Five9 (FIVN) is the leader in cloud contact center technology, which is a market that’s still in the early innings. The shares are off the highs set in the aftermath of excellent Q2 figures, and have slumped back like so many other technology growth names:
We think Five9’s growth perspectives are undimmed, as confirmed by very good Q2 results, and the company has moved into profitability, with valuations at pretty reasonable levels. For a longer-term perspective:
There are a number of tailwinds that are happening almost irrespective of what the company does, like:
- The move to the cloud.
- The proliferation of communication channels (email, chat, voice, mobile, social, etc.).
- The proliferation of systems related to customers.
- The increasing importance of Big Data and AI.
- The strategic importance of customer service, driven by increased customer expectations.
It’s no surprise that the public cloud is increasingly adopted by companies in their digital transformation, as solutions are eminently scalable and the sophistication of tools and solutions has increased dramatically.
The company still host solutions on its own servers, but management has argued that the economics have shifted in favor of the public cloud. The transformation seems to go through a blended model (Q2CC):
over the last quarter we’ve been building out a new software delivery engine, leveraging a blend of our own robust cloud infrastructure, and increasingly public cloud from both Amazon and Google. This new engine that we’re building is built on the latest PaaS technologies that stand for ‘Platform As A Service,’ some of these only recently available, which enabled us to continue to press our advantage and stay ahead of other cloud contact center vendors who rely on architectures, built before this latest wave of technology advancement was available.
The importance of the cloud is further buttressed by Gartner suspending its Magic Quadrant for on-premise contact centers, and how the cloud transforms call center business has been succinctly described by Capital Market Laboratories:
Call centers are a massive industry spread across the globe. The vast (vast) majority are not cloud based, and most are nothing but telephony. This leaves customers unhappy, and costs spiraling out of control with scale nearly impossible without yet more costs. Along comes a new player with a new idea – turn the customer service portion of the business into a technology hub – insert artificial intelligence (AI), go beyond telephony, add data analytics, put it in the cloud, and turn it all into a profit center. Make customers happier, faster – make corporations more profitable. Make scale easier, faster, and less expensive.
With channels multiplying and consumer expectations rising, customer service is becoming of strategic importance to a host of companies. From the Q2CC:
If you look at Gartner’s data, that shows that over the five year period that we are in, ending by 2022, the interactions in the contact center are going up by 3.5x. And you have that that’s sort of under pending the fact that, contact center is emerging as a strategic priority for businesses all over the world, and that was reflected most recently in Morgan Stanley’s Analysis where they looked at Cloud buying patterns and the fact that customer experience was the top priority for CIO’s and other CEO levels.
The market is huge with a TAM of $24 billion and under 15% penetration, as most active support centers are still telephone-based or legacy on-premise solutions, like those from Avaya (OTC:AVYA) and Cisco (CSCO).
The company’s most serious competitor is NICE Ltd. (NICE). From the earnings deck:
There is a similar slide from Gartner in the earnings deck. Management argues that the market is basically a duopoly with NICE, and it argues that Five9 wins 75% of the deals it competes in. From Capital Market Laboratories:
It has come down to a duopoly between us and our largest competitor, Nice Systems. The way we measure it is we look at every deal we get into, and who we see competitively, and what do we win. We win over 75% of the deals we get invited to.
Five9 is benefiting from multiple growth drivers. From the earnings deck:
Most of the company’s growth is coming from enterprise (large) customers. From the earnings deck:
The channel partners are certainly contributing to growth, being responsible for bringing in 60% of the gains in Q2, which is above the trend. The company has a myriad of channel partners of different kinds. From the earnings deck:
As the slide above illustrates, there are different categories of partners, with the CRM and Technology players supplying joint integrated products. The advantages of integrating CRM and call centers is pretty obvious, but (Q2CC):
The contact center is at the heart of the customer service technology landscape and is tied into many, many business systems.
Others like the system integrators help with bringing in business and some of the simpler implementations (most implementations are done by the company itself, as this is a crucial part of its competitive advantage). From the CEO interview on Capital Market Laboratories:
And what they need is, they need somebody to help them be successful in transitioning, moving your IVR [interactive voice response], and your routing rules, and all the knowledge about what your agents know. That’s the heaviest lift for these customers, it’s not the technology. The reality of moving customers into that is so much more complicated. So, where we have been exceeding is our professional services organization, with well over 200 full-time experienced contact center architects and consultants who will fly out to meet the customer, do the discovery, and help them organize differently. So, a big part of our success, one of the top three reasons for our success, has been professional services and a hands-on approach. Unlike all our competitors, we do that directly with customers. Think about it almost as a customer success operation. It’s a big reason for the success of our platform, one of the reasons customers are turning to us is that they have heard when companies move to Five9, they are more successful because of the hands-on attention we give them.
