Research Notes: The Plunge In CPaaS Stocks

A group of formerly hot names highlight the challenges, and maybe the opportunities, in growth's fallen angels

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Bandwidth (BAND) is a CPaaS — Communications-Platform-as-a-Service — provider. The company offers voice or messaging communications for enterprises via the cloud.

The core business model here is familiar to pretty much anyone at this point. Using APIs (Application Programming Interfaces), CPaaS platforms deliver automated text messages for two-factor automation, or audio calls embedded in an app and delivered through a VoIP system. Bandwidth offers these services for over 3,000 CPaaS customers, including Microsoft (MSFT), Zoom Video Communications (ZM), and Uber (UBER).

It’s an attractive model. CPaaS growth is expected to continue at a rapid pace for years, thanks to increasing app usage and other tailwinds:

source: TechTarget.com

Bandwidth itself has increased revenue at a rapid clip: 2022 guidance suggests top-line growth at about 28% annualized over a five-year stretch.

There are some obvious concerns at the moment. A DDOS (distributed denial of service) attack last year is hitting revenue this year by roughly $20 million. Even excluding that headwind, it looks like the 2022 outlook disappointed. Bandwidth guided for a reasonably sharp decline in adjusted earnings (to just $0.03-$0.09 per share). BAND stock dropped 32% after the Q4 release in February and has fallen further since.

Fissures in the company’s culture appear to have opened during the global pandemic (critics see the chief executive officer as too overtly religious, and too blasé toward the pandemic). Those issues, combined with a depressed stock price and the company’s North Carolina location could create problems attracting and retain needed talent.

And the stock price is depressed: BAND is down a stunning 87% from its early 2021 peak. At Thursday’s close of $26.05, it’s not terribly far above the $20 price from its late 2017 IPO. Despite the question marks, the company still was net profitable last year (on an adjusted basis, yes, but in still the black backing out stock-based comp); expects to grow revenue this year; and, as noted, serves an attractive market. Yet EV/revenue now has dipped below 2x (using 2022 guidance), with EV/adjusted GP under 4x.

This looks like the kind of name investors should be targeting right now: a story that remains largely intact despite some near-term challenges and negative sentiment toward the tech side of the market. Indeed, BAND is tempting here. It’s far from the only name in the market, or in its group, to look tempting — and yet somehow still dangerous.

The CPaaS Plunge

For a time, CPaaS was a hot model in the equity market. The biggest player in the space, Twilio (TWLO), became something of a retail investor favorite. TWLO shares saw an early stumble after its 2016 IPO as the company’s then-heavy reliance on Uber (UBER) went from one of the stock’s selling points to one of its key risks.

But Twilio added new customers and re-accelerated growth: from the beginning of 2018 to the 2021 high, TWLO stock rose more than 17-fold. Other CPaaS names soared, if not quite to the same extent.

Over the same stretch, BAND rose 8x. Zenvia (ZENV) (which can be roughly described as the Twilio of Latin America, though that’s not 100% accurate) rose more than 50% in months after its July 2021 IPO. Italy-based Kaleyra (KLR) went public via the SPAC route at the end of 2019; that stock cleared $20, if briefly, in January 2021.

Again, the optimism in 2020-2021 made some sense. That optimism, however, has been absolutely crushed. BAND is off 87% from its highs; TWLO 72% (nearly $60 billion in market value has been erased during that sell-off); KLR 71%; and ZENV a modest-by-comparison 63%.

Surely, one of these four names is a potential buy here. Right?

The Problems At The Highs — And The Lows

It’s hard not to think there’s some value in CPaaS stocks, as with so many growth stocks that have been hammered over the past 14 months or so. Indeed, we’ve argued for two of those fallen angels, AppLovin (APP) and NeoGames (NGMS) already. In both cases — particularly APP — admittedly we were at best early (though to be fair we highlighted timing/market risk in both posts, and recommended position sizing and/or hedged entries).

But for many growth stocks, the seemingly staggering declines make complete sense. The CPaaS group provides a strong example, since the market seemingly missed so many factors at the top.

At its core, the rally to the highs looks like it was built by pretty standard relative valuation errors:

source: YCharts.com

During the rally from March 2020 lows, EV/revenue multiples for TWLO and BAND, in particular, looked ‘cheap’ given top-line performance. Twilio, for instance, gave initial guidance for 2021 revenue growth of 44% to 47%; the top line wound up increasing 60%-plus. In that context, a peak EV/revenue multiple above 25x didn’t seem that crazy; other -aaS names were getting higher multiples with similar or worse growth.

