RingCentral, Inc. (RNG) Earnings Call Transcript & Summary

Joining us this afternoon. I'm Mike Funk, one of these mid-cap software analysts at Bank of America. Really happy to have Sonalee here with us again for the second year, I believe. I think you came...

Yes. I was here last year.

Shortly after starting on the job last year as CFO of RingCentral. So thank you again.

Thank you, and I'm delighted to be here. And yes, this is my second time at your conference, and I've just gone through my 1-year anniversary at RingCentral.

And so as I was putting my questions together, I thought about that, that it's been a bit over a year since you stepped into the role. I was thinking back about that timing, that time last year, we had the Russia-Ukraine conflict kicking off, right? Uncertainty created by that. You Had the Fed raising interest rates, and you had the very beginning of enterprises pulling back on spending, I think also when you began to first see maybe some signs of pullback there as well. So I mean the obvious question, I think, is where are we now today 12 months past all of those events? Is there more light? Is the business more predictable than it was 12 months ago?

Yes. So great question, and you're absolutely right. I literally joined as CFO just as the macro was starting to rear its ugly head. And I joined May 9, actually, or I was announced May 9. I started work officially at the 1st of June. But we were starting to see a small impact in the business then. And then progressively, we saw more and more of that in Q3 and then even more so in Q4. And what I would say today is, and this is similar to what I said at our earnings in May, we are seeing a stabilization of the macro. And what I mean by that is we're not seeing it get worse, we're also not seeing it improve, but it's stabilizing. And within our customer base, the way we segment our customer base, SMB, so small- and medium-sized businesses, are a relative bright spot. And what I would say is on the enterprise side, we are still seeing, again, it's not getting worse, but we are still seeing the macro factors that we called out over the last several quarters, which is the elongation of the sales cycle is returning to sort of the levels that we saw pre-COVID, also additional layers of approval. So we're seeing a lot of CFOs actually being brought into the final buying decision. And that just, again, elongates the actual closing of the deal. Whereas we don't really see that same trend, it's on the SMB side. And then the smaller initial deployments as well, we're continuing to see that, again, not getting more, so really a stabilization. The other thing I called out at our May earnings, which I think is particularly impacting the enterprise side of things, is some weakness in upsell and on the downsell side. And let me tell you what I think is happening there. So on the upsell side, what I would say is that companies, I believe, entered 2022 with a certain view in terms of how they were likely to grow, including us. And then many companies across various industries saw a bit of a slowdown or a decel in their revenues. And as a result of that, the need to procure, and in our case, seats and to upsell or to increase the footprint of seats, they're not quite seeing it come through the way they might have expected, which I think is natural in a slowing macro. On the downsell side, what we're seeing, it's really a result of headcount rationalization or optimization. And we are lucky in that we don't have a large exposure to tech and the tech sector. Obviously, the tech sector has seen a big rationalization in headcount, particularly exaggerated in this part of the world in Silicon Valley. But financial services has also been impacted, and I think we're seeing a little bit of that. Again, it's not outsized our exposure, but we do have some exposure, and I think that is playing out as well. But overall, demand for our product, end-user demand remains strong, and leads are actually up year-over-year. And I think that's particularly interesting in the context of the fact that we actually cut back on our marketing spend in Q4 of last year. And you probably have a question on our OpEx and margins, but we're actually seeing higher quality leads. And importantly, leads are up year-over-year. And I think that's a testament to the fact that customers still need our product, want our product. And where we are mission-critical or where it's mission-critical for customers to reach their customers by phone using voice, RingCentral is still the preferred solution. And we are seeing that both in UC and CC and particularly customers that are looking to save money, which I think is everyone these days, including us. It's a really straightforward ROI decision to adopt cloud telephony, to move from PBX. And we're seeing the positive signs of that, and that continues to be a very, very strong trend. And we save UC customers, the ROI from switching is about 55% and less than 9-month payback period. And for UCCC, it's a 200% ROI, and the payback period is less than 6 months. So...

