8X8 Inc /De/ Q2 FY2023 Earnings Call

Thank you, operator. Good afternoon, everyone. Today's agenda will include a review of our second quarter results with Dave Sipes, Chief Executive Officer; and Sam Wilson, our Chief Financial Officer. Following our prepared remarks, there will be a question-and-answer session. Before we get started, let me remind you that our discussion today includes forward-looking statements about our future financial performance, including our increased focus on profitability and cash flow as well as our business, products 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 vary materially from forward-looking statements as described in our risk factors in our report filed with the SEC. Any forward-looking statements made on this call and in the presentation slides reflect our analysis as of today, and we have no plans or obligation to update them. Certain 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 those non-GAAP measures to the closest comparable GAAP measures is provided in the earnings press release and earnings presentation slides, which are available on 8x8 Investor Relations website at investors.8x8.com. With that, I'll turn the call over to our CEO, Dave Sipes.

Thank you, Kate. Good afternoon, everyone, and thank you for joining us today. On the call today, I will review our second quarter results and provide an update on our plan for fiscal year 2023 as we place greater emphasis on profitability and cash flow generation. We believe that this is the right strategy to deliver value to our stakeholders, customers, employees and shareholders, and it is reflected in our increased operating margin guidance range for the year. We delivered another solid quarter, delivering revenue in line with our guidance and non-GAAP profits and operating cash flow above expectations. Our continued emphasis on operational efficiency as well as a favorable mix of higher margin ex cap revenue resulted in higher gross profit. Second quarter non-GAAP gross margin was above 70% and service gross margin was above 74%. Both were up nearly 5 points in the last year. We have demonstrated sequential improvements in our gross margin performance for both service and total revenue in every quarter since Q3 2021. And non-GAAP gross profit on a dollar basis increased 35% year-over-year. The Fuze acquisition continues to outperform our expectations and was accretive to operating margin this quarter. We also strengthened our already solid financial foundation by refinancing over 80% of our convertible notes due in 2024 in a transaction that increases our flexibility to delever the company as our cash flows increase. We remain committed to our strategy of empowering every employee through integrated contact center and unified communications in the cloud delivering outstanding customer experiences at a lower overall total cost of ownership. We reinforced this commitment by increasing our investments in innovation and repurchasing 10.7 million shares of our common stock. The quality of our ARR remains high, with enterprise ARR growing more than 40% year-over-year and accounting for 58% of total ARR. XCaaS ARR continues to grow at approximately 40% year-over-year and increased as a percentage of total ARR as customers add contact center functionality to their 8x8 deployments. XCaaS accounts for more than 35% of our ARR, and we see an opportunity to grow this percentage materially as we continue to innovate on the XCaaS platform with features designed for our targeted enterprise customer base. Progress in our strategic enterprise XCaaS business was partially offset by continued challenges in our CPaaS business. We believe this business has been impacted by a combination of currency fluctuations and macroeconomic headwinds. We are focused on stabilizing this business and continue to add new customers with innovative use cases like SES Home Services. SES provides professional and reliable home emergency support using 8x8's video interaction solution to enable agents to provide remote support, reducing operational time and costs. On the plus side, small business ARR grew modestly on a sequential basis. The stabilization in small business ARR this quarter reflected good retention and upsell in our commercial sectors in both the U.S. and U.K., driven by our efforts to improve efficiency and focus on customer satisfaction. On our last call, we increased our operating margin guidance for the current fiscal year to 2% to 3%, and said we had line of sight to doubling operating margin in fiscal year '24. We are once again increasing our operating margin guidance for the current year. We now expect to deliver non-GAAP operating margins above 5% this year. We believe we can achieve these targets through increased efficiency in our cost structure, particularly sales and marketing, and have taken steps to rationalize some of our spending across the company. As Sam will discuss in greater detail, we expect these steps, combined with an increased mix of higher margin XCaaS business will allow us to exit this year at or above 6.5% operating margin. Further, we have demonstrated our ability to expand margins and now believe we have line of sight to achieve double-digit operating margin in fiscal year '24. Our unified XCaaS platform remains a competitive advantage for us, and this advantage is only amplified in a more cautious spending environment. Recent research from Metrigy showed that organizations deploying a unified solution achieve a 56% lower total cost of ownership versus a multi-vendor strategy. Casey's, the third largest convenience