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Edited Transcript of TWLO earnings conference call or presentation 30-Oct-19 9:00pm GMT

Q3 2019 Twilio Inc Earnings Call

SAN FRANCISCO Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Twilio Inc earnings conference call or presentation Wednesday, October 30, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andrew Zilli

Twilio Inc. - VP of IR

* George Hu

Twilio Inc. - COO

* Jeffrey Lawson

Twilio Inc. - Co-Founder, Chairman & CEO

* Khozema Z. Shipchandler

Twilio Inc. - CFO

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Conference Call Participants

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* Aleksandr J. Zukin

RBC Capital Markets, Research Division - Analyst

* Bhavanmit Singh Suri

William Blair & Company L.L.C., Research Division - Partner & Co-Group Head of Technology, Media and Communications

* Brent Alan Bracelin

Piper Jaffray Companies, Research Division - MD & Senior Research Analyst

* Daniel Peter Church

Goldman Sachs Group Inc., Research Division - Associate

* Ittai Kidron

Oppenheimer & Co. Inc., Research Division - MD

* Mark Ronald Murphy

JP Morgan Chase & Co, Research Division - MD

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Nandan Girish Amladi

Guggenheim Securities, LLC, Research Division - Senior Analyst

* Nikolay Ivanov Beliov

BofA Merrill Lynch, Research Division - VP

* Richard Frank Valera

Needham & Company, LLC, Research Division - Senior Analyst

* William Verity Power

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Good afternoon, and welcome to the Twilio's Q3 2019 Earnings Conference Call. My name is Daphne, and I will be your operator for today's call. (Operator Instructions)

I will now turn the call over to Andrew Zilli, Vice President of Investor Relations. Mr. Zilli, you may begin.

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Andrew Zilli, Twilio Inc. - VP of IR [2]

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Thanks. Good afternoon, everyone, and thank you for joining us for our third quarter fiscal 2019 earnings conference call. Our results press release, SEC filings and a replay of today's call can be found on our IR website at investors.twilio.com. Joining me today are Jeff Lawson, Co-Founder and CEO; George Hu, COO; and Khozema Shipchandler, CFO.

As a reminder, some of our commentary today will be in non-GAAP terms. Reconciliations between our GAAP and non-GAAP results and guidance can be found in our earnings press release. Additionally, some of our discussion and responses may contain forward-looking statements which are subject to risks, uncertainties and assumptions. Should any of these materialize or should our assumptions prove to be incorrect, actual company results could differ materially from these forward-looking statements. A description of these risks, uncertainties and assumptions and other factors that could affect our financial results are included in our SEC filings, including our most recent report on Form 10-Q, and our remarks during today's discussion should be considered to incorporate this information by reference. Forward-looking statements represent our beliefs and assumptions only as of the date such statements are made. We undertake no obligation to update any forward-looking statements made during this call to reflect events or circumstances after today or to reflect new information or the occurrence of unanticipated events, except as required by law.

With that, I'll hand it over to you, Jeff.

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Jeffrey Lawson, Twilio Inc. - Co-Founder, Chairman & CEO [3]

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Thanks, Zilli, and welcome everyone to this quarter's earnings call. Before I begin, I'd like to take a moment to recognize and thank the nearly 5,000 brave firefighters and other first responders doing their best to keep the fires in Sonoma County at bay, protecting the lives, homes and livelihoods of our neighbors to the north in absolutely horrifying conditions. Thank you.

Now on to our call. Our third quarter results were strong, with total revenue growing 75%, tremendous growth at this scale that reinforces our view that we are still in the early days of this market opportunity. And while we are the leader in the category today, we have much bigger aspirations. We are investing across the business in new products, new regions and much more, to position us for long-term success to take advantage of this fast-growing market. We're very confident that the demand environment for our customer engagement platform and the inputs to our business are strong.

I recognize that base revenue came in slightly below our guidance, and Khozema will go into more details on that, but that doesn't change our perspectives that we've only scratched the surface and are excited about what lies ahead. We continue to help companies reimagine their customer engagement as every company needs to focus on building great digital experiences for their customers. Our commitment to innovation and customer success is driving relationships with companies of all sizes as the breadth of our product offering and our developer-first approach position Twilio as the platform of choice for building meaningful relationships with customers.

I'm particularly excited about some of the new companies we started working with in Q3, which George will talk about shortly. And nowhere with this developer-first approach more evident than at our annual customer event, SIGNAL, where we welcomed more than 3,200 customers, prospects, developers and business leaders and introduced a number of new products and features. And at SIGNAL, I told you we had over 6 million registered developer accounts on our platform. Well, today, that number is now north of 7 million and climbing.

Innovation has always been at the core of Twilio, and you can see that in the new products and features we announced at SIGNAL, the biggest being Twilio Conversations. Everyone has had the experience of getting a message from a brand only to find out that most times responding to that message doesn't work. But we've reached the point where customers expect this kind of easy, frictionless engagement with brands. At SIGNAL, I mentioned some brands who have figured out the importance of meaningful 2-way conversations with their customers, companies like Nordstrom, Macy's, Lyft, Redfin and others. We've heard from many customers, especially as we launched Flex, that they see this as an opportunity to transform the way they engage with their customers. And that's why we built Conversations, to make it easier for every company to build this kind of 2-way engagement across channels and deliver a better customer experience.

We also announced Ads for Twilio SendGrid, a new offering within our marketing campaigns product to address the more than $300 billion digital ad spending market. SendGrid Ads synchronizes across all of your e-mail contacts, and allows you to target ads across 3 of the major advertising platforms: Facebook, Instagram and Google Ads. This is all managed from a single UI, and more importantly, the ads are informed by the intelligence of the e-mail channel, so your ads can be smarter.

We also announced the e-mail validation API, which validates e-mail addresses before companies sends them, decreasing bounce rates and improving sender reputation and inbox placement.

There's always a tremendous amount of energy at SIGNAL, and this year was no different. I want to thank our team and everyone who attended for making this the best SIGNAL yet.

