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8x8 Inc.(NASDAQ:EGHT)

F3Q08 (Qtr End 12/31/07) Earnings Call

January 30 2008 4:30 pm ET

8x8 Inc. (EGHT)

F3Q08 (Qtr End 12/31/07) Earnings Call

January 30, 2008 4:30 pm ET

Executives

Bryan Martin - Chairman and CEO

Dan Weirich - CFO

Joan Citelli - Director, Corporate Communications

Analysts

Colby Synesael - Merriman

Joel Achramowicz - MDB Capital Group

Michael Coady - B. Riley

Chris Lahiji - LD Micro

Ray Archibald - Kaufman Brothers

Naved Rasuli - LD Micro

Paul Packer - Globis Capital

Bryan Horhay - Horizon Management

William Burnham - Inductive Capital

Operator

Good day, ladies and gentlemen, and welcome to the 8x8 Incorporated third quarter 2008 fiscal year Earnings Call. My name is Johaida and I will be your coordinator for today. At this time all participants are listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Ms. Joan Citelli, 8x8 Director of Corporate Communications. Please proceed.

Joan Citelli

Thank you, and welcome everyone, to our call. This afternoon, I'm joined by 8x8 Chairman and Chief Executive Officer Bryan Martin and Chief Financial Officer Dan Weirich to discuss our results for the third quarter of fiscal year 2008. If you have not yet seen this afternoon's financial results, the press release is available on 8x8's corporate 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 otherwise request 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 factor 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.

Please note that management will be continuing our corporate practice of not offering or providing any forward-looking guidance on the company's financial results, forecasts, or similar future expectations, and your cooperation is appreciated in not asking any questions in this regard. Thank you.

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

Bryan Martin

All right. Thanks Joan, and I would also like to welcome everyone to 8x8 conference call to discuss financial results from our third fiscal quarter ended December 31, 2007. I am going to make some opening remarks and then I'll pass the call over to our CFO, Dan Weirich who will walk you through our detailed operating results and some other additional metrics.

This was a great quarter for 8x8 and our Packet8 communication services as we surpassed a significant milestone and extended our leadership in the hosted business Voice-over-IP market with more than 10,000 companies subscribed to the Packet8 Virtual Office services suite as of December 31st, 2007. As of that date, 10,092 companies subscribed to our Virtual Office services, an increase of 1,018 net new companies over our company subscriptions at September 30th, 2007.

8x8 also posted an all-time record with quarterly revenues of $15.8 million, a highest quarterly revenue in the 21-year history of the company. These revenues represent a sequential increase of 7% over the September quarter, and year-over-year growth of 19%.

Revenues from our Packet8 Virtual Office business services contributed to 48% of our total revenues, versus 47% of total revenues for the September quarter, as we saw a sequential growth in our Packet8 residential, consumer, video and mobile services of 5% alongside the 8% sequential growth in the Packet8 Virtual Office revenues.

On a year-over-year basis, we were pleased to see the stabilization of our residential voice services, which were flat with the revenue levels in the year ago quarter. Residential and video services combined, declined by only 3% versus the year ago period, as compared with the year-over-year decline of 19% during the September quarter.

These consumer segments have stabilized following the successful transition of the former SunRocket and NetZero subscribers to Packet8. We continue to pursue new opportunities with several additional service providers who are looking to outsource their Voice-over-IP services, or exit the space all together in the near future concurrent with our marketing and sales focus on the small business space.

During the December quarter, we expanded our gross margins further to 65%, as our business continued to scale. Overall our service margins rose to 70% across all service offerings, product margins increased to 15% and our Packet8 Virtual Office service margins increased to an all time high of 83%.

For the second time this fiscal quarter, we reported a profitable quarter with GAAP, I'm sorry. For the second time this fiscal year we reported a profitable quarter with GAAP net income of $1.4 million or $0.02 per share, a trend that we are focused on continuing. As we've said in the past and are now demonstrating we have a business model that is scaling and continuing to improve.

Our balance sheet shows the benefits of our business model with cash and investments increasing by $1.43 million versus September 30th, the third quarter in a row that we have reported an increase in these assets. Over the last nine months we've added $2.4 million to the balance sheet and we ended the December quarter with $14.3 million in cash and investments and no debt.

The December quarter also saw some innovative new service announcements. At the end of November, we announced our first service offering for mobile phones called Packet8 MobileTalk. Packet8 MobileTalk enables more than 450 models of mobile phones to connect seamlessly to the Packet8 digital network with dialing international calls. Literally saving any mobile user dollars per minute versus the international rates typically charge by the incumbent cellular carriers.

Packet8 MobileTalk is unique over other industry offerings to-date because it can be used on any supported phone from any location in the United States and it does not require that the user's behavior change when dialing international calls. You continue to dial and use your mobile phone as you always have, only your calls are routed over our network instead of theirs.

At the Consumer Electronic Show earlier this month we introduced a free trial offer of this service, so that anyone can see how easy our service is to use and experience first hand, the quality and clarity of our digital phone network. The free trial offer is available at our mobile website mobiletalk.packet8.net.

Also at CES we announced the integration and availability of our Packet8 Tango video terminal adapter with any Packet8 Virtual Office extension plan, for as low as $100. Our Packet8 Virtual Office customers can now add video conferencing as well as the other applications supported by the Tango video phone including our digital photo frame application, outlook integration and native three-way video calls with continuous presence to any Virtual Office telephone extension anywhere in their business.

The video adapter connects right into the Virtual Office telephone handset and requires no change in how customers use their business services.

Extension calls to other extensions with our Tango video device automatically bring up an instant on-video conference, as do worldwide calls to any other Packet8 video phone or Packet8 Softtalk subscriber. There is no additional service charge for Packet8 video calls anywhere on the planet.

Our Packet8 virtual office subscribers who wish to add video conferencing to any of their business phones can simply log into their account at Packet8.net and upgrade their equipment.

We are continuing to work on new, robust product and service initiatives for calendar 2008 and look forward to rolling out additional innovative IP communication solutions to help our customers communicate better and open up our service offerings to new platforms and markets.

