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8X8 INC /DE/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[January 25, 2013]

8X8 INC /DE/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS 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 voice over Internet protocol, or VoIP, telephony products and services, the reliability of our services, the prices for our services, customer renewal rates, customer acquisition costs, actions by our competitors, including price reductions for their telephone services, potential federal and state regulatory actions, compliance costs, potential warranty claims and product defects, our needs for and the availability of adequate working capital, our ability to innovate technologically, the timely supply of products by our contract manufacturers, potential future intellectual property infringement claims that could adversely affect our business and operating results, and our ability to retain our listing on the NASDAQ Capital Market. 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 those factors discussed elsewhere in this Form 10-Q, see the Risk Factors discussion in Item 1A of our 2012 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.

BUSINESS OVERVIEW We develop and market cloud-based business communications services encompassing internally developed Voice over Internet Protocol ("VoIP") technologies. These services enable telephony and video applications as well as web-based conferencing and unified communications capabilities. We also provide managed hosting and cloud-based computing services. As of December 31, 2012, we had approximately 31,500 business customers. Since fiscal 2004, substantially all of our revenue has been generated from the sale, license and provision of VoIP products, services and technology. Prior to fiscal 2003, our focus was on our VoIP semiconductor business.

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 2013 refers to the fiscal year ending March 31, 2013).


No customer represented greater than 10% of our total revenue for the three and nine months ended December 31, 2012 and 2011. Revenue from customers outside the United States was not material for the three and nine months ended December 31, 2012 or 2011.

CRITICAL ACCOUNTING POLICIES & ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our 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. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012. As of December 31, 2012, there had been no material changes to our critical accounting policies and estimates.

18 -------------------------------------------------------------------------------- RECENT ACCOUNTING PRONOUNCEMENTS See Item 1 of Part I, "Financial Statements - Note 2 - Basis of Presentation - Recent Accounting Pronouncements." SELECTED OPERATING STATISTICS 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: Three Months Ended Dec 31, Sept. 30, June 30, March 31, Dec 31, 2012 2012 2012 2012 2011 Gross business customer additions (1) 2,617 2,915 2,943 2,892 2,836 Gross business customer cancellations (less cancellations within 30 days of sign-up) 1,504 2,149 1,458 1,697 1,642 Business customer churn (less cancellations within 30 days of sign-up) (2) 1.6% 2.4% 1.7% 2.0% 2.0% Business service revenue churn 2.6% 1.0% 2.3% 1.6% 1.9% Total business customers (3) 31,473 30,498 29,913 28,671 27,677 Business customer average monthly service revenue per customer (4) $ 260 $ 256 $ 250 $ 244 $ 239 Overall service margin 78% 76% 75% 76% 77% Overall product margin -34% -22% -30% -15% -24% Overall gross margin 68% 68% 67% 68% 68% Business subscriber acquisition cost per service (5) $ 98 $ 89 $ 97 $ 99 $ 92 Average number of subscribed services per business customer 11.2 10.6 10.1 9.8 9.4 Average number of subscribed services per new business customer (6) 17.0 14.7 14.0 13.6 14.1 (1) Does not include customers of Virtual Office Solo or Zerigo, Inc. ("Zerigo").

(2) Business customer churn is calculated by dividing the number of business customers that terminated (after the expiration of the 30-day trial) during that period by the simple average number of business customers during the period and dividing the result by the number of months in the period. The simple average number of business customers during the period is the number of business customers on the first day of the period plus the number of business customers on the last day of the period divided by two. In the second quarter of fiscal 2013, an affiliate with 411 business customers representing approximately $9,000 of monthly service revenue cancelled service. Excluding these 411 cancellations, business customer churn (less cancellations within 30 days of sign-up) was 1.9%.

(3) Business customers are defined as customers paying for service. Customers that are currently in the 30- day trial period are considered to be customers that are paying for service. Customers subscribing to Virtual Office Solo or Zerigo services are not included as business customers.

(4) Business customer average monthly service revenue per customer is service revenue from business customers in the period divided by the number of months in the period divided by the simple average number of business customers during the period.

(5) Business subscriber acquisition cost per service is defined as the combined costs of advertising, marketing, promotions, sales commissions and equipment subsidies for business services sold during the period divided by the number of gross business services added during the period.

