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Edited Transcript of EGHT earnings conference call or presentation 4-Feb-20 10:00pm GMT

Q3 2020 8x8 Inc Earnings Call

SANTA CLARA Feb 11, 2020 (Thomson StreetEvents) -- Edited Transcript of 8x8 Inc earnings conference call or presentation Tuesday, February 4, 2020 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Steven H. Gatoff

8x8, Inc. - CFO & Principal Accounting Officer

* Victoria Hyde-Dunn

8x8, Inc. - IR

* Vikram Verma

8x8, Inc. - CEO & Director

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Conference Call Participants

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* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking

* George Frederick Sutton

Craig-Hallum Capital Group LLC, Research Division - Partner, Co-Director of Research & Senior Research Analyst

* James Dennis Breen

William Blair & Company L.L.C., Research Division - Communication Services Analyst

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Michael James Turrin

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Richard Frank Valera

Needham & Company, LLC, Research Division - Senior Analyst

* Ryan Patrick MacWilliams

Stephens Inc., Research Division - Senior Research Associate

* Timothy Kelly Horan

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

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Presentation

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Operator [1]

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Good evening. My name is David, and I will be your conference operator today. At this time, I would like to welcome everyone to the 8x8, Inc. Fiscal Third Quarter 2020 Earnings Conference Call. I will now turn the call over to Victoria Hyde-Dunn, Head of Investor Relations.

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Victoria Hyde-Dunn, 8x8, Inc. - IR [2]

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Thank you. Good afternoon, and welcome to 8x8's Third Quarter Fiscal 2020 Earnings Conference Call. Joining me today are Vik Verma, Chief Executive Officer; and Steven Gatoff, Chief Financial Officer. During today's call, Vik will begin with business highlights of our third quarter performance.

Following this, Steven will provide details on our financial results and guidance. After these prepared remarks, we look forward to taking your questions. Before we get started, just a reminder that our discussion today includes forward-looking statements about 8x8's future financial performance as well as its business, product and growth strategies.

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 materially vary from the forward-looking statements as described in our risk factors in our reports filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today and we have no plans or duty to update them.

In addition, some financial measures that will be discussed on this call, together with year-over-year comparisons, in some cases, were not prepared in accordance with U.S. generally accepted accounting principles or GAAP.

A reconciliation of non-GAAP measures to the closest comparable GAAP measures is provided with our earnings press release and PowerPoint presentation deck, which are available on our Investor Relations website.

With that, let me turn the call over to Vik.

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Vikram Verma, 8x8, Inc. - CEO & Director [3]

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Thank you, Victoria. Good afternoon, everyone, and thank you for joining us today. Building on our Q2 results, I'm very pleased with continued improvements in execution and financial performance, which led to very strong Q3 results.

I'd like to focus my remarks on 3 topics: strong financial results in Q3; continued channel success and aligning our global operations for both revenue growth and profitability.

Turning to Q3 results. Service revenue and total revenue each grew 32% year-over-year and exceeded the high end of our financial outlook.

Key drivers of growth performance included success with mid-market and enterprise customers and broad-based global strength across our product suite, including both contact center and CPaaS.

The momentum we are seeing is clear customer validation of our strategy of owning a global integrated single-stack technology platform. Customers are increasingly migrating to cloud for their communication needs, and they want to work with the platform leader.

The investments we have made over the last few years in both go-to-market and product innovation are succeeding. Sales execution was strong in Q3 with robust pipeline growth in all segments.

Total organic bookings grew 30% year-over-year. Enterprise ARR grew 85% year-over-year. 4 of our top 10 wins were Avaya replacements who opted for our X Series bundled platform solutions. X Series now represents over 37% of our installed base, up from 32% last quarter.

We also continue to broaden our enterprise customer base with a record 40 new deals closed in the quarter with ARR greater than $100,000. And the common theme for many of these successes was our integrated platform. In fact, 71% of our new bookings greater than $12,000 ARR were from customers that selected bundled UCaaS and CCaaS as compared to 51% 1 year ago. This continues to validate the power of our single technology platform with our customers.

Channel execution was strong again in Q3, with channel bookings growing 62% year-over-year. Channel drove 54% of new bookings overall, including 9 of our top 10 deals. Channel also helped the mid-market achieved ARR growth of 44% year-over-year.

I'm particularly pleased to see accelerating market adoption of our contact center solutions. Contact center bookings grew 90% year-over-year as compared to 41% growth in our last quarter. It represented 33% of our total new bookings this quarter as compared to 24% last quarter. More importantly, all of our top 10 deals included contact center, which demonstrates the criticality of having contact center as part of a single scalable technology platform.

New customer logos represented 59% of total bookings. One such win was a 7-digit TCB Avaya on-premise replacement. This deal included more than 1,300 seats of 8x8 X Series, including both UC and contact center, with an insurance adjusting firm that manages complex environment that must scale up with little notice. Their business requirements included a more flexible contact center and a mobile collaboration solution with a single user experience for voice, video meetings and messaging.

Another large 7-digit TCB Avaya on-premise replacement win was with a North American industrial distributor with over 20 centers throughout U.S. and Canada. The customer was looking to modernize their contact center and enhanced workforce collaboration as well as offer omni-channel communication options to its customers. A biotech series was selected for its tight integration of contact center and workforce management capabilities.

A large Mitel on-premise replacement was a 7-digit TCB win with a U.K.-based service provider. This customer is replacing on-premise communication systems across 250 sites and chose the 8x8 X Series, including contact center to deliver multichannel capability to over 4,000 seats.

I'm also pleased to see that land and expand continues to be the norm with our mid-market and enterprise customers. A great example of our X Series platform, driving a 7-digit TCB customer expansion is Vacasa, North American's largest vacation rental management platform. After a recent purchase of Wyndham Vacation Rentals, Vacasa wanted to remain true to its mission, drive industry-leading revenue for homeowners and unforgettable experience for its guests. It was important to bring the Wyndham Vacation Rentals property management into its contact center process. In doing so, they've added additional 8x8 X Series seats to the initial contact center deployment so the business can continue to operate seamlessly.

