Zoom’s Q2 Earnings Update: What Happened?
by Beth Kindig
If you own Zoom, why are you invested in the company? That’ll be a key thing to answer as the market is clearly doubting the company. I know exactly why we are in the stock. Before I review our thesis and why the earnings report was stronger than the market is pricing in (again, for our purposes), I want to begin with the bad news.
The bad news is that the online business is declining and management is being very conservative in regards to their guidance because they’re unsure of how to forecast the churn and lower signups in the individual and small account category. Zoom uses the words online business to refer to the small accounts that sign up online. They use the words channel and direct to refer to the enterprise sales that require their sales team.
The annual forecast of 51% revenue growth places Zoom in the top tier of cloud stocks this year in terms of growth – and that’s especially impressive considering their 300%+ quarters last year. Some are referring to this as a pull forward but that’s not accurate. A pull forward refers to business you would have secured at one point yet it comes earlier or consolidates into a single quarter or time period. What Zoom experienced was a leap from enterprise to consumer during Covid with consumer not being its core business. This is not a pull forward because consumer was a bonus or unexpected use case for the product. It reminds me of Nvidia’s use case with crypto mining, which the market had a severe reaction to, even though crypto mining was not in Nvidia’s product road map.
There are some reports that point towards a deceleration across accounts as the issue. Well, yeah … it has to decelerate from 300%+ but what’s the deceleration referring to exactly? The write-ups will say something like “User growth exploded for Zoom throughout the pandemic, with the number of customers with 10 or more employees skyrocketing 458% from 66,300 in fiscal Q2 2020 to 370,200 during the company’s fiscal Q2 2021. That growth, however, slowed in Q2 2022 to 36%, with the company reporting 504,900 such customers.”
That looks scary yet the revenue growth in Q2 2022 of 51% is not a problem as it was carried by the critical enterprise segment. I review those numbers below. Believe it or not, some enterprise segments actually accelerated from last year. You wouldn’t know that from the earnings reaction.
However, let me be really clear that the reason the market is spooked is the fiscal year guide, and subsequently what it means for Q4’s growth and beyond. The confusion around the current quarter is mainly journalists trying to figure out what’s causing the sell-off and thinking it was something in the current quarter’s ER so you’ll see those quotes like what I pasted above.
Here's the question on the earnings call that caused the sell-off Tuesday:
So, I look at your implied guide for Q4. It seems like you're guiding it to decel to around 12% or so, plus or minus from 30% or so in Q3 with a similar compare I would argue. Now, it seems like it'll actually be down potentially sequentially from Q3. So, can you elaborate on why that might be the case? You talked about online issues. How long do they last, for example? And if we go to like 10% to 12% growth in Q4, should we accelerate afterward if we — the compares get easier, how should we think about next year? –. It seems like you're guiding it to decel to around 12% or so, plus or minus from 30% or so in Q3 with a similar compare I would argue. Now, it seems like it'll actually be down potentially sequentially from Q3. So, can you elaborate on why that might be the case? You talked about online issues. How long do they last, for example? And if we go to like 10% to 12% growth in Q4, should we accelerate afterward if we — the compares get easier, how should we think about next year? – Shebly Seyrafi, FBN Securities
Here was the answer from management. Notably, Zoom calls the individual accounts the “online segment.”
“Yes. So, in terms of what you're seeing in Q4, it is continued uncertainty around headwinds in the online segment, absolutely, it’s driving that. And we're — in terms of what that implies for next year, we're not ready to give FY'23 guidance today, unfortunately. So we will be prepared to do that when we get on the Q4 earnings call and, of course, we'll have a lot more earnings at that point to share with you, but that is what – exactly what continues to drive that in Q4.” – Kelly Steckelberg, CFO Zoom it is continued uncertainty around headwinds in the online segment, absolutely, it’s driving that. And we're — in terms of what that implies for next year, we're not ready to give FY'23 guidance today, unfortunately. So we will be prepared to do that when we get on the Q4 earnings call and, of course, we'll have a lot more earnings at that point to share with you, but that is what – exactly what continues to drive that in Q4.” – Kelly Steckelberg, CFO Zoom
My read on the situation is that management doesn’t know what to expect right now. It was an unexpected situation last year and unwinding from that is hard to model. 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.
So, where does that leave us considering Zoom is a LTBH position but nearly 5% allocation? As annoying as this may be, I don’t see any change to the thesis we set out for Zoom. There is confusion about the company’s revenue segments and how they’ll unwind but this earnings report saw accelerating growth in enterprise. Therefore, at most, I see us taking the allocation down to 3% and then back to 5% on a breakout. The reason is we will keep the 3% minimum is that this company is rare and special, I’ve already made that case many times.
Cash is the great equalizer in terms of product-market fit; if you knew nothing else about product, that’ll quickly communicate to you the relationship a tech company has with its customers in any given market. Cloud isn’t ad-tech, where it’s this cash efficient either, which makes Zoom’s cash even more rare. Why is Zoom able to keep costs so low while growing this rapidly? I expand on this below.
I want to point out that Knox has done an excellent job with this position as the highest entry he’s guided was in the mid-$300s with the high-$200s in May. He was extremely clear when Zoom became overextended into the $400s and even $500s, that we were not buyers. Therefore, we are about a 10%-15% drawdown from our last entry. It’s not only our wins that make a portfolio but it’s also avoiding the losses. We take both very seriously.
Enterprise > Consumer
Consumers turned to Zoom during Covid because the product is easy to use and has a viral mechanic, which is the easy-to-share URLs that allow a frictionless video call without logging into accounts or downloading software.
