Bandwidth Inc. (BAND) Q3 2018 Earnings Report, Transcript and Summary

Greetings, and welcome to the Bandwidth Third Quarter 2018 Earnings Results Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Marc Griffin. Please go ahead.

Thank you, good afternoon, and welcome to Bandwidth's third quarter 2018 earnings call. Today, we'll be discussing the results announced in our press release issued after the market close. With me on the call this afternoon is David Morken, Bandwidth's, Chief Executive Officer; and Jeff Hoffman, Chief Financial Officer of Bandwidth. They will begin with prepared remarks and then we will then open the call up for Q&A. During the call, we will make statements related to our business that may be considered forward-looking, including statements concerning our financial guidance for the fourth fiscal quarter of 2018 and the full year of 2018, our plan is to execute on growth strategy, our ability to maintain existing and acquire new customers and other statements regarding our plans and prospects. Forward-looking statements may often be identified with words, such as, we expect, we anticipate or upcoming. These statements reflect our views only as of today and should not be considered our views as of any subsequent date. We undertake no obligation to update or revise these forward-looking statements. Forward-looking statements are not promises or guarantees of future performance and are subject to a variety of risks and uncertainties that could cause the actual results to differ materially from our expectations. For a discussion of material risks and other important factors that could affect our actual results, please refer to those contained in our 10-K filing on February 26, 2018, as updated by other SEC filings all of which are available on the Investor Relations section of our website at bandwidth.com, and on the SEC's website at SEC.gov. Finally, during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release issued after the close of market today, which is located at our website at bandwidth.com and on the SEC's website at sec.gov. With that, let me turn the call over to David.

