Earnings Call Transcript - EGHT Q1 2023

Operator, Operator

Good afternoon. Thank you for attending today's 8x8 Fiscal First Quarter Conference Call. My name is Amber, and I will be your moderator for today's call. I now have the pleasure of handing the conference over to Kate Patterson, Head of Investor Relations. Kate, please proceed.

Kate Patterson, Head of Investor Relations

Thank you, operator, and good afternoon, everyone. Today's agenda will include a review of our first quarter results with Dave Sipes, Chief Executive Officer; Sam Wilson, our Chief Financial Officer; and Hunter Middleton, our Chief Product Officer, who will give you an overview of our product strategy. 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 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 obligations 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 these 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 our CEO, Dave Sipes.

David Sipes, CEO

Thank you, Kate. Good afternoon, everyone, and thank you for joining us today. On the call today, I will review our first quarter results and give an update on the integration of Fuze, which continues to go well. I will also discuss our plans for fiscal year 2023 as we place greater emphasis on profitability and cash flow generation in the near term. We believe that this is the right strategy to deliver value to all our stakeholders, customers, employees, and shareholders. We delivered another solid quarter with ARR growth, non-GAAP profitability, and positive operating cash flow in the first quarter. Fuze continues to outperform our expectations with strong customer retention. We continue to advance our strategy of empowering every employee company-wide through integrated contact center and unified communication capabilities, and we are strengthening the foundation for sustainable growth in the future. The quality of our ARR continues to improve with the shift to enterprise and XCaaS. Enterprise ARR grew 54% year-over-year and now accounts for 59% of total ARR. XCaaS ARR continues to grow at over 40% year-over-year and contributed more than 35% of total ARR. The sequential growth in excess ARR was very strong, and we see an opportunity to grow this materially over the next several years. Our CPaaS business declined sequentially and year-over-year and was an $8 million headwind to total and enterprise ARR growth. Our continued focus on operational efficiency resulted in higher gross profit with first quarter non-GAAP service revenue gross margins at another multiyear high of 73%. The improvement in gross margin resulted in sequential and year-over-year increases in non-GAAP profitability and operating cash flow. As a result, both non-GAAP operating income and operating cash flow were ahead of our expectations. As we look to the remainder of fiscal 2023 and beyond, we are committed to driving the operational efficiencies that will allow us to continue investing in core XCaaS innovation and deliver increased profitability and cash flow over time. On our last call, we increased our operating margin guidance for fiscal year '23 to 2% to 3% and said we had line of sight to doubling operating margin in fiscal year '24. This original range for operating margin reflected increased investment in R&D as well as in the sales capacity and marketing programs needed to drive full year service revenue growth in the mid-20% range. Over the last quarter, we have continued to evaluate our mix of investing for growth versus increasing profitability. We are prioritizing increased profitability and cash flow and moderating the growth of our investment in sales and marketing to reflect more cautious behavior by SMB and CPaaS customers. As Sam will discuss in greater detail, we are making changes now that will allow us to exit fiscal 2023 at or above 5% operating margin. Further, I believe we can achieve at least an additional 200 to 300 basis points in operating leverage in fiscal year '24. To achieve our fiscal year '23 target, we're holding operating expenses more or less flat as a percentage of revenue throughout the year and allowing the improved unit economics reflected in our gross margin to flow to operating income. We are also reducing our annual guidance ranges for service and total revenue by $20 million and $30 million, respectively, reflecting lower incremental investment in sales and marketing initiatives as well as foreign exchange headwinds and continued weakness in CPaaS. Let me provide a little more detail on our thinking behind our guidance. We address a huge market opportunity. Migrating telephony to the cloud offers organizations enormous benefits in terms of cost and flexibility, benefits that are likely to be even more compelling in a recessionary environment. Our opportunity is greater than just moving on-premise communications to the cloud; digital transformation and an increasingly mobile workforce and the need to offer hybrid work environment are blurring the boundaries between internal communications and contact center functionality. As the only fully owned unified, cloud-based UC and contact center platform, we are uniquely positioned to capitalize on this opportunity by delivering advanced contact center features tailored to the needs of each user wherever needed in the organization. To fully realize this competitive advantage, we will continue to invest in our core XCaaS offering with an emphasis on extending the Teams' experience, expanding global connectivity, and driving contact center innovation to enhance the end-to-end customer journey. As we add new innovations to enable today's modern workforce, we create the opportunity for greater revenue per user through cross-sell. I believe that our continued investment in innovations like Frontdesk, Agent Workspace, and Conversation IQ is the best way we can build the foundation for sustained growth in the future. With investment in R&D critical to our future, we are making some trade-offs in the near term to build a better long-term future. As a result, we are moderating incremental investments in sales and marketing and, to a lesser extent, G&A initiatives. While I believe this is the right strategy for us given the current macro environment and our immediate priority of refinancing our convertible debt, it does have an impact on our capacity to drive incremental top-line growth. As we shift to a greater emphasis on profitability, we continue to make progress on XCaaS adoption and grow our installed base with our enterprise customers. Our XCaaS platform continues to be broadly deployed across a range of industry verticals and geographic regions, including the public sector. A few recent examples of new XCaaS customers include the leading specialty pharmacy in Europe, providing healthcare solutions to patients with long-term conditions, rare diseases, and cancer. They selected 8x8 XCaaS with nearly 300 CCaaS seats as part of their digital transformation efforts to enhance the patient experience