Finally, I'd like to provide an update on 8x8's portfolio of intellectual property. During the December quarter, we demonstrated the monetary value of the company's patents and intellectual property through the sale of two legacy non-core patents to a third-party for $1.2 million.

The transaction closed in December, and we have recorded the received cash in the other income line of our income statement. Now while we've historically reported approximately 50k to a 100k or royalty and licensing revenue per quarter from our intellectual property, we are pleased to report this success in our ongoing efforts to monetize the company's portfolio of patents and other intellectual property.

We believe that this initial transaction validates and establishes a baseline value of our portfolio in the marketplace, and we intend to continue efforts towards monetizing our intellectual property via licensing, covenant not-to-sue agreements, and other business arrangements and transactions in the future.

I'll now turn the call over to Dan Weirich the company's CFO, who will walk you through the detailed financial results and operating metrics of the business, Dan?

Dan Weirich

Thank you, Bryan, and good afternoon to everyone on the call. As of December 31st, 2007, Packet8 Virtual Office represented 48% of revenues, Packet8 residential services represented 49% of revenues and Packet8 videophone and mobile services represented 3% of revenues.

Average monthly churn for all services for the quarter approximated 3.8%, excluding subscribers that cancelled within the first 30 days of service. This is a reduction from the 3.9% and 4.6% churn we experienced in the September and June quarters.

In an ongoing effort to reduce churn during the first 60 days of service we deployed a diagnostic tool in the December quarter that pre-qualifies a potential customers network, prior to subscribing to the service and simultaneously increase the number of onsite customer installation through our third party installation partner. The pre-qualification tool is available at voiptest.packet8.net.

We are also planning to begin network wide proactive monitoring of customer's call quality to alert us to issues that can be resolved prior to a customer experiencing poor quality for an extended period of time.

The average number of services our Packet8 Virtual Office business customers subscribed to was flat at 7.25 services versus the September quarter. The average monthly recurring service fees billed to a Packet8 Virtual Office customer were $239 in the December quarter compared to $223 in the same period last year and $238 in the September quarter.

The cost to acquire a new business customer increased to $1,168 from $1,031 and $1,013 in the September and June quarters. Virtual Office service margins increased to 83% compared to 81% in the first and second quarter of fiscal 2008.

Cost of sales which includes all network expenses, headcount to manage our network, depreciation on our networking equipment and stock compensation for the employees who manage our network was $40 per business customer per month.

Our contribution margin per company was 64%, compared to 59% and 61% in the September and June quarters. Contribution margin is gross margin less customer support and billing expenses.

In the December quarter customer service and billing expenses were approximately $46 per company per month, 19% of our Virtual Office companies average service revenue.

The contribution margin of a Virtual Office company increased to an all-time high of $153 per month. The gross margin and contribution margin increased due to a continued reduction in our network expenses and increased efficiencies in our customer service department and billing processes.

The payback, which is the cost of acquisition divided by the contribution margin is 7.6 months. Non-cash items in our financials this quarter include a $448,000 non-cash mark-to-market gain on the value of our warrant, a $324,000 stock compensation charge and a $398,000 depreciation charge.

Gross margins were 65% overall, compared to 52% and 64% in the September and June quarters. Our recurring service margins were at 70%, which is an all-time high and product margin at 15%. The product margins were positive due to a one time release of a product reserve which is offset by a write-off of $90,000 and equipment delivered to but not paid for by CompUSA.

Without these two adjustments product margins would have been negative 15% due to aggressive discounting during the holiday season.

Cash outflow for inventory purchases were $688,000 during the quarter. Capital expenditures for quarter were $215,000 or 1.4% of revenue. Year-to-date capital expenditures have been $505,000, or 1.1% of revenue. Advertising expenses were $1.9 million for the quarter, compared to $1.7 million and $1.4 million in the September and June quarters.

As of December 31st, 2007, total shares outstanding were $62 million, and total shares fully diluted were $80 million. I would like to remind you, that as we have disclosed in our annual report on Form 10-K, we have estimated net operating loss or NOL carry forward for federal and state income-tax purposes of approximately $148 million and $96 million respectively. As we move closer to profitability for fiscal year, we will begin to utilize these NOLs.

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

Bryan Martin

Thank you, Dan. As usual, we've reported a lot of numbers today, and posted a transcript of our prepared remarks on 8x8's website at 8x8.com in the investor relation section for your reference and convenience.

We are very pleased to report these strong results and are excited about the company's prospects through 2008 and beyond. All of these results were possible due to the hard work of our dedicated loyal employee team, and I want to thank all of them for their many contributions this quarter and past.

Sustaining profitability is our primary focus, and our efforts this year will be directed towards introducing a stream of new business services, products and technologies, while capitalizing on opportunities in the Voice-over-IP industry for outsourcing and subscriber consolidation.

As a leader in this space with a proven profitable business model of a strong patent portfolio and a track record bringing innovative technologies to market, we believe that we are uniquely positioned to capitalize on these industry trends. That concludes our prepared remarks and I'll turn the call over to Johaida for any questions.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Colby Synesael with Merriman. Please proceed.

Colby Synesael - Merriman

Great, thank you for taking my question. Your residential revenues were very impressive this quarter and you talked about stability in that segment. What is that something that you guys believe it's going to continue? And two, if it is or :can you please us a little idea what is it that you are seeing that's really changed probably over the last three to six months that's allowed you a piece of confident in that?

And also on the profitability side: is there other ways in which you guys can continue to improve the profitability besides just scalability, other areas we got could actually continue to reduce cost so that we could continue to see the gross margins increase?

Bryan Martin

Okay, Colby. This is Bryan. So in general I think we've seen hopefully the rate of reduction on our residential business begin to stabilize. We've seen this as a trend certainly with the exit of some SunRocket, which was the major provider that was at a price point substantially below us, we began to see some strength in our business after that.

We also see a very good strength in the rate of renewal of our annual plans and so we are seeing those renew at rate of about 90%. Is that correct Dan?

