8X8 Inc /De/ Q3 FY2023 Earnings Call

Good afternoon. Thank you for attending the 8x8 Fiscal Third Quarter Earnings Call. My name is Matt, and I'll be your moderator for today's call. All lines have been muted during the presentation portion of the call and will have an opportunity for a question-and-answer session at the end. I would now like to pass the conference over to our host, Kate Patterson, Vice President of Investor Relations. Kate, please go ahead.

Thank you, operator. Good afternoon, everyone. Today's agenda will include a review of our third quarter results with Samuel Wilson, our Interim Chief Executive Officer, and Kevin Kraus, our Interim 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, product, and growth strategy. 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 those forward-looking statements as described in our risk factors in our reports 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 the U.S. generally accepted accounting principles or GAAP. A reconciliation of those non-GAAP measures to the closest comparable GAAP measures is provided in our earnings press release and earnings presentation slides, which are available on the 8x8 Investor Relations website at investors.8x8.com. With that, I'll turn the call over to Samuel Wilson.

Thank you, Kate, and thank you to everyone joining us on the call today. I believe our solid third quarter results were a strong indicator of our ability to perform against our objectives. We said we would forgo some near-term revenue growth for profitability as we build a sustainable long-term business and that's exactly what our teams did in the quarter. Despite the lower-than-expected total revenue, we delivered almost 10% operating income, increased deferred revenue and RPO, and experienced high customer retention, all early indicators of future success for a SaaS business. I'm impressed with the quality of our performance in the third quarter, and I want to thank our employees and everyone in the 8x8 community for their hard work. Turning to the future. I have been working closely with the leadership team and the Board of Directors on a multi-year strategy to grow our business and create value for our stakeholders. We laid the foundation for our next step several years ago when we re-architected our core technology. We built a modern microservices-based platform that powers both our current UCaaS and CCaaS solutions. We have fully embraced continuous integration and continuous deployment and are delivering more than 1,000 microservice updates every quarter. This enabled near-perfect uptime for the third quarter and reduced the number of customer identified defects to single digits. We are innovating faster than we ever have before. At the same time, we embarked on this journey; we could not have predicted the global COVID pandemic or how it would accelerate adoption of cloud-based telephony and internal collaboration tools, especially Microsoft Teams. While UCaaS migration continues to create revenue and profit opportunities for efficient providers like 8x8, I believe the opportunities to differentiate based on standalone UCaaS are becoming increasingly rare. Our XCaaS platform, which delivers the high availability, scalability, and security of a unified cloud-native solution with a lower TCO, is highly differentiated. By focusing on CCaaS innovation within the platform, we can continue to extend our leadership. Specifically, I believe the contact center market is at an inflection point. According to PwC's Future Customer Experience survey, 1 in 3 customers would leave a brand they love after 1 poor experience. No longer can the contact center be viewed solely through a cost lens. It has become the primary way for companies to interact with their customers and build brand loyalty. At the same time, advances in ML-AI technologies as well as customers' growing preference for high-quality digital and self-service interactions set the stage for a new wave of contact center migrations and upgrades. Technologies like large language models such as ChatGPT have the potential to transform the customer experience. Our modern platform enables these technologies today, and I believe we are well positioned as this opportunity evolves. We have identified six areas I believe are critical to our future success. First, further acceleration in CCaaS innovation while maintaining our leadership position in cloud telephony. We began our shift to an innovation-led company with the acquisition of Fuze, which doubled the R&D resources dedicated to innovation. We have successfully accelerated the pace of project completion and are already seeing the results of our increased investment. We are already in beta on a number of new CCaaS features, including capabilities based on advanced machine learning and large language models. We remain committed to our leadership position in cloud telephony as an important component of the XCaaS platform. Our ability to deliver both voice and CCaaS solutions for Microsoft Teams users is increasingly a deciding factor in new business wins around the world. We saw triple-digit growth in voice for Teams seats in the third quarter and have now sold more than 300,000 licenses. The largest Teams customer has already deployed the technology to more than 30 countries. Global coverage matters. Recent XCaaS with Teams wins include the Australian Computer Society, which selected 8x8 XCaaS with voice for Teams to help drive operational efficiencies, productivity gains, and enhance their contact center performance. This channel-led win demonstrates the competitive differentiation of our XCaaS solution within the Teams environment. In the U.K., Gateshead Metropolitan Borough selected 8x8 XCaaS with voice for Teams to support hybrid work for their nearly 3,000 employees and enhance their 200-plus agent contact center. Second, increasing our focus on small and midsized enterprise customers. Small and midsized enterprise customers need the same automation and ML-AI contact center capabilities as large enterprises but don't have the large enterprise budgets or a team of in-house developers. Our mix-and-match pricing model, unified communications, and enterprise-class APIs make XCaaS the natural choice for these customers. Just as important, our modern platform enables the adoption of advanced contact center capabilities, future-proofing their investments. The strong product market fit improves customer satisfaction, often leading to follow-on sales and reference sales down the line. A great example of a win directly tied to a happy existing customer is Chubb Group Security Limited, a