Twilio Inc. (NYSE:TWLO) UBS Global Technology Conference November 28, 2023 3:35 PM ET

Company Participants

Aidan Viggiano - CFO

Conference Call Participants

Taylor McGinnis - UBS

Taylor McGinnis

Okay. Well, hello, everyone. And thanks so much for attending this session with Twilio. We have Aidan here, Twilio's CFO. And for anyone in the room that might not know me, my name is Taylor McGinnis, and I'm one of the software analysts here at UBS. So Aidan, thanks for coming.

Aidan Viggiano

Thanks for having me. It's great to be here.

Question-and-Answer Session

Q - Taylor McGinnis

Yes, of course. Maybe a good place to start would just be on the macro environment, given that that's very topical. I know you guys have been talking about seeing more stable trends on the Communications side, the data and apps business still sounds like it's under pressure. But could you just talk about what you guys saw throughout 3Q? How things like trended towards the start of 4Q, as a start?

Aidan Viggiano

Sure. Yes. So let's just break it down into the two different businesses. So I think, as you know, the largest portion of our business, almost 90% of the revenue comes from our Communications platform. And what we said in that business is we have seen stabilization in volumes.

And we think volumes in our business think number of messages sent, number of voice calls made, number of e-mail sent, et cetera. And kind of coming out of last year, I would say that we saw volumes declining, right? And kind of through, I would say, mid- to end of Q1, and then it started to stabilize, which gave us more comfort, given our usage-based business.

And we've kind of seen that stabilization through Q2 and again in Q3. And we expect, we're optimistic that would continue, I would say, but just given the fact that it is our biggest business, it is usage based. We just continue to plan prudently.

On the Data & Applications side, it's a relatively smaller portion of the business. That's about 12% of our revenue today. Revenue is primarily a function of prior period bookings. And as we said on our earnings call, like while we saw a modest improvement in bookings sequentially from Q2 to Q3, they're not yet where we hope they would be. And so we continue to really focus on building on that improvement that we saw and reaccelerating bookings into Q4 and 2024.

And then as you know, there are other -- just back on the coms side, some short-term headwinds that we're dealing with as it relates to crypto and certain industries that have kind of plagued us for most of 2023.

Taylor McGinnis

Yes. And maybe to dive in on the Communications side, in particular. So I know 4Q tends to be a big quarter for you with the consumer vertical. So any vertical level commentary you can give in terms of the trends that you're seeing with consumer or others? And then as we look at the 4Q guide -- I'm sorry, I'm giving you like a two-parter here, but we can break it up.

But as we look at the 4Q guide, I think what was interesting, at least by our math, when we tried to strip out some of the headwinds you guys talked to on the Communications side, it looked like growth was, let's call it in the like low to mid-single digits for 2Q and 3Q sequentially. And then it looks like the 4Q guide sequential growth, assume something more flattish, and I know that typically tends to be a higher seasonality quarter for you. So is that just simple conservatism? Or as we think there may be some of these vertical trends, is there something to keep in mind in terms of headwinds?

Aidan Viggiano

Sure. Why don't I start with your second question and then go back to the first.

Taylor McGinnis

Yes.

Aidan Viggiano

So, yes. I wouldn't say that there's an explicit headwind to call out in Q4. Really, at the end of the day, Communications business, most of our revenue, usage based, which is just more variable than other business models and a little bit more difficult to forecast. And so we just continue to plan kind of prudently in terms of the forecast for the business.

As it relates to consumer or e-commerce, the question you had before, we were calling that out as a headwind kind of at the back half of last year, maybe through like Q1. But we've seen stability recently on our, I would say, consumer verticals. So like that hasn't been a headwind for us as of late.

Taylor McGinnis

That's really helpful. And then switching over to the data on app side. So I know last quarter, you guys talked about seeing a slight acceleration on the bookings side. So in terms of the drivers of that, was that just a function of now greater than 50% of your reps on that side are ramped. And so there was more self-help. Was that a reflection at all of the environment improving? Maybe you can talk about the drivers there. And then as we look ahead, because you're starting to see that acceleration, I guess, do you expect that to continue into 4Q? And could we start to see some of the metrics related to NRR and things like that start to bottom at these levels for that business?

