Twilio Stock: A Present Under The Tree For 2023 (NYSE:TWLO)

Premise – Risk/Reward Very Much Reward Skewed At Twilio Now

After multiple quarters of underdelivering from management on margins and growth, Twilio (NYSE:TWLO) shares have been slammed, down ~90% off all-time highs in a dotcom-esque tech blowup.

Investors have had to deal with a series of management missteps, company-specific headwinds, and an eroding macroeconomic environment. Coupled with the waning Covid boom impacting digital engagement and falling organic growth rates as the company laps M&A related revenue, sentiment has changed drastically. At one point, Twilio was a software and broader tech darling. Now, it’s largely been relegated to the Covid bubble dustbin.

A brief aside: We think 2023 is going to be another relatively tumultuous year in markets. We see nominal growth rates in the US and global economies slowing as an effect of restrictive global interest rate policy (save certain looser central banks like those in China and Japan). We also believe the economy likely enters a recession this year, with inflation continuing to decline, but hovering above the Fed’s 2% target largely as a result of labor market dynamics propping up wage growth.

Our belief is that the theme for investing in 2023 is going to be ‘the best stock picker wins’. While indexes churn and generally trend lower, we think performance will be generated by those who can pick individual names well or pick catalysts. This is opposed to 2022, where we think riding waves of volatility in trading was the way to make money.

While Twilio clearly has headwinds and is prone to broader macro deterioration, we think that relative to sector and relative to the broader market, the risk/reward profile is compelling.

Thesis – A Lot’s Gone Wrong, But There Are Multiple Positive Paths Forward

The way we look at it, Twilio’s decline can be blamed on three things:

• management missteps
• company specific headwinds
• deteriorating macro environment and easing Covid tailwinds

Management

With regards to management missteps, we think that management has been historically quite strong and has done a good job scaling the business. Recently though, we can point to taking down medium-term growth targets, failure to clearly communicate why margins keep going down (and when they will stop), and a lack of fiscal discipline on OpEx as evidence of deterioration. SBC is another issue, though we don’t have anything to add to that debate other than this: SBC is dilutive, and when you’re diluting and not getting performance in the stock, people tend to start to care about it. Jeff Lawson & Co. have gone from darling managers to must-gos as the story has gotten way out of their hands.

Additionally, you have examples of totally unforced errors like not communicating that Twilio wasn’t going to be getting their normal US-election revenue tailwind in 4Q, throwing investors for an unnecessary loop. You can blame that solely on management and the IR team for poorly communicating.

Company Specific

On the company specific side of things, we’ve learned that Twilio has a few structural and transitory headwinds that affect them almost exclusively. Structurally, core SMS, while seeing great strength during Covid, is a largely commoditized product, with competitors nibbling at the edges of Twilio’s lead. You also have to rely on carrier fees staying flat, and not squeezing out your margins.

While we think broadly the app economy is young yet and that there is room for greater developer uptake of CPaaS as a whole over time, we also acknowledge that Twilio’s core messaging business margins are prone to fluctuation and underperformance relative to ‘normal’ software over time. And that’s something that’ll have to be embedded in the multiple relative to other software stocks.

Additionally, Twilio has problems with their revenue mix solely unique to them. They’re simply not that good at selling software or Flex, Twilio’s cloud contact center solution. Or at least, not as good as you’d expect. After half a decade, Flex is doing $100 million in ARR, which is disappointing when you take everything else (investments, hiring, and expense growth in general) into consideration. Their CDP Engage solution, from what we’ve heard is going to go head-to-head with Salesforce (NYSE:CRM). Who knows how that goes or how much Twilio’s communications edge will play into building that into a large business.

Simply put, on the software side, Twilio’s sales reps have struggled to scale meaningful traction with their offerings, and that’s important because of its weight on the margin mix. Software has structurally higher margins than messaging, so when software revenues go up as a percent of the mix, so do the entire company’s gross margins.

Finally, on the company specific level, gross margin declines have been matched by quickly scaling operating expenses largely because of increasing headcount.

Macro/Lapping

With regards to macro, we think developer uptake has slowed (see slowing customer growth rates) and that a weaker economy as a whole could bode negatively for messaging. You can take this customer by customer.

A weak macro environment could be bad for Twilio because of SMB exposure. As asset-light small and medium sized businesses face headwinds as a result of a weak macro environment, they may shutter or reduce spend on Twilio if their usage isn’t mission critical.

With regards to lapping, we don’t know what truly normalized digital engagement looks like post-Covid, or how much more developer uptake the company can really drive going forward. These are just general unknowns about the future, something you can pin across tech more broadly.

So What/Where Are the Positives?

The positive case for the stock rests on the following:

• low multiple
• low hanging fruit for an activist
• lots of room for cost cuts

We think it’s a relatively simple thesis. The company doesn’t generate cash, right now. They have a nearly $4B revenue base that should grow at least double digit CAGR for the next few years. They have >7,000 employees still, even after the minor layoffs they’ve announced.

Whether Lawson & Co. do it or a new management team does it, Twilio has plenty of room to cut costs and generate inertia in FCF growth.

And at this point, at around ~2x EV/’22 sales, with ~$3 billion in net cash, certainly seems like blood in the water when you have funds like Thoma Bravo raising >$30 billion and activist takeouts in software happening at much greater frequency. Why? Because multiples are bombed out, and these target companies likely have plenty of costs they can cut and push for free cash generation.

The thesis is either management gets its act together in reducing costs, or an activist could eventually step in.

We think management has an incentive to do so. Their stock is in the toilet and growth is unlikely to reaccelerate near-term with all the company-specific and macro headwinds. So if management wants to regain control of the story, cost cuts are the easiest path forward to get Wall Street back on their side.

Conclusion

The bottom line is, the story has been tough, and it could even get tougher. But with where the multiple is and with the fat the company can cut, the stock looks compelling in this environment.