Turning to product innovation. We launched 8x8 Video Meetings, a free standalone service, enabling users to easily schedule start and join HD video and audio conferencing from any device or room without the need to register or download software. Released just in mid-November, early adoption has been very encouraging and stands as another entry point onto the X Series platform. We are on track to launch our 8x8 Meetings Room solution this quarter. This goal is to bring easy video collaboration to every huddle and conference room space with an intuitive interface and smart pairing technology to connect to devices.

We also recently purchased WebRTC quality monitoring and analytics technology from Callstats.io. Callstats has been a long-term technology partner. And with this acquisition, these strategic capabilities become part of our integrated X Series platform.

Looking at contact center, we recently announced new capabilities, including 8x8 Secure Pay, enhanced outbound dialer and expanded quality management capabilities. Also, we were honored to receive the 2019 Customer Experience Innovation Award from TMC's Customer Magazine, recognizing 8x8's contact center approach to delivering exceptional customer experiences.

Turning to CPaaS. We continue to build traction with large multinational customers, including signing a leading food retailer with more than 1,000 outlets across the Asia Pacific region. This enterprise customer will use our CPaaS SMS solution to improve their consumer delivery service.

Additionally, we are very excited to have deployed our initial voice CPaaS services, bringing expertise and capabilities from our X Series platform to our portfolio of CPaaS offerings. We now have several production customers on our voice CPaaS services, including a new contract with one of the largest and fastest-growing ride-hailing and digital service companies in Southeast Asia.

Our strategy of coupling CPaaS capabilities with voice, chat, video and contact center opens up a huge opportunity for us to penetrate our installed customer base and expands the differentiated use case we can deliver with our single technology platform.

The second topic I'd like to address is continued channel progress, particularly with the addition of significant new strategic partners this quarter. As you are aware, there are 2 different types of channel partners in the community. The master agent referral channel and the VAR channel. As I mentioned earlier, our referral program has grown dramatically over the past year and now consistently delivers over 50% of new bookings.

Our global VAR program allows us to reach yet another massive installed base of customers that are also looking to replace the legacy on-premise communications infrastructure, but prefer to buy from their trusted VAR instead of directly from the service provider. 8x8 offers a compelling value proposition for VARs for 3 reasons: first, thanks to the X Series platform, we are the only ones in the market today who can offer both standalone and bundled solutions with no need to integrate additional products; second, VARs can leverage 8x8's best-in-class partner portal, PartnerXchange, which was enhanced to a VARs to independently "order, provision and manage customers" as well access certification content and marketing assets; and finally, the VAR community can continue to operate in their existing reseller business model, retaining ownership of the end customer and leveraging their existing selling motions.

It was these foundational advantages that led to CloudFuel, our partnership with ScanSource and Poly. As we have talked about before, this was the first time a comprehensive frictionless hardware replacement and cloud migration program has been offered to the VAR community. CloudFuel opens up access to over 15 million Avaya seats and gives 8x8 a large market for ongoing customer acquisition and initial set of ScanSource's VARs have already undergone training and enablement, and we expect CloudFuel to be available to end-user customers this month.

In addition to this, I am pleased to announce the expansion of our U.K. VAR program with Softcat, Charterhouse, NSL and Computacenter. 4 prominent U.K. VARs including the U.K.'s 2 largest VARs for channel reseller news.

We have already closed an initial set of X Series deals with these partners including the replacement of an on-premise Mitel customer that is a leading home care provider in the U.K. with both UCaaS and CCaaS solutions.

We're excited to continue to see the VAR community approach us on a global basis to work with them across our all-in-one cloud-based platform for voice, video, meetings, collaboration, contact center and APIs.

In total, there are more than 350 million legacy seats globally, Avaya, Cisco, ShoreTel, Mitel and other on-premise solutions right for cloud migration. And 8x8 has the leading cloud platform available today to meet business needs across unified communications, video meetings, collaboration and contact center.

Finally, I'd like to take a minute to discuss recent leadership appointments and how we are aligning our global business to drive both improved execution and efficiency. We announced Marge Breya as our new Chief Marketing Officer, responsible for all marketing globally, including product and corporate marketing, communications and demand generation.

Second, we promoted Sam Wilson to Chief Customer Officer and Managing Director of EMEA. Sam will own the customer life cycle globally, including deployment, professional services, customer success and customer support. Sam ran the global small business and U.S. mid-market sales for over 2 years, where he built out the sales engine and e-commerce capabilities to drive the flywheel of adding customers and reducing acquisition costs.

Our third executive appointment is the promotion of Homero Salinas to Group Vice President, Commercial Sales. Homero will provide leadership for our commercial sales team in both North America and the U.K. I'm excited to have Homero take the reins from Sam on the broader commercial sales front and expect that moving ahead, we will be able to run even faster.

In conjunction with these announcements, we also took steps to realign our global operations. We have spent a lot of time and energy building out a true global footprint over the past several years with offices in the U.K. Singapore, Sydney, Cluj, Minneapolis and new offices in the Bay Area in Campbell and San Ramon. We're now in a great position where we can hire talent globally to optimize and streamline our operations.

In parallel, we continue to invest in product innovation. We see not just customers, but also market and industry analysts really starting to understand the value of a single technology platform. We will continue to invest to maintain our technology leadership to provide true differentiation for the long term.

In summary, it was a very strong quarter for us, driven by steadily improving execution and market momentum across our global business. We're focused on broadening the mid-market and enterprise business with the investments we are making in our customer-facing teams and deepening our relationship with customers and partners.

With today's new VAR partnership announcement, and the earlier announced strategic partnership with ScanSource and Poly, we're excited to broaden our global channel partner reach and empower enterprises to migrate to the cloud with confidence.

Finally, I'd like to take a moment to thank my 8x8 teammates around the world for their hard work. Their commitment to our customers and partners will enable us to finish the year strong and positions us for future growth in delivering $0.5 billion revenue run rate in the near term.

With that, let me turn the call over to Steven.

