Zoom Video Communications, Inc. $ZM Q3 2023 Earnings Call

Thank you, Eric. Let me now turn to the quarter's results and guidance. In Q3, total revenue came in at $1.102 billion, up 5% year-over-year and 7% in constant currency. This result was approximately $2 million above the high end of our quarterly guidance. The growth in revenue was primarily driven by strength in our Enterprise business, which grew 20% year over year and represented 56% of total revenue, up from 49% a year ago. We expect Enterprise customers to comprise an increasingly higher percentage of total revenue over time. From a product perspective, we had strong growth in Zoom Phone, coupled with contributions from Zoom Rooms and other products. At Investor Day earlier this month, we introduced a new metric, online average monthly churn. In Q3, this metric continued to improve to 3.1% from 3.7% in Q3 of FY '22 and 3.6% last quarter. We are pleased this metric has now returned to pre-pandemic levels. The number of Enterprise customers grew 14% year over year to approximately 209,300. Our trailing 12-month net dollar expansion rate for Enterprise customers in Q3 came in at a healthy 117%. We saw 31% year-over-year growth in the upmarket as we ended the quarter with 3,286 customers contributing more than $100,000 in trailing 12 months revenue. These customers represent 27% of revenue, up from 22% in Q3 of FY '22. Our Americas revenue grew 11% year over year. EMEA continues to be impacted by the stronger dollar, the Russia-Ukraine war, and online performance, which combined led to a decline of 9% year over year. APAC, which was also impacted by the stronger dollar, declined 3% year over year. Now turning to profitability. I will focus on our non-GAAP results, which exclude stock-based compensation expense and associated payroll taxes, acquisition-related expenses, net litigation settlement, net gains or losses on strategic investments, undistributed earnings attributable to participating securities, and all associated tax effects. Non-GAAP gross margin in Q3 was 79.5%, an improvement from 76% in Q3 of last year and 78.9% last quarter. The sequential improvement was mainly due to optimizing usage across the public cloud and our increasing number of co-located data centers. Given this, we expect our full year gross margin to be approximately 79%. Research and development expense grew by 59% year over year to approximately $108 million. As a percentage of total revenue, R&D expense increased to 9.8% from 6.4% in Q3 of last year. This reflects our ongoing investments in expanding Zoom's product portfolio and delivering on our customers' evolving needs. We expect to exit the year in the range of 10% to 12% of total revenue, consistent with our long-term target. Sales and marketing expense grew by 27% year-over-year to $301 million. This represented approximately 27.3% of total revenue, up from 22.6% in Q3 of last year. We continue to invest judiciously in sales capacity and channel partner expansion. G&A expense grew by 6% to $87 million, or approximately 7.9% of total revenue, in line with 7.8% in Q3 of last year. Non-GAAP operating income was $381 million, exceeding the high end of our guidance of $330 million, as we continue to thoughtfully prioritize investments. This translates to a 34.6% non-GAAP operating margin for Q3, as compared to 39.1% in Q3 of last year. Non-GAAP diluted earnings per share in Q3 was $1.07, 24 cents above the high end of our guidance. Due to our share repurchase programs, our Q3 weighted average share count has decreased year over year approximately 4 million shares to 302 million. Turning to the balance sheet. Deferred revenue at the end of the period was $1.4 billion, up 14% year over year from $1.2 billion. Looking at both our billed and unbilled contracts, our RPO totaled approximately $3.2 billion, up 32% year over year from $2.5 billion. We expect to recognize approximately 59% of the total RPO as revenue over the next 12 months, as compared to 67% in Q3 of last year, reflecting the trend towards longer-term contracts. As a reminder, our annual seasonality of renewals is front-end loaded and moderates over the rest of the year, reflecting the sequentially smaller renewal base. As such, we expect Q4 deferred revenue to grow at approximately 2% to 3% year over year. We ended the quarter with approximately $5.2 billion in cash, cash equivalents, and marketable securities, excluding restricted cash. Year to date, we have repurchased $991 million of our own stock, representing approximately 11 million shares. We had operating cash flow in the quarter of $295 million, as compared to $395 million in Q3 of last year. Free cash flow was $273 million, as compared to $375 million in Q3 of last year. Our margins for operating cash flow and free cash flow were 26.8% and 24.7%, respectively. As previously discussed, this year we have seen larger cash outflows from increasing cash taxes starting in Q2, which relates to the depletion of our NOL and the lower tax deductions for stock-based compensation caused by the stock price decline. We now expect free cash flow to be at the high end of our range of $1 billion to $1.15 billion. As a reminder, our range assumes that the Section 174 tax legislation requiring capitalization of R&D expenses will be repealed or deferred by Congress by the end of this fiscal year. Now turning to guidance. This outlook is consistent with what we are observing in the market today. Specifically, it assumes that our Enterprise business will grow in the low to mid 20s, while our online business will decline approximately 8% for the year. For the fourth quarter of FY '23, we expect revenue to be in the range of $1.095 to $1.105 billion, which at the midpoint would represent approximately 3% year-over-year growth, or 5% in constant currency. We expect non-GAAP operating income to be in the range of $316 to $326 million. Our outlook for non-GAAP earnings per share is $0.75 to $0.78, based on approximately 301 million shares outstanding. For the full year of FY '23, we now expect revenue to be in the range of $4.37 to $4.38 billion, which at the midpoint represents approximately 7% year-over-year growth, or 8.5% in constant currency. This represents a decrease of $15 million from our previous full-year guidance, of which approximately $14 million is attributable to the FX pressure in Q3 and Q4. We now expect our non-GAAP operating income to be in the range of $1.49 to $1.5 billion, representing a non-GAAP operating margin of approximately 34%. This is an increase of $50 million, or 1%, respectively, as compared to our Q2 guidance. Our tax rate is expected to approximate the blended U.S. federal and state rate. Our outlook for non-GAAP earnings per share is $3.91 to $3.94, based on approximately 304 million shares outstanding. Zoom remains focused on thoughtfully balancing growth and profitability through platform innovation, customer value creation, and partner ecosystem expansion. Thank you to the Zoom team, our customers, our community, and our investors. Kelsey, please queue up our first question.