global fire safety and security solutions provider protecting more than 1 million locations worldwide. After acquiring a division from an existing 8x8 CCaaS customer, Chubb reviewed and selected 8x8 CCaaS for a complete secure cloud contact center solution. Another example of customer satisfaction driving new business is Indiana Hemophilia and Thrombosis Center, the only federally recognized comprehensive Hemophilia treatment center in Indiana and 1 of the largest centers in the nation. With a key decision-maker having previous experience with 8x8, the nonprofit entity selected 8x8 XCaaS for its comprehensive CCaaS solution that is certified for Microsoft Teams. Our best-in-class reliability was also a factor in the decision. Third, increasing XCaaS win rates and sales and marketing productivity. As we continue to innovate and expand our XCaaS platform, our win rates should increase. We are attracting more go-to-market and technology partners every day, especially around our market-leading Teams integration. This expands our market reach, increases our capacity for innovation, and creates an ecosystem of applications and features that allow our customers to tailor their customer experience to their business needs. A customer that fits squarely in our sweet spot is Panine Care NHS Foundation Trust in the U.K., a provider of mental health, learning disability, and autism services to 1.3 million people across Greater Manchester and beyond. They selected 8x8 XCaaS to upgrade to modern reliable cloud communications and deliver enhanced patient engagement capabilities for over 3,000 staff. Another U.K. win, the Southampton Football Club in the English Premier League, is a good example of how the unified XCaaS platform delivers contact center features to users across the organization to enhance the customer experience. The Saints selected 8x8 XCaaS with 8x8 Front Desk to deliver a premier fan and hospitality experience and introduce new communications channels such as email and web chat because they are customer obsessed. Fourth, maintaining an outstanding experience for customers so they can focus on theirs. The investments we've made in customer success, including more than 8,500 hours of training for our Tier 1 support engineers, are evident in our statistics and customer success scores. We've seen a 50% reduction in escalated issues, a 20% improvement in first-day resolutions, and a 49% reduction in global backlog. As a result, our customer satisfaction scores are up double digits versus a year ago. We still have a lot of work to do, but we are passionate about leveraging our platform and the solutions of our technology partners to drive continuous improvement in customer experience and customer satisfaction. We use our own products and intend to document our progress as an early adopter of each new innovation in an ongoing case study. In this way, we remain accountable to our commitment to improving the experiences of our customers, and we provide a roadmap for our customers to do the same in their organizations. Fifth, establishing CPaaS leadership in the Asia Pacific region. CPaaS was down year-over-year and sequentially again this quarter. It was the single largest factor in our third-quarter revenue miss and downward revision to our revenue guidance for the fiscal year. That said, the CPaaS technology is important to the XCaaS platform, and we continue to add new customers regularly. We are going through a transition in the business, and there are some signs of stability. This gives me confidence that CPaaS will make a positive contribution to our operating performance in the future. Several third-quarter wins illustrate this point. Plugo, an Indonesian D2C e-commerce platform with a vision to democratize e-commerce, uses a combination of 8x8, SMS, APIs, and WhatsApp through 8x8 Chat Apps API to send secure one-time passwords and notifications as well as for customer care. Privy, Indonesia's first and leading legally binding digital signature with more than 37 million users and 1,800 enterprise customers, uses 8x8 SMS API to keep all users secure with one-time passwords. Plusdane Housing, a U.K. housing association that owns and manages over 13,000 homes across Northwest England, selected 8x8 XCaaS with 8x8 CPaaS, voice for Teams, and Verint workforce management to support their over 500 employees and drive customer satisfaction with greater omnichannel capabilities. We love our triple play customers. Sixth, increasing our profitability and cash flow to deleverage our balance sheet and fund investments in innovation that will drive our future growth. We have already shown tremendous progress in fiscal 2023, and we have come very close to our second-half '24 target of double-digit non-GAAP operating margin this quarter, a full year ahead of schedule. As Kevin will discuss, we believe we can drive our margins higher again in fiscal '24 as we align our investments and cost structure and improve our sales productivity. We intend to leverage improvements in our operating margin to pay down debt, which will reduce our interest payments and allow more enterprise value to accrue to our equity holders. We began this process in Q2 when we repurchased $6 million in aggregate principal value of our '24 notes, and we continued in the third quarter with the repurchase of approximately $22 million in principal. What I have outlined here is a long-term strategy based on an efficient, focused innovation engine and a modern cloud-native platform. At the heart of this strategy is delivering superior customer experiences. The experiences of our customers and partners as they engage with us, and the experiences they can deliver to their customers and their employees with our XCaaS platform. This is our North Star. Every customer interaction is an opportunity to delight. And our goal is to make every touch matter, whether digital or in person. This commitment to our customers' experience is already built into our DNA. Our financially backed commitment to Five 9's availability is just one example. We are already well on our way on our multi-year plan to lead with innovation and be the customer success platform of choice for our customers. The best measurement of our continued progress is the willingness of our customers to recommend our solutions to their peers. Our goal is to achieve 100% referenceability within our targeted customer segment. It is a lofty goal, but one I believe will allow us to deliver sustained growth and profitability for many years to come. I will turn the call over to CFO, Kevin Kraus, for a more detailed review of our financial performance.

