8X8 INC /DE/ - Quarter Report: 2017 September (Form 10-Q)

8X8, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS

8x8, Inc. (8x8 or the Company) is a leading provider of truly unified cloud communications. The Company's suite of products weaves together unified cloud communications, messaging, meeting and contact center solutions so today's organization can communicate at the speed of employee and customer expectations. 8x8 technology provides one unified management platform with one communication experience for employees and customers, as well as a real-time data analytics platform for constant learning and improvement. The Company is a provider of cloud-based, enterprise-class software solutions that transform the way businesses communicate and collaborate globally. The Company's integrated, "pure-cloud" offering combines global voice, conferencing, messaging and video with integrated workflows and big data analytics on a single platform to enable increased team productivity, better customer engagement and real-time insights into business performance.

The Company's fiscal year ends on March 31 of each calendar year. Each reference to a fiscal year in these notes to the consolidated financial statements refers to the fiscal year ended March 31 of the calendar year indicated (for example, fiscal 2018 refers to the fiscal year ended March 31, 2018).

The accompanying interim condensed consolidated financial statements are unaudited and have been prepared on substantially the same basis as our annual consolidated financial statements for the fiscal year ended March 31, 2017. In the opinion of the Company's management, these interim condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair statement of our financial position, results of operations, and cash flows for the periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from these estimates.

The March 31, 2017 year-end condensed consolidated balance sheet data in this document were derived from audited consolidated financial statements and does not include all of the disclosures required by U.S. generally accepted accounting principles. These condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements as of and for the fiscal year ended March 31, 2017 and notes thereto included in the Company's fiscal 2017 Annual Report on Form 10-K.

The results of operations and cash flows for the interim periods included in these condensed consolidated financial statements are not necessarily indicative of the results to be expected for any future period or the entire fiscal year.

Certain software development costs capitalized in accordance with ASC 350-40, Internal Use Software (ASC 350-40), that were presented in other long-term assets in the Company's consolidated balance sheets as of March 31, 2017 are presented as property and equipment for the condensed consolidated balance sheet as of September 30, 2017. Assets in the amount of $7.7 million, net of accumulated amortization, have been reclassified in the balance sheet as of March 31, 2017 to conform to the current period presentation. The reclassification had no impact on the Company's previously reported consolidated net income (loss), cash flows, or basic or diluted net income per share amounts.

Certain amounts previously reported within the Company's condensed consolidated balance sheets and condensed consolidated statements of cash flows have been reclassified within each financial statement section to conform to the current period presentation. The reclassification had no impact on the Company's previously reported net loss, cash flows, or basic or diluted net loss per share amounts.

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ACQUISITIONS

In May 2015, the Company entered into a share purchase agreement with the shareholders of DXI Limited for a purchase price of $22.5 million, consisting of $18.7 million in cash paid to the DXI shareholders at closing and $3.8 million in cash deposited into escrow to be held for two years as security against indemnity claims made by the Company after the closing date. During the fiscal quarter ended June 30, 2017, $1.4 million of the cash held in escrow was returned to the Company and the escrow fund was closed. Since the purchase accounting for the acquisition was finalized by March 31, 2016, the proceeds are realized as a gain and reported as other income in the consolidated statements of operations.

The condensed consolidated financial statements include the accounts of 8x8 and its subsidiaries. All material intercompany accounts and transactions have been eliminated.

The significant accounting policies used in preparation of these condensed consolidated financial statements are disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2017 filed with the SEC on May 30, 2017, and there have been no changes to the Company's significant accounting policies during the six months ended September 30, 2017, except as described in the "Recently Adopted Accounting Pronouncements" section below.

In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Stock-based Payment Accounting, which simplified certain aspects of accounting for stock-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, an option to recognize gross stock compensation expense with actual forfeitures recognized as they occur, as well as certain classifications on the statement of cash flows. The following is the impact of the adoption on the Company's consolidated financial statements:

• In recording stock-based compensation expense, the ASU allows companies to make a policy election as to whether they will include an estimate of awards expected to be forfeited or whether they will account for forfeitures as they occur. The Company has elected to continue to include an estimate of forfeitures in its stock-based compensation expense. Therefore, there was no impact to the Company's consolidated financial statements.

• The ASU requires that employee taxes paid when an employer withholds shares for tax-withholding purposes be reported as financing activities in the consolidated statements of cash flows. Previously, the Company already included these cash flows in financing activities. Therefore, the adoption of this provision had no impact.

• The ASU requires previously unrecognized excess tax benefits from stock-based compensation to be recognized on a modified retrospective basis. Unrecognized tax benefits result when a deduction for stock-based compensation does not reduce taxes payable. The impact to deferred tax assets is disclosed in Note 7.

