Twilio's (NYSE:TWLO) stock price plunged to a five-month low after the company posted its third-quarter earnings report on Wednesday, Oct. 27. The cloud-based communication company's revenue rose 65% year over year to $740.2 million, which topped estimates by $56.1 million. Adjusted net income fell 75% to $1.8 million, or $0.01 per share, but still beat estimates by $0.15. On a generally accepted accounting principles (GAAP) basis, its net loss widened from $116.9 million to $224.1 million.
Twilio expects its revenue to rise 39%-40% year over year in the fourth quarter, which comfortably beats analyst expectations for 36% growth. It anticipates non-GAAP earnings to stay in the red.
Twilio is still growing rapidly, but its post-earnings plunge indicates investors are worried about its lack of profits and its high valuation. Should investors heed those warnings or consider its latest pullback to be a buying opportunity?
What does Twilio do?
Twilio's cloud-based platform enables developers to integrate text messages, emails, calls, and other services into their apps with a few lines of code. For example, it helps Airbnb's guests contact their hosts and connects Lyft's drivers to their passengers.
Twilio's approach is disruptive because developers previously built those communication features from scratch -- which was buggy, time-consuming, and tough to scale. By outsourcing those features to Twilio's cloud-based platform, developers can concentrate on improving an app's core features instead.
Relying on more acquisitions for revenue growth
Twilio has grown like a weed since its initial public offering (IPO) in 2016. Revenue increased 66% in 2016, 44% in 2017, 63% in 2018, 75% in 2019, 55% in 2020, and another 65% year over year in the first nine months of 2021.
Its number of active accounts grew from 28,000 at the time of its IPO to more than 250,000 at the end of its latest quarter. Those growth rates are jaw-dropping, but also rely heavily on acquisitions for fresh revenue.
Twilio bought 10 companies over the past six years. Its largest acquisitions include SendGrid for $2 billion in 2018, Segment for $3.2 billion in 2020, and Zipwhip for $850 million this year.
If we exclude Segment and Zipwhip, Twilio's third-quarter revenue would only have risen 48% organically, compared to its reported growth of 65%. On an organic basis, Twilio expects to grow its annual revenue by at least 30% over the next three years.
Declining DBNER and gross margins
Twilio's acquisitions are adding new services to its ecosystem, but its dollar-based net expansion rate (DBNER) -- which gauges its revenue growth per existing customer -- has steadily declined since its IPO. It ended the third quarter with a DBNER of 131%, compared to 135% in the second quarter and 137% a year ago. That rate is still high but suggests Twilio's momentum is gradually waning as the mobile app market matures.
Twilio's gross margins are also declining. It ended the third quarter with a non-GAAP gross margin of 54%, compared to 55% a year earlier. On a GAAP basis, its gross margin declined from 52% to 49%.
That compression can be attributed to two main headwinds. First, some wireless carriers have started charging Twilio application-to-person (A2P) fees to access their SMS networks. That pressure is compressing the margins of its messaging services, which already operated at lower gross margins than its voice call, email, and app services segments.
Second, Twilio faces a growing number of competitors -- including Vonage's Nexmo, Bandwidth, and MessageBird -- which could limit its pricing power in the cloud-communications market.
Twilio believes its non-GAAP gross margin will eventually expand to more than 60% over the long term as it reduces its dependence on the lower-margin messaging business and expands its other higher-margin services.
A lack of profits and high valuations
Twilio is maintaining a confident outlook for the future, but its GAAP losses continue to widen as it relies heavily on stock-based compensation to subsidize its salaries and fund acquisitions. That strategy is also diluting its existing shares. It ended the third quarter with 177.2 million weighted average shares outstanding, compared to just 86.1 million shares at the end of 2016.
Twilio's stock already looks pricey at 23 times this year's sales, and that ongoing dilution will make it ever tougher for those valuations to ever cool off.
Is it the right time to buy Twilio?
The company continues to lead its disruptive niche of the cloud market but declining gross margins, widening losses, soaring share count, and high valuations are tough to overlook. It risks fragmenting its own ecosystem with its steady stream of acquisitions, and the upcoming departure of its chief operating officer George Hu -- who previously held the same post at the cloud king Salesforce -- raises a few red flags.
Twilio is still a solid growth stock, but I'm not sure it's worth more than 20 times this year's sales. Therefore, I think investors should steer clear of Twilio for now until it addresses some of its biggest problems.