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

First, I have to tell a small story about my Zoomtopia T-shirt. [indiscernible] on the team, who was at Zoomtopia in November, got it as part of the swag, intended to put it on when we last had our earnings call with Tim, totally forgot. So challenged me actually to put his Zoomtopia T-shirt on when I'm actually interviewing Tom on stage. I took them up on that bet. Here we are. It's a little bit too tight. So I put the jacket over it. So the photos, if anybody took one, don't look absolutely ridiculous. That's the story.

Thank you for advertising. Is it a straight up there? Or do you have to like shave his head or... Thank you for having me. Congratulations. I hear you are one of the top rated analyst, which makes my wife and my mother proud. I'm glad you noticed.

I'm glad you noticed. Thank you, Tom. Let's dive into your numbers if we can, Tom. You guys reported a couple of weeks back. So you've had obviously a chance to meet with a lot of investors, analysts to talk through the quarter. Do you want to just spend 1 or 2 minutes highlighting what you think were the key takes from the print and to the extent that there's sort of been a repeated common question, I'll probably get to it in my Q&A, but you can hit it as well.

Yes. So the quarter played out like we thought it would. We had seen some softness over summer, and we've factored that into the third quarter. And probably the biggest surprise was -- and we shouldn't mispriced, but the currency -- U.S. dollar continued to strengthen against a lot of major currency, including the yen. And so that was a little bit of an impact. But if you look at it on a constant currency basis, it did pretty well. We came in over the range, and our enterprise business continues to do well, it grew about 20% in the quarter. We had a lot of -- for Q3, pretty good large deal adds on an ARR basis. The other big part of our business is online, and it's about 44% of the business these days. And we have been predicting since the beginning of the year that the churn in that part of the business would return to pre-COVID levels or historic levels by the third quarter. It came in at 3.1% versus 3%. So I'd say we achieved that, which is really good. At the height of the sort of pandemic when term was really high, it was about 7%. So the good news there is that part of the business is stabilizing from a churn perspective, and we're looking at stabilizing it from a top of funnel perspective. We had really strong profitability and really good cash flows as well. Even this year, we're paying taxes. We -- I call them zoomisms, both good and bad. But this one is a bit more of a challenge because we went from paying essentially no taxes last year to paying almost the -- the U.S. rate plus this year. So I don't know many companies that have flipped within just a few quarters. Usually, it takes a few years to kind of do that. And it has a lot to do with the fact that we're not only profitable for the last few years, but we've been profitable going back before the IPO and had positive cash flow. So it's inevitable that everybody has to pay taxes at some point, but we just happen to hit it a little bit earlier. So even with that tax headwind, we still are going to predict we're going to be at the high end of our cash flow guidance [indiscernible] 174 when you talk a little bit about 174 what on there. But that's sort of the take on the quarter. I think the biggest headwind was probably FX.

Yes. One of the areas that FX hit you, but I don't think you Kelly stated to what extent is. There was a little bit of angst when DR and billings came in a little bit light. And we don't know the extent to which FX hit that number. So can you explain why you had that dynamic where deferred revs billings came in line. And I don't know whether you could quantify the FX impact. But -- that was the 1 metric down 10% that felt a little off, give you a chance to address that head on.

Looking at Q4?

Yes, exactly, implied Q4 guidance. .

