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

Good morning. Thanks, everyone, for joining day 2 of the Wells Fargo TMT Summit. I'm Michael Turrin, software analyst here. Very pleased to have Kelly Steckelberg, CFO of Zoom, familiar face with us today. Thanks for making time.

Yes. Thank you. Happy to be here.

Excellent. A lot to talk about. I feel like we've seen you a couple of times within the past month or so. But given this is an investor session, you are the CFO, we can start with just earnings report. Just -- you can start frame the high-level takeaways, the highlights. I'll ask some follow-on questions just on some of the segments and we can go from there.

Yes, sure. So continue to see growth in our Enterprise business, which we're really excited about in Q3, 20% year-over-year growth. Lots of strength and momentum continuing around Zoom Phone and very excited about the early indicators from Zoom Contact Center. So as a reminder, Zoom Contact Center is only about 3 quarters old, but you're hearing really good things and seeing some really great names there, so very excited about that. The online segment of our business was unfortunately still down year-over-year. They are continuing to see headwinds, especially from FX, the strengthening dollar, as well as Europe. So overall, if you look at the segments, Americas grew 11% year-over-year, but we did see an overall decline in both Europe and in Asia Pac. Asia Pac would have been flat if not for FX GAAP impact. So we did -- I don't remember all these different [ numbers ] off the top of my head, but we did start reporting in constant currency. So you're able to see directly what the impact is, and we'll obviously keep doing that so. Yes.

Let's stick with the Enterprise, to start with. You're expecting it to continue to move upwards in terms of mix, still growing 20%. You're providing the retention rates, the upmarket customer metrics. So what are you seeing? What gives confidence in the stabilization on that side? I think that's most important.

Yes. So there's a couple of things about the Enterprise business, as I mentioned. First of all, continuing to see opportunity in meetings, as customers are really embracing flexible work, right? And realizing -- we've seen strength in our renewals, especially over the last couple of quarters in the Enterprise as organizations need to provide that flexibility and keep their employees productive. So that's, I think, a really positive sign for the future. We just talked about Zoom Phone. And then Zoom Rooms as well, as people are really thinking about, okay, this is how we're going to work now, right, especially in technology companies, making sure that they have the right systems in their conference rooms is really important, inclusivity and collaboration, making sure that they can foster that within their company so that nobody feels left out. I'm a remote worker, I live in Texas now. And when you don't have the right technology when all the other execs are in the room and I'm not. Without that right technology, which Smart Gallery is the thing that's really the key now, that it divides the screen up in the conference room so you can see everybody's face. And it feels like you're on a Zoom, right? Like how...

Like I was on with this the other day.

Yes. Yes, it works, right? It's really cool, and it makes a really big difference that you're not staring at the back of people's heads. So that's been really great to see. We also had Zoomtopia a few weeks ago, and that was the first time we've run a fully hybrid event like Zoomtopia on Zoom Events, and that was great to see. We had tens of thousands of virtual attendees and over 1,000 in-person attendees. And if any of you were able to come and have that experience, it's super cool because like you're sitting like this, right? Here's the main stage. And you can see not only Eric, here talking, but you can see all the virtual attendees and how they get to come and join in. And so really excited about -- I think everybody is trying to find the right balance of -- even meetings like this, right? Like I'm going to put it in a little plug like there could be a virtual track for this as well, that...

Agree.

It brings it together in a way that I think we're all sort of understanding now what the future of that could hold.

On the Enterprise side, I think intuition is probably wrong here. When you think about just everyone adopted Zoom overnight almost, is what it felt like. Everything kind of moved to the virtual world very quickly. And so thinking about the drivers of the expansion rate and the Enterprise segment growth going forward, how much new video opportunity is there versus how important is the cross-sell motion? And just as part of the renewal conversation, what does that look like?

Yes. So a couple of things. First of all, there are some other big players out there that remarkably still have a lot of market share that we continuously are targeting, as we -- there are still people that are not using Zoom. And if -- somebody was telling me a funny story yesterday about like when he looks at his calendar and sees it's not Zoom, how he has to remind his team like, "You know you've got to join 10 minutes in advance, right," to make sure that's going to work, because we've all gotten so accustomed to Zoom. So little by little, we're continuing to take market share. And then, of course, this expansion into the platform is really the big transformation and focus. So Zoom One, some of you have heard us talk about Zoom One, it's our bundle that includes Zoom Meetings, Zoom Phone, Zoom Chat and Whiteboard, and that is super early. It's only been out for like 5 months probably now, but saw a really good reception during Q3. And it's great because it makes it really easy for the customers to buy kind of a package of what the products they need, the core products that they need. And it does come at a discount, but it's great for us as well because while it's creating value for them, it also creates value for us. Because the retention rates for customers that have more than one product are dramatically increased, and they keep going up the stack. And so the lifetime value of those customers more than offsets the discounts that they get upfront.