Zoom is clear on who and what they are. The Five9 acquisition that we covered in-depth here expands their enterprise footprint from employee communications to customer communications for call centers.
Channel and Direct Business drove the revenue results this quarter and the company clearly stated they expect this growth to be “robust” into the future. The company grew revenue by 54% year-over-year to $1.02 billion, exceeding guidance of $990 million.
Enterprise customers that spend more than $1 million dollars in ARR grew by 77% year-over-year. Zoom also reported 131% year-over-year growth in accounts with greater than $100,000 in trailing twelve months of revenue. This was an acceleration from 112% growth in the year-ago quarter.
The Net Dollar Expansion rate for customers with more than 10 employees was above 130% for customers. This is contributed to an increase in spend and upsells on Zoom Phone and Zoom Rooms.
Zoom Phone grew customers by 241% year-over-year and the company “set a record for the largest Zoom Phone deal to date twice in the same day.” There are now 26 customers with more than 10,000 seats. The incremental revenue was driven primarily by new customers. The company is growing Zoom Phone seats at a rate of 1 million per 8 months.
Here's an important excerpt from the call: “In addition to these great customer wins, we also closed another strategic channel partnership with Telkomsel, the largest cellular operator in Indonesia, which is the world’s fourth largest country by population. Telkomsel understands and wants to support their 170 million subscribers’ need for seamless and reliable virtual meetings to thrive in the digital workplace era. They will be leveraging the power of Zoom’s Developer Platform and ISV Partner Program to deliver a fully integrated solution via their CloudX offering for the Enterprise segment and Zoom native apps for the Consumer segment.”
Signing one cellular operator can make up for a lot of online accounts. Telkomsel’s CloudX is unified communications and a contact center solution. As noted in past analysis, Zoom also has partnerships with British Telecom, Lumen Technologies, and Orange Business Services. Zoom’s Distributor Partner Program includes Carahsoft Technology Group in the U.S., Nuvias Unified Communications in Europe, eLink Distribution AG in DACH, and West Telco in LATAM and EMEA, Avant Communications and Intelisys.
Zoom’s Cash
There’s no doubt that Zoom’s bottom line is exceptional with operating income of $1.5 billion expected in fiscal year 2022 and adjusted EPS of $4.75 to $4.79.
We can also see that Zoom’s earnings turn into cash, highlighting the high quality of its results. For instance, YTD FCF increased 45% YOY to $909 million, which is impressive considering YTD earnings were $544 million. Zoom’s cashflows are higher than its earnings, which improves the quality of recently reported results.
The firm’s cashflows are largely driven by pre-payments from enterprise customers, which are stored in deferred revenue. Deferred revenue was a healthy $1.15 billion as of Q2, up 62% YOY, and signaling that enterprise customer growth remains strong. As discussed above, a lot of the uncertainty in management’s guide comes from smaller accounts (online accounts), so it is good to see that Enterprise has amble cash support for future sales.
We can gain further confidence that Enterprise is performing strong by scaling deferred revenue to expected H2 enterprise sales. Zoom disclosed on the Q2 call that 40% of its sales are from monthly payers (online accounts), which do not prepay revenues and as a result, do not drive deferred revenue. Last year, around ~40% of Zoom’s H2 sales were from monthly payers.
By stripping out the 40% monthly payers from the H2 guide, we can see that enterprise sales are expected to increase to ~$1.2 billion in H2. Considering Zoom’s $1.15 billion deferred revenue balance, the company’s H2 enterprise sales are 94% supported by pre-payments of cash (deferred revenue), up YOY from 72% support in the prior-year quarter. Viewed differently, Zoom’s enterprise sales are performing stronger than they were last year. If you believe that Zoom’s story is driven by Enterprise (we do), then this is a great trend to see.
However, it also means that any raises or beats for Q4 will require online payments to come in stronger than expected since enterprise is accounted for in the deferred revenue balance.
Hybrid Work-from-Home
As stated above, Zoom Phone is the most prominent product that can drive future revenue growth as the telecom and cellular operators embrace cloud-native. Quite a bit of this will be driven by the developer platform that Zoom has launched and Zoom Apps.
However, hybrid work-from-home is not to be overlooked. Zoom Rooms and Zoom Events are the two products that fall into hybrid WFH.
According to Gartner, by the end of 2021, 32% of workers worldwide will be remote while 51% will be working in a hybrid environment. As you can see from the chart below, Gartner sees this increasing from 50% to 60% in the United States with more percentage increases in India and Western Europe. Zoom Rooms facilitates this by allowing office conference rooms to connect with the remote employees.
Zoom Events capitalizes on the event industry which is one of the last to resume after Covid. It’s not hard to imagine that events will end up being hybrid too, moving forward, to help reduce travel and maximize the number of attendees. Right now, 73% of event planners believe hybrid will be more common in the future.
Conclusion
I’ve been here many times where the wrong revenue segment is driving a market reaction. Zoom is not a consumer story and the current earnings results are showing robust enterprise sales. Regardless, I won’t sugar coat anything with my readers and Q4 is a gamble right now. That’s the issue and why we saw a 16% decline the day after earnings.
I’ve laid out why we will remain in our position so you can make an educated decision for yourself. We also offer backup with Knox’s entries and so you’ll know when the company is rev’ving up again. We won’t blink an eye when the charts say the timing is right to increase allocation. In my opinion, the chances are incredibly high that Zoom becomes the leading cloud-native communications company globally. Notice I’m not saying the leading web conferencing app and notice I’m not saying “one of the leading.” It’s a big TAM, it’s a sharp team, it’s an incredible product, and they’ve got a pile of cash – that’s all I got for ya.