Why Investors Are Paying a Premium for Twilio Inc.

Cloud platform provider Twilio (NYSE: TWLO) was one of the hottest tech IPOs last year, surging from its initial price of $15 to nearly $70 within three short months. But that rally -- which inflated its price-to-sales ratio into the lower 20s -- attracted massive short interest, and a secondary offering caused the stock to plummet to the upper $20s.

Image source: Getty Images.

Yet Twilio still trades at 10 times sales, which is nearly double theindustry average for software companies. Let's discuss three reasons some investors are willing to pay such a high premium for Twilio and whether you should follow their lead.

1. A bet on "no stack" start-ups

Twilio's core service of linking phone numbers to apps benefits from the growth of "no stack" start-ups. In the past, software developers used a "full stack" model, which required them to build all the services for an app. However, newer apps now use so many different services that it would be too costly and time-consuming to create them all from scratch.

That's why many new apps use a "no stack" model, in which the developer creates a core service and integrates numerous third-party services. For example, Uber maintains its core ride-hailing service, but it still uses Alphabet's Google Maps for mapping out routes, PayPal for processing payments, and Twilio's platform for letting passengers contact drivers via phone numbers and text messages.

Other major Twilio customers include Airbnb and Facebook's (NASDAQ: FB) WhatsApp and Messenger. Twilio helps Airbnb hosts contact guests via their phone numbers, and enables WhatsApp and Messenger users to automatically add contacts from their mobile address books.

2. Its surging revenues and narrowing losses

The surging popularity of Uber, Airbnb, WhatsApp, Messenger, and other no stack apps are providing Twilio with massive revenue growth. The company expects its revenue torise up to 62% in fiscal 2016 -- only a slight slowdown from its 88% growth in 2015.

Twilio still isn't profitable on either a non-GAAP or GAAP basis. It reported a non-GAAP operating loss of $3.4 million last quarter, compared to a loss of $4.6 million in the prior year quarter. Its GAAP losses are still widening year over year -- mainly due to rising stock-based compensation expenses -- but its narrowing non-GAAP losses indicate that its bottom line growth might stabilize in the future.

Moreover, its new Twilio Enterprise Plan subscription product -- which offers advanced security, access management, and administration features for its existing customers -- could eventually offset the high cost of acquiring new customers with higher subscription revenues per customer. Its acquisition of WebRTC media processing technologies for programmable video tech and its expansion into analytics with Voice Insights could also widen its moat against potential challengers.

3. A potential acquisition target

When Twilio went public, the bears warned that about a fifth of its revenue came from Facebook's WhatsApp. That percentage fell to 10% in the first nine months of 2016, but Twilio still lacks any long-term contracts withthe social networking giant.

Facebook's growing presence in data centers and cloud-based services indicates that it could develop its own Twilio-like platform for its apps. Yet Facebook recently integrated Twilio's services into Messenger, which indicates that it has no near-term plans to challenge Twilio's "best-in-breed" niche platform.

Another potential challenger is Amazon.com (NASDAQ: AMZN), which could probably add a Twilio-like service to Amazon Web Services (AWS), the largest cloud platform in the world. But instead of challenging Twilio, AWS reportedly deepeneditspartnership with Twilio last December. These strong partnerships indicate that instead of being marginalized by larger cloud players, Twilio might be acquired for its dominant tech. Twilio still trades at a premium to its industry peers, but its enterprise value of $2.2 billion is mere pocket change for tech giants like Facebook and Amazon.

The key takeaway

Twilio is still a very risky stock -- its valuation is high, it won't generate a profit anytime soon, and 29% of shares were being shorted asof Dec. 27. But despite those challenges, some investors are still willing to pay a premium for its robust top-line growth. I personally own a small position in Twilio, but I'm only adding shares on significant dips, since the stock remains a highly volatile play being moved mainly by short-term traders instead of long-term investors.

10 stocks we like better than Twilio Inc. When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Twilio Inc. wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of January 4, 2017

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon.com and Twilio Inc. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Amazon.com, Facebook, and PayPal Holdings. The Motley Fool has a disclosure policy.