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

All right. We're going to go ahead and get started with our next session. For those of you who don't know me, I'm Matt Niknam here, communication software analyst here at Deutsche Bank. We're very pleased to be joined by Five9. We've got CFO, Barry Zwarenstein; and then we've also got the EVP of Global Sales and Service, Dan Burkland. So welcome to you both.

Thank you.

Thank you, Michael.

Matt.

Matt, sorry.

So high-level question, maybe just to start...

Matt, if you don't mind, just one moment. Before we thought, I just like to make a safe harbor statement. We'll be making comments about the factors that could affect our company in the industry. The actual results may differ materially from what we say, and I refer you to our SEC filings for the risk factors or things that could cause such a difference. Thank you. Thanks, Matt.

Always the most fun part of these presentations, and it gives me a chance to calibrate my line of questioning. But with that said, maybe just to start, if we can talk about your top priorities and what you're most focused on right now as we close out the year.

Yes. So I'll start that one. I'll break it into kind of 2 categories. If you look at the go-to-market side, which I'm responsible for, we're really moving upmarket, and that's been our largest growth in pipeline and success is moving into these mega scale deals in the enterprise, international expansion, moving into selective markets that we know have a return and that have the demand for CCaaS. And then if you look at our channel expansion, getting more bodies out there finding and bringing access to us, but the go-to-market are those 3. And then on the product side, for those who aren't familiar with our story over the last several years, we did all the scaling and increased reliability and really architected the solution in a way that can bring it to the largest of enterprises and serve tens of thousands of seats for a single tenant. We're now delivering the innovation and automation that brings them to want to make the transition from premise to cloud because they can only get those automation solutions from the cloud. So things like IVA, where you can deliver self-service, have customers serve themselves through the conversational interface without speaking to a human, helps augment and offset the labor that they're having today. So they can have fewer agents, which is the most expensive part of their contact center and offset that with automation. The ROI is tremendous. We've seen that with some very large enterprise, mega customers who have come in and really said, great. Let's transition to the cloud and the entire cost is being offset by the savings that they'll have in their labor.

Great.

Anything to add?

Okay. So obviously, the macro backdrop on very top of mind. We've asked a lot of our companies at the conference, and so I'll pose the question to you both. We've obviously heard a lot about seemingly worsening backdrop. Can you talk about what you're seeing on the demand front from your customers and how the macro environment may be impacting their behavior or purchasing decisions?

Absolutely. And I'd refu -- refer you back to our second quarter earnings conference call because we provided their framework, and this is the logical right way to look at it. A little under 50%, by close to 50% of our annual revenue growth comes from new logos. Logos that Dan and his go-to-market team bring in. They get implemented, they go live and they ramp. The other half is, obviously, our installed base and how we -- how they expand. Two very different dynamics relative to your question, Matt, on the macro. So in the case of the new logos, there the overall demand remains strong. In fact, at the upper end, probably accelerating. These customers are faced with the reality that the shared donors, the ones that we're converting from premise to cloud, namely Avaya and Cisco, continue to donate a portion in each quarter of their millions of shares. And customers are looking at it and saying, look, we've got an end-of-life situation possibly. We certainly are going to upgrade at some point. On the other hand, we've got the digital transformation where logically, you can move to the cloud. Massive ROIs and short payback varies, measure in the month. It's not even coded as Dan was referring to just a moment ago. And on top of all of that, you can only do automation in the cloud. You can't download Google CCAI onto a survey in your premise. So yes, there are slippages. There is occasionally a deal that goes longer because of additional requirements of a demonstration to IT or extra signature. But that part of the business, we've got truly excellent visibility into it. And given that it's a mission-critical system, that will continue. Different story, however, on the installed base -- the other 50%. There, we've -- saw weakness in the second quarter. Dan and his team hustled to compensate and really were successful in that installed base, and we ended up with a record for a second quarter for the installed base bookings. But if there is, or should I say, given the macro situation, our enterprise customers, if there's less economic activity are not going to pay for agents cite it. And they are entitled to know the contracts most of them to reduce their seats by between 10% - 20%, and then, of course, even further once the annual contracts come up. And that uncertainty combined with the fact that we have a degree of seasonality in our revenue, it's been increasing. Last year, it was 46 for H1, 50 for H2. And we don't know exactly the extent of the seasonality led us to give what we consider to be reflective of that uncertainty in terms of the annual raise, which was only $118,000. One of our smallest raises that would typically be raises.

Okay. And so maybe just a follow-up on those comments. So the installed base, has there been any change that you can speak about or maybe slowdown in activity maybe relative to what was communicated to us on your last earnings call?