Aidan Viggiano

So as it relates to the bookings improvement, it was -- it's a function of the sales rebuild. So this has kind of been a complete rebuild this year. I think you've got the history on the fact that we moved our kind of sales force to a generalist model. We realized that was not the right strategy. We ended up having to rehire the sales force. We spent most of this year hiring, enabling, ramping. We're at a point now where we've done those things. And now it's really about execution. And so the improvement that you saw from Q2 to Q3 on bookings, that modest improvement is really just was driven by that.

Taylor McGinnis

Yes.

Aidan Viggiano

As it relates to -- can you just read your second question, you're good at asking many questions many questions at once. I had that good of a memory.

Taylor McGinnis

No. So, no, no. And then the second question was just is that as we look into like 4Q and beyond, could you start to see this continuation of an acceleration in bookings of easier compares? And given that, that's a leading indicator to revenue, could you start to see revenue and also NRR start to bottom at the levels that we saw this last quarter?

Aidan Viggiano

Yes, I'm not going to call like bottoms or specific forecast. We don't do that by business unit. As you think about Q4, like we really want to build on the momentum that we saw in Q3. And really focus on accelerated bookings into Q4. Like we're intensely focused on that. We saw a modest improvement in Q3 on bookings, on things like sales productivity, but they were relatively modest, and we're shooting for much better than modest in this business.

As it relates to NRR and things like that, now I would say for Q4, again, we'd expect sequential revenue to be growth to be more muted into Q4 and beyond that. I think we'll cover more of that as we get into our Q4 earnings call.

Taylor McGinnis

Perfect. And then staying on this topic with Elena's departure, any anticipated changes off the back of that? I know Jeff's stepping and taking a bigger role there. But just in terms of what needs to happen to really start to like push that business to a further acceleration, I guess how are you guys thinking about some of the near-term sales dynamics?

Aidan Viggiano

Yes. And so Jeff is stepping in to as we look for a new leader. And we're looking at everything, right? And so as we said, the business, we're seeing green shoots, not yet where we want it to be. And so Jeff is spending a lot of time with that team and the sales org in particular, really dissecting what are we seeing, starting from MQLs to QOs, like all the way down to win rates and ASPs and all the different metrics that will look sales productivity and understanding it and slicing it in a number of different ways, by use case, by vertical, by region, et cetera, by enterprise versus mid-market versus growth kind of smaller customers and really try to dig in and look at kind of what are we seeing?

Where is it breaking down in a way that we haven't -- wouldn't expect it to. Like one of the things that we are doing is looking at our target persona historically, a marketing persona. And pivoting a bit to more of a technical buyer where we find that we are more successful, just given the strength of our product. And so there's a number of things like that, that are underway that will be underway for a couple more months, and it will take time.

Once you go through a sales rebuild, it takes time, and we're seeing that. But some positive. We're seeing some really good deals being won, but more work to do to really kind of drive that, I would say, a higher level of looking.

Taylor McGinnis

Yes, it makes sense. Maybe enough with the near-term stuff, and let's talk longer term. So you guys have a medium-term guide out there for 15, I think, to 20% or 25% growth on the top line. So I think today, the Communications business is growing in the teens. You have the data and apps business growing in the single digits. So in order to get up to those levels, it requires a pretty big acceleration. So just in terms of what gives you guys comfort with those outlooks, maybe you could talk about those underlying drivers there?

Aidan Viggiano

Yes. So a couple of things. So first of all, Communications is nearly 90% of the revenue. So it drives most of our growth. And then on the path of 15% to 25%, like that business needs to do much of the heavy lifting, right? I just give them the relative size of it.

And so when you think about that business, a couple of things. Number one, it's usage-based. It's a consumption model. And so we feel the macro effects, both on the downturn, but as well as on the upswing, more quickly than other business models.

