Relatively close to time. I know we have a very fixed schedule. I'm Michael Funk from Bank of America Securities, one of the mid-cap software analysts here at the bank. One of the subsectors that I cover is XCaaS. So very happy to once again have Sonalee from RingCentral join us here today. I think it's, what, your third or fourth year?
Third. Go, yeah, starting my third year.
Yeah, exactly. Yeah, so thank you again for joining us.
Thank you for having me, and delighted to be here, and love your coverage of us. So, you know, happy to answer any questions you have.
That's all, it's all good stuff. Thank you. I'm gonna start with a few that we're asking in all of the meetings. They're really just higher level questions, so we can kinda get a sense of the general landscape. And one you're probably getting a lot, but, you know, can you describe the macro-
Mm-hmm [crosstalk]
environment and the impact in your business today versus 6 or 12 months ago?
Yeah, absolutely, and I knew it was either gonna be macro or AI. It was like, take your pick.
AI questions.
Yeah, AI next, right?
Yeah.
So absolutely, and, like, of course, we addressed this on our earnings at the beginning of May, and what I would say is, no real change since then. But let me tell you what I said then and what we're seeing now versus a year ago and even two years ago, when I remember it was, like, literally right around this time of year when we were starting to see certain trends in the business, and we were kinda like: Wait, what's going on? Something's changing. And of course, it was the beginning of that macro that has since, you know, permeated across the entire economy. So what are we seeing now? Really pretty stable versus where we were at the beginning of May when we guided.
And when we do guide, and this is something I've done now for about the last 7 quarters since sort of macro has been an issue for the whole economy, is guide on the basis of a stable macro. And if you think about where we were at the beginning of May versus where we were a year before that, over a year ago, we were seeing macro trends sort of deteriorate a bit quarter-over-quarter, i.e., some of the things that I called out back then were the elongation of the sales cycle-
Mm [crosstalk]
the added levels of approval, CFOs coming into the deal decision, which, by the way, at RingCentral, I can tell you, I get pulled into so many more procurement decisions, RFPs, et cetera. Smaller deal deployments, that was another big one that we saw. And actually, I was just speaking to an investor earlier, and I remember in December of 2022, we saw this unbelievable back-end loading in terms of linearity, so customers just waiting till... You know, you used to say the last month to make the buying decision. Now, then it became kind of the last two weeks, then the last week, and then it, now it's, you know, the last couple of days. But those trends, instead of getting worse over the last, you know, couple of quarters, they've really started stabilizing.
You know, one of the things that we were really proud about in our last earnings, and I think that the Street really sat up and took notice, and, you know, sell side and buy side alike, is just what we managed to achieve in our enterprise business. So a real stabilization in terms of the ARR growth we were seeing there. And, you may ask me a bit more about it later, but, you know, it was the fourth consecutive quarter of 13%+ ARR growth. And, you know, that stabilization is something that we're continuing to see. And then the other thing I would just call out is, and we're not alone here, I think there is a bit of a dichotomy between enterprise and SMB.
Although I think we more than held our own, if you look at, you know, our last print, we are seeing SMB being slightly more impacted by the economy. I think it's this, you know, notion of inflation staying persistently high and rates staying higher for longer, and, oh, you know, we were supposed to have this rate cut, and then it never happened. I think that's impacting that part of the economy more. You know, we are a very diversified business. We have an over $1 billion enterprise business, but we also have a really large SMB business. So, you know, we are seeing slightly different trends there, but what I would say is fairly stable, and that's macro. You know, this, that's notwithstanding the fundamentals of the business.
I asked one of your competitors this question earlier after the first one, 'cause it came to mind. There are really three separate potential factors here, right? It's, I mean, first would just be that, you know, customers they provisioned XCaaS during COVID to meet the work from home needs of all their employees, right? They scrambled, they added the seats, and then-
Yeah [crosstalk]
figured it out later. And that's one thing where maybe those are, those are going away. That's number one. Second, you could be seeing pressure from headcount reductions in 2023, 2024. That would indicate that, you know, we're lapping that and potentially feeling less pressure today because headcount reductions have been less in early 2024 than they were in 2023. And then the third is just the broader macro, which is my first question, which is rates are higher, CFOs are tighter. There's more approval required to get a deal done.
Yeah. [crosstalk]
But you could have a pig in the python effect, whereas rates come down, as CFOs get more comfortable, then it loosens up the deal flow. Can you help me think through how you think about those three different factors and the impact on your business?
