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8x8, Inc. (NASDAQ:EGHT)

F3Q13 Earnings Call

January 24, 2013 4:30 PM ET

Executives

Joan Citelli – Director, Corporate Communications

Bryan Martin – Chairman and CEO

Dan Weirich – CFO

Analysts

Barry McCarver – Stephens

Dmitry Netis – William Blair

Greg Burns – Sidoti & Company

Raghavan Sarathy – Dougherty

George Sutton – Craig-Hallum

Mike Crawford – B. Riley

Mike Latimore – Northland Capital

Operator

Good day, ladies and gentlemen, and welcome to the 8x8, Incorporated Third Quarter 2013 Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time.

(Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s conference, Ms. Joan Citelli, Director of Corporate Communications. Ma’am, you may begin.

Joan Citelli

Thank you and welcome everyone to our call. Today, I’m joined by 8x8’s Chief Executive Officer and Chairman of the Board, Bryan Martin; and 8x8’s Chief Financial Officer, Dan Weirich, to discuss our results for 8x8’s third quarter of fiscal year 2013 ended December 31, 2012. If you have not yet seen today’s financial results, the press release is available on the Investors tab 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 Bryan, 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, including without limitation, 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, in 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.

Thank you. And with that, I’ll turn the call over to Bryan Martin, Chief Executive Officer and Chairman of the Board of 8x8.

Bryan Martin

Thank you, Joan, and welcome everyone to 8x8’s first earnings call of the New Year. I’d like to begin by providing an overview of our third quarter of fiscal 2013 ended December 31, 2012, which will be followed by Dan’s discussion of the financials in greater detail. We’ll then be happy to answer any questions you have for us today.

I’m pleased to announce that 8x8 finished calendar 2012 with a strong third fiscal quarter, recording a 22% year-over-year increase in revenue from business customers. The expansion of our service margins and the continued growth in monthly ARPU resulting from the addition of larger size business customers.

Total revenue for the quarter was $27.3 million, up from $23.3 million in the same period last year. Our non-GAAP net income was $3.8 million or $0.05 per diluted share and the company generated an impressive $6.6 million of operating cash flow during the quarter to end December 2012 with $46.5 million of cash, cash equivalents and investments.

We increased the net number of new businesses subscribing to our services by 975 companies during the quarter with the average new business subscribing to 17 lines and services. This increase in new customer size is substantial, up from 14.7 lines and services in the September quarter and 14.0 lines and services in the June quarter and demonstrates the continued success we’re having winning larger mid-market business customers.

Correspondingly, the average monthly revenue per business customer increased to $260 per month, up from $256 in the September quarter and $239 in the same period a year ago. Over the entire customer base, our average business customer subscribed to 11.2 lines and services, up from 10.6 in the prior quarter and 9.4 in the same period last year.

Service gross margin also expanded nicely to 78.1% for the quarter, and Dan will provide additional details on our progress towards realizing our previously stated service margin goals. The subsidy on the hardware resale increased in the December quarter and product margin came in at approximately negative 34%.

Sales through our mid-market and channel team continued to make progress growing 147% compared to the same period last year and representing 17% of new monthly recurring revenue added during the December quarter. Last quarter, this group generated 12% of new monthly recurring revenue and 9% in the June quarter. So, I’m very pleased to see the significant sales progress we have made during the last six months. We ended 2012 with 101 channel partners on our program and continued to rotate new channels and partners into the mix as non-producing partners are moved to our referral rewards program.

We achieved our best monthly customer churn level ever at 1.6% despite some seasonality for increased churn in the December quarter due to business closures at the end of the tax year. Business closures and other economic turn maintained its post-2008 levels at 51% of total business customer churn during the third fiscal quarter. Revenue churn during the quarter increased to 2.6% versus the 1% record low we saw in the September quarter due primarily the specific issues with a handful of customers unrelated to 8x8 service.

Without the service reductions with this handful of customers, revenue churn would have been approximately 1.8% more in line with our historic revenue trend levels. We’ve seen a wide range of revenue churn percentages over the last four quarters and Dan will be providing you some guidance on what we believe we will see on a more macro, go-forward basis. Having said that, both business customer churn and revenue churn are figures that fluctuate quarter-to-quarter and we do expect that these figures will continue to see some volatility with each of our earnings reports.

On the marketing front, our acquisition cost per new service increased to $98 per service, up from $89 per service last quarter as we engaged in some new marketing and growth initiatives to drive our core micro business growth strategy in parallel with our mid-market efforts. We are planning to continue to invest in these new marketing initiatives as we believe that this is a very cost effective strategy to continue our sales reach and growth.

We also remain convinced that our softer development assets and ownership of our own communications technology are keys to maintaining our leadership position in the industry. During the December quarter, 8x8 was awarded two new patents for a total of 85 patents to-date. And additionally, 8x8 was named a market leader and was positioned as the most visionary service provider in the Gartner Unified Communications as a Service Magic Quadrant.

