Zoom Communications, Inc. (ZM) Earnings Call Transcript & Summary

Good morning, everybody. This is Nikolay Beliov, software analyst -- one of the software analyst here at Bank of America technology team. Happy to have Zoom Video today with us, represented by Kelly Steckelberg, the Chief Financial Officer. Kelly, welcome to our conference. Thanks so much for joining us.

Thank you. Good morning. Thank you for having me.

What a week for you. So you had your birthday. At the same day, you reported what we call unprecedented results.

I did. Yes, it was the best gift ever.

Yes. And you have enough energy left to spend some time with us. We really appreciate it. Thanks so much. Just to kick off the conversation, and we can jump back into the specifics about the quarter. Q1 results reported on Tuesday. What are the top 3 takeaways investors should walk away with from the results in the quarter?

So we're really excited about doing what we could to support the world in this unprecedented time. And what we saw was companies looking for an opportunity to increase or enhance their business continuity planning. So we saw tremendous growth in the upmarket, where we added 500 customers with greater than 100,000 of ARR. That's a new metric, a onetime metric that we disclose to help everybody understand this. It's more forward-looking than the traditional metric we give, which is trailing 12 months revenue. We had tremendous growth as well in the mass market, and this was evidenced by the fact that over half of our sales in the quarter were on monthly contracts. And this was an opportunity for many new people to get introduced to Zoom and to show us many new use cases that they're using it for, which was super exciting. And then the one other aspect of the quarter 2 everybody should be aware of is that adding this much capacity in such a quick time, did take a little bit of a toll on our gross margin. So traditionally, we have hosted most of our live meeting traffic in our own colos, on our own servers and our own colos. And during the quarter, we were greatly supported by our partners in the public cloud space from AWS and Oracle and adding a lot of capacity there to keep up with the demand. And that, as I said, degraded our gross margin slightly from where we've been in previous quarters in sort of the low 80s, down to 69% for the quarter.

Okay. I have to say, I have a personal use case with Zoom Video, and I've been paying you guys a license for a while. And as a user, which I use Zoom for personal purposes, at least 3 times a week, I saw the -- one of the performance issues that -- the only performance issues I had was the audio and video recording from my sessions, my foreign language sessions. I'm learning Sanskrit.

That's great.

It usually takes -- usually, they come back within 5 to 10 minutes. A couple of times, it took a couple of hours for the audio and the video recording to come in, but during the live sessions, there were no -- I didn't see any change or degradation in performance, et cetera, et cetera. So it's amazing you guys were able to scale from 10 million users to 300 million users in a period of weeks. And yet the overwhelming experience was still pretty good.

Yes. That's great to hear. That is huge credit to our engineering ops team that really was all hands on deck in the entire quarter to ensure that, that was exactly the experience our users were having.

So what is the strategy going forward? Use more public -- the hyperscalers to scale capacity or really expand your own data centers to handle this in a more sustainable way?

It's going to be a combination of both. So as we're looking forward this year, you're going to see CapEx spending as we invest more to bring more capacity into our own colos, but also to continue to leverage the public cloud, especially as we have all of these new users that came in and during very uncertain times in our globe as well as in our economy that what they help give us is flexibility in our capacity to scale up and to scale down if we potentially need to, and we really appreciate that. And as you said, it hasn't caused any difference in the experience or the performance that our users are seeing. So it's a great way to have now a hybrid approach to this.

Great. Great. And I happen to live in -- on a little rock in the middle of the ocean. So my user experience was great.

That's great. Good to hear.

Being geographically remote. So it was great. The other experience I had as a user, Kelly, is, I can see now security icon on the interface. And when I pull up the summary of my identity, I guess, now I can see couple of things. Number one, that when I pull the summary of the session is, the session is encrypted. So that's a new thing. And the second thing I see is, I get another message. All your traffic is going through U.S.-based data centers, right? So can you please give a refresher of the security improvements you have made in the product? And what is left? I mean, what you've done so far in such a quick period of time, it's pretty amazing actually. Is there anything left? Is there anything more you need to do to close that gap?