SIGNAL is a great example of the innovation that Twilio continues to deliver to our customers. And because of this innovation, focus on customer success and our extensive customer engagement platform, Twilio was recently recognized as a worldwide leader in the IDC MarketScape for CPaaS, being named the de facto icon of the CPaaS segment for our vision and strategy to drive digital transformation. The report highlighted how Twilio has almost single-handedly created a new communications segment, and specifically mentioned our recent focus on solutions such as Flex. This is great validation that our constant innovation and our vision of powering the future of communications is bearing fruit.

Speaking of Flex, we're continuing to see great interest and traction with the product as we've just passed the first year of GA. We're continuously innovating to add high-value features our customers are asking for. In fact, at SIGNAL, we announced the media streams API to get companies access to the voice media of the calls coming into Flex, allowing realtime transcription, conversation analytics and more. We also announced native CTI integrations between Flex and Zendesk, and brought Autopilot to GA within the Flex console. While it's still early for Flex, we are seeing some great wins as companies of all sizes continue their digital transformation efforts and look to move their contact centers to the cloud to better drive omnichannel customer engagement.

One of the other announcements we made at SIGNAL was Verified by Twilio, a new feature that allows branded, trusted phone calls that are authenticated by Twilio. This is yet another step that we are taking to take back the voice channel and combat unwanted robocalling.

Now I know that investors have concerns about the impact of robocalls and potential legislation on our business. We talked about it on previous calls, but given the amount of noise, I wanted to address it head on today. When people talk about automated calls or text, there's really 2 kinds of behaviors they might be referring to: automated unwanted calls and texts such as those you may get from a fraudster; and automated but wanted calls and texts such as those you might get from your child's school. To be clear, we do not support unwanted automated calls or texts on our platform. Since day 1, we have had many preventative measures in place. And since the beginning, we have proactively kicked customers off of our platform who have been bad actors. We welcome legislation that will further impinge these bad actors and are working with the FCC, carriers, Congress and industry groups to support this.

That said, we do support customers making automated wanted calls and texts. Think about doctors' appointment reminders, flight changes, fraud alerts or emergency notifications. There's a valid concern that legislation or regulation designed to target the bad actors could impact these good use cases. So let me address what we're doing there.

As of today, both the House and Senate have passed robocall legislation that we support, and we expect a bill focused on SHAKEN/STIR implementation to be signed in the coming weeks. As a reminder, SHAKEN/STIR uses digital certificates based on common public-key cryptography techniques to ensure the calling number of a telephone call is not spoofed. We have made great strides to help ensure calls in our platform will be signed under SHAKEN/STIR and expect to have those pieces in place by the end of the year, in line with the industry goal for initial go live.

And just yesterday, we announced that we have joined the board of ATIS, the standards group that developed SHAKEN/STIR. We're also a member of USTelecom, the industry association primarily responsible for advancing illegal robocall mitigation efforts. And our General Counsel, Karyn Smith, sits on their Board.

With our involvement at ATIS and USTelecom, Twilio is furthering our commitment to protect voice and messaging channels, partner with carriers and other voice providers to combat illegal robocalls, protect our networks and ensure we have strong federal policies that benefit consumers and businesses.

We continue to anticipate that carriers will proceed cautiously when blocking calls, as they understand the consumers want and need to receive calls and texts from their doctors, schools, teachers, pharmacists and others. And importantly, since carriers were given the option to automatically block calls back in June, we have not seen an impact on our customers' traffic. However, even if you look at the most extreme case of carriers or legislation that allows the blocking of wanted communications, including text messages, we currently estimate based on historical data that a single-digit percentage of our total revenue could be impacted. This is obviously the worst-case scenario but we expect that the actual impact will be de minimis.

We feel confident that we are taking the necessary steps to ensure our platform is ready for these changes. And importantly, the FCC has classified text messages as a Title I Service, which indicates that the commission intends to keep this channel largely regulation free. The carriers all support this approach as do others in the ecosystem, including Twilio.

So to close, we are still in the early innings of this massive market opportunity as evidenced by the great customers George is about to talk about, our growth rate at this scale and the demand for our platform. We're focused on managing the business for the long run to help every company reinvent how they engage with their customers in this digital era.

I want to thank all of our customers for trusting Twilio as their customer engagement platform, and thank all of the Twilions around the world for yet another great quarter and for their endless dedication to our customers.

And with that, over to you, George.

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George Hu, Twilio Inc. - COO [4]

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Thanks, Jeff. Our team delivered another strong performance in the third quarter as we continue to build out the go-to-market foundation for the future for multiple initiatives, expanding our enterprise presence, expanding internationally and building a strong partner community. And these investments are paying off. In fact, during the quarter, we signed new or expansion agreements with more than 50 Global 2000 accounts, a great sign of the traction we are seeing in the enterprise. Internationally, we opened an office in Japan, hiring a strong executive in Yoshihiro Konno to lead the region. We continue to see success with our Engage roadshows, where we bring together a community to learn and develop the future of communications. We're holding Engage events around the world with stops coming to Washington, D.C, Toronto, London, Paris and Tel Aviv in the coming weeks.

At SIGNAL, we heard from great customers like Netflix, Lyft, Morgan Stanley and others on why they chose Twilio to power their customer engagement.

Now let me highlight a few of the exciting deals from the third quarter. We entered into a new relationship this quarter with the U.S. Department of Agriculture's National Finance Center, a shared-service provider for financial and HR services for approximately 650,000 employees. The USDA is using Programmable Messaging to authenticate their employees via SMS when they are logging in to review pay stubs, W2s, 401(k) allocations and more. In addition to onetime password authentication, the National Finance Center will use SMS to periodically send account notification and reminders to their employees. This is an exciting new relationship with one of the largest departments of the federal government.

We also extended our relationship with Chime, the fastest growing U.S. challenger bank platform, focused on helping their members achieve financial health. To accommodate their incredible growth, Chime chose Twilio Studio, our innovative digital application builder, to build an in-bound IVR completely from the ground up, serving banking customers for any level of support on their account. They are disrupting the banking industry, and we're excited to support them on their journey.