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [4]

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Thanks, Vik. Good afternoon, everyone. We appreciate you joining us. I'd like to review 3 topics today. First, I'll start by reviewing the financial results for our third fiscal quarter ending December 31. Second, I'll share info around the actions that we've taken that are improving our operating efficiency and support our commitment to exiting Q4 fiscal 2021 at breakeven. And third, I'll go through our outlook for fiscal Q4 and the full fiscal year 2020. We'll wrap up with Q&A.

Jumping into Q3, we delivered very strong revenue results as exhibited across multiple metrics. Total revenue grew to $118.6 million in Q3, up 32% year-over-year and service revenue came in at $113.6 million, also an increase of 32% year-over-year.

Non-GAAP pretax net loss for the third quarter was approximately $16.3 million, coming in better than outlook. This marks the third consecutive quarter that our financial results have finished above the high end of our guidance.

There were 4 primary drivers of our Q3 financial results: one, strong execution in our go-to-market initiatives centered on demand gen and solid pipeline coverage ratios with particular strength again from our channel partners; two, continued success moving upmarket with mid-market and large enterprise customers, growing nicely with 8x8 platform purchases and becoming a larger part of our portfolio; three, contributions from our CPaaS offerings that continue to be integrated into and a compelling differentiator of our global platform, and that included a full quarter of results; and four, strong organic bookings growth of 30% across both new and existing customers, with particular strength in our contact center offerings, as Vik just mentioned.

You can see the strength in our operating and business performance metrics, where total ARR came in at $411 million for the December quarter, 33% year-over-year growth. And the result of a combination of solid organic growth in our UCaaS and CCaaS businesses and contributions from our CPaaS offerings. Q3 had 592 customers, generating ARR greater than $100,000, 57% year-over-year growth, and that speaks to the growing success that we're seeing with large enterprises. We closed a record 40 new deals in the quarter, generating ARR greater than $100,000, and these customers represented 33% of new bookings, up from 29% in the prior year.

Looking at ARR by customer size, Q3 was another quarter of solid growth, where ARR grew above market and small business at 18% year-over-year, 44% growth in the mid-market and 85% year-over-year growth with our enterprise customers.

We continue to focus on mid-market and enterprise customers that have attractive CAC, drive higher lifetime value and lower churn.

Looking at our unit economics metrics, average annual service revenue per customer increased 27% in the mid-market and 28% in our enterprise segment. Coming in at more than $43,000 per year for mid-market customers and more than $181,000 per year for enterprise customers. We're seeing our customers purchase more seats and with our X Series product platform, and we're also seeing more contact center included, such that contact center is growing faster and is making up a greater proportion of our bookings.

Looking at Q3 OpEx, the takeaway is that we're starting to deliver some operating efficiency and improvements. Non-GAAP sales and marketing expense flattened out in Q3 at approximately 47% of revenue, R&D came in at 11% of revenue in Q3 versus 13.5% in Q2, and G&A improved to 12.3% in Q3 from 12.8% of revenue in Q2. As we indicated at the outset of the year, as we look to drive growth from our investments in product and go-to-market, we will also be driving operating efficiencies. As we've discussed, it isn't a linear relationship in which every metric will improve every quarter, but we've begun delivering returns, and we expect continued efficiency improvements going forward.

In this current fiscal Q4 quarter, for example, we expect some improvement in sales and marketing as a percentage of revenue.

Also notable this quarter, as Vik mentioned, our global VAR program is garnering considerable partner and customer interest. Last quarter, we announced the development of CloudFuel our first strategic partnership with ScanSource and Poly. And with it approximately $6 million to $8 million of nonrecurring initial expenses over the course of Q3 and Q4 on migration tools, our next-generation partner portal, marketing campaigns, training and enablement activities and deployment services. We're on track with that plan and expect modest revenue contributions beginning in the first half of fiscal 2021, as CloudFuel and other new VAR partnerships and customer traction begins to ramp.

Wrapping up Q3 results. We further strengthened our balance sheet this past quarter through the issuance of an incremental $75 million in convertible notes from our original issuance from February 2019 on some very attractive pricing in the market.

With that perspective, let me now talk about the backdrop of the investments that we made this past year and the timing of why we've now taken steps to drive returns and operating efficiencies going forward on the heels of our bookings and growth success. We continue to prioritize investing for growth. As we've communicated, our investment strategy is focused on 3 core elements to continue to drive revenue growth and stockholder value: one, investing in our demand gen and go-to-market engine; two, maintaining our strong technology platform advantage with the continued investments in product innovation; and three, driving the VAR channel as another front to unlocking the several hundred million legacy on-premise seats owned by these key ecosystem players.

Throughout the past year, we've invested in our demand gen and channel master agent referral program in both head count and program spend. We invested in getting the right talent on board, sales and channel enablement materials, compensation plans and spit structures, website content and search optimization.

We've seen these investments bear tangible successes in the form of strong pipeline coverage, organic bookings growth north of 30%, channel bookings growth consistently north of 50%, numerous industry and partner recognition and new customers increasingly turning to 8x8 because of our single technology platform.

And so with both the insights and experience that I've gained through my tenure here at 8x8 this first year, and now with strong pipeline coverage, bookings, execution, traction, revenue growth and our global infrastructure in place, this was the right time for us to now implement specific initiatives to drive efficiency in our operations and further support our targeted path to breakeven on a non-GAAP basis.

Accordingly, we recently took steps to realign our global operations and cost structure, so that we may continue to not only focus on our technology platform and go-to-market success, but importantly, also move to drive meaningful COGS and OpEx efficiencies. Our approach to this realignment was about moving forward from our foundation of strength to build the most competitive business structure for the company for the longer term.

Specifically, our recent actions centered around 2 dynamics: first, we took out spend and overhead from our cost structure so we can focus on the core business areas that deliver growth; and second, we shifted how we execute globally to drive operating efficiencies across the company, most notably in the U.S. and through offshoring initiatives to our various geographic centers in Europe and Southeast Asia. I talked about this offshoring last quarter and now we're executing on it.