Thanks, Sam, and good afternoon to everyone. We remained financially disciplined and delivered solid profit and cash results for the third fiscal quarter. In the third quarter, despite service and total revenue being slightly below our guidance ranges, we delivered non-GAAP gross margin, non-GAAP operating profit, and cash from operations above our expectations. Total revenue for the quarter was $184.4 million, and we generated $175.8 million in service revenue, both an increase of 18% year-over-year. Our revenue performance reflected strong customer retention and renewals, partially offset by a continued decline in our CPaaS business in the Asia-Pacific region. Other revenue for the quarter was $8.6 million, roughly flat with the prior quarter and in line with expectations. Fuze accounted for $26.5 million of service revenue and total revenue and was impacted by a $1 million third-quarter reserve adjustment we made as part of our integration of back-office processes. Fuze's customer retention remains strong, and the business continues to outperform our initial expectations. Strong retention across the customer base was reflected in our RPO and ARR metrics. Remaining performance obligation was approximately $750 million for the quarter, up from $715 million in the second quarter on solid bookings performance. Customer renewals were notably strong, and our customer retention was the highest it has been in many quarters. Total ARR was $698 million at quarter-end, up 22% year-over-year. Enterprise customers accounted for 57% of total ARR, and Enterprise ARR was up 30% year-over-year, but down approximately $1 million sequentially due to the continued decline in CPaaS ARR. We had hoped this part of the business had stabilized last quarter, but due to continued challenges, we are taking a conservative view of the potential revenue contribution going forward. Turning to gross margin, operating expenses, and operating profit. Please remember that all items discussed are non-GAAP unless otherwise noted. Service revenue gross margin came in at 75.7%, an increase of approximately 600 basis points from Q3 '22 and 160 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 negative 1.4% for the quarter compared with negative 32.2% in Q3 '22. Other revenue gross margin has shown consistent improvement over the past few quarters due to increased professional services operational efficiencies plus better product margins. Overall, second quarter gross margin was 72.1%, an increase of over 700 basis points year-over-year and up 200 basis points sequentially. Turning to operating expenses. R&D was 14.5% of revenue, which was in range of our 15% target. We improved sales and marketing leverage as we realigned costs early in the quarter with sales and marketing expenses down $3.3 million sequentially, and sales and marketing as a percentage of revenue declining over 100 basis points sequentially. We expect further improvements in sales and marketing efficiency as a result of our most recent cost alignment action in January, which further reduced our investment in sales and marketing initiatives in non-strategic areas of the business. This will be partially offset by the seasonal increase in employee-related costs in the first calendar quarter. G&A declined $3 million sequentially, improving 140 basis points as a percentage of revenue to 11.4%. Total non-GAAP spending as measured by cost of goods sold plus R&D, plus sales and marketing plus G&A was up approximately 8% year-over-year, primarily due to the addition of Fuze's operations, but it was well below our 18% total revenue growth. Non-GAAP operating profit was $18.3 million, up nearly 6 times from fiscal Q3 '22 and more than double sequentially. As Sam mentioned in his opening remarks, we achieved approximately 10% operating margin in Q3, nearly a full year ahead of previous expectations. As you can see, we are committed to improved operational efficiency and delivering enhanced operating profit. Turning to the balance sheet. Total cash, cash equivalents, and restricted cash ended the third quarter at approximately $132 million, substantially equal to last quarter despite consuming $20 million in cash for debt repurchases. As Sam mentioned in his prepared remarks, during the quarter, we made notable progress deleveraging our balance sheet by repurchasing approximately $22 million in aggregate principal amount of 2024 convertible senior notes, after repurchasing $6 million in Q2 '23. These debt repurchases and the exchange transaction from August 3 leave approximately $68 million of aggregate principal value of 2024 convertible senior notes remaining. Given our current cash balance and expected future positive cash flow, we see no issues with repaying the 2024 debt with cash at maturity in February 2024. Going forward, we expect cash flow will increase with operating leverage, subject to timing differences in collections and other payables. We intend to use the excess cash generated to opportunistically prepay debt, including our term loan. This will lower our interest payments and will enable continued investment in product innovation while simultaneously shifting more of our enterprise value to our equity holders. Cash from operations was over $15 million for the quarter, ahead of our expectations and approximately $2 million higher than Q2 despite paying approximately $3 million more in interest expense in the third quarter. We continue to actively manage cash flow, and customer collections remained solid in Q3. Free cash flow was over $12 million for the quarter, a greater than $1 million sequential increase. Our CapEx costs have been declining over time as we have focused on capital