It's all a great color and good context where we are today. Actually, I do want to talk about sales and marketing expense. In general, something else you focused on in your first 12 months was you announced an expense initiative in October of 2022, right? So you did address that. You've also attacked the balance sheet, right? So you addressed upcoming maturities, some of the converts coming due. So just kind of rewind, remind us the initiatives that you've undertaken with opportunity to maybe address expenses incrementally or balance sheet.

Yes. Sure. So you're absolutely right. I think I, a year ago, said that my #1 priority was to drive efficient growth, and that's exactly what we are doing today. Our OP margins have gone from 10.2%. When I arrived this year, we are guiding to exiting 2023 at OP margins of at least 20%. So very significant year-over-year improvement. For the full year, we are guiding to at least 18.5% in aggregate. Again, that's OP margin. And within that, we expect free cash flow to follow strongly as well, and I think that's a really important point. And one that you saw in our last earnings, we delivered $61 million of free cash flow, and we very much expect the free cash flow trajectory to follow the OP margin trajectory. And the reason that I call out cash flow is that you mentioned the balance sheet. And you are, again, right that we have been very proactive in terms of addressing our outstanding converts. And we recently matured -- took out $461 million of our $1 billion maturity that was -- that is due in March 2025, and we did that with our delayed draw term loan A as well as some of our own free cash flow. And we were able to retire those converts at a discount at $0.925 on the dollar. So it was a deleveraging event and a very ROI positive outcome as well. So we're really proud of that. And I think from my perspective, and I don't want to seem glib at all, but we now have a debt maturity ladder that is very manageable. When you think about the strong operating margin, free cash flow and EBITDA profile we will be driving, we're currently driving and that we will be generating over the next couple of years, it means that we have a lot of optionality around how we address the remaining maturities. I have said and I said at our earnings, but I'm going to say it again, we will not allow any of those maturities to go current. But again, we feel like in terms of servicing debt and servicing the quantum of debt that we have, we feel very, very comfortable given the strong cash flow profile that we're driving. And hopefully, you've seen us deliver on that certainly in the quarter, and more goodness to come there. In terms of what's actually driving the operational or OpEx improvements, you mentioned some of the initiatives we took in October of 2022. We are by no means done. There is more to go for there. But in terms of what is actually driving the savings on sales and marketing, which you also called out, we made some changes to our demand gen budget. And what we actually found is that by spending less money in more focused channels, we are actually able to drive higher quality pipeline and, again, better leads and more leads year-over-year with less spend. Part of that was branding. It was things like we were using TV adverts as well as some outdoor that we decided was not the best ROI. And we've since redeployed those dollars into more digital channels, and those are doing extremely well. We also have done a lot of automation. I called out something that we're doing on the finance side of the house, and this is really automating the procurement process. And when you're in a part of a company that's grown so quickly, and we're this $2.2 billion ARR company today, and we grew very, very quickly, what you find is sometimes the processes don't keep up with the top line growth.

They didn't scale in the same way. Sure.

