This report is a 2-for-1 deal with Beth and Bradley both providing an analysis. Please reference Bradley’s Deep Dive on Financials Below.

This one has been especially challenging in terms of price action. Below, I tell you why we continue to hold the stock and added to it after the earnings report. If the market wants to give me a 15 forward P/S on Zoom, I’ll take it.

Growth is “slowing” because we are lapping extraordinary quarters. Zoom’s situation is very different from a company that put up 60%, then 50%, then 40%. I would call that slowing growth while l would call Zoom’s situation “tough comps.” There is an important difference.

When analysts “downgrade” a company yet set the price target comfortably higher than where the stock is trading at, then it’s meaningless because the analyst will be right no matter what happens. If you’re an institutional analyst, finding a way to be right no matter what happens with Zoom is probably a smart idea. The reason is that Zoom is very complicated to predict as management is offering very limited visibility into next year and because Q4 and Q3 are seasonal low quarters due to a unique billing cycle. We discuss the unique billing cycle in detail below.

The 350% revenue growth is a very hard comp to clear because consumers piled into the app unexpectedly. This has placed immense pressure on Zoom’s enterprise segment to carry the growth. Zoom is an enterprise company and the management had no intentions of being popular with consumers. Even now, the company does nothing to grow this segment other than to offer a free and lower priced tier. Zoom’s competition is Teams — not FaceTime.

One of the main reasons we want to continue holding Zoom is that hybrid work-from-home is an important trend for our portfolio. Asana’s growth is participating in this trend and Monday.com is also participating in the productivity tools category with work-from-home tailwinds. When we were down 40% in Asana, the portfolio manager Knox asked about my conviction and I said “we need to have more than Zoom for work-from-home – productivity tools will be winners this year.” The chances this trend wouldn’t carry Asana was low. Now, I’m reiterating “we don’t want to give up on the leader in work-from-home because the trend is not done yet.” On a side note, we will likely revisit Asana OR we will look at Monday.com if these companies get into a buy zone.

According to Gartner, 51% of knowledge workers will be working remotely by the end of 2021 up from 27% of knowledge workers in 2019. Looking forward, Gartner expects that 31% of all workers in the global workforce will be a mix of remote and hybrid with the United States at 53% of its workforce – in other words, not only knowledge workers. The senior research director who worked on the report stated, “Through 2024, organizations will be forced to bring forward digital business transformation plans by at least five years. Those plans will have to adapt to a post-COVID-19 world that involves permanently higher adoption of remote work and digital touchpoints.”

There are 3.3. billion workers in the world, which works out to about 1 billion remote workers.

Here's what is important to consider. On one hand, you could say that Zoom has 50% of the TAM already at more than 500 million users. However, those were many free accounts in the online segment. Instead, it’s important to consider that Zoom has substantial brand awareness yet only has 20% of the Global Fortune 2000.

Regarding productivity tools, Gartner reports 80% of workers are using collaboration tools for work, up from roughly half in 2019. Here’s the main statistic we think adds to our bull case: “Specifically, the use of meeting solutions surged during the pandemic. While workers globally reported that they spent, on average, 63% of their meeting time in-person in 2019, that number dropped to 33% by 2021 as more meetings took place over audio and video-enabled meeting solutions. The shift away from in-person meetings is expected to continue. Gartner predicts that by 2024, in-person meetings will drop from 60% of enterprise meetings to 25%, driven by remote work and changing workforce demographics.”remote work and changing workforce demographics.”

The good news is that Zoom is an enterprise product and always will be so this statistic directly applies (“enterprise meetings”). The consumer or online segment has distracted the market from the company’s core enterprise focus. Even today, Zoom is not attempting to expand on the consumer side or capture any market share here yet Wall Street has deeply discounted based on the drop-off in this segment. I discussed why this reminds me of when the market was deeply discounting Nvidia for fall-off in crypto mining in 2018 when I openly and consistently said crypto mining is not Nvidia’s thesis – rather the story is AI acceleration in the data center segment. Nvidia struggled to keep up with tough comps in Q4 2018 after crypto mining unexpectedly drove record revenue.

Zoom must execute on the enterprise side but there’s no reason in the recent earnings report to think they won’t. Meanwhile, the market is concerned over the wrong part of the story. Let’s talk about Q3 and Q4 specifically.

