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

My name is Will Power. I cover cloud software for Baird. Thanks, everybody, so much for being here. Pleased to have Zoom Video Communications with us in person. From the company, we have Kelly Steckelberg, who is the Chief Financial Officer. It's going to be a fireside format. We've got a bunch of questions to ask. And if you have questions from the audience, there are directions on the placards on the tables in front of you where you can submit them vie email. I'll try to get to those as well. And then we have a breakout session after this for additional questions.

So with that, Kelly, thanks so much for being here. So great to see you.

Happy to be here. Thank you.

Let me maybe just to kick start it. I mean I guess everybody here is familiar with Zoom video and the video platform. Maybe just help us understand the broader platform vision from here. How you build off what you've already established and kind of the key strategic objectives for you and the company moving forward here?

Yes. So we are successfully transitioning from being the killer meeting app that you all came to know and love during the pandemic to a unified communications platform. And that platform more broadly includes, of course, not only Meeting and our Chat product, which comes bundled with Meeting, but also Zoom Phone, which is our cloud PBX solution. It's about 3 years old now, and we announced in Q1 that we crossed over that 3 million-seat mark. So really excited about the momentum we're seeing there. We also have Zoom Rooms, which is our conference room solution. And Zoom Rooms are not new. We've had them for a long time, but they have really also taken a very strategic place in terms of our strategy as everybody is trying to think about what does the future of work look like. And many of you have probably had that terrible experience of being outside the conference room and looking at the back of someone's head or not knowing who's talking. And having the right technology in the conference room going forward is going to be paramount. And there's lots of technology, including features like Smart Gallery, which allows you to see everybody's face in the room. That's part of our Zoom Room strategy, which is really important. And then we have some newer products that have recently been released. So we have Zoom Events, which is a solution that provides a hybrid solution for meetings just like these, right, where people are coming together. They've been doing them in real life before the pandemic. Maybe during the pandemic, they had the opportunity to experience a larger virtual reach and now trying to combine those 2. And Zoomtopia, which is our user conference, which will be held in November. We'll be leveraging Zoom Events, so you'll get to experience that. And then most recently, we are excited to have announced Zoom IQ for Sale, which is an analytics tool. It sits on top of Meetings as well as Contact Center. So Contact Center came out last quarter, and we had some really fun names to talk about on our call in Q1. So really excited to see that we're already seeing momentum there.

Okay. Well, that's a great starting point. So you all reported fiscal Q1 just a few short weeks ago. I mean...

Yes, 2 weeks ago, right?

Yes. I think, yes, looked like a solid quarter overall. Provided solid guidance, I guess, as you look forward. Maybe just talk about kind of the key drivers in Q1, just help level set us, and kind of your visibility as we move into the remainder of the year. Because that's, I think, one of the big questions for investors.

Yes. So as a reminder for everybody, we changed the metrics and how we are starting to talk about the business in Q4, which is splitting it into our Enterprise segment of the business, which are customers that are touched by either our direct sales organization, a channel or an ISV partner; and then our online segment of the business, which are customers that are coming to us via our online channel. Doesn't really matter the size of the customers, which is different than how we talked about them previously. So we saw a lot of strength in the Enterprise segment of the business, which is what we've talked about. We really expect the long-term growth of the company to be driven by the Enterprise segment. And in Q1, we reported 31% year-over-year growth in this segment. And they grew from 50% to 50% -- this segment grew from 50% to 52% of our total revenue, and that's largely what's leading to the strength in the ongoing sustainable growth of the company. Then in the online segment, we talked about -- when we gave guidance at the beginning of the year, we talked about we expected volatility in this segment, and we can certainly talk about more what's contributing to that. But the Q1 results did reflect that. So we saw some volatility and some headwinds in this segment. A lot of those headwinds are driven by macroeconomic events, including foreign exchange as well as the war in Europe. So when we looked at the combination of those 2 factors, we said that for the full year, we expect them to have about a 1% impact on revenue. So it's pretty significant. And that is -- most of that is coming and impacting our online segment. With that said, there are lots of new initiatives in online, including pricing and packaging. And we can talk more about that if you like. But if it -- absent those external factors, the online segment of the business would have been approximately flat for the quarter, which would have been a really good result. But due to the impact from the other things, it was slightly down.

Okay. Let me -- maybe to dig into each of those in a little bit more detail. Enterprise has been the strength of the company. Maybe just talk about the key drivers of that. How much is adding video licenses, seats within your existing base versus new customers versus new products? I mean what's really kind of the underpinning of the strength there?

