8x8, Inc. (EGHT) represents a unique opportunity for investors to participate in a potentially valuable takeover play in the cloud communications and cloud services space. While the company has been in business since 1987, in the most recent years investors have been able to publicly invest in what amounts to a unique "venture-type" start-up situation.
Unlike most venture start-ups, however, 8x8 is highly profitable and has a revenue run-rate which should be well above $120 million in the upcoming fiscal year (FY'13). We believe the current cloud space environment, intellectual property litigation, market dynamics, and competitive advantages of the company make it a high-value takeover target. We believe a near-term valuation of $8.50-$9.38 is likely in a potential bid (based only on FY'13 expectations). If you extrapolate out to FY'14 models, a value of $10.40-$11.38 is reasonable.
On January 18, 2012, 8x8 reported their Third Quarter Fiscal 2012 results of $23.3 million and net income of $2.6 million (a net income increase of 73%), or .04 per share. This represented a 31% increase compared to the same period last year and a 17% sequential increase compared to revenue of $19.8 million in the prior quarter. Total revenue from business customers grew 42% year over year. Churn rate (accounts canceled due to hardship or other reasons) decreased to 2.0%, their lowest on record. Cash on balance sheet increased to $21.9 million. These are incredible growth numbers and very consistent from the company over the past several quarters.
In 1987, under the name Integrated Information Technology, 8x8 originally developed semiconductors for use in programmable multimedia silicon solutions. From 1987 to 2002, 8x8 was a supplier to telecom companies (many of whom have since gone out of business) in the videoconferencing and VoIP chip markets. It was not until 2002, that 8x8 transformed their business from an OEM, to a consumer focused company, selling directly to the end user.
In 2005, the company transitioned its entire business plan to focus specifically on the hosted (cloud) communications market for businesses. Shareholders should concentrate directly on the years 2005 through present to gain an appreciation of 8x8's growth trajectory.
Current Service Offerings
8x8 truly is unique in that investors are able to participate in a company with a solid balance sheet and current annualized revenues of nearly $100 million - but also invest in a company with potential rapid growth rates seen mostly in entities that are private and venture-stage. Their offerings extend well into the cloud sector, under a single umbrella. This enables 8x8 to "cross-sell" their products to existing and prospective clients, and have multiple entry points for new sales under one single source.
8x8's current "cloud" business services can be divided into three segments:
1. Unified Communications:
8x8's "gold standard" offering, in which they essentially own the SMB (small-to-medium business) market. This product represents the "cloud communications" segment of their portfolio of offerings. These are advanced business telephony services supplied to SMB, enterprise business market, and government and municipalities - all extremely user-friendly.
- Virtual Office Pro: a superior business class phone service hosted entirely by 8x8. There is no need for a legacy-equipment PBX system, nor is there a need for an in-house IT person to install and service the PBX. This is truly a cloud-based communication. Enterprise customers can potentially save hundreds of thousands of dollars per year using this service.
- Virtual Office Online: a web dashboard used to make calls, schedule meetings, send faxes, record calls, and much more, all from your computer or laptop.
- Virtual Office Mobile: a high-powered application for your iPhone, iPad, or Android system with most of the functionality of a PBX system. In November of 2011, AT&T announced a partnership with 8x8, Inc. for AT&T's smartphone customers called AT&T Call International. AT&T will do all marketing, 8x8, Inc. will support and provide the service.
- IP Trunking: if you already have a long term commitment with your current IP, PBX you can leverage your current system with 8x8's service, potentially saving a substantial amount of cost to a company's bottom line.
- Virtual Meeting: online conferences with audio, video, and desktop sharing - this product essentially replaces any need for a company to outsource to WebEx or GoToMeeting.
- Virtual Room: in collaboration with Polycom, 8x8, Inc. is providing enterprise-class video-conferencing services to enterprise and government customers using Polycom's VVX or HDX equipment.
We strongly highlight that, according to 8x8's Investor Presentations, their current customer set has extremely well known, large enterprise customers as well as large government agencies. Again, we suggest, as an investor, you pay attention to their ability to focus and rapidly penetrate the enterprise and government sectors. According to the company, their current enterprise customers (both communications and data) include: McKesson (MCK), New York Life, McLarens Young International, HomeAway (AWAY), RE/MAX, Aflac (AFL), Unisys (UIS), Allstate (ALL), Nationwide, Keller Williams, Adecco (AHEXY.PK), H&R Block, AOL (AOL), Intel (INTC), Ameriprise (AMP), Prometheus, State Farm Insurance, Farmers Insurance, among others.
