8×8, Inc. (NASDAQ: EGHT) sells cloud based voice and data solutions. Traditionally a loss making firm, it has moved out of the red with operating incomes $3.98M and $6.24M in 2010 and 2011 respectively. Net cash ending FY2011 was $16.47M with cash flow $(1.58) M which was a direct result of acquiring firms, fixed asset investments and the retirement of stock options. The company is liquid with current assets $22.08M forming 83% of total assets. On the flip side, current liabilities are 99.6% of the total liabilities with no short or long term debt . The company possesses 63M outstanding shares with 29.31% institutional ownership and market cap $267M. The stock price has grown from $0.57 in 2009 to $4.27 (as of September 2011). Most analysts have rated EGHT to be a moderate to strong buy .
8×8 was incorporated in 1987 and the initial goal was to provide semi-conductor chips for the video processing industry. The name 8×8 was coined after the pixel dimensions of a video frame. Since its inception and through 2001-2002, it tried unsuccessfully to gain market share in this segment. In 2002-2003, 8×8 entered the consumer voice market providing VoIP solutions for that market – this also was unprofitable. Post 2008, the firm has reinvented itself as a hosted voice solution provider and has seen moderate success with consecutive years of profitability. Sensing the success of their SaaS model, the company has also moved into the IaaS space by providing multi-tenanted services.
After surviving several loss making years, 8×8 now shows strong financials with ROA at 25.82% and ROE at 44.54% . The YOY Net income has leapt 67.41% while the gross margin is at a healthy 67.57%. Shareholders are also delighted with YOY EPS moving forward at a fast clip: 66.67% . 8×8’s success has been positive with current sales growth of 10-15%. Whether this growth is sustainable in the long term remains to be seen. The most recent quarterly earnings report almost beat the street forecast but wasn’t strong to indicate future returns . Though the firm may have had recent success financially, it is difficult to predict how long this would last given the lack of similar historical trends.
Analysis of current financial situation
In 2008, 8×8 decided to sell cloud based voice solutions. This decision has directly turned its poor financials on its head. Usually software companies have high gross profit margins and low net profit margins. This is due to two reasons: high marketing and administration costs combined with low operating costs and COGS. The same holds true in the case of 8×8; while industry averages are 50% and 16.1% for the gross profit margin and net profit margin respectively, the company has 67.6% and 10.3%. Interestingly the 5Yr net profit margins are -0.6 due to 8 consecutive years of losses .
As of FY2011, 92% of the current sales are in the SaaS segment with the product segment (customer CPE) contributing the remaining 8%. The large chunk of sales absent from the hosted model in the preceding years has singularly contributed to the sudden spurt in revenue and to the firm remaining solvent. All through the loss making years, the firm was able to remain above water due to the $200-210M paid-in capital provided by the primary investors . This is a good indication of the investors’ confidence in the quality of the leadership and in the faith in the firm’s ability to perform.
Cash situation: 8×8 has cash balances of $18.4M after spending about $5M in 2010-2011 acquiring three companies: Central Host Inc., Zerigo Inc. and Contactual Inc. . While the first two operate in the managed data hosting and cloud space, the third provides contact center services. Working capital and FCF are at $11M and $7M respectively. While $208M of the equity is via paid-in capital, the firm offsets it via retained earnings of $192.35M. A firm’s enterprise value is the present value of all its future free cash flows. With the rate of FCF growth, EV is evaluated at $248.28M – an indication that the market still perceives the firm as small-midrange firm and is also a direct correlation to the lack of long term growth and cash flow predictability.
Figure 1: Industry Vs. 8×8
Current performance versus industry: A financial snapshot comparison against the “Communication Equipment” industry is shown in Figure 1: Industry Vs. 8×8. The industry has the upper edge in terms of sales and net income when comparing YOY quarters. But 8×8 has stronger margin due to the low COGS from switching to the hosted model. Lower net profit margin is an element of concern (but it can be passed as a characteristic of software companies when compared with pure communication hardware manufacturers). Both the ROE and ROA have better indicators with 8×8 outshining the industry – a good signal that the firm operates primarily on equity and assets (as opposed to leveraged funds). Finally the quick, current and leverage ratios are not as good as those of the industry which is an indication of limited liability. Note that for a firm perennially languishing in the red, these financials are more than just a welcome break. They indicate that the management has hit the sweet spot in terms of using equity to build product revenue and ownership to the shareholders. These numbers may denote the beginning of a profit making reincarnation of the firm.
