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Thank you for standing by. This is the conference operator. Welcome to the Sangoma Investor Conference Call. [Operator Instructions] And the conference is being recorded.I would now like to turn the conference over to Larry Stock, Chief Financial Officer. Please go ahead, Mr. Stock.
Thank you, operator. Hello, everyone, and welcome to Sangoma's Second Quarter Fiscal 2023 Investor Call. We are recording this call, and we will make it available on our website for anyone who is unable to join us live. Joining me today is Bill Wignall, Sangoma's President and Chief Executive Officer; and Samantha Reburn, our General Counsel, to take you through the results of the second quarter of fiscal 2023, which ends on December 31, 2022. We will discuss the press release that was distributed yesterday, together with the company's financial statements and MD&A, which are available on SEDAR, EDGAR and our website. As a reminder, Sangoma reports under International Financial Reporting Standards, IFRS. And during the call, we may refer to terms such as adjusted operating loss, adjusted EBITDA and adjusted cash flow that are non-IFRS measures, but which are defined in our MD&A.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, estimates, plans, expectations and strategies for the future. Because such statements deal with future events, they are subject to various risks and uncertainties, and actual results may 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 in the company's annual audited financial statements posted on SEDAR and EDGAR.And with that, I'll hand the call over to Bill.
Thanks, Larry. Good morning, everyone, and thank you for joining us today. I've structured my prepared remarks for this call into 3 sections. I will start with our second quarter financial results. I'll then add some commentary on one strategic topic. And finally, I will review forward guidance for fiscal '23. As always, I'll then wrap up with a brief summary and turn the call back over to the operator for a typical open Q&A session. And just before I begin today, I'd like to point out that you may notice some changes in the call, changes intended to improve the way we interact with you to get you the information you want in the way you want it. I will talk about that more in a few minutes. But for now, [ as but one ] simple example, this call will be noticeably shorter and tighter than in previous quarters.So let's get started with our Q2 results. In this section on financials, I will cover highlights from our second quarter as well as year-to-date, and then I'll conclude with a few comments on balance sheet and cash flow. Total revenue for the second quarter was $62.0 million, which is up 17% when compared to the same period in fiscal '22. And this $62 million in total revenue is down just over 3% from the immediately preceding quarter, a drop that I acknowledge was disappointing to us. In order to properly understand that sequential trend, we need to examine the services versus product component because we see very different trends in those 2 buckets this quarter.Let's start with services, the strategic focus for our company and the long-term driver of growth and value. Services revenue increased 34.5% from Q2 of last year, very healthy indeed. Further, that services revenue is up another 2.3% from Q1. As I stated at the beginning, Sangoma is going to try and be more clear about our organic growth rates and other disclosure, and that's much easier to do this quarter given we've not had an acquisition in the past 3 quarters. The 2.3% sequential growth in services is best equivalent to an annualized growth rate of almost exactly 10% organic growth, short and sweet. Given today's economic climate and Sangoma's commitment to growth with profitability, not growth at any cost, we feel quite good about that 10% organic growth figure.And while Services had a solid quarter, our product revenue was down 19.8% sequentially from Q1. We saw the pressure on product sales begin in our first quarter this year and to continue throughout Q2. While the decline was not unexpected, given the long-term trend away from on-premise systems towards the cloud, it was accentuated by current macro factors, supply chain and by FX rates, which impact our international customers because we bill in U.S. dollars, [ all causing the drop ] to be larger than anticipated this quarter. And while Sangoma could, of course, invest more to combat such trends, we consciously choose not to over-rotate there. We will not invest reactively in that way and risks suppressing our profitability.Having said that, product revenue at between USD12 million and USD13 million this quarter is back to where it was a few quarters back. We had some modest quarterly upticks over the past while, perhaps surprising given that product sales are not expected to be a long-term growth driver at Sangoma. That was mostly because we had done a good job of managing supply chain disruptions and avoided other stock situations, possible because Sangoma makes all of our own products. So based upon what we see today, we do not believe product revenue will continue to fall from here and would expect some modest recovery in this area during