Description

Summary    

Bandwidth.com (BAND) is a leading North American Communications Platform as a Service (“CPaaS”) provider, with most of its revenue coming from powering Unified Communication as a Service (“UCaaS”) related customers. For simplicity, we will mostly refer to the broader CPaaS market to avoid too many acronyms.

BAND is not your typical VIC long that is cheap on traditional PE and FCF metrics, as the company is currently investing behind its growth opportunity. Key investment highlights include the following:  

• Investors are materially underestimating BAND’s revenue growth over the next four years.
• IDC research expects the global CPaaS market for voice and text to be $8.2 billion by 2021 (55% 5-year CAGR), and BAND is a North American market leader trading at a 4.5x turn revenue multiple discount to its closest competitor Twilio (TWLO). Our thesis does not rest on a narrowing of this discount, and TWLO has invested more in the faster-growing messaging market.
• International expansion into Western Europe is an attractive call option that is not priced into the stock.
• EBITDA margins and FCF should inflect positively in early 2020 as the current investments in sales and marketing begin to pay dividends.
• BAND has significant strategic value to Google, Microsoft, Cisco, Amazon, Level3 and other much larger customers and competitors. While not necessary to make an attractive return, BAND would represent an attractive acquisition for any of these companies. 
• Strong incentive alignment with Founder/CEO (owns over $125 million of stock).

   

What is CPaaS?

CPaaS essentially provides an outsourced communications software platform that quickly, reliably and cost-effectively enables mobile applications and unified communications (VOIP calling, voice and video conferencing and team collaboration). BAND rents phone numbers and provides wholesale voice usage minutes and texts as a service to its customers. More than 90% of BAND’s CPaaS revenue is voice related (mainly UCaaS) while most of the remainder is messaging related. TWLO does not break out its voice vs. messaging revenue, but messaging is a much larger component of its revenue compared to BAND. The vast majority of BAND’s voice-related CPaaS revenue comes from powering UCaaS companies like GOOG, MSFT, Cisco Webex, RingCentral and 8x8. See the Appendix for more detail on CPaaS.  

Source: Morgan Stanley research, 12/5/17

Company

Led by founder and controlling shareholder David Morken, BAND is a leading North American CPaaS company. Until the mid-2000’s, BAND was primarily a reseller of long-distance services. In 2007, GOOG acquired Grand Central, which in its current form is the GOOG Voice product. BAND was a supplier of long-distance minutes to Grand Central. After the Grand Central acquisition, GOOG helped fund BAND’s buildout of a nationwide CLEC network. With a nationwide CLEC network established, BAND started offering wholesale CPaaS voice services to GOOG, Skype, Cisco-Webex and others. In 2011, Bandwidth acquired Dash Carrier Services (“Dash”), which provides carrier 911 services to its CPaaS customers, enabling high margin 911 calling from Voice over Internet Protocol (“VOIP”) lines and through mobile phone apps.

In 2010, Mr. Morken created a mobile virtual network operator (“MVNO”) within BAND called Republic Wireless that sold low cost mobile phone service. Republic was spun off in 2016 to make BAND a pure play CPaaS company prior to IPO in 2017.

BAND is aggressively investing in sales and marketing to drive growth in existing clients and add new customers, in the process taking EBITDA margins down from 15% to close to breakeven. Prior to its IPO, BAND had been boot-strapped and run more like a private equity backed company. Consequently, BAND was unable to invest in the high growth CPaaS market to the same degree as TWLO. We believe that investors are materially underestimating the future CPaaS revenue growth that will be driven by these investments, creating a compelling entry point for longer-term investors.

BAND should compound CPaaS revenue at 25%+ annually over the next four years. The UCaaS market should grow high teens annually and BAND’s large UCaaS customers (GOOG, MSFT, RNG, and EGHT) should grow in excess of this rate.  Adding new CPaaS customers in areas outside of UCaaS should lead to additional growth. Adding in the optionality of international expansion increases the CPaaS revenue growth to the mid-30’s. As this growth materializes, BAND offers an excellent return for investors, even without any narrowing of the valuation discount to TWLO.

Source: Morgan Stanley research, 1/7/19

Customers

BAND’s key customers are GOOG (Google Voice, Google Fiber, Hangouts, Project Fi), MSFT (Office 365, Skype, Skype for Business), RingCentral, 8x8, and Cisco Webex, who primarily buy phone numbers and voice minutes from BAND.  Providing a low cost, highly reliable and scalable network is a key customer requirement, and customers continue to work with BAND based on the quality and pricing advantage of the network, its software application programming interfaces (“API”), and the high service level and execution that BAND provides.         