Dan Weirich

Yes.

Bryan Martin

So one of the things as we get to the summer time again, July and August timeframe, we are expecting to see those consumer subscribers that came over from SunRocket pay us for another year and provide additional cash.

We also see all of these opportunities that I hinted at during the call, of other service providers that are exiting the space, wanting to outsource their operations to us. So we are cautiously optimistic here that our residential business may not decline as fast as we previously thought it might, just based on the rate of decline we saw, for instance in the September quarter. So that answers that question, I'll let Dan to comment on the second now.

Dan Weirich

On your gross margin question: “yes”, we are continuing to see a very good pricing environment from the network side of our business. It is continuous, its going to exceed our expectation on where we can go and the cost to on support the customer. So things are looking very good there and we don't expect that to end anytime soon.

On our cost for our product, we are not seeing the reduction that we are on the network side, so I would say on the product side we are not really forecasting too much improvement. We definitely would love to be kind of on a regular basis closer to neutral than negative, but it’s still very close to that number.

Colby Synesael - Merriman

Dan and the services side of the business you guys hit 70% gross margins this quarter and I think you did that in the fiscal first quarter as well: should we consider that as the only thing in terms of where those margins can go? Or: there is still room to expand upon those?

Dan Weirich

Yeah, I think that that is definitely not a ceiling. I don't think that you are going to see the improvements that we've had over the last year or so, we've gone from 60% to 70%.

You probably won't see that over the next year, but you definitely -- I think it's fairly reasonable to believe that 70% is closer to a baseline than a ceiling.

Colby Synesael - Merriman

Do you guys expect to continue to be EPS positive from this point going forward?

Bryan Martin

That's certainly our goal, Colby.

Colby Synesael - Merriman

That's very impressive. And then just lastly, I just wondered: if you can expand upon, you said a baseline valuation for monetizing patents: can you explain what that means?

Bryan Martin

Well, in general, my own philosophy has always been that, and an issued US patent in good standing is worth no less than a $1 million, because it takes a $1 million in court to invalidate anything, at least in our experience with the matters, and what we've seen other people do with them.

So we have a pretty high threshold, we think that research and development that's been over the years at this company, in the communications field has yielded a number of innovations. We think our patent portfolio is very strong, and we think that some of these patents are very valuable.

And certainly we would look to -- I would say as we were closing this deal in December with this entity, I think had three other separate entities approach us about intellectual property we have and their interest it, and I'm not a big believer in coincidences, so I would have to think that people in that space have been whispering to each other that, 8x8 is willing to sell some of their patents in order to monetize them.

And we continue to look on the enforcement side towards our competitors in this space who are slowing down our sales increasing and we won't hesitate as our balance sheet improves to go that direction as well.

Colby Synesael - Merriman

Okay. Well, great. Thank you, congratulations.

Bryan Martin

Thanks, Colby.

Operator

Your next question comes from the line of Joel Achramowicz with MDB Capital Group. Please proceed.

Joel Achramowicz - MDB Capital Group

Thank you very much. Good afternoon, Bryan and Dan.

Bryan Martin

Hi Joel.

Dan Weirich

Hi Joel.

Joel Achramowicz - MDB Capital Group

Hello actually, Bryan I like the numbers so don't -- often times you don't get enough, so and in fact I've got a couple of issues with regard to the operating business but prior to that I would just like to visit a the couple of more metrics. Dan, if you might be able to be so kind as to provide them? One being: a headcount.

Dan Weirich

So as of the end of December we had roughly about 210 employees.

Joel Achramowicz - MDB Capital Group

And it's up from what sequentially?

Dan Weirich

That is up from…

Joel Achramowicz - MDB Capital Group

I hope you don't mind?

Dan Weirich

No problem. We had 207 at the end of September, so it's up three people.

Joel Achramowicz - MDB Capital Group

How many total residential subscribers did you have at the end of December?

Bryan Martin

We are not disclosing that number.

Joel Achramowicz - MDB Capital Group

Okay. Did you mention the percentage sales that’s through the company your direct channel?

Dan Weirich

No we did not, but our Virtual Office product we see about 71% of our sales come from our inside sales force.

Joel Achramowicz - MDB Capital Group

Okay, great. And then one final: did you mention the cost of acquisition per service for the quarter?

Dan Weirich

That we mentioned that -- it was $129.

Joel Achramowicz - MDB Capital Group

Well, that's great..

Bryan Martin

But that's overall service

Dan Weirich

Yeah. All services yes.

Joel Achramowicz - MDB Capital Group

But certainly down from the second quarter.

Dan Weirich

Well it's actually up from the second quarter and the second quarter was $99 because we added all those SunRocket customers that are very, very low cost of acquisition and so that compared to the first quarter with 139. So, “yes”, its down from kind of the more normalized quarter.

Joel Achramowicz - MDB Capital Group

Okay, great. I have a question Bryan on the business in particular anything -- can you quantify in any regard any progress you have made with the SYNNEX arrangement? Can you give us some color on any of the programs that are moving forward there and how they are impacting the companies who model..?

Bryan Martin

Sure, I can't quantify anything for you yes Joel but I would say that we have invested a lot of time during the quarter certainly since we announce deal just in training that channel we continue to train that channel, we've had people onsite at SYNNEX on the east coast doing a lot of training and it always takes a quarter or even two quarters sometimes with these larger partners to really ramp them up and make them effective sales people for us and so hopefully by the time we have this call at a fiscal year end we can quantify kind of what percentage of sales might be coming from that channel. But right now its really still too early.

Another partner that I just visited in Del Rey beach, Florida last week, his office depot and we've gotten back into their [in-cap] cycle, so that’s approximately half of their stores right now. I was in the store in Del Rey beach, you will find a very colorful red in-cap that's up displaying all our wares again and we've already seen their sales in January pick up with that.

They go into a mode in the summer time where they start pushing back-to-school items and unfortunately we haven't convinced them yet that all back-to-school students need something from Packet8, and so our office depot sells the second half of the year. Certainly in the December quarter we were down from what we saw earlier in the year but we are seeing that pick up again as well.