Q3.The long-term growth in the future of Sangoma is as a SaaS company, and that is where we will remain focused. So seeing services revenue represent over 79% of total sales this quarter, up from 75% in Q1 from 71% in fiscal '22, and from 62% in fiscal '21 demonstrates our continued success towards a pure SaaS company and an annualized organic growth rate of about 10% in services feels pretty good. Cost of goods sold for Q2 was 31% of revenue as [ compared ] to 32.3% in Q1, reflecting a higher fraction of revenue coming from services. Sangoma does a really good job managing the supply chain that got messier in the past couple of years, producing some of the highest gross margins in our industry.Gross profit for the first quarter was $42.7 million, down slightly from $43.3 million in the immediately preceding quarter due to the trend in total revenue just covered. Gross margin for the quarter was approximately 69.9% of revenue, which is up slightly from the 67.6% in the last quarter and at the higher end of our expectations for margin in fiscal '23. Operating expenses for the second quarter of fiscal '23 were $44.2 million, down slightly from the $44.4 million in the most recent first quarter. Adjusted EBITDA in the second quarter was about the same as that in Q1, coming in at $10.5 million compared to $10.7 million last quarter despite the dip in total revenue, reflecting our commitment to protecting profitability. As a result, EBITDA margins were up very slightly from the first quarter, still at about 17%, in line with previously communicated expectations.Now I'd like to turn to a brief update on year-to-date results. Year-to-date revenue stands at $126 million, up 20.4% from the same 6-month period last year, driven by the inclusion of NetFortris as well as by the growth in compounding in our services business. Services revenue was up 35% year-to-date versus the first 2 quarters of fiscal '22, a very solid figure, whereas product revenue was down 12% for the same periods per my prior comments. Gross profit of $86.1 million year-to-date is up [ 14.4% ] from the same period in fiscal '22.Year-to-date, operating expenses for fiscal '23 was $86.6 million, up $15.2 million from fiscal '22 and is down as a percentage of revenue year-over-year, all part of our long-term operating leverage to grow spending at a slower rate than revenue. In addition, we are taking actions in February to further reduce spending going forward given the macro outlook, like so many companies are doing these days, a decision that should further strengthen operating margins. We will have more to say about that on our next call together after Q3. Adjusted EBITDA year-to-date stands at $21.2 million, up from $20.5 million in the first 6 months of fiscal '22.That completes my remarks on our second quarter P&L, and I'd now like to turn to a few comments on our balance sheet and cash flow. Our cash balance at the end of the second quarter remains healthy at $6.8 million. We continue to deleverage. We paid down approximately $6 million in Q2 on our loans and about $4.5 million of that in principle. Sangoma remains very comfortably within all covenants of course, and our Q2 position with respect to such covenants is stronger still than it was exiting Q1. Trade receivables ended the second quarter at $16.6 million, down slightly from the $17.2 million at the end of Q1.Inventory balances at the end of second quarter were $19.3 million compared to [ $19.0 million ] at the end of Q1. As we've discussed previously, the increase in inventory is driven by supply chain challenges and also by softer product sales this quarter. Adjusted cash flow was quite low in Q1, not uncommon at Sangoma early in the year. In Q2, we expected the conversion from EBITDA to adjusted cash flow to return to something more typical for this part of Sangoma's fiscal year, perhaps around 50%, and we now see that with almost $5 million of operating cash flow this quarter.That brings my commentary on our financial results to a close, and I'll now move to my second section today to cover one strategic and operational update. I'd like to start with a short comment on the new strategic initiatives we began in Q2. Sangoma has engaged with a very well-respected IR firm, one that has deep experience in the cloud communication space as well. We want to optimize how we interact with the [ suite ], both buy side and sell side to get the Sangoma story out, a story we are very proud of, but that we believe can be told better to provide you the information you want in the way you wanted, right down to the way we conduct these calls.Here are a few ways we're strengthening this communication with you. First of all, one thing we've been hearing loud and clear is that you want better clarity on our organic growth rate. On that one, asked and delivered. You've heard me speak unequivocally today about the 10% annualized growth rate in our services business this quarter, [ full stock ]. Second, in future calls, you will be hearing not only for me but also from other members of our excellent executive team.Third, moving forward, we're committed to providing more traditional SaaS type metrics. We look forward to sharing more of those with you in the coming periods as we