store chain in the United States with more than 2,400 locations in 16 states is an example of a customer migrating to the cloud to reduce total cost of ownership. The company is moving all stores to the cloud with 5,000 8x8 UCaaS seats to replace costly traditional phone lines. We continue to deliver advanced features that allow our customers to improve their employees and customers' experiences. We recently released an update to the 8x8 XCaaS platform that extended our global coverage to 56 countries and enhanced our omnichannel customer experience analytics, featuring new visual interaction flow diagrams, enhanced reporting into digital interactions and new advanced search and filter capabilities. Our XCaaS platform continues to be broadly deployed across a range of industry verticals and geographic regions. Recent customer wins included Medline, a leading healthcare manufacturer, distributor and solutions provider with over 30,000 employees worldwide with businesses in more than 125 countries and territories. Medline is moving to the cloud with 8x8 initially to support over 2,500 employees on an easy-to-administer global unified platform. Factom Vision Partners is a leading management services organization, serving ophthalmology practices and ambulatory surgery centers throughout the Mid-Atlantic and New England regions. Spectrum selected 8x8 XCaaS to support employee and customer engagement for its contact center and clinics. Prepay power, Ireland's first dedicated prepaid energy supplier of pay-as-you-go energy with over 250,000 customers working with partner Work Air, they chose 8x8 XCaaS to support employees and a 300-agent contact center that will enable them to scale, gain business insights and serve their fast-growing customer base. The availability of contact center-like functionality such as conversation IQ is driving expanded deployments with UCaaS customers. An example is LSH Auto U.K. They have 8 Mercedes-Benz, AMG, EQ, and smart dealerships across the Midlands and Northwest. LSH U.K. turned to 8x8 XCaaS for a single UCaaS and CCaaS solution to support the employee and customer experience across their dealerships. This past quarter, LSH added 8x8 conversational IQ to 20% of their UC users to drive improvements in the sales team's interactions with customers. Our global reach and rich feature set continue to be important competitive differentiators, with customers adopting Teams as their collaboration platform. In Q2, we added a new 8x8 phone app for Microsoft Teams, providing customers with additional options for enabling cost-effective PSTN calling within Teams. We continue to build momentum in our 8x8 voice routine solution. Customers choosing a voice for Teams in Q2 included a worldwide holiday tour operator recently acquired an existing 8x8 customer in the U.S. The company evaluated 8x8 XCaaS and decided to transition its entire global organization to XCaaS with voice for Microsoft Teams to manage communications and customer engagement from a single platform. Delek, a downstream energy company with assets and petroleum, refining, logistics, asphalt, renewable fuels and convenience store retailing, turned to 8x8 UCaaS with voice for Microsoft Teams to strengthen security, compliance and support global communications for more than 2,500 users. Miller's Ale House is a sports-themed casual dining restaurant with almost 100 locations in 10 states. Following a proof-of-concept trial, a fast-growing chain chose 8x8 UCaaS with voice for Microsoft Teams to deploy at their Florida headquarters and all restaurants to enhance the overall customer and employee experience. We continue to expand our relationship with Microsoft Modern Work Solutions partners through our 8x8 Elevate Partner program. This quarter, we added three new partners, including Cloud Revolution, a Microsoft 2022 Partner of the Year finalist; Cyclotron, a 2020 U.S. top Microsoft 365 team's partner award winner; and Apex digital solutions, also an advanced Microsoft partner specialized in Microsoft Teams calling to our program. We continue to invest in channel with our co-marketing training and lead-sharing initiatives. Cross-sell of CCaaS to existing UCaaS customers is an important aspect of our growth strategy as we expand our enterprise customer base, including Teams users. As one of the first partners to achieve Microsoft certification for integrated contact center, we are in the early days of land and expand cross-sell into our enterprise customer base. In a recent example, the University of Bristol in the U.K. expanded its 8x8 XCaaS with voice for Microsoft Teams deployment by adding 25% more CCaaS seats following the successful delivery of Phase 1 of the project. We believe the next wave of cloud migration is contact center. This was reinforced at last week's Gartner symposium, where our booth was crowded with prospects asking about our contact center solution. We are investing more than two-thirds of our R&D into contact center. XCaaS innovations like Front Desk, Agent Workspace, and Conversation IQ differentiate our solution and increase our ability to win with enterprise customers. It is clear that product innovation is a core value for us, and we are maintaining our investments to deliver a greater customer experience even as we focus on higher margins. I remain confident in the path 8x8 is on, and I look forward to giving you an update on our next call. Before handing the call over to Sam, I want to thank our teammates at 8x8 for their hard work and commitment. I also want to welcome Janet Winters, our new Chief Human Resource Officer.

