Building a Communications Platform Brick by Brick

Senior Equity Analyst

Dan Romanoff

Active Customer Accounts

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With its cloud native communications platform as a service, or CPaaS, we think Twilio is well on its way to unlocking the power of software builders. Twilio’s portfolio of application programming interfaces, or APIs, and ready-made solutions allow software developers to build a communications infrastructure to meet the unique needs of virtually any organization. As organizations have fully embraced the notion that existing clients are the most critical channel from which to generate new revenue, we think Twilio enjoys critical infrastructure and has established a narrow moat. Through extensive innovation efforts and strategic acquisitions, the firm has expanded its portfolio, paving the way for what we think will be robust growth over an extended period. We believe that Twilio is a CPaaS leader and will remain as such for years to come, and that returns will improve as the company scales and applications grow within the mix.

Twilio employs two unique strategies relative to other software companies. First, it operates mainly on a usage model, such that Twilio’s revenue is generated as customers use its software, versus simply employing a subscription model. It then must pay usage fees to the network operators for carrying Twilio’s traffic, which drives structurally lower margins. Second, Twilio targets software developers as its primary audience, rather than CIOs, CEOs, or other high-level business leaders. By doing so, Twilio makes it easy to adopt its solutions, and once the first use case is in place, developers are likely to build additional communication layers within the organization.

Easy-to-deploy, flexible, and affordable solutions have given rise to excellent customer metrics, with retention better than 95% and net dollar expansion in excess of 120% over the last several years. Twilio’s underlying markets are substantial—greater than $75 billion in total and still expanding, leaving ample opportunity for durable growth. We believe the company has demonstrated an ability to innovate, drive adoption, and expand usage with existing customers, so we think Twilio should remain a leader in the disruptive CPaaS space in the coming years.

Business Strategy & Outlook

We assign Twilio a narrow moat rating based on switching costs and network effects. In our view, these moat sources have enabled the company to generate returns on invested capital in excess of its cost of capital in the past. We think the company enjoys excellent retention of 95% or better for larger clients. As is typical in the first several years post-IPO, software companies see declining returns, often temporarily below cost of capital as the companies invest in operations, before scale drives those returns higher allowing for excess economic returns. With Twilio specifically we see several recent acquisitions as also driving near-term returns down, which we expect to ease over the next several years. Combined with the company’s high customer retention rate and strong net dollar expansion rate, we believe it is more likely than not that Twilio will generate returns in excess of its cost of capital for the next decade.

Twilio is a cloud-based communication platform-as-a-service provider. Its core platform allows users to integrate a wide variety of communication capabilities into software applications from other vendors. The tools behind the firm’s solutions include APIs, software development kits, prebuilt integrations, and other ready-made communication applications. Twilio’s solutions address all communication channels, including voice, video, email, text messaging, and messaging on major social media platforms to help drive better customer experience.

The company operates in a three-layer pyramid, with the Super Network serving as the foundation, the Communication Cloud made up of communication APIs and other intelligent services, and the Engagement Cloud's solutions as the top layer.

We think most people have had an interaction based on Twilio’s software without thinking about the underlying technology. Appointment reminders, delivery notifications, and order status updates sent via text message and “click to call” functionality embedded in a website are all basic examples of Twilio’s platform. Uber and Airbnb use Twilio to connect operators to customers via text messaging, Box uses Twilio for security verification via text messaging, and Zendesk has embedded calling into its customer service software via Twilio. There are too many unique use cases to list.

Twilio is the clear leader in CPaaS by any measure, be it market share, presence, revenue, IT consultants, or product portfolio. The company's solutions are easily adopted by developers, who are unencumbered in terms of how they build out their communications capabilities, so solutions can be creative and unique. Given the company's approach to targeting software developers in its marketing and selling strategies, adoption is friction-free. Once a communication node is established and inserted into a company's workflow, it becomes immediately hard to replace. The ease of adoption means the firm is having success supplanting traditional communication applications from legacy vendors.

We can break down the company’s moat in more detail. We think the super network offers a competitive advantage and derives its moat from both switching costs and network effects. We think that the APIs and other software solutions enjoy only high customer switching costs.

The Super Network itself is made up of a variety of software-based infrastructure features, including phone number provisioning, session initiation protocol trunking, and interconnect, and is designed to manage the connections between the internet and the global telecommunications network. The Super Network relies on software to efficiently and cost-effectively route messages across carrier networks. The more data that flows through the network, the more intelligent it becomes, which supports our assertion for a network effect-driven moat source. Since the Super Network serves as the backbone for other Twilio APIs, such as Twilio Programmable Messaging or Twilio Programmable Voice, we think users are unlikely to rip and replace this functionality for key infrastructure, which supports our opinion on switching costs.

Software, in general, benefits from high switching costs, as software system installations are time-consuming processes that require thorough upfront verification, have many touchpoints throughout an organization, are linked to various business applications, and often have new processes built upon them. We also find that software companies compete more on features and functionality and how a software solution meets specific business needs rather than pricing. These considerations are obvious with Twilio given that the whole point is customized embedded communications within other applications. Our opinion therefore is that there would be significant implementation time, financial costs, business disruption, lost productivity, employee training, and operational risk to replacing Twilio within an enterprise customer. 

Twilio employs a self-described “in and up” go-to-market strategy. While conceptually it is running a standard land-and-expand strategy, its initial landing spot is unique. Twilio markets directly to software developers and strives to make its solutions easy to adopt, use, and deploy for coders. The company believes these software developers will push the expansion phase within their own organizations once they have successfully deployed initial APIs to other Twilio solutions. This helps the company drive from APIs to the engagement platform layer, and then ultimately to first-party data via Twilio Segment. Once the Twilio platform is in use in a company, it can move from APIs to the engagement platform layer.

Narrow

Economic Moat

Twilio

SendGrid is a Denver, Colorado-based customer communication platform for transactional and marketing email. The company was founded by Isaac Saldana, Jose Lopez, and Tim Jenkins in 2009, and incubated through the TechStars accelerator program. As of 2017, SendGrid has raised over $81 million and has offices in Denver, CO, Boulder, CO, Irvine, CA, Redwood City, CA and London.

SendGrid

Twilio, Inc. engages in the development of communications software, cloud-based platform, and services. Its products include Twilio flex, messaging, programmable voice, programmable video, elastic SIP trunking, and IoT. The company was founded by John Wolthuis, Jeffery G. Lawson, and Evan Cooke in March 2008 and is headquartered in San Francisco, CA.

Earnings data Q2 2023

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Shares of Twilio Inc. TWLO, +4.28% jumped 4.9% after hours on Tuesday after The Information reported that an activist investor with a stake in the software company was pressing it to shake up its board and think about possible divestitures. The investor, Legion Partners, has met with the business-communication software provider's board and executives “several times,” the Information said.

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Twilio Inc. (NYSE:TWLO ) J.P. Morgan 51st Annual Global Technology, Media and Communications Conference May 22, 2023 10:00 AM ET Company Participants Jeff Lawson - Co-Founder, CEO & Board Chair Conference Call Participants Mark Murphy - JPMorgan Mark Murphy Okay, good morning, everyone.

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