further enhance some of our back-office systems to do so. That project had already been started is scheduled to take place gradually over the next 12 or so months, and we will be increasing disclosure along the way. By the way, there's an ancillary benefit to this as well, and that will save somewhere between 1 and $2 million in OpEx annually once complete. For today, I can start by sharing some information on important cloud metrics such as bookings and activation. Our cloud bookings in Q2 were up by over 5% from Q1 sequentially, an encouraging trend in this strategic part of our business. And our cloud activations were up by even more than that as we revamp that department in order to accelerate installed capacity to keep up with our growing bookings.Fourth, we've heard you say that you want us to be more explicit about our capital allocation and M&A strategy given our share price, our balance sheets and the drastic shift in public markets over the past year. So here's your clear answer. M&A is unlikely for Sangoma at this point. I won't go quite so far as to saying impossible, but we are very focused on organic growth as our priority for now. We would be highly, highly selective in any M&A only considering an acquisition that is accretive to both revenue per share and EBITDA per share and only if it did not unduly increase our debt service risk. We are fully cognizant that times have changed, of course, so finding such a target is very difficult right now, and we agree with many of you on this point. After all, Sangoma was arguably the only sizable player in our industry that grew and made money. So we are naturally a little more prudent than most of our competitors.And there will be more changes to come over the next few quarters as we further strengthen the way we communicate with the [ suite ] and as we increase disclosure. In addition to my comments on that strategic change to our IR approach, I also have one exciting operational initiative to begin sharing with you. Sangoma is increasing our focus on the cost savings benefit to our customer at a time when almost all companies are looking to cut costs. That ability [ stems thumb ] Sangoma's capability to deliver the full suite of cloud communications. I'm going to talk about this more on our next call, but in order to be more strict with time on this one. But if you want a small early case, there's already a teaser live on Sangoma's homepage this week.And now let's move to our third and final section today on fiscal '23 guidance. When Sangoma released fiscal '22 full year results last September, we provided guidance for fiscal '23 as we normally do. We chose not to change that guidance after Q1 this year because we really needed to see more of fiscal '23 unfold to determine if an update guidance was appropriate. We're now at the midpoint of our fiscal year, affording our team a bit more clarity regarding the trajectory of this fiscal period. Given the results for the first half of fiscal '23, our current assumptions regarding the macro environment, industry conditions and our outlook for the second half, we are revising our fiscal '23 guidance to between USD250 million and USD260 million in revenue and between USD46 million and USD49 million in adjusted EBITDA. This updated guidance reflects our best assessment of many challenging factors in an increasingly difficult world when where visibility and forecasting have become more difficult for everyone, and Sangoma is not exempt from that uncertainty. Such factors are fully disclosed in our press release and MD&A.And with that, I'd now like to bring my prepared remarks to a close with a quick summary. Overall, I am pleased with another solid financial quarterly results for Sangoma. And while it was strong in the critical areas such as services revenue and profitability, it was admittedly below our expectations on product sales. It is gratifying to see our growth in services at 10% annualized organic growth, stated simply and clearly that reinforces the point that the transition to SaaS was the right strategy and is the right strategy as we continue to see our competitively differentiated suite of cloud communications services yield success.We continue to build your company with a core belief in growth with profitability, and we, of course, hold that belief even more strongly today. Further, we are focused on delivering that growth first and foremost, these days organically as our #1 priority. We have a resilient business and financial model, one that allows us to protect our profitability, even when faced with the kind of uncertainty we all see these days. And we have always utilized debt conservatively, maintaining modest debt-to-EBITDA ratios and avoiding over-leveraging, even when others encouraged us to take on more debt. That commitment has served us well, and we will maintain that approach.Finally, I'll [ put off ] my personal remarks today by saying that you have a team here at Sangoma that works extremely hard for you every day, one that is determined to continue that work in order to grow the company and create shareholder value.And with that, operator, we are ready to take questions now.
[Operator Instructions] The first question is from Eric Martinuzzi from Lake Street.