Thank you, Marc, and thanks to everyone for joining us on the call today. During the third quarter, we again exceeded expectations on all guiding metrics. Our CPaaS revenue increased 24% year-over-year driving total revenue of $50.5 million. We continue to successfully serve and grow our existing customers as demonstrated by our 117% dollar-based net retention rate. Our CPaaS software platform and IP voice network continue to attract new active CPaaS customers with our CPaaS customer base growing 26% year-over-year. We are very pleased with our third quarter execution, which has yielded broad based strength across all our service offerings, which are provided to a diverse set of enterprise customers. We deliver comprehensive solutions through our vertically integrated platform that addresses that unique and complex needs of the inventive enterprises we serve. As a result, these enterprises have continued to innovate and grow with our platform over many years. And it is common for our customers to use our platform, not just for a single customer use case, but for many; a long tenured customer such as Google or Microsoft will have numerous customer experiences powered by Bandwidth. During this last quarter, for example, Google added voice capabilities within their G Suite services using our flexible software APIs and nationwide IP voice network to enable voice calling for G Suite meetings. Our software platform makes it easy for creative enterprise teams to build, deploy and scale enterprise communication with superior quality, reliability and accountability. We also continued to see demand for our services from new customers as well during the quarter. We entered into a new relationship with a leading provider of cloud-based call center applications, which services various Fortune 500 companies. As cloud providers continue to penetrate the contact center market, they seek a partner in Bandwidth to provide the capability to instantly activate and manage local and toll free numbers at scale via software APIs. Additionally, reliable high quality voice is paramount for such enterprises serving contact centers. Our IP voice network, which we own and operate nationwide, provides us distinct competitive advantages that include consistent high quality in depth enterprise support, real-time network visibility and economies of scale. In addition to our voice offerings, we saw continued demand for our messaging services in the third quarter. Last quarter, we discussed a new relationship with a large e-commerce company that is utilizing text messaging for direct to customer product promotions. Bandwidth Enterprise Messaging services increased capacity to deliver thousands of messages per second to keep pace with this growing demand. Built on enterprise grade toll free SMS, Bandwidth’s A2P messaging offers a scalable, reliable and flexible solution, which features an intuitive customer experience with two way messaging and voice support. Bandwidth is the only software platform that combines comprehensive voice and messaging services with integrated 911 services. We can instantly connect numbers or applications to emergency services with reliable and accurate emergency call routing. For example, we have entered into relationships with leading smart home security providers to offer their customers consistent access to emergency services at a customer's residence from anywhere. Without this technology, dialing 911 from their native phone dialers would automatically route to 911 based on current location rather than the location of their home. Whether enterprises choose to route based on physical location of the called to find the location or X, Y coordinates, Bandwidth is able to connect end users with the appropriate emergency personnel quickly. Companies use our platform to more frequently and seamlessly add both voice and access to emergency services from residential Internet of things devices, whether that is activated when a smart doorbell rings, a security camera detects motion or in homes of the future by voice controlled appliances. Our services extend from our complete platform and trusted network to world class support for the enterprises we serve. We have achieved over 97% customer satisfaction across tens of thousands of customer interactions. At no additional cost, our dedicated enterprise customer support teams help our customers succeed and gather vital feedback for continuous improvement. It has been especially satisfying to maintain our high level of customer satisfaction during a period of rapid personnel growth for Bandwidth. We recently expanded our headquarters here in Raleigh, North Carolina to include an additional building to make room for all of the additional Bandmates that we have hired and for those that will continue to join us in the future. We remain on track with our hiring plans within sales and marketing and in the third quarter have significantly expanded our technology team to provide increased development capabilities. We are making excellent progress learning and discovering our best path to expanding our services in international markets. We are having ongoing conversations with our existing customers on how to best serve them abroad and are also engaging with regulators and partners to better understand requirements for conducting business in new markets. We look forward to moving from learning onto execution in the months ahead. I wanted to mention that hurricanes Florence and Michael did not cause any impact whatsoever to any aspect of our services. Our software platform and IP voice network are purposely designed to be redundant with multiple data centers located strategically across the nation. Additionally, as part of operating our own network, we maintain a network operations and control center at our Raleigh headquarters and two other locations during emergencies, which are staffed to monitor the health of the platform and network 24/7. To the extent any network issues arise, our teams can often identify, diagnose and solve them prior to any customer impact. That said our local communities were not so fortunate. We have been praying for and lending a hand to many who were impacted by hurricanes, Florence and Michael. We're grateful to all our Bandmates, who have been volunteering. Lastly, before I hand it over to Jeff, I wanted to comment on changes to our board of directors. We announced today that Luke Roush has joined our board as an Independent Director. Luke is a Co-Founder and Managing Partner at Sovereign's Capital and has more than a decade of experience in global commercialization and business development at venture-backed and Fortune 500 companies. His extensive experience will be an asset to Bandwidth as we focus on scaling our business. Additionally, and importantly, Henry Kaestner, Co-Founder of Bandwidth and also a colleague of Luke's as Co-Founder and Managing Partner at Sovereign's Capital will be stepping down from the board. Henry has been my co-founding partner and amazing friend, who have helped build Bandwidth into the great company it is today. I want to thank him from the bottom of my heart for his everlasting contributions that have shaped every aspect of how we conduct business. With that, let me turn it over to my colleague, Jeff Hoffman, to provide more details on our financials.