• The ASU also requires excess tax benefits to be presented as an operating activity on the statement of cash flows rather than as a financing activity on either a retrospective or prospective basis. The Company has elected to apply this provision of the standard on a prospective basis.

In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory. Under this guidance, entities utilizing the first-in-first-out or average cost method should measure inventory at the lower of cost or net realizable value, where net realizable value is defined as the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The adoption of this standard did not have a material impact to the Company's consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, along with amendments issued in 2015 and 2016, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard will become effective for the Company on April 1, 2018 and permits the use of either the full retrospective or modified retrospective transition method. The Company has preliminarily selected the modified retrospective method as the transition method.

The Company is in the initial stages of the assessment of the impact of the new standard on the Company's accounting policies, processes and system requirements. The Company has assigned internal resources and engaged third-party service providers to assist with the assessment and implementation. The Company currently believes the most significant impact relates to:

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• The allocation of consideration in a contract between product and service performance obligations; and
• The determination of performance obligations for professional services.

In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718) - Scope of Modification Accounting. The amendments in the update provide guidance on types of changes to the terms or conditions of share-based payment awards that would be required to apply modification accounting under ASC 718, Compensation-Stock Compensation. The amendments are effective for annual reporting periods beginning after December 15, 2017 with early adoption permitted. Upon adoption, the amendment is not expected to have a material impact to the consolidated financial statements.

Cash, cash equivalents, and available-for-sale investments, and contingent consideration were (in thousands):

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Contractual maturities of investments as of September 30, 2017 are set forth below (in thousands):

The Company's contingent consideration liability, included in other accrued liabilities and noncurrent liabilities on the condensed consolidated balance sheets as of March 31, 2017, was associated with the Quality Software Corporation (QSC) acquisition made in the first quarter of fiscal year 2016. This contingent liability was classified as level 3 within the fair value hierarchy. The remaining liability of $0.1 million was settled and paid as of September 30, 2017.

The carrying value of intangible assets consisted of the following (in thousands):

At September 30, 2017, annual amortization of intangible assets, based upon our existing intangible assets and current useful lives, is estimated to be the following (in thousands):

During the first quarter of fiscal year 2018, the Company determined that the tradename/domains no longer have an indefinite life, and has assigned those assets an estimated life of two years. Amortization expenses associated with tradename/domains are included in selling and marketing expenses in the condensed consolidated statements of operations.

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4. GOODWILL

The following table provides a summary of the changes in the carrying amounts of goodwill by reporting segment (in thousands):

The Company leases its headquarters in San Jose, California, and also leases office space under non-cancelable operating leases in various domestic and international locations. Future minimum annual lease payments were as follows (in thousands):

The Company has entered into a series of noncancelable capital lease agreements for data center and office equipment bearing interest at various rates.

There were no material changes in our other commitments under contractual obligations, indemnification and other contingencies since March 31, 2017.

The Company, from time to time, is involved in various legal claims or litigation, including patent infringement claims that can arise in the normal course of the Company's operations. Pending or future litigation could be costly, could cause the diversion of management's attention and could upon resolution, have a material adverse effect on the Company's business, results of operations, financial condition and cash flows.

On August 22, 2017, the Company was named as a defendant in Venadium LLC v. 8x8 Inc., filed in the District of Delaware (Civil Action No. 1:17-cv-1176-LPS-CJB) along with five other defendants. Plaintiff Venadium LLC sued the Company for alleged patent infringement concerning alleged activities involving the Company's alleged methods for protecting computer programs. Based on the Company's subscription to certain patent risk management services, the Company settled the suit without needing to respond to the Complaint. The settlement amount was immaterial. On October 5, 2017, Plaintiff Venadium LLC filed a Notice of Voluntary Dismissal of Defendant (with prejudice) pursuant to Federal Rule of Civil Procedure 41(a)(1), thereby effecting formal dismissal of the suit without a Court Order.

On August 25, 2017, the Company was named as a defendant in Hublink, LLC v. 8x8 Inc., based on a Complaint filed in the District of Delaware (Civil Action No. 1:17-cv-1214-GMS) along with four other defendants. Plaintiff Hublink, LLC sued the Company for alleged patent infringement concerning alleged activities involving alleged implementations of the Company's videophone communications uses and/or offerings. Based on the Company's subscription to certain patent risk management services, a third-party service provider has effectively settled the suit on behalf of the Company without needing to respond to the Complaint. The settlement amount was immaterial. Plaintiff Hublink, LLC and the Company are in the process of filing appropriate papers with the Court to effect formal dismissal of the suit with prejudice.

