Description

EGHT – Investment Thesis

June 2020

All figures presented in US$ millions, except for per share data.

All share price data as of 6/26/20.

Fiscal year ends 3/31.

Short the $12.50 02/19/21 puts for $1.90 and receive an annualized return of 28% (based on 238 days until expiry) so long as the share price is greater than or equal to $12.50.  The stock is currently at $15.40 as of today (06/26/2020).  This trade provides 100% principal protection so long as share price declines less than 31%.

Situation Overview:

8x8 (“EGHT” or the “Company”) is a leading cloud provider of enterprise communications services.  The Company offers a complete range of communications products – UCaaS (unified communications), CCaaS (contact center) and CPaaS (communications platform) – through a unified platform and single stack.

EGHT trades at a substantial discount to its principal comp, RingCentral (“RNG”), due to a persistent gap in growth rates and a lower margin profile.  Over the past three years, EGHT has implemented numerous business initiatives to re-accelerate growth, which are just now beginning to be realized.  We believe the Company is well positioned to accelerate growth which should result in a re-rating of the valuation.

Shorting the $12.50 02/19/21 puts presents a unique risk/reward scenario: if the share price remains flat or increases, the investor will realize a 28% annualized yield based on the option premium of $1.90 and an effective conversion price of $10.60.  If the share price declines below $12.50 and the investor is required to buy the underlying security, the effective purchase price per share is $10.60, or 31% lower than today’s trading price, which equates to a FYE March 2022 Revenue multiple of 1.9x vs. 2.9x today.  For reasons articulated below, we believe there is material upside to EGHT’s current valuation.

Company and Industry Overview:

EGHT offers unified communications, contact center solutions, team collaboration, conferencing and analytics to business customers on a SaaS model through a single-stack, integrated platform. 

EGHT owns all of the core technologies that power its service offerings enabling highly integrated bundling and pricing flexibility.  In contrast, RingCentral (“RNG”), its primary competitor, relies on inContact for its contact center solution and Zoom for its video solution. 

Following a deceleration in revenue growth from 25% in FY 2016 to 17% in FY 2017, EGHT began a lengthy reorganization process that has focused on: 1) shifting from a direct sales model to a channel model similar to its primary competitor RNG,  2) product extension through acquisition and migration of all of its applications onto a single platform (X-Series), 3) a shift in focus away from less profitable small business customers (which are now auto provisioned through the e-commerce channel) towards mid-market and enterprise customers, and 4) the addition of the value-added reseller (“VAR”) channel within its channel model. 

These actions are beginning to bear fruit: revenue growth accelerated to 26% in FY 2020 and bookings growth has exceeded 25% for the past several quarters.  Investors remain keenly focused on the Company’s ability to sustain these elevated growth rates, as well as expand its margin profile, which is reflected in the sizable valuation gap between EGHT (2.9x NTM Revenue) and RNG (20.7x NTM Revenue, growing >30%). 

UCaaS: Unified Communications-as-a-Service – 70% of new bookings[1]

The vast majority of communication platforms in existence today are legacy, on-prem seats such as Avaya, Mitel and Shoretel, amongst others.

UCaaS offers a number of advantages over legacy systems:

1) Enables expanded mobile work forces with a single cloud based application across multiple connected devices for all communication needs which can be configured remotely and dynamically.  Combines voice, text, conferencing, web meetings, audio, voicemail onto a single interface for users that is not device or location dependent.

2) Eliminates up-front capex costs and enables IT departments to manage the entire system from any location because it is hosted in the cloud, thus reducing IT staffing and travel costs.

3) Solutions can be more easily integrated with other business applications, such as customer relationship management (CRM) and enterprise resource planning (ERP) apps enabling more automated customer/supplier interactions.

The $50bn+ enterprise communications market remains less than 10% penetrated by UCaaS which has consistently grown at a 15% CAGR.[2]  According to Gartner, by 2021 90% of IT leaders (up from 50% in 2019) will likely choose a cloud UC offering over on-prem UC infrastructure.

Retention rates across the UCaaS industry are ~100% as nearly all installations replace legacy on-prem systems.