In doing so, we moved several functions and head count out of the high cost locations in the San Francisco Bay area, New York and London, to more cost-effective and still talent-rich areas in Romania, Minnesota, the Philippines and India. The net is that less than 100 roles were eliminated with the majority being non revenue-generating functions.

We expect this approach will further enable us to drive operating efficiencies across all expense areas from COGS to G&A, and importantly, the realignment provide added support to expand gross margin.

While Q3 saw some margin pressure from a full quarter of CPaaS operations in the mix and some incremental spend on operations and readiness for our VAR program launch that we discussed, we anticipate improving our gross margin percentage in the current Q4 fiscal 2020 quarter. Improvements are expected to continue over time through a combination of cost discipline, higher margin organic growth and continued operational efficiencies.

Overall, we expect these actions will drive greater global operational efficiency and achieve alignment between our costs, strategic priorities and capturing organizational efficiencies. They reflect our continued commitment and increased confidence in delivering on our path to breakeven on a non-GAAP basis exiting next fiscal year, as we've communicated. I look forward to talking more about this as we plan to share thoughts with you on fiscal 2021 on our next earnings call expected in May.

Taking this all into account, I'd like to turn to the financial path ahead and share our outlook for the fiscal Q4 quarter ending March 31, 2020, and what that means for the full fiscal year ending March 31, 2020. For Q4 fiscal 2020, we anticipate total revenue to be in the range of $118.9 million to $119.4 million, representing 27% year-over-year growth. We anticipate service revenue to be in the range of $114.4 million to $114.9 million, representing a year-over-year growth of 28.5% to 29%. And we anticipate non-GAAP pretax loss to be approximately $14.1 million.

The implications of this on the full year fiscal 2020 are that we are raising our revenue guidance and maintaining our non-GAAP pretax loss guidance, such that we anticipate total revenue to be approximately $444 million, representing 26% year-over-year growth. We anticipate service revenue to be approximately $425 million or 27% year-over-year growth, and we continue to anticipate full year fiscal 2020 non-GAAP pretax loss to be approximately $60 million.

So to wrap up, I just passed my 1-year anniversary here at 8x8. Demand gen is now consistently working and we have record pipeline coverage. We added leading video meeting and CPaaS technology to our platform. We launched a new global VAR program with well-respected partners who are helping us displace over 350 million on-premise seats. And we realigned our cost structure and global operations to drive efficiency and support our path to breakeven exiting next fiscal year in March 2021. I'm more excited now than when I got here.

With that, we appreciate your support, and we'll open the questions now -- the call now for any questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Michael Turrin with Wells Fargo.

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Michael James Turrin, Wells Fargo Securities, LLC, Research Division - Senior Analyst [2]

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I guess maybe to start off, Vik, in terms of the competitive commentary, you mentioned 4 of the top 10 wins coming from the legacy side. That side was also telling a similar tale, maybe to no surprise at their conference this week. So just maybe more from your perspective in terms of what might be driving that acceleration in migration today and what might give you confidence that can continue?

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Vikram Verma, 8x8, Inc. - CEO & Director [3]

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Yes. So from our perspective, we have a fully formed platform. And the key part that we have noticed is there is no exclusivity between Avaya and Avaya's customers. So the moment that Avaya started offering cloud solutions, all of their customers started shopping around. And we have a fully formed solution where we are able to go-to-market, and it includes a contact center. So that already gives us a competitive edge. So we started to see quite a few Avaya customers come to us.

The second part that was actually even more interesting, and I think that is something we are uniquely positioned to do. Because we have 1 platform and it had voice, video, contact center, and it's all integrated together, it has all the CPaaS, we can essentially enable VARs. We've developed this thing called the PartnerXchange, and that's what the ScanSource relationship is all about and the relationship with ScanSource's VARs, plus the relationships that we just came up with in the U.K. The VAR model is -- the VARs typically have the relationship with the customer, not the service provider. So in essence, what we are doing is we are allowing VARs to go to their customers and sell our products, and it's obviously labeled with 8x8, but the VAR is selling it, the VAR is deploying it and the VAR is supporting it, which is the traditional model. That has been one of the impediments to this whole move forward.

So in essence, now we have 2 routes to market, both of which are working. I have the referral channel, the master sub referral channel, which frankly, as you can see, has been consistently growing, and for us, now represents over 50% of our bookings, and that's working perfectly. And then there's a whole new slew of channel partners, which are the VAR channel partners that had resisted the move to cloud because they wanted ownership of the customer. And what we have done is we are now enabling them to go to their legacy base and offer a complete, comprehensive cloud solution but they are providing it, and they are selling it for us, and we're supporting them and selling it for us.

So as I said, from our perspective, all of the -- the shaking up of the market is all a good thing. And having this complete and comprehensive platform is a good thing. And I think we've literally got hundreds of Avaya customers already online that we've been able to basically deploy. And so we've had the experience of what it takes to migrate those guys and it isn't easy, but it's something we're good at.

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Michael James Turrin, Wells Fargo Securities, LLC, Research Division - Senior Analyst [4]

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That's clear. I appreciate that, Vik. Maybe one for Steven. You stepped through some useful detail in terms of efficiencies. I was hoping to revisit some of that commentary and maybe get into a little bit more detail. Can we talk about the underlying mix shift that may be impacting gross margin trajectory? And then in terms of free cash flow, I'm assuming some of the step-up in CapEx there was related to the relocation in terms of headquarters. But anything you can do to kind of help us quantify and parse through some of those impacts, particularly as we're looking towards this profitability target exiting next year is certainly helpful?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [5]

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Sure. Yes. Yes, great questions. Take the last one first. It's fairly straightforward. Our operating cash flow, our free cash as well improved apples-to-apples from Q3 over Q2. There were a few onetime items in both of those quarters. We had the Wavecell acquisition in Q2. That was a big negative of negative 60. And we obviously had the convert deal in Q3 that was a positive 65, that basically washes. But to your point, Q3, also the cash balance was burdened. In this quarter, a onetime item was the build-out of our headquarters office, new office space for about $15 million and change. And so that was a big degradation. Without that, declining in cash would have been less down to the $28 million ZIP Code, an improvement over Q2 and we expect that to continue improvement going forward.