Earlier this month, we launched our business services in Canada, the first region to rollout, in our new global reach initiative. 8x8 is now offering business telephony and unified communication services to all Canadian businesses including – offering Canadian telephone numbers, number porting, and E911 emergency support. Canadian telephone numbers are now automatically provisioned and billed through all of 8x8 Web portals and customers in Canada will experience the same call quality and feature set as customers with service addresses in the United States. Businesses of all sizes including 8x8’s mid-market customers with employees located in Canada will benefit from these new services in our global reach initiative.

I’m now going to turn the call over to Dan Weirich, the company’s Chief Financial Officer, who will walk you through our detailed financial results and provide additional information regarding our business. Dan?

Dan Weirich

Thank you, Bryan. Revenue growth from business customers was 22.2% compared to the same period last year. This compares to the 25% organic growth rate and revenue from business customers that we reported last quarter and the 23% and 22% growth rate in service revenue from our cloud PBX business we reported in the first quarter fiscal 2013 and the fourth quarter of 2012.

As Bryan mentioned, during the quarter, we had a handful of customers cancel or substantially reduce the number of services they’ve subscribed to, which negatively impacted our growth rate. Also, in the third quarter of fiscal 2012, we recognized a $154,000 non-recurring engineering fee related to the completion and launch of a private label solution for a large U.S.-based carrier. Removing this $154,000 one-time revenue item, revenue growth from business customers would have been 23.1% from the same period a year ago.

On the topic of churn, in the past five quarters, revenue churn has been as low as 1% and as high as 2.6%. Churn, similar to what we experienced this past quarter, happens from time-to-time, and you should expect that events like this will happen in the future. For modeling purposes, I suggest forecasting is between 1.5% and 1.8%, but there could be quarters when it is above or below this range.

Non-GAAP net income for the quarter increased slightly to $3.8 million or 14% non-GAAP net income as a percentage of revenue, consistent with the prior quarter. This non-GAAP net income as a percentage of revenue was flat with the September quarter’s 14% number because we increased our investment in sales and marketing during the quarter, bringing this expense to 42.6% of revenue.

As a percentage of revenue, R&D and G&A were unchanged from the second quarter. From the nine months ended December 31, 2012, non-GAAP net income increased 48% to $10.9 million from the same period a year ago.

GAAP net income was $1.9 million compared with $2.6 million in the same period a year ago. GAAP net income was down year-over-year because this year is fully taxed of approximately 40% and last year was not fully taxed because we did not release our valuation allowance until the fourth quarter of fiscal 2012.

Income before the provision for income taxes during the December quarter was $2.8 million compared to $2.6 million in the same period a year ago. Fiscal year-to-date net income was $12.3 million compared to $5.4 million for the first nine months of fiscal 2012. Year-to-date income before the provision for income taxes was $20 million compared to $5.1 million in the same period a year ago. Service margin improved to 78.1% compared with 75.9% in the second quarter of fiscal 2013 and 76.9% in the third quarter of fiscal 2012.

As we stated in the past two quarters, our goal is to get service margins to 80% as quickly as possible. To achieve this goal, we have turned up multiple new network vendors and continued to optimize our network and network operations activity. Overall, gross margin was 68.3% compared to 67.8% in the second quarter of fiscal 2013 and 67.9% in the third quarter of fiscal 2012.

Contribution margin, defined as service revenue less billing and customer service expense, improved to 63.1% in the December quarter compared to 61.7% last quarter. Payback, defined as the number of months of contribution margin to pay back the subscriber acquisition cost, was 6.7 months. Gross additions of 2,617 business customers were down compared to 2,915 in the second quarter of fiscal 2013 and 2,836 in the same period a year ago.

As Bryan noted, the average number of services sold in the quarter increased 20% to 17 services from 14.1 in the same period a year ago. Business subscriber acquisition cost per service was $98 compared to $89 in the second quarter of fiscal 2013 and $92 in the third quarter of fiscal 2012.

The company’s cash, cash equivalents and investment balances increased $6.4 million in the quarter and $24.6 million in the past 12 months and remain very strong and more than $46.5 million. Cash flow from operating activities was $6.6 million in the quarter and $26 million year-to-date. The company did not have any debt.

Our solid balance sheet coupled with continued strong cash flow from operation, reassures our larger prospects of our ability to continue to deliver innovative technologies and outstanding service on a long-term basis.

Capital expenditures of $515,000 were back to our historical levels at 1.9% of revenue. In the first six months of this fiscal year, we invested $3.7 million on tenant improvements in our new corporate headquarter. As you can see in our non-GAAP reconciliation table at the bottom of our press release, the move-related expenses have stopped.

That concludes my prepared remarks and I’ll now turn the call back over to Bryan.

Bryan Martin

Thank you, Dan. For your reference and convenience today, we have posted a transcript of our prepared remarks in the Events & Presentations section of 8x8’s Investor website at investors.8x8.com.

With that, we’ll be happy to take any questions you may have. Kate, please open the lines for any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Barry McCarver with Stephens. Your line is open.

Barry McCarver – Stephens

Hey, good evening guys and great quarter. Thanks for that.

Dan Weirich

Thanks, Barry.

Bryan Martin

Thank you.

Barry McCarver – Stephens

So a couple of things. On the revenue churn that we saw in the quarter, could you provide just a little more color on what was driving that? What was that related to the customer churn we saw in the previous quarter or is it something completely new?

