Description

Ooma Inc. (OOMA) is a provider of home and business VOIP telephony services. After going public last summer, the stock has languished and trades at  less than 1x EV / 2017 sales (fiscal year ends in January). The top line is growing +20%, and management has repeatedly stated their goal of achieving profitability in the next three quarters. We think the market doesn’t appreciate the quality of OOMA’s high margin subscription revenue and the significant leverage in the business model. With competitors trading >4x revenues, we think it’s likely that OOMA can at least double over the next 12-18 months, which would equate to ~2x EV / FY ‘18 sales with upside beyond that as their relatively new small business offering achieves greater scale.

Consumer Business

OOMA was a pioneer in the home VOIP market. Their main product is called The Telo, which looks like a small router and retails for $100.   The Telo is a complete home communications solution designed to be used as the primary phone in the home. Users plug the Telo into a high-speed internet connection and attach it to a standard home phone device, usually a cordless phone. The base service is free and users are only  required to pay taxes and fees, which typically range from $3.77 to $9.00 per month depending upon their location. 47% of users pay extra for Premier Service which offers a suite of over 25 advanced calling features such as blacklists for telemarketers, instant second line, Google Nest product integration, etc.   

The two biggest challenges facing OOMA’s consumer business come from mobile phones obviating the need for a home phone and aggressive pricing from cable and telcos that bundle phone service with broadband (Dish doesn’t bundle). In spite of these challenges, OOMA has continued to grow this business mid double digits and maintains the lowest churn in the industry at around 5%. Clearly, existing customers are happy with the service as evidenced by the low churn.  The big question remains how to attract new homes that are already buying broadband and can get phone service for next to nothing in a double or triple-play.  As consumers go over the top and cut video services, there is a decent chance they opt out of the phone service provided through the bundle and opt for the OOMA offering with superior features.  

To repeat, this business is still growing double digits. Yet, it appears the market is putting OOMA’s residential business in the same category as legacy dinosaurs like  Vonage’s consumer business. We think this view misses the big picture.  For example, Vonage is churning at >20%  with a $27/ month ARPU vs. OOMA which churns at 5% with a $8 ARPU;  that means that the average OOMA residential customers sticks around for 20 YEARS!  While we wouldn’t expect it to stay this low over the long term, this is one of the lowest churns we have seen in a consumer business. Management is confident that the growth is sustainable given their continued investment in  R&D.  The fact that this business has continued to grow after so much competition from mobile phones and bundled offerings is perhaps the greatest evidence of its quality.

Small Business

      OOMA rolled out its offering for small business around 2013. Similar to the Telo, businesses purchase a small appliance upfront which retails between $100-$250 and pay on average between $10- $15 per user per month. OOMA targets companies with less than twenty employee. Over the last three years, OOMA has seen rapid growth in the category, similar to the other players in the market - RingCentral, Eight by Eight, Vonage, ShorTel etc. The main difference between OOMA’s offering and the competition relates to call quality and lower upfront and recurring costs. Unlike  the pure cloud PBX replacement solutions, OOMA provides every customer with  a box which is in essence a  powerful linux computer and router that  reduces packet loss. Packet loss is the jumbled call quality and occasional inability to hear the other party which is the achilles heel of the industry (at least those that use the public internet).  As relates to cost,  even with the purchase of the box, OOMA ends up being cheaper than the cloud offerings because users don't need to purchase IP phones. In addition, an OOMA office installation doesn’t  need a network to connect the phones as everything is done over DECT based wireless connectivity connected to wall sockets. 

At the end of the day, the whole cloud PBX market is a land grab with all the major players growing +20% (Vonage and Shortel were both written up on the VIC within the 6 months). The reality is that the offerings between the players are more similar than different. While price is an  important consideration, it is  not everything given the annoyance of porting phones numbers and business disruption. This is still a market in relative infancy with only 20% penetration of Internet / Cloud lines for NA business. OOMA’s niche is that they can make money and hold onto customers at the very low end of the market. On the other hand,  their competition has indicated that they want to move up market and service bigger customers.  

