2023-12-01 03:02:55 ET
Summary
- RingCentral's 3Q23 results exceeded expectations, with revenue growth and improved margins.
- RNG's strong top-of-funnel awareness indicates robust underlying demand that is temporarily delayed.
- Management's strategy to broaden the product portfolio increases upsell opportunities and strengthens customer loyalty.
Overview
My recommendation for RingCentral ( RNG ) is a buy rating as I like the fact that things are stabilizing and I'm fond of management strategy to broaden the RNG portfolio of products. I believe the market is going to pay more attention to the medium-term performance as the worry about potential degradation in performance is off the table (as evident from the jump in share price post-earnings). Note that I previously rated a hold rating for RNG as I saw near-term weakness unfolding in the business, driven by the weak macroclimate. Also, the change in leadership introduced further uncertainty into the near-term stock performance.
Recent results & updates
Contrary to my belief that RNG is going to see soft near-term performance, RNB reported better-than-expected 3Q23 results . Revenue grew ~10% to $558 million, beating the consensus estimate of $554 million. Furthermore, EBIT grew significantly from $68.7 million to $106.8 million, with ~860bps of margin improvement. Consequently, pro-forma [PF] net income grew to $76.1 million from $53.1 million in 3Q22. In EPS terms, PF EPS came in at $0.78 beating consensus estimate of $0.75.
With the 3Q23 results cast in stone, I think the market is going to pay more attention to the medium-term, which I believe has a positive narrative given the takeaways from the quarter. First of all, while it is true that sales cycles remain elevated and upsell remains challenged given headcount reductions among customers, it was very encouraging to learn that RNG did not see further deterioration in the market. This should set the floor for the valuation, as I believe many investors, like myself, are worried about further demand degradation in the industry. The key point here is that top-of-funnel awareness remains very strong, which means that underlying demand has not been structurally impaired; it is simply pushed out, which is in line with management's comment that things are more back-end-loaded now. Given the structural advantage of RNG products vs. legacy products, I think the secular tailwind remains strong, and businesses will eventually shift over.
Importantly, marketing-driven lead flow remains consistently strong, demonstrating continued demand for on-prem to cloud conversion. From: 3Q2023 earnings call
I also think that RNG's growth visibility has improved due to management's decision to broaden and strengthen the overall portfolio. This is a pretty smart move, as it has three key positive effects:
- Having more products meant that RNG had more opportunity to upsell to customers, thereby driving growth. Sure, some businesses might be reluctant to adopt RNG's main product, but that doesn't mean they are not open to other products. Hence, more products open up more opportunities. RNG's execution was on-point for this initiative as well, as they saw >60% of $1 million total contract value deals including both UCaaS and CCaaS.
- More products adopted per customer increase the chance of further upsells, as vendor consolidation is a trend lately.
- Successfully driving more product adoption per customer also means that RNG will be more embedded into the operational processes of businesses, making it more sticky and harder to replace.
On another note, this move also speaks well of management's competency in that they are not losing focus on R&D despite the weak macroclimate. This is important as R&D is a driver for long-term growth.
Furthermore, and arguably the most important point in the current capital market environment, RNG remains profitable despite all the recent reinvestment in the business. In the quarter, RNG reinvested heavily into marketing and R&D, which pressured the profit line. As such, when I look forward to FY24, even if growth remains stable at the current rate of ~10%, EBIT should grow at a much faster pace given operating leverage.
While we invested back into the business to support our new products, primarily through sales and marketing initiatives, we were able to drive increased productivity from our current workforce instead of hiring additional headcounts, which resulted in savings that flowed through to the bottom line. From: 3Q2023 earnings call
Valuation and risk
Author's valuation model
Previously, my model showed the near-term upside potential (based on FY24 numbers) and medium-term upside potential (based on FY25 numbers), and I gave a hold rating because of the limited near-term upside. Now that the 3Q23 results are out, I believe the market is going to gradually shift attention to the medium term as the situation seems to have turned from negative to stable (which means the situation might have already troughed). My growth estimates remain the same as my previous model, where I expect stable growth in FY24 and acceleration in FY25. The growth cadence also reflects management comments that things are stabilizing but are back-end-loaded. I expect the backend-loaded demand to flow in FY25. I also reiterate my 1.8x EV/fwd revenue assumption as the RNG is not completely out of the woods yet. Management specifically mentioned that they have not seen any change in terms of easing conditions. Until there is solid proof of improvements, I think the market will remain cautious and not re-rate valuations upward.
And so, I would say, macro goal is stable and we have not seen any change in terms of easing conditions. Hopefully, this answers your question. from: 3Q2023 earnings call
Risks
Changing RNG's approach to going to market is a big risk. Management has revealed that they are making adjustments to their channel programme in an effort to increase direct sales, decrease marketing and sales expenses, and boost overall productivity. In addition, they are actively seeking new partnerships, both domestically and abroad, with ISVs in order to fuel their expansion. Given that RNG has been using the same strategy for so many years already, such a big change might be very disruptive.
Summary
I upgraded my rating to a buy for RNG as the 3Q23 results surpassed expectations. While sales cycles and upselling face challenges, the strong top-of-funnel awareness suggests that the underlying demand remains robust and is only delayed. I also like the management strategy to expand the number of products as it enables more upsell opportunities and reinforces its competitive edge, enhancing customer stickiness.
For further details see:
RingCentral: Rating Upgrade As Things Are Stabilizing