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8×8’s (EGHT) stock price has fallen over 16% since the company reported its Q4 2018 earnings on May 24th, 2018. I believe that investors with a long time horizon should use this as an opportunity to buy 8×8. The company has a rapidly growing software business that is currently unprofitable due to the company’s prioritization of growth over earnings. In the long run, 8×8 should be a significantly larger and more valuable businesses than it is today. The recent pull back marks an attractive entry point for investors.
Before jumping into the business description, let’s quickly review 8×8’s most recent earnings report. 8×8 beat on sales estimates, reporting $79m vs $77m forecast by the street, but missed on earnings, reporting EBITDA of $0.9m vs $3.2m expected (Source: Capital IQ). Finally, the market perceived the company’s guidance for FY 2019 as being light. The disappointing earnings prompted Bank of America’s research analyst to downgrade the stock from “buy” to “hold”, further exacerbating the selling pressure.
8×8 Business Description
8×8 is an enterprise cloud-based subscription software business which helps businesses manage communications with their customers. 8×8 integrates all business-to-customer (B2C) communications facilitated by phone call, email, and chat into an easy to use software which enables a business’s salesforce and customer support team to communicate with a unified voice. All client communications are recorded, any customer notes are stored (similar to a CRM), and analytics are provided to help businesses target and improve their customer relationships over time. You can think of 8×8 as a CRM, a help desk, a business management system, team collaboration tool, and a communications platform all rolled up into one product, potentially replacing several software subscriptions with one.
Taking a step back, this is a huge market. Most mid and large-sized companies have an army of sales people and customer support reps, often siloed in different departments and different offices. The ability for these businesses to seamlessly connect all the client-facing employees with one customer tool creates a great deal of value for 8×8’s customers through more efficient management and better customer satisfaction/retention. Furthermore, to the extent that 8×8’s customers heavily integrate their sales and marketing into the platform, 8×8’s customers become very sticky because they would incur significant switching costs in the form of re-training employees and potentially losing valuable customer data in a transition. This is probably why 8×8’s monthly customer churn rate is 0.3% as of Q4 2018.
According to IDC, the size of the global Unified Communication and Collaboration (NYSEARCA:UCC) software market will be $40 billion in 2018. This includes legacy telecommunications systems as well as software and cloud-based services. The big opportunity for 8×8 is to win market share from companies using legacy PBX telecommunications systems and on premise licensed UCC software as they transition to cloud-based systems. Currently, cloud has 10% penetration in the UCC market. This is the key trend driving 8×8’s historical revenue growth in excess of 20% per year since 2013.
8×8 is on the leading edge of innovation in the UCC software industry. In addition to having strong cloud-based capabilities, the company has been making strategic investments in artificial intelligence and machine learning to develop new capabilities for customers including the recent acquisition of MarianaIQ. Gartner has ranked 8×8 in its UCC “leaders” quadrant for 6 consecutive years.
8×8 is currently rolling out its X Series product which began shipping in June 2018. The X Series marks the first product generation with machine learning algorithms incorporated to dynamically provide new customer insights. I believe the X Series could re-accelerate growth at the company. The company is adding significant headcount to sales and marketing teams which should result in added fuel to the growth fire. Below is a slide from the company’s Q4 2018 investor presentation highlighting some of the benefits of the X Series product.
Source: Q4 investor presentation.
Note: the company’s fiscal year ends on March 31st. Therefore 2018 refers to the 12 month period ending on March 31, 2018.
Over the past 5 years, revenue has nearly tripled, growing at a compound annual growth rate (OTCPK:CAGR) of 23.4%. Revenue growth has been driven by the growth of the UCC industry and the shift from using PBX and licensed software to using cloud-based software services. Revenue growth has decelerated over the past 2 years; however, the company and sell-side estimates expect revenue growth to accelerate over the next 3 years. The re-acceleration of growth will be driven by a few factors: 1) the roll-out of 8×8’s new X Series product and the significant expansion of the company’s salesforce to support it. 2) Increased adoption of cloud-based software. 3) A shift from 8×8 selling to small and mid-sized businesses towards selling to larger enterprises which overall generate greater revenue per contract (see the average revenue per business customer chart below).
All the factors above point to the idea that revenue growth should continue to be strong over the next several years. The below table contains the consensus sell-side analysts forecasts for revenue growth which supports this notion. Analysts expect revenue to grow at a 24% CAGR over the next 3 years, which is a similar rate observed over the past 5 years. This may seem like a stretch to some skeptical investors but keep in mind that cloud penetration in UCC software today is only 10%, if it were to grow to 20% over the next 5 years, that would roughly translate to a 20% compound annual growth rate.
Below is the average revenue per customer for all customers vs. larger customers. There is now a strategic focus in selling to larger enterprise customers.
Source: Q4 investor presentation.
Over the past 5 years, gross profit margins have expanded. This is being driven by a mix-shift from 8×8’s legacy VOIP equipment sales which command lower gross margin to the cloud-based software which are higher gross margin. Also helping lift margins is the average increase in revenue per customer. In 2014 the average revenue per client was $287 vs. $469 in the most recent quarter. The very high gross margin indicates that when 8×8 reaches a mature level of scale, the business will likely have very high operating margins (once SG&A and other expenses have been fully leveraged).