Management has described their business model on the home and small business side as a trojan horse: they lead with high quality, low cost voice and then add on ancillary services. Their largest upsale to date has been a product called Business Promoter, which helps small business with search engine optimization and online marketing. This is a commodity business but OOMA’s hook is that they work with businesses that otherwise would not have any online presence (think of your local plumber or other blue collar service provider. Business Promoter  routes vetted, in-bound leads that come through the OOMA phone.  It’s a no brainer for the small business as they only pay for qualified calls.  

As for actual performance,OOMA office grew 60% yoy in the most recent quarter and now represents 21% of overall revenue. Management targets a 18-24 month payback on all new customers (based upon a fully loaded cost of customer acquisition that includes all variable and fixed costs). The ARPU for small business is higher than the corporate average of ~$8. It’s hard to believe but most of OOMA’s new business still comes from customers paying upwards of several hundred dollars per month to legacy telcos like AT&T for a couple of lines. If you compare that  to an average of $60/ month for a small  OOMA office with a couple of lines, you can appreciate the ease of converting new customers.  As such, OOMA is able to grow its subscription revenue in the high 20% range by only spending around 30% of revenue on sales and marketing versus RingCentral which spends 50% and Eight by Eight which spends 52%.

Why this Opportunity Exists

As mentioned earlier, OOMA IPOed last July just as the market began to sour on small caps. They raised $65mm at $13/share but the stock traded down to a low $6 near the beginning of this year versus its current price of $9. It didn’t help that they experienced some hiccups in  Business Promoter which currently contributes about 5% of revenue.  The takeaway is that subscription revenue has been running above trend (+28% in the last quarter), and the core business has performed well, but it’s been a challenging time to be a newly traded small cap technology name.

Valuation

At $9.10 with 17.3mm share outstanding OOMA has a  $157mm market cap and $54mm of cash of its balance sheet for an EV ~$103mm. Guidance for FY 2017 (fiscal year ends in January) is for revenue between $104-$107mm. The EBITDA loss in the most recent quarter was -$542k, and management has indicated that they will turn profitable in the next couple of quarters. Our main thesis is that the market underappreciates the subscription revenue stream on both an absolute and relative basis. On an absolute basis the subscription revenue, which is 88% of total revenue, is 97% recurring and growing in the high 20% range. In the most recent quarter gross margins expanded 4 points to 68%. Margins increased in the quarter  due to continued growth in the user base and the increasing mix of OOMA office, which has a higher ARPU and higher margins. Their long-term model calls for  75%-80% gross margins indicating that there is still plenty of leverage left in the model. The low blended churn of 6% indicates that customers stick around because the product is great and there is nothing cheaper. On a relative basis, other publicly traded VOIP providers trade at >4x EV / CY revenues (excluding Vonage and ShorTel that both have declining legacy businesses). Even with the possible deceleration in their  legacy residential business, the opportunity on the small business/ enterprise side is significant  and offers the  potential for years of growth.

As relates to the underlying earnings power of the business, management doesn’t provide specific guidance. For illustrative purposes, we modeled  two consecutive years of 17% top line growth  combined with a 20% EBITDA margin and arrived at $28mm in EBITDA or 3.6x EV/ FY ‘19 EBITDA. The 20% EBITDA number is thrown around by the industry as a proxy for what these businesses could generate in a more steady state. While we would traditionally treat such tidy guidance with a big grain of salt, the most recent quarter already demonstrated how there is substantial leverage in the gross margin line.

In summary, OOMA generates similar gross margins to its competitors at less than half the ARPU, generates the lowest churn, and is growing at a similar rate . As the base of revenues grows, we think the market will eventually wake up to the unique story and value OOMA at 2x EV / FY ‘18 revenues which is close to where unprofitable private players in the space are being purchased. Once the latent earnings power of the high margin subscription revenue begins to drop to the bottom line we would not be surprised to see a valuation multiples of the current price.

Catalyst

-profitability in next 3 quarters

-continued top line growth

-further evidence that legacy residential business can grow