8x8, Inc. (EGHT) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter 2018 8x8 Earnings Conference Call. At this time, all participants are in a listen-only mode and later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Ms. Joan Citelli, Director of Investor Relations. Ma’am, you may begin.

Thank you, operator, and welcome everyone to our call. Today, I am joined by 8x8's Chief Executive Officer, Vik Verma; and our Chief Financial Officer, Mary Ellen Genovese, to discuss 8x8's first quarter fiscal of 2018 financial results for the period ended June 30, 2017. The earnings press release which was issued today after market close, conference call script and accompanying slide presentation are available on the Investor section of 8x8's website at www.8x8.com. Following our comments, there will be an opportunity for questions. Before I turn the call over to Vik, I would like to remind all participants that during this conference call, any forward-looking statements are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Expressions of future goals including financial guidance and similar expressions using the terminology; may, will, believe, expect, plans, anticipates, predicts, forecasts, and expressions which reflect something other than historical fact are intended to identify forward-looking statements. These forward-looking statements involve a number of risks and uncertainties including factors discussed in the Risk Factors sections of our annual report on Form 10-K and our quarterly reports on Form 10-Q and in our other SEC filings and Company releases. Our actual results may differ materially from any forward-looking statements due to such risks and uncertainties. The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect events or circumstances that may arise after this conference call, except as required by law. I’d also like to note that during this call, we will provide financial information that has not been prepared in accordance with Generally Accepted Accounting Principles, in addition to our GAAP results. Management uses these non-GAAP financial measures internally to analyze our financial results and believes they are useful to investors as a supplement to GAAP measures in evaluating the company's ongoing operational performance. Please refer to today's press release for a reconciliation of GAAP to non-GAAP financial performance and additional disclosures regarding these measures. I’d now like to turn the call over to Vik Verma, Chief Executive Officer of 8x8.