(6) Total new services sold in the period divided by gross business customer additions.

19 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The following discussion should be read in conjunction with our condensed consolidated financial statements and the notes thereto.

December 31, Dollar Percent Service revenue 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 24,958 $ 21,200 $ 3,758 17.7% Percentage of total revenue 91.3% 91.1% Nine months ended $ 72,307 $ 56,234 $ 16,073 28.6% Percentage of total revenue 91.6% 91.3% Service revenue consists primarily of revenue attributable to the provision of our 8x8 VoIP services and royalties earned under our VoIP technology licenses.

We expect that 8x8 service revenues will continue to comprise nearly all of our service revenues for the foreseeable future. 8x8 service revenue increased in the third quarter of fiscal 2013 primarily due to the increase in our business customer subscriber base. Our business subscriber base grew from 27,677 business customers on December 31, 2011, to 31,473 on December 31, 2012. The increase for the first nine months of fiscal 2013 also was primarily attributable to the increase in our business customer base from approximately 24,000 businesses on April 1, 2011 to 31,473 on December 31, 2012. The increase was partially offset by a decrease in customers of our residential services. These changes were consistent with the redirection of our marketing efforts toward our business customer service. We expect the trends to continue in future periods.

December 31, Dollar Percent Product revenue 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 2,382 $ 2,078 $ 304 14.6% Percentage of total revenue 8.7% 8.9% Nine months ended $ 6,656 $ 5,370 $ 1,286 23.9% Percentage of total revenue 8.4% 8.7% Product revenue consists primarily of revenue from sales of IP telephones attributable to our 8x8 service. Product revenue increased for the three and nine months ended December 31, 2012 primarily due to an increase in equipment sales to business customers.

December 31, Dollar Percent Cost of service revenue 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 5,473 $ 4,890 $ 583 11.9% Percentage of service revenue 21.9% 23.1% Nine months ended $ 16,984 $ 12,764 $ 4,220 33.1% Percentage of service revenue 23.5% 22.7% The cost of service revenue primarily consists of costs associated with network operations and related personnel, telephony origination and termination services provided by third party carriers and technology license and royalty expenses.

Cost of service revenue for the three months ended December 31, 2012 increased over the comparable period in the prior fiscal year primarily due to a $0.5 million increase in third party network service expenses as a result of the increase in our business subscriber base, a $0.2 million increase in depreciation expense, and a $0.1 million increase in payroll and related costs.

The increase in expense was partially offset by a $0.1 million reduction in expensed license and fees and a $0.1 million reduction in temporary personnel, consulting and outside service expenses.

20 -------------------------------------------------------------------------------- Cost of service revenue for the nine months ended December 31, 2012 increased from the comparable period in the prior fiscal year primarily due to a $2.7 million increase in third party network service fees as a result of the increase in our business subscriber base, a $0.8 million increase in payroll and related costs, a $0.5 million increase in depreciation expense, a $0.4 million increase in amortization expense due to intangibles acquired in acquisition of businesses, and a $0.1 million increase in consulting and outside service expenses. The increase in expense was partially offset by a $0.3 million reduction in expensed license and fees.

December 31, Dollar Percent Cost of product revenue 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 3,203 $ 2,584 $ 619 24.0% Percentage of product revenue 134.5% 124.4% Nine months ended $ 8,585 $ 7,467 $ 1,118 15.0% Percentage of product revenue 129.0% 139.1% The cost of product revenue consists of costs associated with systems, components, system manufacturing, assembly and testing performed by third-party vendors, estimated warranty obligations and direct and indirect costs associated with product purchasing, scheduling, quality assurance, shipping and handling.

The amount of revenue allocated to product revenue based on the relative selling price is less than the cost of the IP phone equipment. The cost of product revenue for the three months ended December 31, 2012 increased over the comparable period in the prior fiscal year primarily due to a $0.5 million increase in the shipment of equipment to customers and a $0.1 million increase in warranty expense.

The cost of product revenue for the nine months ended December 31, 2012 increased over the comparable period in the prior fiscal year due to a $0.9 million increase in the shipment of equipment to customers, a $0.1 million increase in warranty expense and a $0.1 million increase in freight expenses.

