8×8, Inc. (NYSE:EGHT) Q3 2023 Earnings Call Transcript
8x8, Inc. (NYSE:EGHT) Q3 2023 Earnings Call Transcript February 1, 2023
Operator: Good afternoon. Thank you for attending the 8x8 Fiscal Third Quarter Earnings Call. My name is Matt, and I'll be your moderator for today's call. All lines have been muted during presentation portion of the call and opportunity for question and answer session at the end I would now like to pass the conference over to our host, Kate Patterson, Vice President of Investor Relations. Kate, please go ahead.
Kate Patterson: Thank you, operator. Good afternoon, everyone. Today's agenda will include a review of our third quarter results with Samuel Wilson, our Interim Chief Executive Officer, and Kevin Kraus, our Interim Chief Financial Officer. Following our prepared remarks, there will be a question-and-answer session. Before we get started, let me remind you that our discussion today includes forward-looking statements about our future financial performance including our increased focus on profitability and cash flow as well as our business, product and growth strategy. We caution you not to put undue reliance on these forward-looking statements as they involve risks and uncertainties that may cause actual results to vary materially from forward-looking statements as described in our risk factors in our reports filed with the SEC.
Any forward-looking statements made on this call and in the presentation slides reflect our analysis as of today, and we have no plans or obligation to update them. Certain financial measures that will be discussed on this call, together with year-over-year comparisons in some cases, were not prepared in accordance with the U.S. generally accepted accounting principles or GAAP. A reconciliation of those non-GAAP measures to the closest comparable GAAP measures is provided in our earnings press release and earnings presentation slides, which are available on 8x8 Investor Relations website at investors.8x8.com. With that, I'll turn the call over to Samuel Wilson.
Samuel Wilson: Thank you, Kate, and thank you to everyone joining us on the call today. I believe our solid third quarter results were a strong indicator of our ability to perform against our objectives. We said we would forgo some near-term revenue growth for profitability as we build a sustainable long-term business and that's exactly what our teams did in the quarter. Despite the lower-than-expected total revenue, we delivered almost 10% operating income, increased deferred revenue and RPO, and experienced high customer retention, all early indicators of future success for a SaaS business. I'm impressed with the quality of our performance in the third quarter, and I want to thank our employees and everyone in the 8x8 community for their hard work.
Turning to the future. I have been working closely with the leadership team and the Board of Directors on a multiyear strategy to grow our business and create value for our stakeholders. We laid the foundation for our next step several years ago when we re-architectured our core technology. We built a modern microservices-based platform that powers both our current UCaaS and CCaaS solutions. We have fully embraced continuous integration and continuous deployment and are delivering more than 1,000 micro service updates every quarter. This enabled near perfect uptime for the third quarter and reduced the number of customer identified defects to single digits. We are innovating faster than we ever have before. At the same time, we embarked on this journey we could not have predicted the global COVID pandemic or how it would accelerate adoption of cloud-based telephony and internal collaboration tools, especially Microsoft Teams.
While UCaaS migration continues to create revenue and profit opportunities for efficient providers like 8x8, I believe the opportunities to differentiate based on stand-alone UCaaS are becoming increasingly rare. Our XCaaS platform, which delivers the high availability, scalability and security of a unified cloud native solution and a lower TCO is highly differentiated. By focusing on CCaaS innovation within the platform, we can continue to extend our leadership. Specifically, I believe the contact center market is at an inflection. According to PwC's Future Customer Experience survey, 1 in 3 customers would leave a brand they love after 1 poor experience. No longer can the contact center be viewed solely through a cost lens. It has become the primary way for companies to interact with their customers and build brand loyalty.
At the same time, advances in ML-AI technologies as well as customers' growing preference for high-quality digital and self-service interactions set the stage for a new wave of contact center migrations and upgrades. Technologies like large language models such as ChatGPT have the potential to transform the customer experience. Our modern platform enables these technologies today and I believe we are well positioned as this opportunity evolves. We have identified 6 areas I believe are critical to our future success. One, further acceleration in CCaaS innovation while maintaining our leadership position in cloud telephony. We began our shift to an innovation-led company with the acquisition of Fuze, which doubled the R&D resources dedicated to innovation.
