Bandwidth Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter ended September 30, 2018; comparisons are with Q3 and the first nine months of 2017. Amounts are U.S. dollars; financial statement figures are in millions unless stated otherwise.
Business context
Bandwidth provides cloud-based communications APIs and a purpose-built IP voice network. Its reportable segments are CPaaS, which provides voice, messaging, 911 and phone-number services, and Other, which includes legacy and indirect services. Active CPaaS customer accounts rose 26% year over year to 1,155. Dollar-based net retention was 117%, up from 105% in Q3 2017.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $50.5 | $41.3 | $151.8 | $120.5 |
| Gross profit / margin | $23.0 / 45.5% | $18.8 / 45.4% | $72.4 / 47.7% | $54.1 / 44.9% |
| Operating income | $0.1 | $3.1 | $10.0 | $12.4 |
| Net income | $2.5 | $1.6 | $19.2 | $6.6 |
| Diluted EPS | $0.12 | $0.11 | $0.91 | $0.42 |
| Adjusted EBITDA | $2.3 | $5.2 | $16.2 | $17.8 |
| Free cash flow | $3.1 | $2.7 | $15.6 | $4.9 |
Q3 revenue increased 22%; CPaaS revenue rose 24% to $41.5 million, primarily on higher voice and messaging usage and customer growth. Pricing reductions offset some usage gains. Other revenue increased 12%, reflecting higher-than-usual indirect revenue partly offset by continued legacy-service declines. For the first nine months, revenue grew 26%, while CPaaS revenue grew 25%.
Operating expenses increased 46% in Q3 to $22.9 million, including R&D growth of 113% and sales and marketing growth of 73%; management cited higher personnel and other operating costs. Consequently, Q3 operating income fell to $0.1 million despite higher revenue and gross profit. Nine-month operating income also declined year over year.
Q3 GAAP net income and nine-month net income benefited from income tax benefits of $2.3 million and $8.9 million, respectively. The nine-month effective tax rate was negative 87.2%; management attributed the unusually low rates mainly to tax deductions from stock-option exercises and the lower federal statutory rate under the Tax Cuts and Jobs Act. Nine-month pretax income was approximately flat year over year, so the net-income increase should be viewed in light of this tax benefit.
Cash, liquidity and debt
At September 30, 2018, cash and cash equivalents were $48.6 million and current marketable securities were $14.9 million, for $63.5 million combined. Current assets were $95.1 million and current liabilities $31.6 million. Nine-month operating cash flow was $24.0 million, compared with $9.7 million in 2017. Investing activities used $23.3 million, including purchases of marketable securities, property and equipment, and capitalized software; financing activities provided $10.2 million, primarily from stock-option exercises.
No revolving credit was outstanding; the company reported $25.0 million of available capacity and covenant compliance. Capital-lease obligations were $17,000, due within the year. Management stated that cash, securities, credit availability and operating cash flows should cover anticipated working-capital and capital-expenditure needs for at least 12 months, while cautioning that additional financing could be needed if requirements change.
Material changes, outlook and risks
- Q3 GAAP gross margin was approximately stable year over year; nine-month gross margin improved. CPaaS gross margin was 42% in Q3, unchanged year over year, and 43% for the nine-month period, versus 42%.
- Management expects operating expenses to increase in absolute dollars and plans continued investment in R&D, sales and marketing, network capacity and growth. The filing provides no specific revenue, earnings or cash-flow guidance.
- A January 2018 settlement with Verizon resolved a CABS billing dispute. Bandwidth received $4.4 million and issued $24.968 million in bill credits; it recognized $6.268 million of previously reserved amounts as revenue during the first nine months of 2018. The settlement also set prospective billing terms.
- Material exposures include multiple lawsuits and investigations over billing, collection and remittance of 911 taxes and surcharges, and a pending California regulatory matter concerning change-of-control approval and licensing. Management said it intends to defend the lawsuits; outcomes remain uncertain.
- Other disclosed risks include intense competition and price pressure, customer usage reductions or churn, reliance on third-party network suppliers, service or cybersecurity disruptions, evolving telecommunications and privacy regulation, and execution risks from rapid growth. The company also warned that certain ownership changes could trigger estimated tax and indemnity liabilities of approximately $50 million related to the Republic Wireless spin-off.
- The company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. A co-founder and director resigned after quarter-end, effective October 30, 2018; the board appointed a replacement.
Important facts for investors to verify
- Whether CPaaS usage and customer growth continue to outweigh pricing reductions, and whether 117% net retention is sustained.
- Why Q3 adjusted EBITDA fell materially despite 22% revenue growth, and how planned expense growth affects operating profitability.
- How much reported earnings growth depends on option-exercise tax benefits and other tax-related items.
- The durability and cash-collection implications of the Verizon settlement revenue, and the trend in CABS receivables and allowances.
- Developments in the 911 tax litigation and California regulatory proceeding, including any potential financial or operating impact.
- Capital spending, cash conversion and liquidity needs against the company’s stated 12-month sufficiency expectation and contractual commitments.