Important new partners in the quarter were Zoom and Microsoft (MSFT). On the latter (Q2CC):
we announced a brand new partnership with Microsoft teams UC, and we met with their partners and global sales organization to develop a joint go-to-market strategy. So we are building a tightly integrated contact center solution with Microsoft, which gives their partner a huge opportunity to make further progress in UC and enter into the cloud contact center market.
And there are additional benefits from such an extensive ecosystem of partners (Q2CC):
And that brings our cost of acquisition down, especially as we continue to not only build trust within those partners, but also build referenceability within the customers that they have referred us to, and once we get those references speaking highly, you know those partners want more and more to recommend Five9 because they trust we’re going to deliver for them.
A major way of extending the platform is to add functionality and capabilities, for instance (Q2CC):
Next our team has been demonstrating industry technology leadership, most recently leading a collaboration with Google, Cisco, Comcast and Free Switch on a standards body submission to drive the industry forward. With this patent pending technology, we’re aiming to make it dramatically easier for consumers to reach an agent by bringing voice calls right from the web browser, all the way to the contact center, without the phone in the middle. Accelerating web RTC adoption and improving customer experience.
The company is also leveraging the 5 billion minutes of customer interaction it processes yearly through its platform with the help of machine learning and condense that into a product: Agent Assist.
This AI-based product produces real-time recommendations and predictions for the agent, and trials are already ongoing with four of its largest customers. Management expects Agent Assist to be included in upcoming versions of the platform in 2020.
Adding features and products produces up-sell opportunities, and this is illustrated by the company’s 107% dollar-based net retention rate.
Q2 results were considerably better than expected:
- Revenue was up 27% to $77.4 million, that’s $5.4 million better than expected.
- Trailing 12-month enterprise subscription revenue grew 36% y/y and is the driving force of the company’s growth.
- Adjusted EBITDA margin improved 2.7 percentage points to 18.6%.
- Non-GAAP EPS grew 82% to $0.20, which was an $0.08 beat.
- More than 60% of deals went through its ecosystem of partners.
For this quarter, the company forecast revenue in a range of $78-79 million, and 14-15 cents EPS, topping the average estimate for $76 million and 14 cents. For the full year, the company projects $312.5-314.5 million and 70-73 cents per share, again above the average estimate of $306 million and 64 cents.
Management also bolstered its longer-term outlook, arguing that the company could maintain its 30%+ growth rate for enterprise for years to come as contact centers are becoming of strategic importance all over the world.
The 65% gross margin was a whisker from the company’s record, despite Q2 usually being the softest quarter. Management argues the rise is simply due to the scaling of its subscription business (which is 92% of revenue, so hardly a surprise).
Both gross margin as well as operating margin (and EBITDA margin) have improved steadily over time. From the earnings deck:
It’s quite remarkable that the company keeps on expanding its gross margin, as lower-margin service revenue is creeping up – from 3% at IPO to 7% in Q2 – as a result of more complex implementations at bigger clients.
And basically, this is the long-term operating model where the company is heading, according to management (earnings deck):
As the company achieved its financial targets a year early last year, it has stepped up investment in R&D. However, investors should note that (Q2CC):
Note that a number of new hires were back end loaded in the second quarter, and therefore we expect meaningful uptick in R&D and in sales and marketing expense in the third quarter of 2019. Nonetheless, in the fourth quarter, we expect to gain be reporting 20% plus adjusted EBITDA margin.
Given the EBITDA margin expectation, it looks like the company can clearly afford to invest in its future (even if Q4 is the seasonal high quarter), a picture which is confirmed by cash flows.
We always like to see these growth stocks producing cash, and Five9 fits this bill for some time already. This opens up the path for acquisitions and buybacks, leveraging growth.
The difference between operational and free cash flow is CapEx, which is guided to run between $20 million and $24 million this year.
Share-based compensation stands at 12% of revenue, which is fairly substantial and has been responsible for a considerable amount of dilution:
The company had $307.5 million in cash and equivalents and $203.1 million in debt at the end of Q2.
Ten times sales is pretty substantial, but this is a company that is already delivering cash and positive earnings, with revenues growing at 25%+ and gross margins at 65%.
Five9 is the market leader in a market that has a large runway in front of it. This picture is unlikely to change anytime soon, and given the revenue growth, gross margin expansion and operational leverage, we think the shares, whilst not cheap, are nevertheless attractive here.
The company is already producing considerable amounts of cash flow, and the share price gains after the stellar Q2 figures have evaporated in the market correction in growth stocks.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FIVN 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.