So I'll make some comments on that, and then, Dan, if you want to add into it. We've given meta guidance, and we're not going to talk intra-quarter. I did say that in the second quarter, we did see weakness, and it doesn't take a whole lot of common sense to see that it wasn't a dramatic improvement in the third quarter. The only other point for the avoidance of doubt, everybody might be listening to, we are talking here not about any contraction in that installed base side, we're talking about a slower rate of growth.

Well said. And if you look at the base, the good news is, we've got a very diverse customer base across many different industries. Some see slowdown in times like this and others see an increase in times like this. So there's some offsetting factors there, but as Barry mentioned, if their business isn't growing and we saw some tailwinds in the -- during the pandemic that there was an increase traffic into their contact centers. People went e-commerce crazy. And it was -- it caused a lot more interactions to take place in a contact center and that's slowed -- that growth has slowed. So we have tough compares that we're lapping. And so yes, across the installed base, we see the puts and takes. The beauty there is, we're seeing new markets that are expanding rather rapidly. So we moved up market into the large enterprise and into the mega deals for the first time as an industry, certainly as a company, and couple of things happened. People said, why did you enter the large installed or large enterprises for the first time. A couple of factors. One is, those large enterprises were waiting to make sure that we could scale and have the reliability, and we've proven that. That's in the review mirror. But they had to have some compelling reason, right? And as Barry mentioned, the automation, the IVA solutions and the AI solutions are really only available in the cloud. So they now have a compelling reason to make that transition, and they have comfort that there's companies that can scale with them. So when you look at that large what now the parcel delivery service trending towards a $50 million ARR with us and large Fortune -- very single-digit Fortune company that is the health care conglomerate, they're ramping up. And we'll have over $40 million of ARR. So we've got a very, very large customers that we can point to and reference. And they -- those large customers do grow and expand in good times or bad. They're just conglomerates that we're moving into new divisions, new subsidiaries, new opportunities and new applications. So they tend to be the stickiest, and they also tend to grow.

Got it. Got it. And so when we maybe extrapolate -- and I don't want to get too specific, but if we are, in fact, heading into a recession scenario next year, how should investors think about the durability of growth and margin ramp for your business?

Great. So the severity and length of a macro is key in answering that question. However, I'd like to give some reassurance and that is that we -- despite these uncertain conditions, we -- Rowan Trollope, our CEO, we reiterated what he has been saying for several years now that our enterprise subscription, the upper part that Dan was talking about that we now fully qualified that is really opening up that our enterprise LTM, the driven growth rate would have a 3 handle for the foreseeable future. And he said that in the second quarter when we reiterated that in the second quarter even when things were uncertain. And there's no givens in business, but from what we see, our ability to execute that we demonstrated over the last many years, we think we can continue to reiterate that commitment.

Margins in theory.

And margins, yes. So in terms of SaaS comp, we're a little bit unusual in that for many years when our square-on growth was in the 90s and the Rule of 40 was in the trash bin, we didn't waiver. We believe in balanced efficient growth. It's more predictable, more consistent. Somewhat boring, but it's what we believe in. And so we've had -- if you look at EBITDA margins, typically in the high teens on an annual basis, it's gone above that. We have been making quite dramatic investments in 2 areas that have now started to moderate, showing up in the gross margin inflection that occurred in the second quarter, a quarter earlier from what we said. And we believe that we can take our current high teens gross margins up to 23% plus in the out year of 2026, which is a number that we gave when we had our Analyst Day in November of 2021. Now that was pre-pandemic but the question is about margins, and we can in fact, understood growth. You probably have even higher margins.

That was the EBITDA margins, by the way. I think you may have said growth, but...

I'm sorry, I mean EBITDA. Matt, thanks for the correction.

Okay. So I think at the last Analyst Day, you talked about your TAM expanding to also include a $34 billion labor automation opportunity, and that's on top of the $24 billion market for contact center software. Can you help us maybe frame where you sit today in terms of share and how your solutions can actually help enterprise customers in today's tighter labor market where cost efficiency may be more top of mind?

