Five9, Inc. (FIVN) Earnings Call Transcript & Summary

Perfect. Welcome, everybody. It's a delight to have Five9 here. We have Rowan Trollope and Barry Zwarenstein, CEO and CFO of Five9. I'm Meta Marshall for the record. I cover communications software here at Morgan Stanley. I'm going to start with a small disclosure for Morgan Stanley, which is if you have any questions on the research disclosures, go to morganstanley.com/researchdisclosures or talk to your sales reps. Barry, I think you had a small disclosure you'd like to read yourself.

We will be making forward-looking statements about events and trends that can affect the company, can affect the industry. Actual results may differ materially. We refer you to our SEC filings with factors that could cause such a difference.

Perfect. Maybe let's start with kind of the investor question that's been on people's minds, which is just contact centers benefit from COVID. And a question a lot of people have is just, is that pull forward demand? Was that strategic investment? And just how do we think about the prioritization that people have in contact center kind of in a post-COVID world, which we are now back into with these in-person events?

We are. Yes, it's great to be back in person. So we had been seeing pre-COVID an acceleration. We shared that in multiple earnings calls. In terms of -- we had been seeing the enterprise opportunity start to open up. And that was clearly 3 years ago, not there. There was still, I think, a lot of on-premises what we affectionately call box huggers that we're holding on to those beloved boxes in their data centers. But as of sort of, I would say, 6 months before the pandemic, we had started to see more and more of those customers showing up, and the pipeline has begun to accelerate pretty significantly. COVID had the effect for us anyways of driving more usage on the platform. But as you know, these cycles are long. So it wasn't as if companies flipped a switch and jumped on to contact center during the -- onto a cloud contact center during the pandemic because these take a year typically, 4 to 6 months at a minimum sales cycle with an additional, often 6 to 12-month deployment cycle. So we didn't really see that. What we did see was from our existing customers, particularly those customers who were in affected industries, where they were no longer able to be in person, retail being a great example, they needed to actually staff up and add more contact center seats. So that's where we saw the pull forward or not, I wouldn't call it a pull forward, increased demand. And we have Barry has done quite a lot of work, Barry and his team to estimate what that was, which we sort of put on the small single digits, correct?

Mid-single digits benefit to the overall revenue, yes.

Yes. So you can see that -- and then just talk numbers, right, during the pandemic, you saw that revenue go up into the 40s and then you're going to see it drift back down and we provided guidance as to where we think that's going to be. But essentially, the demand for -- and what we're now seeing, call it, post COVID, I think we're allowed to say that, maybe not here in San Francisco. What we're now seeing is that -- more and more of the largest enterprises are actually showing up. One of the first calls I went on 3 years ago was to a large bank, and it was like not going to happen. It was like interesting, but not going to happen now. Now that's not the case. We're seeing the biggest companies in the world, the most sophisticated companies in the world, everyone is going to the cloud. And that part of the sales process is no longer a feature of what we have to deal with. It's more about are you the right vendor and how quickly can you get us on board?

Got it. I mean. Does that change the buyer discussion like does who you were talking to, was it a line of business manager, who was a box hugger to now it's a more strategic business decision. Like how has that contact changed over the past couple of years?

Yes. As we've expanded into the large enterprise, particularly, it really becomes more of an IT buy. So in the mid-market and lower part of the enterprise space, if you're -- there was often IT involved, but you would have -- our buyer would typically be the line of business buyer, so the head of the contact center operations, who would be really heavily influencing the spend, but almost always the spend dollars sit within IT. And especially that's true at the strategic enterprise level. But I think the resistance and where I was sort of lovingly referring to box huggers was in the context of really larger IT organizations where it's a real impact to them. When they move to the cloud, they tend to lose staff because they're no longer needed to be manning data centers and upgrading hardware boxes and so on and so forth.

As you win larger enterprises and you've announced a number of them over the past couple of quarters, you've seen a few examples where a large deal evolves into a larger deal even pretty quickly. Like what is that rollout happening? And why are they able to kind of even grow the size of the implementation even maybe before it's totally rolled out?