Thanks, Dave, and good afternoon. We remained a financially agile and disciplined organization that delivered solid results for the second fiscal quarter. We did experience continued challenges in our CPaaS business and foreign currency headwinds were strong, both of which impacted service revenue performance. We are going to make some adjustments and guidance based mainly on foreign exchange. In spite of these challenges, revenue was in our guidance range, and we continue to post broad improvements in gross margin, delivered solid operating income and another quarter of positive cash from operations. Total revenue for the quarter was $187.4 million, an increase of 24% year-over-year and inside of our $185 million to $188 million guidance. We generated $178.6 million in service revenue, an increase of 25% year-over-year, and again in line with our $177 million to $180 million guidance range. The CPaaS business did not bounce back as hoped with a sequential decline for the third quarter in a row, but we are seeing signs of stabilization. The endpoint supply chain improved and this helped other revenue. The strengthening dollar, especially versus the pound sterling, negatively impacted total revenue by about $1 million for the quarter. Fuze accounted for $27.9 million of service revenue and $28.4 million of total revenue. Service revenue from Fuze was in line with expectations and retention remains solid. Fuze continues to do better than we had modeled when we closed the deal 10 months ago. Fuze was accretive to non-GAAP operating income again this quarter and contributed to overperformance relative to operating margin expectations. We committed to remaining non-GAAP profitable post acquisition and so far, so good. As an example, we have raised Fuze's non-GAAP gross margin percentage from the high 50s to the mid-70s. Total ARR was $692 million at quarter's end, up 25% year-over-year. As we stated in our prior earnings calls, we will not be breaking out Fuze from 8x8 separately for ARR reporting but will continue to give you visibility into Fuze contribution to reported revenue. Enterprise customers accounted for 58% of total ARR, and enterprise ARR was up 42% year-over-year. Mid-market was 18% of ARR and grew 23% year-over-year, and small business was flattish sequentially at 24% of ARR and declined 2% year-over-year. Growing our enterprise business is one of the core tenets of our long-term strategy due to the customers' longer commitments, higher retention and better efficiency ratios. Turning to expenses. Remember that all expense items discussed are non-GAAP unless otherwise noted. Service revenue gross margin came in at 74.1%, an increase of 470 basis points from Q2 '22 and 70 basis points sequentially, driven by continued COGS improvement programs, which drove down unit costs and, to a lesser extent, lower CPaaS revenue. Other revenue gross margin came in at minus 11.2% for the quarter compared with negative 35.2% in the first quarter of '23 and negative 16.6% in the year-ago quarter. Overall, second quarter gross margin was 70.1%, up nearly 600 basis points year-over-year and up 150 basis points sequentially. Turning to first quarter operating expenses. This is our third combined quarter with Fuze. R&D stepped up to 15% of revenue where we want it. We showed some leverage on sales and marketing and took a step back in G&A. The increased cost in G&A were mainly driven by several nonrecurring items that should improve over the next several quarters. Total non-GAAP spending, as measured by COGS plus R&D, plus sales and marketing plus G&A, was up approximately 19% year-over-year, below our 24% total revenue growth. In early October, we made the very tough decision to reduce our total headcount. While it impacted less than 10% of our total employees, we have factored the applicable employee-related cost savings into our non-GAAP guidance, and we expect some one-time severance and restructuring costs in our third quarter cash flow and GAAP results. Non-GAAP operating profit was $9.1 million, up from a year ago, but down approximately $1 million on a sequential basis. As a reminder, the first quarter operating income of $10.1 million included approximately $3 million in one-time benefits. Turning to the balance sheet, total cash, cash equivalents, and restricted cash ended the second quarter at approximately $132 million, compared with approximately $143 million last quarter and $146 million for a year ago ended March 31, 2022. Restricted cash was down to $1.3 million, so we will just report a single number in future quarters. With this cash balance and future expected cash flow, we see no current issues with repaying the 2024 debt. During the quarter, we made significant progress adjusting our balance sheet and at the same time, took steps to reduce our share count. As a quick summary, we did the following in August: We entered into a term loan credit agreement with Francisco Partners as lenders for $250 million in aggregate principal amount maturing in August 2027. This is a floating rate loan based on secured overnight financing rate or SOFR. In conjunction with the term loan, we issued warrants to Francisco Partners to purchase an aggregate 3.1 million shares with a 5-year term at an exercise price of $7.15. We exchanged approximately $404 million in aggregate principal amount of old 2024 notes for $202 million aggregate principal amount of new 4% convertible senior notes due in 2028, along with $182 million in cash. After giving effect to the exchange, the total amount of old notes outstanding on August 11, 2022, was $96 million. On September 28, we repurchased another $6 million of par value 2024 notes at 88.5% for $5.3 million in cash, bringing the balance down to $90 million at quarter's end. In conjunction with the exchange, we purchased 10.7 million shares for approximately $60 million of our common stock at a price per share of $5.61. RPO was approximately $715 million for the quarter, up from $700 million in the first quarter. Cash from operations came in at approximately $13 million for the quarter, ahead of our expectations. We continue to actively manage cash flow and watch it closely, and collections remain solid. Free cash flow was over $10 million for the quarter; our CapEx costs have steadily declined as we focused on capital efficiency. Last quarter, we were clear that we were prioritizing profits and cash flow over growth. We adjusted the financial model accordingly with a decrease in revenue, but an increase in operating margin. This quarter, we're going to raise our exit operating margin target for the fiscal year based on cost savings, but it slightly lowers our revenue. The change in revenue for next quarter and the remainder of the fiscal year is primarily due to changes in foreign exchange. We generate about one-third of our revenue internationally. So the strong dollar hurts our headline revenue numbers. From a bottling standpoint, we take the closing month's weighted value and run it through the financial model, and in September, the dollar rallied a lot. We have a number of natural hedges in place, so that on the operating line, FX has little impact. I cannot stress this enough. While our revenue may change because of FX, our operating income and cash flow is a little impacted. We built it that way. For operating expenses, we plan to control sales and marketing spend and would like to exit fiscal '23 between 36% and 38% of revenue, down from 41% four quarters ago. We plan to focus our R&D efforts on our core product offerings and expect R&D as a percentage of revenue to remain about 15%. Innovation is key for any software company, and for us, with a multibillion-dollar market opportunity, even more so. We believe continued investment in our customer-focused product strategy with emphasis on contact center functionality will provide good ROI. We are focused post Fuze on getting leverage on the G&A line over the next few quarters as we further integrate the two organizations. This set of initiatives will drive operating wages higher in the second half of '23. As Dave mentioned, we think we can add more operating margin in fiscal '24 through continued improvements in unit economics, incremental savings in G&A, cost containment and improved sales efficiency. We are establishing the following guidance for the third quarter fiscal '23 ending December 31, 2022. We anticipate service revenue to be in a range of $178 million to $180 million, essentially flat with the second quarter. This is representing approximately 19% to 21% year-over-year growth. We expect Fuze service revenue contribution will be between $27 million and $28 million. We anticipate total revenue to be in a range of $185 million to $188 million, representing approximately 18% to 20% year-over-year growth. We expect other revenue to be flat to down slightly compared to Q2 due to fewer billable days associated with the holidays. We are targeting an operating margin in a range of 5% to 5.8% for the quarter. We should get a sequential increase on a non-GAAP basis from second quarter's 4.8%. We are updating our guidance for fiscal 2023 ending March 31, 2023, as follows: We anticipate service revenue to be in a range of $712 million to $720 million, representing approximately 18% to 20% year-over-year growth; we have reduced second half '23 revenue performance by approximately $7 million due to foreign exchange based on the method stated above. The remainder of the decrease is some incremental caution in the CPaaS business. If FX stays at these rates, we would expect to exit fiscal 2023 with service revenue growth in the mid-single digits on a year-over-year basis. We anticipate total revenue to be in the range of $745 million to $755 million, representing approximately 17% to 18% year-over-year growth. We are focused on improving operating margin over time and have a goal of exiting fiscal '23 over 6.5% for the fourth quarter and roughly or so 5.5% for the fiscal year. In closing, we believe the increased focus on the operating margin and cash flow is the correct strategy for us right now. At the same time, we believe we need to continue to fund our investment in R&D and our contact center product continues to evolve. We address a broad market opportunity and the focused product strategy that leverages our unique advantages of a unified platform, global connectivity and leading Teams integration. As we extend these advantages and deliver superior ROI to our customers, we reinforce our strong financial foundation and remain an agile organization. And with that, operator, we are ready for questions.

