Earnings Call Transcript
Zoom Communications, Inc. (ZM)
Earnings Call Transcript - ZM Q3 2021
Operator, Operator
Hello, everyone, and welcome to Zoom's Third Quarter Fiscal Year 2021 Earnings Release. I’d like to remind everyone that this call is being recorded. And at this time, I'm going to hand the call over to Tom McCallum, Head of Investor Relations.
Tom McCallum, Head of Investor Relations
Thank you, Matt. Hello everyone, and welcome to Zoom's earnings video webinar for the third quarter of fiscal 2021. We will start the webinar with a recording from Zoom’s Founder and CEO, Eric Yuan. Then Zoom’s CFO, Kelly Steckelberg will join to discuss the quarter and our outlook. We will then have a Q&A session hosted by Kelly that will end at approximately 3:30 PM Pacific. 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 the 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 release, include a reconciliation of GAAP to non-GAAP financial results. During this call we will make forward-looking statements about our market size and growth strategy, our estimated and projected costs, margins, revenue, expenditures, investments, growth rates, our anticipated financial performance and other future events or trends, including guidance for the fourth quarter of fiscal 2021 and full year 2021, our plans and objectives for future operations and expansion, growth, initiatives, strategies, market position, and the continued impact of the COVID-19 pandemic on our business. 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 could affect our performance and financial results, which we discuss in detail in our filings with the SEC, including today’s earnings press release and our latest 10-Q. Zoom assumes no obligation to update any forward-looking statements we may make on today’s webinar. Now let’s hear from Eric.
Eric Yuan, CEO
Hello, I hope you are all doing well. I am so sorry that I can’t join you all live today, but I had a personal conflict arise. As we are in the season of Thanksgiving in the U.S., I wanted to express my ongoing gratitude for the commitment of our Zoom employees and the support of our customers, partners and investors during these unprecedented times. You all truly inspire and motivate us every day. Now let me share with you a few recent business highlights. First, revenue grew 367% year-over-year in Q3. Second, with strong sales execution, our customers with more than 10 employees grew 485% year-over-year. And we are very delighted that, just recently, Gartner Research has named Zoom a leader in the 2020 Magic Quadrant for Meeting Solutions, as well as a leader in the Magic Quadrant for Unified Communications as a Service. This is the first year Zoom has qualified for inclusion in the Gartner Magic Quadrant for UCaaS and in the sixth year of Meeting Solutions. We are also very thrilled to welcome Secretary Janet Napolitano to our Board of Directors. We also had exciting wins in the quarter where customers committed to multiple Zoom products to provide a high-quality experience for their users. First, I would like to welcome Peloton to the Zoom family. Peloton is a leading interactive fitness platform. In Q3, Peloton consolidated to one vendor, buying both Zoom Meetings and Zoom Rooms to provide a more feature-rich video communication service to their employees. We are very honored to have Peloton committed to a long-term engagement, where they will deploy services across all locations and employees. A global customer increasing their commitment with Zoom is Rakuten. Rakuten is a global leader in Internet services with 1.4 billion members around the world. Impressed by the simplicity in the Zoom technology, the ease of facilitating the service and the feature-rich application, Rakuten has committed to the full Zoom UCaaS deployment. They have grown to 42,000 meetings licenses, more than 1,000 Zoom Rooms and are currently deploying Zoom Phones across the globe. We also want to recognize the Israel Ministry of Education, which oversees public education institutions. The Ministry of Education has enabled about 200,000 teachers and 1.2 million students to use Zoom. The leadership at the Ministry has told me that Zoom became the most popular app for video meetings in Israel’s schools because of its simplicity, stability and many options for security and privacy. Thank you for their hard work to provide for children’s educational needs during this crisis. And to all educators around the globe, you are all heroes. Thank you, Peloton. Thank you, Rakuten. Thank you, Israel Ministry of Education. I love you all. Also thank you as well to all other customers. Your trust and happiness energize the entire Zoom team. Now let me talk about my favorite event of the year, Zoomtopia. In October, we had over 155,000 unique viewers attend Zoomtopia, our premier customer and community event. This year’s event was held virtually on Zoom technology. We also had over 140 customer speakers, ranging from Fortune 50 companies to small businesses, and across all verticals, sharing stories of how they have integrated Zoom into all aspects of their communication and collaboration. We showcased several customers who are not just conducting their business over Zoom, they are reimagining and delivering new business services over Zoom as well, including the new OnZoom platform. I’m very proud of the Zoom team that delivered this successful event to our user community and at the size and scope that is truly incredible for virtual events. We were also able to demonstrate to the world that you can do this too with Zoom. In summary, Zoom performed well for our customers and communities during the third quarter. I want to thank our over 3,800 employees who continue to scale our business and truly deliver happiness. With that, let me turn things over to Kelly, but first here is a look of what our new OnZoom platform has to offer. Thank you.