Typically, customers sign two- to three-year contracts with various pricing tiers based on volume. As these customers grow and hit higher volume tiers, the pricing for the incremental volume declines. The company called out in their Q1 18 earnings call that one of their large customers was hitting a new volume tier, and that this would be a headwind to revenue. Even with this impact, BAND grew dollar-based net retention due to strong volume growth in its business.

BAND is also investing in its messaging business, powering text messages for ZipRecruiter, MSFT’s GroupMe app, and security app Arlo, among others. Over the last several quarters, BAND has added the following new voice and text messaging customers:

• Large e-commerce company utilizing direct-to-consumer product promotion texts.
• Leading online consumer mortgage and loan marketplace, which provides customers an app that connects to multiple lenders through anonymous voice calling.
• 911 customer Rapid SOS announced initiatives with both Apple and Uber.

Source:  Morgan Stanley research, 12/5/17

Source:  Morgan Stanley research, 12/5/17

Why BAND vs. TWLO vs. Other CPaaS?

We believe that BAND has spent close to $50mm (which we believe would be much greater today) and several years to create a nationwide CLEC network, its key competitive advantage. Owning its network gives BAND a significant cost advantage in voice services vs. TWLO or other competitors, who must pay fees to Level 3, AT&T and Verizon to lease network capacity. Having a pricing advantage is crucial when facing increasing competitive pressures, especially in the text messaging segment. For instance, TWLO lowered full year revenue guidance on its Q1 2017 earnings call due to Uber (17% of revenue in Q4 16) shifting international text and click to call revenue to cheaper CPaaS providers. As a reminder, BAND does not have an international presence today.

In messaging, TWLO has an advantage with best in class software APIs and the largest developer community. However, BAND has built APIs to compete in anonymous calling, click-to-text and app related texting. We believe that BAND’s new software APIs are better than investors’ expectations and should generate incremental revenue growth. BAND does not have a developer community that installs and sells its product like TWLO, instead going directly to large, growing customers and offering direct implementation and highest reliability at the lowest cost.    

TWLO was a BAND CPaaS customer until Q4 2016, when TWLO decided that it no longer wanted to be a customer of a competitor. BAND’s network provided voice minutes, phone numbers and text messaging to TWLO. BAND’s dollar-based net retention was depressed from Q4 2016 to Q4 2017 as TWLO was no longer a customer, choosing instead to lease its network from Level 3, Verizon and others.

Key Metrics

BAND’s key metrics are growth in active CPaaS customers, dollar-based net retention and revenue per CPaaS customer. BAND has been growing its active CPaaS customers by low to mid 20% YoY in recent quarters. Beginning in Q1 2018, the company started investing more in in sales and marketing. Over the course of 2018 and early 2019, the company is growing its inside sales / SMB sales team and its strategic sales team. We do not think the sales additions are driving revenue yet although we see them in costs.  We expect management to provide an update on the hiring plans and the productivity of the early hires on the next earnings call. Management has stated that they will ramp down sales and marketing spend if there is not sufficient return on this spend.

BAND is also investing in digital marketing to drive the acquisition of new customer leads. TWLO is a more well-known brand and has been investing significant marketing dollars to drive total revenue growth. Since BAND has historically underinvested in sales and marketing relative to TWLO, its dollar-based net retention and net new account growth has been constrained.

Dollar-based net retention for CPaaS was affected in 2017 as BAND was lapping the loss of TWLO as a customer. Revenue growth over the last year has been driven by existing customers improving net dollar retention. We believe that CPaaS dollar-based net retention can begin approaching 120% and remain at these levels over the coming years. TWLO’s dollar-based net retention is in the 140% range over the last three quarters. While TWLO’s average customer size is materially smaller than BAND, this figure provides a ceiling on this metric.  

We expect revenue per CPaaS account to continue to decline as new sales efforts add smaller customers and competitors try to compete on price. As BAND’s investment in its sales force begins to show productivity, we should start to see CPaaS growth from new customers accelerate. Our dollar-based net retention estimates also assume price declines in the future as customers hit incremental volume-pricing tiers.

