Zoom Communications, Inc. Q3 FY2020 Earnings Call

Thank you, Matt. Hello, everyone, and welcome to Zoom’s Earnings Webinar for the Third Quarter of Fiscal 2020. Joining me today will be Zoom’s Founder and CEO, Eric Yuan, and Zoom’s CFO, Kelly Steckelberg, who is actually joining us remotely from Los Angeles, demonstrating another capability of using Zoom Video Webinar for its earnings announcement. Our earnings press release was issued today after the market closed and may be downloaded from the Investor Relations page on the Zoom.com website. Also, on this page, you’ll be able to find a copy of today’s prepared remarks and a slide deck with financial highlights that, along with our earnings press release, include a reconciliation of GAAP to non-GAAP financial results. During the call, we may make forward-looking statements about our future financial performance and other future events or trends, including guidance. These statements are only predictions that are based on what we believe today, and actual results may differ materially. These forward-looking statements are subject to the risks and other factors that can affect our performance and financial results and which we discuss in detail in our filings with the SEC, including today’s press release and our latest 10-Q. Zoom assumes no obligation to update any forward-looking statements we may make on today’s webinar. And with that, let me turn it over to Eric.

Thank you, Tom. Thank you, and welcome, and thank you all for joining us on today’s Zoom video webinar. I’m very pleased to report that we had another strong quarter as evidenced by a combination of high revenue growth of 85%, with increased profitability and free cash flow of $54.7 million. We continue to have success with customers of all sizes, and one metric that has continued to impress is customers with more than $100,000 of trailing 12 months revenue. This metric grew 97% from Q3 last year. Our execution so far this year has put us in a position to finish the year strong, and we are raising our revenue and profitability outlook for the fourth quarter, as well as full fiscal year. As Kelly will discuss in a moment, our strong third quarter results were driven by two factors. First, our ability to attract new customers; and second, our commitment to customer happiness, which creates trust and enables us to significantly grow commitments with our existing customers. Let me discuss some of the largest deals we closed this quarter with two happy customers. Both expanded their footprint of our unified communications platform. I’m excited that the U.S. Postal Service is starting to deploy Zoom Meetings more broadly across the organization after an extensive proof-of-concept. The USPS is our first major agency, major business win since we received FedRAMP approval in May. They chose Zoom for our high quality video and audio. Thank you USPS. I love you. We are also grateful to have National Australia Bank as part of the Zoom family. NAB is undertaking a large technology transformation and is looking to Zoom to support its enterprise telephone and video conferencing services in order to better connect its workforce of more than 30,000 employees. NAB is Australia’s largest business bank and one of our largest financial service customers in the region. Since selecting Zoom in 2018 to help seamlessly connect its workforce across any device and internationally, they have continued to grow and adopt Zoom services throughout their business. In Q3, the bank selected Zoom to support the telephony systems for a new Sydney-based major office building development. Zoom Phone was selected to support a unified communications approach, as the bank adopts a wireless working environment, as well as delivering projected cost savings and enhanced features and functionality. They will begin rolling out Zoom Softphones to over 6,500 users next year, focusing on tenants of the new building, as well as continuing to expand their Zoom Rooms footprint. We’re excited to continue delivering improved experiences for the bank through a full end-to-end communication platform, which helps better connect their workforce. Thank you National Australia Bank. Now, let me discuss a couple of business highlights from Q3. First, analyst firm Gartner named Zoom a leader for the fourth consecutive time in their Magic Quadrant for Meeting Solutions. We are grateful that Gartner has recognized Zoom for our completeness of vision and our ability to execute once again. And second, we held our premier customer event, Zoomtopia, my favorite event of the year. It is only our third Zoomtopia, and we had record registrations of 2,600, up over 80% from last year. During the event, customers like AB-InBev, Autodesk, Electronic Arts, Uber, and Walmart shared their stories. Many of these customers spoke to how frictionless Zoom experiences are driving happiness with internal and external stakeholders. It’s truly amazing and humbling to hear from so many happy customers from around the world. Also, at Zoomtopia, we were proud to announce expansions to our platform, including our new Zoom Rooms Appliance Program, expanded Zoom Phone service and capabilities, and the growth of our App Marketplace. Our customers tell us that Zoom just works, and with these new innovations, we empower teams to do even more with video communications. In closing, I’d like to thank the over 2,400 Zoom employees for their hard work and focus on our customers. Their commitment to customer happiness and execution at scale will enable us to finish the year strong and position us for future growth. With that, let me turn things over to Kelly. Tom, your mic is unmute.