Dan Weirich

It’s separate from the customer churn in the prior quarter. That was a small amount of recurring revenue from those customers. Since what we experiences, we have roughly six customers that either their service was terminated or they reduced services and it represented approximately half of the increase from the prior quarter, and two of those customers were terminated by us for non-payment. One was a hosting customer and one was a contact center customer.

We had another that terminated services at their choice because they had a project that failed effectively and they were hosting customer. And then we had three customers that just reduced their services with us and we kind of attribute those changes due to kind of year-end and potentially economic-related decisions.

Barry McCarver – Stephens

So they weren’t picking up services of anybody else, they just maybe saw reduction and then maybe their head count they cut it back?

Dan Weirich

Yes.

Barry McCarver – Stephens

Okay. All right, that’s helpful. And then you’ve mentioned now for several quarters that 8x8 is moving upstream, you’re seeing slightly larger customers come into the mix. I think we’re seeing that and the number of services are picking up and ARPU as well. Could you give us an idea of kind of what you’re seeing in terms of adoption trends and what you’re expecting in terms of additional larger customers moving in say over the next 12 to 18 months?

Bryan Martin

Yes, Barry, this is Bryan. We are continuing to see that trend. I think that Gartner including us and a couple of our industry peers in the leaders’ quadrant for the first time was significant as well because if you think about a typical Gartner client, they are a larger customer, and those customers are clearly expressing interest in hosted unified communications like those that we offer.

I think the sweet spot we continue to see is the distributed workforce within those larger customers. So as those employees become more mobile, do more bring-your-own device, and just – some of it is just playing, rolling us out at this distributed branch offices and remote locations that are away from the corporate headquarters location if you will. That’s where we do very well both on a – certainly from a price perspective, but probably more important from the features we offer to tie all those remote workers together into a single instance that looks like they’re all working from one location and they can be as efficient as if they were working from one location. So that’s the overwriting trend that we just continue to fulfill very well with our solutions.

Barry McCarver – Stephens

Okay. And then just lastly on that number of services per customer going to 17 from 14.7, that’s a pretty significant increase. We have not seen one like that (inaudible) recently. Again, is that just may be a larger customer this quarter or what specifically have they taken out new there that we haven’t seen before?

Dan Weirich

Yes, so it’s primarily just from larger customers. So, the mix is staying fairly consistent from what we’ve seen in the past in terms of what types of services they’re buying. But we’re just seeing customers that have more employees sign up for service today than we had in days before this, so just larger more established businesses are adopting our solutions.

Barry McCarver – Stephens

Okay, great. I’ll get off and let somebody else ask questions. Thanks, guys.

Dan Weirich

Thanks, Barry.

Operator

Our next question comes from the line of Dmitry Netis with William Blair. Your line is open.

Dmitry Netis – William Blair

Good afternoon, guys.

Dan Weirich

Hi, Dmitry.

Dmitry Netis – William Blair

Couple of questions here. So, as I look at the – your growth rate, certainly, it’s been pretty stellar over the last quarter. It has decelerated slightly this quarter. How do you feel about sort of 2013 fiscal? Is it still sort of in that 25% growth rate? I mean, I know you’ve expressed the confidence around that number, is that still sort of the number you’re thinking about for maybe the near-term?

Dan Weirich

Yeah, Dmitry. So, in the last four quarters we’ve had growth rates that have ranged from roughly 22% to 25%. And in the quarter that we just announced, we mentioned that we had some deceleration in our growth rate which related to these kind of anomaly revenue churn items, but I mean that’s just the fact of life of a recurring revenue business, so I’m not going to say that that’s not going to happen again.

But if you just compare it to a year ago, we had this one time (ph) NRE (22:02) revenue and just adjusting for that, we’re 23% growth rate. And so we’re very comfortable kind of be in this range that we’ve been of 22%, 25% but we’re not like dead-set on any specific one of those numbers, but I mean that’s the range where we’ve been and we feel with great confidence that we’ll continue to be in that range. And we just received recent data point is the SEC recently just published some data that’s on the penetration of our services into the U.S. businesses as of December 31, 2011, and there’s 9.5% penetration and year-over-year through a year ago the market grew 24.7%.

Dmitry Netis – William Blair

Yeah, we saw that. It’s been kind of still a lot of runway left there, but thanks for that sort of color. That’s helpful. But another question I would have here is kind of the – I saw the net new customers have rebounded nicely from last quarter. I think you were at 975, still sort of the low, the kind of the average rate you’ve been in the last two years. So I’m trying to – if you could ease our concerns a little bit with the net new customer adds. It’s clearly the size of the customer has grown and you could judge that by the ARPU number.

So you’re getting more money from your existing customers and that new customer seem to be larger, so I’m just trying to – if you could parse that a little bit for us and tell us maybe what percentage of the new customers fall into your traditional voice category under 20 seats bucket and what percentage of new customers are perhaps above that line number. And so maybe there’s a way also to quantify that from the total dollar amount that they spent with you and perhaps you can also maybe compare to a year-ago period where it’s been and where it’s now.