Joel Achramowicz - MDB Capital Group

But of course you are working on that trying to convince them?

Bryan Martin

Yeah well I think with something like MobileTalk, it’s a great service that every student should have on their cell phone.

Joel Achramowicz - MDB Capital Group

Indeed. And your thoughts on the industry in particular, this was a good juncture at the end of the calendar year and getting into the first year. What are your thoughts on the VoIP industry in particular.

I mean: Comcast has been hurting. I mean: that would seem to me that generally, overall they're moving towards VoIP, it seems to be inescapable and yet it seems they have occurred in fits and starts.

Do you see that maybe 2008 being finally a significant transition year in terms of really establishing perspective and visibility for VoIP across the broad number of communications channels?

Bryan Martin

Yeah. I think that's a great question. So a couple of perspectives we have at the Consumer Electronic Show a year ago, there were no fewer than probably 20 Voice-over-IP companies in various forms on the show floor. This year, earlier this month, there were three.

So we've certainly seen the effects of the kind of mass exodus of the smaller players, and certainly I think that's a trend you'll continue to see this year just because we know our players we are talking with that are certainly interested in handing their subscribers over to us, because they haven't figured out how to make money off of them.

The other thing that I think we can't ignore, and I have been getting a lot of questions about lately is how the deteriorating business market, and economy in general might effect our sales here this year, and fortunately for us, because we save these customers so much money, we tend to run counter to those downward economy trends.

And certainly, when times are good, most businesses that you approach and say, I'd like to save 50% to 90% on your telecommunications, they are happy to talk to you. But they are even happier to talk to you when times are tough.

And so while we do see some of our businesses are in areas like real estate, mortgage and they maybe getting hit little more than regular business. I think all businesses in general are always going to be looking to services like ours that can save them a lot of money.

So we are looking forward to the year I think we've already seen in recent weeks a couple of PBX manufacturers disappoint because no businesses were out there are buying shiny new phones and big shiny boxes that are going to go in the closet. But I think, they are all looking to save on their telecommunication cost and we have the perfect suite of services to do that.

Joel Achramowicz - MDB Capital Group

Are you still seeing a pretty good graphic selling from existing base and you are tracking them, it seemed to me that [to ford a mountain] would be very, very powerful than selling this.

Bryan Martin

Yes. That's exactly what we rely upon especially for these business sales where the introduction to the business owner, the IT manager it's the tough introduction to earn and certainly being able to have a fellow business owner recommend us and suggest that the person give us a call is something we try to capitalize on.

Every quarter we run a promotion whereby we offer a large referral fees for anyone that introduces us to a customer that becomes a future customer of Packet8 Virtual Office service and we have a promotion running right now through April 30th where you can earn up to $35,000 in referral fees just by sending us names and emails and phone numbers.

So we certainly do push that. We've got base of very satisfied customers and we love using them as one of our selling tools.

Joel Achramowicz - MDB Capital Group

Very good and one final question: any major events in the calendar that we should be aware of going forward? Any shows or seminars or events of particular note that might involve the [VoIP]?

Bryan Martin

We are going to be at VoiceCon either the week or the week after down in Orlando, that's our next major show and then certainly we are happy with these financial results that we are going to be hitting in the road again and participating in a number of financial industry events. We will be at the SRA Financial Analyst conference in San Francisco, a week from Monday, is that right Dan.

Dan Weirich

Yes, February 11.

Joel Achramowicz - MDB Capital Group

Very good. Well nice expense control and revenue growth and in that margin as well and good luck going forward. We are watching carefully.

Bryan Martin

Thank Joel.

Operator

Next question comes from the line Michael Coady with B. Riley, please proceed.

Michael Coady - B. Riley

Thank you and good afternoon everybody.

Unidentified Company Representative

Good afternoon Michael.

Michael Coady - B. Riley

And you have talked previously about changing the contractual terms on the Virtual Office business such that once your gear is up you don’t go month by month, you would roll over into the new year. Have you started to implement anything like that, I believe, on the Virtual Office or residential side?

Bryan Martin

Yes we have. We are actually in the process of rolling out both two and three year contracts where we will have written contract with the customer, there will be guaranteed commitment term and associated with that, a kind of 10% to 15% discount of the monthly service fees and again I think with reference customers we have and some of the customers we have talked about this type of plan this is something they are very interested in.

Michael Coady - B. Riley

Okay. And talking about getting customers to replace or exiting a equipment whether to save their money in their telecom solution. It seems though your primary customer would be a new startup small business as opposes to going in to an existing business unless it is parameter to upgrade or its time for them to renew a lease or something like that. So I guess: who is your typical customer? Where are they in that regards to that cycle?

Bryan Martin

Yeah I think one of the early questions we get from all our customers that have an existing phone is certainly, can I keep my existing phones or some of my equipment, and we do support regular analog phones like the telecom speaker phone, I am talking on right here, but in general we recommend that the business change out their phones and use the phones that we've integrated with Virtual Office.

When we tell them that those phones are only $100 per station that usually gets us over any objection, because if you look at the cost of traditional PBX phones, and even the new IP phones, even some of the low-end ones, they can easily run $300, $400, $500 per phone. Some of these companies will still make you buy the power supply for an extra $75, our friends up the street on Tasman in Santa Clara are kind of famous for that.

So I think these businesses have already seen those quotes. They know how much some of those IP phones are, and when they hear that our solutions only requires $100 investment in the phone, and by the way you can take the phone with you and keep using it as a regular phone, if you do ever leave our service. There is really very little objection on that.

Michael Coady - B. Riley

Okay. Why was the cost per acquisitions? Is that going to be ex-cost business up?

Bryan Martin

It was -- we spent a little bit more money on advertising this quarter, and a lot of that advertising was kind of loaded in the latter part of the quarter, so we definitely account for it in the period that this incurred, but typically we see a little bit of lag before that takes into account.

