Breaking Down 2016's Hottest Tech IPO

Twilio (TWLO -1.49%) 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.

A full transcript follows the video.

This podcast was recorded on Sept. 30, 2016.

Dylan Lewis: This Motley Fool podcast is brought to you by Pearl Auto. Pearl Auto makes wireless rearview cameras for your car that retrofit around your license plate and sync with your smartphone so that you can drive more safely. Check it out at pearlauto.com/fool and get a free two-day shipping applied at checkout.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It's Friday, Sept. 30, and we're finally getting around to our discussion on tech company Twilio. I'm your host, Dylan Lewis, and I'm joined in the studio by Motley Fool premium analyst, David Kretzmann. David, how's it going?

David Kretzmann: I'm doing well, thanks for having me, Dylan.

Lewis: We teased this show like three weeks ago, we almost did it last week, we are finally doing it. I think we might be more excited than anyone else to 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 of people 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 has definitely 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 an Amazon Web Services [AWS], but for developers working with communication stuff with different apps. I think we'll talk about some use cases that give a very high level of you that will dig a bit deeper into.

Lewis: Yeah, they really like that AWS comparison. They bring it up a couple different times in conference calls, prospectuses. They're this cloud communication platform, and they're not offering up this single software application. What they're doing instead is building a platform of building blocks that allow developers to add communication functionality into different software applications, which is a roundabout 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 "a company founded by developers for developers," and I think that shines through in the solutions that they offer. As we hinted at, since going public in June, the company has been on a tear. The original offering price of $15 per share, first day trading sent it up to the mid $20s and they have not lost steam. I think shares are currently in the high $60s.

Kretzmann: It keeps going up.

Lewis: So, a lot of interest there. To get a better sense of what they do, and use an illustrated example here, we're going to touch a little bit on how Lyft and Uber do very similar things, integrating Twilio into their services. Lyft has this on-demand service where you are able to hail rides and have them show up at your door and you're ready to go. Of course, in order to do that, they need real-time communication between passengers and drivers. So, they've integrated Twilio's software-powered communications, and they have this custom solution that basically allows for real time SMS, or as we most commonly know it, text updates from drivers to passengers to let them know about where they're going to be.

Kretzmann: The benefit for Twilio, it makes it a much more scalable and secure solution for Uber or Lyft, because you're not actually a passenger contacting the actual number of the driver. It's basically a virtual phone 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 more secure 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 appeal with the platform. 

Lewis: Yeah, they use the masked phone numbers product that Twilio offers. Basically, like you said, it lets individuals use their phone number without actually sharing their specific contact information. So you don't have to worry about someone 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 send notifications for when drivers accept requests, and when they arrive at a location, if the ride status changes. It's funny using this as an example because a lot of people probably use Twilio without even realizing it.

Kretzmann: Probably. Twilio has a pretty impressive list of customers. Just to name a few -- we already talked about Uber -- WhatsApp, owned by Facebook, is actually their biggest client. Then, we're talking about Home Depot, Netflix, Airbnb, Nordstrom, Intuit, Box, Venmo, salesforce.com. You can go on and on. TripAdvisor, Expedia. They really are serving customers across the board. Not just tech companies. A company like Home Depot might use Twilio's solution 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 expect on that list. Just to give you an idea of some of the different use cases that Twilio offers to its customers, two-factor authentication is a very popular one. Basically, you have a second form of password, or a second way of identifying that 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 ride will arrive, confirmations, order tracking, that kind of stuff, masked phone numbers like we talked about before. I've also seen automated surveys. So, you can receive customer feedback using either automated voice or SMS surveys, and those integrate with the existing customer relationship databases that some of these retailers use. So, not just a tech company that serves traditional tech companies. They're kind of bridging out and becoming an all-encompassing provider.