Bryan Martin

So, Dmitry, this is Bryan. The only breakdown we are giving is the percentage of new monthly recurring revenue that came out of our, we call it mid-market and channel team, and those are customers, our definition of a mid-market customer is a customer with at least 50 seats with us, and if you just assume just to make the math easy, $20 per seat per month, they fill more than $1,000 per month recurring. And so we broke down that 17% of our new revenue came from kind of that segment. So obviously, it suggest that our inside team that’s targeting the 50 and below are also selling two larger opportunities.

And obviously, number one, I think it’s a good thing. Number two, we’re still looking at why or maybe how to possibly encourage our inside team to continue to maybe the lure of a larger customer means when the salesperson comes in. In the morning, they’re going to – first call of the day and the call they make before they go to lunch and the call before they go home is going to be these bigger opportunities.

And so we’re still looking internally at kind of the mechanics of what we want to do to make sure we don’t lose focus on our core, what we call micro business, which is the 10 line and below customer and that’s – we’re in progress with that right now. So, I think that’s what I would attribute some of the slowdown in (inaudible). I don’t know that has been entirely bad thing to the extent that we’re signing up fewer maybe one and two-person businesses than we did sequentially or that we did a year ago. But that’s something that we’re working on kind of real time here is what we want to do about that.

Dmitry Netis – William Blair

Okay, that’s helpful too. And maybe just – maybe I wanted to touch quickly on the federal and one other housekeeping question on the tax.

Bryan Martin

Okay, go ahead.

Dmitry Netis – William Blair

On the federal side, if you could maybe kind of give a little bit of an update what’s going on there and I know you have six existing contracts and there’s a number of opportunities you’re working on. If that number was closer to 28 or maybe even 30, so if you can give us an update where you are and what’s the progress or status is within each of those opportunities? Well, I don’t expect to hear each 28, but just kind of in broad strokes where you are and how that’s tracking?

Bryan Martin

Yeah, so I would just characterize it is the – during the third quarter, the new kind of – what do you call new bookings are maybe the release is the more accurate description of some of the deals that we’ve been verbally pulled by our partners or the federal customers that we’ve won. It’s extremely slow. This is an extremely slow quarter.

We obviously had the turn up of the presidential transition committee because of the timing of the election and that services installed and then used. But other than that, it was a very, very slow quarter from the federal on the federal front. We still are very optimistic that we’ll see the release of these deals in calendar 2013, but it’s a very – it’s a slow waiting game. So it’s – we’ll keep updating as it goes, but that’s overall is a very – the federal contribution to the new monthly recurring revenue is extremely small.

Dmitry Netis – William Blair

Have you lost any of the new opportunities you were working on or you still have about the same number?

Bryan Martin

No, lost is probably too strong a word. There are constantly contracts that are getting rebid or they go around for a second go or whatever. So, I mean, there were some of that. But it was just – I think that business in particular is an extremely lumpy business for us, and so you’re going to hopefully see some very large quarters in the future and then you may see none for a couple of months or a couple of quarters. And so it’s just as the nature of that business right now. It’s still very, very small for us.

Dmitry Netis – William Blair

Okay, great. And then last one for Dan on the tax, so when – I know you just reversed the valuation allowance at the start of this fiscal year, so when would you expect the cash tax pay around? I don’t think it’ll be for some time as you noted last quarter. But can you maybe give us an update there, what fiscal year can we expect you to pay cash tax has been and what is sort of the status of the NOLs?

Dan Weirich

So, we released all of our valuation allowance except for approximately $2 million related to California state tax that in our forecast it was uncertain whether we were going to be able to utilize that remaining $2 million. And so our fourth quarter is when we do our review of that analysis each year, so we’ll have a formal update in May when we announce our year-end numbers. But our approximate estimates are at the later part of this decade maybe 2018 to 2019, we could start to become more of a cash taxpayer. We expect that cash taxes for the current year that we’re in will be approximately 2%. And then in the next year in the 2% to 3% range and we expect that for the foreseeable future, borrowing, some tax rule changes or something of that sort.

Dmitry Netis – William Blair

Okay, thank you so much. That’s it for me and keep up the good work gentlemen.

Dan Weirich

Thanks Dmitry.

Operator

Our next question comes from the line of Greg Burns with Sidoti & Company. Your line is open.

Greg Burns – Sidoti & Company

Good afternoon guys.

Dan Weirich

Hi Greg.

Greg Burns – Sidoti & Company

I just wanted to dig into the Canada initiative a little deeper. What is your go-to-market strategy there and will you be able to support that of your current, I guess infrastructure inside salesforce they got to extend in any meaningful way to support the growth in Canada? And how should we think about the kind of the growth rates there and how that’s additive to the subscriber growth numbers and maybe any potential impact on margins?

Bryan Martin

Yeah, great question. This is Bryan. The go-to-market is the immediate need that we’re going to fulfill is the need of – I’d say there tend to be mid-market customers against some of our larger customers that have employees located in Canada, that we have through the years been unable and we’ve essentially handed out U.S. phone numbers in some instances or if that wasn’t sufficient for the application that the customer had in mind, we weren’t able to service those employees.