Thank you. So you highlighted a couple of the key initiatives that we've embarked on over the -- we're in the -- almost, I guess, at the end, and we're in the last month of our 90-day focus on security and privacy. And we've implemented many new things to not only make the product more secure, but also more available and more usable, especially in this new consumer -- set of customers that may not have had historically training or are as used to using technology like this. So a couple of things you talked about, the shield. What that is meant to do is really bring all of the security and privacy features together to put them really easily accessible right in the hands of the host. This allows you to do things like lock your meeting, to mute and unmute participants, to control who's having the ability to screen share. And that just makes it super easy for you to be in control of your meeting. We've also changed a few of our security procedures in terms of making them on by default now when you come as a new customer. So when you start a meeting from -- when you're a new user who comes into Zoom, all of your meetings will start with a password by default. You have the ability to control that, of course. All of your meetings will also start with a waiting room, which allows you then to admit people into the meeting. You can also turn that off if you so choose, but we want everyone to have the most secure position by default. And then as you also said, we've added the ability for people to control which data centers their data is flowing through. So that's what you're saying is you can now see that yours is all flowing through U.S. data centers. And we -- on last weekend, last weekend was when we upgraded everybody to 256 GCM encryption. So you ask what's left? One of the big things that's left is we are embarking on a journey to ensure that the platform is end-to-end encrypted. And that is something that hasn't been done at this scale before. We're really excited about the acquisition we did at the Keybase team. They bring a high degree of technology and security knowledge to our team that we haven't had before, and they're the ones that are going to really be focusing on that.

Was security an issue with lending new enterprise or mid-market accounts over the last 90 days?

We certainly have spent a lot of time with both our existing and prospective customers as we've been going through this 90-day plan, helping them understand what's on the road map. We formed a CISO council that is made up of many of our customers and prospects that joined. What we saw is most customers understand the position, and we're grateful for the transparency in which we've shared our road map, our plans and acknowledging what we could have done better in the past. We have not seen significant impact on our ability to close deals during this time. In fact, we've seen -- we saw some of the most conservative financial institution that bought a large number of seats kind of right in the middle of that plan, so -- last month. So we have not seen significant impact from the privacy and security during this time.

That's the company who bought 175,000 licenses?

Yes.

Wow. Is that the largest number of licenses? Is that the biggest customer you have in terms of number of licenses?

That is not the largest, but it's probably in the top 3.

Top 3, wow. So clearly, COVID has benefited the business here, but were there some negative offsets like the ability of people to roll out Zoom Rooms, et cetera, et cetera?

Yes. Certainly, we saw tremendous growth during the period. It was primarily concentrated in Zoom Meetings. It -- as I said, it was really companies that were focused on ensuring they could keep their employees safe and productive at the same time and realizing that video communications is the best way to do that as cell phone and e-mail isn't enough when we're all working remotely like this. We did continue to see growth in Zoom Phone and Zoom Rooms. We highlighted Arm on the call that bought -- pretty -- bought all 3 of the components, Zoom Rooms, Zoom Meetings as well as Zoom Phone. And we did see quarter-over-quarter growth in Zoom Rooms and in Zoom Phone as well. So very excited about that. What's great is now that we have this much larger base of customers. We have the opportunity to continue to sell into them, and we especially expect to see acceleration in Zoom Rooms as people prepare to go back to the workplace.

Got it. Got it. Traditionally, Zoom Video has been a pretty horizontal product. One might say that. And now that it is clearly -- one can make an argument the emergence of sustainable, durable use cases in education, medicine, et cetera, et cetera, healthcare. Are you guys envisioning maybe verticalizing the product around some key verticals?