Yes. I wanted to dive into the product shortfall and make sure I have a good understanding of it. Bill, you talked about several factors behind the shortfall shift to the cloud, the macro supply chain FX. Could you kind of sort of stack rank those as far as the bigger drivers of the shortfall?
Speaking candidly, Eric, it's hard to stack, right? We never really know, of course, what portion of that drop, and it was a sizable drop, $3 million comes from which of those I'll give you my subjective opinion as long as you take it as such. I think the biggest one is the macro environment. We've been dealing with the long-term industry trends for years and years and years, so they couldn't possibly explain the suddenness of the drop in Q2. Secondly, I think the supply chain. And this is a little bit counterintuitive. So I'll explain this because I know you follow this, Eric. But if you want more or someone on the call doesn't understand it, call us afterwards because it's not what most people expect. It's not the case that the supply chain is a bit messed up.The supply chain has been messed up for several quarters now, and we all read about that regularly. It's that because Sangoma makes all of our own product, we have more control over the supply chain for our products than our UCaaS competitors do. So when they had trouble getting products, which they purchased from third parties, we were able to benefit from that. And as some of those other competitors begin to deal with their supply chain issues and their third parties begin to deal with those supply chain issues, that begins to unlock a little bit for them. So that's the next one I would put in order.I think the foreign exchange comment is very important, but it only really applies to our international business, right? The international business is, I don't know, less than 15% now or something like that. So if you're buying in Germany or Japan and you think of the price converted into euros or yen and that price looks higher now, it's a big deal. But if you're buying in Texas, of course, the FX rate doesn't affect you at all. Is that helpful?
Yes. There's confidence that in Q3, we'll see a recovery. Is that to say that there is the year-end -- calendar year-end budget flush didn't materialize, but we've got an easy comp in Q3? Or is it the cloud -- shift to cloud is less impactful in Q1? Why the recovery anticipation for Q3?
Yes. I think 2 things. One, if you reflect on my comments about the supply chain, and that's one of the reasons I described it in as much detail as I did. That unlocking resulted in [ some, oh ], we can buy products from vendor X again that we weren't able to get [ for well, let me buy lots ] and then it started getting dumped into the marketplace. And that's now cleared through or pretty much cleared through, Eric. The second reason is we're sitting here on whether the February 10. So we're 6 weeks into the quarter. So we have some visibility to have Q3 is shaping up. And for those 2 reasons, that's why I said what I said.
Okay. And then on the services side, definitely outperformance relative to peers as far as that sequential growth, that's great to see 2.3% annualized at 10%. Was there any kind of large customer sign-ups, small SMB versus commercial purchases? What can you tell us about why the services actually so resilient?
Yes. The services is definitely, I agree with you, over performance of our peers. And while I've read some of the earlier reports from some of our analysts pointing out the revenue mix, and that's why I tried to acknowledge it head on. The revenue mix comes from the part of the business, which is not, as I said, the strategic driver, both of our revenue growth and shareholder value. So this is the piece we feel really quite good about and I have to acknowledge some humility here. It's hard to talk so confidently and positively about a part of the business when you know the other part, which is less strategic underperformed. I don't feel good about that.But on the services side, we feel really good. It's not because of a single big order at all, Eric. In fact, the 2 or 3 big ones that were well over [ $100,000 ] that we talked about in the last call, we didn't really have any huge ones like that this quarter. We had several at [ 40 or 50 or 60 ], but we didn't have $150,000 or $200,000 order this quarter. I think it's more the company's progress into and comfort with and stability on the process of doing cloud sales is normalized now. It's more predictable. We have 40 channel managers in the field, up from 20 to 25. We have 20 account managers servicing our existing customer base.We have specialty teams servicing the upper tier of the distribution channel. [Technical Difficulty] the regions, they don't [ hit that term anymore that ] technology solutions, distributors or technology, sorry, telecom service distributors. And all of this is really only possible because of our scale. It's the scaling, which allows us to invest more in each of the critical pieces. The question you asked about services growth is the result of investing mostly more in our marketing and sales area. And I think that's what it is. It's not something out there in the market. It's us doing a better job and winning more market share.