And so over a longer-term period, like the medium term, we do expect that the macro does improve, and so some of the short-term headwinds that we're dealing with start to abate a bit, and we do have a bit more of a stable macro environment. We're not assuming it goes back to where we were in like 2020, 2021 or even 2022, but just a more stable operating environment.

That's not to say that all we're doing is banking on the macro. There's a number of things that we're undertaking in that business to drive growth. So just to name a few. So first, just new products like Verify really driving kind of focus and sales incentives around some of our newer products.

Second is cross-sell. And so we've incentivized our sales teams differently coming into 2023 than we have historically, and that will incentivize the cross-sell of products within our portfolio.

And then third, I would say is international expansion. We have historically been like relative to the U.S. underpenetrated internationally. And so we think that we have a lot of opportunity to go into the international markets and grow there. So a lot of work being done on the Communications side, I'd say the one assumption around getting to the medium-term framework is we do assume a more stable operating environment.

As it relates to a smaller portion of the business, Data & Applications. I'd say it's two things: number one, a more stable operating environment will help that business. So what we're seeing there as it relates to the macro is increased levels of kind of churn and contraction. And it's really driven by two things, like customers are cost-cutting just like we are, and when that happens, like we are seeing instances where they will come up for renewals and possibly churn off of our platform or what we're seeing more often is that as customers come up for renewal, they're contracting.

So they entered into a contract a year or two ago. They had assumed a certain trajectory from a volume perspective within their own business, that has played out very differently given just what we've seen over the last three or four quarters. And they're rightsizing the volumes and the contracts to reflect their volume realities.

And so we are seeing higher levels of churn and contraction in that business. We think a lot of it is macro. So we do assume a more stable macro environment to be operating with TD&A as well, but also better execution, right? And so we've talked about the fact that we've now rebuilt the sales force, we've enabled the sales force. Now we do see the sales force executing and getting productivity up to our expectations.

Taylor McGinnis

Yes. And on the first part that you mentioned on the optimization side. So do you feel like we've gotten through a lot of the renewal activity in terms of peak-COVID time frames when everyone thought growth was going to look like this. And then obviously, the macro hit, and you had, to your point, a lot of companies having to contract there. In terms of what you guys see on -- see in the renewal base for that, do you feel like we've largely gotten through that activity? There might be a few more quarters left to go on the optimization side. I guess, where do we stand there?

Aidan Viggiano

Yes, I'd say we've gotten through some of it. I would expect for it to play through for a few more quarters. So like on average, probably our terms are, I don't know, a year to 1.5 years on average, some are longer, some are shorter. And so I think we have a few more quarters to play through on that.

Taylor McGinnis

Yes. Makes sense. Maybe moving on to the long-term communications growth profile. So one area that tends to be an investor concern is on the password-less opportunity, right? And what that could mean for Twilio longer term. So I know you have like three main buckets of use cases, whether that be notifications, the multifactor authentication, and then on the marketing side.

But I guess, first, on the authentication side, I guess, how do you guys think about that risk longer term? I know earlier you mentioned Verify. I think there's things that you guys are doing on that front to make your value proposition stronger, but would love to hear how you think about that in terms of the longer-term growth profile of Communications.

Aidan Viggiano

Yes. So a couple of thoughts on that. So first, that is not creating like increased churn today. And I'll come back and talk about churn in this business, which has been low and continues to be low. And I'd say as it relates to verification, what we're actually seeing in the short term is that with, I would say, bad actors, fraud actors, in particular, becoming more sophisticated, the need for verification is actually increased right now.

And so that's something that we deal with. We have a lot of products and like Fraud Guard and Verify and other things that help protect against fraud. But bad actors are becoming more sophisticated. And so the need for verification, at least here in the foreseeable future has not dropped off.

The other thing is when you look at the majority of our verification traffic, it's actually for the initial verification of the device. It's less so the second, third, fourth kind of verifications or two FAs that yet or the password resets and things like that. It's not all. I understand what the majority of it is the initial verification device.