So we do have 4 key verticals that we focus on that have slight adjustments to the product already today. And that is healthcare, where we support HIPAA compliance; it's education where there are some use cases where they need additional functionality; government, where we are FedRAMP certified; as well as financial services, where also, there are some specific functionality and features that are needed to meet the regulatory requirements. And during the quarter, what we saw was that government and education were our 2 fastest-growing verticals as -- I think that's also a testament to the confidence people have in the security of the platform as government and education, which are one of the areas that we want to ensure that are the most secure. We're buying the platform and growing very quickly.

Are there any other certifications besides FedRAMP and HIPAA you need to get -- to go deeper into other verticals? Or these are the major ones?

Those are the major ones. I mean, we listen all the time to certain -- for example, financial services is one of the common request by the services, the ability -- some organizations want chat to always be on, some want it to always be off, or recording of meetings always to be on, always to be off. So those aren't certifications, but just ensuring that we have the ability to give them the admin rights that they need to control the platform in the way that works for them.

And has COVID maybe shown to you and the product team, maybe some new features that you want to add that people have been requesting? Just purely based on the frequency and volume, of course, like maybe deeper chat or anything else?

Not specifically related to COVID. What -- we've seen all these new user cases really in the consumer/prosumer area of our business. And that is what -- how we've responded to ensuring that our platform is really intuitive for everyone to use, all the way from the individual up to the enterprise. So that's what's been -- we've really been focusing on is thinking about the user experience itself.

You recently added, I'm going to butcher his name, Velchamy Sankaralingam?

Yes. Velchamy, yes.

I can help you with that. I can help you with that. It's Velchamy Sankaralingam. I'll bet nobody can ever say that like the way I did.

Well done, Kash.

Because I'm from the same ZIP code. I'm from the same ZIP code. I get it.

Kash, you're the man.

See, that's my value add on this webcast.

Great teamwork. So what is -- what did you like about his background, Kelly? What is he bringing to the table? And does this mean any maybe change in product direction?

So Velchamy, many of us had the opportunity to work with him at Webex, and he and Eric have been best friends for a very long time. And as you know, trust, first of all, is a key component of our ethos at Zoom. And so coming in with already knowing him is really helpful. And then he has gone on to have an amazing career at VMware where he was really an influencer there and a very significant part of their leadership team. So we're looking forward to having him come into the organization, not only with the relationships that he's built historically with many of us, but also that view into scale that he's had at VMware. And looking forward to having him come here and being able to bring some of what he's learned and developed over the last -- I think he's been at VMware for the last 10 years, bringing that to Zoom as well.

Another aspect of my personal experience being a Zoom Video user is, my daughter who's 7, she uses Zoom for school. My wife uses Zoom for work. I use Zoom for my language classes. How do you guys think about the prosumer versus enterprise split and strategy over the long term? There aren't many companies in software, I can think of Intuit, Adobe, Microsoft, that have been able to do both consumer and enterprise. And clearly, both markets carry different requirements, go-to-market motion, different unit economics, et cetera, et cetera. How do you guys think about that?

First of all, thank you for being a 3 -- or 3 Zoom family. I appreciate that. Yes. So the product itself has always been oriented towards being something that was able to be used by an individual all the way up to an enterprise. Our go-to-market strategy, though, clearly is different across these 2 segments of the business. And what we saw in Q1 was, of course, our upmarket teams were very busy. And that buying process for most of those organizations didn't really change. It's still been the typical approach. What we did see was in the individual's consumer/prosumer end of the segment, many, many of those bought online, which is great to see. It's a very efficient approach for them and for Zoom as well. It's very easy. We give them the -- it's very flexible. They can buy there. They can cancel there. They can upgrade into an annual contract, if they like. So trying to make -- individuals and consumers are used to buying online. They're very oriented to that, right? We all buy everything on Amazon these days. And so wanting to make the ability for them to buy Zoom the same way as easy as it is to go to Amazon and buy something.