Kelly Steckelberg, CFO
Hello, everybody. We’re so glad you could join us today. In Q3, we continued to be inspired by the many creative ways our customers have been using Zoom to work anywhere, learn anywhere and connect anywhere. Let me start by reviewing our financial results for Q3, then discuss our increased outlook for Q4 and the full-year FY 2021. Total revenue grew 367% year-over-year to $777 million in Q3, achieving a $3 billion revenue run rate. This top line result exceeded the high end of our guidance range of $690 million due to strong sales and marketing execution in both our online and direct businesses, as well as lower-than-expected churn. For the quarter, the year-over-year growth in revenue was primarily due to subscriptions provided to new customers, which accounted for approximately 81% of the increase, while subscriptions provided to existing customers accounted for approximately 19% of the increase. This demand was broad-based across products, industry verticals, geographies and customer cohorts. Let’s take a look at the key customer metrics for Q3. We continue to see expansion in the upmarket as we ended Q3 with 1,289 customers generating more than $100,000 in trailing 12 months revenue, up 136% year-over-year. This is an increase of more than 300 customers over Q2, the highest number of adds we have had in a quarter. We exited the quarter with a total of approximately 433,700 customers with more than 10 employees. We added approximately 63,500 of these customers during Q3. Year-over-year, we added approximately 360,000 new customers with more than 10 employees, representing a 485% increase. In Q3, customers with more than 10 employees represented approximately 62% of revenue. We also continue to benefit from significant growth in our segment of customers with 10 or fewer employees, as small businesses and individuals adopted and maintained their Zoom licenses. In Q3, customers with 10 or fewer employees represented approximately 38% of revenue, up from 36% in Q2. Our net dollar expansion for customers with more than 10 employees was over 130% for the 10th consecutive quarter as existing customers continue to support and trust Zoom to be their video communications platform of choice. Both domestic and international markets had strong growth during the quarter. Americas grew over 300% year-over-year. Our combined APAC and EMEA revenue grew 629% year-over-year and was consistent with Q2 at 31% of revenue. We plan to continue to invest in international expansion to capitalize on our brand awareness and the increased global opportunity. Now turning to profitability. The increase in demand and strong execution drove net income profitability from both GAAP and non-GAAP perspectives. I will focus on our non-GAAP results, which exclude stock-based compensation expense and associated payroll taxes, charitable donation of common stock and acquisition-related expenses. Non-GAAP gross margin in the third quarter was 68.2%, compared to 82.9% in Q3 last year and 72.3% last quarter. The impact to our gross margin is partially due to the dramatic increase in usage related to the pandemic, as we are experiencing a higher percentage of free users, including those in over 125,000 K-12 educational institutions that went back to school in the fall. It is also due to the continued higher utilization of public cloud services. We ended the quarter with an annualized run rate of 3.5 trillion meeting minutes, approximately 75% growth quarter-over-quarter. We are thrilled that a significant percentage of the usage was from both paid and free participants in the education sector, as millions of students and teachers returned to the classroom virtually. With the uncertainty of the longevity of the pandemic, it is unclear how long gross margins will be impacted as we remain committed to supporting the global community. Consequently, we expect gross margins to be consistent with Q3 into the next fiscal year before starting to improve towards our long-term target margin. R&D expense in Q3 was approximately $25 million, up 80% year-over-year. As a percentage of total revenue, R&D expense was approximately 3%, which was lower than Q3 last year mainly due to the strong top line growth. We are committed to prioritize R&D hiring to drive further innovation, expansion and security into our platform. Sales and marketing expense for Q3 was $141 million. This reflects an increase of 71% or $59 million over last year primarily due to investments to drive future growth. As a percentage of total revenue, sales and marketing expense was approximately 18%, a decrease from Q3 last year mainly due to strong top line growth and marketing efficiencies from the virtual production of Zoomtopia. We plan to continue to invest in adding sales capacity and marketing programs over the next several quarters to capture market share and to deliver on our growth opportunities. G&A expense in Q3 was $73 million, up 257% on a year-over-year basis as we continued to scale our G&A functions to support a company of our size. As a percentage of total revenue, G&A expense was approximately 9%, a decrease from Q3 last year. The revenue upside in the quarter carried over to the bottom line, with non-GAAP operating income of $291 million exceeding our guidance. This translates to a 37.4% non-GAAP operating margin for the third quarter. This is an increase compared to Q3 last year’s result of 12.8%, and a decrease from Q2 FY21’s margin of 41.7%. Non-GAAP earnings per share in Q3 was $0.99, on approximately 299 million of non-GAAP, weighted average shares outstanding and adjusting for undistributed earnings. This result is $0.25 more than the high end of our guidance and $0.90 higher than Q3 of last year. Turning to the balance sheet, deferred revenue at the end of the quarter was $855 million, up 324% year-over-year. Looking at both our billed and unbilled contracts, our RPO totaled approximately $1.6 billion, up 215% from $517 million year-over-year. The increase in RPO is consistent with the strong demand and execution in the quarter. We expect to recognize approximately 72% or $1.2 billion of the total RPO as revenue over the next 12 months as compared to 64% or $330 million in Q3 last year. We ended Q3 with approximately $1.9 billion in cash, cash equivalents and marketable securities, excluding restricted cash. We had exceptional operating cash flow in Q3 of $412 million, up from $62 million in Q3 last year. Free cash flow was $388 million, up from $55 million in Q3 last year. The increase is attributable to strong billings and collections. For the fourth quarter, we expect to have additional capital expenditures related to the build-out of our data center infrastructure. And as a reminder, we will see the semi-annual cadence of net cash outflows from ESPP purchases to occur in Q4. Now turning to guidance, we’re pleased to raise our outlook for FY21 for both revenue and non-GAAP profitability. And although we remain optimistic on Zoom’s outlook, please note that the impact and extent of the COVID-19 pandemic and its associated economic concerns remain largely unknown. Our higher outlook for FY21 is based on our current perspective of the business environment. For the fourth quarter, we expect revenue to be in the range of $806 million to $811 million. We expect non-GAAP operating income to be in the range of $243 million to $248 million. Our outlook for non-GAAP earnings per share is $0.77 to $0.79 based on approximately 306 million shares outstanding. For the full year of FY21, we expect revenue to be in the range of $2.575 billion to $2.58 billion, which would be approximately 314% year-over-year growth. We expect non-GAAP operating income to be in the range of approximately $865 million to $870 million which would be approximately 876% to 881% year-over-year growth. Our outlook for the non-GAAP earnings per share is $2.85 to $2.87, based on approximately 300 million shares outstanding. In closing, as the world is changing, Zoom is privileged to be a driving force enabling connection and collaboration worldwide with our high-quality, frictionless and secured communications platform. Thank you to the entire Zoom team. With that, let’s open it up for questions. If you’ve not yet enabled your video, please do so now for the interactive portion of this meeting. Matt, please queue up our first question.