CCaaS: Contact Center-as-a-Service – 30% of new bookings

Contact centers are increasingly providing omni-channel customer engagement channels, which include VoIP, email, website interfaces and SMS. 

Much like UCaaS, CCaaS reduces the need for on premise capex and makes it easier for businesses to add additional lines and features without any incremental on-prem installations / equipment.

The $24bn market is estimated to be 15% penetrated[3] and growing at a 10% CAGR[4].

Our channel checks have indicated EGHT’s contact center solution is particularly appealing to mid-market customers (<500 seats).  It is estimated that 95% of the world’s contact centers have fewer than 150 seats.[5]

While standalone solutions, such as from Five9, Genesys and Talkdesk are more effective for large enterprises with the need for a sophisticated contact center solution, EGHT’s offering is ideal for mid-market customers who require a sophisticated UCaaS solution, but would also like a sufficiently capable and integrated CCaaS offering from a single company.

As shown below, Garner buckets 8x8 as a contact center challenger, at close range to the industry’s incumbent platforms.

While RNG offers a bundled solution with inContact, our channel checks have indicated that the solution is less seamless than EGHT’s offering and requires support be conducted through two different companies.  At the beginning of the sales process, RNG’s bundled offering requires a demonstration with an inContact sales rep and a separate bidding process. 

The customer ROI for a UCaaS solution is highly compelling, while the economics for a CCaaS solution are not nearly as attractive.  EGHT’s ability to offer bundled, cost-effective solutions uniquely positions the Company to offer the customer an attractive ROI on a consolidated basis.

The value proposition for EGHT is straightforward for VARs to pitch: access to a leading UCaaS and CCaaS solution with a unified interface on a single platform with “one throat to choke.”  The combination is also attractive from a security and analytics perspective as EGHT has sole access to the data on its platform in an aggregated form.

In the most recent quarter, 71% of new bookings for customers with over 50 seats were for bundled UCaaS and CCaaS solutions, which compares to 52% a year ago, suggesting that the model is resonating with customers.  Contact center bookings grew 76% in the most recent quarter and now represent 30% of new bookings.

Investment Thesis

1)   The Company’s pivot towards mid-market and enterprise customers is driving materially higher ARR growth and improved churn, yet represents just 45% of ARR today.

EGHT’s growth rate has been constrained by is historical focus on small business and its over-reliance on a direct sales force.  The small business segment is more penetrated and has lower lifetime value due to substantially higher churn compared to mid-market and enterprise customers.

The Company’s small business customer ARR growth of 16% is consistent with the broader market.  By comparison, ARR for enterprise and mid-market customers grew 79% and 55%, respectively, during the quarter ended March 31, 2020.

In the past year, the Company has retooled its sales strategy with a focus towards mid-market and enterprise customers.  In the past four quarters, the Company has grown its mid-market and enterprise mix from 36% to 45%, proving management’s ability to capture this segment of the market.

EGHT’s overall net revenue retention rate is just below 100%, which is comprised of a consolidated mid-market and enterprise customer retention rate of 110% and a small business customer retention rate below 90%.  As with other SaaS businesses, EGHT’s economic model is highly sensitive to retention rates.  Even small reductions in churn equate to a significant uplift in a customer’s lifetime value.

The Company’s small business customers account for 2/3 of total churn.  70% of the small business customer churn is from customers using legacy handsets who are unable to generate value from the platform.   As this legacy customer cohort churns off, overall retention should improve significantly.

Customer lifetime value will also grow as EGHT shifts its sales focus to a larger customer.  The typical small business churn scenario involves either the customer going out of business or staying on its current platform, but receiving price concessions.  Mid-market / enterprise customers typically increase the number of seats and services consumed over time resulting in dollar retention greater than 100%.

2)   The recent roll-out of a VAR business model creates an interesting opportunity to take seats away from Avaya, Mitel, Shoretel and other legacy providers

EGHT has not historically utilized the VAR channel to generate sales.  The Company’s value proposition to VARs is particularly attractive as it allows them to create better economics for themselves by converting their existing legacy customers. 