Thank you, Eric, and welcome to everyone joining us. Let me start by first reviewing the financial results for Q3, and then I will discuss our outlook for Q4 and the full fiscal year. Overall, we delivered another amazing quarter, and demand for Zoom’s unified communication platform remained strong across our major geographies and offerings. Total revenue grew 85% year-over-year in the third quarter to $167 million. This top line result exceeded the high-end of our guidance range. Key drivers of our revenue performance included both our acquisition of new customers and expansion of Zoom’s footprint within existing customers. Specifically, new customers accounted for approximately 61% of our year-over-year growth in subscription revenue, while the remaining 39% was due to additional purchases from existing customers. Now, let me share some of the key customer metrics for Q3. Our two-pronged strategy of land and expand continued to drive growth. First, we added 7,800 customers with more than 10 employees in the period and exited Q3 with over 74,100 customers, up 67% year-over-year. Our continued expansion in the up-market resulted in 546 customers with more than $100,000 in trailing 12 months revenue, up 97% year-over-year. This is an increase of 80 customers and a record number of adds in a quarter. Our ability to expand with existing customers was evident in our net dollar expansion rate that was over 130% for the sixth consecutive quarter. Our net dollar expansion rate remains at the top tier of our industry and reflects the high level of satisfaction and trust that customers have in Zoom. This is further evidenced by our Net Promoter Score, which remained above 70 in Q3. Eric discussed two examples of how this strategy contributed to our Q3 results and let me give you a third one. During the quarter, we had an expanded commitment from Quinnipiac University, a nationally-ranked private university in Connecticut with over 10,000 students. The university originally moved to Zoom Meetings based on the ease of use and reliability of the technology, as well as a way to consolidate into one platform for their diverse community of users. Looking to drive further adoption of an innovative communications platform, the university has also selected Zoom Phone to modernize their phone system. The University has been a great partner and applauded Zoom’s willingness to work with the university to enhance the feature sets of our technology on their journey toward a unified communications platform. Next, as we discussed at our recent Analyst Day, international expansion is a key multi-year growth initiative for Zoom. In Q3, our APAC and EMEA revenue combined grew 98% year-over-year and represented approximately 20% of revenue. Revenue from the Americas was up 82% year-over-year and represented approximately 80% of revenue. We see significant opportunity ahead for international expansion. Now turning to profitability. Our sales execution in Q3 also helped drive strong growth in our profitability and free cash flow. We were net income profitable from both a GAAP and a non-GAAP perspective, but today, I will focus on our non-GAAP results, which exclude stock-based compensation expense and related share-based equity taxes. Non-GAAP gross margin in the third quarter was 82.9%, compared to 81.7% in Q3 last year and 82.2% last quarter. For the full-year, we expect non-GAAP gross margin to be at the top-end of our long-term target of 80% to 82%. R&D expense in Q3 was approximately $14 million, up 64% on a year-over-year basis. As Eric discussed, we announced several expansions to our platform at Zoomtopia. We continue to invest in innovating our platform with our highly efficient R&D model. Given our hiring plans over the next several quarters, we expect R&D to return to the top end of the range of 10% to 12%, which is consistent with our long term view. Sales and marketing expense for Q3 was $82 million. This reflects an increase of 58%, or $30 million over last year with investments in initiatives to drive further growth. As