Yes. Yes, because the Q3, we came right in line -- so I think, The Street -- one of the challenges we have at Zoom is our seasonality for renewals is unlike any other company. Again, it's a zoomism. It's good because you get a lot of visibility into the full year when the renewals happen. They happen in Q1, but a lot of software companies, they're big renewal quarters in the fourth quarter. I think a lot of people are more used to that. What happens for us is we get to the fourth quarter, and that's actually our lowest renewal quarter. And on top of that, you have some FX impact. And we also do something called co-terming. So if you had a big meeting deals in Q1, and so the renewal was coming up in Q1, and you say you closed a deal for Zoom Phone, well, you would only get a partial piece of that in the fourth quarter, and then we put the rest into -- co-term it into the first quarter. And we do that because it's easier for the customer to only have a few POs or 1 PO as opposed to a per order as opposed to many. And it's also easier for our sales people so they don't have to keep going back to the customer all the time. And if you look at our renewal base, we had slide at our Analyst Day, and you can see there's just a slight shift from Q4 or Q1 -- excuse me, Q1 of last year to Q1 of this year, where the renewal base increased from 28% of the total renewals to 29%. And that will continue on for, I think, a little bit longer. -- eventually, sales behavior will drive us a little bit more towards where all other software companies are. But just everybody knows, the reason most software companies have huge Q4 is the salespeople are closest to their sales comp. Ours are the same way. They work very hard to get to their multipliers. The challenge is it's just a smaller renewal base, and then you've got co-terming and FX. One quick thing about FX everybody should think about for next year is Q1 renewals this past year happened at the beginning of the year, and we converted all those to dollars so we build them and sits on our balance sheet for the rest of the year or rolls off to revenue. Next year, the dollar has strengthened, so you're going to have more FX impact as we move into Q1. So even if dollar stabilizes here in the fourth quarter, it's the same in Q1. You'll have less impact on the monthly deals, i.e., the online, but the enterprise deals will have more FX impact. So make sure you take a look at both the as reported and FX impact.

So it sounds like the implied 4Q billings guide at negative 10% is less FX, but more invoicing related where the seasonal skew changed and maybe there was some change in invoicing duration.

Okay. And we anticipate we're going to have -- from a revenue perspective later linearity in the quarter. But it's typically been a good quarter for us. You'll see some larger deals typically close in the fourth quarter. It's -- like just this year, you've got a little bit more macro rolling through.

So let's talk about macro. It's a small subject here at the -- So maybe, Tom, what are the assumptions around the macro environment that were baked into your fourth quarter guide? And then maybe a second related question. It seems like Kelly, I wouldn't use the term bless, but certainly didn't push back on the idea that next year growth could be in the 0% to 5% range. And I'd love to know what sort of macro assumptions would be embedded in a growth rate like that, if it were to transpire?

Yes. So most of the impact outside of the U.S., specifically, you'll see it in our numbers in Europe, but even a little bit in places like Latin America, some parts of Asia. Places like Japan continue to do really well. They're a larger portion of our business. But there's definitely pockets outside of Europe that are also seeing a little bit more impact from the macro. And it does hit both sides of the business. I think more on the online portion on the top of funnel, but we are seeing longer periods where people are for sign-offs and things, more CFO involvement and deal signings. Our guys have to work a little bit harder. We try to get them moving earlier. Don't wait to try to close the deal just because it seemed to close a year ago in a week, don't expect that. Get it started earlier. So we have embedded that into the fourth quarter. It's very similar to what we saw in Q2 when we gave guidance. So I'd say Q3 came in exactly where we thought it would. Again, no FX. And then most of the impact to Q4, again, is FX. I think of the $15 million delta between the two, $14 million of it was coming from FX. I think the other $1 million is sort of just prudent guiding just to make sure that we've taken everything into account from a revenue perspective.

Tom, why would the macro impact be somewhat more muted in the U.S. where other software companies are feeling it. What's the offset that might offer you some resilience in the U.S.

Yes. I think, first of all, people have just gotten used to using Zoom, right? Yes, video conferencing, it's like. You can justify it very easily. We're not talking saying earlier, Bloomberg screens, the list price is $15 per user per month. We've kind of gotten past a lot of that pandemic cohort, where people -- if they didn't need it, we're 2 years into renewals at this point. And so it really is more about the macro. And so when we get to the macro, I think -- and we're seeing this at our own company. People are looking to cut discretionary spending, so travel. I know I'm here, but like internal travel is more discretionary. So we've cut back on that. We're looking to cut back on things like contractors. Just to be prudent about our spend, given how fast we're growing. We have invested pretty heavily, and we can talk a little more about that, but as we kind of look forward into the next back, we kind of hit this point where we've done a lot of the catch-up hiring and now it becomes very focused on ROI and do we get enough ROI on things. And so discretionary spending is something that people should reduce. Well, if you reduce things like travel, Zoom fits in very nicely into that. The other place that we can help customers is even if they're downsizing, we can show them where to save money on things like phone. A hardware-based PBX system is really, really expensive. And we can come in and upsell them phone. We also Zoom rooms, a lot of companies as people are back in the office, and they want that hybrid world where they have the same kind of Zoom screen in the office. They don't want to be talking to simple Polycom on the table. They want to be able to collaborate in exchange. You see more Zoom rooms popping up. So Zoom Rooms and Zoom Phone are doing really, really well right now. And I would think that would continue on. Meetings, it's a little bit more about a share shift. There's sort of 3 major players in the space as ourselves, Microsoft and Cisco. And then there's still some small amount of everything from blue jeans to Adobe. And I think as we go into this more into this recession, people will be looking to reduce the number of vendors they have. And so there's still companies that have multiple video conferencing or communications platforms. I think there's room for a couple, but there's no reason to have 4, 5. Yes. And so there's still companies out there that are doing that. And then some of our competitors don't perform as well. And so I think there's share shift going over specifically to us at Microsoft from those people.