Yes, yes. So it's -- some of the key drivers are new products as well as international expansion. And so we see lots of opportunities still outside of the U.S., especially around Meetings. While video adoption really accelerated during the pandemic on an international basis, when we look at the maturation of the markets and our saturation, outside of the U.S., there's still lots and lots and lots of opportunity. And we're continuing to invest in sales capacity in both our direct sales organization as well as the channel internationally as we really see that as a big opportunity. And then new products. Particularly in Q1, we saw strength in Zoom Phone as well as the Zoom Rooms. So for all the reasons that I just talked about, really, really excited to see the continuing momentum there. But those are really the 2 key drivers that we see for Enterprise going forward.

So how do we think about Enterprise growth from here? I mean you just reported 31% growth, as you noted. I mean you continue to have some tough comps -- tougher comps there. You've got some of these growth initiatives. I mean any kind of framework as to how we should think about that continued growth opportunity as we move through the year and into next year and whatnot?

Yes. So if we go back to the full year guidance that we gave during Q4. We said that for the full year of FY '23, we expect our revenue to approximately 11% year-over-year growth. And the way we broke that out is the revenue is almost 50-50 between the 2 segments of the business. We said that is approximately 20-ish percent from Enterprise and flattish from online. And for online, we said it could be up or down a little bit depending on the quarter. What we have also said, though, is that we expect the company to hit an inflection point in Q4 where we start to see growth reaccelerate. And that acceleration of growth is coming from both the Enterprise as we continue to see expansion in our sales capacity as well as some of these newer products start to really take hold and contribute. And then from the online segment, that inflection point is coming from -- primarily, there's a huge advantage or stability that we'll start to see at the back half of the year as some of our cohorts are aging. So those of you that have followed Zoom for a while, at our last Analyst Day, we shared this analysis that shows these cohorts, especially the large ones that we acquired during some of the pandemic years, how when they hit this age of kind of 15 to 16 months, the retention rates really stabilize. And that will add a lot to the normalization of stability in this segment of the business once -- when we get to the back half of this year, we'll get 80% plus of those cohorts having crossed over that magic birthday, if you will. And that really starts to bring stability. As well as we are doing -- by breaking out the business in the way that we're disclosing it now, we -- in addition to that, we have also separated out online as a separate business unit within the organization. There's a GM that's focusing on this now. Whereas historically, online really served as a funnel to our direct business. We're now managing it as its own discrete business. And what that's leading to is investment and focus in a very different way. And there's a lot of great initiatives that are happening within this business, including looking at new currencies, new payment types, pricing and packaging. So thinking about how do you really monetize certain markets that might be highly cost sensitive. Think about maybe having a mobile-only plan for certain countries that has a very different price point than we've historically used. So all of those initiatives are also going to lead to online forecasted returning to growth towards the back half of the year.

Okay. Yes, I think one of the big questions, again, I'm sure you get, too, was just trying to understand the ongoing video opportunity given that's still the biggest piece of the business. And when you talk about growth influxing, it sounds like some of that's the newer products being a part of that. How do we think about the video business in terms of maturation? Where you are? Where is that new growth coming from? How do you set up competitively there?

Yes. So we continue to see opportunities for growth in core Meetings. First of all, there still are competitors that we would love and are focused on continuing to take market share from. And then, of course, internationally, there's still greenfield opportunities as those markets just are not at the same level of adoption. I remember doing an investor tour pre-pandemic and walking into conference rooms that didn't have screens on them, which is shocking because that's not the case that you see in the U.S., of course. And while that has really accelerated during the pandemic, it's still not at the same level of video usage that it is outside of the U.S. as it is in the U.S. And so we continue to see growth opportunities. We're continuing to invest in features and functionality every day around our core meeting product and believe that by building this natively-built, fully integrated platform with all those products I just talked about, that is such a powerful value proposition, that it continues to provide opportunity for growth across all aspects of our product suite.

Yes. So it sounds like there's still opportunities to take share from legacy providers, like Cisco, others. On the other hand, we've got Teams that's being aggressive at pushing that broader platform. How do those 2 intersect, I mean, in terms of opportunity on one end, threat on the other side. Maybe just...