And so, we’re in the process of shipping equipment and provisioning service to a lot of customers that we knew had a built in need for a more localized Canadian experience. We do have two partners that are channel partners up there, one is Bell Canada and the other is SaskTel, which is in Saskatchewan which is the location as well of our data center where we’re carrying some of the signaling the media and certainly storing the Canadian customer data.

And so, I don’t foresee any immediate changes to the composition of our sales force or the result in margins. So, we’re not going to go build a new sales force to address that market, but we’ll overlay it on the team we have. I think you’ll see the major contributions they’re having from the mid-market team and the channel team and then as much as possible we want to leverage the relationships we already have in place in Canada that historically has only sold some of our call center services and see if we can expand these relationships to provide some of the other unified communications we’re now offering there.

Greg Burns – Sidoti & Company

Okay. And can you give us kind of idea of how we should think about the growth there, the incremental contribution potentially from Canada over the next year or so?

Bryan Martin

I would forecast it will still be small, but it’s even hard for us to forecast. We know there’s demand. We know that if you look at the footprint, the census data, number of businesses, even in population density up there, it’s a fraction of the opportunity here in the United States. But again, it’s – I think there have been plenty of consumer offerings available with kind of Internet telephony in Canada in the past. I don’t think there’s been the richness of business application and services like those that we’re offering on the basis that we’re offering them with the cloud-based approach and very limited investment into equipment.

So, we’re going to play it by ear and see how it goes. But it’s just nice to be able to go to our mid-market customers that have a vast footprint of distributed employees and be able to tell them now that we are now available and up and running in Canada. And that’s a trend that we expect to continue as we roll out in other regions of the world.

And beyond just being able to handout a Canadian phone number, it’s really about making sure that a call from that region is going to have the same call quality and high fidelity of voice that we’re able to offer in the U.S. because we do have local media handling capabilities up there. We have some local termination capabilities. And so it’s – I think it’s a significant event for us. It’s the first time the company has formally expanded outsight of the U.S. as a service provider since our inception as a service provider.

Greg Burns – Sidoti & Company

Yeah. In the press release, you noted this – I think in the right up you talked about just being the first in a series of expansions. Should we expect to hear some more announcements this year in terms of moving into additional countries or is that of longer timeframe?

Bryan Martin

No, that is our plan, is to continue to expand into additional regions. Again, it’s a regulatory – it’s literally a regulatory patchwork as we do this. So, there are – take me back to my old days of having to wear a regulatory hat there. There is many regulatory issues that there are kind of technological issues in terms of how to expand our network and our media services into these regions. And so it is -I can tell you that Canada launch took a lot longer than we thought it would and a lot of that was surrounding some of those challenges. But the goal is certainly to continue to expand into other regions of the world as well.

Greg Burns – Sidoti & Company

Okay, thanks. And, Dan, I don’t know if you mentioned it, but what percentage of revenue came from cloud data in the quarter?

Dan Weirich

So we’re just going to keep that in total business revenue, so with 97% of all of our revenue came from business customers. And the reason we’re doing that is we get a lot of questions like how often – how much revenue does a lot of different elements of our service represent. And at the end of the day, we’re selling a (inaudible) to customers and the billing is all integrated together and in some instances we discount items very aggressively and raise the price on other items. And so as I’ve mentioned in the past, I mean I think of it as kind of like a derivative of our overall business and it’s growing a comparable growth rate. And so it’s not too different than what it was in prior quarters. But on a go-forward basis, we’re just going to talk about revenue from business customers.

Greg Burns – Sidoti & Company

Okay, thank you. I’ll hop back in the queue.

Dan Weirich

Thank you.

Operator

Our next question comes from the line of Rag Sarathy with Dougherty. Your line is open.

Raghavan Sarathy – Dougherty

Good afternoon. Thanks for taking my questions. Just want to get some color on the larger customers that you’re selling now. Do you see any sort of common thread among these customers in terms of adopting, give a solution, are they replacing legacy solution that’s consolidating several locations? Can you give us some color around – the success you are having among the larger customers?

Bryan Martin

Hi, Rag, it’s Bryan. I think the – I gave you kind of the common characteristic of them being these or at least the use of our service as being to fulfill the needs of a distributed workforce, multiple locations, sometimes many, many locations. And I would say it’s very typical in these accounts that’s even replacing some very old legacy infrastructure. Sometimes, it’s a patchwork of infrastructure, whether there’s different systems at different sites. And we even see quite often now, especially if you get into the companies that have offices kind of spread throughout the U.S. that they even have a patchwork of service providers.

So you may have – we have an example in the investor presentation that’s up on the website where not only was it a patchwork of equipment, but its six different service providers that were replaced by a single bill from 8x8 each month. So, I would say that’s typical. There are certainly Greenfield installations especially at some of the customers that have been with us for a while and as they roll out employees in new locations or move to a new office, we become kind of the go-to for that installation. But I would say the typical quote that we’re sending out is kind of comparing total cost of ownership under the 8x8 brand to what the legacy, usually fully depreciated but again usually quite expensive and difficult to manage solution is that’s in place.

