Bandwidth Stock: Innovative And Undervalued (NASDAQ:BAND)

Bandwidth (BAND) is an experienced player in an industry that is expected to grow at 34% y/y. I believe that the company is trading very undervalued. If BAND continues to innovate, existing customers will most likely purchase new services that will result in revenue growth. With a significant number of employees working in R&D, in my view, we can expect additional successful features in the coming years. I also see some risks coming from a consolidation of the industry or failure of marketing campaigns. However, the current price mark is too low. The discounted cash flow implied a fair valuation of $84-$112. I am a buyer of shares.

Bandwidth

Founded in 1999, BAND is a global enterprise cloud communications company offering a wide range of Application Programming Interfaces for voice and messaging.

With more than 3k customers and presence in more than 60 countries, in my view, BAND has accumulated a significant amount of know-how, which will help management maintain low sales volatility:

The company appears to have built a solid reputation offering Communications Platform-as-a-Service or CPaaS. Management reports growing adjusted EBITDA margin and free cash flow growth. The outlook given in the last presentation was quite beneficial. In my opinion, if BAND meets its own expectations, more investors will study the company’s financials carefully:

With that about the beneficial outlook reported by BAND, let’s note that the company operates in a market that is growing at a faster pace. The global communications platform-as-a-service market is expected to grow at a CAGR of 34% from 2021 to 2026. The company seems to report lower sales growth than its target market, so I believe that there is room for improvement. Note that sales growth was lower than 25% in a period from 2017 to 2019.

The global Communications Platform-as-a-Service market was valued at USD 4.54 billion in 2020. It is expected to reach USD 26.03 billion by 2026, registering a CAGR of 34.30% during the forecast period (2021 – 2026). Source: Mordor Intelligence

Bullish Case Scenario Would Include New Revenue From Existing Customers, An Increase In The Sales Force, And New Features

Bandwidth will most likely obtain significant revenue from existing clients. Note that clients usually acquire BAND’s voice solution, and then acquire other services like messaging and emergency calling capability. In my view, with more than 3k customers and working in many countries, many clients may be tempted to acquire additional services.

Management also claims to be targeting new geographies and a broad range of industries. As a result, I expect a significant increase in the target market and the customer base. I do believe in an eventual increase in the client count because the direct sales force is increasing:

We plan to continue to grow and invest in our direct sales force Source: 10-k

We plan to pursue new coverage areas and expanded offerings within those coverage areas we already serve in response to our customers’ needs. Source: 10-k

I am quite optimistic about new innovations, new features that may be coming in 2022. In the last annual report, BAND noted that it continues to invest in new developments. Let’s note for those investors who don’t know BAND that it has proven to be an innovative business model. The company designed one of the fastest growing IP voice networks in the US:

We were early to deploy software-based networks and to offer hosted cloud-based voice services, while building out one of the fastest growing IP voice networks over the last ten years in the United States. Our team has continued to adapt to a dynamic environment to grow our business, and we intend to invest in continued development of our platform. Source: 10-k

There is another clear indication about BAND’s investments in R&D. According to the annual report, as of December 31, 2020, Bandwidth had 296 employees in the R&D organization, and 216 employees in the sales and marketing organization. It means that management appears to have more employees working on new features than sales personnel.

Under my best case scenario, I would expect 14-17% sales growth until 2032, and growing EBITDA margin from 7% to 14%. I also assumed a tax effective rate of 19%, which I believe is quite conservative and realistic:

With the previous assumptions, I obtained an EBIAT of $14-295 million, depreciation that would grow from $19 million to $99 million, capex of $41-65 million, and the FCF of $3-336 million. If we assume a WACC of 7%, the implied NPV of the future cash flow would equal $630 million:

If we assume an acquisition at $1.46 billion and an exit multiple of 13x, the net present value of the exit would stand at $2.1 billion. Finally, the IRR would stay close to 9%, and the implied exit price would be $84 with $25.13 million shares.