Operator, Operator
And our first question is from Phil Winslow with Wells Fargo.
Philip Winslow, Analyst
Hi. Yes. Thanks for taking my question, and congrats on another fabulous quarter. I really want to focus on that customer segment with fewer than 10 employees, obviously, strong again this quarter. Really two questions here that I want to focus on. First, you talked about some initiatives over the past couple of calls to translate more of these customers from monthly to annual contracts. Wondering if you could give us an update on that? And then second question is, I wonder if you could compare and contrast maybe the trends that you're seeing in terms of Zoom Phone attach between these small businesses and then the 10 employee-plus segment?
Kelly Steckelberg, CFO
So in terms of the activities that we're doing to convert those monthly customers to annual, those continue. It's a significant part of the focus of our marketing team, and we have seen movement in that area. It's not something we're going to talk about really specifically, but we're excited about the prospects and people to continue to see the value of Zoom and want to connect to longer-term agreements. So that's great. And then in terms of Zoom Phone, what's great about this, we have seen consistent performance across all segments of the business, all the way from small businesses up to enterprise. In fact, as we continue to see strong performance in Zoom Phone, we once again had our highest deal to date in Q3. So very excited about continuing to see progress there.
Philip Winslow, Analyst
Great. Thanks, Kelly. And once again, thanks for your support of K-12 education. I've been on two Zooms with my daughter’s school over the past few weeks. Thank you for that.
Kelly Steckelberg, CFO
Great. Thank you, Phil.
Tom McCallum, Head of Investor Relations
Next question please, Matt.
Operator, Operator
Our next question is from Bhavan Suri with William Blair.
Bhavan Suri, Analyst
Hey, everyone. I want to reiterate my congratulations. I have two quick questions. First, Kelly, regarding the quarterly linearity, were there any developments in terms of deals? Secondly, as you consider expanding your product offerings, you've developed Zoom Phone, worked on PBX, and ventured into various sectors. I'm curious about the potential for call centers. How do you view that opportunity? Is it something you might consider exploring, or is it too far off the mark?
Kelly Steckelberg, CFO
Yes, great to see you, Bhavan. Thank you. So in terms of Q3 linearity, it was more front-end loaded than our traditional seasonality, especially as we continue to see strength in that customer base with fewer than 10 employees, that many of them are buying online and they're buying via credit card. What we expect to see is, especially as we move into Q4, that we're going to start, and as we move more towards fulfillment through our direct sales channel, that it will be more back-end loaded and more kind of our traditional seasonality that we saw pre-COVID. And then, in terms of call center strategy, we agree with you. The call center contact center is a really important part of the strategy around Zoom Phone. And the way we're approaching that today is through partnerships with many of the great contact center providers that are out there today. And we think that works really well as we have strong integrations with them. And it gives our customers the opportunity to work with the contact center provider of their choice, but to do it with Zoom Phone in a very seamless way.
Bhavan Suri, Analyst
Got it. Thank you.
Kelly Steckelberg, CFO
Yes, thank you.
Operator, Operator
The next question is from Sterling Auty with JPMorgan.
Sterling Auty, Analyst
Yes, thanks. Hi, guys. So Kelly, I want to circle back to the customers with less than 10 employees. And specifically, you made the comment that churn was better than expected in the quarter. Was that attributable to the entire customer base, or specifically to these smaller customers?
Kelly Steckelberg, CFO
Hi, Sterling. Churn was actually better across all segments of the business. So as we – as I mentioned earlier, the marketing team is very focused on trying to convert monthly to annual customers in that fewer than 10 base. But we've also seen even in the upmarket people that are also expanding, continuing to buy more products, which makes them more integrated into the Zoom ecosystem and makes them more retentive. So we saw that across all segments of the business actually.
Sterling Auty, Analyst
Should the under 10% of revenue, the 38% perhaps fall back as you get into that end-of-year budget flush and maybe bigger spend by large enterprise?
Kelly Steckelberg, CFO
We think certainly over time that we will move back towards more of our sales and bookings being dominated by our direct sales channel, which then yes, would ultimately eventually drive down that percentage of revenue from the fewer than 10 employee base.
Sterling Auty, Analyst
Thank you.
Operator, Operator
Next question is from James Fish with Piper Sandler.
