Despite a soaring rally and a sky-high valuation, we think that the shares of RingCentral (RNG) are still a good buy for investors with an outlook of a couple of years.

The company is the undisputed leader in the $50B UCaaS sector and it’s cementing that leadership through integrations, new products and strategic partnerships.

While at any time, the rally could easily consolidate taking the stock lower giving the extended nature of the rally, that would provide a useful moment to add or step in.

The year has hardly started and RingCentral shares are already up 43%, the company is going from strength to strength:

And behind the soaring share price, there is real business momentum of course:

ChartData by YCharts

But while revenues keep growing, GAAP earnings have moved south since late 2017, although the non-GAAP variant is already well in the black since Q3 2015. The difference is mainly produced by share-based compensation and “acquisition-related matters” (from the earnings deck):

We’re not worried about the GAAP losses as the company isn’t burning cash (although free cash flow plunged negative in Q4, see below).

The company is the undisputed leader in UCaaS (unified communications as a service), witness the Gartner Magic Quadrant (from the earnings deck):

What makes the company special, well, a host of integrated services (earnings deck):

But one feature stands out perhaps above all others, which is the ability for users to integrate Ring with a host of other software and systems they are using (Q4CC):

First, a platform which integrates voice video and team messaging continues to resonate with our customers. Our open platform ecosystem expanded to nearly 30,000 developers. I’m also excited to announce that we surpassed 3,000 certified integrations. The ease and flexibility with which our customers can integrate business applications with our communications platform is a game changer. In fact, over 70% of our seven-figure wins in Q4 cited open platform as a key capability in their decision to go with RingCentral.

Growth

The company has numerous growth avenues

  • Enterprise (ARR $100K+)
  • Mid-market (ARR $25K+)
  • Channel partners
  • Land and expand
  • Verticals
  • Partnerships

In the slide below one can gauge the strength of the enterprise, mid-market and channel partner channels; from the earnings deck:

Very large deals were especially strong (Q4CC):

We did have a record number of over 30 deals, which are seven figures or more this quarter. And 70% of those deals were net new logos, which actually exceeds land and expand going forward.

The sales also manage to stay quite efficient despite the company moving up-market where sales cycles tend to be considerably longer, which creates a bit of a virtuous cycle for the company as these deals rake in more money which the company can then invest in its three channels (direct, channels and partners).

Vertical Markets

Ring focuses especially on several verticals like financial services, healthcare and education. During Q4, these verticals were responsible for 40%+ of its $1M+ deals with financial services coming in particularly strong with deals with Arch Capital and Credit Human.

Land and expand

One of its newer initiative is Contact Center, which offers additional up-sell opportunities (Q4CC):

Over half of our seven figure wins included Contact Center in Q4. Contact Center is a key element of our land and expand strategy. For example, earlier this year, we secured a 10,000-seat win with a Fortune 1000 multinational software company. In Q4, this customer added 150 contact center seats. Also, earlier this year, we secured a nearly 6,000-seat RingCentral office win with Crawford and Company. And in Q4, we added over 400 Contact Center seats.

Over 40% of new business came from existing customers in Q4, another strong quarter for land and expand.

Channel partners

Revenue from channel partners is growing at 60%+ and is responsible for 35% of the gain in ARR. More than 70% of the $1M+ deals also come through the channels, and the channel business has sound fundamentals (Q4CC):

I think channel is a very profitable business for us; it’s more profitable in dollars wise than the direct business, given the higher lifetime value to CAG, with the lower upfront investments we have to do and better churn.

The company also continues broadening the channel network and deepening relationships with key partners, such as Carousel, Solaris, and Westcon.

Partnerships

The company is launching three strategic initiatives:

Of these three, the expanded strategic cooperation with AT&T (T) is most advanced and already generating revenues, from the Q4CC:

AT&T made Office@Hand by RingCentral a lead offer for UCaaS, as part of its voice and collaboration portfolio. It has been a few short months, but we are already starting to see encouraging trends that are exceeding our initial expectation.

AT&T could be a materially new driver for the company this year, expanding on the $15M a quarter it is already bringing in (Q4CC):

we saw an uptick sequentially in bookings by about 15% to 20% after AT&T made as their lead provider, so that was a sort of a change in step function change we saw.

Atos is helping customers with their digital transformation, more especially the digital workplace. So hooking up with a UCaaS platform, as like with AT&T, involves introducing a co-branded UCaaS solution to Atos customers, makes sense for both parties (Q4CC):

So essentially, our partnership with them is to be this foundation of their digital workplace offerings in their work with their customer’s digital transformation.

While there are up-front investments required, the relationship is going to be accretive from the start. Ring also acquired some IP regarding messaging, communications and collaboration space in the deal.

The potential for the Atos deal is a little hard to gauge for management at this early stage but given that it’s directed mainly at large enterprises and given the long sales cycles, management isn’t assuming much contribution from the Atos partnership in 2020.