They didn't scale in the same way. But those were big opportunities to go after, and they yield big savings. And just that one automating procurement. And actually, the person who's running the project for me is sitting here in the room right there in the front row, a star on my team. But just that alone is generating high single-digit million of annual savings. And we have a huge procurement project running across the entire business, and we are going through every single contract. And that's just one example. So there's more of that, that will come through, and much more so in 2024. Because labor savings in some ways, they're not easier, but they are -- they hit the P&L more quickly. The program savings take time because it's contracted spend, so you'll see more of that come through in 2024 when you ask about incremental. And there's also more we're going to be doing on the sales and marketing side. And we called out in our earnings project IGNITE, that's something we're doing around go-to-market transformation and improving the economics with our channel partners. So channel today represents a significant portion of our overall go-to-market. It's about 40% of our sales today. And we saw opportunities to actually hand over more of the end-to-end sale process to our channel partners. And what we found was that, that actually improved our overall customer acquisition cost and actually freed up our sellers to go out and hunt, and that is not yet coming through in our sales and marketing. But that is, again, more good news to come as we look forward. And then, of course, there is the labor reduction that we announced at the end of last year, which was a difficult decision but needed. We overhired like most companies in the Valley in the second half of '21 and probably early 2022, and you will continue to see OP margin improvement and cash flow improvement as a result of that. The other thing I'll just call out is, you didn't ask about it, but stock-based comp. You've also seen, hopefully since I've arrived, we brought that down by about 450 basis points year-over-year. You'll see incremental improvement this year in 2023. And that's something that we, as a management team, are very, very focused on. And you should see it come down, not the same quantum, but it will decrease again and going forward.

So if I understand correctly, so the sales and marketing, the reduction in spending there, it's mostly -- it's the advertising dollars, it's the change in the partner relationships, it's more efficient spending. But if I remember correctly, most of the headcount was focused outside of sales and marketing for the reduction in October, correct?

So I would say outside of sales, yes. I wouldn't necessarily say outside of marketing, but we were very careful not to touch frontline sellers. So it was a combination of marketing, parts of sales that we're not touching the end customer, G&A and some R&D. But again, R&D, there were 2 areas that we really wanted to protect. And I think last year, you asked me why did you join RingCentral, and innovation is core to what we do. And our founder, Vlad Shmunis, is a product and technology guy. And I think the reason we are who we are and we have the gross margins we have and the ARPUs we have is because we have the leading product that all our customers love. We felt it was really important that we continued investing in product and technology and R&D through the cycle, including through this macro. So we were very careful not to scale back on R&D too much and innovation and also on anything to do with frontline selling. There was some labor reduction in marketing and then in other parts of the business as well.

Okay. Maybe just moving on from the expense reduction then for a moment. Avaya had been a very important partner. Historically, I think, brought in a lot of the seats and the partner in the partner channel. This exited bankruptcy. What should we expect in the next 12 months from Avaya? Obviously, they're probably restructuring their own operations. But how do you change that relationship? How is the monetization different? Any kind of payments going to Avaya? And how do you think about seat additions?

Yes. Okay. Great. So Avaya continues to be a very important partner. They were and they are today. And we feel actually and I personally am very excited about our new agreement with Avaya. And I believe it's new and improved, and there were some big wins for RingCentral in terms of that renegotiated partnership agreement. So first and foremost, we have preserved our exclusivity with Avaya. So we are the natural destination for Avaya's PBX legacy customers. ACO is absolutely the natural destination, and we are set up to win those customers. Secondly, we have negotiated minimum commits in the revised contract. That is something that didn't exist in Avaya 1.0. And those were hard thought and hard won, and we feel like it was a big win for us. And we have included those minimum commitments in our guidance for this year. But as you can imagine, Avaya has just reemerged from bankruptcy. And although you've probably been reading about it for a really long time, and it was a long drawn out process, the actual bankruptcy just took place a couple of weeks ago. And there is a timing, like a ramp-up of Avaya reemerging and coming back to life. So those seats, as you think about them through the year, they will ramp as the year progresses, and that is fully baked into our guidance. And one of the reasons that we talked about our bookings number and our ARR number, our ARR growth outpacing our overall subscription revenue growth because those Avaya seats will likely be more back-end loaded. And another really important factor is no, there will not be payments to Avaya upfront. We make money when Avaya makes money and vice versa. So as they move seats over, they make money, and we make money. Both parties are aligned. And I don't think that we had that perfect alignment previously in Avaya 1.0, but we certainly do today, which is what makes us very upbeat about the opportunity ahead. And Avaya does remain the largest holder of on-prem PBX seats today. And as far as we're concerned, it's not a question of if, it's a question of when, and those seats will eventually move over. And we, again, are the best placed to take those seats.