Got it. And how do you think about the split in the long term? Now -- last quarter, it was 30%; consumer, up from 20%. Where do you think it settles in the long term?

Yes. I mean, this is -- we talked a lot about this on the call. This is the area that we're spending a lot of time studying how they're behaving as we're continuing to move into now the second quarter of having a lot of [indiscernible] on our platform as there was such an increase in the user -- the number of users of consumers that our historical data around them is changing. And it's probably the area that we have the least amount of visibility into. So we talked about on the call, as we're modeling forward, we are assuming a higher multiple of churn in this area of business. And I guess, what I'm trying to say is it's really kind of too early to tell, and we're watching them very closely to see, I think it's largely dependent upon the pandemic as well as the economy in how that continues to perform.

How do you think about unit economics of consumer versus enterprise and the impact on the business model?

Yes. It's interesting because they both have puts and takes, right? So on the consumer end, in some ways, the unit economics are better because they're buying online. There isn't a sales organization that is involved in it. And yet they have a much higher rate of churn. So their lifetime value is a lot shorter. At the upper end of it, those enterprises typically buy on annual or multiyear contracts. So they have a much longer lifetime value, but it is somewhat offset by the cost of having a sales team that is supporting that.

Got it. Got it. Taking a step back in the business, when you put the 3 pieces together, Video, Video Rooms and Zoom Phone, what do you think the split could be in the long-term at maturity? And has your view changed because of COVID?

Yes. I mean, before COVID, we certainly were seeing more equal strength, I think, across all 3 of those tenants. Q1 was definitely dominated by Zoom Meetings, but just as a reminder, our go-to-market strategy for both Zoom Phone and Zoom Rooms is that we sell into our existing installed base. So I view this as a great opportunity. Now we've created a much greater platform in which our sales organization can sell Zoom Phone and Zoom Rooms. The long-term view, we've said is that Zoom Meetings should be approximately 50% and Zoom Phone and Zoom Rooms each could take up the balance of that remaining 50%, so approximately 25% each. But remember, Zoom Meetings has a long, long head start as compared to Zoom Phone, but we've seen -- we're really happy with the performance to date. It's been in market now for just 5 quarters and has seen great progress already so far.

If I could jump in with a question or 2, if that's okay with you, Nikolay?

Of course, Kash.

Kelly, with respect to the incumbency, when you go to a large enterprise like a Bank of America or whatever, what do you run into? It would seem to people like Nikolay and I that it is the most logical thing to use Zoom to do our meetings, but we don't, right? What are the things that you run into in the enterprise market that are objections to using Zoom? And what are the things that the company has been doing to overcome whether it's technologically or product-wise or user experience wise? And I have a follow-up question.

Yes. Well, we look forward to the opportunity to earn your business and next year doing this -- the whole conference via Zoom, that would be amazing. So especially large organizers and financial institutions, which are typically understandably more conservative, it is a combination. It can be a combination of the IT organization wanting to make sure they understand what the change management is going to be. It can be a combination of the security team wanting to make sure that the security protocols that are in place in our product meet the needs of your organization as especially every financial institution has different requirements, and we understand that. So it -- the approach that we take is having -- we have a financial services sales organization, and they work very closely with each prospect to understand what that is to take time to educate across the organization, everyone around the product, what we can do for you. And those are usually the 2 key objections. Zoom is very competitively priced against those in the market. So typically, that is not an objection. It's more around -- for large organizations, it does take some change management, but Zoom is so intuitive and easy to use, as we mentioned on that call, the other financial institution that bought 175,000 seats, they rolled those out in 10 days. I think that is a record in terms of how quickly that number and that magnitude of seats were rolled out across an organization. So again, we would be thrilled to have the opportunity to help you with that.

We're making all the things that we need to. How strong is the Cisco Webex incumbency? Is that an inhibiting factor at all in the short term? Although end users clearly want Zoom. How strong of that is an objection from the IT department or the Chief Information Officer that values the security and incumbency more than maybe on the functionality?