The company traded in the past at much more than 13x EBITDA. Right now, it is trading at more than 51x EBITDA. I don’t believe that traders could sell the company at 51x EBITDA in 2030. With that, an optimistic case scenario of 17x EBITDA appears reasonable.

If we use an exit multiple of 17x, the IRR would stand at 13%, and the implied exit price would be equal to $112. Let’s say that I am very conservative. Other investors may use a larger exit multiple:

Pessimistic Case Scenario Would Include Consolidation Of Competitors And Failure Of Marketing Campaigns

In the last annual report, BAND promised new marketing campaigns, which may push the company’s revenue up. With that, management also noted that the company may be unable to maintain effective marketing programs. If acquiring new customers becomes more expensive, in my view, the company’s FCF may decline, and sales may also grow less than expected.

If we are unable to maintain effective marketing programs, then our ability to attract new customers could be materially and adversely affected, our advertising and marketing expenses could increase substantially and our results of operations may suffer. Source: 10-k

BAND acquired competitors in the past, so I would be expecting a process of consolidation in the company’s target markets too. If competitors merge, the FCF margins in the industry may decline, which would lead to a decrease in BAND’s fair valuation.

There are some risks related to M&A transactions in the sector. If competitors merge, new emerging players may control a larger market share, which may not be beneficial for the company’s business results. In the last annual report, management even discussed about potential reduction in revenue or failure of the company’s services:

If one or more of our competitors were to merge or partner with another of our competitors, the change in the competitive landscape could also adversely affect our ability to compete effectively. In addition, pricing pressures and increased competition generally could result in reduced revenue, reduced margins, increased losses or the failure of our services to achieve or maintain widespread market acceptance, any of which could harm our business, results of operations and financial condition. Source: 10-k

BAND will have to deal with applications developed by large enterprises like Google (GOOG) (GOOGL). If the company does not adapt its products to these new technologies, customers may decide to work with competitors. The demand for BAND’s products may decline significantly.

Wireline and wireless telephone providers or cell-phone operating system providers such as Apple and Google have developed and may in the future develop new applications. Any failure to operate effectively with evolving or new technologies could reduce the demand for our services. Source: 10-k

In my pessimistic case scenario, I assumed sales growth of 10%, an EBITDA margin of 7.3%-10%, and EBIT/Sales of 4%-6%. My numbers are not very different from the previous case scenario because the previous case was already very realistic:

The DCF model includes FCF close to $5-45 million, net debt close to $177 million, and an exit multiple of 15x. The IRR would be slightly negative, and the implied fair price would equal $40. Given the results of the previous scenario and the results of this scenario, in my view, there is more upside potential than downside risks.

Balance Sheet: Substantial Amount Of Goodwill, Which May Lead To Operating Synergies.

Bandwidth’s asset/liability ratio stands at 2x, and management reported cash in hand of $72 million. In my view, the company’s financial health appears quite stable.

The total amount of intangible assets and goodwill from previous M&A transactions are also remarkable. In my view, if management has correctly assessed the operating synergies and the value of the targets acquired, we may see revenue and FCF growth:

With respect to the total amount of liabilities, I am a bit concerned only about BAND’s convertible senior notes. If convertible note holders decide to ask for conversion into class A shares, equity dilution would push the stock price down. But, that’s not all. Under certain circumstances, conversion could affect the company’s liquidity:

If one or more holders elect to convert their Convertible Notes during a period in which the Convertible Notes are convertible, unless we elect to satisfy our conversion obligation by delivering solely shares of our Class A common stock, we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity. Source: 10-k

Conclusion: Bandwidth Is Very Cheap

Currently operating in a target market that grows at more than 34% y/y and assuming sales growth of 14%-17%, BAND appears very undervalued. In the best case scenario, BAND would offer new features to existing customers, which would enhance sales growth, and I would expect a target price of $84-112. The fact that more personnel work in R&D than in sales and marketing indicates that management is really trying to offer new capabilities. I do see some risks from consolidation of the industry or failure of marketing campaigns. With that, in my view, the upside potential is more significant than the downside risks.