Avaya, the company with the largest and most sought-after legacy customer base (~100mm endpoints), recently announced a partnership with RNG to offer RNG’s UCaaS platform to Avaya customers. 

While the Avaya / RNG partnership is certainly a competitive threat, we believe it is incrementally positive for EGHT as ~60% of the Avaya customer base has a relationship with the VAR, not Avaya.  Our channel checks have confirmed that the introduction of the RNG product to Avaya customers is catalyzing customers to explore a range of UCaaS options, of which 8x8 is a beneficiary.  Avaya has been the largest share donor to EGHT over the past few quarters.

The opportunity for EGHT arises from the economic model of the Avaya / RNG partnership.  In the Avaya / RNG model, RNG pays the VAR a small cash payment and 25% of revenues, as opposed to the existing model in which the VAR receives 50% of revenues.  

As such, VARs are highly incentivized to include 8x8 in customer upgrade discussions.  Avaya’s largest distributor, ScanSource, approached EGHT to offer the existing Avaya customer base a cloud product with economics which more closely resemble the traditional VAR / vendor relationship.  In January 2020, EGHT launched its VAR strategy with ScanSource, and it is expected to begin contributing more meaningfully to bookings in the second half of this year. 

More broadly, the channel strategy is paying off, as channel partner bookings grew 63% in the quarter ended March 31, 2020 and represented 54% of total bookings.  5 of the top 10 wins were Avaya replacements, demonstrating EGHT’s ability to capture this customer base.

3)   Management expects to expand gross margins by 1,000bps driven by the Company’s e-commerce platform, reduced support for smaller customers (where too much time is spent today) and CPaaS GM growth as international scales

EGHT’s gross margin of ~55% is materially below software peers and RNG’s 74% gross margin.  Management has attributed the margin differential to: 1) small business deals which remain highly resource intensive, 2) recent investments into the channel, and 3) its recent entrance into CPaaS which is lower margin at the moment[6].

In July 2019, the Company launched its e-commerce platform for the 1-9 seat “micro” segment of the market, which enables customers to buy, deploy and support products with zero human intervention.  This enables the sales force to focus on larger customers, while lessening the burden of unprofitable / resource-heavy small business customers.  Of the 5,500 new logos on-boarded in Q4, 2,000 were from the e-commerce offering.  We believe the e-commerce platform will be a key driver of future margin enhancement.

Management also cited outsized costs to support larger small business and lower mid-market customers.  To reduce costs related to deployment and administration, earlier this year the Company offshored several functions out of high cost locations (SF, NY, London) and eliminated numerous roles relating to non-revenue generating functions.

EGHT’s CPaaS margins remain a drag on the Company’s overall margin profile.  EGHT entered the CPass through an international acquisition.  As the overall international segment scales, Management expects CPaaS margins to improve.  Additionally, higher-margin services such as chat and voice are increasingly bundled with this offering.

4)   Management has guided towards profitability breakeven by year-end F2021 (3/31/21) with cash flow breakeven following in 2-3 quarters

While the recent sales and marketing initiatives required heavy investment, we believe the Company’s investments towards its go-to-market strategy, sales, marketing, lead generation and delivery and deployment were effective and are reflected in the number of multiple quarters of 25+% bookings growth. 

Recognizing that the Company’s ability to demonstrate the business model’s leverage with sustained growth and expanding margins will be a key driver of share price performance, management has now shifted its focus towards achieving profitability.  In addition to gross margin improvements, EGHT’s S&M efficiency (S&M / incremental revenue) considerably lags peers (~3x vs. 1.6x for peers)[7].  The metric has remained elevated for the past several quarters through the Company’s transition and remains a clear opportunity for improvement. 

5)   EGHT is a highly strategic asset

The Company has indicated they have received in-bound acquisition interest in the past, but deemed the enterprise opportunity was too close and too large to sell.[8]

EGHT’s product set would be a natural fit for any of the large strategic players (Microsoft, Google, Amazon) with existing enterprise collaboration software.  To date, Microsoft has had limited success against EGHT and RNG as their voice solution architecture is not yet competitive.  Google has not yet invested in enterprise class voice solutions.  Amazon has created interest for AWS with Amazon Connect and Amazon Chime, but has yet to enter the market in a more substantive way. 