The next question is from Mike Latimore from Northland Capital Markets.
I guess, Bill, on the change in guidance, is it sort of all from the product segment? Or is there some change there relative to service as well, underpinning that?
It's mostly all guidance change due to product, Mike. There was a little bit of underperformance in services in Q1 versus our expectation because there's some seasonality there. But in general, while I don't know the percentage, it's heavily, heavily dominated by product.
Got it. And then on the cloud bookings, 5% sequentially sounds very healthy. I guess, any change kind of month by month? Did you see sort of a normal pattern each month? Or was December better or worse than expected?
Yes. We have a fairly typical pattern to that, Mike. I don't know we've ever really talked about this. Generally, month 2 was bigger than month 1 and month 3 is bigger than month 2. And that's partly because we're a public company. We think about things quarterly. That manifests in compensation programs that involve some monthly but also some quarterly targets. So it's perfectly normal and is not unique to Q2. If we look back at Q1, August would have been bigger than July and September would have been bigger than August, and that is what happened in this quarter too. December was bigger than November. It was a very strong month for us. And in fact, January was up again from December by more than 5%.So there is a really -- as I said, I want to be careful not to be on a call with you guys that we're saying we're going to try and do a better job of giving you information the way you want it. After a quarter in which the piece of the businesses that we call product went down and then sound [ pump us ]. So we don't feel that way, but we do feel positive and optimistic about this piece. It's 10% annualized organic growth, as Eric said, seems to be outperforming our peers and 5% growth in bookings is a lead indicator that there as well.
Great. And then just last one on the NetFortris, the network services, how did that perform in the quarter in terms of the cross-sell opportunities you want to capture there? And what's the pipeline look for that kind of cross-sell?
Yes. Good question. That's going quite well, Mike. I would say there's 2 directions to this, right? There's the -- can we take the part of both the sales organization and the channel that traditionally sold what you would think of as the Sangoma part of the portfolio and cross-sell MSP services to that. And then there's the other direction, which is the part of the sales force and channel that sold MSP services and can we cross-sell cloud communications to that. The first of those 2, we kind knew in advance and we're pretty confident with work as planned, right? It was the sales force we knew already. We were pretty comfortable we could take the traditional Sangoma sales force and the traditional Sangoma channel and get them to adopt MSP and that's indeed happened. The piece that was a bit less knowable in advance as it is in any acquisition, was whether the portion of the NetFortris sales team that traditionally focused on MSP would have success adopting and cross-selling cloud communications. Now it's only a couple of quarters in, so I'm going to be a little bit more careful about this one, but that's going a little bit better than we expected. It is partly responsible for the 5% sequential growth in bookings.
The next question is from Deepak Kaushal from BMO Capital Markets.
So I want to shift gears here and then talk a little bit about your cost control levers and your cost structure. You did a good job holding on to EBITDA margins as you seen in last quarter. Can you give us a sense of, particularly in cost of goods sold, what's the mix of fixed versus variable costs? And where are the areas that you have to control costs as is the obvious one, which is [Technical Difficulty].
Yes. Let's take the 2 in succession. Whether it's cost of goods or OpEx, the answer to the portion, which is fixed versus variable [Technical Difficulty]. It's not the same number, but it would vary with in cost of goods, for example, the volume. So if we ship more product, cost of goods is going up just as you would normally expect. There's a minority of cost in cost of goods, which are fixed, right? And you see the opposite trend in OpEx. In OpEx, the majority of the cost is fixed. It's mostly people. We're a normal tech company that way. The majority of our OpEx is payroll. And so that's the segue.And so the second part of your question, which is where would we get the savings? So we expect to save a number something like $3 million between now and the end of our fiscal year from those cost savings initiatives. It's quite significant. And the portion of that, of course, is people and a portion is not people. The portion, which is not people, includes things like controlling travel, controlling some marketing programs, delaying some special projects. We always have 2 or 3 or 4 [Technical Difficulty] every year that we then can slide into this year or the next year. And so it's a combination of those. We're going to close 2 offices where leases are coming up. So it's no one thing, but there's absolutely ability to control costs, both from the variable component and the fixed component.