On the online side, you started providing the churn metric. And you noted in the last quarter that's down to pre-pandemic levels. There's been a lot of focus just on stabilization, when that might occur, I think, just to make the model a little bit more intuitive, easier to forecast from the investor perspective. So what are the signals you're watching? Like what should we be thinking about as we watch the churn metric roll forward? And what informs the perspective on where stabilization can occur? Because it's kind of been in this mid-next year target, is what it sounds like currently.

Yes. So we've been sharing the outward-looking churn rate for a while or talking about how when you get to that 15 months, it really stabilizes. But now what we've seen is the total, the aggregate, the average churn rate come in -- come back to the levels we saw pre-pandemic. And that's great news because it was at 7% at some point during the pandemic. And somebody asked me like, can it get better from here? And I'm like, I don't -- maybe because we haven't seen any better than this. However, we have a very different product than we had 2 years ago or 3 years ago when it was at 3%. And the reason it's come down and improved so much over the last couple of quarters is because of all the initiatives that Wendy Bergh, who's our GM for online and our team have driven. So that's great to see, right? Because even -- I mean 3%, you can do the math, right? That still means that 36% of our base is turning out every year. So the way we've got to get the overall business to stabilize is we have to improve what's coming into the top of the funnel, and Wendy has been focusing on that as well. So, those of you that follow the story, I've heard there's been many initiatives this year around free-to-pay conversion like imposing the 40-minute limit on one-to-one meetings, lots of focus on international, adding international currencies, adding international payment types, pricing plans. And those initiatives have certainly had a significant impact on the level of our online business this year. As we're doing FY '24 planning, we say, okay, now we know what the base is -- just generally, sort of know what the base is going to do now. And then we know what those FY '23 initiatives, what they drove in terms of incremental adds and revenue. And then there's a whole road map for FY '24 initiatives as well. And so expectations around what will that do. And that's -- when we put that all together, our current model predicts, I'm going to be very specific about this, that we will see dollar -- quarter-over-quarter dollar stabilization from Q2 into Q3 next year. So currently predicting that Q2 is the bottom and Q3 would be flat. And that we're basically flat to hopefully moderate growth from there, but at least flat.

Okay. That's all very helpful. I mean you touched on Zoomtopia, but there was a lot -- there were a lot of announcements. So I'm going to give you a chance just to kind of unpack those a little bit and we can talk about the sequencing and some of the things behind those as well.

Yes. So one of the -- probably the biggest announcements at Zoomtopia was e-mail and calendar. And there's two very specific components to e-mail and calendar that I want to talk about. So there is e-mail and calendar integration. And this is really geared towards our Enterprise customers. And what it does is it allows you to leverage your third-party e-mail and calendar applications that you're currently using today, like Microsoft or Google, but bring them into your Zoom client. So that when you are in your in Zoom client, you have meetings, you have phone, you have chat, now you also get to have an icon for e-mail and for calendar. So you're all right there. And it starts to bring to life Eric's vision of Zoom being the operating system of where you spend your day. So not expecting Enterprise customers to change, but providing them a way to be as efficient as possible by not having to keep contact switching in and out of all these applications during their day. We are also in beta now with an e-mail and calendar service. That service is really geared towards smaller organizations that may not have a dedicated IT organization and don't want to implement one of those big third parties that we just talked about, or they have a different level of security needs because our product is end-to-end encrypted, which is unique for e-mail. So that was probably the biggest announcement there. We also talked about we've done over -- added over 1,500 features and functionality over the last year, which really shows, I think, that ramping of R&D investment taking hold and what they've been able to produce. And of course, lots of highlights around Contact Center. And then I failed to mention earlier, Zoom IQ for Sales, which is one of our newer products as well.

