Sangoma Technologies Corp (SANG) 2020 Q2 法說會逐字稿

Thank you for standing by. This is the conference operator. Welcome to the Sangoma Technologies Second Quarter 2020 Investor Conference Call. (Operator Instructions) And the conference is being recorded. (Operator Instructions)

I would now like to turn the conference over to David Moore, Chief Financial Officer. Please go ahead, Mr. Moore.

Thank you, operator. Hello, everyone, and welcome to Sangoma's investor call. We're recording the call, and we'll make it available on our website tomorrow for anyone who is unable to join us live.

I'm here today together with Bill Wignall, Sangoma's President and Chief Executive Officer; and John Tobia, EVP, Corporate Development to take you through the results of our second of fiscal 2020. We will discuss the press release that was distributed earlier today, together with the company's unaudited interim financial statements and Q2 MD&A, which are both available on SEDAR and will be available shortly on our website at www.sangoma.com.

As a reminder, Sangoma reports under International Financial Reporting Standards, IFRS. And during the call, we may refer to a couple of terms such as operating income, EBITDA or adjusted cash flow that are not IFRS measures, but which are defined in our MD&A. For fiscal 2020, and that's starting on July 1, Sangoma adopted IFRS 16, a new accounting standard and the fiscal 2020 results incorporate that new standard. Please also note that unless otherwise stated, all reference to dollars are for the Canadian dollar.

Before we start, I'd like to remind you that the statements made during the course of this call that are not purely historical are forward-looking statements regarding the company or management's intentions, hopes, beliefs, expectations and strategies for the future. Because such statements deal with future events, they are subject to various risks and uncertainties, and actual results might material -- might differ materially from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in the accompanying MD&A, our annual information form and the company's annual audited financial statements posted on SEDAR.

Finally, on the last call, I had indicated that we've had request to hold these calls on the same day as the results are released or before the market opened the following day, which can be somewhat challenging for our shareholders on the West Coast. This quarter, we're trying that so that you get management's perspective right after our results released.

With that, thanks again for joining us. I now hand the call over to Bill.

Thank you, David. Hello, everyone, and thank you for joining us today. I have structured my comments into 4 sections. First, I will start by going through our Q2 results. Second, I will cover where we stand year-to-date versus last year. Third, I will provide an update on Sangoma's corporate strategy, including a brief update on the VoIP Innovations acquisition as well as a few comments on the recently announced signing of an agreement to have e4 joining Sangoma. Finally, I will conclude with a section on forward guidance. Following my remarks, I will hand the call back to David for our typical, open Q&A session.

With that, let's turn to Section 1 on Q2 results. Sales for the quarter ended December 31, 2019, were a record $32.3 million, up 10% from the $29.2 million in the second quarter of fiscal '19 and up sequentially by 15% from our recent Q1 of $28 million. The increase in sales was due to the acquisition of VoIP Innovations, the continued growth and compounding of our services business, where our recurring revenue was generated, all partly offset by some softening in demand for our onetime revenue product sales. I'll come back to the topic of product mix and revenue trends in the strategy section of today's call.

Gross profit for the second fiscal quarter of 2020 was $21.3 million, 20% higher than the $17.8 million realized in the second quarter of fiscal '19. Gross margin for the second quarter was 66% of revenue, 5% higher than in the same quarter a year ago due to the steady increase in the percentage of revenue from higher-margin services and to the impact of the VoIP Innovations acquisition. Operating expenses for the second quarter of fiscal '20 were $19.2 million versus $17 million in the same period last year. This was primarily driven by the additional OpEx that came with the acquisition of VoIP Innovations in the quarter. For the second quarter of fiscal '20, EBITDA at $5.2 million was more than double that in the same quarter last year. This was driven by the inclusion of VoIP Innovations for part of the quarter, the operational efficiencies introduced during fiscal '19, the adoption of IFRS at the beginning of this fiscal year and the gradually increasing fraction of recurring revenue as our service business continues to compound.

There are not normally other lines below EBITDA on our P&L that are worthy of significant comment on these calls, but I would like to mention interest expense this quarter. While interest costs are up in Q2 because we doubled our debt to complete the VI acquisition, I am pleased that in January, we converted the base rate loan to LIBOR and then undertook an interest rate swap to lock in the current interest rate of around 4.2% for half of the original loan during 5 of the almost 6-year period. Since our interest rate has been around 6.5%, this is a material savings.