James Fish, Analyst
Hey, Kelly. Hope you had a great holiday. I know our focus would be here on Zoom Phone. But just curious on OnZoom, it's still in beta is my understanding. But how has the monetization strategy developed over the last few weeks since Zoomtopia? What commission does Zoom take? And is there any way to think about the size of this business a few years down the road? And if I can squeeze in a second one, additionally, what percentage of revenue this quarter came from the greater than $100,000 customers this quarter?
Kelly Steckelberg, CFO
Okay. Hi, James, great to see you. In terms of OnZoom, yes, it is still in beta at this point. And we have not yet announced what our monetization strategy is around that platform. We've certainly been working on internally, but we're more focused on ensuring that the platform is ready and is meeting the needs of not only the host, but also the customers and making that a really seamless transition or transaction for them. I hope you saw the video, some of the really cool things that are happening on the platform. And if you guys haven't checked it out, just go look, and you can see the classes and events that are happening there. We will announce our monetization strategy probably sometime next year. But in terms of how we're thinking about it, we don't expect it to have a significant contribution to revenue next year. And we're really focusing on building out the platform itself. And then in terms of your second question, that percentage of revenue from customers greater than $100,000, yes, I need to look, sorry, one second. I just need to look and see exactly what that is. Let me come back to you, James. I have it my stuff. Let me come back to you.
James Fish, Analyst
Just have Tom or come back to me later. Sounds good. Thank you.
Operator, Operator
All right. The next question will be from Meta Marshall with Morgan Stanley.
Meta Marshall, Analyst
Hi, thanks. So you noted at Zoomtopia kind of expansion capability or expansion room within the Global 2K, given a lot of room to grow within that customer subset. I just wanted to see how do you feel that you’re staffed to attack that opportunity? Do you feel you’re staffed up to attack the Global 2K? And then maybe just in terms of, you have a pretty meaningful cash balance at this point. There’s meaningful M&A kind of being discussed in the space. How does that change kind of your viewpoint of how you're looking at M&A? Thanks.
Kelly Steckelberg, CFO
Hi, Meta, nice to see you. So certainly, in terms of addressing and how we’re staffed to serve and take share - continue to take share in the Global 2K, international expansion is a huge area of focus for us, and we talked a little bit about this in the past. But with the increase of brand awareness around the globe, it has really created an opportunity for us to hire into markets very quickly, where historically it would have taken us time to see those markets with marketing spend and now we're able to just go in there, because we're seeing tremendous demand. So we're excited about the opportunity. And yes, Abe Smith and our international team are growing very quickly to address that. And then, in terms of cash balance and M&A, we certainly continuously watch for opportunities to do something with that cash, that would be additive. I think we've talked about in the past, we would look for opportunities in M&A that could either extend our technology or our talents. And those are the two areas that we're continuously watching for the right opportunity.
Meta Marshall, Analyst
Thanks.
Tom McCallum, Head of Investor Relations
Hi, this is Tom. Just wanted to point out on the last question that James asked, it is 18% coming from the greater than 100k.
Kelly Steckelberg, CFO
Thank you, Tom.
Operator, Operator
Next question is from Heather Bellini with Goldman Sachs.
Heather Bellini, Analyst
Thank you, Kelly. I have two quick questions. First, regarding chat functionality and team-based chat collaboration, especially since this area has experienced significant growth during the pandemic. What are your thoughts on the competitive dynamics and your ability to compete in this space? Secondly, could you provide an update on Zoom Phone and how many customers you have over 100,000, as I understand you had another strong quarter in terms of additions?
Kelly Steckelberg, CFO
So our chat product is a really important part of our overall product suite, especially when you look at Zoom Phone. It's a very natural tie into it. And as we've seen the expansion in Zoom Phone we've seen customers continue to ask for more features and functionality and we certainly are committed to continuing to develop and innovate around Zoom Chat. And as a reminder, it does come embedded with our meetings product itself. And then in terms of how much Zoom Phone is driving customers greater than 100k, I don't think that we have explicitly called out the number of Zoom Phone customers we have in that specific category. As we said about Zoom Phone metrics, we'll continue to look at opportunities for milestone metrics along the way. And that could be something we would disclose in the future. We just haven't done it yet today.
Heather Bellini, Analyst
Thank you.
Kelly Steckelberg, CFO
Thank you, Heather.
Operator, Operator
Next question is from Siti Panigrahi with Mizuho.
Siti Panigrahi, Analyst
Hi, Kelly. Thanks for taking my question. I was wanting to ask about the sales productivity. You added a lot of salespeople this year. So could you talk about the sales productivity in fiscal Q3, million dollar up market? And what are you assuming in terms of productivity or expense in the up market segment in your fiscal Q4 guidance?
Kelly Steckelberg, CFO
In Q3, we observed strong sales productivity across all segments of the business. However, looking at the results from Q1 to Q2 to Q3, we are seeing a trend toward more normalized rates. As we look ahead to Q4 and into next year, it appears our representatives are returning to pre-COVID sales productivity levels. This is the perspective we have at a high level. We are still working on our FY22 plan, but this is our overarching view.
Siti Panigrahi, Analyst
Great, thank you.
Kelly Steckelberg, CFO
Thanks, Siti.
Operator, Operator
Our next question is from Matt VanVliet with BTIG.