I mean that's one of the things -- one of the directions I was curious about with what you were talking about with the calendar integrations on the productivity side is -- are there certain use cases or industries where you feel like that is most directly applicable? Eric's vision is the most directly mapped currently that you're equipped to go after or...

Yes. I think if you look across the top, sort of, 5 industries that we do really well in, they are like technology, right, financial services, healthcare. Those, I think all of them lend themselves to the platform. I mean I heard on our -- I joined the forecast calls every Monday, and the FedRAMP and the federal team and the healthcare team are super excited that Contact Center is almost FedRAMP certified. And I think about -- like those are really hard legacy industries to break into. And yet they're excited about the fact that we have a modern -- this modern architecture, right, which is really the most recent new contact center. Most of them are they're aged technologies that have been added on to, and the fact that it's fully integrated within Zoom. And once you're certified into an organization, especially federal government, to keep adding on to that is amazing -- is an amazing opportunity.

Can we just talk a little bit about how you balance the investments towards growth. And a lot of this is because the shape of what you're going through is somewhat different than what other softwares are going through currently. You're aiming to invest, right? You got a lot of new products. You're looking at the sequence and what's ahead. And there is a margin impact to that. So when you're evaluating those trade-offs, particularly in the current environment and getting probably more questions on margin than you were getting a couple of years ago when you were a super-efficient business and just delivering margins somewhat seamlessly, from the CFO side, what informs the perspective? What are you evaluating? And what are the signals that lead to the investment posture currently?

So as you alluded to, we had the very luxurious situation for a few years of just this amazing margin expansion and playing catch-up in terms of investment, which is what we've been doing. Now we are getting to a point that we're very close to our long-term model, right? And so being -- and we started this earlier this year, even being really, really thoughtful on how -- focusing in on investing in R&D, so innovation and sales capacity. We've really scaled back hiring over the last 6 months in G&A as well as like our DevOps teams, anything that's in COGS unless they're revenue-producing. So being very, very thoughtful. And as we're looking forward to FY '24, really bringing that into focus for everyone in the company. And really helping everyone understand, again, we can't have expenses outpacing revenue for another year, right? It's been okay for the last couple of years to get it to this point. But I had a meeting with my team this morning, I said like you know it's not sustainable in your own household to spend more than you bring in, right? It just doesn't work. We're at that point. We're really getting aligned that -- we've hired a lot of people over the last couple of years, looking forward to FY '24, really expecting them now to come into full productivity. We're going to have some carryover effects that you hire people mid-FY '23, you have that full year impact in FY '24, but you should all expect that our hiring comes down significantly. And we're really looking towards making everybody fully productive.

Is it fair to think about this as somewhat of a follow-on to all the product announcements and everything that we've seen, given -- it seems like a lot. So when I see the R&D, and it's been a gradual uptick, but there's a lot of new products. The reason that there is a carryforward is because those need to scale and similar on the sales side.

That's exactly right. Yes. We mean -- look at the amazing products we have, Contact Center, Zoom IQ for Sales, even e-mail and calendar, they aren't contributing significantly. I mean they're contributing, but very minimal amounts right now, and they just -- we need some time for them to start scaling. And I expect them all to follow the very similar path that Zoom Phone did, which was it was in mid second year, third year where it started to really get that momentum. So we need to sort of tighten our belts a little bit, right, while we're waiting for those products to get to that scale.

Can we touch on gross margin as well because we've seen the improvements there. I think you mentioned optimization on the call, and optimization around cloud has become very topical across software. So given you're the expert, you've gone through it, can you just help level set what that means and what that's enabled on the gross margin side?

Yes. So the public cloud providers, especially AWS and OCI were, and have been, amazing partners to us during the pandemic. They really -- we would not have gotten through that period of time without them. They were [ reactive ], they scaled with us as quickly as we needed. And it was absolutely the right thing to do. But you all remember, our gross margins went from 82% to 69% in a matter of quarters. Now some of that was due to the education. 400 to 500 basis points was the education that we -- the education sector we're giving to. But the majority of that was just the inefficiencies of being in the public cloud versus our own data centers. And we've had this multiyear strategy of pulling that back in. And our DevOps and engineering teams have done an amazing job at that. We are a little bit ahead of actually where we predicted we would be from a gross margin perspective. We're always going to keep some buffer in the cloud because it helps us scale up, scale down. Which is why our long-term target for gross margins is 80% and not like 82% where we were before. But that doesn't mean we'll stop, right? We'll keep working on that and seeing what we can do.