Last year, we started our expansion in Australia and we're excited by the progress there. We entered into a new relationship with Westpac, Australia's second largest financial institution and a Global 2000 company with a market value of AUD 100 billion. Westpac is rapidly expanding its digital efforts and needed a new solution for account notifications for its tens of millions of customers. Westpac chose Twilio Notify as its standard across its brands as we offer the most complete omnichannel platform with global scale. We look forward to working together with Westpac as they continue to meet the demands of the modern customer.

Flex continues to be top of mind for our customers, and we've heard great feedback since we became GA in October of 2018. This quarter we signed a new relationship with Allianz SE, the world's #1 insurer and one of the world's largest financial services groups. Working with a close business and developer approach, Allianz Direct chose Flex to power their customer and contact center agent experience. In combination with our partner DVELP, Allianz Direct has rolled out Flex in several regions.

We also entered into a new relationship with CompuCom Systems, a subsidiary of Office Depot that provides end-to-end managed services, technology and consulting to enable the digital workplace. As part of their strategy to reimagine their customer experience, CompuCom chose Flex to provide a more seamless customer interaction regardless of channel for more than 2,000 agents.

These are both great examples of the massive shift in the contact center space, and we are excited to help companies like CompuCom and Allianz adapt to the changing needs of their customers with fully programmable Flex platform.

The Twilio SendGrid cross-sell efforts continue to progress well. And this quarter we had a cross-sell win with a major global airline. They've been a Twilio SMS customer for a few years, and in Q3 we expanded our relationship by adding Twilio SendGrid e-mail, which the company will use for millions of notifications each month, including flight changes, check-in reminders, delays and more. This is a strong team effort and shows the value of combining messaging and e-mail for customer engagement.

I want to personally thank all of the amazing SendGrid team members who are working hard to make deals like this possible, and all who built the product capable of supporting these great customers. As we expand our penetration into a market like travel, we're continually encouraged that this opportunity truly spans companies of all shapes and sizes.

On the IoT front, we signed an agreement with Mason, a leading mobile infrastructure-as-a-service provider that Forbes called the Twilio for tablets. Mason was created to help companies build and scale smart hardware products, and its customers have used its services for ordering kiosks, patient engagement in hospitals and more. They were looking for a partner to scale their Edge computing business and turned to Twilio's Super SIM to connect the customized tablets they built for their customers.

While the IoT market is very early, we're excited about the continued traction of our IoT offering. Overall, we're well positioned as we head into Q4 and into 2020. We're making the key investments that fuel continued growth going into next year, and we'll continue executing on our strategy to grow our enterprise presence, scale our partner ecosystem and expand internationally.

With that, I'll pass it over to Khozema.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [5]

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Thanks, George, and good afternoon, everyone. Q3 was another strong quarter for the business. High growth of this scale is a testament to the power of Twilio's platform, and showcases how our customers continue to choose Twilio as their trusted customer engagement platform.

Now diving into the numbers. Base revenue, which includes Twilio SendGrid, grew 79% year-over-year to $276 million in the third quarter. Organic base revenue for Twilio was $227 million, growing 47% year-over-year. Twilio SendGrid grew 31% year-over-year to approximately $49 million.

As Jeff mentioned, while the growth was very strong, base revenue came in a bit lower than we expected. We've experienced rapid growth, and with that comes some growing pains. Consequently, a few of our older systems sometimes fall short of where we'd like them to be. We faced some of these growing pains in the third quarter as we discovered some errors in our billing processes that resulted in a few onetime credits being issued to customers totaling approximately $5 million, which will also impact our ongoing run rate. Importantly, our internal controls identify these errors, and we understand the root issues and are working to improve our billing-related processes and other systems. We will continue to invest in systems to support our strong growth trajectory into the future.

Let me take a moment to discuss our current revenue disclosures and a change we are planning to make. Given the size and scale Twilio has achieved, we believe the variable revenue designation has become less meaningful, and that total revenue is a better way to evaluate the overall business. Variable revenue has materially declined as a percentage of the total: 7% this quarter, 7% last quarter, and less than 10% in 2018 prior to the closing of the SendGrid acquisition versus 16% in the quarter before we went public.

Accordingly, beginning in Q1 2020, we will no longer break out base and variable, but we expect to continue to disclose the contribution from WhatsApp through 2020, which constitutes the majority of the variable revenue category. One important note regarding this change is that dollar-based net expansion is currently calculated on base revenue. So we will be shifting the basis of our expansion metric to total revenue on an ongoing basis, and we will provide historical data using total revenue to normalize your models.

Dollar-based net expansion rate was 132% in the third quarter, a very strong rate at this size and scale, especially coming off of difficult compares from 2018. Additionally, the credits I mentioned impacted DBNE by a few points in the quarter. As we approach the end of the year, let me provide a bit of context around what to expect for expansion rate over the next several quarters.

First, recall that strong political traffic and the ramp of a large international customer benefited growth by about 10% in Q4 '18. And we do not anticipate those to occur again this year, making for a difficult comp in Q4.

Second, SendGrid's historical dollar-based expansion rate had been about 115%, give or take a few points, at any given quarter, and will therefore lower the overall expansion rate once combined next year. As you may recall, SendGrid was acquired on February 1, 2019, and therefore, only contributed 2 months to our Q1 2019 results. As Q1 2020 will have the benefit of an extra month of revenue from SendGrid, our expansion rate will also benefit when we expect a sequential increase from Q4 to Q1. The full impact of the combined expansion rate will be realized in Q2 2020.

Moving on, we had approximately 172,000 active customer accounts at the end of the quarter. Top 10 active customer accounts contributed 13% of total revenue in Q3, flat sequentially and down from 18% in Q3 2018.

Gross margins were at 58.4% in the third quarter, within the mid- to high-50s range we've been communicating. Going forward, we continue to expect to operate in the mid- to high 50s while the normal puts and takes, customer, product, country mix, carrier fees, FX and others may cause minor fluctuations. A2P carrier fees had no impact during the quarter as they have still yet to be implemented. We do not have any updates with regards to timing but we will provide the P&L impact during the earnings call post implementation.