Matthew VanVliet, Analyst
Hi, thanks for taking the question. Can you elaborate a bit more on the international side of the business? How does it differ from what we're seeing in the U.S.? Additionally, are there any markets that have been more challenging to enter due to security or infrastructure issues that are now either being addressed or that you've successfully navigated past to gain entry?
Kelly Steckelberg, CFO
Let me address the second part of your question regarding security and privacy. Our company has dedicated significant effort on a global scale to this area over the past nine months, and our initiatives have clearly been successful. By continuing to invest and establishing teams in local markets, we have made substantial progress in building trust and confidence with our customers. Regarding your question about how the U.S. differs, were you asking about minutes usage?
Matthew VanVliet, Analyst
No, just mix of, are you seeing larger customers, whether it's our customers, are there more kind of individuals there, any differences?
Kelly Steckelberg, CFO
Yes. Again, we've seen strength across all segments internationally. You remember, I think it was last quarter, our largest customer in the quarter was an international customer. So we're really excited about the progress we're continuing to make there.
Matthew VanVliet, Analyst
Thank you.
Kelly Steckelberg, CFO
Thank you, Matt.
Operator, Operator
Our next question is from Will Power with Baird.
Will Power, Analyst
Great, thanks. Yes, Kelly, you noted the really strong usage growth, I guess, sequentially. You cited 75% usage growth. Anyway to kind of help frame how much that was driven by education versus broader verticals. I guess the other way to kind of cut that would be to kind of look at any color, you could provide around, free growth generally versus we're seeing in terms of paid growth. And I've a second question.
Kelly Steckelberg, CFO
So as I said in the prepared remarks, a large percentage of the growth in the usage was from education, but both free and paid. And paid is certainly an elevated percentage of our total usage. Education continues to be one of our strong verticals. It was the second fastest growing vertical again in Q3. So really excited about the progress we continue to make there as well.
Will Power, Analyst
My second question is regarding the record number of 100,000 customers in the quarter, which is fantastic. Can you highlight any key drivers behind this? Were there specific verticals or geographies that were particularly prominent within that large group? Additionally, were there any changes in your go-to-market strategy that contributed to this improvement?
Kelly Steckelberg, CFO
No, I think that it was really diversified across all markets, all segments and all verticals as well. I think it's more about the continued expansion in our sales organization as well as the increased brand awareness. And as companies are continuing to think about the extension of this remote working and ensuring that they are keeping their employees productive as well as safe during this time.
Will Power, Analyst
Thank you.
Operator, Operator
Our next question is from Taz Koujalgi with Guggenheim.
Imtiaz Koujalgi, Analyst
Thanks for taking my question. I had a question on the average deal sizes. If you look at the number of new customers you're adding every quarter that has gone down, which is expected. But can you comment on the average deal sizes for new consumers? Has that changed at all over the last few quarters, the initial land sizes?
Kelly Steckelberg, CFO
We haven't observed any significant change in our overall deal size. The land and expand strategy remains a crucial element of our sales approach, and we are seeing customers actively embracing it. For instance, customers often start with Zoom Meetings and later add additional services, such as Zoom Phone. Two examples of this are Peloton and Rakuten, who expanded their usage after initially signing on. Therefore, there hasn't been a notable shift in the overall deal size, particularly at the beginning.
Imtiaz Koujalgi, Analyst
Thank you.
Operator, Operator
Our next question is from Walter Pritchard with Citi.
Walter Pritchard, Analyst
You mentioned that churn was lower than expected. I'm curious, among the customers who did churn, did you observe any trends or common factors that might help us understand the reasons behind their departure?
Kelly Steckelberg, CFO
No, the churn is somewhat related to the overall pandemic. As we continue to face uncertainty regarding markets and locations due to shutdowns or shelter-in-place orders, we observe variations. The most volatility is found in the segment of customers with 10 or fewer employees. However, even that has improved compared to our initial forecasts. As I mentioned earlier, this improvement is partly due to successful initiatives, particularly converting customers from monthly to annual contracts.
Walter Pritchard, Analyst
Thank you.
Kelly Steckelberg, CFO
Yes.
Operator, Operator
Our next question is from Zane Chrane with Bernstein.
Zane Chrane, Analyst
Hi, Kelly, thanks for taking the time. I was wondering if you could explain to us what portion of business customers are on the active host pricing model versus a named host pricing model? And why do you make that distinction? What does it mean for you in terms of strategy, adoption, overall growth? And then I have a quick follow up.
Kelly Steckelberg, CFO
Sure, hi, Zane. So in terms of the approach, and why we have active hosts versus named hosts is because it allows customers that aren't sure exactly what their uses are going to be, to come in and buy Zoom at a level that feels comfortable to them, and then grow into that. So it's a very effective mechanism for maybe somebody that's newly adopting video communications, or expanding and extending it to a part of their organization that may not have used it before. And it's a great way for them to have the opportunity to assess what that level of usage is going to be. In terms of what percentage comes from that, that's not something that we disclose. It's really a mix, depending on the customer segments, and how those customers want to buy.
Zane Chrane, Analyst
That's helpful. And as far as the customers that are on the active host pricing model, how long is the lag? Or how should we think about the relationship between revenue and usage? Is it a one month lag between monetization versus usage? Is it a quarter? Is it a year? How should we think about that in general?