Okay. That's a good description of the resiliency of the Zoom model. I want to dig deeper into that vendor consolidation. That's been a concern of some. It's been a concern of ours. The idea of having 3 video conferencing tools may not make sense going forward, so you consolidate to 1 or 2. Zoom's definitely going to be the consolidation winner and some probably Teams in some. So it sounds like maybe Cisco WebEx and some of the point solution vendors are likely the more vulnerable. Can you elaborate on that and the extent to which you've actually offered public case studies where you've won out over Microsoft teams on any notable accounts?

Yes, we have. I mean, it was more -- I think during the last few years, it was more of the Skype for Business as that was end of [indiscernible] part of that went to teams and part of that went to us, but that's now, I think, the -- it's finally over . So I think it's more of a stalemate between the 2 of us. I think you see some companies might go teams internally and Zoom for external -- Yes, use both. And that's fine. It keeps our foot in the door and they recognize the team that Zoom is a better product for more complex meetings, external meetings, they want to make sure they work. We would argue that you don't want to treat your employees any differently than you would treat your customers. So it's not a great thing to do to give someone the product that doesn't work as well. So we'll continue to try to take some of those accounts out. I think what you saw during the pandemic is rising tide raises all boats. So even WebEx was growing at that period where before that, they were shrinking. And I think that for all the other small players as well, they were all seeing some growth because what people were doing, they didn't necessarily all go running to Zoom or Teams. They -- a lot of them had existing platforms, and they built those out more because they have them already. Now that we're in the sort of new world of video conferencing, how important it is, I think people are looking for the better solution. So we will continue to take share. But if you look at the high end of our enterprise business, it continues to grow really nicely. We continue to add really large customers. I think we're all seeing more of a challenge on the macro is at the sort of SMB to the prosumer side of the...

Well, let's talk about that because I think you and Kelly have been saying that, that segment, what you call the online segment will sort of stop declining sequentially -- is that in sort of 2Q, I think I heard Kelly recently say 2Q or 3Q, maybe you could clarify when you expect it to stabilize?

Yes. We said 2Q to stabilize. Hope Q3, it does a little better than stabilized, but I would say stabilized is probably the way to look at it. You won't see it in Q1. I've been again telling everyone that this is -- we have 3 less days of revenue recognition in Q1 And so that will impact that part of the business as well. So I would expect the soonest you could see it is Q2. And that's when -- from a dollar perspective, it will level up, that's what our forecast is today. Things may change, but that's what we see. We saw that in Q2, and it got reaffirmed in Q3. So we're keeping an eye on it, but that seems to be the most logical at this point, given the stabilization of churn that I mentioned as well as what we're doing to drive top of funnel. So on the top of funnel side of the world, we're focusing more on taking our online business, our website essentially and adding local currencies today. We take like 12 currencies. We'll add several currencies and try to be able to address a lot in the world, more payment types. Today, we take mostly credit cards, but most of the world doesn't buy things online with credit cards. They have different payment methodologies. And then you can do some things on a local pricing that might make sense in a country that has maybe really high use of phones -- cell phones also has very high use of free. Maybe you can come up with a package that's a cell phone oriented one. You see folks like Netflix doing that kind of thing. Like you have a cell phone, mobile phone-oriented product. And maybe it's get 100 maybe 5 meetings, something like that.