To your point on gross margin, Q3 had a mix of 3 or 4 things. One, there was more costs in our core in the UCaaS, CCaaS. We talked a little bit about that and so far as the VAR readiness, if you will, so there was some element of that. We also had a little bit more CPaaS than we anticipated. And so there's a bit of a mix shift, if you will, that was pressure on gross margin. One, we had a full quarter's worth, but we had even more than we anticipated. There was also more product revenue.

So that was a drag on gross margin that you could see the economics there that brought that down. And prof services was also a little bit more of a drag. When you add those all up, that's how you get to the degradation.

Looking ahead, and I talked about this a moment ago for Q4, there are 2 meaningful drivers of gross margin expansion, and we would offer that we expect that improvement to be going forward, not just a Q4 event. And that is, we see more favorable cost structure on our underlying core UCaaS, CCaaS operating structure. So our ability to deliver, our cost structure, some of the efficiencies that we just drove in our realignment would all act to drive back up to higher gross margin levels on UCaaS, CCaaS.

We would also anticipate a bit of an improvement in our CPaaS business, both from a mix shift as well as an aggregate rise in the CPaaS gross margins. We've talked a bunch about this in the past, one-on-one as well as with others. Where the CPaaS business is expanding to the European theater as well as the U.S. and offering higher-margin services like chat and voice. And so as those 2 dynamics, geography and products that roll out more and more over the coming months, we expect to see margin lift from the CPaaS contribution.

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Operator [6]

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Your next question comes from the line of Ryan MacWilliams with Stephens.

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Ryan Patrick MacWilliams, Stephens Inc., Research Division - Senior Research Associate [7]

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So first off, congrats on reaching the 30% year-over-year service revenue growth milestone in the quarter. Hopefully, more to come there. And also, the $3 million increase in deferred revenue was another positive, and it seems like an increase due to improved contact center bookings. What about your bundled offering is currently resonating with customers? And do you have any new marketing initiatives under the new CMO to promote this bundled offering?

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Vikram Verma, 8x8, Inc. - CEO & Director [8]

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So I'll take that one. So a couple of things. The main part that is the most interesting thing, and this is where I think there is a big opening for us. Everybody is generally now concluding that you need one platform, right? Which is most people are buying both contact center as well as UCaaS together. The most interesting statistic for me was that for our customers, we look at customers greater than $12,000 ARR. So if you look at those customers, the number of people buying both our unified communication and our contact center solution jumped up from 51% 1 year ago to 71% this year. And we are seeing that as a trend. And by the way, that tends to be a trend, particularly for Avaya customers because they're used to buying both unified communication and contact center. And frankly, that's where a lot of the confusion has been created because there is -- they are teamed up with one vendor for UCaaS, but they're going to go develop their own contact center solution, but their other vendor had another pre-existing relationship with a contact center vendor. And so us being able to go in and offer this complete and comprehensive platform makes it very simple.

And then with regard to VARs, the VARs particularly own the customer. They have had long-standing relationships. And we've seen the effects of that because we started closing our first few deals with VARs, where we play a role of support, we play a rapport of training, we play a role of enablement, but the VAR pretty much closes the customer and what they're able to do is close with either UCaaS or CCaaS and upsell from there.

The more interesting thing is CPaaS then allows them to customize experiences, which allows services for the VARs as well as a level of customization and uniqueness for the customer. So from that perspective, what we're finding is this one platform concept is increasingly resonating, the ability to have APIs through CPaaS is hugely differentiated.

And then the most interesting thing we're finding is add video to that mix where contact center combined with video and a level of customization that can happen there becomes a game changer. It was quite an interesting trend where the number of customers that basically bought our contact center that wanted us to move forward with CPaaS engagements as well as video conferencing as an addition to all of that, it was quite, as I said, heartening. So I'm increasingly bullish about that. And as far as I'm concerned, every Avaya customer that is out there. There is no exclusive relationship between Avaya and their customers, and our intent is to compete for every one of them either directly through our master sub channel, or through our VAR channel, but every one of those deals will be competed because I think we have a compelling offering, which is cost-effective, and we have the migration ability as we have demonstrated by -- I think we have approximately 10,000-plus seats that we've already migrated over. And so from that perspective, we should be in a very positive position.

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Ryan Patrick MacWilliams, Stephens Inc., Research Division - Senior Research Associate [9]

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Perfect. And this one is for Steve. The Wavecell meet your calendar 2019 revenue expectations that you laid out at acquisition. Any color on growth there would be helpful? And for the higher-margin APIs, have you seen any particular traction in voice or video?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [10]

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Sure. So generally speaking, we are pleased with the CPaaS business. I think what the more important thing to us, candidly, is the technology. The revenue piece is obviously helpful and that's nice. But the immigration of the open API framework into our video, voice and, most importantly, the contact center offering and how we're engaging with customers has probably been the biggest high five around the floor. So we're happy with the business, how it's performing. They're growing nicely in region. They're adding more customers. They're adding more countries, most importantly, coming to the U.K. and the U.S., and so we're pleased with where that is.

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Vikram Verma, 8x8, Inc. - CEO & Director [11]

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I'll add another element because CPaaS as a differentiator for our core platform is increasingly valuable. Give you a very simple use case. So imagine if you are a customer with a contact center. So you're a vacation rental company, and you get your customer center gets a call to basically look for keys. The ability to send a -- a link, which can be opened on a web browser and instantly turned the customers phone into a camera, where they can look around and the customer service agent can then point to where they go or how they change the thermostat or something like that is a huge and massive productivity saving. That is an example of how you've taken a package solution, which is contact center and unified communication and by the addition of video conferencing as well as CPaaS, you've turned it into a unique customer engagement that is hugely differentiated. That's why we bought Wavecell, and we are seeing huge traction in that particular area, bundled with our products.

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Operator [12]

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Your next question comes from the line of Tim Horan with Oppenheimer.