Their partnership with Level3 (LVLT) has allowed 8x8 to be a contractor on Networx and WITS 3 Contracts for the Federal Government and State and Local Government. Again, we strongly advise investors pay attention to 8x8's ability to expand rapidly into this potentially huge area of growth. Current list of contracts include: Federal Maritime Commission, U.S. China Commission, Administrative Conference of the U.S., Defense Nuclear Facilities Safety Board. State and Local Government includes: City of Garden Grove, CA., and Indiana Public Retirement Systems.
The ability of 8x8 to move "upscale" into the large enterprise and government services market is a testament to future growth potential. 8x8 currently dominates the SMB market (serving the 2- to 20-person company), however, in recent quarters, they have been able to quickly expand their service to the aforementioned entities, with seats of 100 to 1,400 persons. We expect 8x8 will further penetrate this enterprise and government market and continue to win bids against major market players such as Cisco (CSCO) and Avaya.
We expect, going forward, 8x8 to become one of the dominant players in this segment - competing on the same level of a Cisco Systems. Further, at the end of last quarter, 8x8 announced they have signed 54 distribution partners, including 3 strategic telecommunications providers now distributing call center services - many of these have yet to even start selling 8x8 services.
In an example of the market penetration 8x8 continues to have with large-enterprise and government sales efforts, the Indiana Public Retirement Systems, according to a recent 8x8 presentation, signed a contract with 8x8 for 360 phone lines, 40 call center seats, as well as cloud storage. All three services were ordered at "point of sale." We can estimate a phone line at $25/month, and a call-center seat at approx. $125/seat - or approximately $14,000/month, or $42,000/per quarter revenues from this one, single contract (model excludes cloud-storage).
Competition in this area would be Shortel, CBeyond, Vocalocity, Cisco, Avaya, among others. We believe 8x8 has a competitive advantage in pricing, the broad "one stop shopping" scope of their offerings, and the fact that 8x8 completely owns all of their patent and intellectual property (a strong part of our thesis of 8x8's attractiveness as a takeover from a multinational player in the industry).
Another potentially huge untapped area of growth for 8x8 is in the global markets. A development which 8x8 has yet to announce is their "Global Reach Initiative."
On February 1, 2012, Voxbone announced that is "providing geographical and toll-free numbers to help cloud communications provider 8x8 Inc. expand its international calling capabilities to serve larger business customers on a global scale. The new relationship with Voxbone enables 8x8 to provide geographical and toll-free numbers for business customers with offices outside of the United States."
Mehdi Salour, 8x8 Vice President of Network Operations, was quoted in Voxbone's PR as saying, "Along with the adoption of our communications services by larger-sized businesses, we are seeing an increased demand to provide 8x8 services and phone numbers outside of North America, particularly where the customer requires a follow-the-sun contact center support strategy. The addition of the Voxbone portfolio of numbers in conjunction with our expansion into data centers in Europe and Asia will greatly enhance our ability to satisfy these customers."
We eagerly anticipate hearing more about 8x8's "Global Reach Initiative" shortly, as this would provide a tremendous source of new and yet-to-be-forecast future revenue growth.
2. Hosting Solutions
Through the acquisitions of small private entities such as Zerigo and Central Host (which cost the company well under $5 million USD), 8x8 was able to expand their offerings into yet another strong area of growth: the Cloud Data Services Market. Rackspace (RAX), Amazon (AMZN), LiquidWeb, and Giganet are primary competitors in this segment of the market. 8x8 also acquired the VBlock Infrastructure for enterprise-grade and government contracts.
- Cloud Servers: virtual private servers, hosted DNS, and professional hosted monitoring.
- Managed Dedicated Servers: managed and monitored servers and operating systems 24/7.
- Private Cloud Server Virtualization: dedicated servers and virtualization.
- VBlock Hosting Solutions: IT functionality in partnership with Cisco, EMC and VMWare, the VBlock is a fully integrated storage platform. Enterprise-grade functionality.
A recent study from IDC predicts cloud related service revenues will grow 28% annually through 2014. IDC also predicts that revenues generated from cloud servers will reach $9.4b annually by 2015, with demand for cloud servers growing 21-22% annually over the next five years.
This is the segment of the company we feel is in the "venture," exponential growth rate stage. As previously mentioned, in 2005, 8x8's "Revenue from Business Customers" was ~$2.0 million/year. By March 31, 2011, 8x8's "Revenue from Business Customers" exceeded $60 million. This is an increase of nearly $60 million in 6 years. Assuming 8x8 can grow the "Hosted Solutions" in the same manner (at a minimum), in 5 years the company could also be reporting revenue of at least $60-$80 million in this segment of the company.