And that is still exclusive, correct?

Still exclusive.

Okay.

Yes.

Great color on that as well. So I think you mentioned earlier that you're the only company to be top right quadrant in Gartner for both UC and CC, right? So you have a nice relationship. How much is that combination of UC and CC driving that top of funnel growth that you were talking about earlier? So what percentage of that is the combination of the 2 products?

Yes. So we have a fantastic partnership with NICE inContact as you mentioned, and that partnership dates from 2015. So we have been in partnership together for a long time. And don't underestimate the power of that kind of long-term partnership because it means that there's been a lot of integration between the 2. And I think there are some competitors out there that have since launched partnerships, but they don't have that history in those integrations. And it's -- again, it takes time to get the combined motion humming. And we do feel very much like we have a right to win in contact center as we do in UC given the scale of our UC base. And what we find is the UCCC sales motion is very much complementary, and most buyers want to purchase UC and CC from the same vendor. And we really are the only choice if you want leading UCaaS and leading CCaaS, and over 60% of our enterprise deals come with a CC attach to a contact center attach. Today, our contact center business is over $300 million of ARR, so larger than many stand-alone large-cap software companies. And it is outpacing the overall growth for the market, which means we are taking share. And it has been and continues to be a very important part of our overall growth. We also have our own IP in terms of contact center, and that's our Engage product. That is more down market. And it's a much -- it's a smaller part of that overall $300 million, but we continue to invest there, and we see a lot of opportunity to bring that more and more upmarket. But for now, the NICE inContact sales motion is more upmarket and enterprise, and Engage omni is a more downmarket and smaller customers.

Understand. Can you remind me, what are the economics of relationship with NICE? And is there an eventual goal to have owner economics in that business, meaning to expand Engage capabilities you can serve more upmarket?

Yes. So we don't actually disclose -- I mean there's commercial sensitivity around disclosing the economics.

Understand. Even a broad brush, big picture?

Yes, we don't disclose partner economics for any of our partnerships, and sorry because there is commercial sensitivity around it. But what I would say is that it's included in our subscription gross margins, which you can see are around 82% and industry-leading. And that incorporates the NICE inContact partnership as well. In terms of do we like owner economics, we love owner economics. We would always want owner economics for everything. But we are also really happy with the partnership with NICE inContact. And we feel that Engage is absolutely targeting a part of the market that we couldn't target with NICE inContact. So it's very complementary. That being said, we are always evaluating and looking for opportunities to add adjacencies or find products that would be interesting and exciting to our massive installed base of customers, sticky installed base of customers. And so I would never rule anything out completely, but we're really happy with how we're positioned today.

And actually, a quick AI question here. I mean does AI actually make the partnership more valuable with NICE, given their positioning with their 200 models and very deep datasets? Arguably, probably the strongest positioning with AI in contact center. Does that make the relationship even more valuable versus building internally?

Yes. So I think it is extremely valuable, like with or without AI, but AI has that new added dimension. What I would say, though, is that we feel like we're in a really strong position on UC as well in terms of AI. And actually, I would almost argue that on the UC side of things, we have billions and billions of minutes of voice data. And I actually think AI elevates voice. I sometimes think that voice is kind of a bit of an unsung hero. People actually use voice a ton. And actually, there's a survey that Salesforce.com did. And we didn't even sanction this, or we didn't actually ask for the survey to be done, but the results were sent to us. And over 70% of companies prefer to use voice as the #1 modality to go out to their customers and reach their customers. It far exceeds any other modality. And again, I think AI will elevate voice even further. We see huge engagement from our customers on voice. 96% of our customers are actively engaging in voice. That's a higher number and higher engagement score than previously, so it's up year-over-year. The Salesforce.com data was also up year-over-year. So voice is actually becoming more and more politic. And I would argue that with voice, and you saw we announced RingSense, which is our -- one of our AI modules, in our last earnings. But I think, in fact, you can take all of this data and turn it into much more structured and the kind of data that customers are able to derive insights from and will be willing to pay for. And I think that, that could be something that's ARPU accretive and could be -- and we believe will be a stand-alone product in its own right on our platform, but even beyond that on other people's platforms, including CCaaS platforms. So we think this could be another golden age of voice, and it's revolutionary. So I'm going to argue for the upside on the UCaaS side just as much as the CCaaS side.