Yes. So -- as we started to land some of these larger deals that we shared, they weren't necessarily putting the entire company on the platform, they were contracting for one region. But for global enterprises, they can be very complex organizationally and politically, as you know. And so what we have seen there is, okay, we might land one geography. And then if you do a good job, right, the plan -- they typically would sort of lay this out for us like if you do a good job here, we're going to add you in these other geographies, but it's just more about timing and sort of that kind of thing. So we've equally seen -- I think as we -- we have also seen some of the largest enterprises just go all in, just like, "Hey, you've got a good reputation. We've seen that you can do this. We're willing to just give you the whole business right out of the gate." But we've also seen it it's been more common that it's like we'll get a division or a section of the company and then they'll add more. And then that's one thing. And the second thing is big companies are doing big acquisitions and then they're replatforming and they're doing these other kinds of things. And so we tend to see adds in those kinds of scenarios as well.

Okay. Got it. So you just reported a very strong Q4. And you talked about a lot of your enterprise bookings are having strong AI future attached whether it be IVA. What is it about kind of either the new way that people are doing business or the way that you're selling it, that is making kind of the attach rate of these AI functionality is kind of a bigger portion of enterprise sales?

Yes. So in Q4, IVA sales accounted for 10% of our dollars booked in the enterprise segment. So it's much stronger than we had anticipated. Now at our Financial Analyst Day a couple -- 3 years ago. When was it? 2.5 years ...

November, 2019.

November, 2019, I guess it was just before the pandemic. We saw this coming. We invested. We did an acquisition. We shared and laid out our plans. The adoption has been way stronger than we had anticipated, partially because I think the technology is just moving faster than we had expected. Our teams are making great progress. We acquired an incredible company after that November announcement. And then we've also seen on the demand side, insatiable demand from enterprises. And particularly, maybe it's labor shortages, maybe it's cost of labor going up, a combination of all of these factors probably. So it feels like timing and maturity, both kind of are providing like dual tailwinds behind this adoption trend. So we're following that up with more investment. We're investing more in not only IVA but the rest of our AI and automation portfolio because we're seeing that that's the key difference maker in these large enterprise accounts, and it's an area where we've taken a very, very strong and commanding lead from a technology perspective versus competitors. So it's going to be an ongoing investment area and, I think, growth driver for the company.

Got it. I mean in maybe that November '19 Analyst Day, you kind of noted AI can fall into 3 buckets, kind of this IVA, Agent Assist, kind of filing -- helping fill out forms or just kind of true agent guidance. Where do you feel like the market is on the adoption of these different feature sets? And are we at the same place on all 3 of those?

Yes. We were wrong. I was wrong.

Barry wasn't wrong.

No, Barry wasn't wrong. I made my prediction at the time was I thought Agent Assist. So this is AI with human in the loop and AI augmenting the agent and providing guidance and so on, we thought that was going to be -- I thought that was going to be the thing that drove the market with IVA being in more of an eventuality because that's 100% computer to human. We got that 100% wrong is the opposite, where there's way more demand for the IVA, at least for the customers we're speaking to. And I know there are a handful of start-ups that are making good traction in Agent Assist purely, but for us, that IVA demand has been off the charts. And I think it's a combination of factors in part was that technology has moved really fast. I mean from November '19 to today, it's dramatic, the improvements that have happened. We have an example of this that you can call at 915-Five9AI. And you can hear our latest technology, and it's mind-blowing. How good the quality of the voice is, for example. And that was not the case in November 2019. So I think the technology moved really fast. And the company that we acquired was like on an absolute role. I mean they more than doubled our expectations from a traction perspective, so that one is going really well. Yes. And I think Agent Assist is still there, that's sort of assisting the human but it's a less -- it's a little harder to measure because you're still paying the human. It's just they're faster or something or they're better. Well, how do you measure that? It's not quite as obvious as the ROI case for -- we're just going to replace 10% of the agents taking phone calls and the computer is going to do it or messages.

Got it. I think one thing investors kind of struggle with is, okay, we've traditionally had maybe the TAM of 15 million agents. We can think about this cloud transition. And then something like AI comes in and it's, oh we can replace a portion of the labor. And so we're just kind of struggling with is this to the point where we're actually shrinking the TAM of agents? Or is it just we have so many more interactions now, the TAM stays the same, it's just we don't need to expand kind of that base of agent?

