RingCentral Stock: Valuation Too Cheap At This Level (NYSE:RNG)

Investment overview

I give a buy rating for RingCentral (NYSE:RNG) as I believe the valuation is too cheap, which does not price in the improvements that RNG has demonstrated over the past few years. While growth has indeed slowed, I expect it to recover once the macro conditions get better. The strong secular tailwind should continue to drive growth for the long term.

Business description

RNG is in the business of providing software-as-a-service (SaaS) solutions for business communications. RNG’s main product is RingCentral Office, which enables customers to communicate via multiple channels with their counterparties. Such channels include personal mobile communication devices like phones and tablets, personal computers, and desk phones. Customers can also communicate via a wide range of methods, such as video calls, SMS, voice, etc. The bulk of RNG’s revenue comes from its software subscription revenue stream, which is ~95% of the business as of 1Q24. Breaking down revenue by geography, 90% of RNG revenue comes from North America.

RNG serves a large and growing market

In my opinion, the Unified Communication as a Service [UCaaS] industry is set to grow at a much faster pace than in the past. Based on Mordor Intelligence, the industry is expected to grow at ~18% CAGR between FY24 and FY29, to a size of ~$40 billion. I see two main factors driving this growth: digitalization and remote work adoption.

In terms of digitalization, COVID was a game changer for the industry, and RNG as a work-from-home policy fueled a strong surge in demand for UCaaS. It also sends a wakeup call to businesses that were slow in adopting modern digital tools, as they were put into a position to evaluate which digital solutions best fit their needs (i.e., there was a surge in awareness of the benefits of migrating on-premise solutions to the cloud).

COVID also taught the world that remote work is a viable business model that has potential for better productivity, and I believe there will be more businesses adopting a remote work culture. More remote work also means an increasing need for communication solutions, and this translates into more demand for solution providers like RNG. I don’t see any sense in businesses adopting legacy methods (on-premise-based private branch exchange [PBX]) to facilitate this, as it is not flexible in terms of communication modes, not scalable, and cannot be integrated into the business’s IT stack. Just recently, one of the largest players in the PBX industry exited the industry, which I take as a sign that underlying demand is weak.

On the other hand, (1) RNG enables communication across all mediums; (2) RNG is easily scalable as a new employee is just another subscription; (3) RNG reduces the cost of management since the IT department can manage everything remotely; and (4) RNG enables integration via APIs into the enterprise digital transformation IT stack.

In terms of competition, I wouldn’t worry about RNG’s competitive position because it is the leading player in the industry. RNG has consistently been named the leader in the space (for nine consecutive years) based on Gartner’s ranking. I believe RNG will be able to continue holding on to this position as it continuously develops new products to further cement its market position. On this end, positive progress can be seen in the latest quarter, where new product momentum remains encouraging. It was highlighted that RingCX now has over 200 customers, more than double sequentially, and traction with Events and RingSense was also encouraging, with Events growing logos 25% sequentially and RingSense customers also doubling sequentially.

Strong GTM strategy is a competitive advantage

Even if any new entrants are able to develop a similar product as RNG, RNG should continue to win because of its highly differentiated go-to-market strategy. RNG has a lot of strong relationships (now more than 15,000 channel partners) with key partners like Avaya (exclusive), Atos (exclusive), Alcatel-Lucent Enterprise, AT&T, Verizon, Vodafone, British Telecom, Telus, and Bell, etc., and I see this as a strong barrier to entry for new entrants.

One notable thing about the partners that RNG has is that it is able to secure partnership relationships with incumbent telecom operators, which shows that RNG is a product that they believe will see stronger demand than their own profitable legacy voice services.

I believed there were two main underlying reasons why RNG was able to secure these partners. The first is that they invested heavily in its product to easily enable private branding, and the second is that they invested in staffing to support these partners. The second reason is a major one, as there are >15,000 partners and ~80,000 ground sales staff (source: Baird’s 2024 global conference).