Thank you, Joan, and thank you all for joining us to review 8x8’s progress and results for our first quarter of fiscal 2018. Let’s begin by reviewing our quarterly results. In Q1, 8x8’s service revenue grew 21% on an adjusted basis to $65.1 million. Service revenue from mid-market and enterprise customers grew 33% on an adjusted basis. Total revenue for the quarter was $69.1 million, representing an 18% year-over year increase on an adjusted basis. Our non-GAAP service margins remained strong at 84% and non-GAAP pre-tax income was $3.3 million, or 5% of revenue. While these results demonstrate the continued success of our business model, our traction moving upmarket and our commitment to profitability, I believe they only partially represent what 8x8 is capable of achieving. The mid-market & enterprise segment of our business, which we have defined as customers billing over $1,000 in monthly recurring revenue, is inflecting and now represents 57% of our service revenue. With recent enhancements to our global R&D, sales, marketing, customer support and internal business systems, along with our renewed emphasis on demand generation, we are now better positioned than ever to capture more than our fair share of the $50 billion plus global market opportunity before us. We intend to fully leverage all of our core key assets to our newly guided levels of profitability in order to further advance our technology leadership and accelerate growth. Our strength and differentiation in the market continued to serve us well during the quarter as we again witnessed meaningful adoption of our services by larger and larger businesses. This led to the acceleration of our mid-market, enterprise and channel bookings in both the US and the UK with 14% year-over-year growth on an adjusted basis. We’re seeing more and more prominent, well-established corporations adopt the 8x8 Communications Cloud. This is as sure a sign as any that the cloud is here to stay and that 8x8’s solutions are meeting, and we believe exceeding, the expectations and requirements of the most discerning enterprise organizations. The catalysts for the shift to cloud-based solutions are more compelling than ever with the continued demise of the legacy infrastructure and the tremendous ROI, productivity and overall business benefits 8x8’s solutions deliver to its customers. Let me remind you all that while we are seeing growing adoption of cloud communications services by businesses of all sizes, we’re only still scratching the surface, as the market remains significantly under-penetrated with more than 90% of businesses worldwide still relying on legacy systems. Moving on to a recap of our progress in Q1, let’s begin with an update on our performance in the mid-market and enterprise business segments. 62% of the new monthly recurring revenue booked during the quarter came from customers within these market segments. These customers’ buying preferences are similar to what we have seen in previous quarters, with five of the top 10 deals calling for both Virtual Office and Virtual Contact Center services, three for Virtual Office and two for our Virtual Contact Center solution standalone. Our differentiated, integrated suite of services continues to resonate with large mid-market and enterprise customers while our Virtual Contact Center solution on its own is beginning to gain traction in the marketplace. 8x8’s ownership of the core technology underlying all of our pure cloud solutions has not only garnered industry recognition by respected third party organizations such as the Tolly Group, it also continues to resonate directly with customers as they determine which provider they will trust to handle their mission critical communications. Our integrated UCaaS and CCaaS solution, robust feature set, global service delivery capabilities and enterprise grade security and reliability are some of the common themes you’ll hear as I highlight a few of our noteworthy customer wins during the quarter. One of our marquee customer wins in our first quarter of fiscal 2018 was a major feature film production and distribution company. We are excited to be working with this new customer to upgrade their communications capabilities from a legacy, on-premises Avaya system to our Virtual Office and Virtual Office Analytics solution. We participated in an extensive RFP process with two other pure cloud providers and were selected because of our robust feature set and, most notably, our Virtual Meeting web and videoconferencing service. Our initial deployment of approximately 750 seats will cover four sites, Culver City, Beverly Hills, Australia and London and we look forward to an opportunity to further support their communications requirements with additional seats and services in other global locations. We were also selected by a well known brand that operates the nation’s leading digital platform serving consumers across the entire movie lifecycle. With corporate headquarters in Southern California and plans for expansion, the customer was seeking a reliable cloud solution that would scale to support the company’s growth from a single platform. We’re looking forward to supporting all of this company’s communications requirements beginning with a combined Virtual Office, Virtual Contact Center and Virtual Office Analytics deployment of approximately 500 seats. WGBH, the largest PBS station in the country based in Boston, came to 8x8 last quarter through Softchoice, one of our newest channel partners. This is another combined Virtual Office/Virtual Contact Center deployment of nearly 1,000 seats, replacing a traditional on-premises Avaya system. We won this deal over two pure cloud competitors and are planning full deployment throughout New England and one California location by the end of next month. OnSolve, a leading global provider of SaaS-based critical communication solutions for enterprise, SMB, and government customers, also selected 8x8 in Q1 for Virtual Office, Virtual Contact Center and Virtual Office Analytics services. OnSolve’s requirement for higher liability to support the delivery of life-saving notifications and a unified communications platform connecting all employees were the primary reasons for the selection of 8x8. This U.S. based deployment consists of nearly 400 combined seats across seven corporate U.S. locations. Our 8x8 Solutions team in the UK had a great quarter, bringing in five large enterprise deals. One of these, a 5,000-seat Virtual Office deployment for a UK industrial manufacturer, came through the UK arm of our partner CDW. Other large enterprise deals included 1,500 Virtual Office seats for a consumer goods packaging company and a Virtual Contact Center deployment of nearly 400 seats for the UK Ministry of Justice. Our focus on the UK public sector is paying dividends with this recent large win following last quarter’s win with a legal aid authority. 8x8 Solutions service revenue, which is primarily from mid-market and enterprise customers, grew 37% year-over-year. Expansion revenue from existing customers was again strong during the quarter with orders of 1680 Virtual Office seats from our large office supply retail customer, 200 Virtual Contact Center seats from HomeAway and 300 Virtual Office seats from Lyft. We are also now at over 22,000 Virtual Office seats and almost 700 Virtual Contact Center seats deployed for Regus. Our focus on the channel is another strategic initiative we’re making good progress with. In June, we announced a new consolidated Channel Distribution model aligning individual partners with Master Agents and Distributors that provide sales enablement and support for 8x8 Communications Cloud solutions. This is enabling our partners to accelerate their marketing and sale of 8x8 Communications Cloud services, while providing a clear blueprint for expanding their reach partnership into new regions. We recently signed an agreement with Ingram Micro to add 8x8's solutions to its cloud unified communications and collaboration portfolios. With this new partnership, 8x8 will become one of the largest service providers and the first born-in-the-cloud vendor within Ingram Micro’s Specialty Division for Unified Communications and Collaboration. We also during the quarter announced partnerships with Jenne, Inc., a leading value-added distributor of technology products and solutions and Softchoice, a leading North American provider of IT solutions and managed services. Finally, we are continuing to optimize our sales teams to work in concert with the channel to provide the highest quality pre and post sales support to 8x8 customers. We expect that these enhancements to our sales organization, along with advanced strategic marketing and demand generation initiatives under the leadership of our new CMO Rani Hublou, will have a measurable impact on bookings and revenue growth over the coming quarters. We also made great strides in R&D and product innovation, our third strategic initiative, in the first quarter of fiscal 2018. First and foremost is the quality and depth of the engineering organization we now have in place under the leadership of Dejan Deklich, who joined us earlier this year as Senior Vice President of Global Research & Development. Dejan has recruited some amazing talent to his team with recent high caliber hires from some of the most respected technology companies in Silicon Valley. Collectively, this expertise will be instrumental in keeping 8x8 at the forefront of our industry as we delve deeper into leading-edge technologies such as big data, micro services, machine learning, artificial intelligence, SD-WAN, WebRTC, and more. With five newly awarded patents, for a total of 137 to date, 8x8 already possesses a strong technology foundation and industry reputation. On the product side, our new contact center solution for teams, 8x8 ContactNow went GA here in the U.S. in April as a complete self-service experience and the initial response has been very favourable with customer feedback reflecting the product’s easy setup and use, intelligent routing and rich reporting and analytics. We also just launched new Customer Experience Analytics and Post Call Survey features for Virtual Contact Center, as well as the next version of the 8x8 Quality Management solution. These new capabilities target today’s growing millennial workforce with collaborative performance management and enhanced analytics. Finally, our new, fully redesigned Virtual Office Mobile app which was just released to the app store provides an exceptional user interface and experience that offers communications, collaboration, and messaging in a single app, while maximizing the superior voice quality delivered by the 8x8 Communications Cloud. This is contrasted with other leading vendors that have separate apps for the full capability set. On the global front, our fourth strategic priority, we added a new customer support center in Singapore this quarter, supplementing existing operations in the United States, United Kingdom, Philippines and Romania for global 24/7 follow the sun customer support. We also just launched our global co-selling initiative with Regus in the UK, the first of 17 countries. These developments reflect 8x8’s commitment to delivering the best quality of service and customer support worldwide. 8x8 continues to earn high marks for industry leadership, most recently from IHS Markit in its recently published 2017 North American UC as a Service Scorecard which profiles, analyzes, and ranks the leading cloud unified communications service providers. In this report analyst Diane Meyers states 8x8 continues its leadership for the fourth year due to its installed base of UCaaS seats, financial position, and continued execution on its market strategy. Fiscal 2018 will be a pivotal year for 8x8. We are seeing increasing adoption by mid-market and enterprise customers, our sweet spot in the market, along with legacy channel partners rapidly moving to the cloud, given recent events in the industry. We believe we have a clear lead in the mid-market and enterprise, which brings us the highest ROI and long-term customer value. As we’ve stated in the past, we are only minimally investing in the micro market segment of 1 to 9 lines which is growing at approximately 5%. Our core business, 10 to 10,000 plus seats, is now growing approximately 27% on a constant currency basis and represents approximately $200 million, more than 75% of our total annualized service revenue. Even more interesting to note, if you look at the mid-market and enterprise segments as defined by Gartner, over 100 seats, which is where our incremental investments have been going, we are now growing at 41% and this segment represents well over $100 million of annualized service revenue. We have successfully scaled our business to serve these enterprise customers and now is the time to step on the gas. Expanding the reach and effectiveness of our channel organization will be one of the key areas of focus of this increased investment. With that, I’ll turn the call over to Mary Ellen for a more detailed discussion of our financial results and outlook.