As anticipated, operating profit was slightly in the red, coming in at a loss of $3.6 million, primarily due to SIGNAL, our annual developer and user conference, which was held in August. Additionally, we refined our process for accumulating inputs that feed our capitalized software process, allowing us to make better estimates. This could potentially reduce the amount we capitalize and more closely align our P&L with cash usage.

As we get into Q4 and fiscal year '20, we see a tremendous opportunity ahead of us to continue to increase market share and grow the company. George has talked about some key priorities in the go-to-market efforts and we believe investing in these areas today as well as our product innovation will position us to take advantage of this massive market opportunity. In that context, we now expect to finish 2019 with a slight operating loss versus our earlier guidance of $5 million to $8 million of profitability. We believe these investments will drive multiple years of elevated growth.

Staying on profitability for a moment. While we're not optimizing for this today, I want to reiterate that this is an important long-term focal point for the company. We are in the early stages of a number of changes internally to drive efficiencies over time, including changes to strategic sourcing, working capital and stock-based compensation, to name a few. We have heard your feedback on our stock-based compensation and dilution, and are actively working to bring both of those numbers down over time.

Some of these levers will also close the delta between GAAP and non-GAAP results. We don't have any specific items to highlight today with regards to these items but we will provide more information when the time comes. Ultimately, the investments being made today enable Twilio to extend our market-leading position and take full advantage of this generational opportunity.

With that, thank you, everyone, for joining. And I'll now open the call for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Ittai Kidron from Oppenheimer.

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Ittai Kidron, Oppenheimer & Co. Inc., Research Division - MD [2]

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Khozema, I wanted to really focus on the system you showed, the $5 million credit, just to make sure I understand this. Is this a cumulative effect over multiple quarters that had to be clear in a quarter? Or this is -- just happened in this quarter itself? And -- help me get my hands around this.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [3]

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Yes, it's a little bit of both. So thanks for the question. As we said on the call, I think just based on the growth that we've experienced as a company, I think one of the things that we've looked at is that our systems are going through some growing pains, as we explained. And this particular issue was related to our billing system where specifically some order forms were input incorrectly in sort of a manual fashion.

And obviously, this is not the experience that we want for our customers, given that customer trust is really paramount. And we went back and did a thorough analysis of the problem. And once we found some of these manual inputs, we promptly issued credits to the customers that were impacted. And there were a couple of them that were -- in the quarter, there were a couple of them that were -- preceded a couple of quarters. We think we've got a good handle on what caused the errors historically and we've got controls in place now to address this going forward.

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Ittai Kidron, Oppenheimer & Co. Inc., Research Division - MD [4]

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So just to make sure, as I think about the shift from September actual results to December, the September results already take this credit into effect, fully into effect, and December is now guided with this in mind. So still, there's very little quarter-over-quarter growth in your core business from September to December. And I understand that last year you had that one time -- the political -- the midterms and the onetime large customer. But it seems like this activity -- or the volume of transaction is still decelerating quite substantially from September to December. Is there anything else in here that you think requires highlighting in understanding this?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [5]

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Yes. I wouldn't characterize it that way. Let me give you a little bit of the financials and then I'll have Jeff give you a little bit more of the detail, and George as well maybe from a customer perspective. I think in terms of the December quarter, we did take our guidance down by a bit more than the ongoing run rate. I think we feel like we've got a good handle on the issues and we're certainly actively working to correct them. But I think we felt it was warranted to put in a little bit of an extra buffer until we're absolutely certain that all the issues are addressed. We're not necessarily quantifying that. But I think we felt like it was prudent to do so as we work through the fixes that are entailed with that.

As it relates to kind of the year-over-year, I mean any way that you look at it, really, we feel like that we've got terrific growth at scale and it's really impressive. The comps, as you mentioned, we've signaled for a long time were going to be difficult in the back half of the year. You pointed to the political traffic. I think we reiterated, again, for example, that we had kind of a onetime customer that ticked up particularly last year.

And I think we've been pretty clear that -- around our expectations that the growth rate and the expansion rate would slow down a little bit in the back half of the year. Just maintaining these rates is obviously hard at this size. And then, again, the credits that we referenced, those impact a little bit our base revenue growth, as I explained a moment ago, and will have a little bit of an impact effect on DBNE, too. But we still feel great about where the business is headed. And let me turn it over to Jeff, maybe to add a little bit more color.

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Jeffrey Lawson, Twilio Inc. - Co-Founder, Chairman & CEO [6]

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Yes. Ittai, so I mean despite the manual errors, I think we turned in a quarter growing 47% year-over-year organic at nearly a $1 billion run rate. And so I'm really proud of what we've accomplished. We're one of the only companies growing at this scale at this rate, and we're very proud of that. We're focused on the long-term opportunity. This is one of those once-in-a-lifetime changes that's happening in how companies engage with their customers using all of these new digital channels. And we're here to capitalize on that megatrend.

And we're hearing all the right things from our customers about what they need and our ability to provide it. So I look at it, it's a great market, we've got a great business model, we've got a great team. And I see them all getting better as we grow, so I'm really excited about what lies ahead.

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Operator [7]

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Your next question comes from the line of Bhavan Suri from William Blair.

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Bhavanmit Singh Suri, William Blair & Company L.L.C., Research Division - Partner & Co-Group Head of Technology, Media and Communications [8]

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Khozema, I guess I did want to touch on the dollar-based net expansion rate here. Even if we add a few hundred basis points from the credits to billing issue, it feels like it decelerated reasonably quickly. I guess I'd just like to understand sort of obviously scale matters, but it was -- it wasn't a basis point or 100 bps or 200 bps. I was just trying to understand if you could provide some comment, dynamics that have affected this metric. I guess are you seeing changing spending habits within the customers? Or was it just the volatility of how applications are launched that drives it up and down, the speed of that? I guess just some of that color will be helpful.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [9]

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Yes. Again, let me provide a little bit of the math and then maybe I'll have George comment from a customer perspective in terms of what he's seeing. But I guess just as a starting point, I would say the short answer is no. Again, maybe just to reiterate, Bhavan, I think from our perspective, I mean the growth at the scale that we've reached is really strong. And I think -- again, we always knew that we would have pretty difficult comps in the back half of the year.

