Twilio (TWLO -4.66%) is a cloud communication platform that allows software developers to communicate with customers and clients securely and efficiently, anywhere in the world.
The tech stock charged to an all-time high of approximately $150 in July, but has since fallen 30% to $104. Shares took a beating after earnings came out in July, then again on a strange September day when several cloud computing companies plunged on no news, and the stock fell yet again after third-quarter earnings. Clearly, there's negativity surrounding the company's results and outlook, and these negative periods are happening too often.
Twilio is sacrificing earnings to gain market share
Twilio is undeniably a high-growth story. The company is forecasting 71.3% revenue expansion for the full year of 2019, roughly half of which is attributable to its February acquisition of SendGrid. As the year has progressed, company management has updated its revenue and earnings guidance favorably.
Twilio does not prioritize profits. The company has never reported positive net income, and net losses were actually much higher in 2019 than the prior year. Expenses were significantly higher for each income statement line item, with spending on marketing, product development, and corporate infrastructure contributing to steeper losses. These steps are necessary to deliver continued growth, but it does cause one to pause and consider whether the company can achieve sustained growth in a cost-efficient manner. Investors must also consider the scale at which Twilio can become profitable. The company's focus is on growing market share, though it has noted longer-term plans that are already in motion to settle into a profitable stage.
Twilio is issuing shares at a rapid rate, with 136 million shares outstanding, compared to 98 million last year. The company had a $980 million public offering earlier this year, it issued shares to acquire SendGrid, and it has a substantial stock compensation program for employees. This strategy has a dilutive effect on existing common shareholders. If it indicates the likelihood of activity to come, there is a chance that current holders will be less exposed to financial returns down the road when this company becomes profitable. The longer it takes to reach profitability, the more likely investors are to be diluted.
The valuation is undeniably and predictably speculative
Twilio doesn't have positive earnings, free cash flow, or EBITDA, so it is impossible to conduct a traditional valuation metric analysis, and exceedingly difficult to conduct an intrinsic valuation analysis.
Twilio is simply a speculative stock that's enjoying a spectacular growth phase, which contrasts sharply with competitor Avaya (AVYA), which is experiencing top-line contraction, but delivers a positive EBITDA and free cash flow. For that reason, Twilio trades at a price-to-sales multiple of 13.9, compared to Avaya's 0.44. To put that in perspective, Avaya's operating margin is roughly 8.5%. If Twilio would grow another 35% next year and deliver an 8.5% profit margin, it would still be trading at a 106 price-to-earnings ratio and a 2.65 PEG ratio based on today's price. Those would still be aggressive valuations that assume meaningful positive results moving forward.
Value investors should steer clear of Twilio because this is a story fit only for growth portfolios that are designed to embrace volatility. Without sturdy fundamentals to back up Twilio's market value, next year's stock performance will be based almost entirely on market dynamics and continued growth. A widespread market downturn is likely to send speculative growth stocks tumbling disproportionately. If there are signs that organic growth is slowing for Twilio, then the bull narrative will start to fall apart. The underlying business growth definitely creates some reasons for optimism, but portfolio construction should really consider valuation.