Thank you, Vik, and thank you all for joining us on the call today. My commentary will cover highlights from our income statement and balance sheet along with key operating metrics from the quarter. These will be based on non-GAAP results, unless otherwise noted, and I remind you to refer to the tables in today’s earnings press release for a GAAP to non-GAAP reconciliation. You will also find a slide presentation with our quarterly results posted on our Investor Relations website. For the first fiscal quarter of fiscal 2018, service revenue increased 18% year-over-year to $65.1 million. Adjusting for constant currency and the discontinuation of the non-core, voice-message broadcasting segment of our DXI operations, service revenue increased 21% from the year ago period. Total revenue in the first fiscal quarter grew 15% year-over-year to $69.1 million. On an adjusted basis, total revenue grew 18% from the year ago period. Service revenue from our mid-market and enterprise customers grew 29% year-over-year and 33% on an adjusted basis. 57% of our total service revenue is now coming from our mid-market and enterprise customers, compared with 52% in the same period last year. Product revenue, which constituted approximately 6% of total revenue in the first fiscal quarter, declined 16%from the year ago period. Gross margin for the quarter was 77.8%, compared with 75.4% in the same period last year. Service margin in the first fiscal quarter was 83.9%, compared with 83.2% in the year ago quarter. Product margin in the first quarter was negative 22%, compared with negative 16% in the same period last year. Quarterly pre-tax income was $3.3 million, $0.03 per share, or 5% of revenue on a non-GAAP basis compared with $5.5 million, $0.06 per share, representing 9% of revenue, in the same year ago quarter. Non-GAAP pre-tax income for the first fiscal quarter excludes non-cash charges and a gain of $1.4 million related to an escrow settlement from our 2015 acquisition of DXI. To provide greater color on our non-GAAP pre-tax income for the quarter, we incurred channel commissions in excess of what we had budgeted due to robust channel sales and collections activity. Sales and marketing expenses, which also include customer service, product management and deployment costs, were $37.7 million, or 55% of revenue, in the first fiscal quarter, compared with $29.4 million, or 49% of revenue, in the same year ago period. The increase in sales and marketing expenses was primarily due to an increase in headcount, channel commissions and advertising. Turning our attention to the key operating metrics for the quarter, average revenue per mid-market and enterprise customer grew to $4,592, compared with $4,230 in the same year ago period. Average revenue per business customer was $432, compared with $399 in the same period a year ago. Gross monthly business service revenue churn on an organic basis, excluding DXI, was 0.6%, compared with 0.5% in the same period last year. New monthly recurring revenue from mid-market and enterprise customers and by our channel sales teams comprised 62% of the total new monthly recurring revenue booked in the first fiscal quarter on an adjusted basis. This new MRR increased 14% on an adjusted basis, compared with the same period in fiscal 2017. Cash, cash equivalents and investments were $178 million at June 30, compared with $167 million one year ago. Cash flow from operating activities was $6.2 million in the first fiscal quarter, compared with $6.5 million in the same period last year. Capital expenditures, including capitalized software were $4.4 million in the quarter, or 6% of revenue. As Vik mentioned, in order to fully capitalize on the market opportunity at hand, we are lowering our full year non-GAAP pre-tax income guidance for fiscal 2018 from the previously guided range of $21 million to $26 million or approximately 7% to 9% of revenue to approximately $9 million or 3% of revenue. Our estimated non-GAAP effective tax rate is expected to be approximately 36%. Our cash taxes are expected to be less than $1 million. Our revenue guidance for fiscal 2018 remains unchanged. We expect full year service revenue in the range of $280 million to $285 million, representing approximately 19% to 21% year-over-year increase. We expect total revenue in the range of $296 million to $300 million, representing approximately 17% to 19% year-over-year increase. Adjusting for the currency headwind and the discontinued revenue from the non-core, voice message broadcasting segment of our DXI operations, we expect fiscal year 2018 service revenue growth in the range of 20% to 22% and total revenue growth in the range of 18% to 20%. Taking into consideration our increased investment in the business, our market leading position and the market opportunity, it is our expectation that service revenue growth will begin to accelerate in fiscal 2019, and an exit growth rate of approximately 25% in the fourth quarter of fiscal 2019. That concludes my prepared remarks and we will now open the line for questions. Operator?

Thank you. [Operator Instructions] And our first question comes from the line of Nandan Amladi of Deutsche Bank. Your line is open.

Hi, good afternoon. Thanks for taking my question. So Vik and Mary Ellen as well, the guidance change within the first quarter seems quite dramatic, what factors changed within the last three months for you to lower …

Yeah, that’s a great question. So couple of things. One, as you know, I've been in the market for a new CMO. And I always want to make sure I have the right person in place before I really turn on the gas. Second thing is, we've just brought on board our new head of engineering, who as you know came from Splunk. He managed all of cloud engineering for Splunk. He is starting to see more and more potential to really accelerate engineering. And then we're starting to see some really good traction in the channel. And when you start to look at all of that and then, I mean, you saw some of the news today, it was almost like I wrote it from central casting. The legacy channel is now starting to move in an aggressive manner towards cloud. I think 3 out of our top 10 wins also were former Avaya customers moving to cloud. So at a macro level, my products are ready, right, and I'm starting to feel better and better about them. I got the right person in place to head up engineering, and he's even ramped up that engineering team. I mean, we had a good engineering team. I think we've now got some super studs there. You've now got marketing, where we've had - I've been not subtle about saying that we can get much better at marketing. I think we've been recruiting in that area, and that entire team has gotten significantly better. And then with Avaya's channel starting to move away with Avaya's problems, and now with this most recent acquisition, this is the time. You've turned on the gas. That's why we have all this money in the bank. We are probably the most profitable cloud UCaaS vendor by a significant amount. And I think we can turn a lot of that operating leverage towards really going for it.

And in terms of the channel development, you've begun to sort of whittle down the number of partners about 3 years ago. Now you have some very large partners, like CDW and Arrow, you signed Ingram this week. How much is left to do on the development side? Or is it now micro developing the channel expertise so that they can pump more sales through it?

Yes. It's channel enablement primarily. I think we've recruited some of the really - and you can see it. We're starting to see a lot of these former ShoreTel Avaya, the partners, starting to have an immediate impact. And the key is going down at multiple levels to all the regions, not just the relationship at the very top level, but with individual reps and really amping up that channel coverage model. Channel revenue is the fastest-growing revenue from any of our other revenue segments. And as I said, mid-market and enterprises are sweet spot, and a lot of Avaya's customers are in the enterprise segment. So with those macros events taking place in the industry, that's why we felt, as a board, that this was the best use of the shareholders' money to really go for it. We didn't want to sit there and not take advantage of the market.