Yes. So the scenario is very simple, and it's something like the TAM has gone up by a huge amount. So we were previously looking at that, take those 15 million agents, that is a number, times roughly $200 per seat per month is our average selling price, gets you to the $24 billion TAM that we had previously sort of thought about. The strategy here was we talked to the line of business buyer. The biggest line item in their budget is labor, by a factor of 10, okay? So it's an order of magnitude more spend on labor. So our theory was we could 10x our opportunity if we can help them make that labor more efficient, a lot more efficient, okay? So that's what we did. And we've estimated in the near term being the next 5 years, near term for me, perhaps 10% of that labor could be optimized. And that gets you to a $34 billion -- actually, I think we said 16% -- that gets you to a $34 billion TAM. So we've more than doubled the TAM in the last 2 years, and it's a straight replacement in the sense that you're not assuming that there's going to be more contacts coming into the contact center. You're just assuming that for every human being that was sort of engaging with a -- for every, let's say, the 16% of human beings who you replace with a digital agent, you're paying twice as much for the technology, but you're saving on the labor cost. The labor cost is $2,000 a month. The technology cost is $200 a month. For AI, the labor cost is zero and the technology is $400. So net to Five9, it's doubling our revenue opportunity on a per seat basis with no shrinkage in the number of seats.

Got it. We've had this conversation, you've said 10% of the billings that you were seeing from enterprise were attaching this kind of AI or it had AI included for 10% of the dollars for AI. What are some of the initiatives that you can put in place to kind of propagate this into the installed base versus just on the initial sale?

Yes. We have not even gotten started on the installed base. So here, we have another 0.25 million agents that are captive on our platform, logging in every day, concurrent. It's actually more than that if you use the named account. So hundreds of thousands of captive agents already on our platform. We're already sending those customers' bills. We have not yet started to make this technology available into the installed base and to sell it. So we took our top sales leader in the organization's, individual, the sort of one of our VPs, move them into this new team we've created, which is an AI and automation specialist team, and we've staffed that group up and their #1 target for this year is to go after the installed base, and start to drive more adoption of the technology there. We're coupling that with a series of technology investments that will make that transition even easier. So instead of sort of calling the customer or talking to the customer and saying, "Hey, we got a new thing we'd like you to look at," we're actually replumbing the core platform to take the IVA and embed it into the core platform so that our customers will actually just get it without having to adopt it. And then we can just turn the features on one by one. So we're trying to like massively reduce any friction that is associated with helping our existing customers make their more -- their labor more efficient. And these are, again, captive customers. We're already sending them bills every month. They already trust us, hopefully, and like us. And so we should have an easier time on that front, actually getting traction. But that is still an initiative that's just getting started. The net new opportunity.

Got it. Maybe we can spend some time on just for competitive environment and maybe how that's changed over the past couple of years, whether the legacy vendors are even still in the conversation, a lot of times, once they've made the decision to go to cloud and then what you're seeing in terms of competition within some of the cloud players?

Yes. Yes. The incumbents that are in this space have not really changed their position materially from a competitive perspective. And so we continue to take out the top on-premises incumbents. What's changed over the last, I would say, 1.5 years or sort of through the last 2 years maybe, we've ratcheted up our ceiling in terms of the size of contact centers we're going to go after. And that's introduced one new competitor to us, which is Genesys, who have had a stranglehold -- not -- kind of I would say, they've had -- that's their stronghold, has been on the top end of the market. So we've sort of moved into their territory and become much more competitive there. At the same time, NICE has sort of fallen back a little bit in terms of -- they're still a very strong competitor. It's really us and Genesys and NICE in the market, so you use today. Genesys has done some great work at structuring their offers so that they can keep their on-premises customers happy with subscriptions to -- and then maybe even moving their on-prem software to the cloud. While they still have -- while they do have a new all-cloud offer, I think the maturity has been still a bit of a struggle for them. NICE has done very well, and they obviously have the full bundle, including WFO. So on that front, we compete with our partner -- with our partner, Verint as well as our own offer. So that's kind of landscape. And then look, there's been a lot of announcements, including Zoom and Microsoft, I would say, would be the 2 notable ones. Where Zoom has really just got a toe in the water at this point. And Microsoft announced the product. I don't know if it's shipped yet. And that -- what's notable I think about the Microsoft announcement is it came out of their Dynamics organization and not the Teams group. We've seen incredible traction with Teams. They seem to be just dominating the top end of the market, a strategic enterprise. Everybody is using Teams. And so we're -- and they've done a lot of work on the innovation front to make their product great. So they -- we've seen a huge surge of business with Teams. And they -- the Teams organization made it clear that they didn't build that contact center product. That was some other part of Microsoft, so that we would continue to do business with them, which we have and really accelerated that.