Is there any opportunity, Tom, to leverage price more generally? Or do you feel like just given the price points for Teams in particular, that it sort of caps your ability to raise price as a growth margin lever?

Yes. We've always felt that we've had pricing abilities to take them up, but we want to drive customer happiness.

I think they are already.

Yes. No, no. And the idea is, okay, I sell you something, you see a huge amount of value. So we're kind of the high-value, low-cost players in that space. And then we can come back and sell you more products like Zoom Phone and even Zoom Phone has a disruptive pricing. So generally, we price things in a disruptive manner. If you look at our contact center, it's a $70 an agent list, and I think the competitors are $150 to $200 generally. So we've always had disruptive pricing we are always reluctant to raise pricing. A lot of our contracts have an inflationary aspect to them, but we have, at this point, not announced anything or plans to do anything around it, but we have that flexibility. I think the place we would focus in on, and this is coming from Greg Tomb who is our new President of Marketing online and enterprise. He'd like to see us do a little bit better on how we approach discounting in general, not the discounting tables, but the discipline of the sales team to negotiate down the table and not kind of drop straight to the lowest common denominator, which is the lowest price, but actually kind of negotiate in the middle. He feels that we leave some on the table. It's not a huge needle mover for the total company, but it's -- it would help our salespeople hit their quotas. It would help the salespeople going to have to go out and find new customers to fill it in. And then it's an easy thing to do.

Is that a process that's underway already, Tom or on the come?

It's underway now from an educational perspective. It's hard to change comp plans and things in the middle of the year. So I'm sure there'll be some more thoughts going into next year's plan.

We've talked a little bit about the online segment as we model out the enterprise part of Zoom besides the state of macro, how this almost duopoly between Zoom and Microsoft plays out and whether the wind blows in the direction of one or the other. Are there any other variables that you would encourage investors to keep in mind as they're modeling the enterprise segment, Tom?

I think this world where there's like 2 really relevant players is really across the whole communication space. And it's not just video conferencing because if you look at phone and where phone is going. It's going to more cloud-based PBX systems. Microsoft gave out their numbers. They were at 12 million phones, I believe. We're at 4 million phones, RingCentral is at 5 million phones, we're growing over 100%. We'll be #2 pretty fast. So in the video conference space, we're 1 or 2. I think we're on pretty much as what I think I've seen on most of the industry analysts and then we'll be #2 in the cloud PBX. The next or will probably be fought out in contact center over the next few years . So, there's definitely looking at communication beyond just video conferencing and looking at it as a platform, that's where the battle is going to be fought. And there will probably be 2 relevant players just like in the old days when I was at Redhat, we had way back when we had 800 operating systems. There's 2 in the world now. There's Red Hat Linux, and it's derivatives, and then you have Windows. And for servers -- and yes, there's still some not relevant players out there from a [indiscernible] mainframe. But the vast majority of the servers in the world are running on 2 operating systems. So I think the same thing will be in communication. Over time, things will consolidate and the platforms will build out.

Is there anything that you and the team are thinking through to better monetize the phone footprint. You've got -- as you laid it out, you've done an incredible job going from 0 to 4 million seats in a nanosecond, There's probably an opportunity going forward to better monetize that. So is there -- what are some of the levers that you can use for that, given that, as you described it, it's a pretty low-priced product?

So we definitely are well under penetrated in our base today. I think it's like 14% or 15% of customers -- of the enterprise customers have Zoom Phone. So there's a lot of room in our existing base. If you look at our channel, our channel has been growing very nicely for Zoom Phone. The overall channel for Zoom is like less than 10%. But when you get to Zoom Phone, it's like 30%. Yes. So there's no reason that can't go up. And we brought in a new person to run channels for us, and that's what he is focused on is driving that. It's not only the master agents, but also the telcos and other channel partners to help drive Zoom Phones. So I think those are probably the 2 biggest players would be international, where we have natives Zoom Phones in countries. We have more countries than any other vendor out there, including Microsoft. So we do have the bring your own carrier in places we don't have a native Zoom Phone, but customers like having a native service that the people in Japan have the same dialing capabilities that people in the U.S. have.