December 31, Dollar Percent Research and development 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 2,117 $ 1,955 $ 162 8.3% Percentage of total revenue 7.7% 8.4% Nine months ended $ 5,973 $ 4,902 $ 1,071 21.8% Percentage of total revenue 7.6% 8.0% Historically, our research and development expenses have consisted primarily of personnel, system prototype design, and equipment costs necessary for us to conduct our development and engineering efforts. We expense research and development costs as they are incurred. The research and development expenses for the three months ended December 31, 2012 increased over the comparable period in the prior fiscal year primarily due to a $0.1 million increase in payroll and related costs and a $0.1 million increase in other research and development expenses.

The research and development expenses for the nine months ended December 31, 2012 increased over the comparable period in the prior fiscal year due to a $0.8 million increase in payroll and related costs, a $0.1 million increase in recruiting expenses and a $0.2 million increase in other research and development expenses.

December 31, Dollar Percent Sales and marketing 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 11,651 $ 9,816 $ 1,835 18.7% Percentage of total revenue 42.6% 42.2% Nine months ended $ 33,202 $ 27,076 $ 6,126 22.6% Percentage of total revenue 42.0% 44.0% 21-------------------------------------------------------------------------------- Sales and marketing expenses consist primarily of personnel and related overhead costs for sales, marketing, and customer service. Such costs also include outsourced customer service call center operations, sales commissions, as well as trade show, advertising and other marketing and promotional expenses. Sales and marketing expenses for the three months ended December 31, 2012 increased over the same quarter in the prior fiscal year primarily because of a $1.4 million increase in payroll and related costs, a $0.1 million increase in third party sales commissions, a $0.1 million increase in bad debt expenses, a $0.1 million increase in credit card processing fees, and a $0.3 million increase in other miscellaneous sales and marketing expenses. The increase in expense was partially offset by a $0.2 million reduction in temporary personnel, consulting and outside service expenses.

Sales and marketing expenses for the first nine months of fiscal 2013 increased over the same period in the prior fiscal year primarily because of a $4.7 million increase in payroll and related costs, a $0.3 million increase in third party sales commissions, a $0.2 million increase in amortization of customer relationship intangibles, a $0.2 million increase in bad debt expense, a $0.1 million increase in credit card processing fees, and a $1.1 million increase in other sales and marketing expenses. The increase in expenses was partially offset by a $0.5 million reduction in temporary personnel, consulting and outside service expenses.

December 31, Dollar Percent General and administrative 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 2,136 $ 1,481 $ 655 44.2% Percentage of total revenue 7.8% 6.4% Nine months ended $ 6,270 $ 4,372 $ 1,898 43.4% Percentage of total revenue 7.9% 7.1% General and administrative expenses consist primarily of personnel and related overhead costs for finance, human resources and general management. General and administrative expenses for the three months ended December 31, 2012 increased over the same quarter in the prior fiscal year primarily because of a $0.2 million increase in payroll and related costs, a $0.2 million increase in facility rent and maintenance expenses, a $0.1 million increase in temporary personnel, consulting and outside service expenses, a $0.1 million increase in depreciation expense, and a $0.1 million increase in recruiting expenses.

General and administrative expenses for the first nine months of fiscal 2013 increased over the same period in the prior fiscal year primarily because of a $0.8 million increase in temporary personnel, consulting and outside service expenses, a $0.6 million increase in payroll and related costs, a $0.5 million increase in facility rent and maintenance expenses, a $0.2 million increase in depreciation expense, and a $0.1 million increase in recruiting expenses. The increase in expense was partially offset by a $0.2 million reduction in legal expenses and a $0.1 million reduction in other general and administrative expenses.

December 31, Dollar Percent Gain on patent sale 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ - $ - $ - 0.0% Percentage of total revenue 0.0% 0.0% Nine months ended $ (11,965) $ - $ (11,965) 100.0% Percentage of total revenue -15.2% 0.0% In June 2012, we entered into a patent purchase agreement for the sale of a family of United States patents for $12.0 million in cash. We recognized a gain of slightly less than $12.0 million, net of transaction costs, which has been recorded as a reduction of operating expenses in the consolidated statements of operations.

22 -------------------------------------------------------------------------------- December 31, Dollar Percent Other income, net 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 73 $ 49 $ 24 49.0% Percentage of total revenue 0.3% 0.2% Nine months ended $ 90 $ 58 $ 32 55.2% Percentage of total revenue 0.1% 0.1% In the nine months ended December 31, 2012, other income, net consisted of interest expense, distribution of capital gains on investments and interest income earned on our cash, cash equivalents and investments.