Ring has also entered into a strategic partnership with Avaya (OTC:AVYA), involving Ring to build Avaya Cloud office. From the PR:

Avaya Cloud Office combines RingCentral’s industry-leading unified communications as a service (UCaaS) platform with Avaya phones, services and migration capabilities to create a highly differentiated solution backed by communications experts that delivers cloud services with extensive communication and collaboration capabilities for businesses of all sizes. Avaya Cloud Office will be generally available for customers and partners this Spring.

While ACO (Avaya Cloud Office) is going to launch on March 31 (Q4CC):

And right off the back we will have the automatic migration capabilities embedded into the product. So there is no lag in timing between product launch and the automatic migration capabilities to take every customer of Avaya on prem to the cloud.

However, that doesn’t mean instant migration of Avaya customers and there is some confusion here with respect to the previous quote directly above (Q4CC):

Migration tools are really not going to be there. And we have not as of yet committed to a at least publicly we have not disclosed any specific timeframe for migration tools… I would expect more of a gradual process is going to be sort of a moving train will be introducing these tools over time, but certainly we’ve to cover all of the migration cases eventually.

This is a curious disconnect with the earlier quote but what seems certain is that migration is going to ramp slowly as management has figured little in terms of revenue contribution for 2020 from ACO; so we stick to the second, not the first quote.

We advice investors to read SA contributor Stamina Capital’s take on this partnership:

We estimate that RNG currently has ~2.5m seats today growing ~30% per annum[1] while Avaya (a legacy on-premise provider) has ~100m active endpoints in its installed base. The industry is rapidly moving to the cloud and Avaya was unable to pivot from on-premise to the public cloud. In October of 2019 RNG and Avaya announced a partnership whereby Avaya will exclusively sell a “white label” RNG product to its customers effectively becoming a Master Agent (where they receive a portion of the monthly revenue for each seat they sell).

[1] Company filings and equity research.

Primary research suggests this is a game changing partnership and that RNG has the potential to scale their seats from 2.5m to over 20m in the next 5 years which would drive revenue to >$5bn vs. the sell-side at ~$2.5bn, implying an EV/Sales of ~2.75x

The partnership allows RNG to leverage ~4,000 Avaya internal sales/service reps and tens of thousands of channel partners effectively tripling the selling power and reducing the need for RNG to scale its internal salesforce driving superior unit economics which we believe will result in higher incremental margins.

Basically Stamina Capital argues that growth will re-accelerate and this just on the Avaya partnership, there are two others which will also contribute considerably. So while this year apparently the contribution of these partnerships will be slim (with the likely exception of the AT&T partnership), the potential is enormous.

Q4 results

The Q4 results were a blast, beating guidance (and expectations) handsomely, from the earnings deck:

During the Q4CC, management was asked where the strength came from and the answer was “across the board,” an assessment with which one can only agree (Q4CC):

The beauty of having multiple drivers in the business model is that not every driver needs to work every time. But this time, we did have strength across the board.

Guidance

From the earnings deck:

The guidance only assumes some minimal contribution from Avaya.

Margins

ChartData by YCharts

If there is a negative it’s the falling GAAP margins but most of this is related to investments in partnerships, share-based compensation, amortization and acquisitions. Non-GAAP operating income rose from $17M a year ago to $24M in Q4.

Cash

ChartData by YCharts

The reason for the slump in Q4 is simple (Q4CC):

Operating and free cash flow includes approximately $37 million of one-time payments stemming from our recent partnerships. Excluding these items, our free cash flow margin would have been approximately 8%.

In fact, it looks to be considerably worse, from the earnings PR:

Total cash and cash equivalents at the end of the fourth quarter of 2019 was $344 million, which reflects one-time payments related to our recent strategic partnerships. This compares with $583 million at the end of the third quarter of 2019.

But actually, with $65M in operational cash flow in 2019 (down only a little from the $72M in 2018) there are no reasons for worry.

Share-based compensation isn’t negligible at 10% of revenue, and it has been rising pretty fast. Dilution while not dramatic, the share count has risen substantially with the fully diluted count at 94.5M:

ChartData by YCharts

Valuation

ChartData by YCharts

Analysts expect a non-GAAP EPS of $0.94 this year rising to $1.23 in 2021. Needless to say, the valuation multiples are terrifyingly high, although not as high as those of Shopify (SHOP), but that company is growing considerably faster still.

Conclusion

The company is the market leader in what is a $50B UCaaS market and it is cementing its position through investments in products, partnerships and integration with a host of other applications.

There is also no doubt that the company keeps on exceeding expectations which it did again with a bumper Q4. But what makes us pause is the tremendous valuation multiple expansion that the shares have benefited from.

While we would prefer to advice to buy on dips (which is basically not now), the potential of the company is so substantial and its position as a leader so well established that we think investors are still getting a good deal at today’s prices, despite the tremendous valuation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RNG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2020-02-19