Other potential acquirers may include a CRM platform such as Salesforce which may be a good fit given their base of enterprise customers; or Oracle given their sizable communications arm and existing relationship with EGHT.[9]

Ultimately, we believe it makes sense for EGHT to be integrated as part of a larger player’s enterprise platform.  Potential synergies would be meaningful given existing sales relationships, the cross-selling opportunity, and the deployment cost advantages from significant scale.

Valuation

EGHT trades at a material discount to peers in both the communications segment and the broader software universe.  As discussed, a discount is warranted due to the slower growth profile and margin structure of EGHT. 

The comps below demonstrate that revenue growth is directly correlated with higher revenue multiples.  As such, we believe acceleration in EGHT’s revenue growth trajectory will result in a corresponding uplift in multiples.

At 18.4% forecasted growth for EGHT, consensus estimates for EGHT do not assume any acceleration in revenue growth.  The research community is essentially underwriting a scenario in which EGHT grows just modestly above market and substantially below EGHT’s recent growth in bookings.  We believe this bodes well from a risk/reward perspective, particularly for the trade’s proposed structure.

While difficult to forecast a precise future multiple, the illustrative valuation ranges below highlight that a 1.0x multiple uplift corresponds to a 32% increase in share price.

Risks

1)   EGHT competes in highly competitive markets

Across each of its three verticals (UCaaS, CCaaS and CPaaS), EGHT competes in highly competitive markets with well capitalized, scale players that have the capacity and willingness to sacrifice margin dollars to gain the customer relationship.

EGHT’s most direct competitor, RNG, enables customers to integrate competitive “best-of-breed” solutions across applications (Zoom, inContact).  As discussed, EGHT’s offering does not perform as well when customers require a complex contact center (500+ seats).  

While we believe EGHT’s bundled offering remains compelling for a significant portion of the market, a shift in customer preference away from an integrated offering towards a best-of-breed offering would be detrimental to EGHT.  For instance, if a prospective customer approaches their VAR and insists on retaining Zoom for video conferencing, the VAR may be inclined to push them towards the RNG platform which enables the Zoom integration.

RNG’s additional scale compared to EGHT (~2x the revenue) may enable it to out-invest EGHT in research and development and sales and marketing.

Larger players (MSFT/GOOG/AMZN) may also seek to enter the market more aggressively.  While our belief remains that the natural path forward is through an acquisition of EGHT / RNG, these players may instead choose to enter the market through an offering developed in-house.

2)   EGHT may face challenges scaling upmarket

While our proposed trade simply requires that the Company maintain its current financial profile, a continued shift towards a larger customer base is required to accelerate revenue growth rates from today’s level.  A slowdown in the mix shift may place a ceiling on revenue growth prospects, which would reduce the likelihood of a multiple re-rating.  Any increase in sales / deployment costs to service larger customers may also defer the year-end target for breakeven profitability.

3)   COVID may slow new enterprise deals; IT budgets may remain under pressure

In the medium-to-long term, the impact from Covid is expected to be a net positive for EGHT given the increased mobility of workforces driving the need for additional cloud-based solutions.   However, in the near-term the enterprise sales process will be more challenging as prospective customers remain focused on their day-to-day operations and wait for reduced uncertainty before exploring resource intensive projects.  In particular, management cited the retail, travel and hospitality sectors as having experienced pressure.

[1] Represents quarter ended 3/31/20. Based on contact center representing 30% of new bookings. As per 5/12/20 transcript, new bookings figure does not include CPaaS. 

[2] Stifel research, 7/12/18.

[3] Five9 November 2019 investor presentation.

[4] Guggenheim research, 3/11/19.

[5] Guggenheim research, 3/11/19.

[6] Company call transcript, 3/3/20.

[7] BAML research, 5/13/20.

[8] MS research, 4/11/17.

[9] 8x8 is a customer of Oracle cloud.

Catalyst

Option expiration