Debt: 8×8 has no short term or long term debt. This can be interpreted in one of two ways. First the firm has used equity to drive some of the recent acquisitions and technology investments. It hasn’t had the necessity of borrowing through bonds or loans. But on the other hand, a long term debt structure is missing to finance larger growth plans. As a company that exists in the software business and in particular in the cloud model, it needs to have liquid cash in case there is a dire competitive need for investment. In FY2011, both the purchase of fixed assets and investments has been with cash holdings. The firm has not entered into any debt or bond conditions to drive their new business direction.
Goodwill and intangibles: In today’s economy, all software companies are under pressure to continuously innovate and to have a strong goodwill or intangibles section on their balance sheet. Unfortunately 8×8 possesses neither section. The total value of its 76 patents is $1.4M, thereby proving that the IP they own is either obsolete or unused or both. In addition, the firm has no brand name and thus the limited liquidity of the brand doesn’t allow the company to be a high value acquisition target. Most importantly, it doesn’t permit the firm to borrow against the reputation which is currently nascent with recent financial successes.
Analysis of Financial Growth
Soon after 8×8 hit upon the consumer VoIP model to sustain business, it realized that the CPE business was a low margin turnover. The model initially yielded over 50% gross margin but the operating margin was dismal with negative fluctuations. As a result, the revenue remained flat YOY ($15-20M). From Figure 2: 8×8 Revenue and Income Financials, it took about 5 years for the model to be revamped (to a hosted cloud model) to hit decent milestones. In FY2011, revenues are at $70M and net income is at $6M – new historic levels . Note how operating margins have improved – a direct consequence of increased income YOY. As a result of moving to the hosted model, reduced operating expenses also drive better operating margins.
Liquidity: From a liquidity perspective, the firm can convert its assets into cash rather quickly as can be seen in Figure 3: 8×8 Liquidity Analysis. Till date, all the financing of 8×8 has been through its equity and hence the leverage of the firm remains low. Note that the spikes during 2003-2004 were a direct result of overcrowded inventory resulting in poor sales. Finally the current ratio (2.1) indicates it has twice as much asset as liabilities and an ability to leverage.
Capital Structure: With regards to a capital structure, cash flow for the firm has increased with the recent successes. Equity is driven by paid-in capital from investors which have increased from $5.38M in FY2007 to $15.86M in FY2011. YOY sales and the net income growth have driven higher FCF. Capital spending is specific to the short term and is the cash paid for the acquisitions ($2.32M) and also for the purchase of fixed assets ($2.06) . From Figure 4: 8×8 Efficiencies, cash conversion is also not a problem (though it was hurting the business in 2002-2003).
As a result of the recent strong showing, the company’s efficiency has improved. 8×8 is not burdened with inventories and doesn’t suffer from difficulties collecting accounts from its sales. In Figure 4: 8×8 Efficiencies, DSO’s
and inventory turnover is at an all-time low.
DSO is 3.69, a significant improvement over the 51.5 in 2002-2003. This indicates that the firm is able to get invoices and receivables quickly . It is also in a position to pay its current liabilities without defaulting: the quick ratio is 1.8.
The high value of receivables turnover indicates that the firm operates on a cash basis and that its collection of accounts receivables is efficient. 8×8 has also been successful converting its investments in fixed assets into net sales which is evident in the strong fixed assets turnover.
Assessment of stability, strength, investment attractiveness
8×8 has had relative success the last few years selling cloud based voice and data solutions. But from a financial growth perspective, it is difficult to trust the firm to continue the income growth YOY. The firm’s growth opportunities are market size (~$2B) and the nascent untapped potential of cloud computing. The company’s ability to spend, need to build sales and support infrastructure, its enterprise value, the balanced scorecard model  and market comparisons are used to evaluate long term stability and strength towards investment attractiveness.
Spending Ability: With a fiscal year ending net cash balance of only $16.47M, the company cannot afford to spend without justifying its expenses. This puts the firm in a negative light due to the lack of historical debt (short and long) and the ability to repay. Lack of a credit history makes it unattractive to investors. It also prevents the capacity to forecast the capability of the firm to develop and implement large scale R&D innovation . Since debt is usually considered cheaper than equity, the firm may increase its ROE by increasing its financial leverage . The firm is now driven by a low SFG rate which allows decision making to be centered on current sales and operating cash cycles. 
Enterprise Value: With a “small growth” fund rating, the firm has “hold to buy” guidance from most analysts. With a current EPS of 0.11, the immediate returns may not evident but some analysts have predicted a 27.5% growth rate annually . But a low enterprise value of $248M makes it an easy takeover target. This may increase its stock price in the interim but in the long term, with the exception of about 20K SME customers, there are no advantages to the buyout. The firm has never offered dividends and probably will not considering its dependence on contributed equity.