Net income for the first quarter was a negative $1.3 million compared to a loss of $0.3 million for the equivalent quarter last year. In Q2 this year, the company incurred $2.6 million of transaction costs for the acquisition of VoIP Innovations, whereas in the same quarter of last year, $0.6 million of expense was incurred as part of the restructuring following the acquisition of Digium. It is purely these onetime expenses which take net income negative for these quarters.

And for the final portion of my commentary on second quarter results, I'll briefly touch on a couple of highlights from our balance sheet and cash flow. As you may remember, we raised $21 million in equity during Q1, together with the additional $20 million in new debt during Q2. These raises were principally undertaken to fund the acquisition of VoIP Innovations, leaving Sangoma with a cash balance of $13.4 million at the end of Q2. Sangoma's adjusted cash flow from operations, which excludes the impact of acquisitions, was just under $1 million. This was well below our EBITDA of $5 million this quarter, so it's worth a few moments to discuss. The majority of this delta between EBITDA and adjusted cash flow from operations is due to the realignment of our supply chain, as mentioned on each of our last 2 conference calls. This is a longer-term project in which we've been consolidating some contract manufacturers or CMs. And in Q2, this caused an increase in inventory.

In our second quarter, we completed the move out of one factory and into another, which, by the way, is located here in Canada, as we seek to move manufacturing to fewer CMs. This is a very complex process in which Sangoma is heavily involved and the deep operational aspects of moving manufacturing jigs, test equipment, et cetera, and getting it all set up again in a new factory. It's not typically the kind of situation I would normally include in the quarterly conference call because we know you guys just expect us to handle such operational details, as you should, and that's what we do. But in the process, we needed to build a buffer of inventory, while one factory ramped down and the other ramped up.

In addition, we've purchased the complete stock of raw material that the prior factory had built up on our behalf, but had not yet built into finished goods. Hence, we have seen a $2.6 million increase in inventory this quarter, which naturally affected operating cash flow. There is still some remaining impact of this move that will show up in Q3 but the transition process itself is completed. In addition to this work on optimizing our supply chain in CMs, there were the more typical swings in working capital items as well that net adjusted cash flow from operations to come in just below $1 million. I will address investor requests for more information about our supply chain, and specifically, the impacts from all the news surrounding coronavirus in my section on strategy in a few moments.

That brings my comments on Q2 financial results to the close, and I'll now turn to year-to-date. When we compare on a year-to-date basis, please remember that in addition to this year's VoIP Innovations acquisition, we purchased Digium in September of 2018, both of which affect results and year-over-year comparisons. Sales for the 6 months ended December 31 were $60.3 million, 19% higher than the $50.7 million in the first half of fiscal '19. The increase in sales was due mostly to the addition of Digium in late first quarter of 2019 -- fiscal '19, the acquisition of VI early in the most recent quarter and the ongoing growth and compounding of our services business. Gross profit for the first 6 months of fiscal '20 was $38.8 million, 28% higher than the $30.3 million realized in the first half of fiscal '19. Gross margin for the first half was 64% of revenue, up 4% from 60% last year reflecting slightly higher margins in the newly acquired businesses and the higher percentage of revenue from services.

Operating expenses for the first 6 months of fiscal '20 were $35 million compared to $27.7 million for the same period last year, reflecting the additional costs of the recent acquisitions. For the first half of fiscal '20, EBITDA at $8.9 million was 81% higher than in the same period last year. This improvement is due mostly to the same drivers that I covered for Q2, namely the inclusion of VI for part of this quarter, the operational efficiencies introduced during fiscal '19, the adoption of IFRS 16 at the beginning of this fiscal year and the gradually increasing fraction of revenue from services.

Interest expense is up substantially year-over-year as a result of the acquisitions just as it is for the quarter, but as mentioned earlier, the recent refinancing has locked in half of the loan at 4.2%, down from the 6.5% rate in the recent past. During the first half of fiscal '20, Sangoma recorded $2.6 million of costs directly associated with the legal financing and closing of the VI acquisition on October '18, 2019. In the same period of fiscal '19, we coincidentally incurred a similar amount of $2.7 million for the purchase and integration of Digium. Net loss for the first 6 months ended December 31 was $0.4 million compared to a net loss of $1.3 million last year. That brings my comments on our financial results to a close, and I'll now move on to our strategy section.