Yes, I'll start that one and hand it to Barry, if he wants to elaborate. If you look at the market itself and you just look at the transition from premise to cloud, the estimates are still in and around the 20% range. So we've got the vast majority of this market ahead of us just in providing software to the agents that we serve as we convert them over to the cloud. So that's a huge runway ahead of us for that. And then when you look at the labor arbitrage from AI and automation solutions, that's on top of that. So as we deliver software for agents. If they come and work with us on automating and what we mean by that typically is, oh, this as an example, the parcel delivery service rather than you waiting in queue for an agent for 10 minutes to give a tracking number and find out where your package is, wouldn't it be easier to just voice into the interface and have it look it up and get back to you, text to speech. And we as consumers are getting more and more accepting, and it's very commonplace to be able to do that nowadays with Alexas and the Siris and all the other voice interfaces we are all used to. So the parcel delivery service alone said, the savings in labor that they're going to achieve from just providing that automation, that one example of package tracking, but there's many other use cases. And you can look across all industries, and there are some use cases just in about everybody's environment where they can automate. And so we go in with our customers and say, find a use case what's the most common thing asked for in your contact center, and why have the agents look that up and repeat the same information when the system can do that for them. So we know more and more use cases are going to become automated over the years. We don't know how fast that curve is going to -- the adoption curve is going to happen. But as that transition occurs, we take a $200 per human seat software that we use to enhance what they do, and it converts over to roughly a $400 per automated seat because they're still a port. There's still a conversation happening, and our conversational AI delivers that to an IVA, which is $400 a seat. So we win either way regardless of how slow or how fast that transition occurs. The first step -- and we help our customers understand this and prospects is, the first step is get to the cloud, and then you're prepared to automate. And that's what's happening right now, and that's why the TAM expansion is so rich for us.

Nothing to add, Dan.

In terms of AI and automation, can you talk a little bit about the kind of success you've had, selling these automation-based solutions, like IVA, like Agent Assist, both to new and existing customers?

Yes. The example I just touched on in the parcel delivery source, they said, that's going to more than pay for the system, the annual spend with us a year that they'll get in labor savings. But there's lots of other use cases that we go into new prospects, and oftentimes, we're actually seeing more traction in new accounts than we are installed base, not because it's not fitting for either, but oftentimes the urgency for someone to take the business case to the company and say, we've got to move to the cloud, here's why I need this automation. And so we have to do it now because otherwise, it's just "Hey. Let's move to the cloud. It's a subscription." We get everything we had before, and they're like, well, let's kick the can down the road for another year. The automation is kind of the impetus to make them make the change. The installed base is very attracted to it as well, but there's not quite the urgency level, and they don't have to have it in order to make a new decision. So we're seeing the penetration. It first started with net new logos, and now we're penetrating the base heavily with going after that and upselling, especially in this tight labor market where they're saying, how can you help me save money, here's a great opportunity at the IVA happening.

I'm going to pause. If anybody has a question, just raise your hand. There should be somebody with a mic. I think we got one here. Ryan?

You can speak. We don't need a mic.

They can -- for the people on the webcast, yes, I can just repeat it.

[indiscernible]

It's going to continue to be a combo of both. I mean it really is driven by both, but we do have -- yes, up market in the large enterprise and strategic accounts or mega accounts that you see, that pipeline is growing to an all-time high. And part of it is, as I mentioned earlier, that market has just opened up for us for those reasons. We now can demonstrate that this is a superior solution to what they have, and it gives them incremental value to what they have and so large enterprises are looking for the first time. Yes, so that's -- we can get it from both. We have quite a backlog. If you look at those big deals we've sold, they're ramping and rolling out, and we don't recognize the revenue until they roll out. Got quite a big backlog that we can have tight for quite some time.

And excuse me if I said this before. I don't think I did, though. That enterprise subscription growth -- enterprise subscription revenue is 60% of our total revenue. So we're not just talking about 5% or 10%. And if you were to add in, say, professional services that's typically associated with it, you get closer to 70%.

Maybe to -- go ahead. [Audio Gap]

We've been hearing this for over 20 years. Voice is going to go away. To us, when you log in as an agent, whether you're handling a voice call or whether you're handling a chat or an e-mail or -- you're using a Five9 license. It's an omnichannel license to perform that function. So you need -- it's not just voice, it's -- you need the Five9 license to handle any of those types of transactions. Do we see some over time potentially with what I described earlier, self-service? Taking over some of that labor? Perhaps, yes. We are seeing that. But interestingly, the chat and the e-mail and so forth and the digital channels have not -- they've expanded the number of transactions, but not at the expense of voice. Believe it or not, voice is absolutely staying there, and we become as a society -- and companies are looking at the value of spending more time. It used to be cost cut, cost cut, cost cut, get off the phone, shorten your average handle time, get to the next customer. And that has changed culturally in our society over the last 10 years to where it's worth it for companies. They've recognized the ROI to spend a little extra time with the customer create, customer delight, give them an experience that they'll remember in a positive way and create that loyalty because they don't want to lose the customer. And customers more than ever now, we all see the studies they can switch brands very easily, and they will if they have a bad experience. Companies are investing more in spending the time, spending the effort to make sure customers are well taken care of and that they have an experience that's memorable in a positive way that they'll share with others. Social media phenomena has really created that for us because now if they have a bad experience, they're out on social media spreading bad news about a certain brand. Brands can't afford that.