We have successfully accelerated the pace of project completion and are already seeing the results of our increased investment. We are already in beta on a number of new CCaaS features, including capabilities based on advanced machine learning and large language models. We remain committed to our leadership position in cloud telephony as an important component of the XCaaS platform. Our ability to deliver both voice and CCaaS solutions for Microsoft Teams users is increasingly a deciding factor in new business wins around the world. We saw triple-digit growth in voice for Teams seats in the third quarter and have now sold more than 300,000 licenses. The largest team's customer has already deployed the technology to more than 30 countries. Global coverage matters.
Recent XCaaS with Teams wins include the Australian Computer Society selected 8x8 XCaaS with voice for Teams to help drive operational efficiencies, productivity gains and enhance their contact center performance. This channel-led win demonstrates the competitive differentiation of our XCaaS solution within the Teams environment. In the U.K., Gateshead Metropolitan Borough selected 8x8 XCaaS with voice for Teams to support hybrid work for their nearly 3,000 employees and enhance their 200-plus agent contact center. Two, increasing our focus on small and midsized enterprise customers. Small and midsized enterprise customers need the same automation and ML-AI contact center capabilities as large enterprises, but don't have the large enterprise budgets or a team of in-house developers.
Our mix and match pricing model, unified communications and enterprise class APIs, make XCaaS the natural choice for these customers. Just as important, our modern platform enables the adoption of advanced contact center capabilities, future-proofing their investments. The strong product market fit improves customer satisfaction, often leading to follow-on sales and reference sales down the line. A great example of a win directly tied to a happy existing customer is Chubb Group Security Limited, a global fire safety and security solutions provider protecting more than 1 million locations worldwide. After acquiring a division from an existing 8x8 CCaaS customer, Chubb reviewed and selected 8x8 CCaaS for a complete secure cloud contact center solution.
Another example of a customer satisfaction driving new business is Indiana Hemophilia and Thrombosis Center, the only federally recognized comprehensive Hemophilia treatment center in Indiana and 1 of the largest centers in the nation. With a key decision-maker having previous experience with 8x8, the nonprofit entity selected 8x8 XCaaS for its comprehensive CCaaS solution that is certified for Microsoft Teams. Our best-in-class reliability was also a factor in the decision. Three, increasing XCaaS win rates and sales and marketing productivity. As we continue to innovate and expand our XCaaS platform, our win rates should increase. We are attracting more go-to-market and technology partners every day, especially around our market-leading Teams integration.
This expands our market reach, increases our capacity for innovation and creates an ecosystem of application and features that allow our customers to tailor their customer experience to their business needs. A customer that fits squarely in our sweet spot is Panine Care NHS Foundation Trust in the U.K., a provider of mental health, learning disability and autism services to 1.3 million people across Greater Manchester and beyond. They selected 8x8 XCaaS to upgrade to modern reliable cloud communications and deliver enhanced patient engagement capabilities for over 3,000 staff. Another U.K. win, the South Hampton Football Club in the English Premier League is a good example of how unified XCaaS platform delivers contact center features to users across the organization to enhance the customer experience.
The Sanks selected 8x8 XCaaS with 8x8 Front Desk to deliver a premier fan in hospitality experience and introduce new communications channels such as e-mail and web chat because they are customer obsessed. Four, maintaining an outstanding experience for customers so they can focus on theirs. The investments we've made in customer success, including more than 8,500 hours of training for our Tier 1 support engineers are evident in our statistics and customer success scores. We've seen a 50% reduction in escalated issues, a 20% improvement in First Day resolutions and a 49% reduction in global backlog. As a result, our customer satisfaction scores are up double digits versus a year ago. We still have a lot of work to do, but are passionate about leveraging our platform and the solutions of our technology partners to drive continuous improvement in customer experience and customer satisfaction.