Thanks, David, and good afternoon everyone. On the call today, I will provide a more detailed overview of our third quarter financial performance and then provide our outlook for the fourth quarter and full year 2018. Following my remarks, we will open the call to your questions. Third quarter was another strong performance for Bandwidth highlighted by better than expected results across all guided metrics. Our financial results demonstrate a robust business model as enterprises continue to embed voice messaging and 911 into their products and services. Our growth in 2018 continues to be primarily driven by expanding our relationships with existing customers and we continue to see strength from customers in all verticals across many offerings. Additionally, our results were bolstered by the addition of new CPaaS customers. During the third quarter, our total revenue was $50.5 million, up 22% year-over-year and $2.3 million above the high end of our guidance range. Within total revenue, CPaaS revenue was $41.5 million, up 24% year-over-year and $1 million above the high end of our guidance range. Other revenue contributed to the remaining $8.9 million of total revenue and was more than the $7.9 million from the third quarter of 2017 due to higher than anticipated indirect revenue. We ended the third quarter with 1,155 active CPaaS customer accounts, up 26% year-over-year. In addition, our dollar-based net retention rate was 117%, compared to 105% during the third quarter of 2017. Before moving onto profitability metrics, I would like to point out that I will be discussing non-GAAP results going forward. Our GAAP financial results along with the full reconciliation between GAAP and non-GAAP results can be found in our earnings release. Our non-GAAP gross profit, which excludes stock-based compensation and depreciation, was $24.1 million, using a gross margin of 48% for the third quarter of 2018, up from the $19.9 million and in line with the 48% gross margin we achieved in the third quarter of 2017. Our current gross margin results are tracking to plan as we continue to purposely invest our IPO proceeds to scale our business. Third quarter adjusted EBITDA was $2.3 million, compared to $5.2 million for the same period last year, which reflects our strong revenue and gross profit performance, offset by an increase in operating expenses, primarily driven by our investment in personnel to support our growth. On a GAAP basis, we reported net income of $2.5 million or $0.12 per share based on 21.1 million weighted average diluted shares outstanding during the third quarter 2018. This includes a $4.2 million income tax benefit from stock option exercises. Our non-GAAP net loss in third quarter was $1 million or a loss of $0.05 per share based on 19.1 million weighted average basic shares outstanding. This is well above our guidance for the third quarter of a net loss of $0.19 to $0.21 per share. Non-GAAP net loss excludes the $4.2 million income tax benefit from stock option exercises, as well as the tax impact of these adjustments. The favorable non-GAAP net loss variance, as compared to our guidance, was primarily due to higher gross profit and lower G&A expenses. During the third quarter, we generated $6.9 million in net cash from operations and $3.1 million in free cash flow, which includes purchases of property and equipment, as well as capitalized software development costs for internal use. Now I'd like to finish with some thoughts regarding our financial outlook, beginning with the full year 2018. In terms of CPaaS revenue, we are increasing our full-year guidance to be in the range of $162.3 million to $162.8 million, or growth of 24% at the midpoint of the range. We are increasing our total revenue for 2018 to be in the range of $200.8 million to $201.3 million. Non-GAAP earnings per share, is expected to be in the range of approximately $0.19 to $0.21 per share. This outlook assumes weighted average diluted shares outstanding of approximately 21.1 million. Turning to our guidance for the fourth quarter of 2018, we expect CPaaS revenue to be in the range of $42.1 million to $42.6 million, or up 21% year-over-year at the midpoint of the range. We expect total revenue to be in the range of $49.1 million to $49.6 million for the fourth quarter. Non-GAAP earnings per share, is expected to be a loss in the range of $0.28 to $0.30 per share. This outlook assumes weighted average basic shares outstanding of approximately 19.4 million. Overall, we continue to be pleased with the performance of our business as evidenced by our revenue growth and expansion of customer relationships. We have a tremendous opportunity ahead of us and are excited by the progress we are making on our mission to develop and deliver the power to communicate. With that, I will now hand the call back to the operator for the Q&A portion of the call.

At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Brent Bracelin from KeyBanc Capital Markets. Please proceed with your question.

Hi, it’s Clarke Jeffries on for Brent. David, just a question on that cloud-based call center partnership that you mentioned, is that a first for you in terms of relationship with a software vendor outside of the unified communications space? And is this the first time they're sourcing from a CPaaS partner? Is this then moving to dual sourcing and they already had a CPaaS relationship previously?

Clarke it is not the first customer that we have had that serves the enterprise contact center space, to answer part one of your question. They did displace an incumbent in selecting bandwidth. And as is commonly the experience in the enterprise space multisource across the various providers.

Alright, great. And then a question for Jeff. I think we continue to see upside of profitability. Could you maybe frame the investments for the fourth quarter? You mentioned G&A expenses in terms of rev rec and other ongoing expenses in the second half of this year. Are we going to see that more into Q4 as G&A maybe a little bit higher?

