Description

RNG is a leading provider of cloud-based phone, video meetings and messaging software, collectively referred to as unified communications as a service (“UCaaS”).  Cloud-based UCaaS software is steadily replacing legacy, on-premise PBX solutions with the typical advantages provided by cloud software including lower upfront capital costs, lower total cost of ownership, ease of deployment and management, location and device agnostic accessibility, and real-time product updates.  Currently ~25M cloud-based lines exist relative to a UC install base of 400M lines, representing just 6% industry penetration.  With 5M seats and $2B in ARR, RNG is a market leader with ~20% market share. 

RNG goes to market through a combination of direct sales force, exclusive strategic partnerships with legacy UC providers, global service providers, and a network of channel partners.  Approximately 40% of ARR is generated from enterprise customers, 20% from mid-market, and 40% from SMB.  International revenue is 12% of total, but growing rapidly up from 5% in 2018.

RNG was a former market darling, consistently growing ARR >30% and beating consensus expectations since IPO in 2013.  In the aftermath of COVID, remote work drove increased demand for UCaaS migrations, leading to accelerating revenue growth and a crowded COVID-beneficiary trade.  The stock traded as high as 25x sales, peaking at $440 in 1Q21.  Since 2021, the stock has fallen from grace as MSFT and ZM increased their presence in this market, raising fears of intensified competition and industry commoditization.  RNG now trades at just 2.3x EV/NTM sales, a multiple rarely seen for recurring revenue software business with 78% gross margins and 30% growth. 

As RNG continues to outpace investor growth expectations and increases focus on margin expansion and cash flow generation under new management, I expect earnings growth to accelerate and shares to rerate higher.  I think RNG can compound revenue 20% over the next 4 years, expand operating margins 200bps p.a. and delever the balance sheet with significant FCF generation.  Applying a conservative 20x multiple to my base case 2026 earnings power of $5.75, results in a 155% upside over 2 years, or 33% IRR.  If I’m wrong and growth rapidly decelerates below industry growth rates, margins remain flat and the stock trades down to 15x P/E, I see 25% downside in the near-term.

RNG plays in a large, high-growth TAM that can support multiple competitors.

·   UCaaS solutions offer many significant advantages over legacy PBX-based phones.  They remove any upfront capital expenditure, lower the total cost of ownership, and significantly reduce the ongoing costs of maintenance and management.  As cloud-based software, they are location and device independent enabling portability and mobility across PCs, desktop phones, mobile phones, tablets, etc. ideal for the hybrid and remote work environment.  RNG also offers an open API platform enabling customers and third parties to develop custom integrations and workflows with other mission critical business software (e.g. ability to dial a customer directly from your CRM).

·   The industry is still in relative infancy, with just ~25M lines today compared to a TAM of 400M legacy UC lines, or 6% penetration.  I expect that penetration to reach 15-20% over the next 5 years, driving industry growth of 20-25% and opening up an additional 35-55M incremental seat opportunity for RNG. 

·   Long-term, the market should be able to eclipse 50% of the legacy UC footprint.  Assuming 200M seats with a monthly ARPU of $30, that equates to a $72B TAM.   That is plenty large enough market to support multiple competitor at scale.

·   I have studied several software industries which MSFT has attempted to bundle its way into in the past (collaboration, content management, data visualization, and business intelligence).  Investor sentiment for the independent, “best-of-breed” competitors swung between extremely bullish and extremely bearish over time.  Ultimately, in all of these case studies, the independent vendors were able to maintain meaningful market shares and healthy margin profiles over time.  Many were acquired by consolidators or financial sponsors at healthy multiples significantly higher than where RNG is currently trading.

UCaaS is not a commodity.  RNG has a differentiated product and has been able to maintain market share and pricing discipline despite challenges from ZM and MSFT.

·   While the market perceives UCaaS as a commoditized industry with little differentiation among competitors, conversations with customers and resellers suggest RNG offers a best-in-class, differentiated product.  RNG contractually guarantees 99.999% reliability, offering 10x-100x better reliability than MSFT and ZM, respectively.  Advanced calling functionality including receptionist handling, call routing & forwarding, multi-site support, paging, faxing, analog phone support, among others are product differentiators for many customers.  RNG also offers the broadest international coverage and most robust ecosystem for application integrations. 

·   This has translated into stable market share for RNG at ~20% over the past 3 years.  Share gains for MSFT and ZM have largely come at the expense of legacy players (Mitel, ShoreTel) and marginal cloud competitors that have failed to keep pace with RNG’s product development (VG, EGHT, LogMeIn). 

·   While RNG does not regularly disclose seat count or ARPU for competitive reasons, management sporadically announces a milestone seat count or a range to the nearest 500k seats.  Using these data points and quarterly ARR disclosures, I can estimate ARPU at various points in time over the past 3 years as MSFT and ZM have increased their presence in the market.  While estimated ARPU has declined from $40 to $33, incremental ARPU has remained stable at ~$29 since 2019.  A modest decline in ARPU is also expected given enterprise mix has grown from 30% to 40% of ARR over the period (and accounted for >50% of incremental ARR), with enterprise deals carrying a lower ARPU given larger deal sizes.  These trends suggest a stable, rational competitive environment in contrast to consensus view of rapid commoditization.