Yeah, and it's great the way you laid it out. I might borrow that framework. So firstly, like from our perspective, and you may ask me about margins later, but like, we took the opportunity over the last two years to become dramatically more efficient. And, you know, I do believe as a CFO, that the best way to drive value for all of you, for shareholders and stakeholders, is to, you know, deliver efficient growth. So even if and when the macro lifts and, you know, it's a great Goldilocks economy, I think the future is still about driving efficient growth. So that, that can't change.
What we've done over the last two years in terms of, you know, looking at our cost of customer acquisition and looking at our, you know, overall spend envelopes on things like procurement, I mean, we did massive, massive savings and reprioritization, but also rationalization of, you know, multiple vendors. That's another thing that I think, you know, happened during this, this latest macro. When I look forward and when I think about, you know, what we're doing, apart from driving that efficient growth and continuing to drive that, is really looking at balancing growth and profitability.
You know, I believe that if there is flexibility to use some of those efficiencies that you managed to get from, you know, either headcount or delaying spend, you know, part of it should go to the bottom line, but part of it should be reallocated to. That's what we're doing at RingCentral, to areas where you see outsized growth opportunities or outsized ROI opportunities. So, you know, to answer your question, yes, we absolutely did see, you know, customers rush to deploy XCaaS during the pandemic. But I think we're slightly different having sort of our history in UCaaS as opposed to video. I think the biggest rush was deploying video and actually cloud phone or PBX in the cloud, was something that was already fairly well entrenched in March of 2020 when the pandemic hit.
So I remember when I got to RingCentral, I thought, "Oh, there's gonna be this renewal kind of wave, this wall of renewals, three years when we lapse COVID, and when we lapse three years of COVID." And that actually wasn't the case at all. It was slightly elevated, but it wasn't anything like what I expected. And again, that's because of structurally, UCaaS and certainly cloud phone, which is what we led with, was already very much being used by SMB and enterprise. You know, did people over-provision, which I think is what you were talking to? Like, the answer is yes. I mean, people over-provisioned. That's not just UCaaS and CCaaS. I think that's. You can say that across many software classes, including us.
Like, we over-provisioned in certain areas of—you know, I'm obviously a big buyer of software. You know, we use a lot of vendors. But I think that that is now, as you say, working its way through. And I think that that will absolutely, you know, as we see the economy improve, which, you know, it's not a question of if, it's when, I do think we see that kind of pent-up demand come back, and I think you see CFOs and CEOs and, you know, chief strategy officers wanting to invest for growth. And, you know, we certainly have been continuing to invest in the cycle in terms of new products and innovation, to ensure that we have amazing... You know, we're a multi-product company today. We have amazing products to sell to our customers.
So I, I would, I would agree with you that, you know, as, as we kind of hopefully move on from that era of, you know, cost optimization, that seat growth and, and, you know, software spend will, will follow suit.
That leads my, my next question. I think it was actually, I think it was three years ago at my conference when you were talking about guidance and, you know, your, your nature, conservatism and guidance, but maybe you wanted to guide a little bit closer to the actual, rather than having a 10% delta every quarter, right? Thinking about 2024, and I can-- you've certainly outperformed peers in terms of revenue growth. That's undeniable.
Yeah.
But presumably, you still have conservatism in your guidance. Where are the levers do you think you can pull to exceed guidance? Is it, is it lower churn? Is it higher ARPU? Is it higher growth additions? Where, where is the opportunity to outperform that guidance, which is presumably still conservative?
Yeah. So, great question. I can't speak specifically about the guide, apart from the fact that, you know, that is our guide and-
Hypothetically, why it's conservative?
You've characterized me pretty well in terms of-
Yeah. [crosstalk]
I have, if you look at the last kind of eight or nine quarters, guided closer to the pin. And, you know, what I would say there is, what could drive, you know, outperformance? Obviously, any improvement in the macro. The guidance was based on a stable macro, which is what I'm still seeing. But, you know, within that, net retention is something that I'm very focused on. You mentioned churn. In the last earnings call, I talked about seeing a slight improvement in gross churn. You know, part of why we made the investments in our RingCX, which is our proprietary CCaaS product, and RingSense for Sales, which is AI, and our events platform, the reason we've invested there, is because we want to upsell to more of our customers.
You know, you called out the seat growth point earlier. If customers are optimizing their own headcount and they don't need more UCaaS seats, then what other cool stuff can we sell to them? That is, you know, very squarely in our swim lane and areas where we know we can bring value to customers, and that's in these, you know, CCaaS, AI and events platforms. So I think if we saw better adoption of our new products and, you know, I guided to at least $100 million of ARR from new products by next year. But of course, you know, we're seeing very good adoption. But if that ended up being, you know, better than expected, that would be a lever.