So we absolutely continue to take market share from the competitors you just described. Microsoft is exactly as we expected. I think in any market you see, there are 2 key competitors emerge. And we, for a long time, have expected Microsoft to be that competitor. They are a great partner of ours as well. We do hear from our customers. They often want to leverage parts of the Zoom platform in conjunction with parts of the Teams platform. So we have an integration with them from the Teams UI. You can launch a Zoom meeting or a Zoom Phone call. You can also launch a Zoom Meeting from within a Microsoft-enabled conference room. So we do partner with them very closely. However, we certainly don't take them for granted as a competitor, and it's incumbent upon Zoom to keep innovating and investing in -- the way that we win against Microsoft is that we absolutely have a more usable, user-friendly platform. I saw a win note just last week about a case where we won against Microsoft on a phone deal that they failed to get implemented. And just a few weeks in, they could tell it wasn't going well, and we had the opportunity to win that account. So that's how we're going to continue to win, is focusing on delivering customer happiness, which is at the heart of everything that we do, and doing that at a great value. We are also very competitively priced across all of our products when you look at them compared to the competitors. Because we have such an efficient margin structure, it enables us to do that, and that's how we're going to continue to compete and win against Microsoft.

Yes. Okay. Maybe a couple of questions to kind of come back to the economy in macro. I mean it sounds like in Enterprise, you haven't seen much of an impact at this point. I mean any changes to that as I know we're pretty early in June, I guess, thus far? But any broader thoughts as to any Enterprise impacts at all, whether it be longer sales cycles or higher attrition? And likewise, online, it sounds like it's principally Europe. Are you seeing that with inflation rising elsewhere, is online getting more impacted?

So we really haven't seen impact related to the broader economy. So Enterprise is -- if you think about customers wanting to keep their employees productive, even if they're looking at discretionary spend or to travel, Zoom is a perfect option for that. At $15 a month at list price, it's a very cost-effective way to keep your employees connected. And our renewal rates have remained really, really strong. Because of the sales sort of cycles that happened during the pandemic, Q1 is our strongest renewal period and then it declines each quarter sequentially. Q1 started out strong -- I should say was strong. Q2, coming into Q2, we see larger pipeline than we saw coming into Q1. So really feel good about the opportunity ahead for this quarter. And we haven't seen organizations scaling back on their licenses because of they're retracting in the market. We haven't seen that.

Yes. Maybe just along those lines. One of the upside surprises in fiscal Q1 was the higher billings and deferred revenue that I think what you all maybe anticipated or already guided to. Any other color as to what kind of drove that upside there? I know you expect it to decelerate part of those tougher comps, and as you point out, kind of the seasonality or the timing there. But any drivers you'd point to in terms of that upside?

Yes, there were 2. So as I mentioned, the Enterprise segment performed slightly stronger than we expected against our internal forecast as well as we're continuing to see a shift, especially in the Enterprise back towards longer-term plans. So pre-pandemic, we saw our Enterprise customers typically buying annual and multiyear agreements. During the pandemic, that, even for Enterprise customers, shifted to the majority of them buying annual agreements, and now we're starting to see them shift back towards longer-term plans. And so that can improve -- it does improve potentially both our billings, depending on how -- whether payment terms are aligned to that, but it certainly helps with the longer-term RPO and visibility that we have.

Okay. All right. That's helpful. I guess the other kind of macro-related question I wanted to ask you was just about hiring, retention. I mean the company has been all about delivering happiness, right, to both customers and employees. What does that look like now? And what are you seeing from a labor cost standpoint? And how does that flow through the margins, et cetera?

Yes. So we, as a company, have always been very fortunate to have, I would say, higher than market retention rates from an employee or lower attrition rates. And as you say, we do absolutely focus on delivering happiness to our employees. We have a large portion of our compensation that is aligned to equity, of course. And as the stock has transitioned over the last couple of years, we've made some adjustments there. We did put in place a couple of stock programs over the last 12 months. One of them is that we grant RSUs, and they vest -- there's a cliff vest over the first year. So now we have a program whereby when the employee approaches their 1-year anniversary or reaches their 1-year anniversary, if the value of their RSUs on that anniversary date is less than what was in their offer letter, we're doing a top-up for them. So that if I told you, you're going to get something -- when you get to your first year, we want to make sure you feel really great when you get to that first year. And so making sure that we're able to do that for them. And we also implemented an annual stock grant. So our traditional grants are 4 years. We don't do annual refreshes. Now what we're doing on top of that program, though, is -- I call it an annual stock bonus in a way because it's a grant that vests in a year but it's full equity based. So giving our employees the opportunity to share in what we believe is the upside potential of the overall market value of the company and retaining them that way. We do -- we, of course, always look at our overall cash compensation as well, but we haven't made significant changes in that.

Well, I was going to ask you about that because you're in an advantageous position relative to maybe a lot of your direct peers given the cash flow. You generated cash in the balance sheet, but that's still a smaller piece. Okay.

Absolutely.

Okay. And then I guess from an inflation standpoint, is that -- are you seeing impacts either on the business? Is there much on the cost side there that would impact you? Or doesn't seem like it.