efficiency. As previously stated, we took action in January to realign our workforce to accelerate innovation as we continue to shift to enterprise and XCaaS, and this included the difficult decision to further reduce our total headcount. When completed, the action will impact approximately 7% of our employee population. This action will be factored into our non-GAAP guidance, and we expect some one-time severance and restructuring costs will impact our fourth-quarter cash flow and GAAP results. Before turning to guidance, let me provide some context based on our commitment to building a sustainable growth business with SaaS-like operating metrics. We have been doing a top-to-bottom strategic review of our business to ensure that all areas are operating efficiently. The strategic cost realignment activities from last October and in January allow us to reallocate limited resources to the areas of focus for the future, while improving our operating metrics in the near term. We are raising our exit operating margin target for the fiscal year based on improving efficiency and discipline around the business we are pursuing. For operating expenses, we plan to control sales and marketing spend and would like to exit fiscal year 2023 between 33% and 35% of revenue, down from 39% 4 quarters ago. We plan to focus our R&D efforts on our core product offerings and expect R&D as a percent of revenue to remain about 15% as we continue on the path of investment in our customer-focused product strategy with an emphasis on contact center features and functions. We are focused on extracting more leverage from our G&A functions as we work to improve operating efficiencies in those areas. We are establishing guidance for the fourth quarter of fiscal 2023 ending March 31, 2023, as follows. We anticipate service revenue to be in the range of $175 million to $178 million, up sequentially from Q3 at the midpoint and representing approximately 1% to 3% year-over-year growth as we pass the Fuze 1-year anniversary and remain cautious on the CPaaS revenue outlook. We expect that Fuze's service revenue contribution will be roughly flat with Q3 at approximately $26 million. Please note that next quarter will be the last time we provide Fuze revenue contribution as we will have passed the 1-year anniversary and the businesses are now integrated. We anticipate total revenue to be in the range of $184 million to $187 million, up sequentially at the midpoint and representing approximately 1% to 3% year-over-year growth. This guidance reflects the 1-year anniversary of Fuze and our cautious approach to the CPaaS revenue outlook. We expect other revenue to be approximately flat compared to Q3. We are targeting an operating margin of approximately 10%, roughly flat with fiscal Q3 '23, as we experience our normal expense headwinds related to the restart of employer taxes and other benefits, such as the 401(k) match. These expense headwinds impact all cost lines in the consolidated statement of operations. We expect cash flow from operations to be positive but down quarter-over-quarter as we make semiannual interest payments on our 2024 and 2028 convertible debt and absorb severance costs from our January headcount reductions. We are updating our guidance for fiscal 2023 ending March 31, 2023, as follows. We anticipate service revenue to be in the range of $708.5 million to $711.5 million, representing approximately 18% year-over-year growth at the midpoint. We continue to be cautious regarding our CPaaS business, and with the Fuze 1-year anniversary past us, we expect to exit fiscal 2023 with service revenue growth in the low single digits on a year-over-year basis. We anticipate total revenue to be in the range of $743.4 million to $746.4 million, representing approximately 17% year-over-year growth at the midpoint. Our total revenue guidance for the fiscal year reflects the combined Q3 and Q4 impact, resulting in a reduction of approximately $5 million at the guidance midpoint. We continue to focus on improving operating margin over time and anticipate landing at approximately 7.5% for fiscal 2023. We also would like to provide some directional color on fiscal 2024, which commences April 1, 2023. We anticipate total revenue and service revenue growth in the low single digits, as the revenue step-up from the Fuze acquisition will be reflected in every quarter of fiscal 2023. Additionally, we remain cautious regarding the revenue trend for the CPaaS business. We anticipate non-GAAP operating margins steadily growing from the expected Q4 '23 base of approximately 10%, hitting double digits every quarter in fiscal 2024. For the full year, we expect operating margin to be 4 to 5 percentage points higher than full year fiscal 2023. We anticipate cash flow from operations to be directionally aligned with the non-GAAP operating profit trend. Additionally, I would like to mention that we are reviewing our key metrics to ensure that we are providing the appropriate insight into our revenue growth drivers. We will follow up in subsequent earnings calls on this matter. In closing, I believe that the continued focus on our operating margin and cash flow is the correct strategy for us at this time. This strategy enables us to remain an innovation-led company as we fund investments in key product areas. On a personal note, I also would like to say that I'm happy to be continuing my business partnership with Sam in my new role as Interim CFO. With 8x8's modern, unified XCaaS platform, we are well positioned to deploy our strategy to capture more of the contact center market, to delight our customers and to deliver on our commitment to improve profitability and cash flow generation.