in the U.K. and Europe. Inception Fertility is a tech-enabled company improving the patient experience through an ecosystem of fertility brands. As North America's largest and fastest-growing network of fertility clinics, Inception needed an agile communications partner that would support their growth and selected 8x8 XCaaS to support over 1,600 employees across more than 80 sites. Cross-sell is becoming an even more important aspect of our XCaaS strategy as our enterprise base expands. Our ability to expand the number of seats and average revenue per user within our installed base has the potential to be an important driver of sales efficiency and revenue growth. One of our significant land-and-expand wins in Q1 was TForce Logistics, which is the leading same-day and next-day final mile transportation solution provider in North America. After deploying 8x8 UCaaS with Voice for Microsoft Teams for over 1,000 employees in 76 locations across the U.S. and Canada, they expanded to XCaaS by adding contact center this quarter for a single vendor cloud communication platform to help grow their business. Within the XCaaS solutions portfolio, our 8x8 Voice for Teams direct routing solution continues to gain momentum. We now have more than 200,000 users deployed. Customers choosing 8x8 Voice for Teams in Q1 included Brookfield Properties, which develops and operates real estate investments on behalf of Brookfield Asset Management, one of the largest alternative asset managers in the world. They selected 8x8 UCaaS with Voice for Microsoft Teams with over 2,300 seats due to ease of administration and Five9's reliability. Modivcare is a technology-enabled healthcare services company, which provides a suite of integrated supportive care solutions for public and private payers and their patients. They selected 8x8 UCaaS with 8x8 Voice for Microsoft Teams for a seamless experience supporting over 2,000 employees across multiple locations. Our global reach, rich feature set, and tight integrations across UC and CC continue to be important competitive differentiators with customers adopting Teams as their collaboration platform. To reach more of these customers, we recently launched the 8x8 Elevate Microsoft partner program and introduced an XT addition of Voice for Teams. The XT addition combines our direct routing technology, Azure-based managed SBC as a Service, domestic DIDs, nationwide calling, HD audio, and Secure voice, all in a single package. Customers can easily upgrade or add seats with advanced functionality, including global calling, Conversation IQ, or contact center. We continue to lead the market in global calling capabilities. In the first quarter, we expanded global reach to include Israel, Taiwan, Latvia, and Slovenia. Our cloud-based global UCaaS solution is now available in 54 countries and territories representing nearly 90% of global GDP. Today, about 30% of our users are outside North America. Our ability to reduce the cost and complexity of managing PSTN connectivity across multiple regions is another competitive advantage that becomes increasingly more important in a cost-conscious environment. A great example of a customer implementing XCaaS on a global basis is GCP, a global provider of construction products that include high-performance specialty construction chemicals and building materials and continues to expand with 8x8 XCaaS with over 2,300 seats in 22 countries spanning 5 continents, including providing full PSTN coverage to employees in China and the Philippines. XCaaS also continues to gain traction in the public sector, where our ability to support customer engagement across the organization on a single platform creates a competitive advantage. Examples of public sector wins in Q1 include Cambridgeshire & Peterborough NHS Foundation Trust, which is a health and social care organization supporting nearly 1 million people in the community. They turned to 8x8 UCaaS and Voice for Microsoft Teams to support the employee experience for more than 2,000 users. Norfolk County municipal government supports 63,000 residents in Southwestern Ontario, Canada. They selected 8x8 UCaaS with Voice for Microsoft Teams for the simplified administration a cloud communication system provides. Finally, a brief comment on our CPaaS business. The large customers who reduced their CPaaS usage in Q4 have not yet returned to pre-Q4 usage. While we continue to work with them to design new programs, our guidance does not assume any usage revenue from these customers going forward. Although we expanded our user base with new customers in the quarter, the usage component of the CPaaS business continued to weaken in Q1 and impacted both our ARR metrics and service revenue growth. Despite this, we continue to add well-known names to our customer list, setting us up for long-term success when usage rebounds. These names include Daruma, Indonesia's #1 B2B e-commerce platform for all things from office supplies to maintenance services. They use 8x8 SMS APIs to reliably send secure one-time passwords to their users. They also use 8x8's chat apps API for customer service over WhatsApp, providing their customers a convenient way to contact us. And KitaBeli, one of Indonesia's fastest-growing social commerce apps, is using 8x8 SMS and chat apps APIs and recently added 8x8's Voice IVR and voice messaging APIs to automate customer self-service workflows and user verification notifications. We continue to enhance the CPaaS platform, most recently with 8x8 Connect Automation Builder, a no-code, multiple channel communications management solution for CPaaS. Automation Builder offers a visual, effortless way for anyone regardless of coding experience to easily build engaging customer experiences that enhance productivity, flexibility, and efficiency. In summary, innovation has always been a core value at 8x8, and I'm proud to say our new innovations are gaining acceptance. 27% of new mid-market and enterprise customers have deployed Frontdesk since its launch just 2 quarters ago. And 100% of new users have deployed our new UI and Agent Workspace since it launched in March. Our Voice for Teams offering surpassed 200,000 users, one of the fastest ramps in our history. Innovations such as these lead to improved customer satisfaction and retention, which we see in the numbers. We have already made rapid progress on our XCaaS product roadmap this year. Hunter Middleton, our Chief Product Officer, will give you some additional detail on our product strategy. Before handing the call over to Hunter, I do want to thank our teammates here at 8x8 for their hard work and commitment. I also want to welcome Suzy Seandel as our new Chief Accounting Officer. I remain confident in our opportunity, our competitive advantages, and our strategy. As we grow our enterprise and XCaaS business, we're building the foundation for sustainable growth in revenue and cash flows and we believe this will deliver value for all our stakeholders.

