Zoom

Q3 22’ SUMMARY

Zoom delivered strong performance in Q3 with revenues that were inline with management’s guidance and consensus estimates. The business delivered earnings (EBITDA and EPS) that materially exceeded management’s guidance and consensus estimates. This performance was below Pragmatic estimate for revenue, but materially above Pragmatic estimates for EBITDA and EPS. Zoom’s earnings outperformance was driven by the business demonstrating efficiency in OpEx spending, which has materially increased as Zoom advances the business’ S&M and R&D functions.

While sentiment has been negative on Zoom, the business continues to drive performance in this choppy year full of cross currents. Similar to other periods, the online business continued to face headwinds albeit at a lesser rate as churn has finally returned to pre-pandemic levels. On the other side, the enterprise business continued to demonstrate the massive opportunity Zoom has with large businesses.

Zoom is well-positioned to continue gaining share in the cloud-based communications market, which is taking share from on-prem communications vendors. Additionally, Zoom is well positioned to continue gaining share in the UCaaS market, which is taking share from both on-prem and cloud communications vendors. Overall, Zoom is a major beneficiary of the cloud migration, vendor consolidation, and hybrid work megatrends.

Key Takeaways from Q3 22’

Key Takeaway 1- strong enterprise business

• Zoom continued driving growth from customers spending over $100k.

• Enterprise customers are now the main customer segment of the business.

• Zoom is driving ARPU growth despite pricing pressures.

Key Takeaway 2- online business cross currents

• Churn in online business reached pre-pandemic levels after several periods above normalized levels.

• Online revenue deceleration stabilized in Q3 with decline on par with prior period.

• Zoom drove ARPU growth in the online segment despite headwinds.

Key Takeaway 3- cloud communications spending Remains robust

• While enterprises are slowing deal closings, intent remains high as needs for cloud-based services remain high.

• Hybrid work continues to drive need for modern solutions.

• Cloud players are taking share from on-prem legacy players.

GROWTH TRENDS

growth Factor 1- enterprise business

Zoom’s enterprise business continued to drive growth for the company despite the immense volatility in the online business. This is a major development with long-term implications due to the importance of the enterprise segment of the communications industry. While many individuals are more familiar with Zoom than they ever thought was possible a mere few years ago, the personal segment of the market is the smallest from a revenue perspective. The same is true for small and medium size businesses, which just don’t have the same communications needs as enterprises. Zoom’s foundation is in the SMB segment of the market as these customers were easier to acquire than enterprises as these large businesses had long standing relationships with legacy communications providers such as Cisco (WebEx).

Zoom’s founder was very aware of the industry structure given his time at WebEx, which was the catalyst for founding Zoom. Although the core video product is much better than legacy systems, IT departments’ relationships with distributors, resellers, and legacy vendors made it too difficult for Zoom to penetrate in a meaningful way. As a result, Zoom focused on capturing the underserved market segments until the business built a brand and sales channel to be taken seriously by enterprises. The pandemic really helped put Zoom on the fast track given the business’ ability to scale rapidly while maintaining high service levels. Additionally, issues with legacy systems became much more visible when an entire company was utilizing the service. At the same time, Zoom has been reinvesting the massive profits generated to go after the enterprise market in earnest.

The business also launched additional solutions to serve enterprise customers’ needs beyond video conferencing. Zoom launched Zoom Phone, Contact Center, and Chat to create a UCaaS stack that enterprise customers can rapidly deploy. This positioned Zoom to take advantage of the shift to hybrid work, enterprise efforts to consolidate communications vendors, and migration to the cloud projects that were underway. Zoom is a great example of opportunity meets preparation. While the market is obsessing over the online business, the enterprise business continues scaling as Zoom is securing massive wins. The business is shoring up its place in the next generation of the communications market.

• Zoom One was well received by enterprise customers with Technology, Media, and Financial Services industries called out as early adopters.

• Zoom Phone drove meaningful growth in the enterprise business.

• In Q3, Zoom landed 9 accounts that are deploying over 10,000 phone seats, which brings the total to 64.

• Zoom drove strong enterprise customer renewals in Q3.

• Zoom continued to build out partner network, which helps the business reach enterprise customers the way they want to be reached.

• Macro fears slowed sales cycle as CIO’s demonstrated greater deal scrutiny and deferring deals to later periods.

growth Factor 2- online business

Zoom’s online business is started to demonstrate signs of stabilization after several periods of headwinds as many users lapsed once the pandemic “ended”. While growth continued to contract, the sequential trends are encouraging as the deceleration trends improved Q-O-Q. Specifically, the monthly churn rate fell from 3.7% in Q2 22’ to 3.1% in Q3 22’, which is on par with pre-pandemic levels. Additionally, majority of online accounts are now beyond the 16 month period, which is when stabilization occurs. These developments provide confidence that the online business has navigated through the turbulence of 21’ and 22’. A key driver of the stabilization is Zoom’s decision to put some features behind a paywall, which encourages converting to a paid account and discourages lapsing into a free account. Management estimates that the online business will show Y-O-Y flat or positive growth in Q2 23’, which is likely conservative given the current sequential trends. Overall, the online business is important from a profitability perspective as this segment has very high gross margins given the low touch nature of acquiring online customers. While Zoom’s next stage of growth will be in the enterprise market, the online business’ profit profile adds considerable value to the overall business. This profitability can be leveraged to go after enterprise opportunity in a more aggressive manner.