And the thing that we're seeing is that the dollar amounts that we're increasing for advertising are fairly small in the scheme of things. There was an increase of just slightly more than $200,000 quarter-over-quarter, and so this is something that, I would say that we're not alarmed about.

But as we had a lot of questions in the last quarter about why did your average revenue per company decline from Q1 to Q2, and as you just saw in Q3, it kind of bounced back. So I think that these numbers are going to bounce around in a range, and I would say that this is maybe a little higher end at the range. But I don't know what's going to happen in this quarter but that's the primary reason.

Michael Coady - B. Riley

Okay. Fair enough and regarding advertising: where is the extra spend going more banner ads?

Bryan Martin

Well. So our model is to generate leads and they are generated in a wide different variety of advertising mediums. Primarily it is web related leads where we spend the money and if you spend more you get more leads and so just kind of increasing the budget that we have in those particular areas.

The more traditional planned partnerships that we have in the past I would say there is a probably flat whereas the website is where you are seeing more of it.

Michael Coady - B. Riley

Okay. I actually have seen more 8x8 ads, but I don't know just because I'm more aware of them or because I am seeing in a way they were good. Just one last question regarding that FAS 123: can you just break that out and by line item?

Dan Weirich

Yes. Just give me just a minute on that.

Michael Coady - B. Riley

I know it's pretty nominal but just thoughts for my numbers?

Dan Weirich

Yes. So it is $7000 is in cost of service revenues, $6000 in cost of product revenues, $59,000 in research and development and $252,000 in SG&A, so total of $324,000.

Michael Coady - B. Riley

Okay. Thanks I have just one more thing. Bryan as it relates to the patent sales, was this something that came about opportunistically or have you increased your efforts in monetizing patents and if can put a dollar figure on that just sort of your total patent to apply on with: what's the next and most likely step? Additional patent sales or licensing [your wares] or what’s there in the plan?

Bryan Martin

Yeah I think all of the above. We've had efforts underway I will say, they are kind of concerted quarter to quarter depending on how busy we are just running the business, but certainly we recognize the value of the portfolio, we recognize that to-date we haven’t been very successful in monetizing our portfolio and its something that we have been focusing on a little more, I would say the second half of this year especially with all the noise going on in the Voice over IP industry around patents in general.

So its an area we are interested in. This opportunity approached us opportunistically and it was a pretty simple transaction to close and certainly didn't involve any of our patents related to our current business in the Voice over IP space. But we are going to continue on all fronts as I mentioned in our prepared remarks and hopefully this will be the first of many results to report in the future.

Michael Coady - B. Riley

Great, thanks, nice number. Keep up the good work.

Bryan Martin

Thanks Michael.

Operator

Your next question comes from the line of Mr. Chris Lahiji with LD Micro, please proceed.

Chris Lahiji - LD Micro

Bryan and Dan excellent quarter.

Bryan Martin

Hi Chris how are you?

Chris Lahiji with LD Micro

Fine, I wanted to say that the big event of the year is going to be the LD Micro conference April 13, which is 10 miles from Joel’s office, I'll make sure he gets an invitation.

Bryan Martin

All right.

Chris Lahiji with LD Micro

I wanted to question you guys, I mean Colby, Joel all asked their questions, but my question is on the mobile offering that were just announced. What type of attraction are you guys seeing? Are you happy with the initial result? And: what are you ultimately going to do to let more people know about this product?

Bryan Martin

Yeah I am very pleased with the initial results. All of our reviews have been positive, all of the customers I have spoken with have been extremely positive. We've certainly got a lot of Blackberry users in the financial professional space that are using it, and have written about it.

So we're very pleased on that side. We launched at Thanksgiving week, so we don't have any numbers to report here. We're still in the early days there, but I do think the free trial offering that we rolled out at CES, it definitely had some good [legs], and it's a risk-free way to just put it on your cell phone.

You just text the message to us at 408-386-4137, and we'll respond with the software you need to start using the service immediately, and we give you $2 of free calls. So you can immediately call someone that receives them and make sure it's going to work on your phone and hear how great it sounds.

So we have people do that right in the boot of CES, and then they would make a couple of calls, and they come back over to us and say, okay, I'm ready to sign up. So that seems to be a great avenue.

We're looking at the pricing, certainly for the non-Packet8 subscribers out there. We think we might want to tweak that a little to make it a little more attractive, maybe bundle it up in a different way, and we'll probably do that in the next month or so.

But beyond that, it's really more about just adding more features to it. I think about half the people we talk to at CES wanted to know when they could it outside the US to make calls to other countries or backend of the US, and that's a service that we're actively working on, and we want to rollout as soon as possible, because I think again that's going to have great demand.

Chris Lahiji with LD Micro

And from my understanding this was proprietary technology that we have developed and we have the proper IP where other companies cannot replicate what we're doing.

Bryan Martin

Yeah. We work with a third-part for the software that actually runs on the mobile phone and that enables us to outsource all of the headaches of dealing with all the compatibility issues, the things like Google Android, will hopefully solve in the future.

But today making this work on all these different makes and models in cell phones is a Herculean effort and something that we were glad to let someone else deal with but all of the ways we connect into the Packet8 network and how we carry that all from there, certainly deal with the billing issues and all of that, that's all within our network and our software and as you might expect where we are working on some patent applications around the work we've done on the mobile stuff as well.

So there is many ways to protect it but I think we've looked at the competitors that are out there and I think the strength we bring to this offering, number one, is that it doesn't change the user behavior and I think these little soft plans that you have to run or you have work within a piece of software, import your context. All of these things that make using other services unnatural, we saw, because you can just dial a number on your phone and it goes to our network and you don't even think about it.

But the other thing that is unique is most of these players that were competing with are startups and they are having use companies like Skype to actually carry their calls and what we are bringing into the space is a very mature, very large network that does hundreds of millions of minutes a month and that's giving us an advantage I think for those on the prices we can offer as well the quality of calls.

Chris Lahiji - LD Micro

And is it possible to call Iran? Because I have about 200,000 cousins there that I need to hook up with?