Raghavan Sarathy – Dougherty

And then from a competition’s perspective, so in the mid-market, are you seeing these similar competitors, sort of the Verizon, AT&T, or do you see different competitors? Can you give us some color on that too who are you going up against?

Bryan Martin

Yeah. It hasn’t changed. I mean it’s still AT&T and Verizon, a large percentage of the time. It’s bigger customers that have installed the phone system especially in the last 10 years can be with the CLEC, so they may have better pricing. And the move to 8x8, we still save money but it maybe a little less on an absolute sense than if they have an old relationship with the incumbent carrier.

In terms of the PBX people that are out there again, same kind of group being of people, so again, there’s a slide in our investor deck that just list the 10 most populous PBX vendors that’s ranked by number of sites they installed in last calendar year, and that’s where you see out there in the field typically with these accounts.

Raghavan Sarathy – Dougherty

Okay. And then in terms of the average number of services subscribed, it’s up between 18%, 20% through the three quarters. Just what should we expect going forward? Is it the same what we should expect some of the trend based on sort of the customers you’re engaged now with?

Dan Weirich

Yeah. I mean, it’s hard for us to tell ourselves because it’s been up into the right almost every quarter. I mean, we did include our operating statistics table these figures from a historical standpoint for the last five quarters for your reference, the last line in the operating statistics. And so, other than one quarter where it slightly dipped down, which I believe was the March quarter, it’s been up into the right. And it is a little bit hard to predict because we had a really good quarter and improvement that we just reported.

And I would say just overall on a macro theme, looking at it on a year basis whereas on a quarterly basis, we think that the trends are definitely moving upwards into the right, in the similar growth rates of what they’ve been doing. But on a quarter-to-quarter basis, occasionally it could be due to anomalies of a deal or two kind of excuse the numbers a little bit, but I think if you just look at it on a multi-quarter basis, it’s just continuing to move up.

Raghavan Sarathy – Dougherty

And then, Bryan, you talked about it regards to gross business customer addition. What set of goals do you have to sort of growing of those business customers and obviously you’re adding lot of customers, but (inaudible) seems like this – I mean efficiency there.

Bryan Martin

Yeah. Rag, can you ask the question again. I think I missed the last part.

Raghavan Sarathy – Dougherty

You’re obviously signing larger customers, but you’re talking over the gross subs ads being down year-on-year for the last two quarters. And you kind of talk about improving productivity of inside sales, what kind of goals you have in terms of increasing gross of that? What kind of timeframe are you looking at?

Bryan Martin

Right. Yes, that’s a good question. So, we continue to focus on that effort and I talked about one element of it which is how we continue to focus on very small customers, but essentially this quarter you saw the per line acquisition costs come out a little bit again within our historical range, but we have certainly done some new marketing programs, some of which we haven’t seen any sell through as a result of and so some of that increase is being driven by some new marketing.

We have some new processes and procedures and kind of selling practices that we’ve rolled out to the sales team. And so I think it’s unfortunate we haven’t seen any real tangible results in these numbers, from these efforts but we are very committed to seeing this through and as I said last quarter, we’re really trying to get to our micro business and our inside sales team telesales, really to deliver more than they have historically been able to deliver.

I wish I knew the timeframe on that. It’s something that we are very focused on the day-to-day basis and we expect to see results in the short-term. This is not – this is certainly not a marathon. So we are working very diligently on that and again, hopefully we’ll be able to update you in May with some more tangible results.

Raghavan Sarathy – Dougherty

Okay. Just one final question, Dan, so you mentioned we should be thinking about 1.5% to 1.8% of revenue churn if I heard correctly. Can you give us some color around the customer churn?

Dan Weirich

Yeah, on customer churn, as Bryan mentioned in his prepared remarks, was 1.6%. And so if you look at a year-ago period it was 2%, and six months ago, it’s 1.7%. We had a record low, but it’s come down in the last six months at a slower rate than it has in the last year. We definitely think that our in customer churn we definitely have room for improvement there or once again, it’s something that is hard to predict and kind of bounce up and down on its way down.

But it is definitely an area where we do feel that we have room for improvement and on our onboarding process, we have made significant changes and the way that we onboard customers and the way that we reach out to them immediately after the point of sale to begin the process of getting the customers installed quickly and to their satisfaction. So that is definitely something that we do feel that we have continued room for improvement.

Raghavan Sarathy – Dougherty

Okay, thank you.

Bryan Martin

Thank you, Rag.

Operator

Our next question comes from the line of George Sutton with Craig Hallum. Your line is open.

George Sutton – Craig-Hallum

Hi, guys, most of my questions have been answered, but I did wonder on the channel side, you suggested you’ve been kind of moving new partners in and moving some of the older partners out that hasn’t been productivity. Just give us a little more of a sense of how the channel partner programs working versus your expectations?

Bryan Martin

Yeah. Hi, George. It’s still slower in the macro sense than my expectations so everyone told me it would take a very long time to build and it’s taking a very long time to build, but I am extremely encouraged by the numbers of our team and working with our partners have been able to put up. Like I said in the last six months, I think it’s very good progress towards where we want to be.