The other thing I would say is on the churn side, we've made significant investments in customer success. In some ways, you know, I suppose it should have been obvious, but we had a very small proportion of our overall customer base that had dedicated customer success managers. And, you know, lo and behold, it turns out that you're more likely to churn if you don't have a customer success manager associated with you. So we've changed our coverage model. For a pretty small incremental investment, we've gone from 40% of our customers having customer success associated with them to 80%. And, we're seeing that strategy bear fruit, like, if that ended up being better.
And then, you know, we work with strategic partners, as you know, and you know, we have a very, very diversified go-to-market. And one strategic or one go-to-market motion that we talked about recently on the earnings call is our global service providers. So think telcos and cable operators who have huge installed bases of customers. That part of the business is growing faster than the overall aggregate growth of the business and where I guided. So you know, if that continues to really execute and do well. And then finally, you know, the enterprise, as we called out in our last earnings, you know, we we've adopted this verticalization strategy and these golden verticals that we've laid out.
I think we've proven to ourselves and hopefully to all of you, that we have a right to win in these verticals. I'll just remind you, it's healthcare, retail, financial services and professional services, and state, local, and education. And you know, we have become a lot more focused on how we spend our marketing dollars to ensure that we continue to win in those verticals. But if we saw, you know, continued strength there, I think that would be another lever.
Yeah, it's all a great color. Thank you for that. And you've done a tremendous job in driving free cash flow. You should be congratulated the last few years and, you know, exceeding the estimates there as of most of your forecast. But how do you think about reallocating that capital back into the sales motion? Presumably, you have some weaker competitors now that are struggling and don't have the capital to put into sales and marketing, don't have the cash flow, excuse me, that you do. So how do you think about taking now as an opportunity to claim some of that market share, since you do have a much stronger cash flow position?
Yeah. So thanks. We do. So just to ground everyone, we've guided to $440 million-$450 million -- $445 million of unlevered adjusted free cash flow for the year. And actually, if you look at. And that's about an 18.5% free cash flow margin. And I'm just gonna -- even though you didn't mention the share count, I'm just gonna put it out there. In terms of free cash flow per share growth, I think we're also an outlier. Outlier in a good way. At the midpoint of where I guided, you're looking at about 36%, year-over-year free cash flow per share growth.
But as you say, with that free cash flow, you open up all sorts of opportunities to go out and spend the money, and deploy the capital. So we think about capital allocation in a dynamic way. One, we absolutely need to continue to invest organically, not just in sales and marketing, but in innovation and R&D. And even when we did, you know, a fairly significant cost optimization program, when we took margins from 10% to 20%, we were really careful to protect R&D, because, you know, these new products ultimately are what is going to drive our future growth. Although they're small today, they end up being very accretive.
And you know, we can talk about the pricing, but, you know, we're pricing incrementally, and those products are priced above where our average aggregate ARPUs are. So the investment in innovation has to continue. Secondly, on sales and marketing, where I might disagree with you a little bit is, I believe, although we've come a long way from 46% to 40% sales and marketing as a percentage of revenue, it's still too high today. So, I think we need to continue to find ways to bring down customer acquisition cost. And part of that is, you know, one of the programs that you've heard us talk about before is the Ignite program, where we give more of the end-to-end sale process to our channel partners. So...
And when I say end to end, I even mean after-sale customer support. And what that does is it means that there's less hands, less people touching a given sale. So the unit economics of that go-to-market motion ends up improving for us, and we need to keep finding ways of doing that. And, you know, as you can imagine, as CFO, I spend a lot of time looking at our various go-to-market motions, and we know where the unit economics are best for us, and I try hard to pivot.
You know, on a 2 - close to $2.5 billion ARR base, to change that does take time, but what we are trying to do is pivot towards higher unit economics, or higher unit gross contribution margin ways to market. But when I look ahead, and I - you know, you look back, this is where we've come from, 10%-20%. This quarter, we're guiding to 20.7% operating margin. You know, for the full year, we're guiding to 21% operating margin. The quantum of operating margin improvement you're seeing this year is nothing like what you saw last year. And I think that is what getting the balance.
