Compounder Fund: Twilio Sell Thesis - 21 Nov 2022
Data as of 20 November 2022
We first invested in Twilio (NYSE: TWLO) for Compounder Fund’s portfolio in July 2020. Our investment thesis for the company can be found here. In early-November, we sold all of the fund’s Twilio shares. This article describes our Sell thesis for the company.
When we invested in Twilio, we thought that the company had bright growth prospects. It was operating in the large and fast-growing software-powered communications market. And as an API-first company whose software helps its customers’ developers save significant time and effort when building communication capabilities into their own technology infrastructure, we thought Twilio could produce excellent growth in revenue per share. We also thought that the expected revenue growth would then, over time, translate into commensurate per-share growth in free cash flow. This potential growth in free cash flow per share is of paramount importance to us because it is what ultimately drives a company’s intrinsic value over time.
In the two-plus years that Compounder Fund owned Twilio’s shares, the company’s free cash flow margin (free cash flow as a percentage of revenue) was mostly negative and there was no noticeable improvement. But there was at least excellent growth in revenue per share. Table 1 below illustrates these two dynamics since the first quarter of 2020.
Table 1; Source: Twilio quarterly earnings updates
As recently as Twilio’s 2022 second-quarter earnings conference call, management maintained confidence in achieving Twilio’s target of 30%-plus organic annual revenue growth through to 2024 that was first communicated in the company’s October 2020 Investor Day. But during the company’s November 2022 Investor Day, management walked back on the 30%-plus growth target. Instead, they now expect Twilio’s organic revenue growth to be 29% for 2022 and somewhere between 15%-25% over the medium term (defined as the next three to five years). Management’s latest growth-guidance is lower than what we thought Twilio would achieve when we first invested in the company. But those are still decent numbers. It was something we could stomach, ceteris paribus.
What really troubled us is another piece of guidance management gave during the November 2022 Investor Day: Twilio’s stock-based compensation (SBC) is expected to shift from around 22% of revenue currently, to between 15%-20% of revenue over the medium term. Here’s the problem with the SBC guidance:
- 15%-20% in itself is high, and we would have preferred to see a much lower percentage
- Data from Tikr show that Twilio’s price-to-sales (P/S) ratio was around 4 for most of October, which is the month before Twilio’s November 2022 Investor Day. At a P/S ratio of 4, and with SBC at 15% of revenue, the implied dilution at Twilio is 3.75% annually. If SBC is at 20% of revenue, the implied dilution is 5% per year.
- Putting Twilio’s new annual revenue growth target of 15%-25% together with the implied dilution rates would mean an annual revenue growth rate of as low as 9.5% in per-share terms. This would then also translate into lacklustre per-share growth in free cash flow if and when Twilio starts being able to generate consistent free cash flow.
- To compound the problem, Twilio’s P/S ratio is now less than 3. At a P/S ratio of 3, the implied dilution with SBC running at 20% of revenue, is 6.7%. With dilution of 6.7% and annual revenue growth of 15%, the growth rate in revenue per share would be just 7.8%. At this growth rate, we’re also concerned with the risk of a negative cycle forming, where a low potential increase in revenue per share would lead to a falling stock price, leading to even more dilution, resulting in even lower revenue per share growth. For perspective, with SBC at 15% of revenue and a P/S ratio of 2, a 15% increase in revenue would translate into per-share growth of just 4.5%.
- Twilio has US$4.21 billion in cash and short-term investments as of 30 September 2022 against total debt and leases of US$1.24 billion, which gives a high net cash position of nearly US$3 billion. This provides Twilio’s management with plenty of flexibility to increase the cash component (and thus decrease the SBC component) of their employees’ compensation structure in the current environment where SBC could severely dilute Twilio’s per-share growth because of the company’s low P/S ratio. But we saw no hint of this thought during the November 2022 Investor Day.
- We thus suspect that Twilio’s management team may not have a good grasp of the significant damage to Twilio’s long-term intrinsic value growth that could be caused by their current stance on SBC.
We think that Jeff Lawson – Twilio’s co-founder and CEO – and his team are incredible innovators and product-builders. This is one of the key reasons why we invested in the company in the first place. Over the last 12 months, Twilio’s customers sent 144 billion messages across more than 180 countries with the help of Twilio’s products. The company’s Twilio Flex software solution, which is used to build digital-first contact centres for customers, is a US$100 million run-rate business four years after launch. Twilio Segment, the company’s customer data platform (CDP), which enables enterprises to use their first-party data to better understand and communicate with their customers, is processing more than 1 trillion events monthly.
But we’re now too concerned with the lack of understanding displayed by Twilio’s management team when it comes to what ultimately drives the long-term value of a company, which is growth in free cash flow per share. We initially thought Twilio’s leaders had this understanding, but we now think we got our initial assessment badly wrong. Because of this we decided to sell Compounder Fund’s position in Twilio.