Kelly Steckelberg, CFO
The active host model is most common among our higher market customers. We are dedicated to ensuring our customers are satisfied, so all terms are negotiable. Typically, a deal would allow them access to a specified number of licenses, for which they would pay a portion in the first year. After that year, we would assess their peak usage of those hosts, which would determine their adjustment for the following year.
Zane Chrane, Analyst
So should we interpret that as meaning customers that have not hit that one year anniversary? Those may be in Q1 or Q2, that have expanded significantly in the last year, we should still see improved monetization of those in Q2, Q3 next year maybe?
Kelly Steckelberg, CFO
There's absolutely the potential in that scenario, that yes, there's a step up for those customers if they've expanded through where we started them in their minimum commitments at the beginning of their contract. Yes.
Zane Chrane, Analyst
Super helpful. Thank you very much and congrats again.
Kelly Steckelberg, CFO
Thanks Zane.
Operator, Operator
Our next question is from Brad Zelnick with Credit Suisse.
Brad Zelnick, Analyst
Great, thank you so much. Hi, Kelly. Hey, Tom. How are you guys doing?
Kelly Steckelberg, CFO
Hi, Brad. I'm good. How are you?
Brad Zelnick, Analyst
Thank you. I appreciate the congratulations. I have a follow-up question regarding growth in different regions. It appears that growth is strong overall, but EMEA only saw 5% sequential growth. Can you explain why this region might be experiencing weaker performance compared to the Americas or Asia-Pacific?
Kelly Steckelberg, CFO
No, nothing significant there to call out. Some of these regions are just impacted by larger deals in the quarter, and otherwise nothing significant really happening that's of note. Again, some of the growth across these regions is dependent upon where these markets are from the pandemic sort of cycle. And if you look back to Q3, I think at the beginning of Q3, Europe was in a very optimistic situation. And unfortunately, we've seen sort of some of that reverting as we've gotten to the back half of Q3. So it's a little bit variable with what's happening in the overall pandemic itself.
Brad Zelnick, Analyst
Great. If I could throw in a follow-up for you, just on the channel strategy, any updates that you can share? What's the measure of success there? And how are you performing against that?
Kelly Steckelberg, CFO
Yes. The channel remains a crucial aspect of our long-term strategy, particularly in international markets and with Zoom Phone. One of the ways we evaluate its effectiveness internally is by examining the percentage of revenue generated through the channel. While we haven't publicly disclosed this figure in a while, it may be something we consider for potential announcement in the future.
Brad Zelnick, Analyst
Great, thank you so much for taking the question.
Kelly Steckelberg, CFO
Thank you, Brad.
Operator, Operator
Up next we have Richard Valera with Needham. Hey Richard, can you unmute?
Richard Valera, Analyst
Sorry about that. Sorry. Hi, Kelly. Sorry about that.
Kelly Steckelberg, CFO
Hey, Rich.
Richard Valera, Analyst
Yes, so question on operating margins. You looked like this quarter, you finally started to see expenses catching up with revenue. And you had that expected decline in op margin. You’re guiding for another one in the fourth quarter. I think last quarter, you said you expected several quarters of decreasing operating margins. And I know that kind of takes us into fiscal ‘21. Can you talk about how you think about that trajectory of expenses versus revenue and op margins for the next few quarters?
Kelly Steckelberg, CFO
Yes, we plan to continue investing in R&D, which is a key area of focus for us, aiming for hiring at 3% of revenue. We would like to align that closer to our long-term target margin of 8% to 10%. Additionally, we are concentrating on increasing our sales capacity and slightly increasing our marketing expenditures to promote Zoom Phone and other new products like OnZoom. These are the main areas where we intend to invest. Over the long term, you should anticipate a gradual decrease in our operating margins.
Richard Valera, Analyst
Got it, just a quick follow up, if I could on phone. You've added a lot of functionality to that product over its short lifetime. And I guess most recently really expanded the international footprint. Where are you now in terms of where you want that product to be? And where you need to be competitively? Are there any major outstanding features or functionality you think you need to add to phone to complete it?
Kelly Steckelberg, CFO
Yes, we think we're very well situated from a competitive feature and functionality perspective. And as you said, we announced last quarter that we're in 44 markets from a native Zoom Phone deployment perspective. So really feel great about the progress we've made around that and are excited about the continued progress that we're seeing in Phone.
Richard Valera, Analyst
Great. Thanks, Kelly.
Kelly Steckelberg, CFO
Yes, thank you.
Operator, Operator
Our next question is from Rishi Jaluria with DA Davidson.
Rishi Jaluria, Analyst
Hey, Kelly, I appreciate you taking my questions. It's great to see the ongoing strength in the business. I wanted to revisit the topic of gross margins. The decision to allow free users makes a lot of sense, particularly since you're supporting K-12 education. Additionally, the customer-friendly initiatives, like lifting the free limits over Thanksgiving, are commendable. Can you help clarify what kind of impact this has? Since you're discussing this impact as we move into next year, is there a point where it would be beneficial to analyze the costs linked to free customers? Also, on the topic of Zoom Phone, sorry if you've already addressed this, but how many new Zoom Phone seats were added during the quarter? Thanks.
