspecific contact information. So you don't have to worry aboutsomeone harassing you afterwards,or chasing you down because you didn't offer them a tip on Lyft, or anything like that. They use the service to sendnotifications for when drivers accept requests,and when they arrive at a location,if the ride status changes. It's funnyusing this as an examplebecause a lot of people probably use Twiliowithout even realizing it.
Kretzmann: Probably. Twilio hasa pretty impressive list of customers. Just to name a few -- we already talked about Uber --WhatsApp, owned byFacebook,is actually their biggest client. Then,we're talking aboutHome Depot,Netflix,Airbnb,Nordstrom,Intuit,Box,Venmo,salesforce.com. You can go on and on.TripAdvisor,Expedia. They really areserving customers across the board. Not just tech companies. A company like Home Depot might use Twilio'ssolution to do automated customer service to customers,things like that. So they're across the board.
Lewis: Yeah,a lot of names you wouldn't expecton that list. Just togive you an idea of some of the different usecases that Twiliooffers to its customers, two-factorauthentication is a very popular one. Basically, you have a secondform of password,or a second way of identifyingthat you are the person you say you are. Most of the time, that happens through a user's phone via SMS or text. ETA alerts, if you're talking about Lyft and Uber, so,estimates on when a ridewill arrive, confirmations, order tracking, that kind of stuff, masked phone numberslike we talked about before. I've also seen automated surveys. So,you can receive customer feedbackusing either automated voiceor SMS surveys,and those integrate with the existingcustomer relationship databasesthat some of these retailers use. So, not just a tech company that servestraditional tech companies. They're kind of bridging out and becoming an all-encompassing provider.
Kretzmann: And the appeal of Twilio fordevelopers,they let you scale with the platform. We'll talk more about this later. Essentially, you pay as you go. Youdon't have to pay a flat, high monthly subscription fee for this. But,if you're developer, you can play around on Twilio for free,you can register,and in a matter of minutes,you can create one of these different products, two-factorauthentication or something with the voiceor messaging or video. So it's very easy to use,intuitive platform. And I think that's a part of the reasonyou're seeing a lot of big namesdrifting to Twilio,because you don't have to worry about the infrastructure for this. Twiliobasically gives you the software and the platform. If you're a developer,you have all of these different building blocks that Twilioprovides and helps automateand simplify the whole process, so you can spend a lot more time developingand scaling that product really quickly.
Lewis: Yeah. So,let's talk about a couple different thingsthat I think people should know about this business. You look at their revenue, and they break down the top linea couple different ways,one of the most important ones, in my view, is by customer type. Youlook at their most recent quarter, they break into base andvariable revenue. Variable revenue isrevenue from active customer accounts. That'speople that have spent,I believe it's $5 in the trailing month. So, revenue from active customer accountswith large customers, so,customers that make up at least 1% of thecompany revenue, that have never entered a 12-month minimum revenue contractcommitment. The idea is,they don't have a minimum spend with Twilio, it's variable. And that was $8.1 million in Q2. Base, which iseverything except that, so,pretty much, contracted revenue,at this point, with minimum spends, $56 million. So, they slant heavily toward base revenue, about87% is coming from thereat this point. If you look, year-over-year growth,84% year-over-year growth with base revenue, only 12% growth withvariable. They're clearly pushingthe business that way.
Kretzmann: Right. Andthey look at base revenue as amore reliable indicator of where the business is going. Understandably, you haveat least a minimum contractof revenue coming in from those customers. So that is a more reliable, stableindicator of where revenueis going. That's why the company focuseson it. It is the bulk of theiroverall sales. So that should be the sales number thatinvestors pay the most attention to.
Lewis: Andas of last quarter,the company had nine variable customer accounts,and one of them was WhatsApp. All nine, total,make up about 13%of the revenue contribution. Looking at how they break out geographically, the U.S.makes up a majority of their revenue at this point, about $55 million. Internationally, only about $10 million. Year-over-year growth has beenpretty consistent for both of them. U.S. is at 69%,international is at 75%. I think one of the frustrating things with Twilio is that they do not break out revenue by product segment or by use case. That can make it a little bit tougher to see how businesses areincorporating their products. It would be nice to havethe insight of how two-factor authentication is used in 35% of our customers,and just get a sense of where their strengths are at the moment,and what the market is looking forin terms of communication help.