And then within our products like Verify, or we have a product called Verify, we're trying to meet customers where they are. So that means that if they want to verify through SMS, that's one channel they can use. If they want to verify through e-mail, we will verify through email. If they want to verify through WhatsApp, we'll verify through WhatsApp.

And so we're trying to meet customers where they are within our products, not just be kind of limited to SMS two-FA. And so I think there's a number of things in the short term, like I don't see that kind of risk. I understand like longer term, that's a question we deal with often. But actually in the shorter term, with just enhanced kind of focused on making sure that our traffic is -- traffic our customers want to receive, we really haven't seen that.

And as it relates to just back to churn in this business. So this is the communication side of the business. Churn in this business has been low, and historically been low. It continues to be low. We played through -- we're playing through a very tough macro.

We've played through two write-offs that have impacted our sales team. And we really haven't seen it move, right? And so it's been kind of that historically trended low, and it continues to be low. And so I'd just say that because, I guess, the concern that you're raising would be -- would result in kind of churn internal customers off our platform.

Taylor McGinnis

Yes. That's really helpful. Thanks for that that. And maybe sticking on the Communications business, but let's turn to margins. So I think one of the highlights of last print was the Communications gross margin, which was up 160 basis points. And then when you look at the total company gross margin, I think that's the highest we've seen since 2021. And that historically has always been a focus for investors.

So in terms of some of the drivers there, I'd love to hear you elaborate a little bit more. I know you guys are doing more on the incentive side, more so incenting for gross profit and you've made like some changes there. So maybe you can talk to the group about what those drivers were and the durability of that as we look ahead.

Aidan Viggiano

Yes. So as it relates to the margin accretion that we saw in this third quarter, I think Communications margins were up like 160 basis points.

Taylor McGinnis

Yes.

Aidan Viggiano

And we've kind of seen that trend over the course of the year. It's been trending up. And so a couple of things. Number one, part of it was driven by the divestitures that we did in -- at the end of the second quarter, beginning of the third quarter. I would say that was 70 basis points or so. And so that will obviously be sustained because those business are no longer with the company.

The other piece of it was actually really driven by termination mix. And in particular, the mix of where messages terminate geographically. And what you find is that messages terminating in the U.S. tend to have higher gross margins than messages terminating internationally. Despite the fact that the unit economics for both are very strong and actually the unit economics of an international message are slightly better than the unit economics of the U.S. message.

And so depending on where messages terminate, which is somewhat beyond our control, right? It's depending on where the customer is sending messages. You will see variability in our gross margin line. And so this quarter, we had more messages terminating in higher-margin geographies like the U.S. than we did internationally and that mixes us up. Which is why we're really focused on gross profit dollar generation, not just gross margin rate.

I think if you just focused on gross margin rate in this business, it might lead you to make the wrong economic decisions, right? The unit -- we look at the unit economics as the message is being sent. And so long as those are attractive, that's business we want to keep doing, even though it might drive some variability in the gross margin line in the short term.

Now as it relates to the sales incentive structure that you referenced and the impact on margin. So I would say, in the quarter, we are very focused on cross-sell and maybe just to give like a little summary of what it is we've changed. We are focused on compensating our portion of our communication sales reps on revenue and gross profit dollar generation, which is different than how we've compensated them in the past.

That did drive a little bit of a more of a mix to higher-margin products like voice and e-mail, not significant. And in terms of the impact on the margin, sure, it was a little bit, but it wasn't anything that was worth calling out.

So but over time, we're going to continue to incentivize that. Our voice product, our e-mail products are very high-margin products. And there are products that we want to cross sell. So some traction, more work to be done there, like we'd like to see that trend continue. It wasn't a big driver in the quarter, but we'll continue to focus there as a company.

Taylor McGinnis

Got it. And then as we think about the other side of the business, I know that there's been some pressure on that front. So on the data and app side, you saw gross margins dip below 80%. And I know that there's some back-end cloud infrastructure changes that you guys are making that are pressuring that near term. But could you maybe like talk about what are some of those headwinds? And as we look into the future, like should we see a rebound back to 80% plus? I guess how do you think about the longer-term gross margin structure of that business?