And just one more. I have to ask you your assessment of the Mitel-ShoreTel deal that was announced this morning.

Yes. As I said, I - it was from central casting. I mean, Mitel and ShoreTel, I think, I mean both credible companies, but they have been doing this dance for I think 2 years. And initially, I think one resisted the other. The ShoreTel channel and Mitel channel has a lot of duplication. ShoreTel employees and Mitel employees have a lot of duplication. I think its tailor made for us, and its tailor made for the perfect time that we came into you and said we're going to really amp up our investment and channel.

Thank you.

Thank you. And our next question comes from the line of George Sutton of Craig-Hallum. Your line is open.

Thank you. I wondered if you could give us a sense of the investment payoff here. So if we're talking $12 million in effect that you're going to spend, it looks like the indication you're giving is that you'll see some impact because you're not raising guidance is that you're going to exit the year at a faster growth rate. Help us understand the investment payoff side of that equation.

Okay. So George, thank you for that question. The very first investment is going to be on the channel side. As we mentioned before, channel is growing very rapidly. We have a strong team in place now. We're going to continue to invest there. We're going to invest with headcount. We're going to invest with additional partners. We're going to invest by enabling those partners. We're going to invest with more market development funds. That is really a very, very good area for us. And we're getting a lot of traction, so we want to double down in the areas that we're really doing well. In addition to that, as Vik said, under the leadership of our new CMO, we want to start to really invest in improving our lead gen engine. One of the things that we've mentioned in the past is we're not getting enough hits, we're not getting enough opportunities at that. We have a very good win rate, especially on the enterprise side. We seem to be winning far more than our fair share of enterprise accounts. Now we have to continue to generate more and more leads in that area as well as more opportunities, and then that's when we're going to start to see that rapidly accelerate. So that's the second area of big investment is improve our lead gen engines, and we believe we had a team in place to do that. Lastly is on the R&D side. We want to make some significant investments in the cross-platform real-time analytics. Why do we want to do that? It's one of our key differentiators. Nobody can compete with us on our real-time cross-platform. We're the only ones who have the cross-platform analytics and then the real-time analytics. We believe that those are going to take a little while to mature, right? For instance, on the enterprise side, it's a longer sales cycle. And then once we do win the account, it takes longer to deploy and convert to revenue. So that's why we don't expect to see these returns until fiscal 2019.

Do you feel you're seeing a competitive change that causes some of this on your part, where you obviously moved early into the mid-market and enterprise, and you've seen others move in that direction as well? And would you have needed to do this say, a year ago, if the market was where the market is today if those folks hadn't entered the market and made it more competitive?

No, I would have done it no matter what. I mean, it -- the biggest macro reason to do this is, it's almost been the classic Crossing the Chasm, right? So if you look at the market adoption, what we are trying to build is the - we have always positioned the company as you've got the micro business, you've got the small business, you've got the mid-market, you've got the enterprise and three years ago, we were primarily in the small business and the micro business. And we've been moving upmarket to mid-market and enterprise, but enterprise is the area that we think is the giant prize because that's where multibillion dollar company valuations are made. And so what you start to see with the enterprise is, it's almost like you get the first 5 or 6 or 10 whales, as you know, we've got. And then you have to kind of deploy them and you go through a learning curve. And now we're starting to see faster adoption there. And so in essence, we want to invest because we start to feel like the market is ready. And if we think, within a year or 2 years, it starts to hit the tornado, and I think we are first. And we want to make sure we leverage that. And then as I indicated, I think you made that comment about, I mean, to a large degree, we are first. And at times, we've almost been too profitable for a cloud company. I mean, to a large degree, we have the ability and the dry powder to basically start to really turn on the gas. We've tried to be prudent about it because I think, as you know in the past, I've always guided to a certain non-GAAP net income, and I've always come in way over it because I've always wanted to make sure I only invest when I think I can see a return and that the market is ready and my team is ready. And so we've gone through a massive cycle over the last 2 to 3 years where we have started to integrate all our platforms together, we've upgraded all of our UI. We put emphasis on the analytics. We brought in a guy from the leading analytics company. We've kind of upgraded our marketing. So that's when you kind of light that candle, so to speak, and then you go for it. And to a large degree, I said I want to make sure that the lead that we have in enterprise, particularly as enterprise starts to accelerate and adopt faster and faster, we are there. And then as I said, Avaya has helped us. And then now, the recent ShoreTel-Mitel is also helping us because where are those legacy channel partners going to go other than to cloud? We are the full-service cloud, so that's we want to take advantage of it.

Perfect. Lastly, if I could. The Sameroom offering, can you just give us an update of where that stands?

I mean, basically, it's continuing to be valuable to us because we keep getting some amazing logos. We don't charge a lot for it because initially what we're doing is we're basically allowing people to integrate using the Sameroom, all the various chat engines, HipChat as well as Slack and a few others. We may have some very interesting announcements for you on that one as we start to kind of move forward and do a few strategic partnerships in that arena. But we've had very good luck with that acquisition. And Quality Rocket is probably the best acquisition in my career. And we started off with probably, what, 6, 7 people in Cluj, Romania. That's up to 140 people, of which probably 90% or 85% are software engineers, and some amazing folks. And we've been able to - we've now got a 200 plus engineering team, and the entire engineering team speaks a common language. They are all employees of the company. They're all trained cross functionally so you don't have various silos in different countries that don't necessarily speak to each other. You've got an integrated engineering team, the ability to move towards micro services, ability to have a common platform. I mean, so from that perspective, Cluj has been a way for us to really amp up our engineering team but make sure they're our employees, not consultants.

Perfect. Thank you.

Thank you. Our next question comes from the line of Meta Marshall of Morgan Stanley. Your line is open.

Hi. A couple of quick questions. The first is, I guess, I wanted to just get more detail on how revenue came in, in line, but channel commissions were higher than expected. So I guess, just an explanation of kind of what caused that discrepancy. And then second, on just as you - you obviously made this plan with the knowledge of only Avaya's reseller’s kind of being up for grabs. Is this something where you think there could be incremental more investment as you go through ShoreTel or Mitel opportunities or is this something that you feel like is an adequate investment bucket to kind of go after the growth that you see right now?

