2021 Will Be A Turnaround Year For 8x8

Summary

• 8x8 had good Q3'21 performance, but free cash flow and profitability are still a concern.
• The CEO and chairman of the board replaced in December. This follows CFO replacement last June.
• Consolidation onto a single platform by fiscal year end will improve bottom line although the company will likely incur short term costs as a result.
• The stock is undervalued on a relative basis but the ESE (forward-looking Rule of 40) score suggests that the new management has a lot of work ahead of it.
• 2021 will be a turnaround year, but investors should take a wait-and-see attitude.
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(Source: Shutterstock)

Digital transformation has been front and center this last year as companies were forced to adapt to a new reality. One of the industries that have benefited most has been cloud communications services. Among those companies servicing this industry is 8x8 (NASDAQ:EGHT). Unfortunately, the company's performance has not been stellar, certainly not relative to its competitors. This is not really a surprise as I have written before about the company's struggles, particularly with its free cash flow margin.

Management Turnover

When there are major management changes, it's usually a sign of trouble. In the case of 8x8, there's been a complete changeout of management, and this is likely due to the company's anemic financial performance in recent times. While the company has certainly grown, its expenses appear to be out of control.

The latest turnover was the replacement of CEO Vik Verma by former RingCentral (RNG) COO Dave Sipes in December 2020. The new CEO appears to be ideally suited for the job based on his previous experience within the industry. The company also installed a new chairman of the board although it isn't clear what the circumstances are for that changeout. These latest moves follow several previous management changes, including the hiring of a new CFO back in June 2020 and more recently a CRO.

Cloud Communications Leading the Digital Transformation Movement

The digital transformation movement was always preordained but it accelerated dramatically in 2020 due to the pandemic. 8x8 provides both Unified-Communications-as-a-Service ("UCaaS") and Contact-Center-as-a-Service ("CCaaS"), applications that are at the heart of digital transformation.

(Source: 8x8)

But the company didn't thrive impress, achieving revenue growth of only 15% YoY in Q3'21, with a significantly negative free cash flow of -19%. Compare this to competitors such as RingCentral which grew revenue by 30% or Zoom Video Communications (ZM) which had tremendous triple-digit growth.

2021: A Turnaround Year

While 8x8's financial performance in 2020 was not in the same league as other cloud communications companies, there's some reason for hope. In the latest quarterly report, it was indicated that the applications will be soon hosted on one platform:

As of December 31, 2020, over 90% of our customers have been migrated to the 8x8 X Series platform and we intend to migrate substantially all of our remaining customers through the end of the fiscal year. These migrations may require us to incur professional services and related engineering costs. While we may not be able to recover these costs from our customers, we believe that we will realize other benefits including reducing the number of platforms that we are required to support and improved customer retention.

This will reduce expenses once complete, presumably after the next quarter. But the statement comes with a warning that analysts should be prepared for 'professional services and related engineering costs'. In other words, expect more short term pain before a run at profitability.

8x8 Stock Chart

8x8 stock had been drifting downward from mid-2019 until December 2020, when the announcement of the new CEO was made, which sparked a breakout to a 20-year high, matching its all-time high achieved in 2000. While the recent stock price movement has been impressive, investors should be wary of near-term events such as vaccine rollouts which may impact digital transformation stocks. Couple that with the platform costs mentioned above, and I believe that it is prudent to take a wait-and-see attitude for 8x8.

(Source: Yahoo Finance/MS Paint)

Efficiency Score Estimate (Forward-Looking Rule of 40)

The Rule of 40 provides a single metric for evaluating both high-growth companies that aren't profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule.

Instead of using the Rule of 40, I'm now using a new technique for evaluating future growth and profitability in a visual format. I call the new metric the Efficiency Score Estimate ("ESE"). The ESE is essentially the Rule of 40 on a forward basis, but using earnings as opposed to free cash flow.

(Source: Portfolio123/private software)

The rationale behind the ESE is as follows. If a company has strong revenue growth, then investors should be able to tolerate some level of negative earnings margin. But if a company's growth expectation is lower, then it should have positive earnings to compensate for the less-than-ideal growth.

The ESE accommodates both young, high-growth companies as well as mature, moderate growth companies. It's much more difficult to score 40% using the ESE due to the very conservative nature of analysts' estimates, and I generally reduce the threshold down to 30%, which typically divides the digital transformation stock universe in half, separating the better stocks from the so-so ones. As can be seen from the chart above, 8x8 scores poorly on this metric, primarily due to lack of expected profitability.

For comparison purposes, I also plotted some of 8x8's competitors/peers that play in the UCaaS industry, including Cisco Systems, Inc. (CSCO), Microsoft (MSFT), RingCentral, and Zoom. Zoom and Microsoft have tremendous ESE scores, while RingCentral and Cisco are both marginally above my self-declared threshold of 30, meaning that they are OK but not exceptional performers.

Stock	ESE	EV/Sales Estimate
8x8	17.33	6.53
Cisco	31.98	3.50
Microsoft	44.84	9.53
RingCentral	31.16	19.50
Zoom Video	48.86	25.73

Click to enlarge

Stock Valuation

For stock valuation, I employ a technique that uses a scatter plot of certain fundamentals to determine relative valuation for the stock of interest vs. the remaining 200-plus stocks in my digital transformation stock universe.

The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward YoY sales growth. The plot below illustrates how 8x8 stacks up against the other stocks on a relative basis based on forward gross profit multiple.

(Source: Portfolio123/private software)

A best-fit line is drawn in red and represents an average valuation based on next year's sales growth. The higher the anticipated revenue growth, the higher the accepted valuation. In this instance, 8x8 is situated well below the best-fit line, suggesting that the company is undervalued on a relative basis relative to its peers. Cisco and Microsoft are fairly valued while RingCentral is overvalued and Zoom Video is extremely overvalued, not surprising given the company's rapid growth.

Investors should realize that valuation is not the end-all of investing particularly when it comes to digital transformation stocks. Frothy stocks tend to stay that way for extended periods of time. Likewise, undervalued stocks tend to be that way for a reason. It's one data point that you should consider, but not in isolation.

Why I'm Neutral on 8x8

8x8 a leading digital transformation company with fairly significant future potential provided that the new management can continue to grow revenue in the face of pretty intense competition and keep costs under control at the same time. The latter is of concern in this case and the issue can be seen by plotting the free cash flow margin. I follow this metric religiously. Unlike earnings, the free cash flow figure can't be manipulated easily and it basically tells you whether cash is flowing into or out of the company. In the case of 8x8, the free cash flow margin is pretty bad, now sitting at -19% on a trailing twelve-month basis.

(Source: Portfolio123)

While there has been some improvement in free cash flow in the last few quarters, it's still quite negative. Until I see some improvement, I'm a neutral observer.

Summary and Conclusions

8x8 provides cloud communications services for both UCaaS and CCaaS, applications that are prominent in the digital transformation that most if not all companies are undertaking over the next several years. The global pandemic has accelerated digital transformation, but unlike some of 8x8's competitors such as RingCentral, the company is not achieving superior financial performance in this environment, at least in my opinion.

While the stock is undervalued relative to its peers, the stock could and probably will stay that way until new management finds a way to improved margins and profitability. Until then, I'm giving 8x8 a neutral rating.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.