Aidan Viggiano

Yes. So you've seen gross margins decline in Data & Applications over the last couple of quarters, which is when we started actually providing that information publicly. It's two things. So in the short term, there is a capitalized software headwind. And so as we continue to innovate and build new products and add new features, both within the core CDP within Flex as well as on the AI front.

That is resulting in a higher, I would say, capitalized software amortization expense kind of flowing through our P&L. So that's part of it. The piece that you're referring to, which is more of the infrastructure headwind, I would expect that to actually continue for probably most of 2024, and after which we would reap the benefits of having kind of built a more sustainable infrastructure. And it's really a couple of things.

So it is shifting a vendor. So in some cases, we are moving to different vendors for cost reasons. In some cases, we're moving to different vendors for design reasons. It's really driving a scalable infrastructure within our kind of TD&A businesses. And it's things like eliminating some redundancies as well around things like hosting costs, things like warehousing costs.

Data lakes, things like that. And so we're really looking at all of it. We're really focused on making sure it's sustainable, and we have the right infrastructure in place and at the right cost point.

During that transition, so most of 2024, the reason you have a headwind is because there will be a double bubble of expense, right? Because we don't just go cut off one vendor and move to another vendor that would obviously very risky, and we don't want to really present that risk to our customers. So there's a period of time where you're actually paying two vendors, and you got to play through that until you ensure that the new infrastructure and vendor profile that we have is sustainable and manageable. So I think that will play through that for probably most of 2024 and then see margins start to improve again in 2025.

Taylor McGinnis

Yes. Makes sense. And then on operating income margins, you've seen incredible improvement this year. And so I guess, as like a common question we'll get from investors is, okay, they've shown all this amazing improvement next year, as we look into -- or sorry, this year, as we look into next year, like where are the levers of continued operating efficiencies? So maybe you can comment on that? And how as you guys look into next year, how you're thinking about balancing growth and profitability?

Aidan Viggiano

Yes, I think we'll be balanced in terms of like focusing on both growth and profitability. You're right, in this year, in 2023, we came out of the gates really fast, right? So last year, we were roughly breakeven on a non-GAAP basis. We lost a little bit of money. And Q3 to date, we've generated $360 million of profit.

We came in the year saying $250 million to $350 million, 3Q year-to-date, we're at $360 million. And so year-to-date, you've seen something like 12 to 13 points of like OM expansion earlier.

So doing what we said we were going to do on that front, which I think is important. I wouldn't expect that level of leverage to continue, right? I think that was on the back of two kind of big restructuring a number of different changes that we made around our real estate portfolio and other cost actions. So I'd expect more modest improvement in 2024.

In terms of where we expect to see additional leverage, think it's a couple of things. Number one, broadly, we have, as a company, we're remote first. And so -- and we've actually closed a number of our offices. We still have an office footprint, but seeing remote first gives us the option and the flexibility to hire employees, where it makes sense to, from both a talent perspective as well as a cost perspective. So I think we have some opportunities to continue to shift to some lower-cost geographies.

Second, in functions like my function, like finance and accounting, we've actually done a lot of that work in like say, my accounting or to actually shift to lower-cost geos. And now the next wave of it is like how do we actually leverage technologies to automate. And so there's a lot of work that we can do to automate work and to make workflows more seamless, so that as we move forward, we can -- we don't have to continue to add hedge as we scale, where we can get leverage on lines like by cost center.

And then as you think about other parts of the business, say, communications, one of the areas we've been really focused on this year is self-serve. We've done a lot there. There's still more work we need to get done. But once we get some of that work behind us, I think when you talk to Khozema who leads our Communications business, like I think he firmly believes that once we're on the other side of some of these builds on things like self-serve and some infrastructure stuff, so we get a lot of leverage by not having to add resources as we grow revenue in that business. So those are just some of the areas that we're focused on and really driving efficiencies over the long term of the company.