If you recall, Q3 '18, we had growth that was approaching 70%. And then going into Q4, we had growth that was approaching 80%. And we had a little bit of political traffic in there that was elevating that, and then we had this onetime customer that we actually tried to back out of the results last year to try to normalize it a little bit. That had an impact as well in the expansion rates back in that period.

And so as we lap the year, I think we'd been pretty clear in our expectations that DBNE would, in fact, fade over time in part because of the comps, in part because the business is just becoming a lot larger and we're running into the law of large numbers. And then the foot fault in this, if you will, is this manual error issue that we elaborated on as it relates to billing-associated credits. And so you put all that together and that's what kind of results in the math that you saw in the DBNE that we got in the quarter. But I don't think it's anything related to some of the issues that you've pointed to. But let me -- I'll turn it over to George and he can color on that a bit more.

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George Hu, Twilio Inc. - COO [10]

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Thanks, Khozema. I mean I would say that we don't see any fundamental change in our demand environment. We still see a lot of interest from customers. And we haven't fundamentally seen a shift except for some of the dynamics that Khozema talked about which are -- nothing to do with, really, our customers. We're excited. We're investing, and we still plan to capture the big opportunity in front of us.

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Bhavanmit Singh Suri, William Blair & Company L.L.C., Research Division - Partner & Co-Group Head of Technology, Media and Communications [11]

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Okay, helpful. Let me quickly just ask a follow-up with Flex here. Obviously, a nice win there. I guess maybe, George, for you, maybe touch on what sort of demographics are you seeing from the early adopters? And then how are the initial conversations going with the VAR channel? It's something you and I have talked about multiple times in the past. Just if I can get color on those 2.

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George Hu, Twilio Inc. - COO [12]

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Yes, great question. So I mean in terms of the demographics of the customers, I would say generally speaking, it was consistent with what we've always said before. It's still a newer product, so we're still mostly in the early adopter phase. We have a lot of interest from kind of digital economy customers, very tech-forward companies. We're excited now with Allianz and CompuCom to start to see the beginnings of expanding that more towards the mainstream. But I would caution that this is not the normal pattern or not yet -- we haven't yet crossed the chasm. It's still a newer product. But we're excited about these green shoots and I think it speaks to the power of the value proposition of the product.

In terms of the partners, we're excited about the traction we're seeing there. And as I've mentioned, I believe, in the past, we've not really historically, at Twilio, had a strong reseller motion or, frankly, infrastructures for resellers. We've been investing in that this year and are bringing some initial resellers onto that platform. We're testing it right now. I think it'll be something that we'll be able to onboard more in 2021. I don't think it will be material for a while for us. But we are investing in it. And certainly I think Flex is definitely the catalyst that is growing interest in that for us.

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Operator [13]

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Your next question comes from the line of Mark Murphy from JPMorgan.

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Mark Ronald Murphy, JP Morgan Chase & Co, Research Division - MD [14]

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Khozema, the $5 million billing impact to Q3, is it also $5 million in Q4? And I'm just wondering, for how many quarters do you think that would continue into 2020?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [15]

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Yes, thanks for the question, Mark. Good question. I don't think we see it necessarily continuing into 2020 in the way that your question intimated. I mean obviously, it'll impact kind of the way that we evaluate our run rate from an FP&A perspective. But in general, I mean, we feel pretty good about how things look after Q4. We're obviously not guiding to that today, so I don't want to get too far down the road on that one.

But as it relates to Q4 itself and the way we characterize our guide, as I said a moment ago, it definitely does have an impact on the ongoing run rate. It's about a full $5 million. I think as you probably understood based on the comments that we gave a moment ago, it is a little bit -- we have put a little bit of a buffer, if you will, into the way that we've guided into Q4, just until we have our arms fully around the issue. We just felt like that, that was the smart thing to do in terms of the way that we communicated the way that things would play out for investors. And while we feel like we have a good handle on the issue, we do want to get through all the fixes. But it's kind of a onetime thing in nature. We feel -- we caught it ourselves and we think we're more or less out of the woods, but we want to be smart about the way that we convey it.

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Mark Ronald Murphy, JP Morgan Chase & Co, Research Division - MD [16]

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Okay, great. And then how many customers will be receiving the credits?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [17]

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I don't have that number off the top of my head, Mark. It's pretty small. I mean we're talking about a single-digit number, so I don't know it off the top of my head but it's in that realm.

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Mark Ronald Murphy, JP Morgan Chase & Co, Research Division - MD [18]

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Okay. The other question I had for you, I think we're looking at base revenue growth. If we look at it sequentially, it's around 7% in Q3, and then you're guiding about 9% for Q4. And if we trended that out and just considered how that would look across 4 quarters, I think it would get us to something like low 30s to mid-30s. And so I'm just curious, would you view that as a fair assessment of the glide path on the base revenue currently, and maybe how we trended into next year? Or would you look at this and say it's artificially constrained, I guess, again, due to the billing errors and what sounds like a little extra cushion for Q4.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [19]

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Yes. Mark, I'm just not going to comment on anything into 2020. I mean we'll guide to that obviously when we do the Q4 call. I would simply say that in the back half of this year, we have some tough comps as we've signaled previously. We obviously had the political. We had that onetime customer that we've alluded to previously, and we've got this billings thing. And so you're going to have to kind of put that together in your model. But I think we're just not in the position to be able to guide out to beyond 2020.

What I will say is, is that we feel great about what the results were in the current quarter, 47% organic in spite of the comp, in spite of whatever the self-inflicted issues, and we feel great about the overall inputs to the business.

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Operator [20]

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Your next question comes from the line of Brent Bracelin from Piper Jaffray.

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Brent Alan Bracelin, Piper Jaffray Companies, Research Division - MD & Senior Research Analyst [21]

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One for Khozema and one for Jeff, if I could. Khozema, I wanted to maybe take a little different slice at the slowdown that you saw here. If I just look at the top 10 customer contribution versus the revenue outside the top 10, it looked like the bulk of the slowdown, and in fact you had $11 million sequential decline in revenue at the top 10, but growth outside of the top 10 actually accelerated from about an 84% growth to 85% growth in the quarter.

