It's just the latest sign that the cloud-based software industry is getting crowded and valuations expensive. Twilio (NYSE:TWLO), one of the best-performing stocks so far in 2018 with a 190% advance to-date, just announced the buyout of email communications outfit SendGrid (NYSE:SEND) for a whopping $2 billion. Though software-as-a-service and the recurring revenue it generates is a powerful business model, there is a point where the cost of expansion no longer makes sense. Twilio may have just crossed it -- unless this marriage leads to explosive growth beyond what the two companies have been able to separately achieve.

Reasons this makes sense

Twilio operates a library of cloud-based software telecommunications tools for software developers. The idea is to make life easy for these programmers when they design new ways for businesses to keep in touch with customers. The model has worked wonders: Twilio's annualized revenues have doubled since the company went public during the summer of 2016.

The company's catalog of software covers voice, text, chat, and video communications tools, but email has proved a big gap in its suite. That's where SendGrid comes in, as it is the leader in cloud-based email services. SendGrid says it has over 74,000 customers and sends emails to more than half of the world's email addresses, yet it still only accounts for a fraction of the total email service industry. The company estimates its addressable market at $11 billion, but its trailing-one-year sales are just $128 million.

SendGrid posted a 32% growth rate during the second quarter of 2018 to Twilio's 54%, but the former has a higher gross profit margin of 75%, compared to 54% at Twilio. Besides raising Twilio's profitability profile, the companies think they will be able to promote more growth than the two could accomplish alone by cross-selling services to customers. They also plan to benefit from shared research and development efforts. Since the two entities have been performing well alone, SendGrid will operate as an independent subsidiary of Twilio should the deal proceed. Both companies' shareholders must vote to approve the transaction, which is set to close in April of next year.

Four young people standing against a red wall using their smartphones.

Image source: Getty Images.

Reasons this could be a later regret

Twilio says its purchase of SendGrid will not create any cost savings or synergies since SendGrid will for the most part retain its autonomy. Since the two companies have negligible free cash flow over the last 12 months -- Twilio at negative $4.15 million and SendGrid at positive $4.40 million -- this deal is predicated on the assumption that both will continue to grow at breakneck speed and soon turn a corner in the pursuit of profitability.

And that's the problem with this merger. SendGrid is an undisputed success in the burgeoning cloud industry, but Twilio is ponying up nearly $2 billion worth of its own stock for the acquisition. That's nearly one-third of Twilio's own market cap, and the deal will dilute ownership for existing shareholders. It's also a steep valuation since SendGrid expects to clear just $144 million in revenue in 2018. This translates to a price-to-sales ratio of 15.5 for SendGrid, a richer figure than the 13.7 Twilio currently fetches even though it's posting better sales growth.

Congrats to early owners of SendGrid. Should the deal close, the stock will have nearly doubled since its public debut at the end of 2017. For those who hold onto Twilio shares, acquiring SendGrid could pay off eventually, but it might take many years to do so -- even with SendGrid's target of about 28% top-line growth this year.

If investors give the buyout the go-ahead, Twilio stock will likely suffer as shareholders digest the big purchase. Before voting, Twilio shareholders will want to consider whether growth through high-priced acquisition is the best route, versus the cheaper but slower internal growth route -- the option that Twilio has employed up to this point to great success. If I was an owner now, I'd opt for the latter.

Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Twilio. The Motley Fool has a disclosure policy.