That's great. On the phone side, there's -- it's a noisy market. There's a lot going on.

A lot going on today.

Right? There's a lot going on. There are potential seats up for grabs. Zoom's go-to-market approach, how you go after phone wins? How much of it is using the toehold and meetings, taking advantage of older PBX-based solutions that are on-premise versus head-to-head on the cloud side? And what's your view on Zoom's points of differentiation and the opportunity for share gains going forward?

So we're obviously thrilled with the momentum that we see around Zoom Phone. And you're right, our strategy is to sell into our existing installed base. And as we shared at the Analyst Day, the attach rate with even our existing Meetings space is still low single -- I mean low double digits, like really low double digits. And so there is a massive opportunity even within our existing installed base. And so we generally, we're going up against the typical on-prem, Cisco and Avaya. But we also do compete and absolutely win against the other cloud providers because the integration and the benefits that you get by having a single client as well as the ability to like one-click launch a chat into a phone call or chat into a meeting, like having all of that is just a beautiful experience that you don't get when you're implementing -- integrating third parties. And then of course, there's the price competitiveness and total cost of ownership, where we clearly win against anybody else in this market. And so we're thrilled. We'll be excited to give you the next -- continue to -- you'll get milestone updates and the next milestone, obviously, is going to be a big one for us. So we're really excited about that.

How important is the channel or partners in aligning and going after the phone motion? Is it less the case because of the established footprint you have with video? Or how are you working with partners currently on that side?

So as a reminder, before we had Zoom Phone as a meetings company, we were over 90% direct led. So channel played a very little part in our lives at that point. It's much more strategically important for us now. We, in fact, have a new channel leader, Todd Surdey, some of you may know him, he's great. And Ryan Azus, our CRO, really helped us see the importance of channel and start building that a few years ago, but it's continuing to expand now. In fact, at Zoomtopia, we had Partner Connect. We had 400 partners there. That was really, really great to see. And we -- I think we've done a good job so far in the U.S. but we have a lot of opportunity to expand that internationally, and that's what we're focused on now.

And then the contact center piece, I mean that's -- it's a fairly sophisticated piece of technology. It can take time to build referenceability and move up market. So is it a similar playbook that you've established with phone? Or can you just talk about if you're bringing on more dedicated industry leaders on the contact center side?

Yes. So it's both. Like it's going to follow the same. We're selling it to the installed base, especially phone users. It's just a very natural synergy. But yes, we do have a dedicated overlay team of contact center specialists. Now many of our phone specialists have experience in contact center because of the synergies that live there, they have experience in both, but we do have a dedicated leader. And we -- I think we talked about it even on the Q2 call. By then, we already had seen deal sizes approaching 4 digits, which I think is pretty amazing for the age of this product. On the road map, there's a few things that are really -- they're coming soon that are very important on the road map, which include integrations to really crack the code on some of those big company integration -- big company deals. You need integrations, beyond the contact or they have to be integrated to like their CRM, their workforce management. And those are the things we're working on. We have integrations right now with Salesforce, ServiceNow and Zendesk, but we need many more of those before we can really get into like 10,000 seat deals, which is, of course, what we want to strive for. And then there's a few things like e-mail and social support, which are coming early in FY '24 that will really then give us those features and functionality that will allow us to compete pretty head-to-head for some of those bigger deals.

Part of the strength, the efficiency of Zoom has been organic development. And how Eric started in video was truly efficient. And I think lessons learned from Webex were applied to a new technology base. At the same time, these markets seem like they're poised for consolidation at some point. You're launching products across phone and contact center and broader productivity. The markets are in a different place, particularly in communications now than they were a couple of years ago. So in evaluating the organic versus inorganic trade-offs and the strength of the core organic engine versus the opportunity to accelerate, some of these other initiatives with M&A in a backdrop that's different from a multiple perspective, what goes into that equation from the CFO perspective?