Hunter Middleton, Chief Product Officer

Thanks, Dave, and hello to the investment community. I'm joining today to give an update on our R&D investments and product strategy. As you already know, our R&D efforts saw an infusion of resources with the recent Fuze acquisition. Q1 FY '23 was our first full quarter since the acquisition. And while early, we have been pleased with the R&D results so far. Overall output of the combined R&D team is already up 25% compared with Q4 of last fiscal year and the investment in sustaining engineering for the Fuze platform and an upgrade automation to get customers to the combined XCaaS platform are looking right on target. The integration of the development teams is fully complete. We have one 8x8 roadmap and a single platform that we're investing in. I'm personally very impressed by the quality of the Fuze technical teams, and I'm extremely proud of how everyone has come together. With this increase in innovation capacity, 8x8 has the ability to accelerate our delivery of differentiated services. A wide range of market segments find value in our services, with the core target as mid-sized enterprise organizations using MS Teams for internal collaboration and with a high-value customer base that demands engagement throughout the organization, not just in the contact center. Let me cover each of those points in turn to share how we differentiate. With the move to cloud, midsized enterprise organizations don't want to worry about maintaining their own in-house telephony expertise. Now more than ever, they are looking for a vendor that is a longtime cloud telephony and carrier expert, not a recent entrant. 8x8's best-in-class global cloud voice solution with Five9's reliable, full-featured enterprise-ready voice and SMS service and the largest global footprint of any cloud vendor continues to be the premium option for midsized enterprise cloud telephony. This market is especially motivated by 8x8's ability to ensure a low-risk and low-drama move to cloud. Over the last 2 years, we have upgraded our entire customer base from our legacy platform to our new XCaaS platform while increasing our customer retention rate. We are now preparing to execute that same move with the Fuze customer base and in the process, extending our import tooling and execution expertise even further. We know how to move a customer's deployment from one platform to another, and this expertise is critical to enabling the significant number of risk-averse late adopters to get to cloud. Some of the top investments we are making in this key area of differentiation include exceeding Five9's availability across the platform, expanding our global telephony footprint to add additional countries, and delivering even better import tooling to ensure seamless redeployment from on-prem to cloud. Almost every midsized enterprise communicates through a contact center to its customers via voice, messaging, or other omnichannel methods. These organizations tend to be very ROI-focused and less experimental. They want high reliability, a great user experience to minimize training and operational expense, and core proven technology that is short time to ROI. 8x8 is very focused on deepening our value delivered in this large segment. We recently launched an impressive new agent experience with positive customer reviews. Typical of the customer comments we've had so far is this from National Express. 8x8 Agent Workspace was extremely easy for our agents to pick up right from the start, an incredibly straightforward, self-explanatory, and easy-to-use interface that really helped enhance their overall experience for aiding the delivery of better customer outcomes. We are continuing this coming year with several additional major launches, a superior digital conversational AI solution, a completely revamped team lead experience with user management, team reporting, and quality management capabilities, all in one UI. Furthermore, we're going to do enhancements to our Agent Workspace to further improve usability for digital use cases and better integration with the customer CRM. We have our user research and design teams dialed in on this customer profile and are making sure that everything we deliver scores high on usability and provides a complete end-to-end use case, fine-tuned to the needs of this segment. A significant portion of midsized enterprise organizations today are opting to use MS Teams for meetings and internal messaging. The 8x8 XCaaS solution is incredibly MS Teams friendly, designed to enable customers to easily mix our external communication solutions with the native MS Teams internal collaboration service. Our integration is easily adaptable to the diverse ways that companies choose to operate with MS Teams from having 8x8 Voice and SMS fully embedded in the MS Teams app to enabling mix and match with users adopting the service that makes the most sense for themselves while maintaining effective interoperability with users on each platform. We are very happy to trade the sale of an increasingly commoditized meeting service for the higher value sale of our native contact center and customer engagement capabilities. A recent Baird study found that 8x8's MS Teams integration is preferred four to one over our UC competitors, and we will continue our investment to maintain leadership in this area. For a while now, Dave and Sam have been talking about the success of our XCaaS product strategy. While almost all enterprise organizations found value in one platform, single-vendor solution, our XCaaS differentiation goes well beyond simply selling integrated but distinct UC and CC solutions on a single contract. 8x8 is uniquely able to break down the walls between UC and CC solutions and can deliver traditional contact center engagement capabilities wherever they are needed in the org, focusing on three primary avenues for creating value for our customers. First, every new contact center capability gets built at a platform level so that we can also deliver it to any user or team throughout the organization. Second, we're designing dedicated app experiences that bring UC and CC functionality together in purpose-built configurable UI for key customer engagement personas. And third, we're investing in the data infrastructure and analytics that enables visualization and insights on the end-to-end customer journey so that companies can really see what's going on. I know that all sounds a bit Silicon Valley, so let me discuss two recent launches that make this product approach more tangible. 8x8 recently extended the availability of Conversation IQ, our quality management and speech analytics service, to any user throughout the organization. This product is typically considered to be a contact center capability. AI speech analytics look at individual interaction transcripts to identify coachable moments and topic trends and then feed those into a coaching application for the team lead. You can now apply the capabilities as a premium add-on service to any user in the organization. For instance, we have recruiting agencies that use it to monitor and coach individual recruiters on the effectiveness of their phone screens, reception teams that use it to verify adherence to the right greeting script on the right inbound number, and billing support teams that need to assess customer satisfaction with their agent experience just as if they were sitting in a contact center. This is how XCaaS delivers customer engagement functionality throughout the organization. Another example, the first of our premium app experiences was Frontdesk, our new attendant console that was released in the middle of last year. Receptionists need more than just a phone but less than a full omnichannel contact center seat. Frontdesk combines core UC call handling and a highly usable company directory with the extensive multiuser voice cues familiar in the contact center space. And all of this is composed in a single-screen UI that ensures the user doesn't have to hop around different components to get their job done. Gone from the screen, but available a click away when needed, are our company chat meetings that our research shows are rarely used by this persona during the workday. Seats for these app experiences sell at a premium to traditional UC application licenses, while still being more affordable to the customer than a full contact center license, and they're simpler to deploy. Our data shows that adoption of Frontdesk among our new enterprise logos is already over 27%. Looking forward to some of the highlights in the coming year on our XCaaS roadmap. Our new digital conversation AI capabilities will provide customer self-service options across the entire organization. Our customer journey analytics are being enhanced to deliver more insight into interactions that span UC and CC nodes. And the new team leader experience will work equally effectively for customer engagement teams outside the contact center as it does for those that are in the contact center. We are also actively working on additional premium app experiences that target key customer engagement roles throughout the company, and we'll share more about that in future calls. Thank you for your time today, and I'll be on the line for Q&A if you have any questions. Sam?