Bryan Martin, 8x8's CEO, was quoted as saying, "Over time it wouldn't surprise me to see a 50-50 split (between VOIP communications and Hosting Solutions) because hosting is growing so quickly and is so applicable to our customers." If we follow the CEO's comments, our estimates could be much too conservative.
Recent large customer wins from 8x8 include The City of Garden Grove, CA (which uses the service as a cloud-based disaster recovery service), as well as EBMUD (a California public utilities company also using the service as a cloud-based disaster recovery solution for premise-based call center operation).
3. Contact Center/Virtual Call Center Solutions
In 2012, 8x8 acquired Contactual in a stock deal worth ~$27 million. At the time of acquisition, Contactual had annual revenues of ~$10 million and growing at an annual rate of ~20%. Virtual Call Center growth is expanding exponentially, and is replacing, once again, expensive on-premise based equipment. According to Contactual, "Dozens of Fortune 500 companies that could afford to spend millions on a call center solution selected Contactual over the traditional on-premise providers.
In addition, small businesses can finally experience the benefits of a fully-featured call center application that, until now, was financially beyond their means. Contactual's OnDemand Contact Center is the most innovative and flexible offering among call center providers and allows any organization to quickly and easily reinvent their customer interaction experience for all of their customer contact methods or for a single method such as email response management."
Enterprise customers which 8x8 acquired as of a result of the acquisition include AmericanExpress (AXP), Sony, Hitachi, General Electric (GE), Agilent (A), Schneider Electric, Walgreens (WAG), CORT, Olympus, Hewitt, Boston Market, and Savi, among others. In the mid-market, customers include NetSuite, Elance, SkinMedica, Dentisoft, Lumens, bytescribe, TradeCard, and Yale University, among others. We believe this acquisition will be a massive opportunity for cross-selling existing telephony and hosting services to these large enterprise and mid-market customers.
Again, this solution is the future of call centers: hosted, on-demand, virtual call centers - no more expensive legacy equipment. It is a high growth area and we expect 8x8 to have remarkable success growing the business, cross-selling the product with existing services, and further expansion into the large enterprise customer market. We believe 8x8 can grow this segment at much more than pre-acquisition rates of 20%, and view 20% as extremely conservative going forward.
Intellectual Property - A Potential Multimillion-Dollar Asset
8x8 currently has 79 patents with the USPTO. While we believe all of the patents have value, it is the intellectual property patents granted during the last several years that hold most of the potential. "Virtual Telephone Extension," "Communications Controller," "Arrangement and Method of Internet telephony," "Videoconferencing Arrangement Having Multi-Purpose Digital Still Camera," "Speech Processing," "Network Communications Having Endpoint Device with Automatic Connection to IPBX," "Voice Over Internet Processor," "Sensor-Controlled Telephone System," and several other notables including multiple patents related to videoconferencing are a large hidden asset at 8x8.
We believe 8x8 patents could hold value of up to $50 million for their entire patent portfolio. We also believe, after listening to company conference calls, that 8x8 consistently receives bids for some of their patent families. Should 8x8 decide to license or sell some or all of these assets, we believe it could add between $15-50 million as a hard asset on their balance sheet. It is our supposition that this is quite possible as evidenced by recent litigation in the technology space between several large multi-national corporations (Yahoo v. Facebook, Apple v. Motorola, ZTE v. Ericsson, HW Tech vs. Google et al, etc., and bidding wars over Nortel Network's patent family).
We believe the current share price of 8x8 does not even remotely represent the true value of the company due to very simple factors. First, current sell-side analyst coverage is minimal and the only coverage is from little known, third and fourth-tier firms. Some of the analysts covering the company, in our opinion, have very few followers and we highly question their industry respect. Their coverage was likely initiated after clients of their firm specifically requested coverage of the company because they had a vested position in the company.
Essentially, what shareholders are currently left with are reports from some of these firms, upgrading and downgrading the company after the stock moves in increments of $1.00 - $1.50. Further, the problem with having coverage from low-tier firms is that in many instances, upgrades and downgrades are done to "drum up" trading revenues in low volatility markets. Low-tier firms are struggling in today's environment and tend to "churn" ideas simply in an effort to boost trading revenues - all of the aforementioned, extremely unprofessional in our opinion.