a percent of total revenue, sales and marketing was 49%, lower than Q3 last year, but up from Q2 due to Zoomtopia. We expect to generate a great return on investment in this area and we expect to increase hiring for international up-market growth initiatives in Q4 and into FY 2021. G&A expense in Q3 was $21 million and represented 12% of total revenue. This compares to last quarter and last year, both were 12% of total revenue. Non-GAAP operating income was $21 million, translating to a 13% non-GAAP operating margin for the quarter. This was an increase of approximately $19 million, as compared to Q3 last year’s result of $2 million. The main driver of this result was the higher revenue, while spending was mostly in line with our expectations. Non-GAAP earnings per share in Q3 was $0.09, on approximately 293 million of non-GAAP, weighted average shares outstanding and adjusting for undistributed earnings. This result is $0.06 higher than our guidance and $0.08 higher than Q3 of last year. Turning to the balance sheet. We ended Q3 with approximately $811 million in cash, cash equivalents, and marketable securities, excluding restricted cash. Deferred revenue at the end of the quarter was $202 million, up 89% year-over-year. Looking at both our billed and unbilled contracts, our remaining performance obligations, or RPO, totaled approximately $517 million, up 102% from $256 million last year. We expect to recognize approximately 64%, or $330 million, of the total RPO as revenue in the next 12 months, compared to 65%, or $166 million in Q3 last year. Current RPO was up 99% year-over-year, the same growth rate as Q2’s current RPO. Non-current RPO was up 108% year-over-year. Our execution led to strong cash flow growth. Operating cash flow was $62 million in Q3, up from $18 million, or 240% year-over-year. In Q3, free cash flow was $55 million, up from $10 million, or 440% year-over-year growth. As we discussed on last quarter’s webinar, the benefit we received over the last two quarters from the Employee Stock Purchase Plan will become a use of cash in Q4 when the first purchase will be made. The quarter-over-quarter outflow in cash related to ESPP will be approximately $20 million in Q4. Starting in FY 2021, we expect the cadence of benefits from contributions to the ESPP to occur in Q1 and Q3 and net outflows from purchases to occur in Q2 and Q4. Now turning to guidance. We are pleased to be increasing our outlook for the full-year based on our view of the current business environment, our ability to gain market share, and the momentum we have achieved so far this year. For the fourth quarter, we expect revenue to be in the range of $175 million to $176 million. We expect non-GAAP operating income to be in the range of $17 million to $18 million. Our outlook for non-GAAP earnings per share is $0.07, based on approximately 296 million shares outstanding. For the full-year of fiscal 2020, we now expect revenue to be in the range of $609 million to $610 million, up from our prior guidance of $587 million to $590 million. This would be approximately 85% year-over-year growth. For the full-year, non-GAAP operating income is expected to be in the range of $67 million to $68 million, an increase of approximately 50% from the top-end of our prior guidance of $42 million to $45 million. With this meaningful increase in profitability, we now expect to deliver non-GAAP earnings per share of $0.27 for the full-year fiscal 2020, based on approximately 293 million shares outstanding. In closing, we are pleased with our progress this year and our unique ability to deliver high growth at scale, combined with profitability and free cash flow growth. I would also like to thank the entire Zoom team for their hard work in Q3. We are well-positioned to end the year strong as we stay focused on delivering happiness to our customers every day. With that, let’s open it up for questions. If you have not yet enabled your video, please do so now for the interactive portion of this meeting. Matt, please queue up our first question.