Sales and Support: Primary sources of value addition to its customers are low cost, excellent support services and the adoption of cloud based technologies. By innovating on features, by building a two tiered sales and distribution channel network, and by offering relaxed credit structures to partners, the firm may build further value in the SME segment. Prospective customers may also expect discounted pricing to embrace managed services replacing their on-premise equipment. Currently, 8×8 offers poor credit choices since they are driven by a cash model which is a direct reflection of their lack of stability.
Balanced Scorecard: One framework to evaluate the long term investment perspectives that a company may generate within the stockholder community is to follow the Balanced Scorecard method . Figure 5: 8×8 Balanced Scorecard with performance measures (Robert S Kaplan 1992) analyses the scorecard for 8×8 and drives to focus on specific goals with corresponding measures. It is a financial analysis tool because firstly all the measures need funding and credit worthiness to implement. Second, the focus is to ensure strategic vision which invariably leads to enhancing financial outcomes. Third, the three non-financial perspectives act as complements and levers to the financial piece. 
Figure 5: 8×8 Balanced Scorecard with performance measures (Robert S Kaplan 1992)
From a financial perspective, the company needs to increase its cash flow position either by managing payables better or by tightening credit requirements or by using short term loans. It also needs to reduce COGS and possibly leverage to build its net cash balance since WACC is cheaper than that of equity. One way to drive the EV value is to inculcate the IP of the firm. From a customer perspective, the firm is seen as a low cost provider and 8×8 will have to continue with its cloud based technologies. Part of the USP is providing a high level of support which may need enhanced CSR training. Finally the product may need to be beefed up with partnership from other vendors to enhance scalability and reliability. From a learning and innovation perspective, the firm may need to hire marketing experts in the areas of SaaS and IaaS. Developing platform independent solutions and hiring the right leadership with related experiences will grow innovation and learning respectively. From an internal business perspective, the direct sales model is weak and will need to be bolstered with VAR and channel partners . The firm’s organization focus may need to be tweaked to grow along current market trends. Finally, to fully exploit the managed services model, it will need to redirect its energies to truly building enterprise ready applications and services.
Comparative market analysis: The firm’s current annual revenue is less than that of the industry average $109.74M. In the carrier space the major competition is Vonage, AT&T and iBasis while in the vendor space the adversaries are Cisco, Avaya, Alcatel-Lucent, Nortel and Siemens. The market cap of these larger vendors is in the billions while that of 8×8 is $253.97M (a direct reflection of the value of the stock). While 8×8 has yet to pay any dividends, most firms in this market payout dividend with average dividend yield at 2.4%. Several companies are heavily leveraged with total debt to equity ratio 43.8 – borrowing against assets is a common technique to finance operations and technology investments. One positive aspect of 8×8 is that share ownership is under heavy ownership by financial institutions. Another is that a comparison with other small cap stocks in the industry shows higher than average annual growth returns. The company shows 5-yr sales growth of 17.08% over the industry’s 10.11%.  Similarly, return on capital is 44.1% as opposed to the industry average 9.7%. Though these growth ratios are competitive against those of the industry, the stock is low volume and possesses a high P/E ratio (37.8) when compared to that of the industry (17.2). When assessed against these leading indicators, 8×8 is not an attractive investment in the long term.
Despite posting strong financials in 2010 and 2011 relative to its previous years, 8×8 is yet to prove itself as a mainstay investment opportunity. Given the current economic outlook, cloud based technologies may seem attractive but without consistent annual returns EGHT would remain a small cap stock. Current growth of 10-15% may not be sustainable. For a firm in the SaaS/IaaS space, fixed costs are high whereas marginal costs are negligible. The firm is operating on its contributed capital equity and cash earnings. With a high burn rate following the acquisitions of 3 firms within a year , long term solvency is a deterrent. As a company at maturity stage, it needs funds to take on the competition which invests large sums in this segment and produces more reliable and scalable solutions .
Established firms leverage their innovation and their large scale hosted deployments are driven by effective partnerships with other vendors to include equal fiscal participation based on risk. In the SME segment, the invoices are small amounts and can be collected quickly. But when the firm moves to supporting larger enterprises, the operating cycles are longer and cash inflow will be hurt forcing the firm to leverage heavily. Without debt, the ability to establish credit worthiness is lost – a pursuit which may take several years. In such conditions, the company’s investor rating will diminish and its credit worthiness questioned with fluctuating debt to equity ratio. It may take more than just 2-3 years of predictable returns to convince the market that the company can successfully reinvent and grow in the hosted segment.
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