Okay. So Meta, I'll take the first one, the detail on the revenue is in line, but the channel commissions, why were the channel commissions higher than expectations. And that's primarily because the channel commissions are earned based on when we collect the revenue, not when we actually book the revenue. So it takes a little while, especially on these bigger deals to deploy. And then we've had significant collections as we start to deploy some of these big deals that we won in fiscal 2017. Now they're doing well. We're collecting, and we had some very large collections in fiscal -- in our first fiscal quarter. And that's not easy to predict, right? You never know exactly when it's going to be deployed and when it's going to start billing and when you're going to start the collections. But that's basically what happened, is we underestimated what the collections would be for the fiscal quarter -- first fiscal quarter, and that impacted our channel commissions.

And then the question on the investment. Yes, the intent was to make it all-encompassing, and the ShoreTel-Mitel is not a surprise to us. I mean, it shouldn't be a surprise to anybody. It's been, I mean, ShoreTel started a strategic review. ShoreTel's channel has been inflecting a lot of ShoreTel employees, et cetera, have been moving out. And they've had a few employee actions, et cetera. So the plan I gave you, the board and us have been spending probably quite a few weeks, kind of debating, going back and forth as to when is the right time. And I think we felt that this was the right time, and we sized it so that we more than covered all of our needs for FY '18.

Okay. Thanks.

Thank you. Our next question comes from the line of Rich Valera of Needham & Company. Your line is open.

Thank you. First question is your mid-market MRR bookings number. I think you said that was 14% for the quarter, which is an improvement certainly from last quarter, but still well below your targeted kind of 30% growth rate for that segment. So I wanted to try to understand if there was anything negatively impacting that number in the quarter, like the MSAs that have been impacting it last quarter? And when should we expect that number to get to kind of that 30% level where I think it ultimately needs to be for you to grow that business or that segment at 30%? Thanks,

Yes - no, I think we've talked about this. I don't consider that as relevant a metric anymore. And that's because, particularly large enterprises, tend to buy more and more on MSA where we'll get a portion of the order and then the rest of the order against contracts. So I think the - I think that number will fluctuate. I think the key thing for me is to start seeing overall service revenue growth in that 25% bucket. And we think by 4Q '19, we should be starting to see service revenue on a whole - on that trajectory. And you can kind of start to see micro business, which is the business that is of the least interest to us and candidly we neglected it. We still invest enough to kind of continue to win. But that's growing at 5%, and that's approximately 25% of our business. And that has been the drag on the company. The rest of the business has been growing significantly faster than that if you were to just back out the micro business, you're growing already at 26%, right?

27%.

27%. And as the micro business essentially kind of doesn't grow and the rest of the business continues to be bigger and bigger part, you normalize towards the growth rate of the rest of the business. And then if you look at true mid-market, as Gartner defines it, which is 100 seats and above, you're already talking about that growth rate in the 40%. So more and more, what you're seeing, my bias towards is being pretty aggressive in starting to change my investment trajectory towards the larger and larger customers because I think that's the future. We were obviously - you never want to do it too early, but in this particular instance, I think we start to feel like there's enough good things happening that this is the time to do it.

Yes, and just to add to that one point. I mean, the micro, if you look at the customer's average lifetime revenue, it's approximately $9,000. If you look at the enterprise, that is 1,000 seats and above, the average customer lifetime revenue is $2.4 million. So if you had an extra $1 to invest, where would you invest it? And that's the area that we're doing extremely well. We believe that we're able to manage that complexity better than any other cloud provider today.

Yes, I understood. Just a follow-up to my question. You've said in prior quarters that this quarter we had one big deal done as an MSA that negatively impacted that number. You didn't say anything about that this quarter. I'm just trying to understand were there meaningful deals done as MSAs that impacted that number this quarter?

Yes. I think if you go back and look at the deals that we did close, even though we didn't use the word MSA, they're all pretty much like that. What we're finding now, Rich, is we continue to move into this enterprise, and we see that more of the mainstream is beginning to adopt. They're not going all in, which is the beauty of the cloud. It starts with a few offices and continue to land and expand. So if you look at some of the large ones that we did this quarter, it was the same sort of thing. It's a land and expand. So you're right. We didn't see - we didn't necessarily use MSA. That's exactly what's happening with...

Yes. Consider that as the way of going forward and the way of doing business for very large enterprises. They always give you a portion of the deal, and then the rest of the deal comes in right after. And that's why you see start to see the expanding part becoming a bigger and bigger part of our business.

Fair enough. And just kind of one more kind of big-picture one here. You've talked about reaccelerating the business to the service revenue to 25% almost 2 years out here post this significant incremental investment. And I guess, just devil's advocate, you exited last fiscal year, a quarter ago, at 24% adjusted service revenue growth. So 2 years later, get back to that after sort of significant negative leverage in the model. I guess, I'm not sure that that's that exciting of a business or business model. So just trying to understand when - at some point, one's got to see leverage in the business or significantly higher growth. And what you've laid out doesn't necessarily get us either, if you're looking at quite recent history, which we're growing at. So maybe help me better understand, maybe what the longer-term operating model of the business you think is and if you think you'll see any operating leverage in fiscal '19.