Kretzmann: Yeah,really,besides anecdotal evidence,of what Home Depot says they're using Twilio for or any other company,we don't necessarilyhave that great of an idea of,what are the main Twilio products that their customers are using? Besides anecdotal evidence -- and sometimes the company will share a little bit more, but it is hard to havevery detailed numbers in those areas.
Lewis: Thesecond thing that I think it's really important to keep in mind with this company, is the number of their dollar-based net expansion rate. What this figure does is it compares the revenue from a cohort of active customer accounts, other than their variable customer accounts. People that were base customers and had contractcommitments a year ago to the most recent quarter. Basically, this is a measure of Twilio'sability to get existing customers to continue to spend,either through increased product usage,maybe extending into new use casesand integrating other elementsof their building block platform,or branching out and building their own customer base,which is something that you want to see from people that are using your products.
Kretzmann: Exactly. Taking a higher-level look at dollar-based net expansion rate --they have a lot of complicated terms at Twilio,and that's something that I don't necessarily like. As an investor, I would rather that a companysimplify this for investors. They have a lot ofinsider jargon still.I wouldn't be surprised if they tried to simplify that going forward.But since they're right off the tail of a hot IPO,they don't have to worry about that right now. Down the road, I think they willhave to simplify their statements. But, I look at dollar-based net expansion rate,it's really a measure of how much more or lessexisting customers or active customer accounts arespending compared to last year's quarter. So it's a comps number,and definitely an important one to watch. It has been expanding muchfaster than total salesas a whole. That gives us an indicator that theexisting customers from the past yearare spending more time, more money using Twilio'sproducts and making up a bigger portionof total sales, which wedefinitely like to see.
Lewis: Listeners,if you're still lostwith this idea, I know there's a lot of hyphens in dollar-based net expansion rate, you can think of this figure as comps, like you talked about, or same-store sales, the way a retailer or a fast-casual restaurant would have. What you had last year, and what you have this year, comparing to see, is the growth coming from your existing base of restaurants or your existing base of customers, or is it coming from you growing new customers? You want to see both.
Kretzmann: Yeah,you want to see both, but it's a great signthat you have a product that people like/need,if your existing customers are spending more every quarter, every year. So far, for Twilio, it's beenvery impressive, whatthis number has been.
Lewis: Yeah, Q2 2016, it clocked in at 164%, which ispretty amazing.
Kretzmann: That'sactually an accelerationfrom the same quarter last year. That number is accelerating. It's already very impressive growth,but to see it accelerating, we love to see thateven more.
Lewis: Yeah. The third metricI think is important to keep an eye onis active customer accounts. Active customer accounts, as Twilio defines it, is anindividual account that hasgenerated at least $5 of revenuein the past month of any period. As of Q2, the company'sactive customer accounts were just over 30,000, up from 21,000 a year earlier. You're seeing nice,steady growth there. If you're looking atsome of the key growth metrics for this business,they are growing customer accounts,and they're also gaining more valuefrom the customer accounts they had a year ago,two things that you really like to see.
Kretzmann: Right,and the active customer accounts number, that'salmost tripled since 2013,when they had about 11,000active customer accounts. Now, like you said,it's over 30,000. You love to see that number growing,and then themoney that those customers are spending growing,and so far, Twilio has both of thosetailwinds behind its back. That's part of the reason the companyis putting up some impressive growthnumbers right now.
Lewis: Yeah,Wall Street has certainly beenimpressed so far. Pushedthe business into a pretty gaudy valuation.
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David, we're back for the second half. Wewant to talk about valuation, a couple things we like about the business, maybe some challenges here and there. We hit on this in the first half,but I always love to see companiesthat grow with their customers' growth,businesses thathave a symbiotic relationshipwith their customers,I think they generally tend to do well. Management has aframework for how they refer to thegrowth vectors that are available to them. And you see they all scale with their customers. The first one isdeveloper integrating Twilio productsinto early stage platformsand rolling it out to a small customer base. That makes sense. Like we talked about,you test out this platform,you get to play around with it a little bit and seewhat works, maybe build it intoa very early stageversion of your app.
Kretzmann: Youdon't have to be a big dog to use Twilio,I think that's part of the appeal.