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Timothy Kelly Horan, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [13]

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Vik, can you just maybe spend a little bit more time on the VAR side of things? How -- what percentage of the enterprise market do you think they control? Do you think your relationship with the VARs now is relatively unique? I guess is anyone else kind of given the same level of support and terms and conditions that you are? And when will the VAR channel really be up and running at 100%, do you think?

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Vikram Verma, 8x8, Inc. - CEO & Director [14]

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Okay. Great question. So early days. So just at the ScanSource and the ScanSource control and their distributors and VARs control approximately 15 million Avaya seats plus/minus. And we will have the first set of initial VARs fully trained, enabled, and they will be in market with their end-user customers this month.

With regard to U.K., there are several million seats that are Avaya seats, that are up for grabs. And as you know, we signed a VAR relationship with the top 2 U.K. VARs. Some of them have already closed deals with end-user customers. One of our larger deals last quarter was closed through a VAR. So we are starting to see VAR as a nontrivial approach to the market. And we think that has been some of the impediment to the move to cloud. So if you think about it, the master sub referral channel is phenomenal. They've done a great job for us, and we appreciate the relationship, and we are starting to become more and more the vendor of choice, I think, both Intelisys and a few others just recently recognized us for being their top vendor.

What is now interesting is -- but there's been an entire set of channel or customers that have not moved forward because they're used to dealing only with their trusted VAR and they don't want to deal with the service provider. Us enabling the VAR to essentially be the front where we can basically go out and enable the VAR to go provide the same kind of service to their end-user customer using our PartnerXchange, we think opens up a very significant portion of the market. And that is additive to basically the ability going to the master sub channel. And then the ability through CPaaS for VARs to be able to provide customization services to the end-user customer ends up providing that much more value for both the VAR and the end-user customers. So we believe by building this one platform, we have 2 very unique ways to go to market. We can go the master sub route, which is working very well. And as I indicated, is now 50-odd percent of our bookings. We're enabling the VAR, which now basically is starting to work with the first few initial wins, but it really is a win-win for the VAR. The VAR gets to go in and maintain the existing business model and provide customization services, and for the customer it's a win because they're used to dealing with the same trusted person that they have always dealt with. And I think we're unique in our ability to do that as evidenced by the relationships we are signing.

I think we'll start to see revenue impacts of that in FY '21, in early stages, but we've already had our first few wins using the VAR channel.

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Timothy Kelly Horan, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [15]

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And are these relatively exclusive? I mean I know they're not absolutely exclusive, but do you expect to be the primary partner?

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Vikram Verma, 8x8, Inc. - CEO & Director [16]

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I expect to be the primary partner, but I never asked for exclusivity because I'm never willing to give exclusivity. So from that perspective -- but I think we will end up being the primary partner. And as I said, our single platform is uniquely positioned to do that.

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Operator [17]

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Your next question comes from the line of Mike Latimore with Northland Capital.

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Unidentified Analyst, [18]

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This is [Vijay Devar] for Mike Latimore. Could you talk about a churn in small business segment and generally across your customer base?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [19]

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Sure. So churn, as we've talked about before, is primarily for us a function of customers that are on our legacy platform. And so customers with an generally older functionality of product, not on X Series. A churn by definition is lower for customers we have experienced once they migrate to X Series and for those customers who are on X Series, it's lower. And so our focus has been and is now this year, moving customers, migrating the remainder of our legacy customer base to the X Series. That's something that we're starting to get more traction around and we anticipate moving the bulk of our customer base over to X by the end of this calendar year.

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Unidentified Analyst, [20]

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And is Wavecell in your bookings number?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [21]

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It is not. When we report our bookings number, that is organic, if you will, meaning as the UCaaS and CCaaS business. In that business, that's where customers sign up for committed contracts with us over typically a 3-year period. The CPaaS business historically and currently, for the most part is a usage-based business, where customers are signing up, we become part of their operational infrastructure. And so there is some very core amount of baseline revenue that they generate, but it is usage-based revenue that is not reported as bookings. So when we report our bookings growth of 30%, that is all the core UCaaS, CCaaS business.

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Vikram Verma, 8x8, Inc. - CEO & Director [22]

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And migrations, by the way, will not be reported as part of bookings. Migration is just moving the customers from one platform to the other.

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Operator [23]

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Your next question comes from the line of Rich Valera with Needham & Company.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [24]

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The 4 Avaya deals you mentioned, one, were any of those a result of the CloudFuel partnership? And two, do they require a higher level of incentives relative to your sort of standard deals? Was there anything unusually -- any unusual incentives in those deals?

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Vikram Verma, 8x8, Inc. - CEO & Director [25]

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No. No unusual incentives. The key part with regard to CloudFuel, CloudFuel will be in market this quarter. So the initial wins we've had have been through our U.K. VARs. And also actually 1 other VAR that we have in the U.S. But yes, no unusual incentives. As a matter of fact, it actually is quite -- works out quite well from a incentive perspective because spiffs and other things that are lower, and the customer takes on -- or the VAR takes on a significant portion of the selling, support and deployment costs.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [26]

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Got it. And then just to drill down a little bit more on the gross margin. I know you've given some color on this, Steve, but gross margins dropped about 800 basis points since you have completely folded in wells Wavecell and by my math, about 400 of that should be due to Wavecell, suggesting another 400 from sort of other factors, which you alluded to. So I'm just wondering, should we be thinking about gross margin once you've got through some of the migration stuff you're doing, the CloudFuel costs, should we be thinking of it bouncing back on the order of, let's say, 400 basis points from where it was in the third quarter? Or any way you can help quantify that? And maybe how much you're thinking of in terms of a sequential gross margin improvement? I know you said it improved, but any quantification of that would be very helpful.

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [27]

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Sure. So the short answer is yes. We expect to improve orders of magnitude gross margin back into the 60s. Not next quarter, meaning in Q4. But over time, right? There's 2 sources of that. There is a more efficient cost structure that we have in the core business and there's a higher margin profile for CPaaS contribution. And so -- we'll talk more about kind of target model, gross margin profile, I suspect, in our earnings call next quarter when we close out the fiscal year and look forward. But we do expect an improvement in Q4, not on the orders of magnitude, where -- if you said 400 basis points in Q4, not so much.

