8×8 (EGHT) Beware “Profitable” Non-GAAP Metrics

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

As non-GAAP earnings grow ever more prevalent in the market, despite the SEC stepping up scrutiny, investors are left in a mess of non-comparable metrics that provide little insight into the economics of a business. The non-GAAP problem is amplified when executives fully embrace the reporting practice, are paid on non-GAAP, and measure the success of the firm based on non-GAAP. This week’s Danger Zone is a company that claims consistent profitability and continued success, despite years of shareholder value destruction. Misleading non-GAAP results, large losses, and an overvalued stock price land 8×8 (EGHT: $14/share) in the Danger Zone.

8×8 EGHT
Photo Credit: Allvectorlogo.com

Revenue Growth Masks Profit Decline

8×8’s economic earnings, the true cash flows of the business, have declined from $1 million in 2011 to -$16 million in 2016 and to -$18 million over the last twelve months (TTM). This decline comes despite revenue growing from $70 million in 2011 to $209 million in 2016, or 24% compounded annually. Figure 1 highlights the disconnect between revenue and economic earnings. See the reconciliation of 8×8’s GAAP net income to economic earnings here.

Figure 1: Economic Earnings Fall While Revenue Rises

NewConstructs_EGHT_RevVsEconEarnings_2016-08-15

Sources: New Constructs, LLC and company filings

Fundamental problems can be seen across multiple facets of the business. 8×8’s return on invested capital (ROIC) has fallen from 12% in 2011 to a bottom quintile -3% TTM. The company’s after-tax profit (NOPAT) margins have declined from 9% in 2011 to -2% TTM. Lastly, 8×8 has burned through cumulative $73 million in free cash flow since 2011.

The clear deterioration of operations is caused by 8×8’s aggressive spending. Since 2011, while revenue has grown 24% compounded annually, R&D, Sales & Marketing, and General & Administrative costs have grown 31%, 23%, and 33% compounded annually respectively. Cost of revenues has grown 20% compounded annually over the same time. Revenues are growing quickly, but slower than expenses.

Executive Compensation Leads to Shareholder Value Destruction

Executives at 8×8, apart from base salaries, receive annual cash bonuses and long-term equity awards. The annual cash bonuses are paid out based upon the achievement of target non-GAAP pre-tax net income and organic recurring service revenue goals. Non-GAAP pre-tax net income has a long list of items that are removed to calculate the metric, including acquisition costs and stock based compensation. Executives are incentivized by metrics that lead to shareholder value destruction. Further shifting executive interests away from those of shareholders, 8×8’s long-term equity awards vest upon the achievement of total shareholder return relative to the Russell 2000. Incentivizing executives with stock price can be ill-fated, as business decisions can be made only to drive stock short-term stock price appreciation with little regard to the long-term economic success of the business.

The best way to create shareholder value, and align executives with the best interest of shareholders, is to tie performance bonuses to ROIC because there is a clear correlation between ROIC and shareholder value.

Non-GAAP Income Rises While Economic Earnings Fall

The dangers of non-GAAP metrics can sneak up on investors who trust management’s non-GAAP metrics. In fact, in the company’s 1Q17 earnings conference call, 8×8’s CEO states, “For the 25thconsecutive quarter, 8×8 remains profitable on a non-GAAP basis.” Later in the call, the company’s CFO states “We’re good stewards of the shareholder’s money. We have been profitable now for 25 consecutive quarters.” While true on their face, those statements do not reflect shareholders’ best interests. Here are some of the expenses EGHT removes to calculate its non-GAAP net income:

  1. Stock based compensation expense
  2. Acquisition related expense
  3. Management transition expense
  4. Facility exit expense
  5. Loss on investments

It’s not hard to be “profitable” when removing so many standard costs of running a business. These costs have a material impact on 8×8’s financials, particularly stock-based compensation. In 2016, EGHT removed $16 million (>100% of GAAP net income) in stock-based compensation to calculate its non-GAAP net income. Similarly in 2015, the company removed $9 million in stock-based compensation, which was nearly five times greater than GAAP net income. By removing this large expense, along with others, 8×8 reports non-GAAP metrics that are much better than economic earnings. Non-GAAP net income grew from $7 million in 2011 to $14 million in 2016, or 16% compounded annually. Meanwhile economic earnings declined from $1 million in 2011 to -$16 million in 2016, per Figure 2.

Figure 2: EGHT’s Misleading Non-GAAP Income

NewConstructs_EGHT_NonGAAPvsEconEarnings_2016-08-15

Sources: New Constructs, LLC and company filings

Lacking Profitability In A Fragmented Market

The cloud service industry is highly fragmented. Within the cloud industry, the unified communications industry hosts numerous firms all offering similar products, but with vastly different financial profiles. 8×8 faces competition from cloud based communication providers such as RingCentral (RNG), InContact, (SAAS), and Five9 (FIVN). Other communication providers that also offer collaboration software include Cisco (CSCO), Microsoft (MSFT), and Alphabet (GOOGL). Lastly, 8×8 faces competition from incumbent telecommunication and/or hardware providers such as AT&T (T), Verizon (VZ), and Mitel (MITL).

8×8 is at a significant competitive disadvantage due to its low profitability. Per Figure 2, 8×8 has a higher NOPAT margin and ROIC than only one competitor, InContact. Such low, and negative, profitability leaves EGHT with little to no pricing power while spending unsustainable amounts of money to win business, as noted earlier. Companies can sacrifice margins in the short-term to boost revenue growth, but long-term, a firm with relatively limited pricing power is at the mercy of competitors who are so much more profitable.

Figure 3: 8×8’s Profitability Falls Below Almost All Competitors

NewConstructs_EGHT_PeerROICcomparison_2016-08-15

Sources: New Constructs, LLC and company filings 

Bull Hopes Imply First Mover Advantage Holds True

As with most new cloud companies, the case for investing in EGHT revolves around its ability to reach critical mass, supplant the incumbents, grow into the large communications market, become profitable, or any combination of the above. 8×8 is not an upstart hoping to break through. The company has been accumulating losses for over two decades.

In 2010/2011, when 8×8 fully began fully integrating its current product lineup of unified communication products, contact center, and cloud offerings, one could argue the firm had a strong first mover advantage. Cisco was still focusing largely on its equipment based enterprise communications, and cloud offerings were still a “new” feature. Since then, Cisco has moved to rapidly adopt cloud integration, Microsoft has moved numerous services into the cloud and ramped up its communications business, and many competitors have created or improved cloud services. While 8×8 may have had a multi-year head start, that first mover advantage has rapidly eroded (see profitability above) as competition has entered the market. Worst of all, EGHT has no profits to show for its jump-start.

Further casting doubt on EGHT’s ability to meet the expectations baked into its stock price, the firms aggressive spending doesn’t appear to be slowing down. Year-over-year R&D and sales & marketing expense has outpaced YoY revenue growth for the

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