Samuel Wilson, Chief Financial Officer

Thanks, Hunter, and good afternoon. We remained a financially agile and disciplined organization and delivered solid results for the quarter. We continue to experience some challenges in our CPaaS business during the first quarter, and foreign currency headwinds were strong, both of which impacted service revenue performance and will make us adjust fiscal '23 guidance. In spite of these challenges, revenue was near the high end of 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 $187.6 million, an increase of 26% year-over-year and inside of our $185 million to $188 million guidance range. We generated $179.2 million in service revenue, an increase of 30% year-over-year and in line with our $177 million to $180 million guidance range. The CPaaS business did not bounce back as hoped with a year-over-year and sequential decline for the second quarter in a row. The strengthening dollar, especially versus the pound sterling, negatively impacted revenue by about $1.5 million. Fuze accounted for $29.3 million of service revenue and $29.5 million of total revenue. Service revenue from Fuze was better than expected, driven by higher retention. On the whole, Fuze did better than expected in both revenue and costs, and therefore, was accretive to non-GAAP operating income. We committed to remaining non-GAAP profitable post-acquisition, and so far, so good. We expect further cost savings opportunities as we continue to integrate Fuze operations with our own, but these will take time to achieve as we communicated at the time of the acquisition. Total ARR was $688 million at the quarter's end, up 28% 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 visibility into Fuze's contribution to reported revenue. Enterprise customers now account for 59% of total ARR, and enterprise ARR was up 54% year-over-year. Mid-market was 18% of ARR and grew 22% year-over-year, and small business was down to 23% of ARR and declined 7% year-over-year. Growing our enterprise business is one of the core tenets of our long-term strategy due to these customers' longer commitments, higher retention, and better efficiency ratios. A comment about the small business segment declining 7% year-over-year. Small business is nonstrategic for us because of the low efficiency metrics and the absence of contact center needs. We expect it will continue to shrink as a percentage of total ARR. I would like to call out some adjustments; we made a change to last quarter's number of enterprise customers, lowering the total from 1,320 to 1,258. When we integrated Fuze into the reporting, we inadvertently included both subsidiaries and parent purchasing centers. This has been corrected. Turning to expenses. I remind you that all expense items disclosed are non-GAAP unless otherwise noted. Service revenue gross margin came in at 73.4%, an increase of 450 basis points from the first quarter fiscal '22 and 100 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 -35.3% for the quarter compared with -19.6% in the first quarter of '22 and -44.6% in the fourth quarter of '22. Looking forward, we hope to see improvement in other margin over time as we further integrate Fuze. Overall, first quarter gross margin was 68.5%, up nearly 600 basis points year-over-year and 180 basis points sequentially. The increase was driven by revenue growth, a higher mix of service revenue, and our gross margin improvement projects. Turning to first quarter operating expenses. This is our second combined quarter with Fuze and our first full quarter of expenses. R&D stepped up to 14.2% of revenue, getting closer to where we wanted. There were several unusual onetime items that increased operating income by $3 million. Non-GAAP operating profit grew nearly $6 million quarter-over-quarter to $10.1 million. On a normalized basis, operating income would have been about $7.1 million, still up nicely quarter-over-quarter and year-over-year. Without the benefit of the unusual items plus the full impact of employee annual base pay increases, we expect a sequential increase in total expenses in the second quarter, resulting in a small decrease in the operating margin on a normalized basis. Consistent with our goal of driving financial leverage, we expect to see improvements in operating margin in the second half of the fiscal year and want to exit the year at 5% or better. Turning to the balance sheet. Total cash, restricted cash, and investments ended the first quarter at approximately $143 million compared to approximately $148 million last quarter and $162 million a year ago. Excluding restricted cash, the balance was $141.6 million compared to $138.7 million last quarter. RPO was approximately $700 million for the quarter, down from $715 million in the fourth quarter. The quarter-on-quarter decline was driven mainly by a small shortening of remaining contract duration. Given the market environment, this was not a surprise. Cash from operations came in at approximately $5.8 million for the quarter, ahead of our expectations. We continue to actively manage cash flow and watch it closely, and collections remain solid. We expect to see a larger-than-usual difference between operating income and cash from operations over the next few quarters. We have several Fuze-related items that will use some cash but will not be a non-GAAP income statement. Recently, we received a number of questions about our $500 million in convertible notes due February 2024 or 18 months out. We are now in the normal window for refinancing. As a non-GAAP profitable cash flow positive company, we have multiple options to refinance. We are going through the process of evaluating the alternatives to arrive at a refinancing strategy that is best for all stakeholders. I remain confident we can refinance our debt this year. Last quarter, we made the comment