Yes. I mean, certainly, in most large enterprises, there is already an incumbent in place. And most of the time, it is, as you say, a combination of Webex and Cisco products. What we hear from our prospects is, yes, the users prefer the ease of use and the usability of Zoom. And as we've been remote, and even over the last 2 days, as I've been doing lots of calls with investors like this, I've heard anecdotes of companies, investors getting on calls, using various competitive products and that they keep coming back to Zoom because it is the most reliable and easy to use. So I think I -- we understand that it takes time, sometimes for organizations to embrace something new, but once the users experience it, I think there's really no turning back.

And what are your thoughts on Microsoft and Teams and where their product goes because they're bringing in the multiple modalities of communicating, whether it's video, audio, chat, messaging, et cetera? So in that world where all forms of communication conversion to one platform, where does that leave the Zoom strategy?

So what we hear from our customers is -- first of all, Microsoft is pervasive. That hasn't changed, and there's a perception in most organizations that it's free because it's already included on some sort of a standard ELA. And what we hear from them is they want to be able to leverage Teams for certain aspects of it. And most commonly, that is the chat functionality, but they want to be able to integrate that with Zoom because they want to use Zoom for the Zoom Meetings and Zoom Phone. And so we have an integration with them. We want our customers to be able to use the product in the way that they see fit, but we still hear from them that the ease of use and the reliability of Zoom is what's driving them to want to use us for meetings and for phone.

Got it. My final question, before I turn it over to Nikolay. Is there a risk at all that there's a front-end wave of buying? There's this mad rush, right?

Yes.

I mean we're going through this COVID situation, and that might have accelerated the demand curve upfront and then you go back to a more normal demand curve. Or is it that this is the catalyst that just opens up the market in a more sustainable way that this just increases confidence in your growth rate because one would easily be tempted to make the former conclusion, hey, it's just a rush like a Y2K, a number of people had to update their systems for Y2K. And so does that -- where do -- what is your assessment of what's driving your business between these 2?

It's a great observation because I actually think it's -- I think it's both. I think that everybody going into remote work has really accelerated the use of video communications and the visibility specifically in brand awareness of Zoom. So that is a catalyst that has forever changed, I think, this market. We did -- the demand that we saw in Q1, I think is an unprecedented event that is not likely to repeat itself. We do see elevated demand coming into Q2. And we entered Q2 with more pipeline than we entered Q1. So what that says is that during Q1, there was a lot of in-quarter pipeline creation and some of that demand has continued into Q2. As we're modeling the back half of our year, we are assuming that our sales teams go back to a more normal level of productivity. We have higher capacity in our system because we've hired a lot more sales reps, but they're going to go back to a more normal state of being as we get to the back half of the year.

Back to you, Nikolay.

Kelly, maybe just to get a little bit more context around this, were there any active monetization campaigns into the installed base during Q1? And how is the strategy evolving in Q2 and for the rest -- throughout the rest of the year?

Yes. So part of our sales organization is focused on acquisition and part of it is on upsell. So that team is always there. And what they're doing is looking at the installed base, watching for opportunities to upsell either more seats as we talked about Zoom Phone or Zoom Rooms. So that did not change in Q1. What happened, I think, in Q1, was there was a lot more inbound as organizations were, as I said before, really looking for ways to ensure they could keep their employees safe and productive during this time. So that was really the shift in Q1 as there was a lot more inbound demand than had been historically.

And what about Q2 and the rest of the year, any active monetization campaigns like blasting 300 million users with all kinds of offers and whatnot or upgrade monthly to annual or whatever the tweaks you're thinking about?

As we've seen such a significant growth in our monthly contracts, we are looking for the opportunity, and presenting them with the opportunity to upgrade to annual as well as we had -- have significantly more free users on our platform as a percentage of users. And so the way -- what typically incents a free user to upgrade to a paid version is the level of usage. So we encourage them and help them optimize on -- to how to optimize their usage on the platform. So those are the 2 kind of marketing campaigns that are running right now is for users to help them understand how to best optimize their usage on the platform as well as converting monthlies to annuals.