December 31, Dollar Percent Provision (benefit) for income tax 2012 2011 Change Change (dollar amounts in thousands) Three months ended $ 913 $ 15 $ 898 5986.7% Percentage of income before provision for income taxes 32.2% 0.6% Nine months ended $ 7,726 $ (284) $ 8,010 -2820.4% Percentage of income before provision (benefit) for income taxes 38.6% -5.6% For the three and nine months ended December 31, 2012, we recorded a provision for income taxes of $0.9 million and $7.7 million, respectively, which was primarily attributable to net income from operations, including the gain on patent sale. For the three and nine months ended December 31, 2011, we released a portion of our valuation allowance against the deferred tax asset as we deemed it was more likely than not it would be used to offset the $0.3 million deferred tax liability recorded in connection with the acquisition of Zerigo.

The increase in income tax expense for the three months ended December 31, 2012 was primarily attributable to net income from operations.

The increase in income tax expense for the nine months ended December 31, 2012 compared with the same period in the prior fiscal year was due to the provision for income tax of $7.7 million which was primarily attributable to net income from operations, including the gain on patent sale.

The effective tax rate is calculated by dividing the income tax provision by net income before income tax expense. We estimate our annual effective tax rate at the end of each quarter. The fiscal 2013 estimated annual effective tax rate is expected to be approximately 40%, but may fluctuate each quarter due to the timing of other discrete period transactions. In estimating the annual effective tax rate, we, in consultation with our tax advisors, consider, among other things, annual pre-tax income, permanent tax differences, changes to tax rates, state apportionment, and the application and interpretations of existing tax laws.

23 -------------------------------------------------------------------------------- Liquidity and Capital Resources As of December 31, 2012, we had approximately $46.5 million in cash, cash equivalents and short-term investments.

Net cash provided by operating activities for the nine months ended December 31, 2012 was approximately $26.0 million, compared with $6.4 million for the nine months ended December 31, 2011. The increase in cash flow resulted primarily from a $12.0 million gain on the sale of a patent family in June 2012, a $1.7 million reimbursement from landlord for tenant improvements, and an increase in service and product revenue in the first nine months of fiscal 2012. Cash provided by operating activities has historically been affected by the amount of net income, sales of subscriptions, changes in working capital accounts particularly in deferred revenue due to timing of annual plan renewals, add-backs of non-cash expense items such as the use of deferred tax assets, depreciation and amortization and the expense associated with stock-based awards.

Net cash used in investing activities was $5.2 million during the nine months ended December 31, 2012, compared with $2.5 million used in investing activities for the nine months ended December 31, 2011. The increase in cash used in investing activities during the nine months ended December 31, 2012 is primarily related to an increase in the purchase of additional equipment, furniture and fixtures and leasehold improvements ($5.2 million). The increase in cash used for the purchase of furniture and fixtures and leasehold improvements is primarily due to the Company's move to its new headquarters facility in San Jose, California.

Our financing activities for the nine months ended December 31, 2012 consisted primarily of cash from the issuance of shares due to exercise of employee stock options ($1.7 million) offset by cash used to repurchase shares of our common stock ($0.3 million).

Contractual Obligations We lease our headquarters facility in San Jose, California under an operating lease agreement that expires in October 2019. The lease is an industrial net lease with monthly base rent of $130,821 for the first 15 months with a 3% increase each year thereafter, and requires us to pay property taxes, utilities and normal maintenance costs.

We entered into a series of noncancelable capital lease agreements for office equipment bearing interest at various rates. Assets under capital lease at December 31, 2012 totaled $110,000 with accumulated amortization of $64,000.

In the third quarter of 2010, we amended the contract with one of our third party customer support vendors containing a minimum monthly commitment of approximately $430,000. The agreement requires a 150-day notice to terminate. At December 31, 2012, the total remaining obligation under the contract was $2.2 million.

We have entered into contracts with multiple vendors for third party network services. At December 31, 2012, future minimum annual payments under these third party network service contracts were $629,000 in 2013, $2,155,000 in 2014, $1,579,000 in 2015 and $52,000 in 2016.

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