Lewis: Yeah. And then,the second one, maybe as you startto build out your app little bit,build out some of the functionality,some of the communicative abilities there, adding use cases, expanding functionality,maybe you start out using masked phone numbers,and now you're looking to use two-factor authenticationon your platform as well. So, you have growth coming not only from the growth of the business, but also from the growth within the portfolio ofproducts that they're using.Then, lastly, as the developer'splatform builds a customer base,they obviously have more end usersto communicate with, which helps buildusage as well. So,that's kind of a nice three-tiered way tothink about some of the growthavenues that are available to them,within people just using the platform.
Kretzmann: Definitely, yeah.
Lewis: Lookingforward to 2016, the company has guided for full-year revenue of $253-257 million. That amounts to about 51-53% year-over-year growth from 2015. And that's really not too much lower than were they went from 2015 down to 2016; you can see there's going to be some deceleration with that growth. So,this is obviously a very high-growth business.I think there are a lot of expectationsbuilt into this company right now.
Kretzmann: To say the least. To give a little context,I think it's important to look at,what's the estimated market size or market potential for Twilio? How big of a portion are they grabbing out of their current competitive market? One estimate I saw from an analyst atWilliam Blair, estimated the market size at about $11 billion. So,over the last 12 months, Twilio has generated about $220 million in revenue. So, Twilio has roughly 2% of itsestimated market size. Obviously, there could be some give-and-takewith those numbers, but that gives you anindicator that Twilio does have abig opportunity ahead of it. Whether or not the companycan capitalize on it, that's what we need to figure out --whether or not that's likely.
But,like you said, expectations are very high. The P/S [price-to-sales ratio] isthe valuation metric that we have to use --
Lewis: No earnings to post at this point.
Kretzmann: -- just by default. Thecompany is not cash flow positive,is not generating earnings. This is a company that'sstill very much in the growth mode. They'replowing a lot into sales and marketing,a lot into research and development. There's not a whole lot of cash flowingdown to the bottom line. But the P/S, like a lot of tech companies, earlier-stage tech companies, that's the fall-backmetric we have to use as investors. The P/S for Twilio is a little over 26 right now. Togive you some context,LinkedIn,which was just bought out byMicrosoft, was bought out at aP/S multiple of 7.4.Facebook is trading at a loftier 16.7.Shopify, which is another tech name that's been floating around the Foollately, has a P/S of about 12 right now. No matter which way you slice it, Twilio obviously has higher expectations. It'strading at a multiple well above a lot of other tech companies in a related market. The market capright now for the company is $6.2 billion.
One way to look at this, to get a better idea of whatexpectations are priced into the stock today, is just to forecast out,how much revenue will the company havein five years, if they can growrevenue, on an annualized basis, at 35% per year for the next five years?
Lewis: Andthat's just in line with what they did 2015 to 2016.
Kretzmann: Right. If they can maintain thatlevel of growth for five years -- it'snot easy, very few companies can do that,but sometimes you do have an exception, you haveAmazon, you haveAlphabet, Facebook. Soyou don't necessarily want to count a company outjust because there are high expectations. David Gardner, one of the best stock pickers,if not the best stock picker at The Fool,he loves finding companies that have thosepremium expectations,because he thinks, sometimes premium businesses deserve the premium. We shouldn't let that be the only factor that scares us away from them.
In the case of Twilio,let's assume they grow sales on an annualized basis for 35% over the next five years. That's a tall order. That would bring them to about $1 billion in revenue by 2021. Then,you have to figure out,what would be a realistic P/S for those sales? Because,again, we don't have any earnings or cash flow today. So,guessing what are earnings or cash flow could be in five years is a little tricky. Justdoing some back-of-the-envelope math here,if you put a P/S of 8 times, then the market cap, in five years, would be about $8 billion. The market cap today is $6.2 billion. So,you might want to adjust your estimates one way or another. Maybe the company grows faster or slower. Maybethe company deserves a higher multiple,if they are able to grow that fast for five years, theyprobably would trade at a higher multiple. What I will usually do is run different scenarios. I'll run a bearish,conservative scenario; a middle-of-the-roadsomewhat realistic scenario;and then a really optimistic scenariowhere the company is just blazing growth and still has a high multiple in five years.