We use our own products and intend to document our progress as an early adopter of each new innovation in an ongoing case study. In this way, we remain accountable to our commitment for improving the experiences of our customers and we provide a road map for our customers to do the same in their organizations. Five, establish CPaaS leadership in the Asia Pacific region. CPaaS was down year-over-year and sequentially again this quarter. It was the single largest factor in our third quarter revenue miss and downward revision to our revenue guidance for the fiscal year. That said, the CPaaS technology is important to the XCaaS platform, and we continue to add new customers on a regular basis. We are going through a transition in the business and there are some signs of stability.
This gives me confidence that CPaaS will make a positive contribution to our operating performance in the future. Several third quarter wins illustrate this point. Plugo, an Indonesian D2C e-commerce platform with a vision to democracize e-commerce, uses a combination of 8x8, SMS, APIs and WhatsApp through 8x8 Chat Apps API to send secure onetime passwords and notifications as well as for customer care. Privy, Indonesia's first and leading legally binding digital signature with more than 37 million users and 1,800 enterprise customers, uses 8x8 SMS API to keep all users secure with onetime passwords. Plusdane Housing, a U.K. housing association that owns and manages over 13,000 homes across Northwest of England. They selected 8x8 XCaaS with 8x8 CPaaS, voice for Teams and Verint workforce management to support their over 500 employees and drive customer satisfaction with greater omnichannel capabilities.
We love our triple play customers. Sixth, increase our profitability and cash flow to delever our balance sheet and fund investments in innovation that will drive our future growth. We have already shown tremendous progress in fiscal 2023, and we have come very close to our second half '24 target of double-digit non-GAAP operating margin this quarter, a full year ahead of schedule. As Kevin will discuss, we believe we can drive our margins higher again in fiscal '24 as we align our investments and cost structure and improve our sales productivity. We intend to leverage improvements in our operating margin to pay down debt, which will reduce our interest payments and allow more enterprise value to accrue to our equity holders. We began this process in Q2 when we repurchased $6 million in aggregate principal value of our '24 notes, and we continued in the third quarter with the repurchase of approximately $22 million in principal.
What I have outlined here is a long-term strategy based on an efficient, focused innovation engine and a modern cloud dative platform. At the heart of this strategy is delivering superior customer experiences. The experiences of our customers and partners as they engage with us and the experiences they can deliver to their customers and their employees with our XCaaS platform. This is our North Star. Every customer interaction is an opportunity to delight. And our goal is to make every touch matter, whether digital or in person. This commitment to our customers' experience is already built into our DNA. Our financially backed commitment to Five 9's availability is just 1 example. We are already well on our way on our multiyear plan to lead with innovation and be the customer success platform of choice for our customers.
The best measurement of our continued progress is the willingness of our customers to recommend our solutions to their peers. Our goal is to achieve 100% referenceability within our targeted customer segment. It is a lofty goal, but 1 I believe will allow us to deliver sustained growth and profitability for many years to come. I will turn the call over to CFO, Kevin Kraus, for a more detailed review of our financial performance.
Kevin Kraus: Thanks, Sam, and good afternoon to everyone. We remained financially disciplined and delivered solid profit and cash results for the third fiscal quarter. In the third quarter, despite service and total revenue being slightly below our guidance ranges, we delivered non-GAAP gross margin, non-GAAP operating profit and cash from operations above our expectations. Total revenue for the quarter was $184.4 million, and we generated $175.8 million in service revenue, both an increase of 18% year-over-year. Our revenue performance reflected strong customer retention and renewals, partially offset by a continued decline in our CPaaS business in the Asia-Pacific region. Other revenue for the quarter was $8.6 million, roughly flat with the prior quarter and in line with expectations.
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Fuze accounted for $26.5 million of service revenue and total revenue and was impacted by a $1 million third quarter reserve adjustment we made as part of our integration of back-office processes. Fuze' customer retention remains strong and the business continues to outperform our initial expectations. Strong retention across the customer base was reflected in our RPO and ARR metrics. Remaining performance obligation was approximately $750 million for the quarter, up from $715 million in the second quarter on solid bookings performance. Customer renewals were notably strong and our customer retention was the highest it has been in many quarters. Total ARR was $698 million at quarter end, up 22% year-over-year. Enterprise customers accounted for 57% of total ARR, and Enterprise ARR was up 30% year-over-year, but down approximately $1 million sequentially due to the continued decline in CPaaS ARR.