The first question today comes from the line of Mike Latimore from Northland Capital Markets.

Great. Yes, I have two questions. It seems that the slight adjustment in revenue guidance is primarily due to foreign exchange and secondarily to CPaaS. Can you share what you are observing in the international markets? Are bookings performing as anticipated? Additionally, regarding the overall sales cycle in the business, have you noticed any changes? Are sales cycles in line with what you expected three months ago?

I'll take the first part, and Dave will take the second part. Regarding international business performance, it's generally aligned with our expectations in constant currency. For instance, our business could have shown improvement in annual recurring revenue on a constant currency basis. As I mentioned in the script, the strong dollar in September had a notable impact on our revenue performance, although it did not significantly affect our operating income. International performance is solid, and we value our international operations. However, the revenue figures appear less favorable due to foreign exchange effects. To clarify, the changes in our guidance are primarily driven by foreign exchange considerations moving forward. The CPaaS business is stabilizing, and we are reflecting that in our model. The strong dollar in September tends to suppress revenues for the latter half of the year. Now, Dave, do you want to discuss the sales cycles?

Yes. Regarding sales cycles, we are noticing that our buyers require more justification and additional approvals. However, we are addressing this by presenting our cost of doing nothing analysis, which clearly shows how prospects can save money by transitioning from on-premises to the cloud. Every day they postpone this switch results in lost savings. Therefore, we emphasize our total cost of ownership advantages to navigate these extra approval stages in the sales cycles.

The next question today comes from the line of Matt VanVliet from BTIG.

I guess, first, as you look towards the channel and how that's been a driving force in your growth here. Curious on sort of two-pronged here. How is that business shaping up, selling XCaaS, selling kind of the full platform of solutions here? And how much is that driving a lot of the contact center growth you've seen? And then secondarily, on the Microsoft team side, how do you feel like you're kind of growing there, what the offering is and how the ELEVATE program is really driving attention from your channel partners there?

Yes. So channel is obviously an important element of our go-to-market strategy. It's over half our new business. And our partners have really moved strongly behind our XCaaS motion and do well in selling the combination contact center UC. On the Teams side, Teams is an important aspect of what we're doing. When I look across our largest new logo wins, about half of them are Teams attached. And we're getting good traction there on the channel with our team-specific ELEVATE program. We talked about the three we added this quarter in Cloud Revolution, Cyclotron and Apex. We're also arming that channel and our sellers with more options, so to speak, with our XT SKU, which really gives operator connect type pricing with direct routing type capabilities. So superior capabilities at a great price and the Microsoft phone app, which gives a slightly more cost-effective solution for different types of users with a different user experience, so we have that. We have our direct routing solutions. Our XT SKUs are allowing us to stay competitive in that market. It's obviously driving a lot of business for us and allows for the ultimate connection of contact center users to Teams users in an organization. So it really enables the XCaaS.

All right. Great. And then, Sam, obviously, never fund reduced headcount. But curious kind of in the wake of that, how you're assessing sort of making sure that those cuts were sort of one-time and deep enough. And then as you're looking forward, projecting out into next year and beyond. What are areas that you expect you'll continue to add headcount versus sort of holding the line to improve that margin as much as you have already?