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6. STOCK-BASED COMPENSATION

The following table summarizes information pertaining to the stock-based compensation expense from stock options and stock awards (in thousands, except grant-date fair value and recognition period):

During the three and six months ended September 30, 2017, the Company issued restricted performance stock units (PSUs) to a group of executives with vesting that is contingent on both market performance and continued service. These PSUs vest (1) 50% on September 19, 2019 and (2) 50% on September 19, 2020, in each case subject to the performance of the Company's common stock relative to the Russell 2000 Index (the benchmark) during the period from grant date through such vesting date. A 2x multiplier will be applied to the total shareholder returns (TSR) for each 1% of positive or negative relative TSR, and the number of shares earned will increase or decrease at the end of each respective performance measurement period by 2% of the target numbers. In the event 8x8's common stock performance is below negative 30% relative to the benchmark, no shares will be issued. These PSU grants are included in the restricted stock unit activity disclosure for the six months ended September 30, 2017.

To value these market-based PSUs under the Equity Compensation Plans, the Company used a Monte Carlo simulation model on the date of grant. Fair value determined using the Monte Carlo simulation model varies based on the assumptions used for the expected stock price volatility, the correlation coefficient between the Company and the NASDAQ Composite Index, risk free interest rates, and future dividend payments.

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Stock Repurchases

In May 2017, the Company's board of directors authorized the Company to purchase $25.0 million of its common stock from time to time under the 2017 Repurchase Plan (the "2017 Plan"). The 2017 Plan expires when the maximum purchase amount is reached, or upon the earlier revocation or termination by the board of directors. The remaining amount available under the 2017 Plan at September 30, 2017 was approximately $10.9 million.

The stock repurchase activity as of September 30, 2017 is summarized as follows (in thousands):

The total purchase price of the common stock repurchased and retired was reflected as a reduction to consolidated stockholders' equity during the period of repurchase.

The Company's effective tax rate was 86% and negative 125% for the three months ended September 30, 2017 and 2016, respectively. The effective tax rate is calculated by dividing the income tax provision by net income before income tax expense. The difference in the effective tax rate and the U.S. federal statutory rate of 34% in both periods was due primarily to the change in pretax profitability, geographic mix of profits and losses, and adoption of ASU 2016-09 effective April 1, 2017.

As described in Note 1, the Company adopted the updated accounting standard for share-based payment accounting in the first quarter of fiscal year 2018. As a result, the Company recorded deferred tax assets of approximately $17.6 million with a corresponding increase to retained earnings related to previously unrecognized excess tax benefits. For the six months ended September 30, 2017, the Company recognized approximately $2.7 million of excess tax benefits within the provision for income taxes. Additionally, the Company elected to prospectively apply the change in presentation of excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity. Accordingly, prior period classification of cash flows related to excess tax benefits were not adjusted.

The following is a reconciliation of the weighted average number of common shares outstanding used in calculating basic and diluted net income (loss) per share (in thousands, except share and per share data):

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The following shares attributable to outstanding stock options and stock awards were excluded from the calculation of diluted earnings per share because their inclusion would have been antidilutive (in thousands):

ASC 280, Segment Reporting, establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas and major customers. Under ASC 280, the method for determining what information to report is based upon the way management organizes the operating segments within the Company for making operating decisions and assessing financial performance. The Company manages its operations primarily on a geographic basis. The Chief Executive Officer, the Chief Financial Officer, and the Chief Technology Officer or the Company's Chief Operating Decision Makers (CODMs), evaluate performance of the Company and make decisions regarding allocation of resources based on geographic results. The Company's reportable segments are the Americas and Europe. The Americas segment is primarily North America. The Europe segment is primarily the United Kingdom. Each operating segment provides similar products and services.

The Company's CODMs evaluate the performance of its operating segments based on revenues and net income. The Company does not allocate research and development, sales and marketing, general and administrative, amortization expense, stock-based compensation expense, and commitment and contingencies for each segment as management does not consider this information in its evaluation of the performance of each operating segment. Revenues are attributed to each segment based on the ordering location of the customer or ship to location.

The following tables set forth the segment and geographic information for each period (in thousands):

Revenue is based upon the destination of shipments and the customers' service address. For the three and six months ended September 30, 2017 and 2016, intersegment revenues of approximately $4.4 million and $6.9 million, and $1.5 million and $2.6 million, respectively, were eliminated in consolidation, and have been excluded from the table above.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, words such as "may," "will," "should," "estimates," "predicts," "potential," "continue," "strategy," "believes," "anticipates," "plans," "expects," "intends," and similar expressions are intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. Actual results and trends may differ materially from historical results or those projected in any such forward-looking statements depending on a variety of factors. These factors include, but are not limited to - customer acceptance and demand for our cloud communications and collaboration services; the quality and reliability of our services; the prices for our services; customer renewal rates; customer acquisition costs; our ability to compete effectively in the hosted telecommunications and cloud-based computing services business; actions by our competitors, including price reductions for their competitive services, our ability to provide cost-effective and timely service and support to larger distributed enterprises; the impact of risks associated with our international operations; potential federal and state regulatory actions; compliance costs; potential warranty claims and product defects; our need for and the availability of adequate working capital; our ability to innovate technologically; the timely supply of products by our contract manufacturers; our management's ability to execute its plans, strategies and objectives for future operations, including the execution of integration plans, and the timing and extent of improvements in operating results from increased spending for marketing, sales and R&D; our management's ability and to realize the expected benefits of our acquisitions, and potential future intellectual property infringement claims and other litigation that could adversely affect our business and operating results. All forward-looking statements included in this report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. In addition to the factors discussed elsewhere in this Form 10-Q, see the Risk Factors discussion in Item 1A of our 2017 Form 10-K. The forward-looking statements included in this Form 10-Q are made only as of the date of this report, and we undertake no obligation to update the forward-looking statements to reflect subsequent events or circumstances.