In my strategy section today, I will cover 3 topics: an update on the VI acquisition; I'll add some significant detail as promised earlier regarding product mix and revenue trends; and thirdly, I'll touch on the e4 tuck-in deal, it was recently announced after the end of Q2. So first, let's start with the strategy update on VoIP Innovations. Most importantly, we remain very pleased with the VI transaction. As some of you will recall, VI specializes in wholesale SIP trunking as the primary line of business, something we refer to internally as "Trunking as a Service", using the same name in convention as SaaS or UCaaS. This service is sold to partners, but not typically to end users and is sold with a usage-based pricing model. Recent activity during the past few months at VI has focused on organization tuning and some coordination of marketing and sales activities, both as part of the integration with Sangoma. We are now in the process of adding a few new employees at VI to enable investment into both their core products as well as the newer CPaaS offering.

From a sales perspective, we have completed cross-training on the products and already started cross training -- cross-selling VI services to the Sangoma user base. This is beginning to generate new incremental leads for the VI services. From a marketing point of view, we are coordinating presence at industry events and trade shows, as you'd expect with VI staff attending Sangoma events such as our recent user conference in Atlanta, for instance. And this month, the websites will come together with the content currently under voipinnovations.com, moving to Sangoma as carrierservices.sangoma.com. And last but not least, we're starting to work on the go-to-market strategy for our CPaaS platform called Apidaze. Finally, as you've seen, the VI operation has immediately added to recurring revenue, EBITDA and cash flow as anticipated.

Second, I will provide some additional color on product mix and revenue trends in this strategy update. I'm doing so in the strategy section of today's call and not in the section on Q2 results because we see this topic is so clearly a part of our highly conscious corporate strategy. And while it's a strategy we've shared with investors previously, I'll take a moment to cover it again as a backdrop to the product mix discussion in Q2 because it's so important in order to understand Sangoma's revenue trends. This is a substantive section for today's call. I previously described Sangoma's very intentional strategy as investing to drive growth through a combination of organic means, augmented with prudent M&A activity, all while demanding healthy profitability. This is a conscious decision from your Board of Directors, one that most of you also support based on my discussions with many of the folks on this call, and we are 100% continuing on this path. In our review, this is the optimal way to deliver both reasonable revenue growth with profitability, in order to produce long-term financial health and returns for investors. This implies that we are constantly balancing the many product lines or assets at Sangoma to adjust our investments into them, such that we're spending more on the growing business and less on the mature assets. This skill with balancing investment across a wide range of growth and mature business assets is something that I'm very proud of the team here for and the core competency that your executive team has worked very hard at over the years.

We may not be able to control the demand side of the equation for every single unit of our business, but we can consciously decide about what new things to invest in, where to focus the company's efforts and what lines to spend more R&D or marketing and sales dollars on. And I think your team here is quite good at that. Those of you who have been with us for over 5 years now would recall that this all started with an initial 3 plank approach. We broadened our product portfolio to move away from a single product line to categories with growth, attacked new customer segments and commenced selling into new geographies. Over the next couple of years, we evolved from a single product line company to become a full solution UC provider who sold not only to SMB, but also to enterprise, carrier and OEM customers and we expanded globally, so we were doing these things not only in North America but around the world. The most recent phase in our strategy was to take this full solution that could be sold on-premise, industry jargon meaning the software is installed at the customer's site, and introduced a cloud-based service in which we host our own software and data centers. We then use it to provide a monthly subscription service for customers who prefer a hosted cloud-based service to the on-premise solution. This enabled the recurring revenue model to begin its growth phase at Sangoma.

As such, we are now extremely focused on growing that services business, where the recurring revenue is generated versus the onetime product sale-type revenue. That is strategically advantageous to Sangoma, since it's higher-quality revenue, more predictable and is obviously valued more highly by you and the investment community more generally. I realize that was a rather long recap, but the essential backdrop to properly understand what is happening with our product mix and thus revenue trends at Sangoma. To take that backdrop and use it to help understand our Q2 results, I would suggest we look at 4 things now. The evolution of onetime product sales versus our service revenue, the balance between profitability and growth, our allocation of marketing and sales and R&D investment between growing product lines versus maturing product lines and any potential impact on our global supply chain from coronavirus.