I'll address those points in reverse order. We acquired Fuze to enhance our R&D capacity, which remains a key focus for us. As noted earlier, over two-thirds of our R&D investment is directed toward the contact center, indicating our strong commitment to this area. Sales capacity can vary more significantly, and as I mentioned, we operate as an agile finance organization. Regarding headcount, we believe we are appropriately sized for what we anticipate in the near term, but we will need to adjust as necessary. Ideally, we hope to add more employees, but we can adapt depending on market conditions.

The next question today comes from the line of Ryan MacWilliams from Barclays.

So as we think about what a more difficult macro environment could mean for 8x8, are you seeing reductions in headcount within your existing customer base at this point? And I know you're less focused on SMB, but would you expect to see continued small business momentum as those deals may be easier to close in a period where the lower total cost of ownership of 8x8 can resonate?

So I think the first part is in the macroeconomic environment. Are we seeing fewer employees with our customer base? You see that occasionally on renewal. Now remember, we have very well contracted customers being enterprise software, 1 to 3 years. So a lot of that will come post this economic cycle anyway. And we do things when we do renewal, allowing people to extend contracts and adjust appropriately if they're impacted economically. Additionally, we try to funnel some of those users into our cross-sell products with contact center, conversation IQ and other ways to enhance their current productivity. And then the second part of your question, Ryan?

Small business.

Small business stabilized this quarter. We experienced an increase in ARR. We are strategically focusing on mid-market and enterprise customers as they have greater contact center needs. However, we are also attending to the inbound interest from small businesses and continue to support our existing clients with excellent reliability and customer support. I believe this stability is a positive indicator, even in the current macroeconomic environment.

Yes, absolutely. I also like seeing the new 8x8 phone app for Microsoft Teams. Maybe one for Sam. As we see more business keep going through this Microsoft Teams channel, are there any differences to call out on profitability of the 8x8 Teams sale versus attritional 8x8 voice?

I want to be careful and answer this because there's a lot of market discussion around this topic. In terms of your question about profitability, we see the margins as being quite similar. However, historically, we have noticed that lower-functionality SKUs are being purchased more often. In a Microsoft Teams environment, we sell significantly more X1s and X2s compared to a traditional 8x8-only customer, where we would typically sell X1s, X2s, 3s, and 4s. That's the main difference we observe.

Any difference in deal sizes? Sorry, I just don't follow up. Like could there be a larger deal size attached to those Teams deployments?

I mean some of them are really big, so they can be just because we sell a lot of seats. And remember, we're selling a lot of contact center when we sell Microsoft Teams. So that's kind of the blend that blends in and makes us enthusiastic about the Microsoft Teams market. So I would say it's not radically different. It could be higher.

The next question today comes from the line of Sitikantha Panigrahi from Mizuho.

Just wanted to ask about this enterprise segment. What sort of trends are you seeing? I see a downtick on ARR? And what sort of visibility do you have into the second half of your fiscal year, given this macro environment?

I'll address part of this, and then I'll let Dave add if he wants. First, one of the factors affecting ARR was foreign exchange. Without the impact of FX, our ARR would have shown even stronger growth quarter-on-quarter, and our enterprise figures would have increased as well. It's important to note that FX posed a significant challenge to our numbers in September. Regarding visibility for the second half of the year, I wouldn't say it differs much from what we've experienced before. We have a deal pipeline with opportunities at various sales stages, and we rely on that to gauge our business performance. As for close rates, we haven't seen any major changes so far, but overall, I'd say visibility is consistent with what we have seen in the past.

Okay. And then you talked about the contact center opportunity. Any trends that you're seeing? And how do you differentiate in that contact center market?

The contact center remains a fundamental aspect of our XCaaS ARR, showing nearly 40% growth and constituting over 35% of our business. It continues to expand, and it's a major contributor to our large deal wins. We've made considerable advancements in our product over the past few years, particularly in reliability, agent experience, and analytics. For instance, we recently updated our analytics with a UX refresh and enhanced digital journey analytics, elevating our digital analytics to a world-class standard. We are allocating two-thirds of our R&D efforts to contact centers, so we expect to see exciting new announcements regarding supervisor and admin experiences, as well as our digital offerings, in the upcoming quarters. We are already achieving significant wins, and while I am pleased with our progress so far, I am extremely excited about what’s on the horizon for our contact center solutions.

That's great color. And one quick follow-up, if I may. You talked about the weakness in the CPaaS. Is it mostly a slowdown in overall volume or any loss of customer? What are you seeing on the CPaaS side?

It's a little bit of both. We have seen a slowdown. So carriers have been raising prices. And that's made some of the maybe marginal traffic, less interesting to send. And so we've seen some reduction in the amount of traffic. And a customer too has switched to doing other methods for things like OTP and that sort of stuff. Right now, we're seeing the business stabilize, and our focus is getting the growth to rebound back to where it was.

The next question today comes from the line of Michael Turrin from Wells Fargo Securities.

Maybe just on Fuze integration there. I think there's been some commentary just around converting that base over to the XCaaS platform over time. Is that something that you're still working towards and is progressing? I'm curious if that all drives some of the gross margin improvements as well. Or just any further update you can provide on just the combination of those two bases.