New management with increased focus on margin expansion and FCF generation can lead to rerating in the stock.

·   The majority of RNG’s management team have turned over in the past 2 years.  The company’s heavy reliance on stock-based compensation became a double-edged sword as the stock price fell severely impairing the market value of management’s RSUs, leading to an exodus of senior management.  The reconstituted management team have backgrounds operating larger, more mature, highly profitable businesses with significantly higher margin profiles than RNG.  This includes a President/COO from AT&T, CFO from HPE, and CRO from AVYA.  I believe this signals a shift in strategy to balance financial discipline with growth, whereas historically management has prioritized growth at the expense of margins.

·   While RNG is FCF positive and profitable on adjusted basis excluding-SBC, earnings quality deteriorated under the previous leadership.  SBC grew from 11% of sales in 2019 to 24% of sales in 2021.  Exclusive distribution deals with legacy UC providers levered up the balance sheet with prepaid commissions expense.  Adjusted operating margins expanded modestly ~50bps p.a. 

·   Many of these issues have begun to alleviate and are now heading in a more shareholder friendly direction.  SBC peaked in Q2 2021 and has since been declining both in dollar terms and margin terms.  On the first conference call with the new CFO, full year margin guidance was raised 50bps despite an incremental headwind from F/X.  This implies 180bps margin expansion y/y, a strong signal to the market of increasing focus on cost discipline under the new leadership.  The company has converted 95% of adj. net income to FCF YTD, which I expect to continue improving as RNG amortizes previously prepaid commissions to distribution partners.

·   In the current market environment with rising interest rates and uncertain financing markets, the company has the ability to craft a compelling story around margin expansion and FCF generation.

Private market valuation would significantly exceed public market value.

·   Given the long-term secular growth drivers in the UCaaS industry, combined with RNG’s industry-leading product and market share, I believe RNG is a strategic asset that would be an attractive acquisition target for both strategic and financial acquirers.  CRM, MSFT, ZM, CSCO, Mitel and NICE could all make sense as strategic acquirers.

·   ERIC’s recently completed acquisition of VG (7/22) provides a compelling deal comp for RNG.  ERIC paid $6.2B for VG, or 4.0x NTM revenue, for an asset with less scale, slower growth (low double-digit revenue growth), and lower gross margins (50% GM vs. 78% for RNG).  Excluding the secularly declining consumer revenue and zero-margin USF fees, VG’s valuation was 5.0x NTM revenue for the growing UCaaS and API revenue streams most closely comparable to RNG’s business, albeit with a significantly lower gross margin profile.  Applying 5.0x multiple to RNG’s NTM subscription revenue implies an EV of $10.5B, or $92/sh stock price (+105%).

·   Private equity is another logical acquirer of RNG with the wealth of dry powder in tech and software focused PE funds.  RNG is cash flow positive and has substantial margin expansion opportunity in the hands of a disciplined financial buyer.  Historically, M&A multiples trough ~4x EV/recurring revenue for assets with structural challenges and revenue growth rates in the single digits.  For secular growth assets more comparable to RNG, LBO multiples have typically ranged from 6x-8x EV/recurring revenues.  Applying a conservative multiple of 4x-6x EV/recurring revenue implies a valuation between $71 - $113/sh, or 60%-150% upside from current trading levels.

·   It is worth noting that the two co-founders have near voting control through super-voting Class B shares, collectively controlling 46% of the voting power.  Any acquisition would need buy-in from the co-founders, which could reduce the likelihood of a strategic acquisition and favor a management-led buyout. 

Read-through to the model

·   I believe RNG will beat consensus estimates by 10-15% over the next several years.  In my base case I expect ARR and revenue to grow 20% in line with industry growth, and margins expand 200bps p.a., ahead of consensus expectations.  FCF conversion should improve meaningfully as RNG amortizes prepaid commissions expense from large partnership deals, delevering the balance sheet.  I forecast $5.75 in earnings power in FY26.  Applying a conservative 20x P/E multiple (implying just 3.0x EV/revenue) results in a base case price target of $115 by YE25, or 33% IRR.

·   If I am wrong and growth rapidly decelerates to HSDs due to increased competition, margins stagnate and FCF conversion deteriorates from current levels, I see $2.25 in earnings power in FY24.  Applying a below-market multiple of 15x P/E results in a bear case price target of $34, or 25% downside.  That would imply an EV/revenue multiple of just 1.8x, rarely seen for recurring revenue software businesses with ~80% gross margins.

Catalyst

- I expect revenue and ARR to continue compounding at 20%+ CAGR

- New management's increased focus on margin improvement and FCF conversion to drive EPS and FCF above consensus