The top #1 question I have been getting from investors after the quarter was, what trends did the company see in May -- in the month of May versus the month of April?

Yes. So we continue to see an elevated level of demand, but not at the level of Q1, which is, again, if I go back to our guidance, why we've guided that the back half of the year will be -- we expect it to be consistent with the revenue of Q2, kind of flattish -- Q3 and Q4 to be flat to Q2 because we expect that to start to moderate now. And so what could happen for us in the back half of the year is that our gross bookings from the enterprise and the upmarket teams could actually be offset by churn in this mass market that we've seen, getting us to a more flat for the back half of the year.

Okay. So the numbers are mind-boggling here, right? So even though the -- I mean, revenue growth up 189% or whatever the guidance is for the year. Despite that massive increase, there's a pretty -- the way I hear you, Kelly, is, there's a pretty good level of conservatism embedded in the guide?

We are -- where we're sitting right now, there are a lot of unknowns, including how long does this pandemic last? And what is the behavior of this new court of users -- cohort of users that we have. And so we have modeled the back half of the year, assuming an elevated level of churn against that. And we think that is prudent at this point.

Got it. Got it. Switching gears to gross margins. Are we ever going to see gross margins coming back to the low 80s?

Yes. I don't think we're going to see gross margins in the low 80s for a long time. And the reason for that is there's 2 things -- really 3 things that impacted our gross margins in Q1. It was the increased percentage of usage from our public cloud providers, it was the increased percentage of minutes being used by free users, as well as our increased investment in security and privacy measures, which gets split across 3 lines in the P&L, but one of them is COGS. So even if we -- as we move forward and we add more capacity to our data centers, even if we were to get all of that capacity into our data centers, it would still -- our gross margins would still not go back to the same levels they were due to the increased number of free users on our platform. And you know what, that's okay because remember that we really love and value our free users. They are a big reason that the virality of this product has continued and why we've grown so quickly. And if we weren't paying for them in gross margins, the way I view this is, if we weren't paying for them in gross margins, we would be paying for them in marketing. And so that's the trade-off that you see in the P&L is we're taking a few more points out of gross margin to support these free users as opposed to paying higher subscriber acquisition costs in marketing. But we -- as in our guidance, we indicated that we expect to get back to the mid-70s in the next several quarters. And I think for the long term, you're going to see gross margins kind of at 80%-ish at the upper end of the range.

Got it. Got it. So now that a lot more dollars are dropping into the bottom line, free cash flow and operating margin, why -- how do you feel about sales hiring? Why don't go out and double and triple your sales headcount, take advantage of the opportunity? How do you think about the trade-offs here?

Yes. We are really investing in sales hiring. We have not only accelerated our plans for the year and hired ahead in Q1, we have also our -- have expanded our total hiring plan for the year. And this is on a global basis because we saw this demand not only in the U.S., but also internationally as well. You may have seen that international as a percentage of revenue grew from 20% to 25%. So we're really excited about that. And the brand awareness also grew, not only in the U.S. but globally. So now we have the opportunity to put sales reps into markets that would have taken maybe another year or 2 to seed with marketing dollars, but because the global brand awareness has been so accelerated to go straight ahead and put sales reps into those markets as quickly as we can.

Got it. Kelly, we're out of time. Thank you so much for joining our conference and get some rest this weekend.

Thank you. Thank you for having me. I really appreciate it.

Bye, everybody. Everybody, please stay safe and healthy. This concludes our presentation with Zoom Video.

Bye, everybody.

Thank you, Nikolay. Thank you, Kelly. Have a lovely day, everybody. We'll see you soon. Bye-bye.

Thank you, Kash. Right. Bye.

Bye, Kelly.