I guess as you look at sort of the realigned cost structure here and an outlined kind of focus around servicing smaller customers and also the Teams ecosystem. Just curious on sort of where within the sales and go-to-market organization are we seeing the most cuts? And it sort of feels like some of these investments are in areas that were maybe less focal for the previous leadership team. So just curious on how much of this is a change versus just kind of moving from 1 pocket to another.

I'm going to provide a response that reflects a bit of both perspectives. We are aligned with our previous statements, continuing to moderate our investment in our smaller customer segment while maintaining our focus on mid-market and enterprise. We have reduced some investments in sales and marketing, consistent with our earlier comments about prioritizing profitability over revenue growth, as demonstrated by our 9.9% operating margins. One change we've made is being more proactive in implementing these adjustments sooner rather than later, while still focusing on investments in contact center, XCaaS, and innovation. We are also more aggressive in supporting those investments. So it's a bit of both in terms of our strategy.

As you consider the Fuze business that we acquired, we are understandably facing some challenges in growth. However, I am curious about the customer base. Should we expect it to grow at a different pace compared to the legacy 8x8? Are there any limitations on how much we can grow within that base? Since a significant part of the acquisition was related to technology and the development team, could you help us understand what the Fuze base looks like? Additionally, are there still plans to transition them to XCaaS?

The first and most crucial priority is to enhance cross-selling our contact center services to our unified communication base. There is a significant opportunity here, which may not be reflected in the Fuze figures if we continue to report them. Although we plan to stop reporting these figures after the next quarter, we have already begun migrating some customers to the 8x8 platform, and we will keep doing so. This aligns with Kevin's previous comments about how, as we move past this phase, reporting these numbers becomes less meaningful. It's important to note that we are not focusing on acquiring new logos within the Fuze segment; our investment is directed towards the 8x8 side. Thus, the Fuze figures we report correspond to the Fuze unified communication base, and naturally, we anticipate a gradual decline in those numbers over time. However, it has been a very gradual decline over the last year, better than we initially expected following the acquisition. I expect this trend to continue, with our primary focus, aside from retaining revenue, being cross-selling our contact center solutions.

Maybe as you look to fiscal '24 and just kind of the low single-digit outlook that you gave. You guys mentioned a lot of conservatism around CPaaS or conservatism just on Fuze term. But just if you could give kind of an update as far as like what you're seeing as far as deal activity, trajectory, just given kind of the macro environment. And then maybe as a follow-up question on the CPaaS business. I guess, just like what is the ongoing rationale particularly just given it's in a region that you guys don't do a tremendous amount of business in, like what is the business rationale in continuing to kind of invest in that business when you're making kind of cost decisions elsewhere?

This is Kevin. Regarding the growth in 2024, we're anticipating low single-digit growth for the CPaaS business and are approaching it with caution. While we are observing signs of stabilization in that sector, its usage-based nature makes it quite dynamic. Therefore, we will maintain a conservative outlook until we see clear signs of change. The reasoning behind our investments in this business is that it has the potential to generate revenue quickly, which makes it an area of interest for us. It could drive significant growth in a shorter time frame compared to our usual recurring revenue streams, so we are considering increasing our focus on this opportunity.

Yes. A couple of small things to note: regarding economic sensitivity, areas like CPaaS, which isn't contracted revenue, are showing some increased sensitivity. However, our core business is performing exceptionally well, particularly in terms of collections. As Kevin mentioned, our cash balance exceeded our expectations for the quarter, and our collections portfolio is the strongest it has been in a long time, which is also reflected in our retention metrics. Our retention metrics reached their highest levels in many quarters, although I can't recall the exact details Kevin provided. The overall quality of our portfolio from an economic standpoint is excellent, and we saw an upward trend in RPO, indicating contracted revenue performed well compared to other areas. From an economic perspective, I'm not overly concerned about our health in terms of recurring revenue and acquiring new customers. Lastly, regarding the cautious nature of our model, as this is my first quarter, I am not inclined to adopt a highly aggressive approach. We have a lot of new innovations entering beta that aren't reflected in the current model, and we are also being prudent on the CPaaS side. So please understand my cautious approach for the first quarter.

Sam, it's good to see focus on profitability side. Just wanted to ask on the revenue side. Your service revenue, I say organic services revenue growth was flat, excluding Fuze. So you did talk about CCaaS, but what do you see in terms of macro trend, anything on the enterprise side? Is it definitely disoriented? What are you seeing in the market right now?

It's a fair question, and yes, your calculations are accurate. It's just a bit challenging for me to provide clarity. We took action at the beginning of October and again in January, which both had effects. As mentioned earlier, we're moving away from low-margin or negative-margin revenue to enhance profitability. We believe that improved profitability enables us to reduce debt and better position the company overall, allowing us to redirect investments into areas with better returns on invested capital. Therefore, economics played a relatively minor role in our revenue performance; it was primarily self-generated. Additionally, I would emphasize that our investment reallocation is yielding positive results, with deferred revenue, deferred commissions, and remaining performance obligations all increasing quarter-on-quarter, and retention rates at their highest levels in quite some time. All indicators of a healthy SaaS business improved last quarter. I believe the right strategy at this moment is to sacrifice some revenue growth in order to significantly enhance these metrics.