Okay. A question for Dan. Do you sense -- we talked a lot about pushing more upmarket with larger enterprise. Do you sense the need for maybe a little bit of a deeper partnership with a UC vendor to help you upmarket? Are these purchase decisions actually being made jointly by your customers? Is it really like the same buyer?

Yes. So first of all, we do have partnerships with UC partners. So if somebody insists that they want to put this in as a single provider, we can bring that solution in. And they're very tightly integrated, whether it's Microsoft teams that we're integrated with, whether it's [indiscernible] a broad soft-based solution or others, we have those partnerships. That doesn't help us at the high end of the market. It helps us more at the lower end, because what happens is, the lower end is for convenience and they're used to having coming off of a PBX that has the contact center embedded in it. Their natural inclination is, oh, we need to replace this, and then it sometimes is the same buyer. When you move up market, it's very different buyers. When you're in the high end of the enterprise, IT typically makes the phone system decision. We're talking to the valued business owner, a line of business owners that support or whatever function is performing in contact.

And if you wanted a proof statement on that, on what Dan just said, for the last 6 years plus 4 times a year at the earnings call, he talked about 3 different major wins. Not once has there been a joint UCCC decision because these are all up end deals.

And so maybe, Barry, to follow up on -- we talked a lot about some of the larger strategic enterprise wins. How do the margins on these larger deals compare to some of your maybe more traditional commercial type deal?

Yes, I'll start that because it's when -- it's counterintuitive to what you would think, oh, they're larger. They're going to get volume discount. They're going to press your margins down. And what ends up happening is, they buy everything on a truck. So there -- we have many of those large mega deals, and I talk about 3 or 4 of them each quarter call. They bought everything. They're like, yes, we need some of what you've got. So when you look at our ARPU, at the high end, our ARPU is much higher than it is at the lower end. And so -- and they can justify the application.

And if I could just add to that, look at it through the lens of the dollar-based retention rate. So currently, the middle digit's 1 and reflective of the fact that we still have, what Dan talked about earlier, the COVID because it's an LTM number, the COVID comparison in the denominator. We also have the macro impact. But we are macro notwithstanding, we are -- remain very confident of our ability to make that middle digit be a 2 and the third digit to be high at the high end. And why do we say that? We say that because $1 million plus customers who account for the vast majority of that enterprise revenue and a meaningful part of the total, they are growing much faster. And that is complemented by the fact that it also have a very high dollar-based retention rate. I'm not going to give you the exact middle number now, but it is not just 5% higher or 10% higher or 15% higher. And that makes sense because in most cases, you land your big company and you expand or you make an acquisition or whatever. So we have that tailwind from these bigger customers in terms of helping not just the actual gross margin, but the LTV to CAC.

On the competitive front, any sort of updates you can give in terms of the competitive landscape? Who you're taking share from? Does that change at all?

It really hasn't. This industry moves rather slowly, and I say that because of the -- there's natural barriers to entry. Companies will announce that they're coming into the space, and then we wait, in some cases, 5 or 6 years before they have a competitive offer. So it's still Genesis, NICE, inContact, those are the primary competitors. We're still seeing very handsome win rates when we go up against them.

And it's still, I assume, the 2 big incumbents in terms of like share donors?

Yes, Avaya and Cisco 1 and 2 every year for the last 5 years kind of a flop or trade spots. Avaya's got some challenges right now. Those challenges aren't new. They may be more extreme than they were, but it's not news to anybody about their financial struggles. Companies have seen that coming for years. Bankruptcy once before, that was a wave of change and other as well, but it's not extreme. It's not -- it wasn't a shock or a surprise.

I meant to ask you, are you getting more inbounds? Has that been -- the recent headlines are ongoing, concerns that there has been a catalyst?

We try to use it as one ourselves to target, but it's not like their customers know and haven't seen this for a long time. They've been struggling to stay relevant and stay on par with the rest of the industry because they haven't had the funds to invest and stay up. So they've kind of lagged behind and their customers know it, continue to help them convert to the cloud.

A question on margins. So we touched a little bit on gross margins, but I also want to be a little bit more granular here because we -- I think we fall into just below 61% the last 2 quarters, given the investments in professional services and cloud expansion. How should we think about that trajectory for gross margins as we close out the year in the second half?