Yes, not huge, right. Because then if you look at our largest -- I mean people is our largest cost, of course. Probably the next biggest area that we would focus on or think about would be cost of goods sold. And we are right in the middle of this significant transition. Again, so as a reminder, pre-pandemic, our gross margins were approximately 82%, and the majority of our traffic then was running through servers sitting in colocated data facilities that we were running. During the pandemic, due to the rapid increase and the need for capacity, we shifted the majority of our traffic into public cloud providers, and we had some amazing help from them. But that certainly came at a cost. And our margins -- gross margins at one point dipped all the way down to 69%. Those have gone back up into the high 70s again. And on the call, we indicated we expect for the rest of the year then to be in the range of 76% to 78%, which was up from the mid-70s, the way we had spoken about them before. And so we've really been focused on driving efficiency through our COGS and getting them back into our data centers. So that's one area that we are seeing improvement. Otherwise, potentially with the exposure we had to the public cloud, I think that could have been a potential area we would have seen inflation. And then other than that, we have a very -- much more limited exposure to other things, like consulting services, et cetera. But we haven't seen a big impact there.

Okay. Let me ask you a couple of maybe kind of product segment-related questions. I want to sneak in a couple of financials, too. Phone, so you touched on it. You crossed 3 million subscribers. I mean how do we think about the growth opportunity there? I mean -- and are there opportunities to accelerate that quarterly cadence? Or is it just -- is it a part or the function of just having the resources and the professional services, or whatever it might be, to implement that? How do we think about the growth opportunity from here?

Here. Well, so I mean, the TAM for Phone is huge, right? It's about a $30 billion-ish market, approximately. So lots and lots of opportunity there. The growth will partly come from just us continuing to build out our sales capacity and our international channel. Like I can't overestimate how important the channel is to decisions around Phone, and we're working as quickly as we can to add that international piece. The U.S. piece, we've done a lot of work on it over the last couple of years, and that's in a really great place. In terms of the acceleration, so the -- we talked -- we did over 500,000 seats in Q4. I didn't -- when we talked about it, I said that's not necessarily the new low watermark, right. It's going to ebb and flow depending on how it's going, but I think you'll see that we're adding on a quarterly basis more seats than anybody else in this market right now. So I mean, Q4 was a record not just for us but for the industry itself, so really exciting to see. The model for selling Zoom Phone is an overlay team. So our account executives that are responsible for their organizations, their customers, they have a general knowledge that they can bring in the overlay team. So it's a highly leveraged model that works really well internally. And then again, we rely on the channel in addition to that.

And is most of the growth coming from existing customers? And if so, any rough idea where you think you are in terms of penetrating your kind of core video base?

Yes. So yes, the majority of our sales are coming from existing customers. Our -- that's our strategy. It's been all along, is to sell into the existing installed base. And from a deal attach rate, I would say we're still in single digits as compared to our Meeting installed base. We currently only report one product revenue. And so that tells you, by definition, no product yet. Other product, other than meetings, has reached 10% of revenue, so that tells you what the growth opportunity still is and exists.

Yes. Okay. What -- I mean as you walk into that cross-sell opportunity, I mean, are there any areas of pushback? I mean it seems like a pretty natural opportunity, right, I mean just in terms of the national integration, user interface.

Yes, I think -- I mean, the only pushback is inertia, right. Like cloud PBX, and maybe Contact Center a little bit, seem to be the last areas of IT that have remained on-prem, and I think that's because they just work. There's a bunch of servers sitting in the closet somewhere that when you pick up your phone, there's a dial tone and it works. So why bother with it? The pandemic certainly shifted some of that as there was a move towards getting everything into the cloud and making it more accessible and portable with people. And that's what we're seeing, is when are people ready to finally make that leap? And then when they are, we have a great product now that really wins based on features and functionality. So it's more about when are they ready to make that decision.

Yes. Okay. I have a question. Actually, I'm having trouble reading the whole question. But it's coming in from the audience, asking about the share count dilution, comments, or the stock compensation, comments. I think the question's just around how to -- if I could read the full question, that would be helpful. But to, I would say, yes, the dilution impact, yes.

So there's 2 things that we talked about on the call. I've gotten lots of questions about stock-based comp in Q1 in terms of the increase that we saw there, and that was due to some of the new stock programs that I just talked about that we think are very important for the long-term retention of the organization. There was another comment that we made on the call about cash flow and about the impact that it's having. The -- we're seeing a decrease in disqualifying disposition deduction due to the volatility of the stock that is driving up -- down the deductions for tax purposes and potentially up our payment for cash taxes. And so this was all around a discussion on cash flow, that you should expect to see cash flows decline slightly for the rest of the year due to that impact. So there's 2 things going on, which is, one, around stock-based comp that you're seeing in the P&L; and then one about a decrease in disqualifying dispositions that you won't see on the P&L. But it's going to show up potentially in higher cash taxes.