BAND, meanwhile, could be (and repeatedly was) pitched as the cheaper alternative to Twilio. Sure, the company wasn’t quite as big, and it didn’t have the M&A-built reach that Twilio offered, but its absolute growth rates were impressive while EV/revenue was less than half that of TWLO. In that context, Bandwidth stock seemed ‘cheap’; TWLO was “pricing in” its potential, BAND was not. Bulls toward KLR and ZENV, both of which were and are substantially cheaper on an EV/revenue basis, no doubt made similar arguments.

The problem is that these relative valuations start building on themselves to create absolute lunacy. TWLO’s growth tops expectations; thus that stock deserves a premium to BAND, so TWLO rises. From there, the discount applied BAND needs to expand, so that stock gains; the group looks ‘cheap’ against SaaS or UCaaS or BSaaS names, so they all rally. At some point, everything is overpriced, as the market ignores key problems.

And for CPaaS names, the particular problem appears to be margins.

These aren’t SaaS plays that can generate 80%+ gross margins. Twilio’s non-GAAP gross margins in 2021 were 53%. Bandwidth’s were 49% (that a seemingly disappointing figure; the company owns its own VoIP, or Voice over Internet Protocol, network, which should improve profitability).

And there is a good deal of commoditization in the end product, particularly relative to the critical, value-enhancing nature of some cloud-based software offerings, which can create some longer-term price compression. Twilio is targeting 20% non-GAAP operating margins, but that target a) seems potentially aggressive and b) still is below peak profitability for ‘true’ SaaS companies.

So, in retrospect, it’s pretty obvious that the four names here simply went crazy. Even ignoring the danger of anchoring bias, the fact that CPaaS stocks are down 63%-87% doesn’t necessarily seem like a buying opportunity. Twilio should not have traded at ~55x gross profit. BAND neared 20x on that same basis — and it’s not even the leader in the space. Of course CPaaS stocks sold off — they should have sold off.

There Will Be Winners

And yet…there is at least a case that the declines have gone too far, and that there’s value to be had. The argument for long-term growth in the end market doesn’t seem that impacted (though many CPaaS customers clearly were ‘pandemic winners’, like Bandwidth’s key customer Zoom). Twilio seems like it’s cemented its competitive positioning (though Dutch startup MessageBird shows some potential). Bandwidth has its niche. Kaleyra now trades under 1x FY22 revenue guidance after reaching EBITDA profitability in FY21. Zenvia has a huge market and a surprising rally of late.

At the same time, however, are the names really compelling? Twilio’s valuation is more reasonable. But the stock doesn’t look necessarily cheap. Applying the company’s 20% adjusted operating margin target to FY23 consensus revenue of $5 billion still suggests the company is trading at ~20x EBIT. Again, that margin target hardly seems guaranteed — and it’s years away. TWLO still is pricing in a good deal of success on the top and bottom line going forward.

Bandwidth is under 4x EV/gross profit, yes — but is guiding for miniscule operating margins in FY22. And, again, it has some question marks beyond the fundamentals. Small-cap ‘value’/turnaround/”if they just can get another point or two of market share…” cases like Kaleyra didn’t do all that well over the past decade when things were going well; they seem more scary in a clearly more nervous market. Zenvia adds emerging market (Brazil, Mexico, and Argentina) risk as well.

To top it all off, the declines only seem to be accelerating. BAND looks ‘cheap’ below 2x EV/revenue; but it looked pretty cheap at less than 3x EV/revenue three weeks ago, and the stock is down another 25% since then. Are we sure that ~1.8x revenue is the absolute bottom? Are we sure that’s even an unreasonably low multiple?

There are going to be a lot of big winners that rally from current levels, and I wouldn’t be surprised if at least one of these CPaaS names was one of them. (Forced to choose, despite the numerous negatives, I’d put my money on BAND, though KLR has an argument as well) But there also are going to be a lot of stocks that have dropped 80% from their highs— and have another 60% or 80% or 100% to go.

Obviously, many of those names are going to be junky de-SPACs, electric vehicle manufacturers or pumped-up crypto miners. But there are seemingly attractive “buy the plunge” cases out there that will get fundamentally-driven investors into trouble, too. We are not out of the weeds, or the woods, by any stretch. That suggests some caution for the long side — and maybe the need for aggressiveness from the short side.

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Vince Martin has no positions in any securities mentioned.

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