That, that's where we're getting the balance right, is as we look forward, it's important to ensure that we have flexibility, particularly if the macro, you know, lifts or, or improves, to go out and, and, invest in that growth. And, you know, we do have some competitors and, you know, I don't need to name them, but I think if you're subscale, it's really hard in this market. But make no mistake, it's still a very competitive market. So again, I need to make sure I have flexibility because ultimately there's almost always someone who breaks rank with the channel or with the... And, and, you know, we need to have the flexibility to make sure that we can maintain our growth where we've guided, and, and hopefully not just stabilize it, but accelerate it.
I like to keep a little bit of cushion to be able to make those investments. So, you know, conservative or not, what I would say is that, you know, the way I think about balancing the two is, I allow a degree of flexibility to be able to go after those opportunities as and when we see them.
Are people breaking rank?
So- [crosstalk]
I feel like last year there was some scuttlebutt about people breaking rank late in the year and telling me to cut you off.
Yeah, yeah. So, okay, well, right now, like literally right now, no. But that doesn't mean it won't happen tomorrow. Like, I always, you know, it's, it's a dynamic market. It just is. And, you know, people do it for various reasons. I think sometimes really short-term reasons, which is not how I like to run the company, but, again, we need to be able to react appropriately. And what I would say is we're never kind of on the super high end or super low end. We, we tend to be kind of in the middle.
But I remember a year and a half ago, in January of 2023, people were talking about, "Oh, the market's become, you know, much less competitive, and, you know, nobody's breaking rank." And if that was the case, it lasted for less than a quarter. Like, it, it wasn't noticeable to me, but I remember hearing it on sell-side notes, and people would ask me in Q&A. So, so we're always prepared for a range of outcomes, and the market remains competitive, but we are, you know, we, we operate at scale, and we have great operating leverage in the business, and we've managed to, over this kind of 2-year period, become a lot more efficient on, you know, the cost per dollar we book, you know, the cost, the marketing cost, the cost, around pipe generation, all of those things.
Now, there's more to go for, but I think that puts us in, you know, a better position than many of our competitors.
Now, it's great, it's great color. I mean, just on thinking about modeling out free cash flow, I mean, I think you started your efficiency initiative when in October of 2022 was the first-
Yeah [crosstalk]
... path that you took, and you've-
Yeah [crosstalk]
Offset incremental, incremental since then. But if I'm thinking about building up a free cash flow for 2024 and 2025, are most of my moving pieces, you know, operating leverage, reduction in cash interest? Or are those the major pieces, or is there more to take on the, on the operating expense side?
Yeah. So, there is always a more to take on the operating expense side. Again, like, without I don't want to commit to anything, apart from what I've said for 2024, but, you know, I you should expect us to continue driving margin improvement beyond this year. Part of it is the operating leverage. Even what I said on the R&D side, you know, as we continue to grow this very large ARR base, the R&D dollars on certain products become more maintenance mode-
Mm [crosstalk]
and then it frees up dollars to be able to go and invest in newer products. But of course, you know, we've made significant investments in those new products at the end of last year and this year. So as you look forward, you know, that investment ends up being less onerous as a percentage of the total. So when you think about what's gonna drive free cash flow growth as we go forward, it's gonna be, you know, on the OpEx side, some sales and marketing, which I said is still too high. It'll be some R&D as we look forward, and it'll be some G&A.
Okay. This is the concept of, say, like, you know, maintenance CapEx for capital-intensive industries. You obviously have the concept of maintenance R&D.
Yeah.
Just to keep kind of that ARPU, right, to keep that running, running flat, hopefully.
Yeah.
Continue-
We call it Keep the Lights On, KTLO.
Yeah, continuous improvement, just to keep that-
Yeah
... keep the ARPU flat. What's the right way to think about that maintenance level of R&D versus actual revenue, if you ever got there?
... Yeah, so I mean, we haven't ever broken that out, but what I would say is that, you know, we are today a multi-product company. That's fairly new for us, because if you think about RingCentral in the past, we've been message, video, phone, kind of bundled product. And now you can imagine that we're spending significant R&D on things like our CCaaS, proprietary CCaaS offering. And as a CFO, I would always prefer to ensure that R&D dollars, incremental R&D dollars, are being spent on initiatives that drive the highest ROI, and also that, you know, at the end of the day, drive bookings or meet a customer need. So where we're spending our R&D dollars has evolved quite a bit.
And, you know, I prefer to index on growth R&D investments as opposed to the maintenance investments. That being said, our five nines reliability is sacrosanct. Today, it's six nines for the last two quarters, it's been six nines, but 99.999. But you know, the reason we win the deals we win, the reason we win against Teams Phone, the reason we won, you know, our largest seat deal ever in the company's history last quarter, is that reliability and those features. And, you know, our cloud phone is so differentiated relative to the competitive set. And, you know, I always read why we win certain deals, and actually, I would say almost every single one I've ever read is that, it's that reliability.