Bryan Martin

Absolutely, that is one of our target markets that we are advertising to and we were picking some of these different regions and ethnic groups because I agree the demand I think would tend to be unlimited with some of the applications there.

Chris Lahiji - LD Micro

Excellent, thank you so much and best wishes moving forward.

Bryan Martin

Thanks Chris.

Operator

The next question comes from the line of Mr. Ray Archibald with Kaufman Brothers. Please proceed.

Ray Archibald - Kaufman Brothers

Good afternoon and thank you.

Bryan Martin

Good afternoon Ray.

Ray Archibald - Kaufman Brothers

I just have a couple of follow-up questions, one on the MobileTalk beside from existing Packet8's customers: can you kind of walk us through what the go-to market strategy is? Because obviously this has a to see that says that very extensive market opportunity beyond the current customer base.

And then that other thing is more of housekeeping item. If you could just refresh my memory: when you bring on the SunRocket and NetZero subs were they re-priced at your pricing? Or: did you just continue with the pricing that was offered by SunRocket and what would be the implications then if that's the case of churn going forward?

Bryan Martin

Okay. So, on the go to market strategy with MobileTalk. What we launched to-date is really a direct offer. We are running an advertising campaign with some small dollars on the internet. So you will see some MobileTalk ads out there.

But our thrust is really to target these ethnic communities, where there is built-in demand to call overseas, and it's being done today with calling cards. We simply want to enable, very easily, and very inexpensively. The ability to do that off the cell phone.

So we are doing a lot of advertising in some of these targeted kind of community newspapers that the groups read. We are doing that for certainly Iran, because we have a number of Persians that work for 8x8 here in Santa Clara. We are targeting the India community, the Philippine community. So that's really where the thrust of our effort is right now.

It's kind of the same way the calling card types of products have traditionally been brought to market. I think there is an opportunity though to get some of our channel partners using MobileTalk as kind of incentive. So, I would love to get to a point where one of our office retailers with every line of Virtual Office or every IP phone that is sold in the store. They can give out one or two, free MobileTalk accounts or something like that. So I think it's a great spit, to all that we can use in the channel and so we are working towards that. We haven't rolled that out yet.

The second question, with the SunRocket subscribers. It's a little complicated, the migration offer that they had and we use similar with the folks at NetZero was they could either join our services at $19.99 per month on a pay-as-you-go basis, or we did offer an annual plan, and we saw about what then 60%?

Dan Weirich

Yeah.

Bryan Martin

Then 60% of their subscriber base actually picked up our annual plan, which they prepay a $199 to us, which was the same price that SunRocket offered their annual plan out. The difference being that on the 8x8 plan, you still do pay a small monthly fee to cover taxes and surcharges and regulatory recovery fees and so forth.

And that actually adds up over the year to a substantial amount something in the range that varies depending on where the service address is, but something like $10 to $20 over the course of the year. So that is SunRocket didn't do that, they had all-in price, and certainly had some inflexibility if the rules changed in the middle of the year, they didn't have a way to recoup that new cost center and we do.

You know subscribers complain a little bit about it, because they don't like having that charge every month on their card, but we just explain to them we have to do it, because we don't know what the SEC or some of the these states are going to do next to Voice-over-IP. So those are the two offers that we use.

Ray Archibald - Kaufman Brothers

Okay. Then if I could just follow-up, one more follow-up on the MobileTalk.

Bryan Martin

Sure.

Ray Archibald - Kaufman Brothers

The focus on ethnic communities, partner such as MoneyGram and Western Union: have you considered them or not? Or: if not, why not?

Bryan Martin

Yeah, we're in the process of really rolling out kind of a partner with channel strategy around MobileTalk. We do have existing partners, people like American Wireless and folks that have carried the Packet8 product, and certainly we're looking to add MobileTalk to their offered services, but I'd still say it's early days. And we certainly haven't talked to someone like the names you mentioned, but I think those are both good suggestions, and I'm sure our channel teams will pick that up right after this call.

Operator

Your next question comes from the line of Colby Synesael with Merriman. Please proceed.

Colby Synesael - Merriman

I just have one quick follow-up, the last three or four or maybe five quarters that you broken out Virtual Office your net ad has been roughly a 1000, and I was just going back to my notes and this time last year you guys talked about: how? You talked that that might be able accelerate. Can you just explain to us why that has been so consistent over the past year? And: is there an opportunity to accelerate that or it’s just a matter of pouring more caution to advertising? Just a little more color would be helpful. Thanks.

Bryan Martin

Yeah that's a great question Colby. That's what we fixate on around here quite a bit and I would say at least it's been consistent, so at least we have a baseline there but certainly we'd like to see some growth in those numbers as well.

And a couple of things to point out if you assume just flat churn over the last 12 months, we are having the ad about 360 more gross companies each quarter in order to keep that net number flat and so there is growth but you don't see which is masked by the fact we lose.

Companies do churn and I will say that one of the ways beyond just increasing advertising, which we are going to do is as our cash flow increases, we have a big focus this year that it really reduce the churn rates. There is about a third of the churn that we probably don't control because its businesses that really downsizing and going out of business and I don't think they go out of business because of their phone system.

So I don't think there was a lot we can do for those customers but we are focusing in on different areas including providing the tools we need to really allow this customers to solve any local network issues they might have. Dan mentioned in his remarks the VoIP on packet8.net site.

We are also working on basically at the end of every call as we like the billing record for the call we are reporting a bunch of quality information about that call. How good the latency and buffering and jitter was on the call. So that we can actually begin to mine data in real time from our network of customers that might be having quality issues.

One of the things we found is, a lot of these customers won't call us when they have quality issues, they just assume, they are paying so little and they go, well this kind of Voice- over-IP its just like Skype and that's the price I pay for having Voice-over-IP and so if they don't call us we can't solve their issues and I can tell you 99.5% of all this issues is related to quality issues we can solve but it assumes that we are able to talk to the customer.

So we want to get a lot more proactive about calling the customer. We've also continued to automate and streamline a lot of our internal processes, our billing engines are getting faster and better and customer service in general. I think we are doing a great job.

