Twilio Accelerates Its Profit-Margin Expansion Plans. Is It Too Late to Buy?

The bear market of 2022 set longtime owners of Twilio (TWLO 0.05%) back by about four years. The fast-growing cloud-communications company got wiped out last year as the market turned its attention to profitability and found Twilio severely lacking. 

The stock has been heating up again lately thanks to Twilio's management team getting serious about turning things around. Shares are up 40% so far in 2023, bolstered by a fourth-quarter 2022 earnings report that showed the company is doubling its efforts to get profitable sooner than later. Is it too late to buy this rally?

Exceptional progress toward exceptional financial performance

Twilio's days of hypergrowth are over, and the Q4 2022 revenue and guidance for 2023 prove it. Still, year-over-year Q4 sales growth of 22% (or 21% on an organic basis excluding acquisitions) isn't so bad considering big organizations have been tightening their belts. Recession has been on the market's bated breath for the better part of a year now, so any double-digit-percentage expansion is pretty darn good. This was also Twilio's first $1 billion quarter, reporting total sales of $1.02 billion.  

Data source: Twilio.

Of course, revenue growth and all the "digital transformation" happening in the corporate world are fine, but investors have begun demanding more quantitative commentary (financial numbers) with pitchforks in hand. Thus, Twilio's 35% full-year 2022 revenue growth to $3.8 billion was impressive, but it's the generally accepted accounting principles (GAAP) net loss of $1.2 billion that has been the big problem dragging the stock price lower. 

A big chunk of this net loss is attributable to employee stock-based compensation, which is doled out to retain talent and when Twilio has made frequent acquisitions of smaller peers over the years. Stock-based compensation tallied up to $799 million in 2022. Another $279 million worth of expenses was attributable to depreciation and amortization, mostly of intangible assets (again, related to acquisitions). 

Twilio management has begun rapidly addressing these issues to appease shareholders. It has reorganized its management structure and announced layoffs of 17% of its workforce since last autumn. It has also been tightening up its expenses.

The result of these expense cuts (paired with weakness in the global economy) is a 14% to 15% expected-revenue growth rate in Q1 2023 (or just 13% to 14% on an organic basis). However, when adjusting for non-cash expenses like stock-based compensation and amortization, Twilio is forecasting an adjusted operating profit of $250 million to $350 million for full-year 2023. The market has been pleased with these moves. 

Backdoor method of dealing with stock-based compensation

Investors dislike stock-based compensation because it dilutes ownership of their stake in a business. Although Twilio has been growing its overall sales at a rapid pace for years, you can see how the issuance of new stock to employees lowers this growth on a per-share basis in the chart below. Since its initial public offering (IPO) in 2016, Twilio revenue is up nearly 2,100%. But revenue is up about only 730% when factoring for all the stock the company has doled out over that time frame.

Data by YCharts.

Because stock-based compensation is tied to an employee's long-term compensation contract, it isn't an easy problem to fix overnight. But as I outlined here a couple of months ago, one "backdoor" method Twilio could employ to offset the effects of stock-based compensation is through share buybacks. Twilio could use its hefty balance sheet ($4.16 billion in cash and short-term investments, debt of just $987 million) to get the ball rolling as it ramps up toward generating positive free cash flow.  

Twilio ultimately announced a $1 billion share- repurchase plan during the Q4 2022 earnings update. Part of the balance sheet's net-cash position will need to be used for this, but Twilio does expect to be free-cash-flow positive (in line with an adjusted profitability outlook) in 2023, so that will help fund the repurchase plan as well. 

GAAP profitability (which includes non-cash expenses) won't be achieved until 2027, so Twilio's reorganization plan will still take time to bear fruit. Nevertheless, the company has embraced the profitable growth demands the current economic environment (increasing geopolitical tensions, slower global growth, and higher interest rates) requires.

Is Twilio stock a buy?

Given Twilio is still far from generating across-the-board profitability, I fully expect this stock to remain incredibly volatile. The company's revenue growth has decreased dramatically, but adjusted profits (on a free-cash-flow basis) is fantastic news that can help the company offset employee stock-based compensation. At the midpoint of guidance, shares now trade for 36 times enterprise value (market cap minus net cash and equivalents) to expected 2023 adjusted operating profit.

To be sure, shares aren't exactly cheap. Further upside will only be justified if Twilio management continues to deliver positive progress on right-sizing its expenses. I would still file this away as a high-risk and potentially high-reward investment. However, if you think this cloud-communications business can keep expanding and start doing so profitably, it certainly doesn't look too late to buy. If you do add this stock to your portfolio, just remember to keep any position very small and consider employing a dollar-cost averaging plan to do so.