Okay. I think you did mention in the filing that you're not expecting to take any further special charges, right, or restructuring charges, currently?
Yes, exactly.
[ If we move ] to the debt side, [Technical Difficulty] any kind of color you can give on the nature of the covenants and maybe the size of returns in terms of EBITDA on your calculation and the bank's calculation. And then when I think of the payments milestones coming up, I don't see any [Technical Difficulty] 24 months, but there is that contingent consideration payable on M&A. [Technical Difficulty] product services, overall revenue. How do you think about that [Technical Difficulty]
I'm happy to take that, if you like?
Yes, Larry, I will hand it to you. I just want to make a comment, first. Deepak, just so you know, everybody else on the call had a lot of trouble understanding, you were breaking up a lot. So I think I got it. And if I got it, Larry, probably got it to the same extent. So we'll try, but please just know it was hard to hear your question. So I think as you talk about the debt, talk about the covenants, how does that work? Where do we stand with respect to them? So Larry, for sure, why don't you take that one?
Yes. And Deepak, I did have trouble, but I know we'll follow up later as well. But from an overall covenant perspective, the main covenant, of course, is total debt to EBITDA. It's a formal calculation that we do, and we are quite, quite comfortable, very comfortable at [ 2.25% to 1% ] versus the requirement to be at [ 3.0% ] or less. We manage that very, very well all the time. And from our current cash flow projections and what we see for the remainder of the year, we don't contemplate any issues relative to that or with the payment from a NetFortris perspective, whether it's through additional borrowings and still meet that or not, but our cash flow projections are fine for the remainder of the year. Does that get you there.
That's very helpful. I appreciate that. Sorry about the static on the call.
No problem. I just wanted you to understand that if we missed something, it wasn't because we were ignoring you. It was just a little [ hard to follow you ].
No, I appreciate that and the specifics on the numbers and the [Technical Difficulty] is very helpful.
The next question is from David Kwan from TD Securities.
Maybe a question for Larry. Just on the gross margins, are you expecting it to remain, I guess, in the high 60s here just given the more favorable revenue mix with a softer product revenue? Or [ couldn't that focus ] services revenue, in particular, help offset some of the gains that we saw?
Yes. So certainly, David, the gross margin was a little bit higher on the higher end of our norm and our expectations for this quarter. It will be in a relative range around that based on what we're seeing moving forward. It could move slightly, but I'm not expecting significant changes to that. As clearly Bill indicated where services are and where we're seeing growth there. So could it move slightly short, right? You get a big order on one side or the other, that could certainly impact that. But nothing significant on our radar right now.
And I guess another one for you probably. But just in terms of the guidance, it seems to imply a pretty significant pickup in margins in the second half here. I guess how much of that is related to kind of the higher gross margins due to the revenue mix versus some of these cost-saving initiatives that Bill has outlined just kind of the tougher revenue environment? And I guess it sounds like you're not planning on implementing much in terms of further cost reduction initiatives outside of what is [ talked about in the ] call?
Yes. So let me take that a couple of different ways. So from an ongoing operating perspective, what we see in terms of revenue and pass-through all the way to the EBITDA line is what we're projecting as we move forward. While we do have these cost-cutting initiatives as we move forward and they're all very well defined and they're all very well in place. As you know, the company does a very good job of managing how we spend money and where we put our investments relative to that and what we see on EBITDA. So there's a very defined plan as to how we will achieve that. But operations is the key to that, and that is where we're putting our focus. And I think you see that as we talk about services and where that's going and where we're going to invest as it relates to spending the money. So I think another way to answer, David, it doesn't require anything other than what we've already talked about.
Okay. That's helpful. Just in terms of the free cash flow, it's been a struggle, I guess, over the last couple of quarters here, particularly related to the kind of noncash working cap, which has been a drag for almost -- [ for their past 2 ] years now. I think inventories, in particular, has been the key challenge, just this past quarter, the accounts payable and accrued liabilities with [Technical Difficulty] what happened there? And do you expect to see a reversal of that in the coming quarters here, which it sounds like probably see much stronger free cash flow in the second half and maybe into fiscal '24?