Yes Clark, I'm glad to respond to that. So when we look at our operating expenses, and I'll just go from top to bottom, we're going to start with research and development. We're continuing to add to our team there, particularly software developers, engineers and the like. And this is what's driving sort of our roadmap and how we can not only serve our current customers with better future customers, you’ll be able to see that continue to grow. You will also see us as we deliver on the plan that we've outlined all year on sales headcount and what we're going to continue to hire there. And so you should expect to see continued growth in sales and marketing expenses in fourth quarter. And then finally, what you were ringing on was G&A. That will also have some growth with it too. We talked about this on last quarter's call, as well as there's a little bit of lumpiness. There are some projects that we're doing in the second half of the year, more acutely in fourth quarter, like ASC606, some other security and other routine things that we do that we should be doing as a business that serves enterprise customers. And that’s how we see the fourth quarter shaping up.

Alright, great. Thanks very much.

Our next question comes from the line of Pat Walravens from JMP Securities. Please proceed with your question.

Oh, great. Thanks very much. I guess my first question and I think your strong results probably answer it. But I just want to specifically ask it anyways. Did you see any signs of hesitation out there in spending because of sort of macro concerns?

Pat, this is David. Just reflecting for a moment, there wasn't a particular enterprise engagement that extended the decision timeframe or withdrew from the market that I've got top of mind. So well certainly macro environmental variables see more volatile. I don't have testimony that could corroborate that individually with an engagement.

Okay, thanks. And then David, I guess I would love to hear the more perspective on international. First of all, I mean, how important is it to you, you talk about it on every call. Is it – in sort of your set of priorities, where does it fit?

It fits as extraordinary upside and strategically important because it's so valuable to our large enterprise customers, many of them who spend more outside the United States on communication services with existing partners in various countries than they do in the U.S. And so we are following demand and doing so leveraging the many years long existing enterprise relationships that we have to hopefully, if we do it right, source, anchor tenant partners with whom we innovate well with and have in the U.S. and then deploy with them around the world. So instead of build it and they will come, it's important to us because our customers importantly have told us please serve us in other jurisdictions.

Okay. And then my follow up on that is what's the hardest part?

The hardest part for me is to make sure that Jeff and I do this in a fashion that is consistent with the value that we've built in the United States in terms of being both CapEx light and having an integrated platform and network strategy that we can promise and keep a promise on quality to these enterprise customers and that means navigating different regulatory environments and making sure we're building that which our customers value. And sometimes you can be tempted to settle and couple together aspects of an IP network and platform just in the name of doing something faster and we don't think that that's the right approach. We want to do it right and we've learned an enormous amount with the help of some great additions to the team and as I mentioned in my comments, getting close to starting to execute.

Right, great. And then Jeff, a quick one for you, so on the dollar based net retention rate, I mean 117% is great, but it went up the last three quarters or everything, 105%, 111%, 115%, 119% if my chart is right and so now it's back down a little bit. How should we think about what it does in the future?

Great, Pat. So your numbers are right. And this is something that's really common in a usage based revenue business such as ours. You'll see fluctuations in this metric as well as usage and there's a lot of things that can kind of go into that. So I wouldn't read too much into a quarter. We the management team don't get to up or down based on one quarter. What we do look at is annual comparisons that we do. And so the 117% that we posted this quarter is 12% better than the 105% that we posted a year ago. And we do look at that because that will sort of smooth out any waviness that would be in there.

Okay, great. Thank you.

Our next question comes from line of Meta Marshall from Morgan Stanley. Please proceed with your question.

Great, thanks. Just kind of diving into the net retention a little bit, if you could just talk about is it purely just increased usage of the same products they were using or kind of any trends as far as large customers or smaller customers kind of influencing that one way or another or kind of deeper product usage that contributed anything to that metric? And then maybe second, I know you guys have been kind of investing in some areas that would improve gross margins, gross margins continue to be, but your guide would kind of imply maybe a step down in gross margins, if I'm thinking about it right. So just trying to understand how we should be thinking about gross margins and the pacing of some of R&D that you guys are doing? Thanks.