Our first question is from Brad from Credit Suisse. Hey, Brad, you’re unmuted now.

Hi. Can you guys hear me?

Yes. Hey, Brad.

Hi, Brad.

Fantastic. It’s great to see everybody, especially Eric and Tom on the beach enjoying themselves after such great results, you deserve it.

Brad, they wouldn’t take me.

Well, Kelly is – fantastic. Well, Eric, it’s great to see the traction that you’re having with Zoom Phone, particularly the National Australia Bank deal that you highlighted. How’s the pipeline trended since the focus on Zoom Phone and Zoom Rooms at Zoomtopia? And when should we start to see you sign more of these Phone and Rooms deals?

So first of all, I can tell you, we’re very excited about Zoom Phone opportunity. And even at Zoomtopia, we shared our vision, because we’re seeing – we’re conversing on a cloud with PBX, those truly can be converged into one service is cloud-based PBX. Customers really like this story. With that, we have one consistent upfront and experienced the same bug and architecture. I think a lot of our customers, I mean, existing customers, existing installed base for us have up-sell opportunity, that’s huge. And free to bug from our existing installed base is very, very positive, especially after that goes through a few seats. Their feedback is, wow, that’s amazing. I think we have a high confidence about the future opportunities.

Okay, great. Thank you. And Kelly, just in follow-up, your operating and free cash flow profitability was very strong yet again. How has the company been executing against its sales and marketing productivity goals? And why not take some of the outperformance and invest it back into driving more customer ads, or would you be at a point of diminishing returns at that point?

We certainly are committed to investing as much as possible in terms of continuing to drive growth in the top line. And we expect to see hiring to actually accelerate in Q4. So you should see our headcount numbers for the end of the year finish really strong, as well as – Janine has seen a lot of progress in terms of efficiency and marketing. So we continue to look for opportunistic ways to add, but ensuring that we continue to produce a high ROI on any of our marketing spend.

Thanks, Brad.

Okay, great. Thank you.

Thank you, Brad. Matt, next question, please.

Tom, unmute.

Matt, you’re unmute unfortunately.

Sorry. Our next question is from Sterling Auty from JPMorgan. And Sterling, you are unmuted now.

All right. Great. Thanks, guys. Given that you’re sitting on the beach, I thought you’d bring you a little virtual snow for a little white Christmas.

Yes.

All right. So actually, a question to start with Kelly. The growth in current RPO, especially outpaced what you saw in revenue. Is that kind of telling us something in terms of what the linearity looks like in the quarter? And what should we be thinking that tells us in terms of the growth contribution here into the fourth quarter?

Thank you, Sterling. Hi. So you got it exactly right. What we’re seeing is a couple of things, is that a lot of our seasonality is for renewals is lining up to be July and January. Due to the nature of our six-month quarter for our teams, as well as, as we continue to move more and more up-market, we’re seeing a shift with those customers that deal with those customers to shift more and more, not only to the back-end of the year, but also to the back-end of the quarter, which is exactly what’s driving that.

All right. Great. And then one follow-up question for you, Eric. I think the big news in the quarter was the deal that RingCentral signed with a buyer. Can you give us a sense of what you think of that partnership? And is that something that would be interesting to Zoom? Is there a partnership similar to that, that we might look for you to sign in the future?

So, first of all, I think Brad, he already shared their view about the partnerships of Avaya. I’m not going to repeat what he cited before. But from our perspective, I think, first of all, listen, we still have a customer, partner, and reseller, right? We’re still in a good partnership, and also this market is very big. And when we look at the cloud PBX system, I think it’s different than any other vendors, because we should believe video and voice is the ones, that’s why we will focus on our existing installed base for up-sell. It’s essentially, customer whoever wants to deploy the traditional phone solution, I think they still might go with other vendors, that’s okay. However, for those customers that would like to look at – we do first unified communication experience, I think that’s our opportunity. I think, occasionally, we might have a little bit of overlap. But overall, the market opportunity is huge, and I think many are good partnerships. And Avaya and RingCentral, I think one is on-prem legacy vendor, another one is cloud PBX, and probably it’s good for both of them. And we really focus on our existing installed base and deliver our converged solution to our installed base.

Great. All right. Fantastic. Thank you.

Thank you, Sterling.

Thank you, Tom.

Matt, next question, please.

Our next question comes from Kash from Bank of America Merrill Lynch. Kash, you are unmuted.

I think he’s still muted.

Yes. Am I audible now?

Yes.

Yes, Kash.

Am I looking happy? Am I looking happy?

Yes, very happy.

Very happy.

Excellent, okay. I haven’t had your backdrop, but I’ll be there hopefully in a couple of weeks. I wanted to just ask you a little bit about the up-market traction. You talked about the HSBC win last quarter. This time, it’s the USPS. When you look at the pipeline coming up for next fiscal year, what kind of enterprise deals are you seeing in the pipeline? And do you feel like you need to add more salespeople that come from the enterprise background, where you might need to invest a little bit more upfront, but the payoff can be certainly huge? And what does that mean for retention rates ultimately for the business model? Thank you so much and congratulations.