Yes. I'll take the first half and Sam will take the second half. But we continue to build the coding to make that upgrade onto the XCaaS platform seamless and easy for those customers, and I'm happy to say we anticipate launching that in the very first part of the new year, and that's on track. And so we'll have our first set of customers experiencing that seamless upgrade around that talent our fiscal year Q4 time frame.

I'll cover gross margins. As I mentioned on the last call, we've managed to raise Fuze gross margins in our UCaaS business more quickly than anticipated. There are a couple of factors contributing to this. First, we've increased Fuze gross margins to the mid-70s. We are blending this with our total UCaaS business as a percentage of our overall operations, which includes both UCaaS and CCaaS. Our communications business is performing better relative to the CPaaS business, leading to higher overall corporate margins, and we have plans to continue enhancing gross margins. This quarter, they were over 70.1%. Our goal is to maintain them above 70% moving forward. Additionally, the acquisition of Fuze has strengthened our buying power at core 8x8, allowing us to negotiate lower costs with our carrier partners. It's important to note that we spend nearly $100 million on carrier interconnect. By increasing our volume, we obtain better per-unit pricing, which positively impacts our gross margins.

Okay. That's interesting. I guess just on the margin in general, there's clearly a lot of focus there. What are some of the things you're finding that allow you to keep moving the targets up into next fiscal year? And are you feeling good about the continuation of those trends as needed just based on what you're finding there so far sound?

I'll address those points in reverse. Dave mentioned in his script that we have a clear path to double our operating margins next year, which sets a concrete goal for us to pursue. We do have a plan on how to achieve that. While I'd like to say it's a single factor, it really involves a lot of focused efforts on efficiency. Right now, our main goal is to improve our efficiency. The trade-off you might notice is somewhat related to revenue growth. We've scaled back our spending in sales and marketing, particularly in less effective areas that previously contributed to revenue growth, but not necessarily in a highly efficient manner. We're shifting our focus towards generating operating margin, EBITDA, and cash flow, especially now that we've made our first interest payment on our debt in the September quarter and have more payments coming up. We want to ensure we have ample capacity to cover those payments while also reducing our debt over time. So, while we have a clear path towards improved operating margins, that may result in less revenue growth than we've experienced in the past.

The next question today comes from the line of Josh Nichols from B. Riley.

Clearly, the company has been making a very big pivot here. I think it's probably the right decision and good to see the cash flow numbers moving in the right direction, especially when you think about the debt payments and stock at these current levels. I guess if you're going to do double-digit operating margins next year, could you talk a little bit about what that would translate to for free cash flow? And how you might use that between some debt payments and potential stock buybacks?

Our capital expenditure needs have been decreasing, and we're becoming much more capital efficient. This has been a focus for us for several years. Our attributable cash flow, which is cash from operations minus capital expenditures, is increasingly resembling cash from operations. As we increase our non-GAAP operating income, we expect to see a positive correlation with that. We anticipate single-digit revenue growth while maintaining double-digit margins, which is encouraging and gives us room to start reducing our debt levels if everything goes as planned. Regarding your second question, we currently have $132 million in cash and $90 million of 2024 debt due. We're generating sufficient cash to manage the 2024 obligations comfortably. Starting from the second year of our term loan, we can repay an extra 10% without penalties, and from the third year onward, we can pay down our term loans without incurring any penalties. The company is focused on generating enough cash to meet these milestones. We are confident we can meet the 2024 obligations and aim to start prepaying the term loans swiftly to save on interest at the current rates.

If I look at it, I estimate around $800 million in revenue for next year based on the growth rate you've mentioned. If you maintain the margins discussed, that could lead to approximately $80 million in free cash flow, which should provide sufficient capital to start reducing some debt. I believe you mentioned assuming mid-single-digit service revenue growth as a long-term target, so is this a reasonable basis for building out the model?

I believe everything you mentioned makes complete sense. For those who are more accounting-focused, we can consider $80 million in operating income, which is roughly our cash from operations. After accounting for a small amount of capital expenditures, let's say $10 million, that leaves us with $70 million. Subtracting $30 million in interest payments gives us about $40 million annually. Over five years, that could allow us to take out $200 million of the $250 million debt. We would also save a significant amount in interest during this time. It’s possible to find a way to eliminate the remaining $50 million. If we achieve this, we may see the stock appreciate enough to convert the 2028 notes. I believe there is a feasible option to make the company almost debt-free within five years.

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

This is Erik on for Meta. I want to go back to the XCaaS side. I know a couple of quarters ago, you noted that nearly half of your incremental ARR was coming from contact center. Can you maybe just give us an update on if that percentage has changed meaningfully at all over the past few quarters in either direction?

Can you repeat it?

Incremental ARR.

Half the incremental ARR is coming from XCaaS?

From I think a few quarters ago, you had said from contact center in new XCaaS deals? Just curious if that's...

Yes, if you consider the growth mentioned in the script regarding XCaaS, around half of that typically comes from the contact center. Looking at the standalone figures, we are generating a significant portion of our incremental ARR from the contact center.

Okay. That's helpful. And then if we just think about the focus kind of shifting more towards operating margins and that in the context of Fuze product strategy, is this plan largely to leave the Fuze product as is and gradually upsell contact center? Or do you see kind of initiatives within Fuze to maybe shift from that in any way?