that we were shifting to a greater emphasis on improving profitability and cash flow versus driving higher revenue growth. We have continued to evaluate our mix as the selling environment has become incrementally more cautious with CIOs and CFOs being slower to make decisions. We spent the quarter analyzing the situation and believe it makes sense to continue to pivot to our profits-plus-growth strategy. As such, we are taking down our revenue guidance for fiscal '23 but raising our operating income guidance. The decline in revenue growth rate was driven by three major factors: One, we are moderating growth in sales and marketing investments to focus on improving efficiency and margins; two, the impact of the stronger dollar, particularly the British pound to U.S. dollar, which is suppressing revenue; and three, continued weakness in CPaaS. As a reminder, we generate about one-third of our revenue internationally. We remain focused on improving gross margins, but these can be variable quarter-to-quarter based on product mix. For operating expenses, we plan to significantly slow the growth in sales and marketing spend and would like to see us exit fiscal '23 between 38% and 39% of revenue, down from 41% two 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 in the range of 13% to 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, as described by Hunter, with an emphasis on contact center functionality has good ROI. Lastly, we expect to see continued leverage in G&A as a percentage of revenue as we fully integrate the Fuze operations. This set of initiatives will drive operating margin higher in the second half of '23, and we expect to exit '23 operating margin above 5%. This brings our operating margin for the year to about 4%, give or take. As Dave mentioned, we think we can add more operating margin in fiscal '24 next year through continued improvement in unit economics, incremental savings in Fuze G&A as the integration progresses, and improved sales efficiency. While we expect the increased emphasis on profitability and cash flow to have an impact on our top-line growth in the near term, it gives us more flexibility to refinance our debt and further options to drive shareholder value in the future. With this in mind, we are taking into account the recent performance of the CPaaS business and FX, we are establishing guidance for the second quarter of fiscal '23 ending September 30, 2022, as follows: We anticipate service revenue to be in a range of $177 million to $180 million, essentially flat with the first quarter, representing approximately 24% to 26% year-over-year growth. We expect Fuze service revenue contribution will be between $27 million and $29 million. We anticipate total revenue to be in the range of $185 million to $188 million, approximately 22% to 24% year-over-year growth. We have uncertain visibility on the supply chain and for hardware shipments but for now expect other revenue to be flat to down slightly compared with the first quarter. We are targeting an operating margin in the 2.5% to 3% range for the quarter. The sequential decline from approximately 3.8% in Q1 on a normalized basis is primarily due to the annual pay increases implemented in June. We are updating our guidance for fiscal '23 ending March 31, 2023, as follows: We anticipate service revenue to be in a range of $720 million to $730 million, representing approximately 20% to 21% year-over-year growth. We expect to exit fiscal '23 with service revenue growth in the mid- to high single digits on a year-over-year basis. We anticipate total revenue to be in a range of $747.5 million to $762.5 million representing approximately 17% to 19% year-over-year growth. We are focused on improving operating margin over time and have a goal of exiting fiscal '23 over 5% for the fourth quarter and at least 4% for the year. In closing, I believe the increased focus on our operating margin and cash flow are exactly the right strategy at this time. I believe we need to continue to fund our investment in R&D. We address a large market opportunity, and the focused product strategy Hunter outlined 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, I'd like to turn it over to Q&A.

Operator, Operator

Our first question comes from Sitikantha Panigrahi with Mizuho.

Sitikantha Panigrahi, Analyst

Just wanted to ask about your plan to reduce your guidance for this fiscal year. You didn't talk about the demand environment or any kind of macro slowdown. Wondering what are you seeing in the market right now? I appreciate. Also, what's triggered this lowering sales and marketing spend after Q1?

David Sipes, CEO

Yes. On the demand side, our enterprise customers were not seeing any material impact. We have seen some impact on small business and our CPaaS customers. We do have in a few cases customers performing additional due diligence and a slight decline in average contract length may reflect some caution, but it's not a clear sign. Overall, not a major signal coming from our enterprise business.

Samuel Wilson, CFO

All right. And I'll take the second part of that. We're moderating our sales and marketing spending growth. And I think that's just driven by the fact that we are continuing to focus on sales efficiency and ROIC, and we just want to be careful that we continue to drive up the ROIC, and we're also setting the stage for debt refinancing later in the year. So I think all those things combined just make it so we moderate our sales and marketing growth a little bit this year.

Sitikantha Panigrahi, Analyst

Okay. And then a quick follow-up to Microsoft Teams. Where do you see the competition at this point? Where do the Microsoft Teams telephony offering stand? And what's Microsoft strategy? How do you plan to compete in the next few years with their offering, especially pricing is so competitive?

