How This Company Will Change Communication Services


It's hard to find undervalued tech companies right now. Particularly in the cloud segment, nosebleed valuations and exorbitant price-to-earnings ratios are common. Cloud company BroadSoft may be a rare exception.

This company missed earnings in February this year, causing shares to plunge. However, a careful analysis of BroadSoft's competitive advantages and business model shows the poor performance in February was a one-time occurrence. The company has huge underlying value, and investors are starting to realize this. Just look at the recent stock price trend. Since May, shares are up an amazing 31%.

What makes this company so special?

BSFT Chart
BSFT Chart

Source: Ycharts

Explaining BroadSoft's attractive business model
When companies decide how to manage their phone lines, they usually have three choices. First, they can use a private branch exchange, or PBX. This technology allows companies to connect all of their phone lines into a single box, which is connected with the carrier provider. The PBX market is currently dominated by Cisco , which enjoys a 27% market share. Second, companies can also rely on communication software, such as Microsoft's Skype or Lync, which can be integrated to the company's PBX.

There is a third way, which involves upgrading the PBX to a new technology called voice over Internet protocol, or VoIP. Cisco calls this an IP PBX system, because it integrates the first and second options smoothly. Since VoIP allows communications and media sessions to be transported from one place to another using the Internet, it's cheap, safe, and robust. BroadSoft makes this possible by selling its product to carriers, such as AT&T and Verizon, and cable companies, like Comcast.

The best part of BroadSoft's product is that it leads to a profitable win-win situation. By creating a cloud-based infrastructure to support VoIP, BroadSoft can reduce cost expenses, and therefore charge less, satisfying most customers. By selling the product via carriers and cable companies, BroadSoft gives them a chance to control the customer. This is fundamental. As buy-side analyst Josh Burwick notes, carriers are more willing to have their customers use BroadSoft's technology, because if customers go for Microsoft or Cisco, the business interacts with them every day. In this case, Cisco and Microsoft have the business relationship instead of the carrier.

Source: Broadsoft Investor Relations

BroadSoft's strong business model is reflected in the company's healthy fundamentals. Between 2008 and 2012, BroadSoft strengthened its partnerships, selling its products to 18 of the 25 largest telecommunications carriers in more than 70 countries. As a result, BroadSoft almost tripled its revenue in this period, from $62 million to $165 million.

The best part of the story is BroadSoft's future growth prospects. According to Infonetics, there's a $10 billion addressable market in the making. Roughly $8 billion per year will come from companies migrating from PBX to cloud solutions. The same report mentions that the majority of remaining PBX trunks will have disappeared by 2016.As a first-mover, BroadSoft could benefit enormously from this flight-to-the-cloud technological transition. Since its origin, the company has made continuous innovation a central part of its culture, increasing the number and quality of its product offerings, and reaching more than 520 customers across 70 countries.

As the market increases in value, competition will likely become fiercer. However, Broadsoft has enough competitive advantages to be safe.

Microsoft's Skype, for example, has a strong user base, but it was not designed for enterprises. Aware of this, Microsoft launched Lync, which is geared toward business use. Notice, however, that Microsoft's products are not complete substitutes to BroadSoft's offerings. There's an increasing consumption pattern among businesses: installing BroadSoft technology as PBX, and on top of it, using Lync and Skype for call controls. Tech giant Cisco may be threatened by BroadSoft. With 40% of its revenue coming from switches, Cisco not only has scale advantages, but also the ability to cross-sell its PBX technology to businesses that already bought its routing and switching solutions.

Apart from selling conventional PBXs, it seems the company is targeting every segment of the market involved in the transition from PBX to VoIP, by providing both the hardware and software that integrates PBX and VoIP. For example, its Unified Communications Manager Express product is particularly designed for small companies.

What a Fool believes
BroadSoft's main competitive advantage is its win-win licensed-based business model. Carriers have an incentive to promote BroadSoft against Cisco or Microsoft solutions, because BroadSoft is basically a tool that allows them to own the customer. This could help BroadSoft to indirectly capture most of the market, which has promising prospects due to an increasing interest in systems that combine PBX and VoIP technologies.

Finally, because BroadSoft's model is based on selling license fees to carriers and providing support and maintenance to its products, it does not have high costs of operation. Therefore, profitability is set to increase due to economies of scale. Between 2008 and 2012, BroadSoft increased its operating margin from a negative 17% to a positive 15%, and is targeting a long-term ambitious margin of 28%-30%.

Overall, BroadSoft's core competence and fundamentals look strong enough to consider investing in it. There's even an upside scenario that implies an acquisition of this promising company by either Microsoft or Cisco.

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Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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