8x8 has done a fair job at promoting the future of the company at first and second-tier investment banking firms at technology conferences. The sad reality about the lack of ethics on Wall Street is that most investment banking firms will not initiate coverage on a company, no matter how good, if the company is not paying banking fees to the firm, through either corporate financing or some other structured deal. So, unfortunately, 8x8 is left with a lackluster following of third and fourth-tier firms that add minimal to absolutely no client value.
Secondly, we would prefer 8x8 management to be a more dynamic team. Their current management team is good, but not outstanding or visionary. We would prefer a visionary as CEO, or, at the very least, to fill a vacant Director spot with a true technology visionary - a current or former star in the industry. 8x8 has done a decent job recently with replacing two Board members with Vikram Verma (currently President of Strategic Venture at Lockheed Martin), and Mansour Salame (former Founder of Contactual).
Also, 8x8 hired Kim Niederman, who now serves as President of 8x8 (formerly Sr. V.P. of Worldwide Sales at Polycom and other senior positions at Cisco Systems). We, however, still prefer a more dynamic visionary, at the very least, serving on the board. We feel this would greatly enhance shareholder value in the company.
8x8 at a current market-cap of ~$270 million is not being valued properly in the market. It is undervalued in our opinion - plain and simple.
EGHT is currently trading well under 3x FY'13 revenues. The current enterprise value is ~$250 million. FY'12 Q4 income will be reported in the next couple of months and we fully expect, at a minimum, $25 million topline revenues. Our conservative model would suggest FY'13 (which begins in April, 2012) to have topline revenues of at least $125 million. FY'14 would suggest revenues of around $160 million.
When recently asked about operating margins, CFO Dan Weirich stated that they intend to aggressively "grow the topline well in excess of over 20%". We believe this is conservative, and highly attainable. Again, our projections of FY'13 and FY'14 are based on a conservative model. Further, we think it is a mistake for current analysts to rely too much on EPS forecasts as operating margins will likely bump around as they continue to aggressively grow the company.
It makes no sense whatsoever for a high growth company like 8x8 to focus too much on solely ramping up EPS, while not pursuing aggressive growth of the topline. For instance, if 8x8 simply decided to maintain status quo and pursue moderate growth, they could very easily achieve .05/EPS per quarter going forward. Even with increasing SG&A due to growth expansion, we still think it is quite possible EPS will increase exponentially.
Our thesis on our long position remains that the company is a high potential acquisition candidate based on its current revenues and growth trajectory in cloud computing/services, potential global outreach, developing partnerships and channels, and largely in part due to its wholly-owned intellectual property patent portfolio. Patent wars are heating up, and are not going to go away. Nor is the cloud-services space and hosted computing.
The sector is growing exponentially and the legacy telecom and cable providers, as well as premise-based telecom equipment makers will see further erosion to their markets as well as earnings. In 2010, Google purchased VoIP provider Global IP Solutions for $68.5 million or 6x revenues. In 2011, Microsoft paid 32x Skype's adjusted earnings in their acquisition of the company. Shortel (SHOR) recently acquired M5 for, we estimate, 4x revenues.
There has also been a flurry of private and public managed cloud services buyouts in the past year. In 2011, Verizon bought Terremark, a cloud services company, for $1.4 billion. Small private companies have also fetched high multiples in acquisitions. 4-6x revenues would not be out of the question, whatsoever, for 8x8.
Potential acquirers would be cable companies such as Comcast (CMCSA), large telcos such as AT&T (T) or Verizon (VZ), equipment makers such as Cisco or Avaya, large technology corporations such as Microsoft (MSFT), Google (GOOG), Apple (AAPL), Salesforce.com (CRM), and even social media corporations looking to broadly expand their business services, such as LinkedIn (LNKD) and Facebook.
Assuming a conservative 4.5x FY'13 revenue model, we could see 8x8 being acquired for $612 million (4.5x revs + $50 million for Intellectual Property), or approx. $8.50/share. At a higher multiple of 5x revenues, we derive $675 million (w/IP), or $9.38/share. Assuming a conservative FY'14 revenue model, 4.5x w/ IP equates to $770 million, or $10.40/share. At 5x revenues, $850 million, or $11.48/share. The point is, it will not get cheaper for a potential acquirer as time passes.
Even if our thesis that 8x8 is acquired does not come to pass, the company still should be trading inline with other SaaS providers out there. 8x8 should, at the very least, be trading between 3.5-4.0x FY'13 revenues, or $6.25-$7.14/share, conservatively. We maintain that 8x8 is extremely undervalued.
Disclaimer: This is our thesis. Please do you own due diligence and research, as this literature is not a recommendation to buy or sell.