Why Q4 is Lower

An important factor as to why Zoom has reported lower third quarter (35%) and also low fourth quarter revenue guidance (19%) is because enterprise revenue is billed in Q1 and deferred revenue and billings are lower as the year continues.

So, how did Zoom put up its biggest quarters during Covid in Q3 and Q4? Well, it’s because consumers were piling in and paying monthly. This places Zoom in a predicament because enterprise is where the growth is coming from (and should be coming from) but the billing cycle means enterprise revenue is very weak in the second half at the very point in time that Zoom has high comps to clear.

The analysts covering the stock point towards lower deferred revenue growth as a concern, yet this is also front half-weighted.

“Turning to the balance sheet. Deferred revenue at the end of the period was one point two billion dollars, up thirty nine percent year over year from eight fifty five million dollars, and slightly up quarter over quarter. Looking at Q4, we expect the year-over-year growth rate in deferred revenue to be in the mid twenty. This is driven by the cyclical decline in the average remaining term of our annual customer contracts, which are front-half weighted.”This is driven by the cyclical decline in the average remaining term of our annual customer contracts, which are front-half weighted.”

There was a question from a financial analyst who covers Zoom and yet was not clear on this point. I’ve included the transcript below. I think it’s important to put into context what is contributing to the slower Q4 growth. Candidly, I find it strange that the analyst had to ask again as it’s pretty clear what management is saying. The last analysis I/O Fund published discussed this here when we said: “Please also note, that Zoom has what’s called “front-weighted seasonality” which means contracts renew more in the first half of the year than the second half of the year. This is technically a headwind to Q3 and Q4 although that was already taken into account with the guide.”

Here's the earnings call transcript:

Kyle Keirstead, UBS

“39:21 Okay, Great. Maybe Kelly, metrics like deferred revenues and RPO are certainly not the most important to watch with Zoom, but they can be indicative of changes in the business, so it's still important to keep an eye on them. And you made some color about DR and RPO next quarter that I'd love if you could elaborate. I think on DR you mentioned that it'll grow mid-twenties due to a cyclical decline in average remaining term of annual contracts. I'm not sure I totally understand what that means. So I'd love to ask for a clarification. And then likely as well on RPO, you mentioned that we would see a shift back to long term plans. I'm wondering if you could elaborate on that as well. Thanks so much.”

“40:05 Yes. So for deferred revenue, there's two things to remember, which is the seasonality trend of our renewal is that Q1 is the largest quarter for renewals and Q4 is the lowest. So, in terms of new deferred coming on to the books, Q4 is the lowest quarter because of that, as well as the fact that Q1 is the largest quarter when deferred gets out of the balance sheet, but they are annual contracts, by the time you get to Q4 most of that has already been amortized and recognized. There is only twenty five percent of it in theory about left when you come into the quarter. So the combination of the fact that anything added in Q1 is almost fully amortized and will get refilled and renewed back in Q1. And the fact that Q4 is the lowest renewal quarter, those two things are what's driving this trend of renewals. — Sorry, of deferred, which I know is probably counter intuitive to any other company that you see because of the seasonality that we have.”

Karl Keirstead

41:25 Yes. And so the fact that DR growth would slow to mid-twenties is due to what?

Kelly Steckelberg

41:30 It's due to the fact that Q4 is our lowest renewal period as well as all those annual renewals that came on in Q1, which is the biggest quarter are now almost fully amortized and recognized.

Kelly Steckelberg

41:49 And then this has a strong impact on billings and RPO as well, because the same thing like they are adding to the building of the collections are happening earlier in the quarter and the remaining term is being amortized throughout the year, so there is — it's the short amount of contract left during Q4.

The goal of my analysis is not to sugarcoat the slowing growth in the consumer or online segment that is billed monthly. That growth is slowing – no argument here. Rather it’s to help put into context that the 19% growth is not reflective of enterprise growth. Zoom is and always will be an enterprise story. In fact, the company is so ambitious at the enterprise-level that its goal is to disrupt traditional telecom with cloud communications.

Let’s Talk About the Enterprise Segment

Zoom is returning to an enterprise story with strong growth in customers that spend over $100K. The growth in this segment is higher than pre-pandemic levels at 94% year-over-year. This is on a high base, as well. The law of large numbers states it’s much harder to grow 94% YoY on a base of 1289 customers (2021) than to grow 86% on a base of about 350 customers (2019). The acceleration here is impressive if we remove 2020 as an anomaly and on top of the strong 2020 base.