First is the evolving balance between our onetime product sales versus the services business at Sangoma. This mix is evolving very closely to what we want to see. For example, if you look back on the past couple of years, you would see a typical quarter in fiscal '18 had somewhere around $5 million per quarter in services revenue. In fiscal '19, that had grown to about $10 million per quarter. And now in fiscal '20, you see we finally exceeded $15 million per quarter in this past quarter. This is very dramatic, and it's precisely what we're trying to manage towards. Again, highly conscious. Looked at as a percentage of total revenue, Sangoma was in the 20% range in fiscal '18 for services, as a fraction of total sales, which grew to the 30-plus percent range in fiscal '19. And we expect it to be in the 40% to 50% range this year. Q2 validated that fact quite nicely, with almost half of our revenue coming from services. This is a very dramatic shift, one that we prioritize highly and work on every day here.

Secondly, at Sangoma, we do not attempt to squeeze every last dollar of possible revenue growth out of a line of business, especially a maturing one. We try to balance our desire for EBITDA and EBITDA expansion with protecting revenue. And to repeat, this is especially relevant when the revenue we could act to protect is coming from the more mature parts of our business, such as with onetime product sales.

Thirdly, as a result of this desired balance, it then becomes a highly conscious decision to moderate the investment into more mature product lines, as mentioned, especially those with onetime product revenue. So while we can't always control the demand in the marketplace for such products, or at least not precisely, we do get to decide whether we deviate from our strategic focus of gradually moving the company to more and more recurring revenue. Sangoma is very deliberate about that decision. Sure, we could theoretically decide to ramp up spending on customer acquisition for those product categories that deliver onetime revenue by spending more on marketing and sales or on R&D, an attempt to offset part of any softer demand in that category, but that is not what we choose to do. We are focused on growing the services side of our business because it's where long-term value creation resides and that's what we believe most of you want. We do sometimes get an occasional question about this part of our business, the onetime product sales and what the drivers of this demand are, so I will touch on those 3 principal drivers here and how they affect our product mix and revenue trends in fiscal '20 generally or Q2 specifically.

First, let's recall that such products are CapEx-type purchases for the end user, not OpEx as it is with the cloud subscription. So if, for example, an IT director, at one of our customers is looking at a purchase of, say, a gateway or our premise-based UC solution, they will see it as a onetime capital outlay. Their CFO gets asked by the IT Director to approve this, say, for example, $47,000 purchase order. When the economy feels good, the CFO says, yes, sure. But if the CFO is slightly more worried about economic headwinds as many folks seem to be nowadays, but what seems like an ever-increasing number of global flash points these days, then maybe he says it's a good idea, but let's wait a quarter or 2 and see how things look then. We are seeing some of that in our onetime product sales. It doesn't affect their services business in the same way because the comparable purchase decision is not $47,000 once, but instead, a $1,000 or $2,000 per month type of decision.

The second key industry driver for our onetime business is the macro trends that are not general economic ones, but industry-specific, some of our onetime product sales are our products that connect to the PSTN, which is gradually getting replaced by IP networks. And some are based upon premise UC, which is gradually migrating to the cloud. Both of these put some pressure on our onetime product sales.

And the third key driver of our onetime product sales is the periodic single larger orders, which are inherently unpredictable and contribute to the lumpiness in this half of our business. You know from prior calls and prior press releases that we've always thought to be transparent about those when they occur. This helped our Q1 and Q2 in fiscal '19, as we've discussed previously, while it did not contribute meaningfully in fiscal '20 so far, including for Q2.

So overall, my key message about onetime product sales is that Sangoma can't precisely control demand, and we choose instead to remain very focused on our central strategic direction, which is moving more and more business to MRR. That means that we're prepared to accept some dips in revenue for our product sales rather than risk destroying profitability in an attempt to counter any market or economic dynamics. By the way, that was not really true 5-plus years ago at Sangoma. Then, we had no choice but to fight tooth and nail, working to squeeze out every last dollar of product revenue because we were still building out the product portfolio to underpin the turnaround. So we did not yet have material recurring revenue. But thankfully, that's no longer the case. We now consciously choose to focus on our longer-term strategy of increasing recurring revenue as the key driver of our growth. As you've heard us say for years, as complemented by carefully selected acquisitions.

And finally, my fourth and last topic on Q2 product mix and revenue trends involves our supply chain and any impact we're seeing relative to events in Wuhan, China and the coronavirus. Several of you have asked us about this via e-mails and calls over the past while. So I'd like to address it here rather than waiting for a possible question in our Q&A session at the end. To start, I'd like to point out that while our supply chain is relatively sophisticated for a company of our size, as I've covered previously, more of our manufacturing is onshore versus offshore. That is for our product clients which still have a hardware component to them because please remember, services are now half of our business. Chinese manufacturers represent a minority of our supply chain, though admittedly, it's an important one. The impact of the coronavirus on Sangoma initially involved some delays in shipping products across certain borders internal to China.

