Bandwidth Stock: Differentiated, High-Growth And Room For Upside (NASDAQ:BAND)

On December 14, analysts at Morgan Stanley (MS) upgraded the stocks of Bandwidth (NASDAQ:BAND), RingCentral (RNG), Five9 (FIVN), and 8×8 (EGHT) on grounds that investors had been overly pessimistic about these stocks based on commoditization concerns, or the fact that instead of opting for their customized solutions, clients could instead choose from some readily available software.

They added that these companies offered ample opportunities. Still, a look at the price performance reveals that for Bandwidth, investors had not waited for the analysts to place their money, and also its stock gained the most, or 130% in the last three months.

My objective with this thesis is to understand the reason for this outperformance and assess whether it can be sustained, but, first, for those who are new to this industry, I explain how the convergence of software, communications, and the cloud has given rise to CPaaS.

CPaaS, APIs, and Cost Savings

First, the above stocks come from neither the same sector nor the same industry as pictured below. Whereas Bandwidth hails from the Communications Services sector and Alternative Carries industry, the rest are all IT (Information Technology) plays doing Application Software. This is all due to the convergence of communications and software into what is termed CPaaS or Communications Platform as a Service. This also encompasses solutions for team collaboration, video conferencing, contact centers, analytics, communication APIs (Application Programming Interfaces), and other related services.

CPaaS is about communication platforms offered as a service, just like Amazon’s (AMZN) AWS provides computing as a service. One of the characteristic features of CPaaS is that it provides several channels of exchange like chats, SMS, email, telephone, or videoconferencing, between a company and its customers, or prospective clients. One of the beauties of CPaaS is that instead of launching several applications to contact someone or query a database, all are directly integrated into a sort of unified interface.

This is done through the use of cloud-based APIs and represents a rapid and relatively inexpensive way of integrating communications features into an application rather than having to develop from scratch. Now, cost reduction together with the Opex-based cloud model where customers are charged on a pay-per-use model constitutes two powerful magnets for corporations in the current uncertain macroeconomic environment.

Topline and Bottom Line Growth Amid Uncertainty

As a result, Bandwidth has seen an acceleration in customer contracts with their associated spending also picking up. Other factors which have helped are the digital transformation trend, the focus on larger Global 5000 companies, and the ability to provide solutions for different industry verticals. Thus, when results, were announced on November 1, the company’s third-quarter revenues of $148.43 million beat consensus by $7.5 million as pictured below.

More important, the EPS of $0.27 beat the consensus of $0.03 by a whopping $0.24, or 896%. Moreover, the company bought back $160 million of debt (convertible notes due 2026) on October 31, at a 29% discount to par value. Then, with such news, it’s no surprise that there was such a surge in the share price at the beginning of November as per the introductory chart.

This upside in the share price can also be viewed as investors rewarding Bandwidth for its alignment with the current monetary policy, as, with the Federal Reserve raising the fed funds rate to 4.25%-4.5%, borrowing costs are at their highest since 2007. There is also no relief in sight as the fight against inflation remains a priority. In these circumstances, with the value strategy having the upper hand on growth, investors’ focus tends to be more on profitability and debt reduction.

Furthermore, going into 2023, uncertainty is likely to persist as recession odds have increased beyond 50%. In these conditions, while Gartner has maintained its projections for cloud growth in 2023, it has also highlighted certain issues which may crop up in case there are cuts to corporate IT budgets. At the same time, this remains a highly competitive market as, unlike semiconductors or computer hardware, the software API industry has a relatively low barrier to entry.

Moreover, as shown in the peer comparison table above, with a market cap of less than $600 million and revenues of $414 million in 2021, Bandwidth does not have the scale or the marketing budget of RingCentral. This is the reason it needs strong product differentiation, which on top allows for cost reduction.

Product Differentiation

For this purpose, Bandwidth can firstly rely on decade-long partnerships like with Microsoft (MSFT) for developing communications apps around the software giant’s Teams collaboration tool. This is pretty much beneficial to Microsoft as Teams users within an enterprise get a unified communications experience, while Bandwidth’s team of API developers benefits from an increase in utilization rate, which props up the gross margins.