When you separate the segment of under 10 employees, we can see the effects Covid had on the company with the current quarter being the highest hurdle to clear at 485% growth in the year-ago quarter although Q4 is not much easier to clear in terms of comps with 470% growth. To be honest, the fact the growth isn’t negative in this segment is a miracle. It seems preposterous that any consumer would be getting on Zoom for the first time 18 months into the pandemic – meaning negative growth would be logical. Of course, the growth is probably small teams creating accounts. Don’t forget that any churn in free accounts like K-12 don’t affect revenue growth.

Notably, we are going through a hard stretch for enterprise account growth in terms of comps with 156% growth and 160% growth to clear from the year-ago quarter of Q4 and Q1. The last two quarters Zoom has done an excellent job of maintaining and pacing growth here. I’m expecting Q4 to be lower in enterprise growth while hoping Q1 will resume strength again here.

What was Zoom’s valuation when it was fully understood to be an enterprise story? At its lowest point, it was at 30 P/S and at its highest point it was at 60 P/S in 2019. Once we lap the consumer growth and clear it out, which is weighing on Zoom’s enterprise story, then we should see these valuations again.

The I/O Fund thinks Zoom is oversold at these levels.

Bradley also pointed out on the forum that enterprise is showing strength in long-term deferred revenue, which grew 30% year-over-year compared to 26% growth in the year-ago period. This could be a return-to-normal after concessions were made during Covid (Datadog also moving in this direction), yet it shows strength to lengthen a contract period. He does a deep dive on the financials below.

The one thing that bothers me about the Zoom earnings report this quarter is the Zoom Phone Acceleration slide disappeared as did the numbers for account growth over $1 million. This could indicate the company is not disclosing the growth rates because they were weaker than expected. This is what we got last quarter that was missing from this quarter’s presentation:

Does Zoom Have a Catalyst on the Horizon?

The catalyst for Zoom remains the transition to hybrid and remote work. What makes a market is demand and Gartner predicts strong demand through 2024. Zoom Phone also remains a catalyst with one analyst on the call pointing towards the addressable market of 400 million business phones on legacy technology. AR/VR is a catalyst as Zoom will likely release an avatar and other augmented features. You likely saw that Facebook “Meta” is now integrated with Teams. There are technically integrations already with Zoom and Meta, as well, and Facebook worked with Zoom on Portal. As you know, I don’t think Facebook is actually leader in this space and Zoom could easily acquire a startup for avatars or AR/VR features. Hybrid events is another catalyst that we’ve covered in the past on our LTBH webinar.

Bringing video to the contact center as the video engagement center is not something I would shrug off although it does require more time to build a solid solution. Zoom is also spending its cash to encourage developers to build on its platform, which is a tried-and-true approach to innovation.

Where this Leaves Zoom Investors

There is certainly some suspense here as there is no visibility into Q1 at this time. Q4 tells us essentially nothing about how Q1 will perform. Again, this is partly due to the unique billing cycle and partly due to unusually high comps this year. Management is not willing to discuss guidance more than a quarter out. The combination of tough comps and seasonally low Q3 and low Q4 has beat up the price quite a bit. I/O Fund is willing to wait another quarter as the guidance for Q1 will start to show us what post-Covid Zoom truly looks like.

Deep Dive into Financials

By Bradley Cipriano

Zoom’s Q3 sales increased 35% YoY to $1.050 billion, which came in ahead of the Street’s estimate by $31 million (3%). Q3 also marked the 14th consecutive quarter that sales increased on a sequential basis. It is impressive that Zoom has been able to continue to grow sales every quarter even after its blockbuster 2020 results. Looking forward, management raised their guidance and now expects that total FY2022 sales will increase by ~54% YoY to $4.080 billion at the mid-point, which also implies another quarter of sequential growth.