We’re continuing to regularly sign up new partners, so a partner that has not sold anything or in some cases, even quoted anything and they’ve been on our program a year, we thank them and politely introduce them to our referral program where they can get, pay to one-time bounty.

We also send a lot of those partners to some of our kind of master agent telecom aggregators where they can kind of participate in that program. So the partners we’re bringing in, we’re kind of bucketing them in the three different types of folks, they’re either kind of hardware sellers, who have traditionally sold PBXs and other equipment and are now starting to sell cloud services. That group contributed quite significantly to our sales in Q3.

The second bucket is people that kind of sell circuits. They’re kind of telecom sellers. They sell connections to ISPs. That group had a significant contribution during the quarter. And then the third group, which had a much smaller contribution, and to me to this is a little somewhat puzzling or it’s counterintuitive to what I would have expected, are kind of the IT consultants and the people whose business is helping businesses run their IT and pick how they’re going to manage their networks, how they’re going to deal with viruses and spyware and by the way how you’re going to hook up to unified communications on the 21st century. So that it’s a significant portion in terms of the bucket but their contribution in new sales was significantly weaker than the other two categories during the quarter.

It surprises me just because that is in a lot of cases that business is trusted resource for their IT needs of all different shapes and sizes and it made just be that is not translating into communications yet. So, I would expect that group to be able to contribute more in the future. But if it is what it is today that I’m very happy with what Don Trimble and the team had put together for Q3.

George Sutton – Craig-Hallum

Okay. Thanks for the detail there. And then lastly, you see the same consolidation that we are seeing and your cash balance continues to build. I’m wondering, how do you view consolidation relative to customer list/other vendors or are you predominantly looking at other services, kind of like we sold contractual?

Bryan Martin

Yeah. I think – we’re always looking for opportunities so I don’t want to discount anything. But I think in general, our thinking is that this phase is an extremely strong segment. It has almost no penetration, Dan referenced the SEC 9.5% penetration in the U.S. and we’re orders of magnitude of sales away from having even 1% of the market. So, I don’t view it – I view it as a stage where there’s significant growth ahead, we can continue to grow organically very strongly.

So it would take kind of a special situation for me to look at a customer-based rollout. If you look at the three acquisitions we’ve done in the last 24 months. In all cases, there was a technology or service enhancement component, so the strategy is to why we’re acquiring the company. And I would guess at this point that would continue to be the case in any future acquisitions, but I don’t want to rule anything out because the space is consolidating at a tremendous rate and just a reflection I think of what the funding environment is out there post 2008.

George Sutton – Craig-Hallum

Very good, thank you.

Bryan Martin

Thank you.

Operator

Our next question comes from the line of Mike Crawford with B. Riley. Your line is open.

Mike Crawford – B. Riley

Thank you. Bryan, I think at a recent investor conference you talked about cloud data being about 5% of your revenues so if that’s say $5 million, do you think that is something that we should expect to grow faster than service revenues in the future as you have larger customers, do you think it should remain in about that same percentage?

Bryan Martin

I think as Dan commented, Mike, it’s growing and historically has grown at roughly the same rate as the rest of our business and so we’ve kind of, I think, in our models taken the position that it’ll be around that number that you quoted, the 5% number is what it was last quarter. We just – we’re trying to segment it a little less because we do see application of those services especially a lot of the midmarket types of customers. We also see significant interest in the industry at large there around some of the virtualization and kind of larger enterprise cloud types of applications that we’ve been involved with. We’ve been involved with different people, our services and so forth.

If you look at some of the companies that people like Cisco have acquired in the last quarter, it is just a lot of interest in that space. And so I think that’s an interesting area that we’re continuing to focus on with R&D dollars and kind of developing new services there. We’ve certainly backed away from kind of the commodity managed hosting where we just rack up one for one. You need 10 servers and suddenly 10 boxes to appear in our data center. We’ve backed off of sales in that area, but we are continuing to see very good interest and I think we have some good opportunity with larger customers around some of these virtualized and different services that are more of a niche and have a little more higher margin value for us and for the customer.

Mike Crawford – B. Riley

Okay, thanks. And then on sales, there’s been a lot of discussion of inside sales, channel sales. First, I don’t know if you can quantify what your channel partner churn is. And then more broadly if you just take a step further back, what do you find has been the most successful means of reaching larger customers?

Bryan Martin

Any idea of partner churn.

Dan Weirich

Our channel group was just over 100 active channels at the end of the quarter and our channel profile is kind of 80:20, so it’s like 80% of them are generating 20% of the sales and the remaining 20% are actually really good and generating the 80% of sales. And as we’ve been told from our channel team that that’s just like kind of the classic breakdown. So I’m not going to say that our channel churn is like 80% or something like that, but we definitely have a large number of unproductive ones that we’re to continuing to kind of recycle through. So we’ve been at roughly hundred channels for the last few quarters.

And then on where do we get our bigger opportunities, since what we’ve done over the past year is that if an opportunity comes in and has above 50 seats, we have determined that the point of sale needs to be made at a different touch level than out of a telesales environment and so that lead opportunity migrates straight to our channel in mid-market group. And in some instances, we’ll sell it direct and close it and in some instances we’ll give it to a channel and they will assist us in closing and fulfilling the opportunity.