At this CES, I certainly had one or two customers with data who would come up to me and they had an issue that they wanted us to solve that. I would say the ratio of happy customers that just wanted to come up and shake our hands and thank us for providing service was way up and so I have not been to a CES show where we saw so many happy customers and so few customers with issues and I think that's just a testament to the job we are doing in customer service.

So we are going to continue to try to improve metrics and if we can ever make it a significant dent in that churn, even if we keep sales flat you will see an increase in that company account, it’s a very powerful lever we have to work with.

Colby Synesael - Merriman

Thank you.

Operator

Your next question comes from the line of Mr. Naved Rasuli with LD Micro.

Naved Rasuli - LD Micro

Hey, Bryan, Joan, Dan good quarter. Congratulations.

Bryan Martin Thank you Naved.

Naved Rasuli – L D Micro

My question is pretty much not even touched on, but I'll try to look to you. I basically want to ask you about MobileTalk, you mentioned maybe Bryan that these international newspapers are what you have been targeting. I was just curious to see the feed back on that. Is it hard getting people away from these calling cards? Are they skeptical things of that nature? And, in the future: do you think that more of the ad budget will be allocated to a more aggressive marketing campaign that kind of builds your market share?

Bryan Martin

Yeah. I think MobileTalk is a service, one of the reasons we're so excited about it is you don't have to have special hardware from us in order to start using the service. So literally anyone carrying the cell phone around in their pocket and there is 240 million of them in the US, can basically start accessing our services right away, and we think it's a great way to introduce people to the Packet8 services and Voice-over-IP in general, so that we're able to up-sell them to a home line or business line later.

And so yeah, we're going to be pretty aggressive on getting MobileTalk out there, because it's just the great way to try our network. I think it's too early for me to try to qualify difficulties or what the challenges are in that channel.

We're really just started running these ads; we have only had about a month of even having the service out there. The free trials has only been out there for about three weeks, so I think next quarter, we might have a better update for you.

But in general, I think there is certainly a skepticism when someone who does make international call on their cell phone, and they think they are getting a great rate from their carrier, and I say where do you call and they say why, I'm paying extra $5 a month to get super saver international plan, and what are you paying per minute? And then say, well, I'm paying about $1.02 a minute, and we look up, what the corresponding rate would be on the Packet8 network, and it's typically in the $0.02 to $0.05 a minute range.

And at that point people can't believe that they could possibly save that much and still have the convenience of their cell phone. So I think it's just an issue of getting the name out there, of letting people know how easy it is to use the service that they don't have to change the way they use their cell phone in any way and like I said we were signing people up right on the show floor taking credit card numbers in our booths. So attraction of the service kind of speaks for itself.

Naved Rasuli - LD Micro

Real, it's fantastic and: any timeline for, the initiative of being able to make international calls when you are out traveling internationally or is that still far off?

Bryan Martin

No, it's pretty close. I don't have an exact timeline but certainly in the next, it's within the next three to four months at this point.

Naved Rasuli - LD Micro

Okay. Because that would create, I mean: just a huge loyal customer base in my opinion if you are able to offer that for people traveling on business and all sorts of things.

Bryan Martin

We agree and I think we just we are exposed to something like half of the attendees to the consumer electronic show come from outside the U.S. So we had a huge international audience at the show and that was like I said the number one question they were asking.

Naved Rasuli - LD Micro

Great. Well great work and thank you for answering my questions Bryan.

Bryan Martin

Very good. Thank you.

Naved Rasuli - LD Micro

Bye-bye.

Operator

Your next comes from the line of Paul Packer with Globis Capital. Please proceed.

Paul Packer - Globis Capital

Hey guys how are you?

Bryan Martin

Good, Paul.

Paul Packer - Globis Capital

Quick question for you I know you were taking about: how your amount of NOLs you guys have? Just offer that comment. Do you guys believe you could be sustainable here in positive cash flow going forward?

Dan Weirich

As we said that's certainly our goal and certainly one of the reasons we threw the NOL remark into our prepared comments was we want to remind people that we are sitting on some large NOLs and should give us some tax preferred status here for sometime in the future.

Paul Packer - Globis Capital

Okay. Going forward just on the MobileTalk: are you guys be throwing out type of numbers like you do -- are doing on the -- for number of subscribers like you are doing for the Virtual Office?

Dan Weirich

Yeah I think as we get more of a base established there and the numbers becomes significant we will certainly breakout various metrics the way we do with our other services.

Paul Packer - Globis Capital

Okay, great. Thanks guys.

Dan Weirich

You're welcome.

Operator

Your next question comes from the line of Mr. William -- I am sorry [Bryan Horhay with Horizon Management]. Please proceed.

Bryan Horhay - Horizon Management

Thanks. A couple of questions. You said that you were able to step up advertising somewhat this quarter. Does that reflect, some new [venues] of the web that you guys have found that are productive or that just reflect kind of growth in the web in general? Can you add any color to what's behind that?

Bryan Martin

Yeah I think it's a mixture. We certainly did some targeted geographic advertising. We did and certainly added the MobileTalk advertising for a little bit there. The internet advertising is something, where we were constantly refining and even changing where we run these ads in order to keep it effective. So we like to have between 11 and 15 campaigns that are very effective campaigns, and if a campaign starts becoming less effective we remove it and take a campaign that's on the ramp up and stick it in.

So there is a lot of places. We are very addicted to this internet advertising because the feedback is in real time. It's reaching a customer base that is relatively, technically sophisticated. They can understand that some of the messages we are putting out there in terms of how our services work. And we are just continuing to try new and different things to reach a wider audience and make our advertising as cost effective as possible.

Bryan Horhay - Horizon Management

So, this is just an incremental progress I guess on trying to find new places to generate leads?

Bryan Martin

That's right. And it's we also limit it based on just what our cash flows will allow. So as the cash flow continues to increase, we certainly intend to continue to increase the size and reach of our advertising.