Next, as the problem then emerged in Wuhan started to grow, it also began to coincide with the Chinese New Year, which is such a pervasive holiday there that most North American companies know their factory partners will shut down during this period. Coronavirus extended that shutdown in a few cases, as workers have not been coming back after the Chinese New Year as fast as they normally would. And thirdly, the flow of raw materials has also been impacted slightly, thereby delaying our factories in China from getting some of the components they use when manufacturing our products. While the impact of these events on Sangoma, thus far, has been reasonably modest, we can't be naive. It is feasible that, that impact could grow if the shipments of finished goods or the supply of raw materials gets disrupted more. No doubt, some of you have now seen announcements from many other tech companies already getting affected by this right up to Apple earlier last week. So while we are quite intentionally looking at multiple ways to mitigate all that and the recent move of more manufacturing to a Canadian CM can help, the global impact from the coronavirus was indeed considered as one key factor in our decision to revise revenue guidance, which I'll speak about more materially. That concludes my comments on product mix and revenue trends in the strategy section, and I'll now turn to the third and final part of the strategy update today, the recent announcement about e4 Strategies.

Although this is not strictly speaking Q2 news, some of you may have seen in our press release earlier today about second quarter results that subsequent to the end of that quarter, we entered into an agreement to acquire e4 Strategies. The deal is not yet closed, but it's planned to do so shortly. e4 is a smaller company based in Michigan, and they have been selling our products into the open source ecosystem for many years very successfully, always having been strong supporters of Sangoma during that whole period. This is a tuck-in-type acquisition. And when it closes, we do not plan to announce further financial details of this transaction. The deal is being done to strengthen our sales capability in open source, and it would have Mike White, e4's founder and owner as well as his whole team joining the Sangoma sales organization to focus on that part of the market.

And with that much longer than normal update on corporate strategy, I'd like to move on to forward guidance for fiscal '20. As you know, for the last few years, Sangoma has typically released guidance at the end of each fiscal year for the next year to come. So when we released Q4 results for fiscal '19, we provided forward guidance for fiscal '20 and so on. Then throughout the year, if conditions warranted, we update guidance as appropriate. At the end of Q1, we indicated that we would update guidance for fiscal '20 on this call at the midyear point. As you've now heard, there are a number of factors affecting our perspective, including a growing concern in some minds regarding the global economic outlook, you can especially see that the last few days in the markets; the feedback loop between economic uncertainty and CapEx-type decisions; trends in the industry, such as the shift away from the PSTN or towards more cloud adoptions; the growing impact from the coronavirus on supply chains; and finally, an increasing number of worrying flash points around the world, be it Brexit, passenger planes being shot down by military force, impeachment proceedings, wildfires devastating core regions or the lack of train travel and pipelines being built in Canada.

The list just seems to be getting longer. So while there may be no single factor to point to, Sangoma has elected to reduce revenue guidance for fiscal '20, and at the same time, we're slightly increasing the range for EBITDA guidance. As many of you will have seen in our press release earlier today, we now expect to hit $128 million to $132 million of revenue this year, with the reduction from earlier forecasts coming from onetime product sales. We are also increasing somewhat our guidance for EBITDA, which we now expect to be between $19 million and $21 million due to the growth in our services business, which comes with higher gross margins; the higher fraction of total sales coming from recurring revenue; our updated visibility to VoIP Innovations after having them part of Sangoma for a few months now; and the impact of IFRS 16.

I realize that there has been a lot to digest today, so I'd now like to bring my prepared remarks to a close with a quick summary. Sangoma has grown from a very small nano cap company with about $10 million in sales to a strong growing business with well over $100 million in revenue, a level that we expect to continue adding on to significantly. We have demonstrated proven top line growth over an extended period; solid and expanding EBITDA; increases in our services business, where the recurring revenue is generated; and positive cash flow. We are building on our track record with the management to win new clients, build new products, satisfy our customers and acquire new businesses. We acknowledge that there are a few headwinds in the market these days and that these can have modest effects especially on our onetime product revenue and supply chain, but that will not be tracked nor defocused us from the primary objective of building out an increasingly more valuable company based upon a growing services business augmented by prudent acquisitions.

