Why I sold TWLO

Investment Analysis Clubs Saul’s Investing Discussions
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Twilio reported their September quarter results yesterday, and for the most part the market liked what they saw. Shares were up as much as 6% in after hours trading, though to be fair, they had dropped a lot in the week leading up to earnings.

On the surface, Twilio grew revenue at 41%, kept EPS loss at 4 cents, and pretty much met or beat expectations. But under the radar, at least in my Fool eyes, the bottom was falling out.

Firstly, growth is slowing fast. 41% is good of course, but down from 49%, and over 65% last year, it’s falling quick. The real problem is, I don’t know where it stops. Base revenue, from what I understand, is pretty secure. Not subject to customer whims. So I was really alarmed when it only increased $4.4M this quarter, after increasing 6.9M in the June quarter and 7.7M in the September 2016 quarter. 4.4? Eww.

OpEx, on the other hand, was up 48% YoY. More than revenue! That’s not good.

But then I saw it. The silver bullet that made me sell all my shares (of a large position for me). Gross Profit. It actually declined sequentially from $53.5M to 52.3M. Even as revenue was up $5M, Cost of Revenue had increased 6M. Insane. Twilio’s gross margin had never been that of Hubspot or Wix or so many others we follow – I already knew that. But this was a huge hit to it. An analyst or two asked about it on the call, and the answer was that some of the new revenue sources (international, and I believe some new products) are lower margin. That’s a problem. Twilio’s pricing power or lack thereof has always been a concern. I had no idea it could drop this fast. When all was said and done, gross profit, which grew 54% YoY in the March quarter and 47% YoY in June, grew only 30% this quarter. Up against an OpEx increase of 48%, that just won’t do.

I’m out. Twilio may right the ship and do fine. They may get pricing and spending under control and get margins going in the right direction again. But I’m not betting on it. I wish them well, but another investor will be the beneficiary if they succeed.

Bear

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Hi Paul

Just a thought but the Twilio announcement involving declining growth rates from 49%/65% to 41% and a rise in cost, could surely be explained by the drop off in the revenues from its leading client Uber? Having to generate growth from new clients is always more expensive than retaining business from existing clients.

Last quarter backing Uber out of the equation for base revenues meant base revenues were growing at 65% rather than 55% and the Uber impact had hardly started and was slated to really impact Q3 onwards. Base revenues this quarter grew 43% so my hypothesis is that this was very much Uber impacted.

Ant

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Last quarter backing Uber out of the equation for base revenues meant base revenues were growing at 65% rather than 55% and the Uber impact had hardly started and was slated to really impact Q3 onwards. Base revenues this quarter grew 43% so my hypothesis is that this was very much Uber impacted.

Ant, you are 100% right on base revenue. I didn’t catch this, but this quarter it was up 63% sans Uber – much better than 43% including Uber. That growth slow down is much less scary. Perhaps that means total revenue will tick back up, now that Uber has bottomed?

That would be really interesting to watch, for sure. Except at this point, I’m questioning their business model, so I really need to see them move back in the right direction, specifically with Gross Profit. Pricing power, or lack thereof, was always a concern for Twilio. This isn’t a question of sales and marketing, it’s a matter of the cost of revenue line. The last three quarters it’s increased YoY by:

Mar17: 39%
Jun17: 50%
Sep17: 54%

Seeing that last quarter increase more than revenue was a flag, but they were roughly equal, so I didn’t think much of it. But this quarter revenue increased 41% and the cost of revenue increased 54%. Wow.

So going back to the question above: Wouldn’t it be great if revenue ticked back up and increased faster than 41% next quarter? Well, only if the increase in cost of revenue slows down. If not they’re on a crash course with disaster. If a company has a steady gross margin, revenue growth can create operating leverage with just a slight reduction in OpEx. But if gross margin (and even gross profit) are going in the wrong direction, reducing OpEx doesn’t necessarily help – and that’s even while revenue grows. It’s a much scarier picture, in my opinion.

Bear

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When Twilio first came out, the perception around it was a strong CAP, enormous TAM, was going to remake the telecom infrastructure, and would print billions of dollars in the future.

Reality is that Twilio does not have an enormous CAP and its TAM is potentially enormous, but much of that market is not yet available to it and may or may not ever become available to them.

Twilio is showing no indication with its current business and current business plan and results, that it will ever be able to print billions of dollars of free cash flow.

Losses are fine as long as it leads to building a franchise that can some day print billions of dollars of free cash flow. A company like SHOP, yes it may be able to. A company like TTD, sure, it already is printing cash at much smaller amounts. Arista, $200 million in free cash flow last quarter alone.

But does anyone here get the sense that Twilio is going to be able to gain enough operating leverage to be anything but marginal into the future?

I can compare that to Nutanix that is spending all of its gross margin on marketing, but it is building franchise with over 7000 enterprise customers, high switching costs, that has the real potential to someday, like with SHOP, be able to print tons of cash (that is potential - not that it will). That is worth investing in for me. Twilio, absent a change in their business model (it seems to me that these enterprise products taking off is a key to this happening), does not give any indication that it will.

Yes, we ave discussed the Uber thing. For me the Uber thing was not material because of the lost revenues (Twilio clearly could make that up) but because it demonstrated the lack of pricing power and utility it offered so that Uber would prefer to take it in-house or to utilize other vendors as well. Without either pricing power, or without being the low cost producer, how is Twilio going to leverage its business into a cash producing machine?

Yeah, it might in years to come, but there is simply no evidence of this change going to happen at this point in time.

As such, Twilio is a trading stock and not necessarily a long-term investment, if I was into trading stocks.

Tinker

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Very week growth fundies…

Checklist Rating
Composite Rating 18 Fail
EPS Rating 11 Fail
RS Rating 12 Fail
Group RS Rating A- Pass
SMR Rating D Fail
Acc/Dis Rating E Fail