Yes. So spot on relative to how we normally see cash flow usually a little bit lighter in the first half of the year and get strong in the second half of the year, timing is a key consideration relative to when payments are made and things of that nature. So we do expect to see stronger cash flow as we get into the second half of the year. And that's also in, as I mentioned earlier, our cash flow projections and what we contemplate that being as we exit. So that always strengthens as we move, and we're seeing that today as well. We manage that really well. And I'm not seeing anything on the horizon that would cause us any issues relative to that.
And maybe one question for Bill here. A lot of stuff going on in the AR market, particularly [ since the launch actually we see at end of ] November. So can you talk about to what extent, I guess, you guys might be using AI in your platform and maybe how you're responding to what's going on out there in the market, particularly, I guess, as it relates to the CCaaS part of the market?
Yes. Happy to do so. If you'll permit me, I have one little bit of additional color to add to Larry's answer to your first question, which I think you'll find useful and then I'll come to your AI. Is that okay?
For sure.
Yes. So on your question about, hey, Larry, is it possible that growth in the MSP business could counteract the expanding gross margins that come from more of the total revenue deriving from services? So very interested to answer it perfectly. I don't have anything to try and add to what he shared. I want to give you something additional to, if you think about it. This is a place where the economy of scale helps again, right? Just like when I answer Eric's question and Mike's question, there's just so much value in getting to be an at-scale company. So right now, on a monthly basis, you can look at our services revenue in the quarter, we're somewhere between USD15 million and USD16 million.So imagine getting a really good, healthy order $100,000 to $200,000 that has a big chunk of it being MSP. And instead of getting whatever our services margin might be on 70%, 80%. It comes with slightly lower margins. It's almost impossible for that one order, even if it is large to have a material impact on the margin in the negative way you were asking about [Technical Difficulty] just too big of an installed base now as Sangoma continues to scale, that one particular order, even if MSP is a bigger component and it comes with slightly higher COGS for that to drag down quarterly revenue -- quarterly margin. Does that make sense?
No, I just know that you guys talked about the lower gross margins on the MSP side and that over time, you expect that the gross margins could come down a bit as MSP becomes a greater percentage of the overall business. So I was just trying to get an understanding of the dynamic of what you guys [Technical Difficulty].
I totally understood the question. I'm just trying to say, in addition to the way Larry helped you understand it, I was trying to add a slightly, I don't know, higher macro level view that it would have to be an enormous MSP order, or it would have to be 3 years from now as the MSP has grown and grown and grown and grown and is now a much bigger part of the business. And so you don't have to worry about that at all right now. It's not going to pull down margins in any material. Yes?
So it sounds like if margins are going to come down from these levels? Is it really either going to be product revenues being much stronger than what we've seen at least last quarter and/or probably supply chain issues coming up?
Yes, [Technical Difficulty] as I said in my answer, time has elapsed and the portion of our business that comes from those MSP types of offerings is now much bigger 2.5 years from now or something. But right now, there's no chance that even a large MSP order could bring down margins by a large amount.
Yes. [Technical Difficulty] last couple of quarters in the second half, but I appreciate the color.
Yes. No, it couldn't do that in the next couple of quarters, David. That's what I'm telling. Okay. So to AI, Sangoma is not heavily invested in AI yet, although we're certainly paying attention and we have some of it. It's not a large part of our product offering. We have capabilities in an area that uses some part of what AI is [ sought ] to do. And here, you have to have a fairly technical understanding of what constitutes AI versus what is machine learning versus what is neural networks. But for example, you asked about call centers, one of the things that call centers are looking to use AI to do and I acknowledge this is a little contentious to some people is reduce the cost that they were in a call center.So one way to do that is AI continues to advance at the rate it might is, perhaps you'll be able to replace some agents entirely with AI agents, and that's certainly being talked about in the industry, and we think about that, too. But the way it manifests for us and product capabilities right now is something different, which is can you tell when you have the live customer at the other end of the phone, so that you only connect a contact center agent into that call once you know there's a live person to speak to. And so there's an area of AI that's involved with understanding whether the other party is a person or not. Sometimes it's called answering machine detection, but that's kind of an older term for it. And so Sangoma has the capability. We do it. We try to make sure that customers -- sorry, agents at a call center only get connected into a call once the contact centers offer knows there's a live person there. So that's about as far as we go in that area, David. It's a small step into it. And just because it's a new space, we're carefully monitoring and thinking about it, but not overinvesting there yet.