And on the contact center side, Tom, that's an interesting story. -- how needle moving do you think the monetization of that opportunity will be in fiscal '24? Are you discouraging people from modeling too much in this next 12 months? Or is it going to start to move the needle, let's say, by the second half?

I have $4.5 billion is not much. I mean I don't think it's going to get that big that fast -- the reason being is we are seeing some early traction that we're excited about that we didn't expect . A lot of people thought, especially our competitors, we would only have a few dozen agents at a customer, and we have customers that are in the hundreds, all the way up to almost 1,000 -- sub 1,000. So that's good. The main use case right now is more internal IT help desks, HR help desks. And what we really need to do is continue to build out the capabilities, and we've hired a lot of engineers, a lot last year to help us there. And then the other thing is we need to drive more integration. So we have integrations with folks like sales force. I'm pretty sure ServiceNow is another one, but there's a lot of point of sales data. And then eventually, what you want to do is build out a an integration channel. So there's a few more steps we have to go. But for a product that's been out for less than a year, we're pretty happy with the traction so far. -- if you think about Zoom Phone, people said we never get anywhere on phone. I mean people just laughed us a few years ago when we had phone.

It's been incredible.

Yes. And we're kind of on that same trajectory. The contact center is clearly more complex. I don't think it's as hard as doing video, to be honest with you. video is part of it, but the coding of video is much harder. than building out a contact center. Just there's a lot more to contact center you have to build out -- so you need more bodies to throw at it. And I think we've got the engineering prowess now that we built out the engineering team.

I've got several more questions for Tom, but I just want to let you know that if you did want to ask a question, hit the QR code, you can just submit it, and I'll pick it up on this iPad rate here. So Tom, let's talk about a little bit on the margin side. Most software companies that I've been talking to up here are guiding to an increase in margins, and I need to talk to them about ways that they can get their margins up. You're in the unusual category of, a company that's running at a current margin level above what your medium-term guide is. You're at 35%, and you set your medium-term guide for 30. So maybe what you can describe is not ways in which you're cost cutting, but where are the investment dollars going that will get your margins down actually?

We're actually doing a little both.

I'm sure you are.

So if you think about the pandemic and how fast Zoom grew, one of the things that specifically that fell sort of the wayside was innovation. We didn't hire enough engineers. During the pandemic, we were solely focused on keeping the lights on so people in the world to communicate. And we put a lot of focus on security back then. And we still have a lot of focus here, but really kind of ramped up because we saw these use cases explode around the world, and we needed to put more focus there. Now we've been out hiring investing in innovation. And we're kind of -- this year will be caught up to where we want to be. So if you look at the long-term model we shared with folks at our Analyst Day, we said we want to be between 10% and 12% in R&D. We're going to go from, I think, 5.7% at the end of last year to over 10% this year. And so that puts us into that range. So I think we're getting pretty lined up with the range at this point. There's still some room probably in the future around gross margins. We keep moving workloads to our own private cloud, and that's less expensive for us. So we can keep driving that up. We're at 79 now. If you go back to early in the pandemic, we were at 69. We went from 82 to 69 almost overnight. And that it all has to do with the fact that we picked up a lot of free and we put up a lot of the -- a lot of our traffic was going across the public cloud, both Amazon and Oracle. They've done a great job for us. It just happens to be a little bit more expensive. If you think about it, it's probably similar, but we wind up not having to pay ourselves profit we can give it to our investors. So I think it's probably the big difference. But -- so as we look forward, next year, we're not there quite yet. We'll end this year in January, you'll see very little hiring. We'll probably do some hiring, but it will be a fraction of what we've done this year in the previous year. I think we're going to wind up, I don't know, somewhere between 1800-ish employees we've hired this year. A lot of them in engineering, and believe it or not in the cost of goods line, you don't see it because they were actually helping to improve the cost of goods. But a lot of headcount is up there as well. So I think something like 40-ish% of our headcount is either in R&D or operation, which is not it's even smaller than that. I think it's less than 30% of revenue. So we have a very efficient model. I think as we look forward and you all are trying to model, you've got to remember that we hired these people pretty consistently across the year. And that your next year, you're going to wind up with a full FTE, a full-time employee for the whole year, all things said, so we don't hire anyone else. You've got -- if we hired 1,800 people, you've got 900 more FTEs rolling through next year. So there's still going to be -- the impact from this year's hiring into next year. And it should kind of dissipate as the company grows out and you get less of that impact quarter-over-quarter. So we are being very cost conscious. We are slowing higher earnings pretty significantly. Like I said, we cut back a lot on discretionary spending, everything from contractors to consultants, things that we have built up over the years when we didn't have the people, but we now feel we have the people. So it really is more of a focus on productivity and automation. Don't throw bodies at things, try to automate as much as possible. .