So as you think about the cohort of top 10 customers that did decline, is it safe to assume that, that's where some of the bulk of the credits were applied? And maybe could you just talk about net expansion rate looking at this cohort outside the top 10 that actually accelerated in the quarter? Is there broad-based change to net expansion rates? Or do you think some of these top 10 customer declines sequentially are having a bigger impact on just that calculated net expansion rate? And then, again, one quick follow-up for Jeff.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [22]

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Okay, a lot in that particular question. So just to start off with in terms of the credit itself and where that was placed -- or the credits, there were, as I said earlier, there were a handful of them, single digits. There were a couple different customers that would have been in our larger customer base. Off the top of my head, I don't think they were in the top 10, maybe top 20, but among our larger customers to be sure.

In terms of the overall dollar value generated from that top cohort of customers are -- tripling that up here, but I think overall that was up actually on a quarter-to-quarter sequential basis. And so feel good about obviously the fact that the percentage of total was about flat, which speaks to the concentration of our overall top 10 kind of holding steady or declining as time goes on. But I think the premise of the question is incorrect. We'll follow up on the exact math with you off-line or in the callbacks, but I don't think that's right.

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Brent Alan Bracelin, Piper Jaffray Companies, Research Division - MD & Senior Research Analyst [23]

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Got it. I thought it was 18% last quarter, 13% top 10 mix this quarter. It was 13% last quarter, 13% this quarter?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [24]

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That's right. That's right.

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Brent Alan Bracelin, Piper Jaffray Companies, Research Division - MD & Senior Research Analyst [25]

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Okay. And then, Jeff, for you, getting some questions around RCS. Obviously, Visa 4 months ago, Google going kind of direct with RCS, 4 months later -- when I was in Europe, 4 months later now you have Verizon, Sprint, AT&T and T-Mobile joining up. I guess the question we're getting from investors here is how should we think about the potential impact of pricing relative to kind of this next-gen SMS RCS service, this new consortium and what that has to do -- what potential impact that could have on the overall business as you think about the next couple of years?

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Jeffrey Lawson, Twilio Inc. - Co-Founder, Chairman & CEO [26]

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Yes. Absolutely, Brent. Thanks for the question about RCS. So first of all, Twilio has supported RCS since early 2018 and we're a strong supporter of RCS as a channel. And just as a reminder, you alluded to this, but think of RCS as an upgrade to SMS, right? So the reach is similar. The economics are similar, but it adds new capabilities that you can do within the message. You have things like commerce or maps or call-to-action buttons and more.

And this is really exciting because we, and the developers building on Twilio, can build even more rich experiences inside of the core messaging app that's already on all the Android phones. And that's really exciting, it opens up new opportunities. Now the CCMI, the Cross-Carrier Messaging Initiative that was announced by the 4 carriers in the United States this week, is about building interop between those 4 carriers, which we view will hasten its implementation and its rollout, which is good. So that we and our customers can really start leveraging it because the promise of RCS has been out there for a long time. It's just all been dependent on carriers rolling it out.

And when you get the top 4 carriers in the United States agreeing on rolling it out and how they're going to do that and interop-ing with each other, that's good. It means that our customers can get the benefit of RCS probably sooner than if the 4 carriers weren't interop-ing and cooperating on this effort.

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Operator [27]

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Your next question comes from the line of Nikolay Beliov.

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Nikolay Ivanov Beliov, BofA Merrill Lynch, Research Division - VP [28]

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My first question is for both George and Khozema. When you look at the expansion rate and specifically the customer cohorts outside of the top 10, what are you seeing -- are the newer cohorts trending in line with the older cohorts? And part b of my question is are you happy with the expansion rate of the older cohorts?

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George Hu, Twilio Inc. - COO [29]

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This is George. For our newer cohorts, I wouldn't say that the expansion rate characteristics to them have changed materially quarter-over-quarter.

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Nikolay Ivanov Beliov, BofA Merrill Lynch, Research Division - VP [30]

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Okay. And I guess a different question for you both. Sales and marketing as a percentage of revenue picked up for the first time above 25% for a while versus historically 20% to 25% of revenues. Is 25% to 30% kind of like the new normal in terms of like sales and marketing spend as you guys overlay a direct sales force?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [31]

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Yes, this is Khozema. I wouldn't say per se that it's the new normal. I mean I think what we've said for a while is that we feel like that we want to continue making investments in the sales and marketing engine so long as we believe those investments are efficient. I think the one particular outlier as you look at the Q3 numbers is SIGNAL, which shows up as a large onetime expense and also is a driver for the loss that we took in the quarter. So I think you're comparing a little bit of an apple and an orange there in terms of Q2 to Q3.

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Operator [32]

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The next question comes from Alex Zukin with RBC Capital Markets.

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Aleksandr J. Zukin, RBC Capital Markets, Research Division - Analyst [33]

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So maybe just on the favorite topic of dollar-based net expansion again. In terms of the guidance for Q4, if we add -- and I know this has been asked a little bit but I'm going to try it a different way. If you add back the credits, you do still see a fairly material drop off that I think -- I mean by our math which -- correct me if I'm wrong, looks like it's in the very low 120s for Q4. You mentioned both the extra cushion and the bounce back in Q1 in terms of dollar-based net expansion and then the anniversary-ing -- completing the anniversary-ing.

So is there any way you can help us just understand kind of which ZIP codes should we be thinking about for a sustainable dollar-based net retention. Is it in the 120s? Is it in the 1-teens? Is it higher than that? Just any help there would be appreciated. Then I have a quick follow-up.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [34]

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Yes, I'll give you -- this is Khozema, thanks for the question. I'll give you a little bit of a directional math. We don't guide on DBNE specifically but I'll try to help you in terms of updates to your model. I think the way to think about it is this, is that in Q3 and Q4 both, as I mentioned earlier, we had extremely elevated growth rates in Q3 '18 and Q3 -- excuse, Q3 '18 and Q4 '18. And approaching 70% in Q3 and then approaching 80% in Q4.