Okay, Rich. Fair question. As far as leverage goes, I will say this is a $50 billion market, which is less than 10% penetrated today. And we're just starting to see the area that 8x8 truly excels in beginning to adopt, become more mainstream. So this really is the time to invest for us. And we're still going to be profitable. But it is the time to invest. We're going to be a much more valuable company if we can continue to win in this mid-market enterprise space and continue to grow our revenues. So what you saw last year in fiscal '17, remember in fiscal '16 was the very first time that we had - when we started to see the early adopters for the enterprise. If you remember, we called them whales, right? And we had expected to win 1 or 2 whales in the year. Hey, we ended up exiting the year with about 7 whales. I think it was 7 whales, right, at the end of fiscal '16. So fiscal '17, you're going to see that large growth as we continue to deploy and turn to revenue all those whales that we found in fiscal 2016. That's great news, right? Now what we're finding is as we continue to move up market, more and more of these customers are -- have a much more mature procurement process, call it the MSA process, or call it just a very mature procurement process. We're seeing that we're winning in those accounts. And we're landing 2, 3, 4 of their offices, and we continue to expand over the long-term. So there is significant runway inside of these large accounts that we have acquired over the last 2 years. We have a lot of runway to go, continue to deploy in that space. So we believe that, yes, I mean, we're going to continue to accelerate our growth rates. This is a time to invest. It's a large market. We're in the right place at the right time. We've got the right team in place, as Vik had said. We have strong product capability. We're differentiating ourselves in a number of different ways. This is the time to invest. When will we start to see leverage? You're not going to see a SaaS company show leverage at $250 million to $300 million of revenue, right? What SaaS company out there has done that? Most SaaS companies are not profitable at this stage.

Yes, right.

So we're still one of the most profitable, I think, SaaS companies at this early stage of the market really starting to adopt. So we will a portion of leverage. We have a focus on profitability. We can definitely show leverage. When will we do that? I can't tell you exactly, to be honest. But absolutely, the model can be profitable. And as we continue to accelerate and accelerate our growth, I think we're going to start showing leverage, but it's probably a few years out. And I think to go back to my original comment, we're going to be a more valuable company if we continue to grow into this high-quality enterprise revenue which has favourable annual retention rates of well over 100% and has a customer lifetime revenue, that's our current customer base today has a customer lifetime revenue of greater than $2 million.

Yes. I think, I'll just add a comment. I think your point is valid, but where I think -- where I would point you towards is, in an early growth market or an adopting market like that, investors value growth over profitability. We have been consistently profitable, and to some extent, we've almost been a victim of the level of profitability that this company was able to do because we get measured on profitability pretty much everybody else around us, Oh my God. They only lost x amount of million dollars, right. And so to a large degree, we are now in a mode where we feel comfortable that this is the time. We're still committed to making sure we're profitable. We'll continue to make money, but at the same time, we believe the best uses of the shareholders' capital is not to keep changing $178 million and adding another $3 million, $4 million, $5 million extra to turn that into sales and marketing and really grow where the lifetime value of the customer is well over $2 million, which is enterprise currently represents 18% of the company. I guarantee you, if in 3, 4, 5 years, enterprise is well over 50% of the company, this is a significantly more valuable company even if the bottom line is not 7% or 8% or 10%. So I think that's where I kind of come out and that's the analysis we did as a company.

Got it. Thank you.

Thank you. And our next question comes from the line of Dmitry Netis of William Blair. Your line is open.

Great. Thank you very much for taking my question. I have a couple of questions, guys. Number one, I was reading through the press release listening to your call. You mentioned a lot of organizational changes in R&D and marketing departments, which is all good. Are you making any changes in the sales organization?

Yes. So what we're doing is increasingly channel is becoming a bigger and bigger part of our business. So what we're starting to do is, in the past, we had almost had a bifurcated sales and organization, which is, you had a skill-based organization that did direct selling, mid, small enterprise. And then you had essentially channel managers that basically sold for the entire channel, so they were basically distributing in such a way that the same channel Manager sold anything from a 10-seat deal all the way up to a 10,000-seat deal. Its part of our legacy and its part of our growing pain, but what we're finding is we can get huge efficiencies as well as much greater velocity if you have a common sales team and the channel is a lead source but the same common sales team basically prosecutes. So that's an evolutionary change that we're starting to do. And I think it will continue to accelerate. And the reason we waited to do that change is we wanted to make sure that channel was a nontrivial portion of our revenue because you don't want to suddenly make this change and find out the channel is a small portion. Channel is growing 2, 3x, right, of anything else, and we're starting to see particularly with new channel partners, Jenne, et cetera, Packet Fusion, they're starting to really perform for us. So we think over the next few weeks, we will start to do that. And we think we'll have one common sales team which is purely skill-based and channel becomes a lead source, organic becomes a lead source, and we just literally go for it.

Okay, very good. And then Vik, what gives you confidence? As you go out - one of the things you mentioned was the channel commissions spiked up. I was just making sure you're not buying the channel partners here and you have a...

No.

You've got the 3, 5, 4, 5-year contract where people will stick with 8x8 solutions and not just switch over because somebody comes in with a higher residual, which is what we're seeing out there. So I'm just curious what you are seeing. Is this the industry - general industry seeing that's happening on the channel front that everybody's going at the same channel and everybody wants to succeed. How do you ensure they stick with 8x8 solution and go with your product for the end?

So I think 1, 3-year contracts - so one, buying channel is not worth it, right? Because in the end, stuff's got to work, and so I'm a big fan of you don't buy stuff. The main reason, which I think is a good thing, and Mary Ellen and I've always chat about this, we always pay commissions to channel partners on collections. And the reason is I'm a big fan. If I get money, I make sure other people get money. What I don't want to have is we basically pay and then maybe collections get delayed because now everybody's interests are aligned, and we are partnered with everybody. So the good news is, a lot of our customers that we deploy to a channel all paid, which is why, I guess, it was greater, which is why collections were higher, which is why the commissions were higher than anticipated. So that's the comment. With regard to channel, we're going through with it consistently. We're not going to buy the channel. We are spending actually an awful lot of time really enabling the channel and really getting into, I guess probably better way to say this, just partnering with them, getting into the details, enabling them, educating them, spending a lot of money and time on that. But our compensation structure is consistent with what everybody else has. It's nowhere close to, I think, some of what other people pay. And we don't believe we need to.

All right. And I apologize for falling into this trap, but there was a press release by your competitor earlier this morning, and it's one of the customers that you have signed a couple of years ago. And I'm just - how do we think through this? Can you help us explain what's happening there? Are they replacing you at that – customer or is there an expansion opportunity for them? What is really going on there?

