2023-05-18 13:36:03 ET
Summary
- RingCentral has been growing exceptionally quickly for a decade running.
- It has also been generating positive operating cash flow throughout most of that time, and it is making progress towards profitability.
- The fundamentals end up looking excellent for RingCentral, but then we find out that it has convertible notes due in 2025 and 2026 that represent 96% of the market cap.
- This creates the prospect of significant dilution, at minimum, and makes what would otherwise be a good investment a hold.
Overview
RingCentral, Inc. (RNG) is a B2B communications software company. It provides a unified platform for video, phone calls, and any other kind of digital media, such as documents. This comes along with an analytics and reporting capability. To be more specific RingCentral is a ‘UCaaS’ company – Unified Communication as a Service. This is a distinct type of technology that sits at the intersection of computer and telephony networks, which do not interoperate as readily as may be assumed.
This is a stock that has seen significant volatility over the last 5 years. It appreciated well ahead of the SP500 as well as the NASDAQ Composite in late 2021 but has since come down to earth. It now trailing these indices on a price performance basis significantly.
This year has seen a continuation of this historical volatility, with RingCentral initially outperforming these indices YTD before again depreciating. Interestingly, this occurred against the backdrop of back-to-back consensus-beating earnings reports.
Looking further, we see that this is a company has been beating EPS estimates for 16 quarters running.
While having mostly beat consensus revenue estimates as well, the company posted a noticeable miss in Q4 2022. For a growth company such as this one that is a significant negative indicator. The company has returned to beating revenue estimates in the quarter since.
Along with this, the company’s growth prospects as a whole were questioned by Goldman Sachs recently . An analyst from the firm questioned the durability of the firm’s growth in the face of continued competition from Microsoft (NASDAQ: MSFT ) and Zoom (ZM). Considering that Microsoft Teams and Zoom’s products (seemingly) provide near-identical capabilities to RingCentral’s, I think this concern is warranted.
Yet, not all may be as it seems – RingCentral actually builds products for Microsoft Teams, and it has been doing this for some time. This makes the product picture here significantly more cloudy.
This article will review RingCentral’s financials and value proposition while establishing a view on its forward-looking prospects.
Fundamentals
RingCentral has a unique growth profile in which it has continued to grow rapidly in the entire decade since its Q4 2013 IPO. It is rare to see this level of revenue growth sustained for this period of time.
The company is operating at decent level of scale, hitting the $1B yearly run rate mark in 2020.
This has come along with a gross margin of around 70%, although notably the company dipped under that for the first time in almost a decade this past year.
This growth has been ongoing without RingCentral having ever been profitable. It has, however, been pushing for profitability in the near-term – although not guiding for that to occur in this year.
The company has a ways to go with positive operating income on an annual basis, yet it has made progress over the last few quarters. The company maintains reasonably high R&D spend and has appeared reluctant about lowering that too far. Overall an operating margin of -9.38% in its most recent quarter shouldn’t be insurmountable in 6 months, assuming a similar rate of progress on operating margin.
Importantly, the company has been generating operating cash flow for 7 of the last 10 quarters and appears on track to have a record year. Cash from operations for Q1 2023 was $108.5 million, a record figure for the firm.
The company has $1.68B in total debt and on its balance sheet but pays minimal cash interest on this number due to having its debt in convertible notes.
Overall these financials show a growth company that could credibly become profitable. The rate of growth has been excellent and sustained over an unusually long period of time so far. Clearly there is something customers like about this product. The company’s mostly-positive cash from operations indicates that the business model works, and this should allow for a proper transition into profitability.
Valuation
RingCentral looks to be trading cheaply on both a P/E and operating cash flow basis right now.
This valuation is present even as RingCentral has excellent prospects for earnings and cash flow growth. Its 3-5 EPS CAGR is more than double the sector median and its cash flow growth metrics hit it out of the park.
These numbers are exceptionally high at the moment because the company is at an inflection point. At this point RingCentral is expected to become a profitable SaaS company for the first time. As it does so it should capture the economics of SaaS, which are very good. Based on its fundamentals, current growth rates, and business model, I think these forward-looking assumptions are credible for 1 year out.
Since the valuation picture here is excellent overall, one starts to wonder why the company’s share price has performed so poorly.
My impression is that some of it has to do with the large amount of debt that the company is carrying, a remarkable 62.4% of its market capitalization right now.
Of course, this number would be lower if the firm’s valuation were higher. More importantly, the balance sheet looks fine, with a liability/asset ratio of 0.81 and a current ratio of 1.44. The levels of cash flow that this company will be generating for the next year should also make debt service not much of a problem, although we haven’t seen how those numbers line up as of just yet. In either case this debt will need to be paid off and will act as a significant drag on earnings for years.
Another likely concern, and material risk factor, is competition. Here I think RingCentral’s product is more differentiated than it may seem at first glance.
While it evidently competes with Microsoft Teams and Zoom, I don’t think these are too pressing. As mentioned RingCentral actually integrates into and provides several features for Teams in particular. If they were identical products, this wouldn’t even make sense to be doing.
As to Zoom, I believe its best days are behind it. Zoom has had 2 consecutive quarters of less than 5% y/y revenue growth, and the quarter before that was less than 8%. Compared to RingCentral’s ongoing high double digit rate of growth across the last 3 quarters, Zoom’s level of product uptake in the market doesn’t present it as being a customer favorite.
Additionally we must recall that this is a subscription software product that derives most of its revenue from existing customers. This creates higher switching costs and a ‘stickier’ product in the market. From last quarter we can see that Subscriptions revenue grew more than Total Revenue y/y. This indicates that per-customer economics and the existing customer base contributed marginally more to the company’s growth as compared to new customers last quarter. This is another good sign that the product continues to see traction.
Convertible Debt
With that being said, the factor really driving down the company’s stock here is the structure of its debt.
The entirety of RingCentral’s long term debt ($1.65B) is held in 2 zero coupon convertible notes that are due in 2025 and 2026. These convertible notes are structured such that RingCentral has to pay the principal due on them in 2025 and 2026 or have them convert to shares at a premium.
The $1B due at the end of Q1 2025 would provide creditors with $1.5B worth of shares and the $650M due in 2026 would provide creditors with up to $991.25M in shares due to conversion premiums of 50/52.5%. This would make creditors the new owners of RingCentral, with the total conversion sum of $2.49B equating to 95.77% of the company’s market cap. At minimum this would create significant shareholder dilution, and could result in a variety of other changes to the firm.
Conclusion
RingCentral looks great on every level apart from its debt covenants. Unfortunately these make what would otherwise be a great investment not so. With the looming prospect of dilution and/or a creditor takeover of the firm, the fundamentals here become a lot less important. I have to rate this a hold until that situation is sorted out.
For further details see:
RingCentral: Great Prospects, But Looming Debt Covenants Make It A Hold