Therefore, so long as RNG remains the leading product (which is why new product innovations are important), there is little incentive for channel partners to prioritize selling new entrants’ products. Doing so would risk their own reputation (for selling an inferior product if anything goes wrong), and they may not enjoy the same level of support.

Macro environment turning better for RNG

Despite having a strong product and clear secular tailwind, the challenging macro impacts over the past two years have deeply impacted the RNG growth profile (dropping from >30% to 11% in FY23). I cannot say when the macro environment will recover, but the good news is that things seem to have stabilized. From the latest numbers, enterprise ARR growth was stable at ~13%, in line with the previous few quarters, while SMB and mid-market y/y growth fell by ~90 bps to 11.2% (a new low).

I should also note that on the enterprise front, RNG signed its largest UCaaS deal in company history in the latest quarter, a 40k seat deal with a F500 retailer (replacing Skype for Business). This implies two important things that instill confidence in RNG long-term growth once the macro situation recovers. The first is that enterprises are not letting their foot off the accelerator in adopting the best UCaaS tool. Second, RNG is able to win over a large competitor (Skype is by Microsoft), and this is a major factor to note because it implies that the RNG product works better than Skype, and RNG was still able to reach and convert a customer within Microsoft’s strong distribution networks.

Valuation

I get the point that the RNG share price got punished because growth slowed over the past two years; however, my view is that the poor macro environment is the main cause of the slowdown and not that the RNG product is structurally inferior to peers (they did win Skype to seal the largest enterprise deal after all). Hence, growth should recover eventually when the macroenvironment turns for the better. Moreover, RNG is much more profitable today than it was in FY22, where EBITDA margins have improved by 630 bps (16.1% to 24.4% in 1Q24). The free cash flow [FCF] profile has significantly improved as well. To put things in perspective, FY22 generated $218.9 million in FCF, and in 1Q24 itself, RNG generated $216.3 million in FCF. With regards to FCF, importantly, stock-based- compensation is now just 16% of total revenue vs. 20% in FY22, which means that on a like-for-like basis, the RNG FCF margin is much higher today.

Therefore, I strongly believe that RNG share prices are not reflecting the worth of RNG’s business on a normalized basis, as the stock is trading at just 7x forward earnings. For reference, 7x forward earnings basically means that the stock is priced for perpetual decline (assuming earnings are $1 and the required rate of return is 10%; in order to get a 7x forward earnings multiple, earnings must fall by 4% a year).

This doesn’t make sense to me, as the business is still growing with margins inflecting upward. Additionally, RNG is the player with the fastest expected growth among peers in the industry.

1. Zoom Video Communication trades at 11x with expected revenue growth of 3 to 4%.
2. 8X8 Inc. trades at 4x with expected revenue growth of a low single-digit percentage.
3. However, RNG trades at 7x forward earnings with high single-digit expected revenue growth.

Assuming that RNG grows as it did in 1Q24 for FY24 (~10%) and sees minor acceleration when the economy gets better next year (hopefully inflation comes down) and that margins stay the same (making the underlying assumption that RNG stops improving margins to reinvest profits in new products), the business should generate $382 million in earnings in FY25.

I think RNG should trade minimally in line with where Zoom Video Communications is trading today. Applying a 10x multiple, I believe RNG could be worth ~$40.

Risk

A further slowdown in growth even when the macro environment turns for the better will be a big red flag, as it suggests RNG is facing a lot more competitive pressure than I expected. It may prove that the competitive advantage is not strong enough to withstand a share loss. RNG is also gradually putting more focus on enterprise accounts, which means fewer resources for its SMB markets. If not handled properly, it could lead to a share loss as SMB customers are not well served.

Conclusion

I give a buy rating for RNG. RNG has a leading product in the UCaaS market and enjoys strong secular tailwinds from digitalization and remote work adoption. It also has a strong GTM strategy with established channel partners. While growth has slowed, I believe growth should improve as the macro environment improves. RNG’s has also greatly improved its margin and FCF profile. Given these factors and its cheap valuation, I believe RNG is a compelling buy.