David Sipes, CEO

Yes. On Microsoft Teams, there is a platform approach to enable telephony into Microsoft Teams, both through direct connect and operator connect in addition to calling plans. So we really see direct connect and operator connect as the big opportunities. We're a top player in direct connect, and we've added a couple of hundred thousand users there. We see that as a big opportunity to make that significantly larger. That's why we launched the Elevate program focused on Microsoft Partners and our XT SKU that will fit nicely into the Teams offering. I would like to see us 10x those users over the next couple of years.

Operator, Operator

Our next question comes from Ryan MacWilliams with Barclays.

Ryan MacWilliams, Analyst

Just a follow-up on the Microsoft Teams side. Another 50,000 seats added to 8x8 Voice for Teams. Are you seeing good success here in upselling cloud contact center into the Microsoft opportunities?

David Sipes, CEO

Yes. We're seeing good success with XCaaS, which is both contact center and UC, and that's a specialty of our platform. The XT SKU does fit into our X Series as well as our X1, X2, and X3 SKUs. So those are all UC SKUs. We sell X6, X7, and X8, our contact center SKUs, and those do sell nicely. We did see XCaaS ARR continue to grow at over 40% year-over-year, and it's 35% of our installed base. So it's accreting share within our business, and the goal is to push that up into a majority of our business.

Ryan MacWilliams, Analyst

Excellent. And then, Sam, just on the guide, I guess, how do you think about where conservatism is here? Is it more towards the next quarter or more towards the end of this year from the top-line perspective? Just because if I add for each quarter, that kind of gets you to the midpoint of your guide, but then you would exit the year kind of at mid-single-digit revenue growth. So is it more near term or towards the end of this year? And then if you could just double click on what are your thoughts around maybe some of that CPaaS traffic coming back, what the outlook looks like there. We appreciate that.

Samuel Wilson, CFO

All right. So in terms of conservatism or just visibility, I guess I'll just use a more generic term. Like all companies, we have more visibility in the quarter we're in. And then progressively, over time, the visibility gets less and we naturally get more conservative. We do bottoms-up forecasting, and so that's what drives that. We did further de-risk the CPaaS model because it was down quarter-on-quarter. So incrementally, that business got a little worse. And as everyone knows, we sort of take the exit run rate of that business and run it flat in perpetuity, and then that's kind of how we think about it for those customers, then we layer in new customers on top of that. And so I would say, definitely more conservative. I did say in my script that exit the year kind of mid- to-high single-digit growth once we lap the Fuze numbers. And just in general, your question on CPaaS, I would say, incrementally, the environment has gotten a little harder. I don't know exactly if it's macroeconomic or just specific customer things, etc. It's always hard for us to tell in a usage-based business. We're not seeing substantially more customers go to zero. So I don't think the traffic is moving. We're just seeing less total aggregate traffic.

Operator, Operator

Our next question comes from Meta Marshall with Morgan Stanley.

Meta Marshall, Analyst

I have a couple of questions. Sam, when you mentioned the mid- to high single-digit services growth rate as we finish fiscal '23, how do you think that compares to the overall market growth? Do you believe you will be able to maintain your market share at those growth rates? For the second question, as you focus on operational efficiency and become more conservative with your spending on sales and marketing, what opportunities do you think you are missing out on? Does this affect the enterprise or SMB business more?

Samuel Wilson, CFO

I will address both questions and let Dave add his insights. We are currently experiencing a transition period. Our small business segment is declining, which presents a challenge, while the enterprise side is growing at a relatively fast pace and the quality of our annual recurring revenue is improving. We anticipate finishing the year with a higher growth rate in enterprise, although this will be offset by slow growth in the small business segment, which is experiencing various issues. Regarding the market, the latest figures I have indicate that the overall Unified Communications market is growing around 10%. We believe we are growing faster and gaining market share in the enterprise area compared to on-premise providers, while the small business sector is somewhat stagnant. Improving efficiency and deciding where to allocate resources is an ongoing conversation for us. Sometimes, we need to forego certain opportunities to invest in new ones. A key focus for us is innovation, which is why we wanted Hunter on this call. Our R&D spending has increased to 14% to 15%, aligning with our intermediate and long-term financial goals. We are prioritizing innovation to support our financial objectives while pulling back slightly on sales and marketing spending. Once we complete our R&D cycle, we plan to reinvest in sales and marketing. For now, we believe the best investment is in innovation, which will be reflected in our financial model.

Operator, Operator

Our next question comes from Matt VanVliet with BTIG.

Matthew VanVliet, Analyst

I guess can you give us an update on where we're at with Fuze integration in terms of not just migrating customers to the overall XCaaS platform, but also what you're seeing in terms of attach rates and upsell on the contact center as I know you highlighted that as a big opportunity when you closed the deal?

Samuel Wilson, CFO

All right. So Matt VanVliet at BTIG, I'll take that part of the equation. All right. So, look, I would say in terms of the back-office operations, we're effectively integrated now with Fuze. You can't really tell the difference. And I would love R&D, I'll say, is a separate case. If Hunter, you want to throw a few words, please do. But in terms of Fuze and R&D, we're fully integrated now. You can't tell the Fuze Teams from the non-Fuze Teams? And I don't know if you want to add anything?

Hunter Middleton, Chief Product Officer

No, I think that's exactly right, Sam. We've fully integrated the development teams. We're working on a single roadmap. The innovation is focused on a single platform going forward. So that integration has gone really smoothly. We're really excited about the team that has come on board, and everybody is working great together.