And then in the CPaaS business, I know you talked about weakness in the CPaaS business the last few quarters. So wondering what's the current run rate of CPaaS right now?

We don't disclose that. As Kevin mentioned in his script, it's one of the things that we're looking at disclosing potentially in future quarters, so we kind of put the breadcrumbs out there, but it's under review.

Sam, when you talked about your bullet point #5, Asia Pac and CPaaS revenue has been down. What other assets are you looking to build that up with so you can really drive that as a key growth driver?

It's a completely fair question. In the past, we missed a bit of a product cycle in CPaaS in Asia. I can provide more details at another time, but we missed the product cycle and have since caught up. We're investing in the platform and the business. Our unit volumes have continued to increase, and we're landing brand name customers, as I mentioned earlier. The business funnel is strong, and we just need to close the gap on a few product features. There will be some updates in the near future regarding the CPaaS business. I believe that the conditions are starting to align for us to turn that business around. It is taking longer than we had expected, and I acknowledge that, but I am optimistic about our ability to improve.

Well, then, you also then layer on your CCaaS business in like the Australian market, it seems like that would be a right market for you.

I don't want to downplay the Australian market, but it's important to note that Australia ranks as the 58th largest population country globally, while California is the sixth. Personally, I think I would prefer to invest in California over Australia. Currently, we are focusing our investments heavily in the U.S., U.K., California, Canada, and Ireland, as these are excellent contact center markets for us right now.

Sam, you talked about the importance of your customer recommendations to their peers as being a driver of your business. Can you talk about that in a little more detail? Is that something you've actually seen? And is there something you can quantify there?

Kate may know the quantification numbers off the top of her head, but one of the things that we've been very focused on over the last few quarters has been improving our referenceability. So we really were talking about NPS, so there's the notion of referenceability, and we saw a pretty substantial increase in our referenceability. This all goes sort of full circle, right? So in my prepared remarks, I talked about our investment in customer success. Kevin talked about the very high retention rates we're having. That, in turn, leads to happy customers, happy customers give good references, which then, in turn, drives RPO improvements and deferred revenue improvements and those kinds of things, right? So we're trying to get that virtuous cycle, maybe spinning a little faster than it has in the past.

Just as a follow-up. You mentioned customer churn is something you're comfortable with. I'm curious if you can talk about seat churn. And of course, as we're starting to see some layoffs around the market. Is that starting to have an impact on the results?

I'll let Kevin follow up if he wants to add anything. When we discuss retention, we consider both logos and seats. For example, if a customer reduces their seats from 100 to 90, or from 10 to 0, we view that in the same way. Last quarter, we experienced the highest retention we've seen in years. What's noteworthy is that we're launching several significant initiatives, such as Conversational IQ and various beta projects. Even though we may see a slight decrease in average revenue per user from our core product due to the number of seats, we are observing an increase in the number of add-ons being integrated into our contact center.

Yes. Regarding customer retention, I need to look back over three years, and I haven't found any numbers that surpass those we've reported this quarter. I can also mention that our investments in global customer care are starting to yield positive results, helping us retain high-value customers. While we typically do not provide guidance, we are proactive in monitoring upcoming customer renewals and addressing any potential risks. We're managing this process effectively right now, which is evident in our recent trends.

Yes, I guess I had a question on the revenue guidance, both for fiscal Q4 and in '24, thanks for the initial framework there. And I guess I recognize that CPaaS is going to be a headwind. You've talked about that. Is there any way to kind of help us parse apart what you're seeing in kind of XCaaS and CCaaS, which I know is the strategic priority versus UCaaS? I mean, are there demonstrably different growth rates there? Any color you could provide on that front?

Yes. I mean, I'll start, and I'll let Kevin fill in. So a couple of things, right? So XCaaS is now almost 40% of our ARR and has growth rates well in excess of what we're seeing across the whole business, right? So the whole business is flat, and our growth rate in XCaaS is high 20s. And so definitely a situation where we've got a lot of moving pieces under the table. CPaaS, you mentioned small business, UCaaS. It had an okay quarter this quarter. It was kind of flattish on a year-over-year basis, right, up 4%, those kinds of things. But not blowout numbers. And so we are still under the covers. I think all of this is starting to show up in a complete soup though, right? XCaaS, our contact center doing better. That's driving higher growth rates in enterprise. And small business is starting to become a smaller and smaller component of the overall ARR mix. And so as all that flushes out over time, we should naturally see a lift in growth rates.

Let me ask you two questions that might relate to that. You mentioned that RPO had a nice sequential increase. What is driving that? Is it the adoption of XCaaS? What are the key factors involved?

Yes, I would love to make it sophisticated and cool, but we had a good quarter for XCaaS sales. The combination of UC, CC, and a world-class Microsoft Teams integration is noteworthy, as Microsoft Teams experienced triple-digit growth year-over-year. This growth is benefiting our contact center, which has higher dollar ARPUs and good margins associated with it. If we can maintain our pricing and continue this trend, the numbers will keep improving.