Taylor McGinnis

Yes. And then I would -- are those all the longer-term drivers then of your long-term target where if you look out, you guys are calling for 30 to 40 basis points, I think, of operating improvement per year?

Aidan Viggiano

300, 400.

Taylor McGinnis

300, 400? Yes. So curious if some of the things that you mentioned are things that are just going to take time. You're going to see that gradual improvement over time. Or is there things that as you look at, right? Maybe they're not drivers today, but you would say, hey, in a couple of years, like these are other things to keep in mind.

Aidan Viggiano

Yes, I think those are a lot of -- many of these things are multiyear efforts. It's not something that you just do and you're done. It takes time to work through and some of them, like we're in the early stages of investing in order to reap the benefits on areas.

So I would say those things, I think the other things like cross-selling into kind of higher margin, higher gross profit dollar type products will also drive improved OM expansion as well. And so I think it's a combination of the actions we're taking on the top line to incentivize different increased sales and then combined with not having to add cost at the levels we were historically, as well as some of the actions that I spoke to earlier.

Taylor McGinnis

Yes. That's really helpful. And then just how this translates into cash flow. So free cash flow margins have been trailing EBIT margins. So as we think about the guide that you have set out for EBIT, what does that mean on the cash flow side? Are there certain cash flow tailwinds to keep in mind, any headwinds that we could see in the near term? How do we think about the puts and takes there? .

Aidan Viggiano

Yes. So we kind of -- we just got to free cash flow positive this year, in line with our non-GAAP operating margin. In the last two quarters, we actually generated meaningful levels of free cash flow for the first time as a company. And what I would say is that I would expect the trend -- those two things correlate, right? Like as you reduce the cost structure of your business, obviously, like you would expect that your profitability increases and your free cash flow increases.

And so I would expect that as we continue to get more and more profitable over time, free cash flow follows. Whether those two things converge, we haven't committed to that. But I do -- I would expect that over time, those two things trend in the same way. I think that's the obvious.

I think within any one given period, there's always variability on cash flow. So like, for example, in the third quarter, we actually had a tailwind from collections. We approved our DSOs by like three days. And like that won't necessarily continue every quarter.

Flip side, in the first quarter, we have the restructuring payments and severance payments we're making, so we had a cash headwind. So there's always variability in cash, and so within a given quarter, you might see that those two things don't exactly correlate. But over time, that trend should continue.

Taylor McGinnis

Perfect. Maybe with the last minute we'll end on a fun question with generative AI and all the other AI initiatives that you guys have been doing, too. So could you maybe talk about the opportunity with CustomerAI? So I know that you had Predictions that just went GA recently, what's been the customer feedback? How are you, like from the CFO seat, thinking about the potential revenue opportunity longer term, and how we can see that ramp?

Aidan Viggiano

Yes. So we had our SIGNAL conference, which is our customer conference in August. And then we've actually had some regional SIGNAL conferences in EMEA, APGA, I think we are LatAm this week over the course of like November. And it's been really exciting to talk to customers about our product and kind of feature road map.

You called out Predictions as is one of the products that we talked about. I think we have like 100 or so customers leveraging that feature. Another one is like the voice intelligence where we basically make a voice, at least like a transcription engine powered by AI that makes like a voice call more intelligent and action-oriented and actionable and traffic optimization in terms of optimizing when and over what routes you're sending your marketing messages or other messages depending on the importance of delivery and cost. So we have a number of initiatives underway, like we have a pretty robust product road map that we talked about at SIGNAL.

In terms of the financial expression, I think it's early days, candidly, like in the near term, like I'm not banking on that and to be like a meaningful contributor to revenue. I think everyone's kind of figuring out like what is the commercial structure, what is the pricing and packaging structure of all of this. And so I don't have much to add there today. We're excited about the excitement that we've seen but more to come over time on how it all plays out through the financials.

Taylor McGinnis

Perfect. Awesome. Well, that's it for time. So thank you for taking the time. This was great, and thank you to everyone in the audience for joining us as well, too.

Aidan Viggiano

Thank you.