Variant View

• BAND’s owned network and its 2018 investment in its sales force and marketing spend will enable CPaaS revenue growth of at least 25% annually from 2018-2022 vs. consensus at low 20’s to high teens.
• IDC projects the global CPaaS market to grow 55% annually (FY16 to FY22). See the chart in the Appendix.
• Based on the strong growth of BAND’s customer base, we believe that BAND’s net dollar retention ratio can increase from the mid-teens in FY 2018 to greater than 120%. GOOG, Skype and Cisco Webex should be significant drivers of BAND’s growth as they take share from telecom incumbents and share from traditional UCaaS providers. As two examples:
• In Q3 18, GOOG added voice calling features to G Suite becoming a new UCaaS player.
• MSFT’s Skype for Business had a recent UCaaS product refresh that is positioning the company to be a leading provider of UCaaS services to its MSFT 360 customers.
• While TWLO has more mind share within the CPaaS market, BAND’s cost advantage and marketing investments will enable BAND to grow CPaaS revenue at a higher rate than it has historically. 

• While a valuation re-rating is not necessary for a compelling return, BAND is materially undervalued compared to TWLO. BAND’s significant investment in its CLEC network, the robustness of its software APIs and its consistent execution with its large customers makes BAND’s business stickier than a pure telecom company.
  • BAND’s declining “Other Revenue” segment (fees from VOIP & hosted VOIP lines, data resale, call termination fees and SMS registration fees) masks strong underlying CPaaS revenue growth. 

• International growth opportunity could increase revenue growth to >30%. 
• BAND has been working with a few of its large, long-time customers regarding expanding CPaaS services internationally.
• The international market is at least as big as the US market and international expansion could drive the overall net dollar retention above 120%.   
• The announcement of its first international CPaaS customer could come as early as 2019.
• We believe that management will test and learn on this market prior to investing significantly in a facilities-based network in the UK.
• If the opportunity makes economic sense, we believe that management will raise additional equity capital to build out a Western European network.

• Mandatory use of 911 services for VOIP calling and more use of voice calling on AMZN Alexa type devices provide material option value for future growth.
  • 911 services are currently <20% of CPaaS revenue (see chart in “What is CPaaS?” Section), but growth could materially accelerate if these services are mandated on outbound calling for Alexa enabled devices.

• BAND has significant strategic value to GOOG, MSFT, CSCO, AMZN, and others.
• BAND is clearly a strategic asset. In the past, BAND also owned Republic Wireless, a less desirable asset. Now that BAND is separate, it should demand a higher valuation.
• BAND’s network is strategic to many large players and could GOOG, MSFT or CSCO a competitive cost and service advantage in key markets.
• BAND’s small size (<$1.0b market cap) is easily digestible without much disclosure for the aforementioned players. 

Why this Opportunity Exists

• On December 21st, 2018, BAND unexpectedly announced that co-Founder and long-time President Henry Kaestner was resigning and leaving the board. On the same day, the company filed a $200m mixed shelf offering (S-3). The company did not reiterate quarterly guidance at the time of the announcements.  
• The stock dropped 28% from the previous day’s close to the intraday low.
• Investors were caught off guard by the President leaving and the large, potentially dilutive equity offering with little explanation.
• We are comfortable with the President leaving as he was not very active in BAND, and he is being replaced on the board of BAND by his partner at his new investment firm.
• It appears the timing of the filing was not really considered and was not meant to signal the company was going to raise capital to immediately go out and build out Europe.  Management has stated that the company has enough cash to fund operations in North America and the initial roll out of Europe.

• CEO selling shares for the first time.
  • Mr. Morken owns 2.7mm Class B shares worth over $125mm.
  • Post Q3 2018 earnings, Mr. Morken established a plan to exercise and sell his entire 338k of vested options.
  • He has since sold all of his vested options in the $38 to $42 per share range, which resulted in a $12mm net gain. This is the first time he has ever sold shares.
  • We are comfortable with the $12mm sale as he has over $125mm of exposure and has never taken money out of the business since its founding in 1999.

• BAND had a large YoY decline in CPaaS gross margins in Q4 2018 that has not been well explained.
  • Since the IPO, BAND has been a beat and raise story on top line and CPaaS revenue.  After the Q3 2018 earnings call, management provided total gross margin guidance for Q4 implying CPaaS gross margins would be down at least 250 bps YoY. Management explained that they were adding network operations people (recurring expense) and some one-time network investments (non-recurring) in Q4. Management has discussed flat total gross margins in FY 2019, but BAND may want to invest more to strengthen its network advantage.
  • In FY 2016 and FY 2017, BAND’s CPaaS gross margins expanded annually 170 and 255 bps, respectively, as the company was able to leverage strong CPaaS sales growth and lower network operating costs. As BAND continues to grow its voice related services through large players like GOOG, Skype, Cisco, and others, more of the voice call volume should be originated and terminated on its network over time. More “on-network” traffic leads to higher gross margins as BAND would not have to pay fees to terminate a call that was originated on its network.