That was a good turn on that question, so I like that. One quick one on free cash, and I will leave a minute or 2 for any questions from the audience. You pulled for the expectation for, I think, $280 million in -- sorry, in unlevered free cash flow, right? It's the guidance unlevered.

Correct.

By 2024. What -- how should I think about operating leverage in the business though and upside to that number if the macro does improve? I think your base case right now is kind of treading along sideways with the macro, no material deterioration, no material improvement. If we do see improvement, how does operating leverage maybe add upside to that $280 million?

Yes. So you're right, and the numbers you quoted were right, but just let me be very specific. So we had originally guided to a doubling of free cash flow by 2024, which was implied $280 million. And at the last earnings call, I said that we will be able to deliver that much earlier, so $280 million much earlier than the end of 2024. And that is based on current assumptions, which is the macro staying exactly as it is. No deterioration, no improvement. Now as you correctly point out, there is a lot of operating leverage in the model, particularly as we are at this level of scale as we go through $2 billion of ARR, $2.2 billion. As we scale up, the operating leverage starts to shine through in the model, and more and more of that revenue growth hits not only operating margin, but also free cash flow. And if the macro were to improve, I'm not going to say that 100% of that improvement would go straight to OP and free cash flow because there would also be opportunity to invest. And we are absolutely a growth company, a company that believes in durable, sustainable, profitable growth. But what I would say is that if we were to see an improvement in the macro, you would see more and more of that operating leverage come through. And you would see an even stronger free cash flow generation profile, but you would also see incremental investment in driving growth.

And I have one last one here in the last minute. So I think you also mentioned last quarter that you have seen some ARPU or pricing pressure on the UCaaS side. Overall, ARPU was flat, it is consistent, but some pressure on the UCaaS side. Industry is still relatively fragmented. There are some competitors using pricing as a tool to gain market share. Do we have to see consolidation for market health to stabilize and allow the overall market to begin to grow again? Or do you believe that there can be market health and stability without consolidation?

Yes. So I don't think consolidation is necessary at all. I think if you're a company like us operating at scale, where we are today and with our leading product leadership and market leadership, we will continue to grow with or without consolidation. And you see that in our guidance. And I believe the market will continue to grow as well, the overall UCaaS market, because it's so underpenetrated today. That being said, it is a very fragmented market. There are fewer players today than there were a few years ago. But I think if you were to ask me, if I had a crystal ball going forward, I think there'll be even fewer players going forward. And I think players that are subscale will find it more and more difficult to operate in the current environment. And when I say subscale, I mean subscale in terms of revenue and subscale in terms of go-to-market reach and subscale in terms of being able to invest in innovation. None of that describes us obviously. So I think if you were to ask me, I feel that we and I clearly believe in our organic stand-alone plan, we will continue to be a leader as we are today if you were to look out several years from now. But I think overall, some players will ultimately drop out of the market because it's really tough to be subscale in the current environment. In terms of competitive intensity, I don't think that we need consolidation in order to see a bit more discipline in terms of how even some of our competitors are behaving with the channel. I think, in general, there has been a bit more discipline across the board, at least from what we've seen from our various competitors. But we feel like we're in a very, very good position in terms of being at scale, being highly profitable, becoming even more profitable and addressing our capital structure in an optimal way.

No, it's a great interview. Thank you.

Thanks.

Thank you, everyone. Sonalee, thank you.