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Demand is still strong, with only a few spots of weakness and no clear indications of a downturn in the economy. Flex, Engage, and Segment's continued growth within the mix will lead to higher gross margins over time, however expect Twilio to ultimately offer a lower margin profile than a lot of other software companies. To its credit, management has reaffirmed its commitment to achieving positive non-GAAP results and increased its focus on profitability. in 2023, operational margins. Twilio reported $943 million in revenue for the second quarter, up 41% year over year or 33% organically.compared to the $918 million FactSet consensus estimate. Contrary to a lot of stocks nowadays, currency has no bearing on this. Sales cycle lengthening was observed by management, along with some pockets of consumer on-demand and social media softness and slight small company weakness that were counterbalanced by growth in the financial services and technology sectors. The business closed its largest Flex deal yet during the quarter, a deal for an eight-figure sum. I give Twilio a fair value of $167, compared to it’s current price of $68.39. This assumes that from 2032 onward, Twilio will generate a free cash flow margin of 24%, with a terminal growth rate (revenue) of 5% being used, which is roughly equivalent to GDP growth. This model also assumes that Twilio has a narrow and expanding moat, along with an average of 22% growth over the next ten years. I believe that these numbers are easily achievable if execution remains robust. Lastly, I did apply a 13.5% discount rate, which equates to a 9.5% equity risk premium, which is higher than 5.6% (the average equity risk premium). This gives me a bit of a margin of safety, along with the fact that Twilio is more than 60% undervalued.



Moat


Twilio, in my opinion, is well on its way to liberating the creative potential of software developers with its cloud native communication platform as a service, or CPaaS. With the help of Twilio's portfolio of application programming interfaces, or APIs, and pre-made solutions, software developers may create a communication infrastructure that is tailored to the particular requirements of almost any type of business. I believe Twilio has a narrow moat (but widening) and vital infrastructure because businesses have fully embraced the idea that existing customers are the most important source of new income. The company has broadened its portfolio through significant innovation efforts and well-timed acquisitions, opening the door for what I anticipate to be steady growth over an extended period of time. I think Twilio is a CPaaS leader and will stay that way for years to come. I also think that as the business expands and more apps are added to the mix, returns will get better. In comparison to other software businesses, Twilio uses two distinctive tactics. First, rather of just using a subscription model, Twilio's business model is primarily based on consumption, which means that clients pay Twilio as they utilise its product. Following that, it must pay network operators usage fees for carrying Twilio's traffic, which results in structurally lower margins. Second, rather than CIOs, CEOs, or other senior corporate executives, Twilio's primary audience is software developers. Solutions that are simple to implement, adaptable, and economical have produced exceptional customer metrics, including retention rates higher than 95% and net dollar growth that has exceeded 130% over the past few years. The underlying markets of Twilio are huge, totaling more than $75 billion and still growing, providing plenty of room for long-term growth.I think Twilio should continue to be a leader in the emerging CPaaS market in the years to come since it has proven its ability to innovate, promote acceptance, and increase usage among current customers. A narrow moat grade is given to Twilio based on switching costs and network effects. According to my analysis, the company has historically been able to provide returns on invested capital that have exceeded its cost of capital. For larger clients, I believe the organization has exceptional retention rates of 95% or above. Software companies typically experience declining returns in the initial years following their initial public offering (IPO), sometimes falling temporarily below their cost of capital as they invest in their business operations, before scale causes those returns to increase and enable excess economic returns. With regard to Twilio in particular, I see a number of recent acquisitions as also lowering near-term returns, which I anticipate will ease over the next years. Along with the business's high percentage of client retention and good net dollar expansion rate, I believe it is more likely than not that Twilio will generate returns in excess of its cost of capital for the next decade. Users can include a wide range of communication capabilities into software programmes from other vendors thanks to its core platform. The software development kits, or SDKs, prebuilt integrations, and other ready-made communication applications are the technologies that underpin the company's solutions. To improve customer experience, Twilio's solutions cover all kinds of communication, including audio, video, email, text messaging, and messaging on popular social networking sites. The business functions as a three-tier pyramid, with the Super Network acting as the base, the Communication Cloud, which is composed of communication APIs and other intelligent services, and the Engagement Cloud's solutions acting as the top layer. Without giving the underlying technology a second thought, I believe that the majority of individuals have interacted using Twilio's platform. Twilio's platform can be used to send text messages for appointment reminders, delivery alerts, order status updates, and "click-to-call" capabilities that is integrated into websites. Twilio is used by Uber and Airbnb to connect operators to consumers via text messaging, by Box to conduct security checks by text message, and by Zendesk to integrate calling into its customer support platform. Too many distinct use cases exist to mention them all. By every metric, including market share, presence, revenue, IT consultants, and product portfolio, Twilio is the undisputed leader in CPaaS. Developers can quickly adopt the company's solutions because they are not constrained in how they can expand their communications capabilities, allowing for the development of innovative and distinctive solutions. Adoption is frictionless because of the company's approach to targeting software engineers in its marketing and sales efforts. A communication node that has been developed and integrated into a company's process is difficult to replace once it has done so. The ease of adoption indicates that the company is succeeding in displacing established communication applications from legacy vendors that high client switching costs are the only benefit that APIs and other software solutions enjoy. In order to handle the connections between the internet and the global telecommunications network, the Super Network itself is composed of a range of software-based infrastructure elements, such as phone number provisioning, session initiation protocol, or SIP, trunking, and interconnect. Software is used by the Super Network to cost- and efficiently route messages between carrier networks. My claim about a network effect-driven moat source is supported by the fact that the more data that passes through the network, the more intelligent it becomes. Users are unlikely to tear and replace this capability because the Super Network serves as the foundation for additional Twilio APIs, like Twilio Programmable Voice and Twilio Programmable Messaging, which confirms my view on switching costs for critical infrastructure. Since software system installations are time-consuming procedures that demand thorough upfront verification, have numerous touchpoints throughout an organization, are linked to various business applications, and frequently have new processes built upon them, software, in general, benefits from high switching costs. Furthermore, I see that rather than pricing, software businesses compete more on features, functionality, and how a software solution satisfies particular business demands. Given that the entire goal of Twilio is customized embedded communications within other applications, these considerations are evident. Therefore, in my perspective, replacing Twilio within an enterprise customer would result in considerable implementation time, financial costs, business interruption, lost productivity, employee training, and operational risk. Twilio has a "in and up" go-to-market approach, according to its business plan. Although in theory it is employing a typical "land-and-expand" method, its initial landing place is distinctive. Twilio aims to make its solutions simple for programmers to accept, use, and deploy by marketing directly to software engineers. Once they have successfully implemented early APIs to other Twilio solutions, the business hopes these software developers will push the expansion phase within their own enterprises. Through the engagement platform layer and finally first-party data via Twilio Segment, this aids the business in moving from APIs. The Twilio platform can go from APIs to the engagement platform layer once it has been implemented in a business.