We had hoped this part of the business had stabilized last quarter, but due to continued challenges, we are taking a conservative view of the potential revenue contribution going forward. Turning to gross margin. Operating expenses and operating profit. Please remember that all items discussed are non-GAAP unless otherwise noted. Service revenue gross margin came in at 75.7%, an increase of approximately 600 basis points from Q3 '22 and 160 basis points sequentially, driven by continued COGS improvement programs, which drove down unit costs and, to a lesser extent, lower CPaaS revenue. Other revenue gross margin came in at negative 1.4% for the quarter compared with negative 32.2% in Q3 '22. Other revenue gross margin has shown consistent improvement over the past few quarters due to increased professional services operational efficiencies plus better product margins.
Overall, second quarter gross margin was 72.1%, an increase of over 700 basis points year-over-year and up 200 basis points sequentially. Turning to operating expenses. R&D was 14.5% of revenue, which was in range of our 15% target. We improved sales and marketing leverage as we realigned costs early in the quarter with sales and marketing expenses down $3.3 million sequentially, and sales and marketing as a percentage of revenue declining over 100 basis points sequentially. We expect further improvements in sales and marketing efficiency as a result of our most recent cost alignment action in January, which further reduced our investment in sales and marketing initiatives in nonstrategic areas of the business. This will be partially offset by the seasonal increase in employee-related costs in the first calendar quarter.
G&A declined $3 million sequentially, improved 140 basis points as a percentage of revenue to 11.4%. Total non-GAAP spending as measured by cost of goods sold plus R&D, plus sales and marketing plus G&A, was up approximately 8% year-over-year, primarily due to the addition of Fuze' operations, but it was well below our 18% total revenue growth. Non-GAAP operating profit was $18.3 million, up nearly 6x from fiscal Q3 '22 and more than double sequentially. As Sam mentioned in his opening remarks, we achieved approximately 10% operating margin in Q3, nearly a full year ahead of previous expectations. As you can see, we are committed to improved operational efficiency and delivering enhanced operating profit. Turning to the balance sheet. Total cash, cash equivalents and restricted cash ended the third quarter at approximately $132 million, substantially equal to last quarter despite consuming $20 million in cash for debt repurchases.
As Sam mentioned in his prepared remarks, during the quarter, we made notable progress delevering our balance sheet by repurchasing approximately $22 million in aggregate principal amount of 2024 convertible senior notes, after repurchasing $6 million in Q2 '23. These debt repurchases and the exchange transaction from August 3, leave approximately $68 million of aggregate principal value of 2024 convertible senior notes remaining. Given our current cash balance and expected future positive cash flow, we see no issues with repaying the 2024 debt with cash at maturity in February 2024. Going forward, we expect cash flow will increase with operating leverage subject to timing differences in collections and other payables. We intend to use the excess cash generated to opportunistically prepay debt, including our term loan.
This will lower our interest payments and will enable continued investment in product innovation while simultaneously shifting more of our enterprise value to our equity holders. Cash from operations was over $15 million for the quarter, ahead of our expectations and approximately $2 million higher than Q2 despite paying approximately $3 million more in interest expense in the third quarter. We continue to actively manage cash flow and customer collections remained solid in Q3. Free cash flow was over $12 million for the quarter, a greater than $1 million sequential increase. Our CapEx costs have been declining over time as we have focused on capital efficiency. As previously stated, we took action in January to realign our workforce to accelerate innovation as we continue to shift to enterprise and XCaaS.
And this included the difficult decision to further reduce our total headcount. When completed, the action will impact approximately 7% of our employee population. This action will be factored into our non-GAAP guidance, and we expect some onetime severance and restructuring costs will impact our fourth quarter cash flow and GAAP results. Before turning to guidance, let me provide some context based on our commitment to building a sustainable growth business with SaaS-like operating metrics. We have been doing a top-to-bottom strategic review of our business to ensure that all areas are operating efficiently. The strategic cost realignment activities from last October and in January allow us to reallocate limited resources to the areas of focus for the future, while improving our operating metrics in the near term.
