Dec 10 2020 - We Add Twilio To Our Decade Portfolio

Summary

  • Twilio has been a hot stock for some time now, and one could be forgiven for assuming it is due to fade.
  • We beg to differ. We think this company can continue to grow well over the long term. We've been at Buy for some time.
  • Today, we include the stock in our Decade Portfolio - those cloud stocks we think will deliver the next stage of industrial deflation.

DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security, or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.

The True Uncarrier

You may recall a marketing campaign by T-Mobile a few years back, Uncarrier. As longtime telecom mavens, we loved this. Everything bad we had ever said about big telco - was now being said by big telco! "Our industry is terrible", implied the campaign, "Everyone hates us. Just check our Net Promoter Scores" - one might imagine was being said. "But don't worry - this big telco is here to save you from big telco! Sign up here - oh, wait, we mean, don't sign up, just, er, you know, use the service, no ties, Uncarrier!".

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Image Source: Wikipedia

Big telco, an industry approaching 150 years old, has been ripe for deflation for a very long time. Despite many moves to introduce price competition - the most famous example being the breakup of AT&T in 1984 to produce the Baby Bell regional operating companies plus local competition - this highly capital-intensive industry has a knack for reverting to monopolistic or, at best, oligopolistic structure.

Here's a very succinct way of illustrating the evolution of the US telecom carrier market since that 1984 breakup of AT&T.

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Image Source: Wikipedia

From monopoly to competition to oligopoly in around 25 years. Not shown in the graphic above is the short-term joy and long-term pain endured by equity and debt investors in competitive local exchange and long-distance carriers that sprang up during the 1990s. These companies raised colossal quantities of debt and equity in order to fund competitive physical network buildouts. If this isn't your first Big Telco rodeo, you'll be familiar with some of the names. MCI, MFS, WorldCom, Qwest, Global Crossing. And only some of those collapsed in accounting scandals. Most simply groaned and were slowly quashed by the weight of their own balance sheets. This is because big telco is a scale game. It's not complicated. You need a critical mass of network connections and users, you need to know the cost of building and maintaining that physical infrastructure, and you need to calculate the correct end user pricing to achieve a return on capital sufficient to satisfy your bondholders and shareholders. It's economics 101. It really is. If it weren't for pesky regulators getting in the way every few years, it would be, quite literally, a license to make money.

It was only a matter of time before software started eating Big Telco. There have been many false dawns over the years - again if you have a few miles on the road, you'll recall names such as Vonage (VG) - the name is a mangled abbreviation of Voice On Net, which is what passed for exciting in 1990s telecoms, Free World Dialup (led by the then-visionary Jeff Pulver) and others. There's a nice history at this blog. And yes, it was all just as flaky and unreliable as it looks. The Skype you know and hate today was even more annoying back then. And nobody had enough patience to do video calls, since the time to pretend-dial (it was a packet connection but the systems used to soothe your senses by making dialing noises!) and connect was usually longer than the call. Kudos to Zoom (ZM) for making this actually work!

Once the Internet really started to rock and roll - OK, put another way, actually start to work properly - from around 2012, along came a number of new entrants that had a new take on how to run telecom services over somebody else's capital plant. We've written previously that if you want to make money as a shareholder in telecom, get somebody else to pay for the capex. The two that caught our eye after a fashion were Bandwidth (BAND) which we'll talk about another day, and Twilio (TWLO). Our staff accounts have been on-again off-again TWLO holders since the stock was in the s. The name has been good to us, as it has to most all its long-term shareholders.

Here's why uncarrier has been such a good idea. This is a total return chart (so any dividend hoarders have no reason to cry foul) since 23 June 2016, the TWLO IPO date.

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Source: YCharts.com

Unsurprisingly to no-one, AT&T (T) has delivered a negative return. Verizon (VZ) at least gave you a mid-30s return which in a four-and-a-half-year period would likely be considered acceptable from a low risk stock. The Nasdaq proxy ETF, QQQ, gave you a 185% uplift - not too shabby. And surprisingly to everyone - OK just us maybe? - here's the original uncarrier, T-Mobile (TMUS) beating the Nasdaq! Why? Beats us. We'll look into it. But the crown goes to the True Uncarrier, TWLO, with nearly 1000% returned. Not without stress as you can see from the volatility and periods of underperformance in its chart. But, who said 1000% in 4.5 years would be easy? If it was, everyone could do it, right?

There's a lot of chatter right now about how TWLO's secret sauce is getting out of date, how it doesn't have any real moat, and so on. And that could prove correct. For now however our hunch is otherwise. TWLO, as everybody knows, is a software company. It produces tools that software developers can use to embed communications in their own applications. Be it phone calls, text messages, emails, whatever it might be, you can use TWLO software to comms-enable your app. Our hunch is that scale wins in the new software defined telecom, just as it did in Big Telco of yore. The scale here isn't so much wires and fibers and towers - it's developers. The whole point of TWLO code is that non-comms developers don't have to worry about writing comms routines. They can just embed TWLO stuff. So we think there's a good chance those same non-comms developers would rather not have to go learn four other vendors' versions of embedded comms code. We think that TWLO has a critical mass of developer end-users which can itself act as a moat - it works this way in, for instance, EDA software from Synopsys (SNPS) or Cadence (CDNS) - the reluctance of developers to use new tools is, inter alia, what keeps the EDA market ossified and margins high for the incumbents.

We believe the 2020s will be the decade the 1990s expected the 2000s to be. We think that cloud cover will be completing, not just on the horizon. We explain our logic in this recent blog post. From that belief comes our 'Decade Portfolio' (terrible name, hopefully better performance) of cloud stocks we think will form the basis of this decade-long expansion. And TWLO is in that portfolio as the comms element.

Here's the company's numbers up to and including Q3.

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Source: Company SEC Filings, YCharts.com, Cestrian Analysis

Growth just accelerated as you can see, and whilst the company continues to be cash flow negative, it also has a huge bucket of cash on its balance sheet - net cash of .9bn vs. TTM unlevered pre-tax free cash flow of 0m - so it can keep on spending for a while yet.

Valuation is in line with the cloud software cohort on the basis of its revenue growth. Here's the absolute multiples.

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Despite that revenue acceleration in Q3 - a pretty meaningful acceleration - since TWLO printed its Q3 numbers on 26 October, the stock is barely up and indeed it has underperformed QQQ which, given the mainly now old-line "Grandpa Tech" components in QQQ, makes no sense to us.

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Source: YCharts.com

We're at Buy - Long-Term Hold on TWLO and we do plan to hold it long, for as long as it keeps eating Big Telco, and for as long as some younger whippersnapper doesn't start nibbling at its heels.

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