Kelly Steckelberg, CFO
Hi, Rishi, thank you as well. Regarding the gross margin, we are also looking ahead to the holidays like Thanksgiving, and we are very excited about the opportunities it presents. Currently, we are not ready to change our outlook on the gross margin, and for the foreseeable future, you should expect it to remain within this range for at least several quarters before it gradually begins to approach our long-term target again. As for breaking out the free segment, we do not intend to do that. We highly value our free customers and hosts, as they play a crucial role in our ecosystem. If they weren’t factored into our gross margin, they would instead contribute to our sales and marketing expenses. This is simply how we have chosen to structure our go-to-market strategy, and this explains the differences you might notice in spending across various functions compared to other companies.
Rishi Jaluria, Analyst
Thank you. I'm sorry, just in terms of Zoom Phone seats out in the quarter, did you…?
Kelly Steckelberg, CFO
Sorry, we don't disclose the exact number of seats added in any quarter. However, I can tell you that we achieved the largest deal to date in Q3 along with other record-setting deals, which is very exciting.
Rishi Jaluria, Analyst
Wonderful. Thank you, Kelly.
Operator, Operator
The next question is from Alex Zukin with RBC.
Alex Zukin, Analyst
Hello, Kelly and Tom. Thank you for taking my question, and congratulations on a strong quarter. Kelly, we haven't discussed much about next year. I understand you're not providing guidance for that period. However, I'm sure you can appreciate the frequent inquiry from investors regarding how Zoom will grow after the pandemic. Are we seeing a pull forward? As people return to work and school, will they reduce their use of Zoom? Considering the remarks you've made concerning the churn rate for the business being better than anticipated and the details about Zoom Phone attachments, I'm not seeking specific guidance but would appreciate a high-level perspective on how to calibrate growth for next year. Will it lean more towards churn or Zoom Phone attachments? Any insights you could offer would be very helpful.
Kelly Steckelberg, CFO
I believe there are a few important points to consider. Firstly, the trends in remote work that began before the pandemic have certainly picked up speed. While we all look forward to a vaccine, remote work seems to be a lasting change. We are excited about the new features and functionalities we announced at Zoomtopia, which are designed to support customers and employees who may be returning to work in a hybrid environment. For instance, Smart Gallery aims to enhance communication between employees working from home and those in the office. We are committed to facilitating such an environment, especially for our larger clients who want to offer flexibility to their employees. Regarding key growth drivers, Zoom Phone is certainly a major factor for the upcoming year, having been our fastest-growing product in Q3. The momentum is encouraging, and considering the large customer base of Zoom meetings that we built in the first three quarters, we anticipate these customers will help drive our strategy of upselling within our existing base. We fully expect this to be a significant growth contributor next year.
Alex Zukin, Analyst
As a follow-up, Kelly, regarding churn, could you discuss the churn rates among different cohorts, particularly the consumer cohort? What assumptions do you have for Q4, especially as we transition into a vaccine-led world? Although you'll provide guidance, there may still be some global engagement trends from regions currently at different stages of the pandemic. What will give you confidence in your churn assumptions for next year?
Kelly Steckelberg, CFO
We are taking a cautious approach since we cannot predict the pandemic. We expect that churn in the mass market, specifically among customers with fewer than 10 users, will remain higher than both pre-pandemic levels and significantly higher than our upmarket segment. Overall, our relative assumptions remain unchanged, but we have noticed slight improvements compared to our previous expectations. This is likely due to various factors we have discussed, such as customers recognizing the value of Zoom and adapting to remote work, as well as our efforts to demonstrate that value and encourage transitions from monthly to annual subscriptions.
Alex Zukin, Analyst
Great, thank you so much. Stay safe.
Kelly Steckelberg, CFO
Thank you, Alex. Thank you, you too.
Operator, Operator
Our next question is from Ryan Koontz with Rosenblatt Securities.
Ryan Koontz, Analyst
Hi, great. Thanks for the question. Can you expand a little bit in your relationship with the Lumen Technologies, former CenturyLink, a little bit there? And do you envision that’s something that you would expand the DSP market, potential channel relationships? How do you frame that up? Thank you.
Kelly Steckelberg, CFO
Yes, as I mentioned earlier, the channel remains a key focus and presents an opportunity for growth for us. We don't discuss specific relationships because we value all of our channel partners equally. However, this is certainly an area that will drive growth for next year.
Ryan Koontz, Analyst
Helpful, thank you.
Kelly Steckelberg, CFO
Yes.
Operator, Operator
Our next question is from Tom Roderick with Stifel.
Tom Roderick, Analyst
Thank you, Matt. Hi, Kelly, it's great to see you. I appreciate you taking the time for this discussion. I want to revisit a previous question regarding operating margin and leverage in our model, particularly in relation to our investments in sales and marketing, which we all understand. It's noteworthy to see that R&D spending has decreased sequentially, especially given the various advancements and enhancements we have made to our product. Could you elaborate on the structural aspects of R&D? How much more investment is needed specifically for Zoom Phone? We’ve observed significant developments in those numbers. Also, as we consider structure and geography, does R&D naturally increase over time as we expand into different regions? Please help us understand this as we look ahead to next year.