In this case, there's a lot priced into the stock today.There might be a little bit of hype with Twilio right now. Given what I see as arelatively limited upside over the next five years,I don't know if it's worth the risk ofputting a lot of capital upfront today. But then again, you don't want valuationto be the only reason you stay away from the company. If you're looking at Twilio and you love the business --I like that it's a founder-ledcompany. The CEO came fromAmazon Web Services. They have some impressivemanagement and leadership at the company. They obviously havea pretty attractive model. They're getting a lot of big-namecustomers using their product. So there is something here. So if you're looking at Twilioand you like the company,and you're a little fuzzy on the valuation,maybe just start with a small position. You don't need to go all in with the stock right now. You could buy a little bit, and if it goes up, you'll be glad you had some, if it goes down, you'll be glad you only put a little bit in. Maybeyou can evaluate whether or not you want to add more.
That's the way I look at it. Butgiven the expectations of the company today, aP/S of 26 times is pretty high. For some context, in a recent Rule Breaker Investing podcast episode,David Gardner said his sweet spot for P/S when he'slooking at these tech companies, faster-growth companies, he looksfor a P/S betweenthe ranges of 3 and 10. Twilio is quite a way above that.
Lewis: A lot higher.
Kretzmann: So,I don't know, I have a hard timewrapping my head around the valuation. The stock, as we've noted,has done incredibly well in the few months since the IPO. It'll be interesting to see.
Lewis: Ifyou're looking for a couple of other reasons to double think about this,some challenges facing themand some issues that the business might present,at this point, I think their top 10 customers make up about 31% of revenue. We would like to see that diversify outa little bit. I've also seen analystsmake the point thatthey are already working with Uber, Lyft, WhatsApp. They haveintegration with Facebook Messenger. They're withZendesk. They'rewith a lot of very big names already. Are they going to be able to continue to sustain the growth they've seen with either incubating some of these low-level customers and bringing them up and seeing them become increasingly more valuable to them as a business? Or are there going to be new people out there that come in and are these stalwarts that are interested?
Kretzmann: International growth is another one. International makes up about 16% of total salestoday. Management hashighlighted international expansion as a growth opportunity. One thing that is attractive about Twilio is there's no clearPepsito theirCoke. You do have a competitor, Nexmo, which was just acquired in May byVonage.But,Nexmo is still quite a deal smaller. They don't have nearlythe number of customers that Twilio has. So, that is attractive,when you're pretty clearly the top dog in your niche, in your space. But then, the question is, like you mentioned, is that niche going to remain a niche? How much bigger can that be? It's still unknown at this point. Butgiven that they have those big names on board,it is a worthwhile question. Will those big accounts get bigger? Can you find other accounts to supplement that growth, which clearly the company needs to do to live up to those expectations today?
Lewis: Yeah. It sounds like,a lot is really like with the core businessand what they offer their customers. Tough valuation to wrap your head around,and some challenges for the company to meetin the coming quarters and coming years.
Kretzmann: Yeah. Can they meet thoseexpectations? Can they grow to the levelthat they need to grow to reward investors? That's the big question.I'm staying on the sidelines for now,but I'm definitely watching with a lot of intrigue. We'll see how it goes.
Lewis: We'llcertainly be watching it.Thanks for your time, David.
Kretzmann: Thanks for having me, Dylan.
Lewis: Well,listeners, that does it for this episode of Industry Focus. If you haveany questions, or you just want to reach out and say, "Hey," you can shoot us an email at email@example.com. Or, you can always tweet us @MFIndustryFocus. If you'relooking for more of our stuff, subscribe on iTunesor check out The Fool's family of shows at fool.com/podcasts. As always,people in the program may own companies discussed on the show, and The Motley Fool may haveformal recommendations for or againststocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis,thanks for listening and Fool on!
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. David Kretzmann owns shares of Amazon.com, Facebook, Home Depot, LinkedIn, Netflix, and TripAdvisor. Dylan Lewis owns shares of Alphabet (A shares) and Zendesk. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Amazon.com, Facebook, Intuit, Netflix, PepsiCo, Shopify, and TripAdvisor. The Motley Fool owns shares of LinkedIn and Microsoft. The Motley Fool recommends Coca-Cola, Home Depot, Nordstrom, Salesforce.com, and Zendesk. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.