And indeed, we continue to seek overall growth and complementary acquisitions, all while balancing that growth and the investments in appropriate areas of our business to drive it with the desire for reasonable profitability. And by the way, there were several interesting opportunities on our M&A radar screen. Some of these companies might be skewed somewhat to higher recurring revenue or EBITDA, and that also holds interest for us because it benefits the business over the longer term. Management and your Board understand these trade-offs, and they're focused on building shareholder value over both the short and long-term horizon.

With that, I'll turn the call back to David for questions.

To make sure everybody knows how to ask questions, I will ask the operator to go over the instructions. Operator, we're ready to take questions now, please.

(Operator Instructions) Our first question is from Gavin Fairweather with Cormark Securities.

Just wanted to start out on the gross margin, obviously, a meaningful kind of step-up this quarter. I think that when you did the VI acquisition, we kind of chatted about it remaining kind of in the low 60s. So I just wanted to dig in a bit on whether kind of this quarter was kind of a different allocation of the VI costs or maybe just the mix in the quarter. And maybe your thoughts on kind of whether this is a good like run rate going forward?

Yes, maybe I'll start, and David, you can jump in. There's a number of factors though, Gavin. It is the product mix as you hinted at for sure, including the fact that more of the revenue is coming from services, which naturally drive better gross margin. And David, maybe you want to expand on that a little bit?

Yes, Gavin, so you're right. That question was asked and what we identified when we were going through the detailed accounting for the end of the quarter that there were some costs in their business model that they treat as cost of sales that we would treat as part of operating the business and vice versa. So all that's happened is we've realigned those to match the same reporting that we do for other businesses. And hence, therefore, the benchmark, if you like, for Q2 is not an unreasonable one to plan on going forward.

Okay. That's helpful. And then I just wanted to move on to guidance here for a second. So you discussed kind of what's been going on, on the product side in your prepared remarks. What I thought was interesting is that given the lower revenue, you actually kind of increased your range on the EBITDA side. So is that just the changing mix as we've talked about? Or are you being kind of a bit more mindful about R&D or sales marketing or G&A spend?

Yes, I don't think it's any one of those, Gavin. It's a combination, right? It's back to my comment about the higher the fraction of revenue is that comes from services the better gross margin we can drive, the better gross margin we can drive the better EBITDA we can drive. Some of the product lines that come with slightly lower margins have a lower fraction in the mix. And so EBITDA looks a little bit better because of that. And factor that in IFRS helps the view that if some of the product sales are a little bit weaker. That would include products like phones, which typically come with slightly lower gross margins. So it's no one single thing. It's a combination of a whole bunch of factors.

Okay. And then appreciated your color around the supply chain. Can you just talk about -- have your CMs kind of restarted and kind of they running at kind of partial throughput at the time being? Or are they kind of still shut down?

No, they're not still shut down. That's a good question. They were shut down for longer than they would normally be. And when they came back, they didn't come back at full capacity. And I think that's typical for many, many North American tech businesses and contracted manufacturers they might use. But it varies widely, Gavin, from CM to CM and where they are in China and what's happening in that particular region. So there's no single answer to that one. It's unique to the ones that Sangoma uses.

Okay. Thank you, Gavin. We actually don't have any other callers in the queue right now. So I'd just like to remind people that we're open for questions. Oh, a couple more have come in. So operator, back to you.

Our next question is from Gabriel Leung with Beacon Securities.

Couple things. First, Bill, did you disclose or are you in a position to disclose what revenue contribution VoIP Innovation provided in the quarter?

No, we didn't. And we've typically not done that Gabe. I don't think we're going to do that. But I'll think about your question and come back to it once we reflect on it. We typically have not broken out revenue into sub-buckets across the business in ways other than you see in the financial statements, which includes product versus services and geographical breakdown.

Got you. Moving over to the, I guess, the supply chain. Thanks for the feedback during this call. I was wondering if you could provide a bit more detail around -- if you're able to provide what sort of revenues -- what the revenue contribution is on the product side would come from your China-based contract manufacturers or from that supply chain.

Well, I wouldn't know that off the top of my head, Gabe. As I said in my remarks, it's perhaps surprisingly to some people, a minority, we don't build most of our stuff in China. But the exact fraction, I would have to go away and do some research on.

Well, I would just add to that. It's not just where the production is. It's where the parts are coming from. So it's not necessarily that one is -- it impacts multiple things. Right now, we're moving forward smoothly, but we remain very conscious to what changes are occurring.