Tom, we've got 2 questions from the audience so far. So one would be, we're seeing a lot more layoff announcements. And if there is an economic downturn, we'll probably see more. Zoom is a seat-based business. Can you talk through Zoom's sensitivity to layoffs? .

Yes. I think we're like NEC-based -- the one thing that might be a little bit different again is some of the discretionary spending we can save you for things like travel. That might be helpful if people are looking and they're trying to decide. But if you see significant movements in the number of seats, that's bad for all software companies. Whether it's C count or even servers. It's not good to have a high level of unemployment. It's not what we're seeing today here in the U.S. and a lot of our business here in the U.S. So if that can hold in, especially for we call knowledge workers, that's a good thing. We have a very diverse base of customers. We go from the mom-and-pop shop all the way up to the Fortune 5. And we have customers like 1 license to hundreds of thousands. And we are across all industries. There's definitely spots where you might see more meetings or less. If it's a like a consulting firm or a law firm, you get a lot of meetings customers. It's manufacturing, it's usually like the corporate headquarters. So -- but we are in all industries. It's a very diverse product. It works across all those. And like I said, I think the ability to upsell additional products can save people money. The cost of a hardware-based PBX system is huge, the hardware, the maintenance and you'll get the flexibility. So we definitely have ability to show customers who save money in other places.

So 1 or 2 more. As we look into next year, how are you thinking, Tom, about stock-based comp and buybacks to offset it?

Yes. So this is long, it could take a little too. I apologize everybody. So we have been hiring a lot, right? And so as we hire we grant people for your grants and they get spread over the 4 years. Last year -- last fiscal year, we had decided that we had a number of employees whose initial grant when we gave them, say, $100,000 in equity at, say, $500 those shares, we granted them with the stock price declining so much that they were way out of the money. And you remember back then, it was more about the great resignation. I think we felt that it was more fair to give them a true-up. We call our supplemental plan. It was all about retention. We have in the last, say, 2 weeks -- yes, 2 week -- 2 weeks ago, we announced that to the employees that we were discontinuing that program sunsetting at the end of this year. So a lot of the stock comp you've seen in the last 4 quarters going all the way back to Q4 last year, the big step-up is a part of that's the supplemental program. And so over time, that should sort of wean away and but it will take a while because it's already kind of locked in -- so stock-based comp accounting is very interesting. As you know, it doesn't mark to market. So those $500 grants are still out there, $500 or not at 75. So you've got all those rolling through and then the true-up on top of them. And so on the dilution side though, we are below where we started the year. So we not only covered the dilution from the true-ups or the supplemental plant, we also have covered it from the new hires as well. So we've been very aggressive on our stock repurchase plan, probably a little bit faster than we thought. We kind of set thresholds and we unfortunately went below those thresholds in this economy. So we want up buying more faster. And we have a little stub left that we will use up and then we'll go to the board and talk to the Board and see what the recommendation there is. Could you do need more approval to do these things. You don't just say, "Oh, hey, we're going to spend $1 billion. You have to go talk to more about it until all of the different options you have, what the cash flow looks like and then they'll make a decision.

Stock-based comp is never a s**y subject to end the conversation, but we -- it has to be the case today because Tom needs to run and catch his flight. Thank you for attending our event and happy holidays to you and your family. .

Yes, you too. Thank you, everybody, and thank you for hosting me. .

Yes. Thank you. .