Yes. Kash, that’s a wonderful question. So if you look at our growth potential, international and also enterprise, we already hired a lot of enterprise reps over the past 12 to 18 months. Also want to focus on the quality rather than just quantity. And from a leads perspective, it’s very healthy. Like HSBC, like USPS and also government, public sector as well and especially for a lot of enterprise customers, they would like to go through the PUC to make sure of the solution they are going to deploy for the next several years. That’s why architecture plays a very important role. That’s why we are winning, especially when customer, they are going to go through the PUC. They want their employee involved to test the solution rather than just one person, two person make a decision to upgrade from the other legacy solutions to the new cloud solution. And inside of that, I think our pipeline is pretty healthy and we really are doubling down our enterprise expansion.

Great. And, Kelly, if I could follow-up with you on the free cash flow side, there are certain other items in accrued. I cannot believe I’m actually asking you a cash flow or a balance sheet question, but there was a certainly a big number that boosted the free cash flow, I think it was prepaid and accrued liabilities or something that looked a little big and contributed to the jump in otherwise what would have been still a great free cash flow quarter? Just curious what that one-time item seem to be?

In the – let me just pull up the balance sheet.

It was – yes, we can follow-up offline if needed...

Okay.

...but it was a fairly large item that stood up in the cash flow statement.

When we have our call back later, Kash, let’s talk about it then.

Yes, wonderful. It’s accrued expense and other liabilities, a big jump there. Well, we can talk about it later.

Okay.

Thank you, Kash.

Thanks. Next question please, Matt.

Our next question is from Meta Marshall from Morgan Stanley. Meta, you are unmuted.

Great. Thanks. Just wanted to ask if, I know that Zoom Voice has kind of initially been targeted at customers as kind of an add-on once they are already onboard. But if you’re seeing more interest upfront from customers wanting video and voice at the same time. And then maybe just as a follow-up question for Kelly. So just a little bit more rationale for the gross margin outperformance and just some of the factors there? Thanks.

Eric, you want to take the question about the Zoom Phone?

Yes, go ahead. Yes.

Okay. So in terms of the gross margin, Meta, what we saw is obviously outperformance on the top line without additional expansion needs in this quarter in the data center, as well as we saw outperformance – or sorry, improvements in both our third-party audio costs, as well as our professional services margins. What you will expect is in Q4, remember, as a reminder, because we run our own servers in these co-located facilities, whenever we add servers, it was kind of step function into the expense. So that’s why we are guiding for that to be in line, but you’ll see a slight tick in terms of Q4 for – from a gross margin perspective as we’re going to make some further investments in servers.

Okay.

And then, Eric, do you want to talk about the strategy about continuing to focus on Zoom Phone for our existing customers?

Yes, for sure, because over the past several years, a lot of our existing installed base, they told us they are still using a traditional legacy PBX solution. They would like to move to one unified solution. That’s why it’s still our top priority to focus on our existing installed base, because those customers already understand video conferencing or we already build a trust relationship. I think that’s low-hanging fruit, that’s our top priority. And inside of that, for sure, down the road, we are going to open up the Zoom Phone service to the greenfield as well, and that’s the next growth opportunity for us in FY 2021 and the future as well.

Okay. Thank you, Meta.

Our next question is from Tom from Stifel. Tom, you are unmuted now.

Thank you for taking my questions. Greetings from Chicago. Things go softly nice out there. Good work. Eric, I was hoping you could talk a little bit more about the international opportunity. It’s obviously a huge opportunity and it’s still pretty small relative to the overall size of your business. On that topic, how ready is the market to really expand kind of wall to wall on Zoom as you look at international prospects? And then can you talk a little bit more about go-to-market? How easy is it to hire sales reps? How do you want to build those territories out? Just an update on what you’re seeing in Europe and APAC? Thanks.

Yes, sure. Absolutely. So if you look at it revenue-wise, a rise of 20%, but the growth rate is much higher at 97% last quarter. And we’re already doubling our expansion in Amsterdam, which is our headquarter for the EMEA. We hired a lot of people over there. I think if you look at opportunities, especially for video conferencing, I think the market is ready. We just need to hire more people and have enough leads. However, if you look at the phone service, for sure, we are going to add more and more international coverage, and I think that’s another opportunity. But probably we are going to play a different game. Here, we focus on the video for us and obviously phone. For international, video and voice at the same time. I think probably we’ll see accelerated growth for customers to deploy both video and voice at the same time, not only for the EMEA but also APAC as well, like in Japan, Australia, I think those are two greater countries where we see huge opportunity.