Yes. So we see a big focus on our installed base overall as we do more laser-focused on sales and marketing efficiency. And we've done a lot of improvements, both in the product basis and the customer support levels. On the Fuze side, we talked about the coding we're doing for seamless upgrades onto the X-Series product for those customers that will kick off next calendar year, and that gives us even more opportunity on cross-sell of those customers into the 8x8 contact center.

The next question today comes from the line of Catharine Trebnick from MKM Partners.

With this macro backdrop, you guys did a really good job. Can you talk about the competitive landscape and especially hit on contact center with Zoom coming out with a contact center, you get pretty active. Can you just lay out where you think your opportunities are in terms of seat size or even in terms of which vertical markets might be more attractive?

We have been focusing on XCaaS for nearly two years, directing 70% of our R&D investment towards contact centers. This approach has allowed us to enhance our contact center product, making it more effective and appealing to clients in the market. This is a key factor in our success. In our experience, we encounter more existing players in the contact center space rather than new entrants, and this dynamic hasn't shifted with the recent players mentioned. Our XCaaS capability provides numerous advantages over standard contact centers, including unified analytics and administration, reliable service level agreements, enhanced visibility for front desk operations, and the ability to perform sentiment analysis across all employees and teams. The differentiating features we offer enable our customers to achieve a lower total cost of ownership compared to maintaining two separate platforms.

And then are you seeing any pickup with Avaya troubles and your opportunities for just your core UCaaS business?

There are many buyers who are considering transitioning from their historical on-premise PBX systems, such as those from Cisco or Avaya, to collaboration tools like Teams. We are noticing significant interest in this shift from IT and CIO organizations.

The next question today comes from the line of George Sutton from Craig-Hallum.

I appreciate the details on the Microsoft partner ads in your app. I'm wondering if we could talk about Microsoft relative to that friend versus Ultimate so argument. And I'm curious how you look at it. We look at about 260 million seats out there and 12 million or so, we believe, using third-party voice. I'm just curious if you can address your objectives relative to some of those numbers and relative to Microsoft's own voice objectives.

Yes. I think a huge universe of collaboration users. Not many currently lit up with voice, but a substantial number when you think of the 12 million. But we really look at that relative to maybe the 250 million, 270 million active users on collaboration and lining those up. And we see the bulk of that, or almost all of it going to either direct routing or operator connect to ecosystems. So we have a leading direct routing solution and by doing things like our XT SKU, we've become very price competitive with the increased functionality you get from direct routing and the phone app helps also. I think that universe, the 12 million voice users can go up very significantly over the next couple of years. I think Gartner's thinking that you get to 20% penetration of those teams users over a couple of years, which gives you like tremendous growth on that 12 million. And we want to capture a good share of that.

Perfect. And second for me, regarding Fuze, I don't think anyone on this call would have anticipated that you would perform as well with that acquisition as you have. This raises the question of whether there are other businesses that could benefit from a more suitable home in a consolidating market. What is your ultimate goal concerning other mergers and acquisitions?

George, maybe last. Look, I think with the...

The next question comes from the line of Pete from Evercore.

Maybe just, Dave, one for you is segmenting contact centers as a stand-alone. How are you priced on a seat-by-seat basis versus competitors? Are you above or below the mean? And then one for you, Sam, gross margins contact center historically have been, call it, high 50s, 60s, if you just look at some of the companies trading today. How should we model margins from contact center going forward?

Yes. Well, contact center pricing is very advantageous for our customers. I mean we're a fair pricer. We're not a premium pricer, but we give great functionality and capability, and we do it with super high reliability. We do it now over 56 countries, which is the largest footprint of any UCCC player, and we do that with both UC and CC in every one of those countries. So our pricing, while it's significantly higher than UC seats, 4 or 5x higher, it's very competitive in the market, and then by combining it with UC, so it's competitive stand-alone, just straight up. But when you combine it also with UC, you get all the lower cost of ownership by having like single integration to manage with things like Teams or Salesforce or other integration CRMs and the easier to deploy, manage, so much lower total cost of ownership than anything else in the market.

Regarding gross margins, I understand your point. However, I believe it's not the best perspective to take. If we look at my service revenue margins, they're at 74.1%, which includes the relatively lower-margin CPaaS. I'm seeing very similar margins between my UC and CC businesses. This is because XCaaS is effective; it operates on a single platform. We can distribute our carrier interconnect costs and other expenses across this one platform. It's largely a matter of scale and it functions well. I don't notice any significant differences in gross margins between the two products. However, it is challenging to assess because they are integrated. I think the integration leads to minimal differences in margins.

And just to follow up on a prior question. Sam, help me think through steady-state organic growth, right? I mean, are there levers you can kind of pull to reaccelerate to call it double digits? Or is it just should we think about it going forward as just a highly efficient single-digit story?

No, we're not giving up our goal of being double-digit grower. I think right now, we have a currency headwind that's causing suppression, and we're focused on pivoting to more cash, and that has some consequences associated with it also. I think if we were really focused on being a central digit grower, we would probably reduce our R&D spending, and we're not. We continue to invest very aggressively in R&D. We hit our 15% goal that we've been trying to achieve for a while this quarter. And so I think the next leg will be based on innovation and those kinds of things to read at a higher growth rate. And maybe just maybe the dollar weakening a little bit would help me also.