Yes. In addition to the strong new logo bookings, we had a great renewal quarter as well, which shows the investments we're making in delighting our customers.

Thank you for calling that out, Kevin.

So that's reflected in our RPO. Our deferred revenue is also up quarter-over-quarter as well.

Yes. And XCaaS has a net dollar retention well in excess of 100, right? So like the more that XCaaS becomes a bigger part of the business, the more the math starts to work itself out.

I'm sorry, could you please clarify? Regarding the operating margin guidance for fiscal '24, I believe you mentioned it would be 400 to 500 basis points. Is that in comparison to the full year of fiscal '23, or is it relative to the exit rate of '23?

Yes, we took about 7.5% we'll have for the full year and then just add 400 to 500 basis points on top of that for the full year, but we do expect a steady improvement on the strength of the balance sheet.

When we think about foregoing, I think, near-term growth of profitability, managing the business for more cash. I think your comments on having become more of an innovation-driven company, it does sound like the offsets that will be sales and marketing. So is the idea to rely more on partners for net new? Or is the strategy to kind of focus back on the base? Just what initiatives are in play, I think, today to deliver, I think, greater sales and marketing efficiencies, if you're going to be pulling back a little bit on the sales for?

We are a partner-led company and it's important to understand that there is a timing aspect to our investments. When we invest in innovation today, it takes some time for those efforts to reflect in our pipeline. Consequently, we have focused on enhancing our sales and marketing efficiency while developing a strong innovation roadmap, especially concerning our contact center solutions. Once this roadmap begins to enter the market, we anticipate shifting towards a customer pull model rather than relying heavily on sales or partner pushes, which will ultimately be more efficient. We acknowledge that this transition may result in a few quarters of slower growth as XCaaS expands and innovations drive more of our business. Our primary goal is to improve our efficiency metrics compared to previous approaches.

I apologize if I missed it, but can you quantify, I think, the CPaaS headwind this quarter? If I look at organic growth year-over-year, I'm just trying to understand how much of that was attributable to the CPaaS headwind versus kind of macro just impacting customer purchasing decisions?

We do not disclose CPaaS as a separate category due to compliance with SEC segment reporting rules and other regulations. However, I can state that the majority of the discrepancy between our guidance and actual results was primarily due to the CPaaS business, which may help you gauge its impact.

Sam, I want to ask you about the kind of the broader UC space and obviously slowing growth across the board. Are you seeing signs yet of consolidation that could improve the health of the industry?

We consolidated Fuze, but the market was not favorable towards that decision, leading me to believe that consolidation may not happen again soon. Fuze has been a significant success for us, and I would repeat that move if given the chance. However, at this moment, I don't see much activity in the consolidation arena.

And in terms of the Fuze installed base, no update there in terms of customer migration or how we should expect any kind of impact on the model going forward at this point?

We're accelerating our upgrades and promoting migration. With our automated tools and the engineering work we've done, we're making the transition easy and seamless, and that is starting to hit the market. We expect these upgrades to speed up over the next few quarters. For any Fuze customers listening, we will not force you to migrate or upgrade; we'll do it when you're ready.

Sam, also nice to see the improvement quarter-over-quarter in non-GAAP gross profit. It seems like you're certainly targeting the right revenue. For the 2024 target for low single-digit top line growth and look, I'll cut you some slack on this one, but on a quarterly basis, should we think about any differences in the year-over-year revenue growth rates for the first half of the year versus the second half? Like at this point, are you thinking stronger year-over-year growth later in the year?

Yes. I mean, we haven't baked really any of the new products in, but because of the comps and some of the other things, the growth rates will naturally lift as the year goes on. Thank you for calling it out, right. Last quarter, 31% year-over-year growth in gross profits. And we would expect that next year gross profit growth is in excess of revenue growth. We continue to get solid gross margin improvements. But yes, more back half of the year. Kevin, anything you want to add?

And provided what happens with CPaaS, we're going to be taking a look at that and doing what we can to help ramp that above our conservative estimation.

Yes. Good to hear that for sure. We also noticed that your disclosure for Microsoft Teams licenses went from a few hundred thousand last quarter to over $300,000 in this quarter. Do you have a sense of what percentage of 8x8's net new business comes with the Microsoft Teams integration? And then separately, the strength around renewals, but did you notice any additional price headwinds, perhaps from competition around those renewals in the quarter?

So I'll get back to you on the first one because we give away the integration for Microsoft Teams for effectively free. So it has no real consequence on the UCaaS number. Just before everybody freaks out, it's not I'm giving seats away for free. They stop to buy an X1 or X2 or X3 or X4 seat to go with it. The integration is free. So it's easy for me to get the seat number, but I have to go do some math to say what percentage of new logo dollars that was. Microsoft Teams is an important aspect. And obviously, if we're talking about organic growth at zero and Microsoft Teams growing at triple digits, it's becoming a larger share of our new logo wins. And I think it is pulling through contact center and some of the other things.