Second, the company also offers toll-free services whereby emergency calls can be effected within an application in the case of some extreme event. This offering has been found to be highly resilient by America’s largest security company, and, after scrutinizing the competition, it chose Bandwidth. For investors, this is about redundancy with automatic failure rerouting whereby if the network path from source to destination fails, the other links will automatically route the incoming call through an alternate path.

Third, there are also Bandwidth analytics tools. Now, these enable customers to make sense of the vast amount of data which are collected as part of their CPaaS implementations and derive useful decision-making insights namely as to more efficiently manage their high traffic volumes, like for example going through less congested routes at certain times of the day.

Therefore, with more communications features embedded within applications themselves taking centerstage, Bandwidth’s solutions have become “mission-critical” to clients as it can help them “cut their communications spend nearly in half”, which is significant. As a result, Bandwidth revenues are on an uptrend, and, at 116.5% its growth in the last six years has outshined peers.

Second-placed Five9 (FIVN) with its rapidly growing cloud contact center platform, is more of a partner than a competitor as Bandwidth has supported its growth, namely by accelerating migration, managing the huge workload of telephone numbers, and providing backup insurance.

Looking forward, to the fourth quarter results, revenue levels are not only likely to be sustained but exceeded thanks to campaign-related messaging for the mid-term elections.

Looking Forward to Q4 and Valuations

In this case, in addition to TV broadcasts or physical meetings, politicians have increasingly resorted to messaging in order to engage deeper with potential voters, members of their constituency, or Americans across the nation. Looking at concrete figures, compared to Q3 where midterm elections-related messaging revenue contributed approximately $7 million, the management expects the figure to be slightly higher in Q4, due to the six weeks of political campaigning.

Looking at other growth drivers, in addition to civic engagement, messaging continues to see an uptake both for commercial communications and for essential services due to Bandwidth’s ability to deliver “instantaneous visibility” for advertisers in a more targeted fashion than TV for example. Moreover, the management also has an appetite for international growth.

Consequently, with revenue growth prospects, Bandwidth deserves better Price-to-Sales valuations. Considering the trailing P/S of 1.1x, which is lower relative to the Communications Services sector by 19%, I obtain a target share price of around $28 (23.58 x 1.19) based on the current share price of $23.58. It must also be noted that the P/S is beneath the five-year average of 5.84x by 81.2% as pictured below.

However, when considering the P/E or Price to Earnings, one will note that the stock is overvalued relative to the IT sector by over 268%. This is because investors have high expectations as to forward earnings, but, as seen in the “Revenue and Earnings Surprise” chart above, the bottom line has more of a fluctuating nature from quarter to quarter. Furthermore, since Q3’s earnings were driven by the company’s “highest non-GAAP gross margins ever” due to pricing improvement driven in part by the product mix, do expect some moderation in the fourth quarter (Q4). On the other hand, the consistency of the annual earnings progression chart shows that the management’s intent seems to be focused more on the yearly profit margins.

Concluding with a Dose of Caution

Therefore, except for volatility associated with quarterly earnings results, macroeconomic uncertainty, and the Fed’s actions, the upside should continue in 2023.

Furthermore, this thesis has shown that Bandwidth has outperformed peers based on its better revenue growth, earnings that beat consensus by 896% and there was also the timing of debt reimbursement. However, it is unlikely for all these three factors to occur again when Q4’s results are announced on February 20, but, with strong product differentiation and the deflationary nature of its CPaaS, it should continue to attract new customers.

Moreover, the company is not immune to loss of revenues in case there is a massive cyberattack that cripples clients’ networks or in the event that large customers switch to more commoditized products requiring less customization. These two were the two most important headwinds in Q3 but were largely offset by broad-based growth.

Thus, there are risks of volatility in the stock price in case incremental growth in Q4 is not able to offset revenue shortfalls.

Finally, with EBITDA and free cash flow margins both at 8.8% for the third quarter, this is a profitable company based on non-GAAP earnings measures and the $28 price target, which is well below historic highs of above-$60 remains achievable.