And as a result, you had this onetime political dynamic, obviously, which contributed pretty significantly and then you also had this onetime customer that we called out. And so those impacts are obviously stripped out in the back half of this year in the absence of an election and with that customer behavior having normalized.

The second dynamic is that, as you pointed out, you do have this credits issue, which also affects a little bit our revenue run rate into Q4 as well. And so you do have a little bit of a fade in both Q3 and Q4 relative to prior periods in terms of that overall DBNE. And so, again, I mean we don't guide on that number specifically. I think you're a little low based on the way that you marked it. But I don't want to provide any real specificity beyond that.

As we get into Q1, it becomes a little bit more complicated obviously because you've got a January stub month, and then you got the anniversary of the SendGrid acquisition, at which point we'll start to fold in that DBNE with the overall DBNE which just, by definition, is going to make it come down a little bit. But based on the way that we're currently calculating it, what I will say is that we don't expect that combined rate to come down as much as I'd previously suggested. And again, we're not providing guidance around it for Q4 or out into 2020, but we feel quite good about continued expansion out to 2020.

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Aleksandr J. Zukin, RBC Capital Markets, Research Division - Analyst [35]

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Got it. And then maybe just a follow-up for Jeff or George on Flex adoption. You signed a nice customer, Allianz. I think their -- you guys have previously talked about this business potentially being a pretty meaningful contributor to overall revenue over the next few years. And I'm just curious, how should we think about this business over the next 2 years from a contribution to revenue perspective on a decent time frame?

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George Hu, Twilio Inc. - COO [36]

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Well, it's George. So without commenting specifically on like revenue time frames, I'll let Khozema take that on. Your question on adoption, we are excited about the adoption we're seeing of our customers. And I think that obviously people that are interested in buying Flex are obviously talking to our existing customers. And I think that's a sign that we are seeing success with the existing customers in the field.

And yes, we're encouraged by certainly these data points to kind of continue us on our journey. And as I said, it's a long journey. We're early. But it's a huge market opportunity, we think, with a very differentiated value proposition. And yes, we definitely think that this is something that has a potential for the long term to be meaningful.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [37]

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In terms of its contribution to revenue -- this is Khozema. I think it's in our revenue today, obviously. We generate revenue off of the product today. And obviously, that will continue to grow as time goes on. It's not really a material contributor to revenue yet. We certainly expect it to be over time. I think what I've signaled in the past is that our expectation is certainly that, that would happen over the next several years, and we expect that to be a fairly material number as time goes.

But I think in terms of its material contribution to revenue, I wouldn't really anticipate that until really the back end of 2021, maybe 2022. But as George said, we feel great about where things are headed and some of the most recent customer wins.

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Operator [38]

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The next question comes from Heather Bellini with Goldman Sachs.

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Daniel Peter Church, Goldman Sachs Group Inc., Research Division - Associate [39]

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This is Dan Church on for Heather Bellini. I just have a quick question. It's been about 9 months since the SendGrid acquisition. Any color or commentary you could give us on -- in terms of how cross-selling initiatives have tracked relative to expectations?

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George Hu, Twilio Inc. - COO [40]

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Yes, this is George. Yes, I mean I think you heard our example of the airline that we closed in Q3. I would say generally speaking, we're on track. I think we've fully integrated, at this point, the sales forces. And we are going together to existing customers and new customers to cross-sell the product. So yes, I think I would characterize them as on track.

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Operator [41]

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The next question comes from the line of Meta Marshall with Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [42]

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I wanted to refer to kind of the expansion agreement you alluded to in the prepared script. Just to get a sense of time line of those contracts closed or perhaps more broadly like as you head into application, what you're seeing around sales cycles when you're not dealing directly with the developer.

And then maybe on the second question, gross margins obviously remain very healthy in the quarter. Is there any customer account churn we should be kind of thinking of from pricing competition or deals that you kind of walked away from?

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George Hu, Twilio Inc. - COO [43]

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This is George. So I would say that in terms of the sales cycles, I think, yes, I think you asked a good question in the sense that we definitely do see 2 types of sales cycles. I think the ones where we have a developer self-service start in the account definitely can be in a relatively shorter cycles than in our commercial segment. Those can be intra-quarter transactions at times, so start and complete within the quarter.

For -- as we've said, for example, on the other side of the spectrum, for Flex, which typically is not going to be started by a self-service developer start, it's more of a sold product, so to speak. We've been saying now that for enterprises, these are going to have longer sales cycles. And I think we're seeing that to be true. They're having what I would describe even more normalized enterprise cycles, and I think that's frankly to be expected and I think it's totally fine. In terms of -- can you remind me the second half of your question again?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [44]

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Gross margins.

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George Hu, Twilio Inc. - COO [45]

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Gross margins. In terms of customers, we haven't seen like a material change in like churn or logo churn, customers leaving, from that perspective. So I don't know if Khozema wants to provide any more gross margin color, but that's what we're seeing in the field.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [46]

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Yes. I mean as it relates to churn, I think George answered the question. I think the only other thing I would say about gross margins is it's in the zone that we have been signaling for a long time. It's kind of where we expected it to be. The only thing to really call out is that it was clipped by about 60 bps due to the billing issue that we've talked about a lot about during the course of this conversation. But otherwise, it moves around a little bit within that zone due to a variety of factors, and we've talked about those in the past.

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Operator [47]

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Your next question comes from the line of Nandan Amladi with Guggenheim Partners.

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Nandan Girish Amladi, Guggenheim Securities, LLC, Research Division - Senior Analyst [48]

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So as you merge the basic and variable revenue streams, what may be a way to think about leading metrics as we head into next year?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [49]

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Well, I mean I think maybe just to take a step back for a second, I think the reason that we're doing that in the first place, I think that variable revenue designation has become a lot less meaningful certainly in terms of the way that we manage the company internally, the way that we run the company. And so I think it was a change that we felt like we should make. It was certainly something that I've been thinking about a long time and since I joined the company, but kind of wanted to see the way that it would play out this year in terms of that particular metric.