Sure. And just around the renewals in the quarter. Did you notice any additional competition around price renewals? Or was it pretty similar?

Yes. If I speak really candidly, it's the fiscal fourth quarter, December for a number of our competitors, and I swear at the end of the year and at the end of their fiscal year, they have absolutely no pricing discipline at all. So did we see mud thrown in several directions? Sure. I suspect that while they're busy, they're SKOs now and posting on LinkedIn, they'll forget to do that this quarter.

This is Austin Williams on for Michael Turrin. I wanted to go back to margins. I'm wondering if there's any way to quantify how much of the margin improvement that you've seen thus far are from taking costs out of Fuze and how that compares to just the core business efficiencies?

So we have really gotten a lot of great margin out of the core business as well as Fuze. So it's really on both sides. And the Fuze gross margins are comparable with the 8x8 organic gross margins. And we've done the same kind of work on, say, COGS that we did with the Fuze base. So it's kind of been done in tandem. So I would say that there's a fairly equal distribution of margin improvement from both entities, if you will.

Just one follow-up. RPO was up nicely on a sequential basis. I'm just wondering if there's anything to call out as it relates to deal duration, if there are any longer-term deals in there?

Yes. We saw a slight change, but the vast majority of it was just more contracts. It's roughly the same. It's roughly the same.

Yes. A couple if I could. So earlier, you mentioned hoping to see the attach rate of CCaaS increase over time. So just wondering more details on what's going to make that happen? Is that just a sales training and processes, better partner training? Is it technical integration? So what's the gating factor there?

I believe that as the innovations we are investing in, particularly in the contact center, come to market, our contact center will start to gain more traction. The presence of features like Conversational IQ gives us a competitive edge in moving customers to unified communications from the same vendor and platform. As our contact center improves, it will lead us to more deals, encouraging prospects to recognize our offerings, which include Five9 SLA, a unified platform, high availability, reliability, and an extensive feature set, making it an easy choice to purchase everything together in one package. This is why XCaaS is resonating well in the market, contributing to 40% of annual recurring revenue, improved retention rates, and higher net dollar retention figures. The more we invest in the contact center, the faster this cycle accelerates, especially since there is significant room for innovation in this space.

Understood. And then also, I think the comment was made about addressing risk about expirations and that being helpful with the retention rate. Is that related to some of the competitive pricing pressure you were seeing in the market? And then how are you addressing those risks? Is that through discounting, incremental product additions? How are you addressing that with customers?

I think that was my comment about how we're looking forward. So yes, what we're trying to do is, first of all, we have a good understanding of customer renewals and when they're coming up. We’re addressing this well in advance of their renewal to ensure that the customer is using the product, that it's performing as promised, and that they are satisfied with the product's performance. This is where the investment I mentioned comes into play, focusing on customer happiness. By doing this, we can avoid unnecessary discounting at renewal. While it might happen, our main goal is to stay ahead of it.

Yes. And I would sort of piggyback on what Kevin said, right? Switching costs are not low in this industry with line nonreporting and everything else. We are training agents or doing it as other things, right? So really, like once we land to customers, there are ours to lose. And the GCC organization here has just done an exceptional job of removing the bottlenecks to renewal, number one. And then the engineering organization has done an exceptional job with just very high reliability. I mean, we have Five9 platform SLA, and most of our competitors don't because they can't meet those kinds of numbers.

It’s great to see the improving operating margin guidance as the company makes strides in reducing debt. Most of my questions have been addressed, but I would like to know how the U.S. market compares to others like the U.K., especially considering the economic challenges we’re currently observing and the recent rapid growth in foreign markets. I’m curious about what the current situation looks like.

Kevin, I believe the key distinction I notice is that our XCaaS messaging and its alignment with Microsoft Teams has a strong appeal in the U.K. market, and the performance in foreign markets is also somewhat better. In the U.S., there still exists a separation between the Microsoft and telecom channels. However, our channel team has excelled in developing our Microsoft Teams channel, and this effort is yielding positive results. I perceive economic factors as less significant; rather, it seems we are dealing with two distinctly structured markets, making it easier for us to achieve meaningful traction in our foreign markets.

Yes. I think that's spot on.

Our focus should be a bit more aggressive in the U.S. at this time. It's reminiscent of how we approached Amazon e-commerce to understand the U.K. market and gain insights into what the future may hold for us. We are optimistic that this direction will lead to positive outcomes. All right. Thank you, Matt. Thank you for your continued support. I hope we have conveyed some of the excitement about our opportunity and our future path tempered by the recognition that success will require commitment and hard work. I am confident we can do this. We are a vibrant and financially strong organization, and we are accelerating the pace of innovation. With a steady stream of new products coming this calendar year, including ML-AI based features and tailored experiences, we are well positioned for the future. Thank you so much, and I look forward to reporting our progress next quarter.

That concludes the conference call. Thank you for your participation.