Shares of Twilio (NYSE:TWLO) tumbled on Feb. 13 after the cloud service provider posted its fourth-quarter earnings. Its revenue, boosted by its acquisition of SendGrid, surged 77% annually to $204.3 million and beat expectations by nearly $20 million.
Twilio's base revenue, which comes from customers who signed 12-month minimum revenue contribution contracts, also rose 77% to $186.2 million. This indicates that it's depending less on big non-base "variable" customers like Facebook. Its dollar-based net expansion rate, which measures its sales growth per customer, jumped 147%.
On the bottom line, Twilio generated $4.9 million in non-GAAP net income, compared to a loss of $2.6 million in the prior-year quarter. Its non-GAAP EPS of $0.04 matched analysts' expectations, but ended a four-quarter streak of earnings beats.
That seemed like a minor speed bump, but investors were likely looking for reasons to take profits after Twilio rallied more than 300% over the past 12 months. It might be tempting to buy on the post-earnings dip, but I think it could still go lower for three reasons.
1. A lofty valuation
Twilio expects its revenue to rise 65% this year, but that's mainly due to the acquisition of SendGrid. If we exclude SendGrid's estimated contribution of $168 million to $170 million in revenue, Twilio's revenue would only rise about 39%.
We should also note that prior to Twilio's takeover, analysts expected SendGrid's revenue growth to decelerate, with 29% growth in 2018 and 25% growth in 2019. This means that once Twilio fully laps the SendGrid acquisition, its revenue growth would likely drop to about 40%.
That growth rate seems reasonable relative to Twilio's forward price-to-sales ratio of 12. After all, Veeva (NYSE:VEEV), another high-growth cloud service provider, trades at 20 times this year's sales but is only expected to grow its revenue by 25%.
Yet Veeva, which deals with life science companies instead of mobile app developers, is also more profitable than Twilio. Veeva trades at 128 times this year's earnings and 67 times next year's earnings.
Twilio trades at over 1,000 times its estimated non-GAAP earnings this year. It also expects its slim earnings to decline slightly (at the midpoint) this year on integration costs and higher investments. Twilio's bulls will likely argue that it deserves that premium valuation, but that still makes the stock a sitting duck during a market downturn.
2. Widening GAAP losses and negative free cash flow
Twilio looks slightly profitable on a non-GAAP basis, which excludes stock-based compensation (SBC) expenses and other "one-time" charges, but it's still deeply profitable on a GAAP basis, which includes all those expenses.
Between the fourth quarters of 2017 and 2018, GAAP operating loss widened from $20.2 million to $44 million, and net loss widened from $18.9 million to $47.2 million. Its total operating expenses surged 89% to $152 million.
As a result, Twilio's free cash flow (FCF) has stayed negative ever since its IPO in 2016. Twilio previously issued a secondary stock offering and convertible senior notes to boost its cash reserves, but it could keep burning cash as it launches more services or acquires additional companies.
3. Rising competition
Twilio's cloud platform processes text messages, calls, videos, and other services for mobile app developers. Outsourcing those features to Twilio saves developers lots of time and money, and they're easier to scale across a cloud platform.
Twilio has a first mover's advantage in this market, but it faces a growing number of competitors. Vonage (NYSE:VG), for example, leverages its core telephony business to promote Nexmo, which offers similar services as Twilio. Facebook, one of Twilio's biggest customers, also uses Nexmo.
Another growing rival is Bandwidth (NASDAQ:BAND), which bundles similar services with its own nationwide IP voice network. Bandwidth posted 25% revenue growth last year, and it maintained a dollar-based net retention rate of over 100%.
Nexmo and Bandwidth aren't crimping Twilio's growth yet. But as the market gets more crowded, developers will start shopping around for more cost-efficient services, thereby throttling Twilio's ability to raise prices. Bigger customers could also develop their own similar services and cut Twilio out of the loop, which is precisely what Uber did nearly two years ago.
A great company but not a great stock
I personally admire Twilio's business model and I think it still has great long-term growth potential. But I also think the stock is overheated, and it could dip lower before it finally rebounds.