Okay. I mean whether it be Teams or Zoom or -- like any time we see a press release that mentions contact center and an enterprise software name, I tend to have a very busy calendar in that day. And so what do you think that some of these announcements make -- or some of the -- what is kind of the market missing about some of the barriers to entry within this space that kind of some of these announcements?

Yes. Well, if I wasn't seeing those announcements, I would say something is wrong because we think this is a hot space. Well, you don't see people trying to get into it and Microsoft and that's the other thing. But I think one of the things that's easy to mistake here is, if you look at the traction that Zoom has had with phones, the analysis is basically, well, gosh, they made all this like they launched this phone product, took the prices out of the market and now they've been driving huge volumes, now that maybe they're going to do them with contact center too, which is really not right. The -- what Zoom -- if you think about a phone call, a phone is -- a phone call or a phone product is like a subset of a meetings product. A phone call is like a meeting between 2 people with no video turned on. It's a pure subset of the capabilities of a meeting. So it actually is a very near adjacency for Zoom to move into phone, and they've done that very successfully and made very good traction that was my analysis of their success. Contact center is a very far adjacency. It is nothing like that. So while voice is a component of a typical contact center, there's a huge other number of capabilities, including all of the new channels and WhatsApp and messaging and Facebook Messenger and [indiscernible] the other thing automation, AI, as we've talked about, reporting, analytics. It's just a different universe. And so I think, look, there was a reason why Zoom was willing to spent $14 billion to acquire Five9. They didn't think they could do it themselves. So they're doing the alternative, which is do it themselves, but start small, start with the companies under 25 seats and kind of go at it that way, which good luck on that front. But we're not seeing -- this market is not slowing down or stopped. The acceleration is accelerating and the innovation is accelerating. So it's going to be -- if you enter the space, you're not chasing a fixed target, you're chasing a moving target where there's more investment, a harder problem, I think.

I mean a lot of these competitors whether it's Zoom or 8x8 or RingCentral, it kind of a lot of telephony-led sales where you're attaching it to an enterprise sale. And that would have been a lot of your kind of commercial market maybe beforehand. And so just how do you see kind of the commercial portion of the business, the outlook of that business or just the criticality of that business going forward? Or will it be just ...

Yes. So it's -- our commercial business is, I think it's 16% of our total now. Yes. 16% of our total. So it's been shrinking as -- because our enterprise has been growing so much faster. And it's that commercial segment where the bundle is a more important feature of the market. And so because of that, we haven't really felt the pinch in our growth numbers in the sense that the 8x8s of the world, now Zoom, they're going to be able to make faster traction there than they will upmarket. So we've moved upmarket away from any sort of pressure there. And you can see that number will continue to decrease because we're just not investing in that commercial segment. We believe really were the sticky, high net dollar retention rate, high ASP, consumers of lots of technology where CX is a big priority is in the enterprise. So that's why it's going to continue to be a driver of 30s-level enterprise, 30s level growth in our enterprise subscription business.

Right. Bringing Barry into the conversation kind of on the cost side of things. You're seeing some gross margin investment kind of in the near term as you scale kind of cloud footprint and the Professional Services organization. Can you just kind of give us a sense of where those investments are focused and then when you would expect to see kind of the little [ leverage ] in them?