We are a leading provider of truly unified cloud communications. Our suite of products weaves together unified cloud communications, messaging, meeting and contact center solutions so today's organization can communicate at the speed of employee and customer expectations. Our technology provides one unified management platform with one communication experience for employees and customers, as well as a one real-time data analytics platform for constant learning and improvement.

Our fiscal year ends on March 31 of each calendar year. Each reference to a fiscal year in this report refers to the fiscal year ending March 31 of the calendar year indicated (for example, fiscal 2018 refers to the fiscal year ending March 31, 2018).

In the second quarter of fiscal year 2018, our service revenue from mid-market and enterprise customers grew 28% year-over year and represented 58% of total service revenue. New monthly recurring revenue (MRR) bookings from mid-market and enterprise customers and by our channel sales teams was 61% of total bookings for the quarter, reflecting strong demand for our services in our target market segments. Also, average monthly service revenue per mid-market and enterprise business customer (ARPU) increased 8% to a record $4,697, compared with $4,351 in the same period last year. The increase resulted from our success in selling a greater number of subscriptions to larger, more established customers.

In October 2017, we launched the new 8x8 Virtual Office Editions, in three product bundles: X2, X5 and X8. X8, our most unified offering, weaves together communications, collaboration with our contact center all into one solution. It includes an unlimited calling zone to 45 countries and a full suite of 8x8 Virtual Office features, such as HD voice, Virtual Office Meetings, HD Video, integrations with Salesforce, Zendesk and NetSuite CRM, Salesforce analytics for better and faster data insights, call recording, call quality reporting, and barge monitor whisper capabilities.

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In order to position ourselves most effectively for our next phase of growth, we have identified the following strategic initiatives.

First, we are aligning global business units around our core market segments to optimize for growth. We bifurcated our internal sales operations into two separate sales operations - Small Business & eCommerce and Mid-market & Enterprise. These operations will align sales and delivery, connecting demand generation, services and support to drive revenue growth and profitability globally. Small Business & eCommerce will focus on our high-volume, transactional business, with the objective of accelerating growth and productivity through eCommerce and self-service. Midmarket & Enterprise will focus on creating and leveraging channel relationships to drive a consultative approach to our land and expand strategy for larger accounts in the US, Europe, Middle East and Asia, and Asia-Pacific regions.

Second, we have made several executive appointments in our marketing and sales organizations to align with our new sales operations and accelerate adoption of our solutions across all market segments.

Third, we have expanded our global field sales organization with both Mid-market and Enterprise Sales Executives and Channel Development Managers. Our field sales executives work directly with customer prospects to understand, customize, and optimize communications solution for customer's business while Channel Development Managers are responsible for recruiting and enabling partners in their respective territories, evangelizing the 8x8 brand and growing the sales pipeline with partners.

In the first fiscal quarter of 2018, we announced increased investments for sales and marketing expenses to accelerate the growth of our business in the mid-market and enterprise segments. We commenced these investments in the second quarter of fiscal 2018 and intend to incur them over several quarters. The precise timing of these additional expenditures, and the reporting periods in which they occur, will depend in part on when our management can implement the steps, particularly hiring additional personnel, necessary for achieving anticipated growth in our bookings and revenues. In addition, though we believe our new marketing and sales expenditures, and, to a lesser extent, our product development expenditures will help us achieve the bookings and revenue growth we are seeking, such growth in not assured, and will be impacted not only by the timing of those expenditures but also by our ability to effectively implement such plans and limit disruptions to our current operations while we do so. If we do not timely and effectively implement our new marketing, sales and product development plans, and productively

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

See Item 1 of Part I, "Financial Statements - Note 1 - Basis of Presentation - Recent Adopted Accounting Pronouncements."

See Item 1 of Part I, "Financial Statements - Note 1 - Basis of Presentation - Recent Accounting Pronouncements."

We periodically review certain key business metrics, within the context of our articulated performance goals, in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The selected operating statistics include the following:

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