You can count on us. It's the reliability and the security. So as much as I would want to invest the R&D dollars towards, you know, growth and new products, it's really important that we maintain that reliability, that security, that safety, and, and the features. We just don't want to. What you never wanna do is become in a situation where you're customizing too much. I'm kind of allergic to customization, and, and I think that's something that we've got really good at.
You mean less of a bespoke-type product-
Exactly. [crosstalk]
and more, you know, off, off the shelf, right?
Exactly. Exactly.
And I do wanna ask about AI. These 30-minute sessions go so fast-
I know! [crosstalk]
that I don't wanna leave that out today. But, you know, how should we think about the AI opportunity, and, you know, has there been any traction in that-
Yeah [crosstalk]
AI for RingCentral? And then I guess kind of the follow on, because I wanna get it all into one question is, you know, thinking about pricing.
Yeah. [crosstalk]
A lot of questions around pricing and AI, if you can charge a premium for it or-
Yeah, we're having those discussions as well internally around pricing, and I can tell you what we're doing today, but I think that we also realize that this could, this is likely to evolve the pricing models for AI in general. But, you know, are we seeing traction? So our AI platform is RingSense, and the big product that we went out with is RingSense for Sales. And at earnings, I mentioned that in Q1 our customer numbers more than doubled versus Q4, so sequentially more than doubled to well over 600 customers, and paying customers. And that's, you know, totally incremental to the ARPU that we charge for UCaaS and/or CCaaS or a combined UCaaS, CCaaS. So, like, very, very incremental and accretive.
You know, we also are seeing very strong demand for our RingCX product, which is infused with AI. So the AI features are included in that product, and that product, we're charging $65 per seat per month. In terms of engagement, you know, we're seeing very, very high engagement from our customers and a willingness to pay incrementally. The other thing I would say, and it's early days on this, but you know, we expect it to positively impact churn and net retention. And I think it could be a very valuable tool to... You know, say you have a customer that's threatening to churn, but you wanna retain that logo, to be able to throw in these incremental products around AI. And I think we're so uniquely positioned.
Like, if you think about RingCentral, we have billions of minutes of customer conversations on our network, and our customers are begging us to help them create value from that data. Now, the data belongs to the customer, but we can use that data for them to do things like live transcription, you know, live call summaries in our contact center offering. Not just live transcription, but if you're on the phone and a customer is talking or is complaining about something, you can then immediately arrange to have that customer follow up with the next person in the chain, and they can see it live, right there, happening real time. You know, we... Coaching.
So you see something that's worked really well for one contact center agent, and you think: "Oh, wow, they managed to get off that call much more quickly than the others." We can immediately put that out to the entire floor. Those kind of things are extremely valuable. The sentiment analysis, all of that. So, you know, AI is something we've been talking about for years, actually, at RingCentral. We did an M&A, I think about four years ago, a company that was, you know, squarely in that field. But, you know, we continue to invest there, and we absolutely see it as, you know, being incremental and something we can charge for. Right now, we're charging on a subscription basis, but I know I've seen many companies talk about consumption basis, et cetera.
I would say, you know, we remain open-minded, but we're really excited and feel uniquely positioned to exploit it.
There's a lot of debate around the pricing model. I'm gonna go about a minute over, if you don't mind.
Yeah.
Microsoft Dynamics 365 Contact Center was announced.
Yep.
Seems like much more of a specific push into contact center for Microsoft. Do you have a hot take on that?
Yeah, I mean, look, we coexist with Microsoft extremely well in the Teams environment. You know, we, the large deal that—the large win I just mentioned, the largest deal in our company's history, that happened in a Microsoft environment, so they're using Microsoft for... or they're using Teams for their video and their messaging, but they're using us for phone. So I think, you know, we still feel like we are highly, highly differentiated relative to Teams in certain areas, where we're mission-critical to our customers, and we don't think that that will change with their offering. And theirs is such a new offering, and we have a long history of, one, a partnership with NICE inContact, where we've OEM'd their product for, I think going on eight years. Significant integrations built into that.
I think it, it's very, very hard to break into what we offer and, you know, all of that, R&D that's been put there. So, so we feel good about where we are.
Great. Thank you for giving me another minute or two. I appreciate it.
Of course.
Thank you so much.
You're welcome.
Thank you, all.
Thanks.