Thanks, Meta. This is David. I'll take the first part of your question and then turn it over to Jeff for your question about gross margin. In regard to the net retention rate and what it sources are, it is broad across our enterprise customer set and diverse in terms of utilization of the services we offer. So we are seeing growth across the board on the platform for voice and messaging and emergency service. In some cases, larger enterprise are consuming new services for them for the first time, but there isn't a single driver in a particular customer that is causing the net retention rate to be at the level that it's at.

And then I'll pick up on the gross margin and investment question. So, I think your interpretation of the fourth quarter margin based on the annual guidance overall 48%, you're right. It is down a little bit. It's primarily in our other segment. We had more indirect revenue in third quarter, which made that margin even better in the third quarter of 2018. We won't see that reoccur in fourth quarter. And so that that's the primary driver. I would say CPaaS margins beneath the word of total remain buoyant, but at the same point we are continuing to make investments. We did that right out of the blocks once we had the IPO proceeds in our possession and we continue to do that each quarter. And some of those have bared fruit and our yielding margin expansion at the same point we're still putting capital to work and so there's a downward pressure offsetting that with the net of that as we have generally sort of flat margins for the year as we’ve guided.

Got it. And then maybe just kind of jumping on, I know you gave a couple of customer examples, but of the 60 or so new customers this quarter, how is the composition maybe changing of those 60 customers versus maybe the 60 customers you saw kind of at the beginning of the year that maybe would have been leads you had already started to harvest pre-IPO.

The composition of the customers on boarded in the third quarter is relatively consistent with prior periods largely because the lead sources from which we derive these customers remain constant throughout that period. We haven't gone fishing in new ponds. We have increased the sales capacity on the desk, which the yield from which will be out into the future, but right now we are really focusing on a curated database of about 50,000 medium-sized business customers and then for our strategic hunters, the Fortune 1000. And so no significant difference Meta in terms of the composition or expectation on how those customers will be productive for us in the years to come.

Got it. Thanks guys. Nice quarter.

Our next question comes from the line of Richard Davis from Canaccord. Please proceed with your question.

Thanks. It could be kind of brief. But so guys have a strong foundation in kind of voice CPaaS and a good presence in SMS. One of the areas that we've seen, I don't know to what extent that will be big, but is video CPaaS, what do you think of that area? What your plans there and what's your thoughts there? Thanks.

Thanks, Richard. We have historically not considered video to be a usage based opportunity that's attractive to our platform and network strategy. We do provide voice and messaging and emergency service to some of the greatest productivity experiences for the knowledge worker that include video conferencing I think you're familiar with whether it's Cisco Webex, Zoom, BlueJeans, Microsoft Office 365, Skype for Business and Teams or Google Suites, many of those are video rich experiences for those who are in the workplace. So our strategy has been to make sure we are the best choice to complement that experience with both voice services and messaging. And I think that's what you should expect our strategy to continue to be in the years ahead relative to video.

That’s kind of like a Lego block into those guys. And then quickly, one of the questions I got from some investors was like, look, you guys have kind of round numbers 10% of U.S. phone numbers. Is there a cost effective way to increase this number either U.S. and I think Pat even asked kind of internationally, but is that a scenario or how do you think about that?

We think about the benefit of having almost 10% of all the phone numbers in the North American dialing plan on our platform and IP network as fundamental to providing network effects, which is to say more and more calls remain on net as between those numbers. And in these large walled garden enterprises we serve, when they call each other, there's no third-party incremental cost for completing that call that remains on net and that's a powerful financial and quality complement for our strategy. That number of numbers in production continues to climb up into the right as a function of porting numbers from existing Verizon, AT&T and CenturyLink customers over to our network, and we support an extraordinarily large number of phone numbers porting from customers that are finding out of services to be more valuable than the legacy provider. Does that answer your question, Richard?

Yes, perfect. Thanks so much.

Ladies and gentlemen, we have reached the end of the question-and-answer session and this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.