Management also provided guidance for bookings, which is a key metric used by investors to gauge the sustainability of future topline growth. On the call, CFO Kelly Steckelberg stated that the company expects deferred revenue to increase around “mid-twenty” percent YoY in Q4. This implies a bookings growth rate of just 7%, which seems low, but is due to tough comps as bookings had increased 320% YoY in Q2 FY2021. Furthermore, the company’s bookings have become more seasonal and are now front-loaded to the beginning of the year. As a result, Q4 bookings will be relatively depressed while Q1 FY2023 bookings will be more robust. Nonetheless, the relatively low bookings guide may have spooked investors.

The soft bookings guide was offset with strong trends in RPO and net deferred revenue. RPO represents contracted sales that have yet to be fulfilled and can be used as a proxy for forward growth. RPO increased 51% YoY to $2.5 billion, while RPO to be completed in the NTM increased 39% YoY to $1.6 billion. Stated differently, long-term RPO increased 80% YoY to $821 million, which highlights Zoom’s strength with enterprise customers. Enterprise customers signing long-term deals is a favorable trend as it showcases their commitment to Zoom’s products. We can also see this in deferred revenue trends, as long-term deferred revenue increased 30% YoY, the fastest pace of growth since Q2 2020.

However, despite the strength in enterprise, small customer accounts do represent a headwind to growth in the near term. CFO Steckelberg explained on the Q3 call that small/online accounts represent a headwind that has been incorporated into the Q4 guide. She added that online churn in Q3 performed better than they had initially expected at the beginning of the year, but that online/small accounts are more impacted by the holidays than enterprise customers, leading to temporary increases in churn. This churn should reverse in FY2023, leading to stronger growth in future quarters. Furthermore, small accounts fell YoY from 38% of total sales to 34% of total sales in Q3, highlighting that this customer cohort is not as significant as enterprise customer strength.

Even with these temporary churn headwinds, forward looking metrics remain strong. For example, the growth in NTM RPO was also strong and grew 39% YoY and NTM RPO represented 38% of next twelve-month sales, up 751 bps YoY. The increase in NTM RPO as a percentage of forward sales signals that Zoom has more contractual support for future sales, which improves the quality of forward growth (Zoom is more likely to meet or exceed its sales targets).

Trends in deferred revenue also highlight the quality of recently reported sales. Net deferred revenue (which is total deferred revenue less accounts receivables) increased 41% YoY to $808 million, which was faster than the 35% YoY increase in sales. Looking forward, net deferred revenue represents 27% of NTM sales, which is up 309 bps YoY. The increase in net deferred revenue provides balance sheet support for future sales, which improves the quality of forward sales growth. So, while bookings may be slowing, the quality of the company’s forward sales is improving. In our opinion, analysts are likely being conservative with their forward sales estimates.

Continuing down the income statement, gross margin increased 750 bps YoY to 74%, while non-GAAP gross margin increased 774 bps YoY to 76%. Non-GAAP R&D and S&M expense margin increased 320 bps and 444 bps YoY to 6.4% and 22.6%, respectively, while non-GAAP G&A expense declined 163 bps YoY to 7.8%. It is great to see that management has kept G&A under control despite the surge in sales during the last two years. Following these trends, non-GAAP operating margin increased 173 bps YoY to 39.1%, and non-GAAP EPS also increased 12% YoY to $1.11, which beat by $0.02.

Finally, cashflows also remained robust during the year. In the LTM, free cashflow increased 60% YoY to $1.7 billion, which followed a 1,019% YoY increase in the prior year quarter. Relative to TTM sales, TTM FCF margin fell 1,063 bps YoY to 42%, but this remained well above the pre-covid levels of 17% (in Q3 FY20). Zoom’s valuation also does not appear to correctly reflect the company’s strong cashflows. As shown below, Zoom’s EV/FCF metric is well below other SaaS peers, yet Zoom is growing nearly 2x as fast as the peer median.

In all, Zoom beat top and bottom -line estimates and raised its sales guide for FY2022. However, trends in bookings may have spooked investors as they are expected to grow just 7% YoY next quarter, which could signal that sales may slow down in FY2023. However, this is offset with a rise in both contractual and balance sheet support for future sales as NTM RPO and net deferred revenue increased YoY relative to forward sales estimates. This increase in support for future sales improves the quality of forward estimates and suggests that sales estimates are conservative. Furthermore, gross and operating margins improved YoY while cashflows remained robust and increased YoY despite tough comps. Zoom remains a high-quality company with strong growth and cashflows and also appears to be undervalued relative to other SaaS companies.