Got you. Maybe ask another way. In order to hit your revised revenue guidance, is it predicated on sort of the supply chain working the way it is right now? Or if there is a material shortage or if it gets worse, would that have an impact on your full year revenue guidance?

Yes. What we've tried to do, Gabe, is build in what we see and think is possible. The situation is pretty fluid, as you know, right? Look at the markets the last few days, it's extremely difficult to be precise on this, and I'd really hate to say something and then something else changes. Based upon everything we know today, what's happened so far into Q3, what we think is likely to happen. Our communications with the CMs we use. We put our guidance, we think we can make. I guess if the world gets worse somehow, anything's possible, but we've tried to be realistic, and that's one of the things we have factored in already.

Got you. All right. I want to spend a moment on the -- on your discussion around, obviously, the revenue mix. You guys are putting a greater emphasis, I guess, towards services, not necessarily ignoring products, but obviously, it's deemphasizing to a certain extent this line. Can you talk about -- if I look at the product revenue mix itself right now, and I know the quarterly revenues and products would range anywhere in the last year, between $16 million and $20 million, but if I look within product revenues itself, what portion of that revenue can actually be moved over to -- can be resold as a recurring revenue service? Because I know, obviously, there's probably going to be some VoIP supply, for example, revenues in products, but what percentage of that product revenues can actually be converted to services?

Yes, that's a good question. I don't know that I'll be able to quantify it for you in real-time on the call, but I'll explain how it works and which things can and we could do a little bit of checking on that. So Gabe, it really depends upon what the services are that we offer. And our view of that services portfolio is that we're moving more and more strategically to a communications as a service company with multiple services underneath that umbrella. So for sure, that includes UCaaS. You also heard me describe that includes trunking as a service. It includes CPaaS. We're looking at other communications as a services offerings under that umbrella now. And our ability to move sales that in the past have been product into recurring revenue-type services expands as we add more services to the portfolio.

So for example, if you think about, I don't know, premise UC, right? We have 3 different premise UC products. And when we sell a premise UC solution or we talk to an existing premise customer, that is a logical way to move someone into services, whereas some things could never be put into services. So for example, I don't know, a hardware gateway is never going to be sold as a service, and at least, I don't think so. And some are in the gray area, and that's why I don't know this from the top of my head. So for example, Gabe, I remember in, I don't know, 1990 at Nortel, every single desk phone in the world was going to be a softphone and there were never going to be any more desk phones, so -- and sure enough, almost everybody has a desk phone still.

And so while it's a desk phone that can't be made into a service. Other than you can do things like billing it as a service using a device as a service model and turning it into recurring revenue, even though there's still a piece of hardware at the end or you can start to offer a software-based solution that does the same thing like a softphone, and that softphone can be charged on a monthly basis as well. So I don't know how to quantify that right off the top of my head, but those are the ways that we're trying to move in that direction.

Okay. Got you. One last thing. Obviously, your strategy will be predicated on what your customers are asking of you. But I'm curious, are you changing the sales force commission incentives to move them more towards pushing services versus onetime product sales where it's applicable.

The answer is kind of yes, kind of no. The first step in that direction is not modifying the commission plan, it's creating a subset of a team or an overlay that sells services only. And so we've begun that process game. We have a few people on that team. I see that expanding over time. And that, I think, is a more direct drive input to services revenue than the commission structure of the sales comp plan for the rest of the sales team. But I will say we do already try to incent that behavior by following a commission structure that's slightly different than some other companies in the industry. We compensate our sales team and their commission structure for services based upon the total contract value and paid upfront, not just the small fraction in commission rates over time. So we already have that in place and have had it in place for certainly over a year now.

Got you. And maybe one last thing just on the number side. Remind me again, just based on your Q2 revenues, what percentage of that would be -- would you classify as recurring in nature now?

We were between 45% and 50% in the services line, David, is that right?

Yes.

Between 45% and 50%, Gabe.

Our next question is from [Derek Zaremba], a private investor.

So it was great to hear about interesting opportunities in the M&A pipeline. So my question is more in regards to capital structure. What's your comfort level with the current level of debt and debt going forward, I guess, for funding future acquisitions?

Yes. I think we're perfectly comfortable with today's debt. As you've seen, it's coming down quickly after the acquisition. You've seen that after the Digium acquisition for over a year now. And I don't think anything dramatic has changed about our debt tolerance, Derek, our view has always been between 2 and 3 or 3 in a bit, and it goes up at the time of an acquisition and then naturally levers down as we repay some of that. And there's nothing about today's view that would make me feel different about that. If we were to buy another company tomorrow, I would be equally comfortable with that debt strategy.