Yes. So I think I know which one you're talking about. This is the -- the timing of the press release is quite interesting to me, but this is a customer we -- that we were replaced in about a year ago. And so it was surprising that it took a year to issue a press release. But anyway, and it was primarily because of a fax feature that we were not -- a custom fax feature that we were not willing to provide. And look, we've got customers that we won. I mean, and I'm sure they have customers that are one of ours. This stuff seems to happen. But again, I will probably not overly tout it. The part I would tell you that is interesting is, there is no contact center that our "competitor" has. They're selling somebody else's contact center. When we are talking about contact center, we're talking about ours. It's - whatever. I mean we announced a couple last quarter. We didn't announce who they were from, but most of our enterprise wins are against our friends, and we just move on from there.

All right. Good. That’s it from me. I’ll take the rest offline. Thank you, guys.

Thank you. Our next question comes from the line of Jonathan Kees of Summit Redstone. Your line is open.

Great. Thanks for taking my questions. I guess I'll start with the channel. I think you're talking about they're a material part of your business, now they're significant. And so, I guess I wanted to try to get some more details on, like, can you provide some color in terms of like what part of the services revenues they are? Are you seeing they're also fastest-growing and that's with just the current investment? What are you looking at in terms of where they could be? What is your channel strategy in more detail, please?

Yes. So we're not going to provide you all of the details. I mean, we have not broken our channel. We probably will in the next - actually, all the revenue is going to come from the same place. So we love to think through which parts are coming from channel. We've never broken our channel revenue per se, but it's meaningful enough now that I think we felt comfortable in making this realignment of the sales teams. Channel grows on an average probably 3 to 4x the company growth rates. And so when you start to look at that, this was prior to some of these investments that we're making. And so again, and I think I want to keep hammering this point because it comes down to -- I have a lot of dry powder, and the reason I have a lot of dry powder is because our gross margins are in the 80% range. And we've got obviously sales and marketing spend. And so the issue is where other people in our space are significantly lower in profitability than ours, we have, in the past, chosen to be profitable so we keep building up our war chest. This is the time we feel comfortable in deploying that war chest and so that's the whole reason behind why - and channel is, as I said, the fastest-growing segment, and particularly with Avaya, ShoreTel, et cetera, you're starting to see Legacy, prime-based channel starting to go towards cloud. I think it's a little bit of a land grab where, I think, we're in the perfect place to grab that land, so to speak. And so that's why we are going to put significant investment, and our investment is going to be multilevel. We have invested in the master level where we go in and build relationships with a top tier channel, but we're also investing in the subagent level where we're investing in building relationships at each of the territories where the subagents are. And we're spending a significant amount of time in training our channel on how to sell our products and also to deploy our products. So that's essentially a core part of the strategy.

Okay. Yes, I would think that, especially if it's growing that fast that you would want to try to highlight that as often as possible, breaking out the details. So - let me ask you this, this is more of a housekeeping. Can you at least share with me what percent of the top 10 deals came from channel this quarter?

Sure. I think it was 5 or 6. I don't have it, you've got the number?

It was 6.

6 out of the top 10 came from the channel.

6 out of the top 10.

Including some of the really big ones.

Okay. All right. And then lastly, if I may here, I know you're talking about - you won't see the benefits of this investment until fiscal year 2019. I mean, are you looking at targeting - I realize this is not official guidance, but are you looking at trying to grow faster than the market substantially faster? Just are you trying to outgrow your major peer, number one. I guess, what kind of growth rates are you thinking about in terms of your investments?

Yes. So we believe - I mean, so we believe we can grow faster. We currently are growing faster than market, depending on the segment. We are going way, way lower than market on the micro segment, which is 25% of our business, which kind of affects our overall revenue. If you just back that out, we are growing, as I said, north of 27%. If you back - if you just focus on mid-market and enterprise, growing well north of 40%, right? So in both categories, we're growing faster than market. In my world, I don't really care about the micro business growth rate. I want to make sure I take care of my customers in the micro business. I provide all the add-on value. But all incremental investments I want to bias towards mid-market and enterprise, and the goal is to continue to grow faster than market there.

And that's just with the current investment, so?

Right.

All right. Good luck with that. Thank you.

Thank you.

Thank you. Our next question comes from the line of Will Power of Baird. Your line is open.

Great. Thank you. Yes, just a couple of kind of follow-up questions. First, just on the gross services margin outlook, you've been around 84%. I mean, up a little bit year-over-year, but ticked down a little bit for the last couple of quarters. How do we think about that going forward? Is this - should it stay in this 84% range, why don't I start with that?

Yes, a good question, Will. We would expect that that would be right around 84%. We have significantly - we have made significant improvements here in the U.S. on our cost reductions. So we're definitely doing well here in the U.S. Where we do need to improve is in the U.K. side. So for solutions as well as our DXI business, we believe that there's some opportunity to continue to improve. So I don't know if it will go up much more than 84%, but there is opportunities to improve in the U.K. When I look at the third-party cost as a percent of our revenue, it's not going up at all. It's going down, if anything. So I think that we have an opportunity in the future to fine-tune that. But we're doing pretty well. 84% on the service revenue is we're doing extremely well. Some of the costs that are coming in are more of the fixed cost and also the new software, software licenses, that we're buying that's increasing some of the cost in that area. But on the variable cost, it's definitely - we're doing well. We're doing extremely well.

Okay. And then Vik, you talked about some of the changes underway, right now, I guess, in terms of the management of the master agents and just kind of the sales structure of the business. How do we think about potential for sales disruption, I guess, your near term is that's underway, right? Because there's always risk when you're working on changes with the sales channel.

Yes. These changes have been underway for sometime. In other words, we've been kind of planning for it for a time. And so, I think the biggest part of the change is, I think, the bifurcation around the various segments, right? So making sure that a micro and small business person has very clear rules of engagement as to when to kind of bounce up from one to the other. So it's primarily around making sure that the leads flow to the right scale person. And so I don't think it's going to have a material impact one way or the other because, in the end, I think we've got now a mature enough sales team that they know how to prosecute different types of deals. I think, over time, the efficiencies should increase.

Okay. Thanks.

Thank you. Our next question comes from the line of Mike Latimore of Northland Capital Markets. Your line is open.

Great, thanks. Last quarter, you gave, I think, a growth rate in your enterprise segment. I might have missed it, but did you give that this quarter?

Yes, so we gave it to you onetime, but I mean, basically, enterprise is the fastest-growing, and it's growing probably...

Kind of 150% or more, right?