Kretzmann: And the appeal of Twilio for developers, they let you scale with the platform. We'll talk more about this later. Essentially, you pay as you go. You don'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-factor authentication or something with the voice or messaging or video. So it's very easy to use, intuitive platform. And I think that's a part of the reason you're seeing a lot of big names drifting to Twilio, because you don't have to worry about the infrastructure for this. Twilio basically gives you the software and the platform. If you're a developer, you have all of these different building blocks that Twilio provides and helps automate and simplify the whole process, so you can spend a lot more time developing and scaling that product really quickly.

Lewis: Yeah. So, let's talk about a couple different things that I think people should know about this business. You look at their revenue, and they break down the top line a couple different ways, one of the most important ones, in my view, is by customer type. You look at their most recent quarter, they break into base and variable revenue. Variable revenue is revenue from active customer accounts. That's people that have spent, I believe it's $5 in the trailing month. So, revenue from active customer accounts with large customers, so, customers that make up at least 1% of the company revenue, that have never entered a 12-month minimum revenue contract commitment. 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 is everything except that, so, pretty much, contracted revenue, at this point, with minimum spends, $56 million. So, they slant heavily toward base revenue, about 87% is coming from there at this point. If you look, year-over-year growth, 84% year-over-year growth with base revenue, only 12% growth with variable. They're clearly pushing the business that way.

Kretzmann: Right. And they look at base revenue as a more reliable indicator of where the business is going. Understandably, you have at least a minimum contract of revenue coming in from those customers. So that is a more reliable, stable indicator of where revenue is going. That's why the company focuses on it. It is the bulk of their overall sales. So that should be the sales number that investors pay the most attention to.

Lewis: And as 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 been pretty 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 are incorporating their products. It would be nice to have the 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 for in 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 necessarily have 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 have very detailed numbers in those areas.

Lewis: The second 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 contract commitments a year ago to the most recent quarter. Basically, this is a measure of Twilio's ability to get existing customers to continue to spend, either through increased product usage, maybe extending into new use cases and integrating other elements of 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 company simplify this for investors. They have a lot of insider 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 will have to simplify their statements. But, I look at dollar-based net expansion rate, it's really a measure of how much more or less existing customers or active customer accounts are spending compared to last year's quarter. So it's a comps number, and definitely an important one to watch. It has been expanding much faster than total sales as a whole. That gives us an indicator that the existing customers from the past year are spending more time, more money using Twilio's products and making up a bigger portion of total sales, which we definitely like to see.

Lewis: Listeners, if you're still lost with 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 sign that 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 been very impressive, what this number has been.

Lewis: Yeah, Q2 2016, it clocked in at 164%, which is pretty amazing.

Kretzmann: That's actually an acceleration from the same quarter last year. That number is accelerating. It's already very impressive growth, but to see it accelerating, we love to see that even more.

Lewis: Yeah. The third metric I think is important to keep an eye on is active customer accounts. Active customer accounts, as Twilio defines it, is an individual account that has generated at least $5 of revenue in the past month of any period. As of Q2, the company's active 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 at some of the key growth metrics for this business, they are growing customer accounts, and they're also gaining more value from 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's almost tripled since 2013, when they had about 11,000 active customer accounts. Now, like you said, it's over 30,000. You love to see that number growing, and then the money that those customers are spending growing, and so far, Twilio has both of those tailwinds behind its back. That's part of the reason the company is putting up some impressive growth numbers right now.

Lewis: Yeah, Wall Street has certainly been impressed so far. Pushed the business into a pretty gaudy valuation.

We're going to touch on that in the second half of the show. But before we do, I want to thank Pearl Auto for supporting this episode of Industry Focus. Pearl Auto makes wireless rearview cameras that fit around your license plate and sync with your smartphone to keep you safe on the roads. It's pretty quick and easy to install. You just add the camera frame around your license plate using a simple screwdriver, plug in a car adapter to your onboard diagnostic port, mount your phone into the dashboard or vent, and then download the Pearl app, which is iOS and Android compatible. Then, you're ready to go. It's a system that helps keep you safe behind the wheel. The camera frame has two HD cameras, which give audio and visual alerts to warn you of obstacles in your way. It also allows you to switch between normal and wide angle views, and can even help you see around corners in day or night. It's also very versatile. The camera frame can retrofit to any car with its rearview camera. It has a solar-powered panel, so it's stays charged on its own. It also uses Bluetooth wireless technology, and the Pearl app automatically updates to add additional features.