Yes. So we think about this every day. And the first thing we look at, and we -- even though we've only done a few acquisitions, most recently with Solvvy, which worked very well. That's what brought conversational AI into our chat bot. We evaluate deals constantly, many a week, actually. And the first thing we always look at is technology. Will this be accretive to our platform and our customer experience? That's the very first thing we look at. And then probably the next thing we look at is the culture of the company. Will this be accretive to our employee experience, ours or theirs? And then thirdly, then, of course, you get to the price, the value of the ROI. And you're right. I mean, historically, we as a company, we've been incredibly frugal, and that includes looking at opportunities. And -- but that's changing dramatically. I think what we've done successfully so far is smaller technology tuck-ins. And I think that makes a lot of sense in -- especially if you think about like contact center. Now where you could potentially see us do a bigger one is probably something that's a little more adjacent. So if you stick with contact center, for example, probably not something directly in the core functionality. But one of those integrations I was just talking about, like you needed an integration to a workforce management. Well, maybe we would buy a workforce management. So it's something that's kind of outside the core, but easier to bring in and not have to be directly integrated into the product.

Makes sense. There's a natural coupling of a few vendors there. So I mean we're a few minutes away from time. I think what's useful is to kind of hit on a couple in terms of your planning hat for next year. And I think part of why this is interesting from your perspective as you're heading into fiscal year-end planning, that your seasonal profile is also a little bit different in terms of selling than some other businesses. So what you're focused on, currently planning for next year? And how much the macro environment is affecting that, if at all?

So it definitely is -- the biggest headwind that we can't control right now is FX. And so FX has been largely concentrated this year in the online segment of our business just because it's more -- has more international exposure and it has shorter duration deals. But what you're pointing to is our seasonality of renewals to remind everybody is the largest in Q1, and it declines from there. So in this past year, 29% of our renewals happened in Q1 and down from there, right, which is the opposite of what you would expect in most asset businesses. As the dollar has continued to strengthen throughout the year this year, some of those renewals were shielded earlier this year. And as we're coming around now into FY '24, there's going to be some broader FX exposure than we had last year. And so that is a headwind that we're planning for that is out of our control. And then certainly, I'm sure the same things you're hearing from all the other companies, elongation of sales cycles, what does that look like, change in linearity, everything is getting pushed back, way back again into the back end of the quarter and then thinking about rep productivity, what are we doing to enable them.

Is that sales elongation comment more attributed to new business versus your existing?

Well, existing -- existing customers buying even like Zoom Phone. There's a compelling reason there. But we're -- we all enjoyed for a few years where the CIO was empowered to make decisions. And now my fellow friends of the CFO suites are getting involved and really taking a bigger role. If I may, can I just talk -- can we talk about stock-based comp for just one quick second?

Absolutely, yes.

Okay. Because I do want to -- there's -- I know there's been a lot of concern about stock-based comp at Zoom. And a lot of what's driven that has been the supplemental grants that we gave and have been giving to employees. And as I remind everybody, we had this -- I know we've seen pressure on stock across all tech companies, and I've gotten a lot of questions about why are we doing this? And -- the reason is because I would put forth, we had a very unique situation where our stock escalated so dramatically, and we were hiring so quickly. We had employees that when they were hired, the stock was at $400 in a year. When they were invested a year later, it was $200. So we had these supplemental grants in place that allow them to get topped up on their anniversary date. And that has been very important to retaining our employees, which is key in these [ assets ]. If you can't retain your employees, you're going to have a lot of challenges executing your strategy. However, given where our stock price is today, we announced this week that we are sunsetting the supplemental grant program February 1. And I know that's important to investors and understandably so, going -- so any new grants made after February 1 will not be eligible for the supplemental grants. And we hear you. We all have to share in the risk and the reward of the stock, and that's the message to our employees as well.

Appreciate you sharing that. So closing thoughts, just your focus areas. If we're having this conversation next year and ideally we're talking about macro and stock comp quite as much, what you think we'll be focused on based on the planning forecast, on what you have in front of you and the sequence of drivers ahead?

Yes. I mean what I hope we're able to execute upon as a company, what we're focused on is, first and foremost, right, stabilizing our growth rates. And that will come -- I mean, hopefully, the way -- the story I'm going to tell you is because we continue to see taking share from -- in Zoom Phone, that Zoom Contact center is really coming into its own at that stage. And then who knows? You never know what's in Eric's mind, we might have new products again to talk about next year. And then the other thing we're really focused on as a company is stabilization of margins as well, right? Again, spending can't exceed incoming, and we are really focusing on that as we're setting forth our FY '24 plans, which, of course, means cash flow will follow as well.

It's a great point to close on. Kelly, thanks so much for your time. I appreciate you.

Thanks. It's great to be here.