growth Factor 3- global business

Zoom continued to drive majority of the business’ growth from the Americas business as the EMEA and APAC businesses continued to face macro headwinds. The EMEA business faced FX headwinds and reverberations from the geopolitical issues. This affects the capex decision making by CIO’s in the form of deferred deal closings. The APAC business also faced FX headwinds and reverberations from the Zero-Covid policy that the government of China imposed. This has had an effect on the entire APAC given the importance of China to many APAC markets.

While these headwinds added more pressure to the company, they are immaterial compared to the long-term opportunities in the international businesses. These businesses have experienced massive increases in significance since the pandemic as these markets were really unprepared for hybrid work. This makes the megatrends even more important relative to the Americas market. Going forward, these markets are poised to be drivers of Zoom’s growth in 23’ and beyond as they scale.

OPERATIONAL EFFICIENCIES

Zoom continued to experience operational inefficiency as the business is undergoing a significant investment year. This consists of allocating a portion of the recent surge in profitability to lay the foundation for the next stage of growth. Specifically, Zoom invested significantly in S&M to build out the sales channel in a manner necessary to attract enterprise customers. Unlike SMB customers, enterprises prefer to use intermediaries to consider communications vendors as the market is highly fragmented. Given Zoom's focus on the SMB market pre-pandemic, the business had not built an adequate sales channel to reach enterprises in the manner that they wanted to be reached. Additionally, Zoom invested materially in the R&D function to create further product differentiation.

The business is working hard to make a true platform that has optimal features that enterprise customers would utilize in the daily course of business. Overall, Zoom has delivered upside surprises as the business has been more efficient than initially expected at the outset of the year when the step up in OpEx was communicated. Going forward, the expense increases should not exceed revenues like they did in 22’. Importantly, the business is still much more profitable than it was pre-pandemic as the cost structure has material operating leverage.

INDUSTRY TRENDS

While many were expecting corporate budgets to contract in 22’, spending on cloud based communications products and services expanded this year. This is the results of the cloud migration megatrend sustaining momentum as companies are still incentivized to transition communications hosting to the cloud. This has substantial economic benefits as well as operational benefits. As a result, companies are more inclined to migrate as the total cost of ownership will drive much needed ROI.

Another megatrend driving enterprise investments in cloud communications is hybrid work, which many companies are still not designed to optimally facilitate. The view that hybrid work was a pandemic dynamic has really lost support this year as majority of companies have retained a hybrid work schedule. This means that many decisions that were held off in order to observe workforce dynamics have to be acted upon. As a result, demand for video, chat, and phone cloud-based communication services are still in demand.

Lastly, the megatrend of vendor consolidation (UCaaS) showed no signs of slowing. Not only does a single vendor for video, contact center, chat, and voice reduce complexity, it also reduces costs for many companies. This translates to many cloud-based players offering UCaaS services that are taking even more share from traditional vendors who have had a tight grip on the industry for decades. The three megatrends have caused market research firms to continue forecasting strong double digit growth in 22’ and 23’, at least.

FORECAST AND VALUATION

Zoom’s outperformance in Q3 provides additional evidence that the business’ long-term potential is intact despite post-pandemic cross currents. The business has significant growth opportunities ahead in the enterprise market, which is much larger than the personal and SMB market. While the online business’ high margin profile helps Zoom maintain strong profitability levels, the enterprise business is supported by massive corporate budgets. Zoom’s performance in the difficult environment in 22’ was driven by continued share gains in the enterprise market. The business has also managed through the elevated volatility abroad, which is likely to moderate in the coming quarters.

While the business has been the subject of intense negative sentiment, Zoom’s ability to manage through exogenous developments sets the business up for strong performance in Q4 and beyond. The business started facing meaningful growth headwinds in Q4 21’, which creates positive base effects as the comps are going to be much more reasonable going forward. Additionally, the normalization of churn in the online business is a tailwind for the overall business as the online business was the reason growth moderated in 22’. The business is likely to continue facing sales cycle delays due to enterprises scrutinizing deals more closely. Importantly, this does not reduce the opportunity ahead of Zoom. The friction in the sales cycle is just pushing some revenues into future periods. Overall, Zoom’s opportunity is a function of the megatrends around hybrid work and cloud migration, which are permanent developments in the global workforce.

The stock continues to be impacted by the intense negativity in the market. This has caused valuation to compress even more despite Zoom demonstrating that the cost structure is fundamentally changed driven by the massive scale the company has achieved. The depressed valuation will be even more apparent as Zoom continues growing in 23’ and expense growth normalizes after growing materially in 22’. Additionally, Zoom is positioned to realize material gains from the investments in S&M and R&D this year. As a result, the stock is poised to surge once sentiment shifts and Zoom continues demonstrating that it is much more than a pandemic beneficiary.