Right, right. Yes, I remember that coming up on the call. Right. Okay. That's helpful. Okay. But let me just -- maybe just one last one on Phone. Just thinking about competition. I mean how do you kind of view your competition on the Phone side then? I mean is it Teams? Or is it really just the legacy provider that you're -- we have to allude, it's against Cisco or Avaya or whoever it might be?

Yes, when we get the opportunity to go in on a Phone opportunity, it's typically against the legacy on-prem providers, so it's typically Cisco and Avaya. And other competitors that are being considered are the other cloud-based providers, so Microsoft and potentially Ring. I would say, against both of those, though, our product fares very well. And again, we're very competitively priced. And we now have Zoom Phone natively available in the high 40s number of countries. So I think we're probably 47, 48 markets today. So that -- what that allows for then is organizations to have a natively implemented phone that reaches the needs of almost all of their employees. And we have a Fortune 10 customer that's using Zoom Phone today. So that tells you that the features and functionality of that product now have gotten to the level they can meet the needs of the most sophisticated users in the world.

Right. Okay. Well, I know the next -- one of the next big opportunities, of course, is Contact Center, right, which you've just delved into. And I know it's still early, and yet, you still had a couple of nice wins you're able to allude to on this last call. Maybe just help us understand what drove those wins. What are the features, functionality that are enabling you to already have some traction in the market at a very early stage?

Yes. So we're really excited about the early momentum that we've seen. We've had several deals, already over 50 seats. So that's exciting to see. What we see is in smaller companies, using the product to replace their full existing contact center, and in larger organizations doing departmental deployments. And so the product today has, of course, video, voice and SMS capabilities, and we will continue to innovate around it and develop it into a full omnichannel contact center that will do all the things, including things like social media. We also announced that we just acquired Solvvy, which will really help accelerate our development around conversational AI in this area and, of course, add some amazingly talented engineers into our team very quickly.

Yes. It seems like there's a sizable opportunity, I guess, there for you. How do you think then about the evolution of the capabilities around WFO and workforce management? A lot of things either others partner with or add-on that are pretty critical to contact center.

Yes. It's a really good point. And I think that M&A is a really important part of our ongoing strategy for acceleration of development, especially around contact center. And like workforce management is a perfect example of something that -- the way that we think about the capabilities of Contact Center is we have a core feature set that is likely best to be developed natively because it's so core to it. But then there are auxiliary services that are equally important but, potentially, can more easily be bolted on. And that's like the conversational AI, workforce management. Those are perfect examples of potential acquisitions where we could find something that aligns well from a -- like a technology -- modern technology standpoint that could easily add and accelerate our development. So those are the types of things we're looking at.

Well, let me -- that's kind of a segue then, I guess, maybe to that. I mean how do you think then about the use of the balance sheet, generating cash? You have a lot of cash on the balance sheet. I mean is M&A then one of the top priorities? I know you had a buyback, too. Where does that fit in? How do you prioritize, yes, from here?

Yes. So we are absolutely focused on using our cash to drive top line growth and take market share, absolutely. And the way that M&A plays into that is accelerating our product development, both from a technology and a talent perspective. So absolutely, that's front and center. In the meantime, we are in the midst of a buyback. The Board authorized 2 quarters ago up to $1 billion as we just saw an opportunity, given where the stock was trading, to potentially reduce the dilution for our shareholders and felt like that was a good use of cash. I don't know that we'll make a habit out of that, but it's a unique position and time that we thought it made sense.

Okay. And I guess maybe just to close here, just on the financial front. I know there's some free cash flow headwinds this year because of some of the items you've kind of alluded to. But as we look out over the next couple of years, how do we think about both operating margins, free cash flow margins? What's kind of the outlook over the next couple of years?

Yes. We haven't given long-term guidance or even updated our long-term model in a while. We'll do that at Zoomtopia in November. But we -- where we're sitting -- what we said in general is cash flow should approximate operating margins. Free cash flow to approximate free -- operating margins in the future, which is the relationship they had pre-pandemic. And I think that our long-term model from an operating margin is -- the last one we gave was 25% plus. I think the new one will have a 3 in front of it. So somewhere in that range. So...

Okay. All right. That's great. Please join me in thanking Kelly for all of her nice remarks today.

Thank you, everybody. Good to see you.

We do have a breakout session outside this room in the Astor room if there are additional questions. And presenting next in this room is Shake Shack.