Next question today comes from the line of James Breen from William Blair.

Just a couple. One on growth and just sort of think about across your segments in small, mid and large enterprise. Any color on how much of the growth is coming from existing customers versus new customers? And does it differ amongst those groups? And then a little bit in relation to the question on sort of M&A and consolidation. Any change in the competitive environment? Are you seeing some of the smaller players just not show up as much because they don't have the funding available to be affected competitors?

I'll take the first part, and either one of us can handle the second part. Let's focus on the first section first. Regarding the competitive environment, I would say there haven't been any radical changes, but ultimately, it’s us versus the other major player in Belmont that we encounter most frequently. I believe the smaller players are facing challenges. While it's not as evident this quarter or the next, I think they will struggle to keep up with innovation. We are using this downturn to keep investing in our innovative processes. Competitors will need to step up their investments to keep pace with companies like ours. Over time, I think you'll see a divergence in performance.

Yes, installed base versus new. We do about half of our bookings from the split is about 50-50. And we have an even greater emphasis on installed base as we have great cross-sell products with contact center, things like Conversation IQ. So that's been a focus of the organization as we improve sales and marketing efficiencies. We'll continue to do that. And I think our customers have been more receptive as we've improved product reliability and customer support elements and with the innovation we're getting on contact center, it all goes hand in hand.

The next question today comes from the line of Ryan Koontz from Needham Company.

Dave, I wanted to circle back to your comment about direct routing versus Operator Connect there and how you frame up that competitive threat. It looks like Operator Connect is a little more integrated into the selection process, admin panels and onboarding and how you think about that competitive environment there for the new Operator Connect competitors?

Yes. The Operator Connect gives you like carrier connectivity; the direct routing really allows you to apply core routing PBX functionality to that and enhance the overall capabilities for adding voice to Microsoft Teams. So it's truly a superior functionality solution. And so our goal is to stay price competitive, and we sell the value of that solution. And we're doing things to continue to lower our costs. We talked about the XT SKU. We talked about the phone app; all those continue to have the superior capabilities that you get with the 8x8 platform, and it's all that series. So it allows you to seamlessly integrate contact center users on top of that. And really connecting your contact center to Teams users is like a big pain point with CIOs today. And something like Operator Connect doesn't solve that for you. So we think we have a tremendous number of advantages there, and it just creates a much richer experience for the customers and what they get.

Next question today comes from the line of Michael Funk from Bank of America.

A couple if I could. As you think about sequential revenue growth heading into fiscal '24, what are the variables that you're most focused on to present the most upside and downside risk to sequential revenue growth? Is that net revenue retention? Is the CPaaS business? Is it SMB? What are those variables we should be thinking about?

You highlighted some of the key points. Currently, the main factor for sequential revenue growth is FX, which took me by surprise with how the dollar behaved. I want to emphasize what I mentioned earlier: while it doesn't impact our operating numbers, it does influence our headline revenue figures due to the numerous natural hedges we have in place. There was significant concern about the CPaaS business 90 days ago, but it seems to be stabilizing now, which is encouraging. As for SMB, we've focused on improving efficiency and generating cash, and we believe we have that under control now. You brought up potential downsides, but I want to stress that we also have exciting new products emerging from the R&D effort we initiated when we acquired Fuze nine months ago. Our design teams have been busy, and we expect new innovations to come out over the next six to twelve months, which is promising. We've also been actively working with Microsoft on new SKUs and enhancing pricing and packaging. The Microsoft channel partners highlighted earlier are a substantial advantage. Overall, we see several positive developments related to Microsoft Teams and new product innovations that could bolster our growth in the future. No, it's a little bit of both. We have seen a slowdown. So carriers have been raising prices. And that's made some of the maybe marginal traffic, less interesting to send. And so we've seen some reduction in the amount of traffic. And a customer too has switched to doing other methods for things like OTP and that sort of stuff. Right now, we're seeing the business stabilize, and our focus is getting the growth to rebound back to where it was.

Our final question today comes from the line of Will Power from Baird.

This is Charlie Erlikh on for Will. Just one quick one for me. What are you seeing on the pricing front, maybe on a seat per seat basis relative to three months ago? Are you seeing any pressure on pricing, especially you mentioned there are some customers that are looking at elongated sales cycles? Are they maybe pushing back on price at all when it comes time for renewal or just your customer conversations? Any change in pricing appetite?

I'm not going to say much about the pricing situation in this environment. Everyone is examining their pricing, perhaps even adding a few extra evaluations. For anyone supplying to us, I held your contracts until the very end of the quarter before signing them. I believe we're observing some aggressive moves, which seem more related to the economic climate than to competition. Regarding renewals, I've frequently heard that it doesn’t hurt to ask. I don’t think these factors are outside our guidance considerations; we are aware of them and actively addressing them. It's crucial for us to lower our costs in this environment, and we are concentrated on protecting and enhancing our margins. When faced with pressure from customers, we also apply pressure to our suppliers.

This concludes today's conference call. Thank you all for your participation. You may now disconnect your lines.