Yes. Thanks, Meta. So just [indiscernible], what we've told the Street is that you should expect, and been telling the Street, 2 to 3 percentage points 2022 gross margin compression. Two reasons, major not as quite as important. The major one is Professional Services. So the history over here is we used to have, and you could see it from what we disclosed, quite big fluctuations in our Professional Services. Some quarters growing 74% year-over-year. But it's only in the second half of 2021, when we saw just how persistent the growth was in the upper end of the market and the pipeline that we decided to go consistently and we went up in our Professional Services by over 60% in the second half of last year and continuing in the first half of this year. That will abate and start normalizing in the second half. And so the gross margin decline will trough in the second quarter and then start to go out from that. And by the way, the other one, which is our investment in the cloud, this enables our international growth. That will be a little bit more persistent because we're not going to get all of the Google Cloud platform instances built this year. We've got some other countries that our mega customers will take us into that will happen in 2023.

Got it. I mean and Rowan just laid out a very -- wasn't picture of the growth outlook of this company and you're going to make some operating investments in that as well. just to kind of invest in the sales organization. Just when -- what kind of level of investment are you seeing on the OpEx front? And similar, when would you expect to see leverage there?

Okay. So just to level set here again, since we went public, 49% improvement in operating leverage, that's gross margin and OpEx in that 8 years. So we come in here with a little bit of credibility. Start with the easiest one, which is the G&A. We've now gone 29 quarters of year-over-year declines. With respect to R&D and sales and marketing, we're at the low end of our long-term model, which will take us to 23% in 2026. So we will get some leverage there, not quite as material as in the past, but solid.

Got it. There's been a lot of questions over the last year as to why was this good of a growth outlook you would have been willing to sell versus kind of going it alone with such a strong investment thesis. As you look at the strategy now post dissolution of that merger agreement, has anything changed about how you look at the market versus last summer?

I think what's -- like what has emerged really notably in the last 6 months has been the IVA demand. And really, it's reflective of a shifting basis of competitive differentiation. What my sellers are telling me in the enterprise space is we're winning more deals because of the differentiation on AI and automation, which is quite far away from the story of sort of consolidation and the single communications platform. This is a -- it's a net new growth opportunity for this business, and it's a brand new area of technology that's just hitting its stride, you should say. So I think that's like the big thing for me is we did not anticipate that, that would happen that fast. We're still in the early days of this technology evolution and this next-generation wave. But I think if you just step back for a moment, I used to watch Mad Men and they would have like these scenes with the secretary pools, I think they call them. Now like we don't have that in business anymore. So like business can change in a very dramatic way over a period of time. And the contact center is like that. Like the contact center -- when you think about a contact center, you probably think about a field of cubicles and like people with headsets on, answering basically mundane questions from customers, that's a facet of modern business that's not going to be there in the future. And I think we're at the front end of that transformation, right? That's probably 5 years before you start to see completely not contact center less, but what technology has replaced what once -- what today and once was a massively human labor-driven operation, moving to a highly-optimized technology sort of picture, just like the word processer to replace the secretary pool. That's what we're doing in this space, and that's what's emerged now in the last 6 months really as the evidence that the traction is there, the progress is there, the maturity is there and the customer demand is there. That's the biggest, I'd say, learning.

Got it. And then Barry, maybe just ending with you. another kind of outcome of the M&A process is just the proxy estimates being out there. And just what would you like investors to kind of understand about the proxy estimates versus kind of some of what [ Rowan ] laid out?

Yes, briefly, this was a long year projection made in the midst of a proposed acquisition of Five9, as we describe it, a 50-50 forecast, 50% chance of making it, 50% chance of not making it. In sharp contrast to the prudent unchanged guidance philosophy where we've always been, as I say, very prudent or conservative and then succeeded as we saw the revenue coming in and increasing. It is top down. We -- obviously, you're not going to involve a lot of people. It's linear extrapolation. So we feel very comfortable given the 3 drivers that we have to get to the $2.4 billion on a 50-50 basis. And the 3 drivers being expansion in our dollar-based retention rate, international expansion and continuing success in the new logos.

Great. Well, Rowan, Barry, thank you so much for being here today. A pleasure seeing you again.

Thanks, everyone.