So the bulk of the lead generation is coming from our more traditional lead generations of online related advertising, a little bit of (inaudible) areas such as established their lines. And then the channels are actually starting to generate some deal activity themselves and it’s still small but the encouraging signs that we saw this quarter is that some of the traditional hardware vendors you’re used to just getting big lump sum check for selling a big piece of hardware or starting to adopt the subscription-based to think of it as a newly revenue stream business that we’re offering in our subscription-based offering.

Mike Crawford – B. Riley

Okay, thanks Dan. And then have you seen any changes in the effectiveness of your online advertising which has been your probably best and lowest cost, source of lead generation? But I asked because it’s relative to some other channels like say investor conferences that seem to be getting a little bit more saturated, how is the online advertising performing?

Dan Weirich

It’s been very comparable over the years and even in recent quarters, I mean we see like consistent kind of close rates from those channels and the dominant player there is Google and it’s just a function of how many businesses or outsourcing for replacing new business (inaudible) such as that on Google is the primary function. But once they get over to us, we have very, very, very comparable close rates to the past few years.

Mike Crawford – B. Riley

All right. Thank you.

Dan Weirich

Thanks, Mike.

Operator

Our next question comes from Mike Latimore with Northland Capital. Your line is open.

Mike Latimore – Northland Capital

Okay, thanks a lot. Hi guys.

Dan Weirich

Hi Mike.

Mike Latimore – Northland Capital

Just on the – I guess on the channel, you mentioned sort of 20% of the partners doing 80% of sales, are those channel partners taking the payment structure where they get kind of the more of the upfront payments style or are they doing kind of the recurring revenue over the long horizon there?

Dan Weirich

So the structure that they have is, all of them have a residual component so they’re getting, participating in a percentage of the subscription revenue. And the way that we have it structured is, is that depending on kind of big price of the hardware and/or the price of the activation-related fee, there could be a bounty or an upfront component, but it’s not in all instances. So, it’s interesting when we move up in selling into larger customers, some businesses have a business mentality that they’re going to go and pay for the equipment and they want a lower service fee. And so in instances like that we’ll make profit from the equipment that we sell in those instances we’ll share a portion of these profits with the channel. And then we do have some opportunities where could be a big (inaudible).

And they have a business philosophy that there are no capital expenditures whatsoever and they’re going to – they want to be equipment amortized over the life of the agreement. And in those instances, we’ll work with the perspective customer in charge of nothing upfront and we’ll charge them higher subscription fee at a favorable interest rate 8x8. And in those instances, the channel is not going to receive upfront conversation. But we’re kind of quite flexible on the way that we structured these and we have standard plans, but as we are convincing some of these traditional hard working folks to migrate over to subscription-based services, we kind of mix it up to meet their needs.

Mike Latimore – Northland Capital

Okay. And then ARPU has been growing kind of $4 to $6 a quarter. Is that the way to still think about it going forward?

Dan Weirich

Yeah. I mean while I got the question about where do we see services coming in on new customers and we see it as kind of up into the right and ARPU has been much more consistent because it’s kind of working over a much larger base other than just the new customers were signing up in that period but yeah, we’ve got tremendous confidence in kind of the historical figures and what we’ve done that will continue to happen in the future.

Mike Latimore – Northland Capital

I guess as the ARPU of the growth -or is the ARPU of the gross adds is going to be accelerating maybe they would (inaudible) ARPU acceleration at some point or does it all kind of balance on over time?

Dan Weirich

And the only thing I can say is that I mean look at our gross adds they’re down year-over-year, they’re down sequentially but the new monthly recurring revenue that we sold in this quarter was higher than any quarter in the past so we’re just – the theme of a more established larger businesses adopting solutions such as ours is continuing. And it continued even in a more rapid rate this quarter.

Mike Latimore – Northland Capital

And just last, what should we use for stock comp in the fourth quarter?

Dan Weirich

Yeah, stock compensation was roughly $765,000 in this most recent quarter and I would say roughly (inaudible) investments, kind of $800,000 to $850,000 range.

Mike Latimore – Northland Capital

Great, thanks a lot.

Dan Weirich

Bye-bye.

Operator

I’m not showing any further questions at this time. I’d like to turn the call back over to Bryan Martin for closing remarks.

Bryan Martin

All right, thank you, Kate, and I just want to thank Dan and Joan for their presentations. Thank you everyone for joining us on the call today. This quarter 8x8 will be presenting a Stifel Nicolaus Technology Conference on February 5 in San Francisco, the Northland Capital Markets 2013 Technology Conference on March 13 in New York, the Sidoti & Company 17th Annual Emerging Growth Investor Forum on March 18 also in New York and at the 25th Annual Roth Conference on March 19 in Dana Point, California. We hope to see you at one of these events.

And also if you’re not already a customer, again, you can see these larger businesses and businesses of all sizes are adopting these services. Please visit our website to learn about the different services we can offer to your business. You can also call us at 1-866-TRY-VOIP and we’ll be happy to assist you there.

With that, we conclude today’s call. Go ahead, Kate.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a great day.

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