Bryan Horhay - Horizon Management

Okay. With the liquidation of CompUSA do you expect that to have any measurable impact on Virtual Office revenues or growth of subscribers, and are there any potential fill-ins for them?

Bryan Martin

Yeah, so we actually -- we were with CompUSA on the consumer side, two to three years ago, and then we reengaged with them in November. And then when they started their wind down on the 7th of December, we had equipment in their stores, but we hadn't even really got it going yet. So effectively there was nothing in the quarter related to CompUSA, an so therefore we're not going to miss out on -- we're not going to lose anything that we had, but we're going to miss out on the opportunity that we had with them.

But yes, so as we've mentioned before Office Depot is working well, particularly when we have encamped with Office Depot. And as we've mentioned in the past, we definitely are in discussions with the other big name retailers that are competitors of Office Depot.

Bryan Horhay - Horizon Management

Okay. Dan, I think you mentioned that there was a 90% renewal rate on annual, as plans came up for renewal on their anniversary: what had that been historically?

Dan Weirich

Well, we rolled that out -- that product out in August of 2006, so we started the renewals in August of 2007, and so it's been very consistent for the five months that we've been doing renewal.

Bryan Horhay - Horizon Management

Okay. And then I know it's new and you don't want to get too far out in front in terms of guidance, but I mean: have you guys thought about what would be the success for the mobile product? Say as a percent of revenue for this year. What would make you guys particularly happy with the rollout?

Bryan Martin

Yeah, I don't think we've a number there. But as I hinted I think it's a service that could certainly get into some big volumes and I think that would be our hope. But, again I think, one of the most valuable aspects of it, just because it is kind of a lower margin product. We are trying to make this international rate as cost effective as possible.

But I think it's invaluable as a tool to introduce people to the Packet8 service and: how well our network works? How good the call sounds? How inexpensive they are? And I think our bigger hope would be that it becomes a significant lever and lead generator that can be consumed by some of our other services and up-sell a customer from MobileTalk to a fixed line solution.

Bryan Horhay - Horizon Management

Okay. And then finally, I think Dan, you mentioned that the product gross margin was negative 15% due to some promotional activity at the end of the year. Is that something you expect to continue or what? Where do you see product gross margin settling out here as we go forward?

Dan Weirich

Well, so in the first quarter it was negative 4% and then in the second quarter it was negative 77% because of the SunRocket piece. But if you remove the SunRocket segment, it would have been a negative 4% .And so we ran promotions over about a 10 day period around Thanksgiving and then but at a 10 to 15 day period around Christmas.

And so, I mean, I would hope that it's going to be closer to the negative 5% number then the negative 15% number. But in kind of absolute dollar terms, it's a small dollar amount but the 10% difference in percentages, this sounds a lot bigger than it really is in dollar terms. So it is a little hard to determine where it is going to come out.

Bryan Horhay - Horizon Management

Okay, thank you.

Bryan Martin

Thank you.

Operator

The next question comes from the line of William Burnham with Inductive Capital. Please proceed.

William Burnham - Inductive Capital

Hi guys just a quick question for Dan first on cash flow from operations: what was that in the quarter?

Dan Weirich

It was for the nine-month period it was 2.6 and…

William Burnham - Inductive Capital

Okay. So, that's about like a one…?

Dan Weirich

Yeah it was 1.6, yeah.

William Burnham - Inductive Capital

1.6 okay

Dan Weirich

For the quarter

William Burnham - Inductive Capital

And that's up from around 750 to 800 in Q2?

Dan Weirich

Yes. For the six months of fiscal '08 it was about positive 900 or so.

William Burnham - Inductive Capital

Okay. And Bryan: could you just talk a little bit about maybe outside the retail partners, are there indirect channels that you guys are pursuing in addition to the retail side for the small business effort? Or: you really just focus sort of online and retail at this point?

Bryan Martin

No there are other partners. It's historically been a pretty low percentage of our business sales. But we do have catalog partners people like Hello Direct that put out a monthly magazine of kind of office productivity tools. We work with some just standard resellers and bar and compensate them on a kind of per [download] basis.

I think historically the bar channel wasn't really that successful for us because our services and certainly the equipment are priced so much lower than a like a traditional Avaya, PBX, but the [prom] was that the telecom bars would rather sell those expensive boxes and get a $1,500 commission rather then sell Packet8 Virtual Office at kind of a $500 per month service fee, and get a very small commission.

But I think, one of the interesting dynamics in the space is, we're seeing so much competition and price erosion in the legacy PBX offerings that I think, we're seeing a little bit of renewed interest from some of these bars, both because they are beginning to recognize that hosted Voice-over-IP is such a unique proposition, and then it really does fit very well at the small business solution, as opposed to one of these other boxes.

But also as their commissions start coming down from the legacy solutions, we're hoping that we will actually begin to see more sales through some of those channels because we're going to get a little more competitive on the spread and what we can pay there or what they are going to make there.

William Burnham - Inductive Capital

Yeah. And I guess, just finally in terms of the patent portfolio and some of the actions you guys have taken there. I noticed in your prepared statement in the press release, you had a covenant, not-to-sue agreements; you did not have cross-licensing agreements in there. I was just wondering: if cross-licensing is on the table or not?

Bryan Martin

Yeah. We do cross-licensing as well. Cross-licenses tend to not end up in numbers on the income statement at the end of the quarter. So, but yeah, we do those all the time as well.

William Burnham - Inductive Capital

You did do this all the time, okay.

Bryan Martin

Yeah.

William Burnham - Inductive Capital

Thank you.

Bryan Martin

Thank you.

Operator

At this time, we do not have any more questions in queue. Now I'll like to turn the call back over to Mr. Martin for closing remarks.

Bryan Martin

Okay. Thank you, Johaida. Thank you everybody for listening. If you are not already a customer of our services, I encourage you to signup today for Packet8 services for you business, home and mobile phones by visiting us at www.packet8.net.

Thank you very much. Go ahead, Johaida.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: 8x8 Inc. F308 (Qtr End 12/31/07) Earnings Call Transcript
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