Last Tuesday Twilio (TWLO) acquired small-cap SaaS stock SendGrid (SEND) for $2 billion, a 19% premium to SendGrid’s closing price on Monday. The deal came at a time when software stocks were reeling from their worst correction in years. What does it mean for the sector moving forward? Are there other potential M&A opportunities in small-cap software that investors should be positioning for?
Let’s start with an overview of the deal.
Twilio’s $2 billion takeout of SendGrid implies a price of almost 37 a share, a 19% premium to SendGrid’s closing price on Monday, October 15. That price also implies an enterprise-value-to-2019 revenue multiple (EV/2019 revenue) of about 11 times paid for SendGrid.
On the surface, that appears to be a relatively high multiple. The takeaway message when thinking about potential M&A deals in the small-cap SaaS space is that deals can happen, even if the acquirer needs to pay up to buy the right asset.
It is also notable that Twilio is using its own stock to buy SendGrid. On October 15, Twilio was trading at an EV/2019 revenue multiple of 12. That means Twilio’s stock was more “expensive” than SendGrid’s stock when the acquisition was announced. In other words, Twilio is trading one pricey asset for another.
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What’s also relevant is that SendGrid is on track to grow 2018 revenue by almost 30% and is profitable. Twilio is on target to grow 2018 revenue by almost 50% and is expected to deliver its first profit this year. This puts both companies squarely in the rapid-growth category, which, along with profitability, helps explain why their valuations are somewhat elevated.
The bottom line here is that, even though prices in small-cap SaaS stocks are coming down, a takeover premium still exists for rapid growth companies that fit a strategic need for potential acquirers.
On that note, what does Twilio do? And how can SendGrid help it?
Twilio (TWLO): The Amazon of Communications Software Vendors?
Twilio is a category leader in the Communications-Platform-as-a-Service (CpaaS) market. J.P. Morgan has called it the Amazon of communications software vendors because of the breadth of solutions that run on AWS. It is the only publicly traded pure-play CpaaS stock out there.
Twilio’s solutions give enterprises multiple ways to build, scale and operate real-time communications, including voice, video and text message, and to embed these capabilities directly into web and mobile applications. The company’s “Super Network” even dynamically routes communications through the most efficient channel.
These solutions are elegant and modern, and represent a significant upgrade from the old, patchwork solutions that many current customers became frustrated with. Analysts believe the company’s addressable market is north of $45 billion, and that it’s become a credible threat to competitors like Cisco (CSCO). Big name customers include Airbnb, WhatsApp, Uber and Nike.
The company has reached a critical mass of customers and, like ServiceNow (NOW) and Salesforce.com (CRM), is transitioning into one of those “the big get bigger” stories. One data point to support that assertion is that the next biggest competitor, Nexmo, has less than 500,000 developers on its platform. Twilio has over two million. Further evidence is found in Twilio’s growth rate; revenue was up 44% in 2017 and is likely to hit 50% in 2018.
The story only gets better with SendGrid as a part of Twilio. SendGrid brings robust email capabilities into the fray, and email was the only channel Twilio was previously missing. SendGrid’s SaaS-based platform helps developers and marketers communicate with prospective and existing customers with services that span everything from shipping notifications and friend requests to newsletter sign-up confirmations. The company has scale (management says over 50% of the world’s email addresses have received email through their service in the last 12 months) and market leadership in what amounts to a roughly $9 billion addressable market.
When talking about the acquisition, Twilio CEO Jeff Lawson framed the trend in communications very well by reminding people that it used to be communications meant you picked up the phone when it rang, if you were near it. Today, communications means chatting with somebody inside a live video stream and even sending money! And all of this from a mobile device that be taken virtually anywhere.
The bottom line is that Twilio’s mission to transform the way people communicate is likely accelerated with SendGrid. The acquisition was completed at a price that was almost a like-for-like exchange in terms of stock valuation. And it represents a rational marriage of two companies that are likely stronger together than separate.
Should You Buy Small-Cap SaaS Stocks Now?
What does the acquisition mean for other software stocks, especially small-cap SaaS stocks?
First, some context. Software stocks are in the midst of their third significant correction since the beginning of 2014. The chart below shows the iShares North American Technology Software ETF (IGV), which is a decent proxy for software stocks (it includes 65 stocks across market caps).
As you can see, the index dropped around 12% in early 2014, then roughly 22% in early 2016. After breaking out to new highs in the middle of 2016, then building a base in the latter portion of the year, the ETF started to climb in early 2017 and enjoyed a steady climb until the end of September 2018. It then promptly fell 12% in October and hasn’t given a good sense of what the next direction is yet.
Despite this pullback, the IGV is still up 20% year-to-date (it was up 33%). That compares very favorably to the S&P 500, which is up 3% year-to-date, and the Nasdaq, which is up 8% year-to-date. In other words, investors that have been in software stocks for a while are likely still sitting on gains.
That said, the recent pain is notably higher in the super-high-growth mid-cap and small-cap SaaS stocks, where many names are down 20% to 30%. These are the stocks that many investors are likely wondering whether they should buy, hold or sell.
The best advice I can give is the same we’ve followed in Cabot Small-Cap Confidential, which means taking partial gains along the way while continuing to hold some shares of the strongest names.
Doing this allows you to forget about being right or wrong and focus more on making money. We didn’t take profits at the exact top in September, but by selling some shares at 45%, 108%, 219% and 222% gains over the last four months we’ve made sure to lock in some tidy profits. And we’re still positioned to benefit if and when these stocks move higher again.
In terms of identifying the strongest names that you should consider buying, it’s a little too early to know for sure. We’re seeing some small-cap SaaS stocks hold up better than others, but very few are in an uptrend at the moment.
When those leaders emerge, Cabot Small-Cap Confidential subscribers will be the first to know! To become a subscriber and gain access to all my small cap SaaS research, including the 10 small-cap SaaS stocks in Cabot’s Special Report on Cloud Computing, click here.
Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!Learn More