Bandwidth: The Coronavirus Demand Surge Has Now Been Proven

Summary

• Shares of Bandwidth shot up nearly 10% after the company reported stellar first-quarter results.
• The company's revenue growth soared to 29% y/y, accelerating more than ten points quarter-over-quarter from Q4.
• Among Bandwidth's key clients is Zoom, which has seen a surge in usage since the lockdowns began.
• Increased usage among Bandwidth's install base has driven net retention rates to a sky-high 121%.

One unexpected stock that has risen to all-time highs during the coronavirus - and not beset by security woes or misleading user counts like Zoom (ZM) - is Bandwidth (NASDAQ:BAND), one of Zoom's backend service providers. The CPaaS company, a smaller competitor to Twilio (TWLO), has seen its revenue growth and customer retention rates soar to record heights in the midst of a lockdown that has upended most other industries. Prior to Bandwidth's first-quarter earnings release this week, we were able only to speculate that Bandwidth's exposure to Zoom and other API-driven services that have risen in usage since the lockdowns would swing Bandwidth's growth skyward. Now, that thesis has been proven, and Bandwidth jumped 10% after reporting Q1 results:

Data by YCharts

We have to stress the idea that not all services that are seeing an uptick in usage will necessarily generate more revenue. We know this to be the case with several of Facebook's (FB) products - though the use of Facebook Messenger has risen, Facebook isn't necessarily driving a proportion increase in Messenger's monetization. Ditto for Zoom, who hundreds of millions of free conference participants won't have to pay the company a penny.

But for Bandwidth, increased usage directly translates into higher revenue, thanks to its usage-based pricing - a key driver of the bullish thesis for Bandwidth that I laid out in March when shares were ~30% lower. Bandwidth prices per API connection - with prices starting, for example, at $0.005 per outbound message and $0.01 per minute of outbound call time. In other words, the fact that Bandwidth charges per message/call means that Bandwidth is a direct beneficiary of our surging digital activity since the lockdowns began.

Now approaching $90, Bandwidth is at all-time highs, and a far cry from the underappreciated ~$20 levels at which the stock was trading immediately after its 2017 IPO. Yet the coronavirus has given Bandwidth a chance to rewrite its growth trajectory - in the past, Bandwidth was growing below 20% y/y; now, growth looks poised to sustain in the ~30% range. This added growth gives the stock a good justification to re-rate Bandwidth's valuation multiple upward.

At present share prices near $90, Bandwidth trades at a market cap of $2.11 billion. After netting off the $491.9 million of cash that Bandwidth has on its current balance sheet against $268.4 million of debt, the company has an enterprise value of $1.89 billion.

Bandwidth has inched its FY20 revenue outlook upward to $281.6-$283.1 million in revenue, representing +21-22% y/y growth and up from a prior range of $272.7 million-$274.7 million, or +17-18% y/y growth (suggesting a fairly conservative guidance approach, considering Bandwidth exited Q1 at a 29% y/y growth rate). Nevertheless, at the midpoint of Bandwidth's new guidance range for the year, the company trades at a valuation multiple of 6.7x EV/FY20 revenues.

Figure 1. Bandwidth FY20 guidance updateSource: Bandwidth Q1 earnings release

Now, most of Bandwidth's SaaS peers don't make for perfect comps because Bandwidth has lower gross margins in the ~50% range versus other SaaS companies in the mid-70s. Still, with many companies in the ~30% growth range trading at double-digit valuation multiples even given the sharp market pullback since March (see several comps of companies that are expected to grow around 30% y/y this year), I'd say Bandwidth has the capacity to hit a multiple of 8x EV/FY20 revenues, with an adequate ~20-30% discount to peers to make up for its gross margin deficit.

Data by YCharts

An 8x forward revenue multiple would imply a price target of $105 and 18% upside from current levels. Stay long here and continue to ride Bandwidth's momentum upward.

Q1 download

Let's now dive into Bandwidth's Q1 results in more detail. Take a look at the company's earnings summary below:

Figure 2. Bandwidth 1Q20 earnings resultsSource: Bandwidth Q1 earnings release

The biggest surprise from Bandwidth's quarter was its revenue growth, which soared +29% y/y to $53.3 million, far surpassing Wall Street's expectations of $63.3 million (+19% y/y). Consensus had Bandwidth accelerating only slightly to its Q4 y/y growth rate of 18%, but in reality Bandwidth saw revenue growth accelerate eleven points.

Underpinning this growth was a huge increase in Bandwidth's net expansion rates - which is among the most closely-watched metrics not only for Bandwidth, but across the SaaS software space. Bandwidth's dollar-based net retention rate boomed to 126% in the quarter, fifteen points higher than 111% in 1Q19 - indicating that on average, Bandwidth's installed client base consumed 26% more usage.

This metric is particularly important because it's far cheaper for software companies to chase growth via expansion than new business. Upselling existing customers and expanding their usage doesn't incur incremental cost for Bandwidth beyond its typical cost of revenue, whereas new business would typically require a higher-touch sales process that may not even result in a win. To that extent, we're also glad that Bandwidth's revenue growth and retention boost helped to drive tremendous operating efficiencies that led to profit expansion. Pro forma gross margins, shown in the table below, ticked up two points to 51%, while Bandwidth also swung positive on an adjusted EBITDA basis to $3.1 million. Adjusted EBITDA margins, meanwhile, ticked up 760bps from -3.1% in the year-ago quarter to 4.5% in Q1 - affirming the thesis that higher net retention rates translate directly into richer bottom lines.

Figure 3. Bandwidth gross margin

Figure 4. Bandwidth adj. EBITDA Source: Bandwidth Q1 earnings release

Recall as well that Bandwidth invested heavily into its sales and marketing headcount toward the latter half of 2019 (by year-end, its sales staff had seen a ~40% jump in headcount). With these hires ramping this year, Bandwidth should see growth rates sustain and continued tailwinds on the operating margin front.

We also note that Bandwidth continues to maintain substantial liquidity to give it flexibility through the duration of the coronavirus; as previously mentioned, Bandwidth holds just under $500 million of cash on its balance sheet, thanks primarily to a $350 million convertible debt offering that the company raised in February. Q1 operating cash burn, meanwhile, reduced to -$7.6 million, 16% better than -$9.0 million in 1Q19 - suggesting that at its current burn rate, Bandwidth has plenty of time before it needs to raise additional capital.

Key takeaways

There's a lot to like about Bandwidth exiting Q1. The company had never grown at a ~30% y/y pace before, and though Bandwidth's guidance implies that growth will taper back down in the back half of 2020, this low bar gives Bandwidth a good opportunity to set a strong "beat and raise" cadence throughout the year.

It's important to know as well that it's not only increased usage within Bandwidth's existing customers that is driving growth, but there is an element of new business growth as well. Bandwidth's core CPaaS customers has expanded 34% since Q1 of last year, to a total base of 1,800 customers. Bandwidth is a great example of the "land and expand" strategy that has driven growth in many other mid-cap software names.

Stay the course here.

Analyst’s Disclosure: I am/we are long BAND. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.