It's also declined pretty substantially, 7% of revenue now. So I think what you'll see from us going forward around growth is simply that total revenue instead of necessarily breaking out base or variable. We talked about the fact that we would continue to provide some data around WhatsApp given what a significant percentage of variable revenue that's been in the past.

But otherwise, I think we feel pretty comfortable around total revenue as the metric. We'll obviously report on things like DBNE and ARPU, et cetera. But otherwise, that's the suite of metrics that you should expect from us.

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Operator [50]

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The next question comes from the line of Will Power with Baird.

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William Verity Power, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [51]

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Just a couple of follow-up questions. Khozema, just come back just quickly to the dollar-based expansion rate. I guess the one other piece that maybe I missed, I think you said you pulled the variable revenue into that calculation as well. Is that going to begin in 2020 that you do that? What's the anticipated impact just in terms of kind of level-setting in front of that from, again, WhatsApp and the variable revenue being part of that?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [52]

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Will, you mean on DBNE specifically, what's the impact associated with folding in variable as part of the total calc?

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William Verity Power, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [53]

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Yes.

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Khozema Z. Shipchandler, Twilio Inc. - CFO [54]

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Yes, I think it's going to be pretty de minimis, honestly. I think that's one of the many reasons that we've been thinking about doing this for some time. I think you won't see a material impact -- I mean there could be an impact, plus or minus 100 basis points. But I don't really think it will be material and something for you guys to think about.

There was a second part of the question that I missed.

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William Verity Power, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [55]

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Yes. No, that was it. I just want...

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Khozema Z. Shipchandler, Twilio Inc. - CFO [56]

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The timing of the change, the timing -- yes, sorry, the timing of the change is we'll make that change in Q1. And we'll provide you all with a bridge to make sure that you can see the different moving pieces, so that we're not just bringing a number on you guys for the first time. We'll kind of walk it through.

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William Verity Power, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [57]

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Okay. And then maybe just a question for Jeff or George. Just the Conversations API, it seems like a lot of excitement at SIGNAL from that. I recognize in beta here, but any further color you can provide on early use cases, customer feedback, how you're thinking about the excitement you're seeing as that kind of moves into 2020?

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Jeffrey Lawson, Twilio Inc. - Co-Founder, Chairman & CEO [58]

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Absolutely, Will, this is Jeff. So just a quick background, we launched Conversations to help companies to connect better with their customers. We've all got experience. A few years ago, it was kind of novel when you got a text message saying your flight was delayed or your flight was boarding or your package got delivered, and that was exciting. And then when you replied to the message, it was like nothing would happen. You'd get back an automated thing that said, "If you need help, call us." Like it's just not a great experience.

And so what we're seeing the leading companies out there do is say, hey, look, obviously, there's a lot of alerts and things like that, but then you should be able to reply. And the company should be able to route it to the employee who can best help you. Sometimes it's an in-store employee, sometimes it's a contact center employee. It's a variety of workers who instead of like 20 years ago, all these people may have been sitting at desks with a desk phone, and now people are out and about. They've got a BYOD device in their pocket and messaging is the preferred medium.

So really the way consumers connect with the employees of a company has changed. And Conversations is the product designed to capture that change and enable every company to be able to service their customers in the way that those customers really want to talk to the company.

I'll say that it's a brand-new product, obviously. We just announced it at SIGNAL, so it's a beta product, so it's the very early stages of that product. But I think there's a macro trend here going on that starts, as often happens in the consumer world, with how we engage with each other and then bridges into how we want to engage with companies. And like that notion that I want to text with a company is not necessarily new. It's just in the past, it's been a one-way thing for most companies. And with Conversations, we're trying to answer the call of making that a 2-way dialogue. And what I'll say is that since we announced Conversations, no pun intended, it's created a lot of conversations with our customers. And so I think we've struck a nerve there and it's started to pique interests from customers. But it's super early in the life cycle of that product.

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Operator [59]

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And your last question comes from the line of Rich Valera with Needham & Company.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [60]

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A follow-up question on SendGrid. Doing the math, it seems like it grew just over 30% in the quarter, which is I think a little better than it's been growing recently and well above, I guess, the 25% sort of bar you'd initially set. So just wondering, given that you're still, I think, somewhat early in the cross-sell process, where you think the growth rate for that could go. And could we see that sustained at a 30%-plus growth rate in next year as you kind of really flesh out the cross-selling initiative?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [61]

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Rich, this is Khozema. In terms of the growth rate for the quarter, it came in at 31%, so your math is right, just above 30% at 31%. We feel pretty good about the growth prospects of the business. I mean again, we're not going to guide out into next year. But I think as I've said previously, we would be disappointed if the growth rate fell below that. And I think we have a really great shot at it being above that. And so that's kind of in the zone of our expectations. Again, I don't want to provide any like detailed guidance around the number, but our expectations have consistently been somewhere in that range.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [62]

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Great. Just one follow up, if I could, on the expense side. Should we think of the 4Q expense levels as sort of the run rates for going forward and sort of scale upward from them as we head into next year? Is there anything exceptional in Q4 that we would back out or is it sort of a good run rate to serve as a base going into next year?

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Khozema Z. Shipchandler, Twilio Inc. - CFO [63]

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Yes, that's a good question. I mean I think we're still figuring out what the 2020 plan is going to be, right? So I wouldn't, one way or the other, read anything into Q4 necessarily. What I will say is this, is that I think the way that we think about it is that so long as we see multiyear elevated growth at scale, we certainly see great opportunities to put investable dollars. And so there's an opportunity for us to continue investing and continue generating great returns for investors.

There's nothing onetime per se. But otherwise we're looking at our investment deck for 2020 as we speak, and those are the kinds of returns that we're expecting. It's kind of what you saw in the Q3 from us, 47% growth organic at scale. And hopefully we can deliver something elevated in the future.

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Operator [64]

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There are no further questions at this time. Thank you for participating in today's conference. You may now disconnect. Goodbye.