The next question is from James Breen from William Blair.
Just a little bit more color on the previous question. Just as you see the business evolving over the next 3 to 5 years, how do you think about the changes in the margin structure and the capital structure as you move more toward the MSP side away from some of the core revenue [Technical Difficulty] today?
Yes. Good question, Jim. I think that really is the salient point that if we're talking 3 years or 5 years from now versus 2 quarters, then I think MSP can become a larger fraction of our business. It's very hard to model out 4 years from now to be blunt, Jim. And what I think is likely to happen is 2 offsetting things, which I suspect will lead margins to kind of stay in the 70%, maybe low 70% range over that time. One is the services part of our business is going to become a larger and larger factor to total revenue, which will push gross margin up. And as MSP grows with slightly lower gross margins that will partly offset. And we won't go from 70% to 85%, but we might go from 70% to higher 70s over time, and that's how those 2 kind of play against each other.
The next question is from Robert Young from Canaccord Genuity.
Sorry, I was on mute. I just wanted to better understand the visibility going forward. And I think last quarter, you were saying that you're seeing buying behavior getting worse month over month over month. And I guess you see that manifesting in the product revenue this quarter. Now it seems like you're more positive on the visibility in the short term, yet you've reduced the guidance by more than what I would have called the shortfall this quarter. And so I'm trying to parse those 2 things. It seems like you're maybe more conservative on the macro, yet it feels as though the visibility has gone a little better. And maybe if you could just nudge me in the right direction there.
No, that is exactly how we feel. You've answered your own question. That's right, Rob. I think I confessed in my prepared remarks that the drop in the product revenue, while not a surprise as a general case that it dropped. It drops by more than we expected. And so you've also heard me say, we think it's kind of bottomed out. I've explained why we think that both in terms of the supply chain kind of clearing or having cleared itself. And we're well into the third quarter. And if you combine our bullishness on services, a little bit of being careful about product, right. We got caught a little bit off guard in Q2, as I've acknowledged. So the last thing we want to do is put out revised guidance and then have some risk of missing it. So yes, I acknowledge it's a little bit more conservative than you might see from the trends and from the comments I've offered about the fact that we think product is not going to decline further, but it's a conscious decision. There's nothing more to it than that, and there is 2 factors working against each other that you described.
Great. Okay. That sounds very prudent. Second question would be just a high level, some of the questions they have been very specific around some of the elements of the business around maybe some competitive issues. And so I mean, for someone who's looking at the business at a high level and maybe worried about some of the developments in voice. I mean, Mitel just made an acquisition and a few other things. Just maybe if you can just resettle where you see the competitive dynamic in this tighter macro. I think that would be helpful. And then I'll pass line.
Yes. Actually, that's a good question. I don't think anything has changed in our view, Rob, of the role or the importance of companies that we consider to not be cloud companies. And without trying to be disrespectful or judgmental about other firms, I don't see any value to that. Companies that were primarily on-prem PBX companies. And we know who those are, right? Panasonic, Toshiba, what's going on with Avaya, I won't comment specifically about Mitel are not progressing into the cloud space successfully are no more a threat now than they were a quarter ago or a year ago and one particular acquisition by one of those or a bankruptcy risk to another doesn't change any of that. It might be whatsoever.The competitors in the much more pure cloud landscape. I think generally are starting to stratify the markets harder, financial conditions are harder. If you lost money forever and funded operating losses by going and getting cheap debt or raising always available equity that's harder now than it was a year ago. So a little tiny [ $20 million or $15 million ] companies are not having as much success as they did in the past. And larger companies that have heavy debt loads have had to put a lot of corporate energy into dealing with that, some successful, some [ less sold ]. I would say we continue to see the 3 primary competitors being Microsoft, Zoom and Ring in no particular order.
This concludes the question-and-answer session. This also concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.
Thank you, everyone.
Thank you.