Our next question is from [Brandon Austin] with Cantor.

Did you say -- did you guys say recurring revenues, that's 50% of service or 50% of total?

Services is almost 50% of total, right, Dave? Between 45% and 50%, [Brandon].

Sorry. Service as well recurring?

Yes. So services includes all of the cloud business and all of the maintenance business, right? That's...

Okay. So -- got you. So recurring is about 50% of total revenues. Just under?

Yes. That's what the services number is and it's a combination too.

All right. That's what I thought. Can you just remind me what are your gross margins in the service versus your gross margins in product? I'm assuming product is lower?

Yes. We've never disclosed that, so I don't think we'll do it numerically. But of course, you're absolutely right. The nuance of that would be that you might be surprised that it's true, if you look on a blended basis across products and services. But it's not true of every single product line inside the product portfolio. Some of those products come with 80% gross margin and some come with 40% gross margin. But averaged across the product suite, your assumption is completely right.

Yes. You guys might want to think about disclosing that in the future only because if your service business is recurring, kind of assume that your service -- I mean, I would assume your service business is probably like 70% to 80% margin. I mean RingCentral is all service, all sort of recurring and 8x8 and all your competitors. So we kind of have an idea of what software margins are and recurring margins are. So we might be making assumptions you don't want us to make, given how much data there is out there in terms of service margin. But I guess -- I guess that leads into, I mean, I guess, without disclosing the service margin specifically. If you're holding your EBITDA margin flat. Sorry, your EBITDA dollars flat on a $10 million guide down in revs. And your service business is obviously the higher-margin business. I guess, is there an implication there that -- I mean, is this because your gross -- is this because your operating expenses are going to come down because you guys are tightening your belts? Or is this because the product mix is such that your gross profit dollar number isn't going to change much because it's your lower-margin business that's getting hit and not the higher-margin business?

Yes, as I was saying...

Yes, of course. It's a combination of all of those, plus the ones I covered in the call, with the exception of your question about (inaudible). We're not cutting back or reducing marketing spending or telling salespeople not to travel or doing less R&D or letting people go, none of that. So everything you said is right, with that one exception, [Brandon].

Okay. So sorry. So your sales and marketing, G&A and R&D are about where they were going to be expected to be about where they're going to be so basically, your product revenues are coming down, but your gross profit is going to be about where you thought it would be because you're doing so well on the higher-margin service side. Is that fair? Or…

David, do you want to try that one?

I think there's a variety of circumstances that we do (inaudible). In general, that could happen, [Brandon], but we have sales in multiple geographies, different types of products and businesses. So we aim to hit our total numbers, and how it's delivered in any one quarter isn't always the same. But generally speaking, the margins on our services will strengthen the overall margin as we continue to have a high percentage of those -- of the total.

Yes, [Brandon]. I don't want you to feel we're being evasive. So I'm going to give you an example. Like, If I...

Well, I don't think you're being evasive. I'm just trying -- like you've taken your top line number down by $10 million, which would presume your gross profit number would drop by $3 million. And clearly, that's not the case, right? Because that $3 million will just drop to the bottom line, right?

Yes. So that's why I said, you're right. In all of the mix of things you said, and everything I covered in my remarks, and where I was going was, if I was trying to give you tangible examples about how to think that through. If you reflect back to Q1 and Q2 of fiscal '19, we had a large order that was executed on and delivered over 2 quarters, and even though that was a product sale, it came with 80-plus percent margin. And so David was trying to explain that you're asking the question in a way which presupposes there's a single general explanation that applies across the business in any one quarter. And what we're trying to describe to you is because the business is going through this transition from product sales to services sales, the explanation can differ from quarter-to-quarter or geography to geography, and it's the mix of those business, including what I covered in the call, that explains it.

Yes. I just think the analysts, generally speaking, and shareholders have to. I mean because we know that the product business is not like a vibrant growth business, but the service business is a growth business and the service business is the business you get the higher multiple, right? So I'm just trying to figure out is this weakness -- is the weakness almost exclusively on the product side, which is a lower-multiple business anyway? Or is there some reason it's creeping into the service side?

No, it's on the product side. I think I covered that in my prepared remarks and if it was in any way uncertain or ambiguous, I'll just say it again here, it is on the product side.

(Operator Instructions)

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Thank you. This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.