Coming -- as you said, coming from where we are now with a trough hopefully, then that would be great if we start our client back up.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [28]

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I think would 50 to 100 basis points be reasonable?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [29]

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Yes. We just haven't technically given guidance on gross margin percentage per se, but you would hope to see some expansion, at least, in that ZIP Code.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [30]

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Got it. And then you -- just with respect to the guidance, you raised -- the service revenue by $3 million, and you kind of maintained the loss there and would have hoped see some flow-through of that to the -- should improve bottom line. Is there anything you can point to there? Why the bottom line didn't improve despite the improved rep guide?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [31]

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Yes. We -- this was part of our approach to managing the business. We decidedly invested a lot, really the first 3 quarters of the year. And so it really was in anticipation of returning back to a more healthy expense growth and expense run rate. And so we saw this as part of our target and operating structure that we needed to get to, which is why, candidly, we've been so vocal about calling out that we are spending a lot of money historically here in Q1 and Q2 and Q3 on those 2 big areas of go-to-market marketing specifically, demand gen and on our product innovation and technology. And so this was part of our thought process and how we saw it go forward. So there's no surprise to us, and so far as the bottom line, this is what we have been managing to.

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Operator [32]

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Your next question comes from the line of Catharine Trebnick with Dougherty.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [33]

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So I want to drill back into the Avaya opportunity. So my question has to do with, there are, as you said in your prepared remarks, over 15 million Avaya seats out there. But also in talking to all the various channel partners, there's hundreds and difference of Avaya implementations, right? Different operating systems, different integration. So what kind of plan do you have in place to facilitate an easy win, if it's this version -- over this version to speed up some of that?

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Vikram Verma, 8x8, Inc. - CEO & Director [34]

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Yes. That's a great question, Catharine. And that was why some of the press we saw about how it would be easy just through quick relationships for competitors to migrate everybody all over to Avaya. I mean as you know, even Avaya has multiple flavors of phones. So I think they have the SIP phones, but they have a whole series of other phones. So there is no easy answer. So we have built a lot of migration tools as part of it. As I indicated, we have had quite a few wins with Avaya customers and Avaya replacements, and they fall into 3 or 4 very broad buckets. And so that was part of the thing as part of our relationship with ScanSource as well as some of our relationship with the various VARs is to develop a series of very clear migration tools and processes by which we will be able to migrate existing Avaya customers. And we also kind of highlighted 2, 3, 4 features that are important to Avaya customers and make sure we try to kind of prioritize them on our product road map, so that they are able to move forward in that area. And then that is also part of the relationship with Poly when, in some instances, where you have legacy phones and that are not SIP compatible. And so the idea is on those phones, we will work with Poly to basically to make it easy for the customer to be able to literally get a subsidized phone and transfer over to a very modern phone.

So this is a big, very thoughtful process that our team put together about 1 year, 1.5 years ago, and we've been systematically working towards it because Avaya has 100-odd million seats, through ScanSource, we accessed 15 million of them, but my intent is to go after everyone that isn't Avaya seat. And frankly, if you're an Avaya customer, and you have no exclusive relationship with Avaya, it is very much in your best interest to look out for what is your best option. We are a very credible option. And since we particularly have one integrated platform with the contact centers already built in, and we have the CPaaS and the video conferencing, and it's not a hogdepodge of stuff assembled together. We think we provide something very compelling for those Avaya customers and our intent is either through our master sub channel or through our VAR channel to go after every one of them.

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Operator [35]

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Your next question comes from the line of Meta Marshall from Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [36]

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Question on -- I know part of the intent of Wavecell was to kind of bring better analytics to the X Series platform. And just wanted to get a sense of kind of progress on some of those initiatives? And then second, on the professional services drag, just -- is that investment just due to growth? Or is contact center kind of taking more professional services? Just any insight on that.

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Vikram Verma, 8x8, Inc. - CEO & Director [37]

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Okay. So Wavecell was actually -- we have analytics. Wavecell was actually to provide customization to our core platform. So the example I would use and happy to set up a demo because it really is kind of unique is if you were, for example, a vacation rental company and you rent out a house, and you call the contact center agent and say, I can't find the keys. The normal approach would be, okay, I'm going to get somebody in a car to go meet you at the house, so they can help you find the keys. With CPaaS, what you're able to do is literally send a custom link, somebody presses it on their web browser, and now their phone becomes a camera, and they can look around and say, "Hey, no, no, point the camera to the left or right, there's your keys." Now you've saved a huge amount of work and you've increased customer satisfaction. That's one example. Also the ability that if you have a phone call at the end of it, I can send you a quick link, where did you like the phone call? Did you not like the phone call or something like that. That's what CPaaS is intended to do. It adds that customization, it adds that customer engagement as in addition to our overall package solution.

Callstats.io which is the company we just bought, which is de minimis actually no revenue, but a very interesting technology is for WebRTC. It analyzes all call stats and flows for our -- for WebRTC endpoints. So it ensures that we had end-to-end analytics. So that's something that's core to what we did. And now we've added Callstats.io to add that to WebRTC as well.

But as I said, that's one part. Wavecell is intended to add the customization and that entire layer of personalization to both contact center and UCaaS. And increasingly, a lot of our customers are using that as a way to say, okay, it won't just be a contact center, I'll be able to personalize my experience unique to my customers, and we're seeing Wavecell be a significant player in that.

I think with regard to professional services, why don't you take that, Steven, and...

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [38]

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Sure. So Meta, professional services for us is mostly -- I know you and I have talked about this, mostly deployment services. There's some element of higher margin, high value-add prof services, sure, but it's mostly deployment. And the dynamic of those services is fairly different between more of the flywheel SB model and the large mid-market enterprise deployments. By a large mid-market enterprise deployments are fairly understood economics and pricing, and we still have some pricing power on that, and those are not really massively loss-making ventures for us.