Samuel Wilson, CFO

All right. Specifically on migration and cross-sell, we've always sort of hinted that this is a fiscal '24 type of initiative. Remember, we've only had this company for six months. The average sales cycle is generally a year for that type of stuff. We're focusing on that. And also, it takes time to get the automation of those other things. We're not pushing Fuze customers to migrate. We'll get there over time. Right now, we want them to get comfortable with us. We want them to be comfortable throughout the transaction. And if you notice, just point blank, the Fuze revenue numbers have actually been substantially better than we even hoped for. Our strategy is really showing through in the numbers of really trying to engage these customers, keep them engaged, and keep in front of them, but not push them too aggressively. We'll get there and get them migrated over really starting next year as we make it super easy for them. The cross-selling activities are occurring. We're having things like webinars, marketing campaigns, and a lot of interest from the Fuze base that's just going through now our normal sales cycle.

Matthew VanVliet, Analyst

All right. Very helpful. And then as you ramp up the channel to help further sell into Teams and the broader Microsoft ecosystem, how should we think about the contribution rate or the profitability of the Elevate program relative to your more traditional partnerships and channel partnerships selling XCaaS? Is there any meaningful difference there? Can the volumes of a Teams' organization often offset a little bit lower pricing?

David Sipes, CEO

Yes. I think economically, the volumes are significant in that market, and the Elevate program is focused on people that have traditionally been Microsoft resellers and not necessarily cloud telephony resellers. It's bringing an incremental group into the fold. And as far as how we go to market, you're right; it's higher volumes in that category with Teams' add-ons, and we make it up through additional contact center sales into that installed base and our XCaaS selling. So overall, when you look at the revenue per account, it's very large, larger than average, and creates that opportunity for the partners as well as our sellers.

Operator, Operator

Our next question comes from Peter Levine with Evercore.

Peter Levine, Analyst

Thank you for the information on the convertible. Sam, could you discuss the options you currently have and your thought process regarding them? Also, just to clarify, are you planning to convert it before it becomes a current liability? How should we approach this?

Samuel Wilson, CFO

Well, I did say this year, so you could take it as calendar fiscal, which everyone suits my needs in the moment. But this year, we'll get it taken care of, and it would become a current liability by the end of this fiscal year. Yes, that would be our objective to do that. In terms of options, we've got term loan capabilities. We've got exchange capabilities. We've got equity capabilities. I mean, it's pretty amazing how many different options there are. I mean, 20 years ago, when I was first on the street, for a company like us, it would be equity and equity only. Now literally, there is a broad range of options from traditional banks, alternative lenders. Sovereign funds have approached us. We've talked to a host of different opportunities, each with certain pluses and minuses, and we're trying to weigh through all those options to come together with a complete package that's literally best for all of our stakeholders.

Peter Levine, Analyst

And then just a final one here is how much of the guide down is related to CPaaS, if you can break it out, like CPaaS versus FX versus the macro environment? And then to that, how much of an FX headwind do you think there is for the remainder of the year?

Samuel Wilson, CFO

If you consider the service side range of $20 million to $25 million and the $25 million to $30 million range, I would estimate that it breaks down roughly into one-third FX, one-third CPaaS, and one-third UC/CC or applications in total. I'm hesitant to use the term macro since we're a small player in a large market, so I'm unsure about fully committing to those categories. However, that's the perspective to adopt. Regarding the UC/CC side, we are taking a cautious approach, especially concerning small businesses. We anticipated this, and we still expect growth on the enterprise side, which is where we are focusing our investments and strategic efforts. Given the current environment, we're trying to be more careful, and the challenges have slightly increased for small businesses.

Operator, Operator

Our next question comes from James Breen with William Blair.

James Breen, Analyst

Can you talk a little bit about the channel and any changes you may have seen there, whether it's a slowdown in potential bids, etc.? And maybe some of the pricing dynamics?

David Sipes, CEO

Yes. We brought in new leadership on the channel back at the beginning of the year, Lisa Del Real, and that team is performing very well. We've also gone into the channel with improved how we deal with escalations, customer support elements, and have improved our reputation in the channel and continue to do that. As you know, the channel has been growing quite nicely, I think, growing at 70% year-over-year. So we're having success in that market. I love the specialized programs that we're doing now with Elevate and some other programs that Lisa is bringing to bear. Overall, I think we're improving our traction, and you're seeing it in the numbers. But I think there's a lot more opportunity there for us.

Operator, Operator

Our next question comes from Tim Horan with Oppenheimer.

Timothy Horan, Analyst

On Elevate, can you just describe what your competitors are doing there? Maybe how far ahead of the competition you are at this point? And I would think the relatively new channel partnership would really probably prefer to use you guys at this point than maybe even Microsoft themselves or others. Just a little bit more color around that would be great.

David Sipes, CEO

Yes. I think the channel itself doesn't really make much money selling Microsoft. The opportunity for them is really getting into the higher-level services, such as cloud telephony and contact center. The things we're doing to make our product fit well, stuff that Hunter's team is doing with our XT SKU create a nice alignment. Now, going after these incremental sellers that have traditionally not been able to sell those high-value services like cloud telephony and contact center, bringing those into the fold and teaching them how to sell that category and get that incremental economics is a huge win for the channel.

Timothy Horan, Analyst

And maybe just can you talk a little bit about how much free cash flow you think you can generate next year if all goes well? Any color around that?

Samuel Wilson, CFO

Next year, you mean fiscal '24, don't you? I'd like to see us be generating between $30 million and $40 million, but that's an off-the-cuff guess; it's not guidance, put some other SEC words around it. But that's an off-the-cuff guess, plus or minus. If you give me a couple of hours, I'll probably get you a more refined number.