Yes. So indeed, it did inflect, but only to 60.7. We've told the Street that we fully expect this year at the end -- in the second half within revenue and stronger, and these investments moderate to continue with a slight improvement and to finish the year at 61% or a bit more. But longer term, what we experienced for many, many years before we started making these investments in professional services to go worldwide and to accommodate these needs of these mega customers. Before that step up in that investment and also moving to the public cloud, we enjoyed almost every quarter almost without exception. A sequential increase slow, but steady on a subscription -- on our subscription revenue, simply deleveraging against fixed and semi-fixed costs. And that now is in the 70s going -- it will go up in our minds steadily to the 80s because of this leveraging plus the fact that we have the higher potential ARPU that Dan talked about earlier on. We then have another tail breeze and that is that approximately 20% of our recurring revenue, which is 91% of the total -- the other 80%, of course, being subscription, that 20% is growing a little bit slower than our subscription because an agent can only speak 8 hours a day. There's no add-on products or anything like that of any consequence, and those margins are in the 50. So you have a mix impact there. And then the third and final item is on our professional services, where we're currently single-digit negative, and we are very confident that over time, we can emulate many other business SaaS companies and get that into the -- at least the high single digits.

Okay. And as we think about then maybe some slight improvement in gross margins in the second half of the year. Does that drop down to adjusted EBITDA? And I guess maybe more broadly, how do we think about sort of OpEx as it relates to R&D and sales and marketing investments relative to current levels?

Yes. So we've been telling the Street that we've been trying not to beat too much on the bottom line, trying really hard. We haven't been successful in the past, but we're getting better at it. And the reason for that is, we are awash with really good opportunities. And so the gross margins would go up a little bit, but you'll see if you do the conversion from our adjusted net income guidance to EBITDA that, in fact, we don't have that improvement at the bottom line in the adjusted EBITDA. And that's because we're making additional investments. One prominent one, for example, is just we had 2 weeks ago, a very successful customer user group meeting here in Las Vegas, very well received. One of our best ever, but there are many other examples. Now switching to longer term, in terms of -- I've already talked about the gross margin going from the 60.7% to 70% plus and the reasons for that. Looking at operating expenses, both in R&D where we're currently at 11, and the midpoint of our guidance is 13. And sales and marketing, where we are at 26 going to 28, we plan to spend more -- the midpoint being 28, to spend more. Bringing up to the real G&A, and we're at 6%. We've got 31 quarters of consecutive year-over-year declines, and that's about as low as we can go.

And so maybe let's bridge this then to free cash flow, which is obviously very topical. We were slightly negative, I believe, in the first half of the year on a free cash flow basis. I guess, how do we think about the prospects of more positive free cash flow in the second half of the year? And maybe more broadly, how should investors think about your path more sustainable free cash flow generation over time?

Perfect. So let's start with operating cash flow. So first segment of fact. Five9, since I think the second or third quarter of 2016 has been a consistent operating cash flow generator on an LTM basis. LTM because there is volatility and that will continue. It's been somewhat lower in the recent past because we've had onetime events. The Zoom transaction hit us about $6 million. We also had to pay out a very successful earn-out payout for the acquisition of Inference that they've now learned, et cetera. But we expect to get more to our traditional 5% conversion factor from our EBITDA to operating cash flow. The cash flow we take is not as granted by a strong where we now have got an opportunity and will come in the second half starting already is to moderate our fixed -- our investments. We've been making investments for that public cloud to build extra capacity because the head of operations we already get depressed when Dan bring in a new order because you didn't have the capacity. We've now built that capacity. And we're also investing in a hybrid structure where we have the gross margin implications. So we think we can bring our gross fixed assets down to as a percent of revenue from the current 9% or so in the guidance down to the more traditional 6%. And then when you look out into 2026, where you will see that 23% guide, if you take out the 5% conversion and the 6%, you come to about a 12% free cash flow number.

Great. I'm glad we got through that. It's a lot of good detail there. Last question because we're coming up on time. How do you prioritize your uses of excess cash? And maybe you can talk a little bit about prospects for smaller M&A.

Yes. So we do have a $0.5 billion on our balance sheet. We do also have debt that's due in 2025. Is there -- in these uncertain times, sometimes the customers want to see a very solid balance sheet, and they don't focus so much on the market cap. And secondly, we do need from time to time to consider making acquisitions more on the tuck-in side of the equation. Rowan has built just a top-flight corporate development team as demonstrated by the 3 successes we've had from both over from Cisco, and they know how to do these things. And they know how to integrate, and so we can ride on those coattails.

That's great. I think we're just about out of time. So we'll end it there. Thank you, both. Appreciate it.

Thank you.

Thank you, Matt.