RingCentral: Expect Continued Margin Expansion and Steady Debt Reduction (NYSE:RNG)

investment thesis

RingCentral (NYSE:RNG) continues to hold a leading position in the unified communications as a service (“UCaaS”) market, which is forecast to grow at a CAGR of 19.4% through 2032, reaching a of 311 billion dollars. Although demand is growing, intense competition in the market has put pressure on prices. RingCentral has differentiated itself from its rivals mainly due to its reliability and strategic partnerships. In addition, the company has now launched several AI-based products that it aims to sell to its large existing customer base.

In terms of profitability, the business demonstrated strong operating leverage, with margins increasing from 10.4% in Q1 2022 to 21.9% last quarter. The resulting solid FCF generation has reduced risks related to the company’s future debt maturities. The current valuation, while undemanding compared to peers, is not attractive when considering the high of share-based compensation (“SBC”) involved. Therefore, I maintain a Neutral rating on the stock.

Financial highlights and my future expectations

Revenue rose 10% to $593 million in Q2, which was well above management’s guidance. The main driver of the outperformance was increased traction for the company’s new AI-based offerings, which are outlined above. RingCX, its Contact Center as a Service (“CCaaS”) offering, saw exceptional quarter-over-quarter growth of 70%. In addition, RingSense, which provides customer insights, and RingCentral Events, which manages large-scale events, also saw strong growth. Although these new products are growing from a relatively small base, management expects their global contribution to reach $100 million in annual recurring revenue (“ARR”) by the end of 2025. Given that the company is able to offer these products to its customers at substantially higher prices compared to the current spot price below $30, I expect this to increase ARPU in the coming quarters. Discussing the pricing of these new products, the company’s CFO said:

And just to remind you about ARPUs around new products. RingCX, we live at $65 per month per seat, so well above the corporate average. And RingSense for Sales costs about $60 per month.

As shown above, ARPU has declined in recent quarters as the company has focused more on enterprise customers, which typically involves large price concessions. This has been a headwind to revenue growth so far, but I expect this metric to improve going forward, mainly due to strong sales growth. I expect this to support single-digit revenue growth over the medium term, in line with analyst estimates.

I also expect the company to continue to demonstrate operational leverage. In Q2, sales and marketing expenses fell 150 basis points as a percentage of revenue. Going forward, I expect R&D expenses to decline as a percentage of revenue as well, given that new products have already been brought to market. This should lead to an increase in margins of at least 200 basis points each year over the medium term. Therefore, investors can expect earnings to outpace revenue growth by this margin going forward.

Given the solid FCF generation from the business, which management expects to be close to $400 million for this year, and its cash position of $200 million, I expect the company to face no problems major in debt repayment due in 2025 and 2026 as shown above. Excess capital is likely to be used for share buybacks to offset dilution from SBC.

ASSESSMENT

At the current share price of $33, the company has a market capitalization of just over $3 billion. Given its net debt position of $1.3 billion, the enterprise value is $4.3 billion. Based on management’s guidance for FCF this year of around $400 million, the stock is trading at Price/FCF and EV/FCF multiples of 7.5 and 10.7, respectively.

Meanwhile, RingCentral competitors like Zoom ( ZM ) and 8×8 ( EGHT ) are growing at mid-single-digit rates and are valued at EV/FCF multiples of 9 and 10.4, respectively. Based on my expectations for RingCentral’s FCF to grow at around 10% over the medium term, I consider this valuation to be relatively attractive. However, a major concern for me is the company’s high SBC. At an annual run rate of about $350 million, that’s almost as high as the annual FCF generated by the company. Management has clearly begun to address this by significantly reducing the amount allocated to shares, as the CFO explained when he stated:

Through the first half of 2024, net new equity awards are down nearly 60% from last year, which is ahead of our previously stated goal of reducing equity awards by 58% from the 2023 level.

The high level of SBC makes the company’s valuation much less attractive on a GAAP basis. In addition to being valued on par with its peers, I would argue that investors are afforded reasonable downside protection as the company is an attractive acquisition candidate from much larger players such as Cisco ( CSCO ) or Salesforce ( CRM ), which is looking to strengthen its offering in the UCaaS space.

Risks to consider

Competition

In addition to competing with major players like Microsoft ( MSFT ), Zoom and 8×8 in the UCaaS market, RingCentral now also faces competition from players like Five9 ( FIVN ) in the AI-driven CCaaS space. Given its substantial existing customer base, I believe RingCentral is well positioned to achieve greater success by selling new products to existing customers rather than focusing solely on acquiring new ones.

Automation based on artificial intelligence

Chatbots and AI-powered virtual assistants could drastically reduce the number of people needed for work, which in turn would lead to fewer seats needed per customer. RingCentral is working to counter this impact by offering its own suite of AI-powered products to its customers.

Debt

The company has nearly $1.5 billion in gross debt, compared to $200 million in cash. Successful downsizing is based on continuous and strong FCF generation from the business.

Macroeconomic weakness

A challenging economic environment could particularly affect RingCentral’s small and medium-sized business customers. In the event of large-scale layoffs, these companies may reduce their workforce, resulting in a decrease in the number of seats required by RingCentral.

Conclusion

While AI may pose a significant threat to long-term business growth, management is currently using its AI-powered products to drive revenue growth and profitability in the medium term. While the current valuation seems reasonable, it is not particularly attractive, especially when factoring in SBC expenses. Accordingly, I maintain a Neutral rating on the stock.