• A general rerating of high growth tech names in Q4 2018.

Risks

• Sales force and sales and marketing expansion / productivity below expectations causing overall CPaaS revenue growth to be below consensus.
• The company has never grown its sales force at such a large rate. There is a concern that the new sales reps will not be as productive as the past sales reps.
• The company is very cash flow and metric driven (refreshing for a technology company), and it appears they will adjust the growth spigot accordingly.

• Gross margin pressure from continued investments in the network and pricing pressure in CPaaS voice minutes from competitors.
  • There is a concern that the company may have to continue making network investments to maintain its cost advantage, which would pressure gross margins and free cash flow generation.
  • BAND may have to lower prices to maintain business against competitors, but has a cost advantage given they own their network.

• International expansion is a distraction to management and requires a large dilutive capital raise.
  • BAND does not have a CLEC network in Western Europe.
  • Building out a new market could be distracting to management’s North America efforts.
  • Management does not have experience in building out an international business.

Appendix

Unified Communications / Wholesale Voice & Collaboration Services

BAND provides its communication platform as a service to UCaaS companies like RingCentral (RNG), 8x8 (EGHT), Cisco Webex and GOOG.  These companies do not want to deal with the regulatory and cost burden of owning their own networks, so they rent phone numbers and voice minutes from BAND to power their voice and video products for UC providers.

UCaaS leaders RNG and EGHT are growing high teens to mid-20’s top line and continue to take voice spend share from the incumbent telecom providers AT&T and Verizon.  Historically, UCaaS services were basic VOIP calling for small and medium businesses that did not want to spend the cap ex dollars on an IP Private Branch Exchange (“IP PBX”) solution. However, RNG and EGHT are gaining traction in mid-to-large sized businesses offering a combined solution of VOIP calling, audio and video conferencing, and contact centers.

One potential high growth opportunity for BAND that is not well understood is providing CPaaS voice and texting services to the virtual assistant providers (AMZN’s Alexa, Google Home Assistant, Apple Home Pod). While Alexa accesses your mobile phone contacts, it does not use your wireless minutes or network to complete the call. In this example, AMZN would pay BAND for the use of its network.  This is a large and untapped opportunity that could start having a material contribution to BAND’s CPaaS revenue in FY2020. Additionally, if there are state or federal laws that mandate virtual assistants have 911 location and calling capabilities, BAND should pick up additional 911 service revenue as well.

Click to Call or Click to Text

This is the most common and well-known use case for CPaaS services.  The clearest example is the click to text or click to call on the Uber mobile app.  Owning and operating a facilities-based telecommunications network is not a core competency of Uber, but customers’ ability to communicate with drivers is a key function of the app.  Uber can go to BAND or TWLO to integrate voice calling and text capabilities in the app through a software API.

Texting

This use case includes application to person (“A2P”), 2 factor authentication, and mobile marketing texts.  This is one of the largest and most competitive parts of the CPaaS market where Twilio is the clear leader.

An example of A2P texts is when Uber texts you that your ride is arriving.  An example of 2 factor authentication texts is when you log into your Schwab account from a new device, and Schwab sends you a text to your mobile phone with an additional log in code for your account. An example of mobile marketing text is when you receive a text from Jet.com that there is a sale going on.

There is increasing competition is this space that should pressure margins over the next several years.  There are very low switching costs and it is easier to undercut competitors on pricing to take business.  

CPaaS Market

IDC breaks out the CPaaS market into voice and text message services.  IDC expects the Worldwide CPaaS market to grow from close to $1.6 billion in 2017 to $8.2 billion by 2021 (55% CAGR).

Source:  Morgan Stanley research, 12/5/17

Disclaimer:

The views and opinions stated are the personal views of the author. Do not rely on the information set forth in this write-up as the basis upon which you make an investment decision – please do your own work. The author and funds in which the author manages hold positions in and trade, from time to time, securities issued by BAND and options on such securities.  This write-up does not purport to be complete on the topics addressed, and the author takes no responsibility to update this write-up in the future. This is not a recommendation to buy or sell any securities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

• Sales and marketing investments translate into revenue growth.
• Potential 1H 2019 announcement of new international customer(s) opportunity.