Capital Allocation



I believe that Twilio’s capital allocation is exemplary. My evaluations of the company's excellent balance sheet, exceptional investment, and reasonable shareholder payouts are reflected in the rating. Since the company does not offer dividends or share buybacks, I believe that investments in the business are more likely to be the primary factor in overall shareholder returns and should therefore be given priority over these alternative capital returns. The business is acquisitive, with the majority of its transactions being tuck-in, feature-driven deals. However, from 2019 through 2021, the business closed one sizable deal year. Therefore, I draw the conclusion that Twilio will keep pursuing its acquisition strategy, which concentrates on smaller, technology-driven transactions, while I cannot completely rule out additional significant deals. The balance sheet of Twilio is solid, with a net cash position as of December 2021 consisting of $5.4 billion in cash and short-term investments and $986 million in convertible notes. These new senior bonds have two $500 million payment due dates: 2029 and 2031. In our opinion, there is no significant risk to the firm's ability to fund the note repayment.

Overall, I see no problems with governance. The company has experienced significant growth, and over the past few years, free cash flow margins have been roughly breakeven. Management has stated its desire to continue to be profitable on a non-GAAP basis moving forward, which I believe will increase free cash flow margins and also, I believe that both organic product creation and acquisitions have been wise strategic moves. Since its IPO, Twilio has executed a number of acquisitions every year. Even though three larger deals have been executed, these deals are primarily feature-driven and cost less than $30 million each. Twilio bought the email API platform SendGrid in 2019 for $2.8 billion, the customer data platform Segment in 2020 for $3.0 billion, and the toll-free messaging platform Zipwhip in 2021 for $839 million. Even if they were margin-dilutive in the short term and the goodwill affects estimates of return on invested capital, these larger agreements, in particular, have assisted in accelerating growth and improving retention. I recognise the strategic justification for these purchases, but as deal sizes grow, so does my skepticism. To put it another way, I believe the company's acquisition approach is riskier than the normal software company. The management team at Twilio has developed a sound strategy and successfully carried it out. Twilio was established in 2008 by Jeff Lawson, Evan Cooke, and John Wolthuis; Jeff Lawson presently serves as CEO. The company uses a two-class share ownership structure with different voting rights. Lawson has a 4% ownership holding with 24% of the voting rights as of December 2021. Less than 1% of the corporation is still owned by co-founder John Wolthuis, who also has 6% of the voting power.


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