Kelly Steckelberg, CFO
Yes, sure. So in terms of the dollar decrease that you mentioned, from Q2 to Q3, that's due to the fact that there was a pretty significant consulting agreement in Q2, related to continuing to build out security and privacy on the platform. And that's why you see that decrease from a dollar perspective, quarter-over-quarter. And then long term, our target R&D is to be 10%-ish. That's really where we want that level of investment to be. And your point is exactly right. It will start to increase naturally, as we diversify our talent pool, in terms of geographic locations and hiring. We’re really focused on hiring the best talent wherever they are. And working remotely has really enabled us to do that and define great talent in multiple locations in the U.S., and also continuing to expand as we've talked about previously in India, as well. So all of that will help us not only increase our spending, as it diversifies our talent pool and opportunity for hiring, but also to give us this 24/7, follow the sun development approach as well.
Tom Roderick, Analyst
Yes, and I'm glad you mentioned the consulting agreement. So just really quickly as a follow-up, I mean, you got the end to end encryption really, quite quickly. What's been the feedback from corporate clients on that? And how has the performance of the overall system held up relative to keeping that an option for all customers out there and not just paying?
Kelly Steckelberg, CFO
Yes, to clarify, it is currently available for all free and paid customers with up to 200 participants in their meetings. We are in a state of general availability but still in technical review. We are gathering feedback from our customers, which has mostly been positive so far. We haven't observed any impacts that would suggest a need to change our go-to-market strategy for this.
Tom Roderick, Analyst
Great. Congratulations. Thank you.
Kelly Steckelberg, CFO
Thank you. Thank you, Tom.
Operator, Operator
Our next question is from Ittia Kidron with Oppenheimer.
Ittia Kidron, Analyst
Thanks, Kelly. Great results. I have a clarification and a question regarding Alex's inquiry about churn. I want to confirm your assumptions about churn heading into the fourth quarter. Are you maintaining the same assumptions as you did for the third quarter, or are you using the actual churn data from the third quarter? Additionally, I'd like to ask about the Federal vertical. You held the roll in September, which falls into your October quarter. How did that perform, and what does the pipeline look like for that vertical moving forward?
Kelly Steckelberg, CFO
Yes. As we look towards Q4, we believe our churn assumptions will remain consistent with our initial thoughts entering Q3, without expecting the same level of improvement that occurred in Q3. Regarding our verticals for Q4, I previously mentioned that education has been one of our fastest growing sectors, while government emerged as the strongest growing sector quarter-over-quarter in Q3. We are thrilled with the progress that team is making.
Ittia Kidron, Analyst
That's great. Thanks.
Kelly Steckelberg, CFO
Yes, thank you, Ittia.
Operator, Operator
Our next question is from Shelby Seyrafi with FBN Securities. Hey, Shelby, are you there?
Shelby Seyrafi, Analyst
Can you hear me?
Operator, Operator
Yes, here we go.
Kelly Steckelberg, CFO
There you are, hi, Shelby.
Shelby Seyrafi, Analyst
Yes, hi. So on the gross margin, which was pressured in Q3, and you're lowering the outlook for the near term. Was the bigger factor, the free usage or the public cloud increase?
Kelly Steckelberg, CFO
They are both having about the same impact honestly. It's a pretty comparable split between the two.
Shelby Seyrafi, Analyst
Okay. And the second one I have for you, is we're in the middle of a brutal second wave. And obviously, last time when the first wave hit, you guys benefited a lot. So I'm just trying to see if, over the past month or two, you've seen some inflection point higher than the typical trend over the past six months, because of the second wave?
Kelly Steckelberg, CFO
I wouldn't say that we've seen an inflection point like we experienced in Q1.
Shelby Seyrafi, Analyst
No, I know that, but just slightly higher, because of the second wave, any kind of positive effect.
Kelly Steckelberg, CFO
It's really early. I think that however you're characterizing when the second wave is occurring, some of that will fall into the fourth quarter. Therefore, that will be reflected in the guidance we just provided regarding the current business environment based on our understanding of the pandemic.
Shelby Seyrafi, Analyst
Okay, thanks a lot.
Kelly Steckelberg, CFO
Yes.
Operator, Operator
All right. We have time for one more question. So our last question is from Ryan McWilliams with Stephens.
Ryan MacWilliams, Analyst
Hey, Kelly. Thanks, guys for squeezing me in once again.
Kelly Steckelberg, CFO
Hey, Ryan.
Ryan MacWilliams, Analyst
One thing we haven't talked about recently is Zoom Rooms, and maybe I'm taking an optimistic approach here. But hopefully as things return to normal into next year, are you seeing enterprises starting discussions now about rationalizing their office footprint and video enabling more Zoom Rooms, and just talk about how that's changing? Thanks.
Kelly Steckelberg, CFO
Yes, we are seeing customers taking advantage of this time while their offices are vacant to update or install Zoom Rooms. They are considering how this will function in a potential hybrid environment and how to foster inclusivity with a workforce divided between remote and in-office employees. This is why I’m particularly excited about Smart Gallery, which will enhance the experience and support the democratization of communication that has emerged while we've been working from home. With all participants appearing equally on the screen, Smart Gallery will help companies maintain that support for their remote workers when we eventually return to some form of hybrid work.
Ryan MacWilliams, Analyst
Thanks for taking the question. Congrats on the results.
Kelly Steckelberg, CFO
Yes, thank you, Ryan.
Operator, Operator
That was our last question for today.
Kelly Steckelberg, CFO
Okay. Thank you, Matt. And thank you all so much for joining us. We appreciate your support during Q3, and thank you again to all of our Zoom employees that made our quarter possible.
Tom McCallum, Head of Investor Relations
Thank you, everyone.