Where we have some work to do, and we're thrilled that Sam is now taking this on as Chief Customer Officer and putting together all of the deployment and thereafter, facing work with customers, is looking at really partnering with our engineering team and building a more fluid, less friction, higher speed deployment tooling to our capabilities to drive leverage to get customers deploy it quicker, faster and cheaper. And so it's something that we've begun the migration to. And so we're pleased with that, and we expect to see improvements in our deployment gross margin over time. Are we going to see a huge lift in Q4 from that? Not so much, but I'm kind of looking at Vik, and I'm sure that's on Sam's goals for the next 6 months to start driving that to be better.

Is that make sense so far as the color on what -- how that comes together?

I mean could I've objections so ordered?

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Vikram Verma, 8x8, Inc. - CEO & Director [39]

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Meta, you there?

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Operator [40]

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Your next question comes from the line of James Breen with William Blair.

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James Dennis Breen, William Blair & Company L.L.C., Research Division - Communication Services Analyst [41]

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Just a couple, a little bit on the margin structure as well. Is there any difference as you're talking about a lot of the sales this quarter with contact center? How does that in the mix -- excluding CPaaS, how does that impact the overall margin structure? And then around CPaaS, as you're getting scale there and you're getting the -- there's a cost side to that equation, which I'm assuming you're getting some benefits there as you get bigger. Are you passing on some of that savings to the end user in an effort to drive higher volume growth? Like, sort of what's the thought there in terms of the direction you're going?

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [42]

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Sure. Vik and I will tag team on this. So the gross margin structure, the first part, I apologize was -- the second part was CPaaS and the first part was...

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Vikram Verma, 8x8, Inc. - CEO & Director [43]

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Contact center.

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [44]

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Contact center. Yes. So short answer is yes. The contact center gross margin is lower than UCaaS gross margin. And so the more contact center you do, that will pull it down more towards the mean. It's still above where our gross margin is right now. So doing more contact center still pulls our gross margin up. If we were to add one more dollar of gross margin today, it would have pulled it up. So that's an important message. But your instinct is correct. On the CPaaS side, it's a usage-based volume model. And so a lot of the economics for us are baked into a lot of the contracts with our customers at the time of signing. And so the margin expansion for us comes really from geography and product, less so from changing in pricing with existing customers. Over time, do you have more pricing power with more value-add services? Sure. But for the most part, in the very, very core SMS message-based products, we're really looking at maintaining pricing rather than driving savings and passing that on.

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Operator [45]

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Your final question comes from the line of George Sutton with Craig-Hallum.

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George Frederick Sutton, Craig-Hallum Capital Group LLC, Research Division - Partner, Co-Director of Research & Senior Research Analyst [46]

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Steve, I wondered if you could just walk through the goal of non-GAAP profitability by next year's, year-end. As you're doing the planning process, could you just talk through the importance of that metric where you may run into situations where you might otherwise want to invest for growth? I just wanted to get a perspective on that.

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Steven H. Gatoff, 8x8, Inc. - CFO & Principal Accounting Officer [47]

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Sure. That metric candidly is top of the list for us. We are doing our fiscal '21 planning right now, had a Board meeting a few weeks ago and started going through that with our Board. Our whole team is oriented around that. And we see that candidly as a very important sustainability and credibility factor to driving growth, right? And it's a mix of driving growth, by driving profitability to support that growth. And so how we get there? Really is two factors: one is growing revenue and contribution at a higher rate; and two is increasing costs at a decreasing rate. So it's the divergence of those 2 curves. When you ask, how do you get there? That's how we expect to get there. And so what we just did, the realignment we talked about was we removed a whole bunch of costs. And so that was good. We ratcheted down the whole cost structure, and we will look to increase costs at a decreasing rate.

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Vikram Verma, 8x8, Inc. - CEO & Director [48]

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And the point I would add, this goes back to the conversation I think we've had in the past about the platform. The whole idea of a platform is that you have multiple technologies with shared services on one common structure. And some of the painful things we had to do, we did -- now, I guess, 9 acquisitions over the last few years, is to put everything together with one common engineering team, which means anything that gets developed for contact center also applies for unified communication, any analytics. And this, I think, was one of Meta's questions.

We had acquired this company, MarianaIQ, which provided a layer of analytics. That entire analytics applies for everything from CPaaS to UCaaS to video conferencing to our contact center, et cetera. So that leverage of a platform means that for one more incremental dollar of engineering spend, I get a lot more productivity as opposed to -- I mean there's probably 30% to 40% shared between all of these various technologies. So that's one. Second, increasingly, because you're selling a platform to your customers, the same CAC can now be leveraged because once you sell UCaaS, you can sell a video conferencing, you can sell contact center service. This is all part and parcel of our core strategy. That's why you're starting to see engineering costs moderate, even though our innovation continues at this kind of pace. And then at the lower end, the big investments we made in e-commerce is so that the lower-end customers, we can increasingly send more and more towards e-commerce because then that CAC goes down. So from that perspective, you can kind of see how all the chess pieces over the last few years and the massive investments over the last few years are now starting to get to a point where they bear fruit, and that's how it will be reflected in our FY '21 planning process.

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George Frederick Sutton, Craig-Hallum Capital Group LLC, Research Division - Partner, Co-Director of Research & Senior Research Analyst [49]

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Great. One last thing relative to our CMO change. We've obviously seen different iterations over the years relative to search engine optimization and the branding focus. What generically would you say might be different with our new CMO?

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Vikram Verma, 8x8, Inc. - CEO & Director [50]

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So I mean, look, Marge has been -- she's a very experienced CMO, she was at MicroStrategy, so knows analytics. She was CMO of Informatica, CMO at BEA, a very senior market executive at HP, at SAP. There are very few people with that breadth of experience. She's been there, she's done that, everything from -- and she's very familiar with this whole concept of platform. So more and more we're heading towards platform and then leveraging the platform to basically get maximum utilization and CAC. So I think you'll see Marge continue to focus on efficiencies, digital spend, go-to-market on channel, branding, product marketing, et cetera, and kind of combining it all together.

But as I indicated, what Marge has done is she's come from an analytics and -- a background and a platform background, which we think gives us a huge edge.

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Operator [51]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.