The shares of communications infrastructure provider Bandwidth (NASDAQ:BAND) were having a great 2019 until the rally was halted by BAND’s fourth-quarter guidance. Through early September, Bandwidth stock was up a whopping 120% in 2019. The surge was driven by the accelerating momentum of the company’s rapidly expanding Communication-Platforms-as-a-Service (CPaaS) business.
Then Bandwidth provided weak Q4 guidance which indicated that its CPaaS business momentum was slowing. Investors freaked out. The rally ended, and since then, Bandwidth stock has lost 30% of its value.
Has the decline of BAND stock created a buying opportunity?
I don’t think so. Instead, I think that the trends that affect Bandwidth stock will remain adverse and bearish for the foreseeable future. This reality, coupled with the fact that BAND stock isn’t cheap by any stretch, keeps me on the sidelines on the name for now.
Bandwidth’s Performance May Remain Bearish
The fundamental trends that affect Bandwidth have suddenly turned bearish, and I think they could remain bearish for the foreseeable future.
The main idea is that Bandwidth is aggressively moving into the CPaaS industry and transforming its business towards a direct selling model.
Those are great moves. Direct sales models lead to bigger contracts and increase the loyalty of customers. Meanwhile, CPaaS is generating all of the growth of the communications sector. As a result, it’s not surprising that Bandwidth’s revenue growth rates have improved dramatically, jumping from 7% in 2017 to 20% last quarter.
But there are two problems facing Bandwidth stock. First, all of BAND’s high growth is being fueled by even higher spending by the company. That’s because adopting a new business model and jumping head-first into a new sector requires a ton of research and development investment by the company.
Moreover, the CPaaS industry is very competitive, so the company has had to spend a great deal of money on sales and marketing.
As a result of these factors, the company’s expenses have been rising much faster than its revenues, and its margins have been getting squeezed.
Secondly, its previously high revenue growth is now slowing. BAND expects its Q4 revenue growth to come in at 12%, down from 20% in Q3. Sure, some of the slowdown was caused by a timing issue (a portion of the company’s revenue will be recognized in Q1 instead of Q4). Yet it still appears that the company’s growth is no longer accelerating, and that its revenue growth will slow in 2020 and 2021.
That’s a big problem for Bandwidth stock. Slowing revenue growth and high spending growth make the outlook of the company’s margins uncertain. And, because Bandwidth is unprofitable today, its margin growth is an important component of its outlook.
As long as the forecast for the company’s margins remains clouded, it’s tough to see BAND stock going much higher.
Bandwidth Stock Isn’t Cheap
The “buy the dip” thesis could be realistic if Bandwidth stock was cheap after its recent plunge. But the shares are anything but cheap.
Bandwidth’s revenue looks poised to climb by double-digit-percentage levels for the next several years. Its gross margins will trend higher as it wins bigger contracts.
But its gross margins will likely max out around 50%, which is where they have historically peaked. That isn’t very high, especially considering that the company is spending an arm and a leg to grow and will have to keep spending an arm and a leg to sustain its growth in the competitive CPaaS industry.
In other words, there’s no way that Bandwidth will get its operating expense rate down to 35%, which is average for the information technology sector. Instead, its opex rate will likely always be 40%-plus. Assuming its gross margins come in at 50%, that equates to 10% operating margins at best.
Bandwidth’s revenue is poised to be $230 million this year. Let’s say its revenues grow at a 15% compounded annual rate through 2025. That means its 2025 revenue would come in at $530 million. Assuming a 10% operating profit margin, that would put its operating profits at $53 million. Further assuming its taxes are minimal, Bandwidth could perhaps post $50 million of net profit by 2025.
BAND stock has a market cap of $1.5 billion today. The discrepancy between a $1.5 billion market cap today, and $50 million in net profits in 2025 is just too wide to make Bandwidth stock all that compelling now from a valuation perspective.
The Bottom Line on Bandwidth Stock
Bandwidth is a fine company. But BAND stock got way ahead of itself in 2019. Its correction over the past few months is fully warranted. The downturn will continue as long as the company’s fundamental trends remain bearish and its shares remain richly valued.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