In FY 2018, EBIT margins were negative 10.9%. This is because the company has been ramping up SG&A in order to stoke future revenue growth. In 2018, the company grew its headcount from 1,019 to 1,225 or 12% growth. In 2019, the company has guided for headcount to grow 30%. The growth in headcount is an upfront hit to earnings because the company must pay for recruiting expenses, additional leased office space, and expense any stock-based compensation used to incent new hires. The company has also been ramping up R&D which grew from $27.5m in 2017 to $34.8m in 2018.
“Due to this rapid growth, we made a conscious decision in the fourth quarter to accelerate our business spend and hiring plan. We hired more talent across all levels of our organization in the fourth quarter than at any time in our history, and the quality of the talent that has joined the organization is awesome. This accelerated hiring, together with strategic marketing investments in brand awareness and demand generation, resulted in non-GAAP pretax net income that was lower than our guidance. As you know, we manage the business for long-term shareholder gain and will make decisions in the short term that we are convinced we’ll achieve that goal in the medium to long term.”
Despite the negative GAAP earnings, free cash flow has been positive. The company expensed significant stock based comp and has very low capex and working capital requirements. Because the business sells subscription software which doesn’t require physical COGS and often receives payment in advance, net working capital is a significant source of cash. This further demonstrates that 8×8 has a solid financial model that will only improve once the business achieves greater scale.
Finally, the company’s balance sheet has net cash of $152m (9% of the market cap), and the company has been a net repurchaser of its outstanding stock.
8×8 does not generate positive earnings and therefore cannot be valued today using a traditional multiple of earnings approach. The company currently trades for a forward revenue multiple of 4.4x. Comparing the revenue multiple to peers in the below table shows that the company is very cheap to direct peers RngCentral (RNG) and Five9 (FIVN), but relatively expense to some other peers.
Revenue multiples are difficult to compare across companies because they are tied to future growth and profitability. In thinking about 8×8’s valuation more constructively, we should focus on 8×8’s future revenue and potential earnings. In 2019E, consensus analyst estimates expect 8×8’s revenue to grow to $350m. A mature software business can have EBIT margins anywhere between 20% and 60%. Given 8×8’s very high gross margins, it would not be crazy for the business at mature scale to have an EBIT margin of 40%. The S&P 500’s EV / Forward EBIT multiple is currently 15x. Putting these different elements together, we get the below illustrative valuation of 8×8 on next year’s expected revenue.
However, 8×8 is clearly playing a long term game and as investors we should also be more focused on the long run. One way to think about 8×8’s longer-term earnings is to walk through its total addressable market opportunity. If the market for UCC cloud services as a percentage of the total UCC software market increases from the current 10% penetration to 20% within the next 5 years and 8×8 merely maintains its market share, then logically 8×8’s revenue will double. This rate of growth is actually supported by the company’s current growth trajectory of roughly 20% (20% compound growth over a 5 year period is roughly double). Applying the same logic for margins and valuation used in the prior example, the below illustration demonstrates that over a longer time horizon, 8×8 will most likely be worth significantly more than it is worth today.
This valuation exercise isn’t precise, but I would rather be directionally accurate than precisely wrong.
1) 8×8 could face greater competition in the future
At the moment, 8×8 is a strong player in the market for unified communication and collaboration cloud software. There are a number of legacy players losing market share to 8×8 because they are not as strong in the cloud; however, over time, many of these competitors will likely develop strong products more competitive to 8×8. A mitigant to this risk is that 8×8 has been accelerating its R&D spending and has been making strategic investments in areas such as artificial intelligence. 8×8 was an early entrant into the market and in my opinion has been working very hard to maintain its technological advantages. For these reasons, 8×8 may also be an interesting acquisition target for legacy UCC software providers that want 8×8’s capabilities but do not want to spend the significant R&D or directly compete with 8×8.
2) 8×8 fails to execute on its growth plan
I am underwriting continued strong growth at 8×8 as central to my valuation estimates. I believe strong growth will continue at the company because the market is growing and 8×8 is aggressively investing in its salesforce and product development. However, if the dynamics of the market for the company’s software change (for example, an increase in competition or decline in demand), growth could fall below my estimates in the future. The mitigant to this risk is that I am underwriting management’s trackrecord of execution. As noted earlier, the company has achieved strong historical financial performance using a similar playbook and from what I can tell the market dynamics have not significantly changed. Therefore, I am comfortable betting on continued strong revenue growth at the company.
3) 8×8 fails to achieve profitability
In my valuation estimates, I noted that I believe at scale the company could achieve operating margins as high as 20% or 40% at some point in the future. However, the company is currently unprofitable and may never reach the margin targets I laid out. If investors lose confidence that the company will ever be significantly profitable, then the stock’s valuation will likely decline. The reason I became comfortable making the assertions that the company could become highly profitable is that it has very high and expanding gross margins and has significant growth ahead of it which will allow the company to better leverage its fixed costs.
In conclusion, I believe investors should use the recent decline in 8×8’s share price after the disappointing earnings report to buy the stock. 8×8 has an attractive software business in a vertical experiences very strong secular tailwinds. The recent earnings and current valuation may scare short-term investors, but long term investors will be rewarded so long as the company continues to execute on its plan.
Disclosure: I am/we are long EGHT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.