Operator, Operator

Our next question comes from Will Power with Baird.

Charles Erlikh, Analyst

This is Charlie Erlikh on for Will. I had a question on gross margin, Sam. They're coming in strong and just wanted to ask what the expectations are for next quarter and the remainder of the year?

Samuel Wilson, CFO

Next quarter, I would think flat to down. Slightly down, Kate's yelling at me. Not a big down, just flat to slightly down quarter-on-quarter. We just have some moving pieces in there. And then for the year, look, we have a lot of programs underway, and we'd like to continue to see gross margins trend up. Look, the rate of increase will slow down. The wildcard being the CPaaS business, obviously, with the CPaaS business being a little weaker that improves gross margins. If the CPaaS business bounces back, you'll see some gross margin dilution from that. But over multiple quarters, still want to see it trending higher.

Operator, Operator

Our next question comes from George Sutton with Craig-Hallum.

George Sutton, Analyst

You mentioned shortening of contract duration, I just wondered if you could go into a little more detail on where you're seeing that shortening?

Samuel Wilson, CFO

That's a great question, George. I didn't analyze it in that detail. I looked at the overall RPO pool, and we noticed about a month to a month-and-a-half decline quarter-on-quarter in the overall pool duration. I didn't break it down specifically, but I can guess that we'll likely see it more on the small business side, which generally shows slightly weaker business trends. The enterprise side, however, remains relatively solid and strong.

Operator, Operator

Our next question comes from Michael Funk with Bank of America.

Michael Funk, Analyst

One for Sam again if I could. Sam, there is always a balance between messaging to equity versus debt holders. So how much of the guidance and then the decisions around sales and marketing and profitability is geared towards the debt market and the expected refinancing versus your view on near-term market opportunity?

Samuel Wilson, CFO

I don't see them as fundamentally different. What we are noticing is that more of our shareholders are urging us to enhance profitability and possibly reduce low return on invested capital projects due to the changes in the overall market environment and with a bit more clarity in the company's growth outlook. I don't believe there is a distinct message or different emphasis from either group. Ultimately, a discounted cash flow model functions in the same manner. We want to ensure that, depending on how we approach the debt refinancing, we maintain cash flow profitability after any refinancing. So, it’s important to be prepared for that as well.

Michael Funk, Analyst

I understand it. And then one more, if I could, in sales and marketing efficiency comment, just to clarify, a number of different ways to think about that dollar per sales and marketing, obviously, return and profitability of those sales and marketing dollars. Are we talking more about return on profitability, so shifting away from product in the group becoming less profitable, lower return, more towards innovation? Or is it just simply revenue dollars per sales and marketing or sales per salesperson?

Samuel Wilson, CFO

Okay. So I would say it's a great question, and definitely what I'd love to talk to you about at length, and I'll try to give you a shorter answer, knowing that there is a deep, long answer that sits behind this. We look at it both ways. We certainly look at the core change in ARR or change in service revenue divided by sales and marketing spending, those types of metrics. We also look at change in bookings and those kinds of things relative to sales and marketing. But also, if you take a step back, there's a bigger picture here. Right now, we see more and more enterprises wanting to make the move to cloud. We see it benefiting our numbers. We see that industry trends that logjam starting to break through. To meet those enterprise customers, it makes sense to spend more on R&D and continue to innovate our product to meet that market need. When you get those enterprise customers, obviously, they have lower business mortality risk, better LTV-to-CAC ratios, and all those kinds of things also. The more we can innovate, the more we can create product differentiation. The more we can land enterprise customers, the better our sales efficiency numbers will be naturally. And then, on top of that, we are always continuing to focus on making sure that we put incremental sales and marketing spending in the areas of higher efficiency.

Operator, Operator

Our final question comes from Ryan Koontz with Needham & Company.

Ryan Koontz, Analyst

Wonder if you could give some more color on the CPaaS decline. Is this driven by cost and your respective price increases with your customer set driving lower volumes? Or are these like lost deals to alternate communication channels? And then secondly, for transparency, any way you can give us the organic ARR growth without Fuze?

David Sipes, CEO

We talked about how some large accounts reduced their CPaaS usage in Q4 and have not yet returned to pre-Q4 usage. What we're working on is getting better ROIC for them in those marketing campaigns through lower costs. Additionally, we continue to add customers, but we see overall usage down a bit. It's a usage-based business, so we don't have the level of predictability that we do in our standard UC/CC business. And I believe on the ARR...

Samuel Wilson, CFO

I'll take that one. So we don't break out ARR by Fuze and 8x8. We give you the revenue numbers, which you can extrapolate how you see fit. The big reason we don't is because we now have customers migrating, and you get into this conversation of should you count them on the 8x8 side or the Fuze side or whatever the case may be. We're just trying to give you the revenue numbers because that's clean, easy to go through and we don't have to add anything. I would say when we think about segments, the big thing for us is that our enterprise ARR continues to grow very healthy, as we mentioned, XCaaS, which you can sort of take as a euphemism for enterprise, which we think is over 40% year-on-year. Enterprise is probably growing over 30% year-on-year, those types of numbers. So there is where the stronger parts of the ARR are.

Operator, Operator

Thank you. That concludes the Q&A session as well as today's 8x8 Fiscal First Quarter Earnings Conference Call. Thank you for your participation. You may now disconnect your lines.

David Sipes, CEO

Thank you, Amber.