Blended growth math

Investment Analysis Clubs Saul’s Investing Discussions
#1

Sometimes it helps to break apart a business into 2 businesses to get an accurate view of growth, particularly if you are looking ahead more than 1 year. For example, at the beginning of year 1, a company has 2/3 of its revenue growing at 60% and 1/3 of its revenue growing at 30%:

$667 grows to $1067
$333 grows to $433
Total growth was $500 or 50%.

But to take assume a 50% blended rate and project that forward would be an underestimate of future growth. Look what happens in years 2 and beyond.

$1067 x 1.6 = $1708 or a gain of $641.
$433 x 1.3 = $563 or a gain of $130.

The total gain of $771 on $1500 was growth of 51.4%, not 50%

In year 3, we get the following:

$1708 x 1.6 = $2732 or a gain of $1016.
$563 x 1.6 = $732 or a gain of $169.

The total gain was $1185 on 52.2% (note that it is departing father from the initial 50% “blended rate”.

Each year, the faster growing component becomes more and more relevant and a bigger and bigger contributor to the growth.

We have several companies in this situation.

TWLO
Twilio has 2 components growing at different rates, on larger one at 60+% and one smaller one at half that rate. To blend them from last year’s result will result in an underestimate of future growth. So long as the component growth rates don’t change, this difference will become increasingly pronounced. (Ron, be careful when blending rates if you want to project years into the future).

SQ
Square is more complex. It has a fast growing, high margin, recurring revenue subscription business growing at 97%. It also has a slower growing, lower, margin transaction based business. The fast growing business is 45% of SQ and at about 71% gross margin. The transaction based business is only growing at 29% and has only 37% margin. Now, the “hardware business” has not be discussed here yet. It was $72M in 2018 and grew at 55%. However, it is not really a business…more of a marketing expense as it provides zero gross margin. The hardware was a slight drag on the blended growth rate because it was below 59%.

The main point is that a fast growing component of growth is better than having the whole business growing at the same rate. The bigger the fastest growth component, the better. The higher margin of the fast growing component, the better. SQ has both of these going for it. TWLO has the slower growing part with high margin so the reverse would be better. Let’s hope TWLO can do lots of cross selling in the next few quarters!

Chris

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#2

Thanks for that great reminder, Chris. Very useful to keep in mind for Twilio and Square.
Saul

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#3

Excellent point Chris and thanks for the explanation.

So long as the component growth rates don’t change, this difference will become increasingly pronounced.

Totally understood and your math example clearly illustrates the concept.

My blink at present is TWLO/SEND has better odds of holding those component rates than SQ. Do you feel differently? I’m not saying both companies can’t end up holding their rates. I’m just curious how you (and others) might rate the likelihood for each. I think you’ve hit on a key concept going forward, especially given that many of us hold both stocks.

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#4

Chris,
Thanks for the review. Question is, what is the market looking at, right?

Trying to piece together the results and forward looking projection, combining this info and the results, what is the most important part of the forward looking numbers?

What is the market having trouble with that might be “wrong” looking?

If the fastest growing portion is the highest margin, is the market overlooking the “profit” side of the growth? Or does the market believe that the fastest growing part is going to slow down soon? I think this is the case. Question is, is that wrong?

JI

#5

Thanks, Chris, for your analysis of Twilio’s and Square’s growth rates. I appreciate your efforts to get the numbers straight. I do have a few comments and questions, though. And for those of you who just want my bottom line opinion without reading further, let me just say that I have not soured on Twilio. I’ve merely trimmed my overly large allocation by a few percentage points after the latest earnings call.

Twilio’s Growth Rate
To project Twilio’s growth rate, let’s first look at Sendgrid’s annual revenue growth over the past 5 quarters.


  **Sendgrid YoY Revenue Growth Percentages**
        1Q   2Q   3Q   4Q
  2018  31   32   31   30
  2019  30

So Sendgrid’s growth rates have basically been flat all last year at around 30%, and there’s no reason to expect that percentage to increase in 2019. Now let’s take a look at Twilio’s results without Sendgrid over the same period.


  **Twilio ex Sendgrid YoY Revenue Growth**
        1Q   2Q   3Q   4Q
  2018  48   54   68   77
  2019  60

So Twilio had a pattern of accelerating growth rates all last year, culminating in the 77% growth in 4Q. But, since then, we had our first deceleration from 77% down to 60% - which is still a great growth rate, but it’s a sequential decline from 4Q last year.

Secondly, as I showed in my previous post, if Sendgrid had been acquired on Jan. 1 instead of Feb. 1, Twilio’s total 1Q 2019 revenue can be estimated to be


   **$205M Twilio revenue + $42M Sendgrid revenue = $247M total revenue**

So the combined company is already on a $1 billion annual revenue run rate this year. As they said on the Twilio conference call, the law of large numbers is now kicking in to make these growth percentages harder to achieve. But lets assume that Twilio by itself continues to grow at 60% and Sendgrid continues at 30%. Then we can project 1Q 2020 revenue as follows.


   __1Q 2020 Projected Revenue = $205M*1.6 + $42M*1.3 = $383M__

So, the blended growth rate for next year is 383/247 - 1 = 55%

Two years out, I wouldn’t expect the blended rate to be any higher, given the sequential decline we’ve already seen, and given the law of large numbers. That’s why I used 53% for my revenue growth estimate.

Now, there could still be some catalyst out there that could propel Twilio’s growth rate higher than 60% two years out. But what could that be? Their new Flex product? I get that it’s programmable and flexible, but it’s entering a very crowded field of Enterprise Call Center products dominated by the likes of Five 9, Genesys, Avaya, etc. Even Amazon has a call center product called Amazon Connect, which has intelligent chatbots and Alexa-powered speech recognition. Flex just hit the market this quarter, so let’s see what happens. Interestingly, Shopify is a Flex customer.

Square’s Gross Margin
The fast growing [subscription] business is 45% of SQ and at about 71% gross margin. The transaction based business is only growing at 29% and has only 37% margin.

I also initially calculated the gross margin of the transaction business at 37%, just like you did. But then I was told to use Adjusted Revenue, not Total Net Revenue to calculate that number. So let’s take a look at the latest Shareholder Letter at

https://s21.q4cdn.com/114365585/files/doc_financials/2019/Q1…

As per the above, total 1Q 2019 adjusted revenue was $469M (page 7), and gross profit was $397M (page 16). So Adjusted Gross Margin seems to be 397/469 = 84.6%. And Adjusted Revenue grew 59% YoY (49% if you exclude the Weebly acquisition).

The reason I’m holding on to SQ is that I think both these gross margin and growth rate numbers are quite high, and Square seems to be building a rich ecosystem of services for their customers. Also encouraging is that larger customers (not Mom and Pops) accounted for 51% (and growing) of their Gross Payment Volume.

Ron

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#6

If you have “blended (revenue) growth,” wouldn’t it be simpler to work with “gross profit growth” which “blends” not just disparate revenue but also disparate gross margins?

IMO, while numbers are important, excess detail just muddles things. Like I said, JMO.

Denny Schlesinger

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#7

Hi Ron,

I am reaching the same conclusion and holding SQ for another quarter.
While I agree with sentiment in general that when the market is “this good”, SQ price languishing is concerning, we all know that market is not efficient and this does look like an opportunity to me.
I will wait for market to start recognize SQ value before I add more, but I am more than comfortable keeping my current holding even if SQ stays flat in this market.

Nilvest

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