We are raising our exit operating margin target for the fiscal year based on improving efficiency and discipline around the business we are pursuing. For operating expenses, we plan to control sales and marketing spend and would like to exit fiscal year 2023 between 33% and 35% of revenue, down from 39% 4 quarters ago. We plan to focus our R&D efforts on our core product offerings and expect R&D as a percent of revenue to remain about 15% as we continue on the path of investment in our customer-focused product strategy with an emphasis on contact center features and functions. We are focused on extracting more leverage from our G&A functions as we work to improve operating efficiencies in those areas. We are establishing guidance for fourth quarter of fiscal 2023 ending March 31, 2023, as follows.
We anticipate service revenue to be in the range of $175 million to $178 million, up sequentially from Q3 at the midpoint and representing approximately 1% to 3% year-over-year growth as we pass the Fuze 1-year anniversary and remain cautious on the CPaaS revenue outlook. We expect that Fuze' service revenue contribution will be roughly flat with Q3 at approximately $26 million. Please note that next quarter will be the last time we provide Fuze revenue contribution as we will have passed the 1-year anniversary and the businesses are now integrated. We anticipate total revenue to be in the range of $184 million to $187 million, up sequentially at the midpoint and representing approximately 1% to 3% year-over-year growth. This guidance reflects the 1-year anniversary of Fuze and our cautious approach to the CPaaS revenue outlook.
We expect other revenue to be approximately flat compared to Q3. We are targeting an operating margin of approximately 10%, roughly flat with fiscal Q3 '23, as we experience our normal expense headwinds related to the restart of employer taxes and other benefits, such as the 401(k) match. These expense headwinds impact all cost lines in the consolidated statement of operations. We expect cash flow from operations to be positive, but down quarter-over-quarter as we make semiannual interest payments on our 2024 and 2028 convertible debt and absorb severance costs from our January headcount reductions. We are updating our guidance for fiscal 2023 ending March 31, 2023, as follows. We anticipate service revenue to be in the range of $708.5 million to $711.5 million, representing approximately 18% year-over-year growth at the midpoint.
We continue to be cautious regarding our CPaaS business and with the Fuze 1-year anniversary past us, we expect to exit fiscal 2023 with service revenue growth in the low single digits on a year-over-year basis. We anticipate total revenue to be in the range of $743.4 million to $746.4 million, representing approximately 17% year-over-year growth at the midpoint. Our total revenue guidance for the fiscal year reflects the combined Q3 and Q4 impact, resulting in a reduction of approximately $5 million at the guidance midpoint. We continue to focus on improving operating margin over time and anticipate landing at approximately 7.5% for fiscal 2023. We also would like to provide some directional color on fiscal 2024, which commences April 1, 2023.
We anticipate total revenue and service revenue growth in the low single digits, as the revenue step-up from the Fuze acquisition will be reflected in every quarter of fiscal 2023. Additionally, we remain cautious regarding the revenue trend for the CPaaS business. We anticipate non-GAAP operating margins steadily growing from the expected Q4 '23 base of approximately 10%, hitting double digits every quarter in fiscal 2024. For the full year, we expect operating margin to be 4 to 5 percentage points higher than full year fiscal 2023. We anticipate cash flow from operations to be directionally aligned with the non-GAAP operating profit trend. Additionally, I would like to mention that we are reviewing our key metrics to ensure that we are providing the appropriate insight into our revenue growth drivers.
We will follow up in subsequent earnings calls on this matter. In closing, I believe the continued focus on our operating margin and cash flow is the correct strategy for us at this time. This strategy enables us to remain an innovation-led company as we fund investments in key product areas. On a personal note, I also would like to say that I'm happy to be continuing my business partnership with Sam in my new role as interim CFO. With 8x8's modern, unified XCaaS platform, we are well positioned to deploy our strategy to capture more of the contact center market, to delight our customers and to deliver on our commitment to improve profitability and cash flow generation. Operator, we are ready for questions.
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