More than the market. Mid-market is growing essentially a little bit more than market. Small is growing at or slightly below market, and micro is growing dramatically below market. But I gave that to you more illustrative. I don't want to get into a mode of providing all those metrics. But that's why, if you think about the business, and I think some folks have asked this question, what we - the reason for stepping on the gas is micro is now 25% of the business and that grows at 5%, right? Which means the rest of it is growing 26%, right? And that's 10 lines and up. And then when you start to look at just 100 seats and up, that's growing 41%, and that's our fastest-growing segment. So increasingly, we think the Avaya, ShoreTel and other channels are getting you to the mid-market and enterprise. I think our products are perfect for the enterprise. We have major differentiation in the enterprise. We have reasonable differentiation in mid-market. We have no differentiation in micro. So to me, it's a very simple exercise of spending time and energy to really go after the highest-value segment and the fastest-growing segment. And then the other part that is even more interesting is, and Mary Ellen has it, the micro business lifetime value for us is approximately $9,000 a mid - an enterprise customer lifetime value to us is well north of $2 million. And then when you look at retention rates, micro business retention rate is in the 95-ish percent and enterprise, mid-market, et cetera, is well north of 100%. So that's part of the reason why we are biasing more and more towards mid-market and enterprise and focusing on growing that faster and faster. And as micro becomes less and less a part of it, you'll start to see the growth normalized towards what the mid-market and enterprise is growing at.

Yes. That makes sense. And on the small business segment. I guess, which subsets the micro market. That growth rate in that segment has been small. I mean, I know it's not a focal point, but do you think that growth rate stabilized at some point? Or do you think that could slow a little bit.

Mike, just to be clear, the micro is 1 to 9 lines, right?

Yes.

So we also have a small segment which is 10 to 99 lines, so the micro that we've been - I think we've been talking about it for quite some time that we haven't been investing in. It doesn't have a great - it's profitable, but it doesn't have a great return not as good as the mid-market and enterprise. But the 10 to 99 lines is growing slightly less than market. If the market is growing about 15%, we're growing slightly less than that. So that's a good solid business out of the box, right? Where we're focusing most of our incremental dollars as we have talked about in the past is in mid-market and the enterprise, and that is growing very nicely compared to market. So our goal is to be growing in our mid-market and enterprise at greater than market rates, and we're doing that in mid-market and enterprise.

And just last question on the contact center. You've been winning some contact center deals like independent of the Virtual Office.

Yes.

Did you have a marketing and sales strategy around selling contact center? Or are those kind of bluebirds that come in once in a while?

No. We're starting to get more structured. I mean, this is the part -- to some extent -- I mean, this is something that I don't think the investment community has fully understood. I mean, if you think about it, contact center is almost 20-ish percent of our business, and that's growing very nicely for us in the 20-ish percent range. And if you look at the deals we're winning, I mean, you've got Lyft, HomeAway, just to mention a couple, but then also Ministry of Justice. And these are 400 type seat contact centers. So we're starting to win increasingly contact center seats on a stand-alone basis that is -- that says that over the last 2 to 3 years, we have turned our "also ran contact center" to something that is capable of standing on its own 2 feet or if contact centers stand on their own 2 feet, but it's very capable of being stand-alone, and oh by the way, it can win on its own. And I've got contact center and I've got Virtual Office. Those are 2 public companies now if you think about it. On top of that, I mean we have a third-party media player, but all the entire virtual meeting and collaboration is another technology we own. And that, you see, was a key differentiator on this major motion picture studio that I just told you about. These are 3 core technologies that are the hearts of $3 billion plus companies, and we own them. And to some extent, if you add up the overall investments we are making, I think this as market moves towards enterprise, it increasingly starts to become - the fact that we have this one consolidated platform and the ability to provide cross-platform analytics, so I can tell you everything that's going on, whether it's on the contact center side, your Virtual Office side, your SMS side or your virtual meeting side and be able to provide one dashboard to management about most important stuff, I think it's going to be a hugely differentiated thing, which is why, "It's the analytics, stupid." Which is why if you look at the recent hires I've made they're all people coming from an analytics background. So I think that's where I think we've got a huge amount of value in the company that we have not unlocked because I think as the market starts to realize that these 3 technologies are resident in 3 different companies and you can kind of private label them, call them whatever you want, but if the technology is owned by another company, it's owned by another company. In our case, all 3 technologies are owned by us.

Okay. Thanks.

Thank you. Our next question comes from the line of Mike Crawford of B. Riley. And your line is open.

This is Sameet on for Mike. How are you?

Hi.

So just a quick question, a modelling-related question. I think, historically, and I just wanted to follow up on the updated guidance, the 3% of net sales. I think historically just looking at your proxy, I think management computation of bonuses was predicated on hitting a target of 6% of pre-tax adjusted net income. So on a going forward basis, like how should we kind of model out stock-based comp, just given the new kind of 3% guidance you guys laid out?

So how should we model the stock-based comp?

Yes, on the going forward basis just given that I mean the proxy I think is predicated on like 6% of net income. And now you guys have adjusted it down like 3%?

You're talking about the management incentive plan in the proxy?

Exactly...

Which is our cash bonus plan. Okay so that doesn't have anything to do with stock, right, so that's the cash bonus plan that we have for our executives, and it's based on a non-GAAP basis.

I got you, but in that it says that it based the target in the proxy like at 6% of pre-tax net income for a payout of management bonuses and now your new guidance is on 3% net income is the guidance. So like how - are you adjusting that figure down? Or how should we kind of model that out on a going forward basis.

Yes, so each and every year we set new targets, right, so it's all based on the new targets that we set for the plan that's approved by the board. The new target for this year are different than what we had set for the target for last year, right? So it's all based on the plan that we pulled together. So typically, it's a minimum of 3% to do a payout. And that's the way we set it. So we do want to be profitable at a minimum rate of 3%.

Okay. Sounds good. Thank you so much.

Thank you. And at this time, I'm showing no further questions. I'd like to turn the conference back over to Mr. Vik Verma, CEO, for any closing remarks.

Yes, that's - thank you all. We went a little long, but thank you for attending. And we look forward to seeing you at the upcoming investor events. Thank you again very much.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may disconnect. Everybody, have a great day.