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David, we're back for the second half. We want 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 companies that grow with their customers' growth, businesses that have a symbiotic relationship with their customers, I think they generally tend to do well. Management has a framework for how they refer to the growth vectors that are available to them. And you see they all scale with their customers. The first one is developer integrating Twilio products into early stage platforms and 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 see what works, maybe build it into a very early stage version of your app.

Kretzmann: You don'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 start to 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 authentication on 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 of products that they're using. Then, lastly, as the developer's platform builds a customer base, they obviously have more end users to communicate with, which helps build usage as well. So, that's kind of a nice three-tiered way to think about some of the growth avenues that are available to them, within people just using the platform.

Kretzmann: Definitely, yeah.

Lewis: Looking forward 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 expectations built 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 at William 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 its estimated market size. Obviously, there could be some give-and-take with those numbers, but that gives you an indicator that Twilio does have a big opportunity ahead of it. Whether or not the company can 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] is the valuation metric that we have to use --

Lewis: No earnings to post at this point.

Kretzmann: -- just by default. The company is not cash flow positive, is not generating earnings. This is a company that's still very much in the growth mode. They're plowing a lot into sales and marketing, a lot into research and development. There's not a whole lot of cash flowing down to the bottom line. But the P/S, like a lot of tech companies, earlier-stage tech companies, that's the fall-back metric we have to use as investors. The P/S for Twilio is a little over 26 right now. To give you some context, LinkedIn, which was just bought out by Microsoft, was bought out at a P/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 Fool lately, has a P/S of about 12 right now. No matter which way you slice it, Twilio obviously has higher expectations. It's trading at a multiple well above a lot of other tech companies in a related market. The market cap right now for the company is $6.2 billion. 

One way to look at this, to get a better idea of what expectations are priced into the stock today, is just to forecast out, how much revenue will the company have in five years, if they can grow revenue, on an annualized basis, at 35% per year for the next five years? 

Lewis: And that's just in line with what they did 2015 to 2016.

Kretzmann: Right. If they can maintain that level of growth for five years -- it's not easy, very few companies can do that, but sometimes you do have an exception, you have Amazon, you have Alphabet, Facebook. So you don't necessarily want to count a company out just 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 those premium 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. Just doing 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. Maybe the company deserves a higher multiple, if they are able to grow that fast for five years, they probably 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-road somewhat realistic scenario; and then a really optimistic scenario where 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 a relatively limited upside over the next five years, I don't know if it's worth the risk of putting a lot of capital upfront today. But then again, you don't want valuation to 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-led company. The CEO came from Amazon Web Services. They have some impressive management and leadership at the company. They obviously have a pretty attractive model. They're getting a lot of big-name customers using their product. So there is something here. So if you're looking at Twilio and 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. Maybe you can evaluate whether or not you want to add more. 

That's the way I look at it. But given the expectations of the company today, a P/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's looking at these tech companies, faster-growth companies, he looks for a P/S between the 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 time wrapping 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: If you're looking for a couple of other reasons to double think about this, some challenges facing them and 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 out a little bit. I've also seen analysts make the point that they are already working with Uber, Lyft, WhatsApp. They have integration with Facebook Messenger. They're with Zendesk. They're with 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 sales today. Management has highlighted international expansion as a growth opportunity. One thing that is attractive about Twilio is there's no clear Pepsi to their Coke. You do have a competitor, Nexmo, which was just acquired in May by Vonage. But, Nexmo is still quite a deal smaller. They don't have nearly the 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. But given 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 business and what they offer their customers. Tough valuation to wrap your head around, and some challenges for the company to meet in the coming quarters and coming years.

Kretzmann: Yeah. Can they meet those expectations? Can they grow to the level that 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'll certainly 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 have any questions, or you just want to reach out and say, "Hey," you can shoot us an email at [email protected]. Or, you can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or 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 have formal recommendations for or against stocks 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!