Yeah, so as we shared at Analyst Day a few weeks ago, we're really happy with the continued improvement in the churn first of all, and I think it improved even further in Q3. And the fact that now 70% of those cohorts have moved beyond that 16-month period in which they really see stabilization, we've continued to see that happen. Wendy and her team are really focused on continuing to look at initiatives for conversion. Those include things like adding local currencies, adding local payment types, as well as looking at packages that make sense. So all of that is still in process. And what we're thinking, and we had talked about before, is we expect online to stabilize from a dollar perspective in Q2 of next year, and based on our most recent forecast, that is still the case.

Yeah, so we continue to see strength in Zoom Phone. As a reminder, we announced on the last call that we had crossed over the 4 million seat mark. We also added nine customers in Q3 that have purchased over 10,000 seats, and that brings us to a total of 64 customers in that category. So I think it shows continued strength, especially in the upmarket, even in these challenging economic times. So we're excited about the prospects that we continue to see there, and as we keep promising you all, we'll break it out when it gets to 10% of revenue, so you'll be able to see that then a little more clearly.

Yeah, so as a reminder, this occurred due to the significant increase of customers we had during Q1 in the early stages of the pandemic. And what has happened is, due to the practice that we have internally of making it easy for our customers, we co-term when they add on additional products or expand their seat count, for example. So it's continued to actually exacerbate, if you will, when we're upselling customers that front-end loaded phenomenon. So it will start to level out over time as we see customers in Q2 and Q4 being our largest seasonal quarters due to the six-month quotas of our upmarket reps. But as you say, we are used to it now. Internally, everybody knows this is how it works. We're coming into, I guess, our third renewal period, and we've seen strength in each of the last two cycles. So we're able to accommodate, we know how it works, and it's just something we know that it's not aligned with most of the rest of the industry, which is why we keep reminding you and trying to give you as much color as possible around that.

Thank you so much, Eric. And Kash, just in terms of your comment about renewals, I want to highlight especially in the Enterprise, renewals remain very, very strong. We were actually slightly ahead of our internal forecast for Q3. So we continue to see, we've talked about many metrics, growth and expansion in the Enterprise. It's just, as you say, we're waiting for that stabilization in online too, because right now it's really having a dampening effect on the overall growth rate of the company.

So we certainly have seen impact, as I mentioned, from FX. Of the reduced guidance of $15 million, $14 million of that is coming from FX pressure, and you saw that certainly in our year-over-year growth in Europe and in APAC. In the Enterprise, again, renewals stay strong, excitement about the products, but as we discussed, it's continued in terms of additional deals scrutiny. I think all of my peer CFOs now are looking at deals, and that's just causing elongation in general. Not that we're losing deals, they're just taking longer to get done, and potentially some of them pushing over quarters. But we haven't seen that have a big impact, it's just taking longer and longer. Not that they're going anywhere else, it's just taking longer to get those done. Now the good news is, especially with all the new products, the consolidation that we offer is a really great value story for our customers in terms of elimination of additional vendors, getting rid of on-prem servers, and that continues to be a great story that our customers love.

Yeah, so we've certainly talked about this the last couple of quarters. We've seen more and more of our deals just into the end of the quarter and taking on that more historically natural cycle that we haven't seen since really early in the pandemic.

But that is absolutely the case for us, and we have adjusted our forecast for Q4 for some of that linearity as well. We have continued to see, as I keep saying, strength in our renewals. I think that's because while there's concern about layoffs, there's this other phenomenon about flexible work. Everybody wants to continue working in the way they've become accustomed to, and as long as employers are supporting that and their employees, it really means everybody needs a Zoom license. If you're out of the office even one day a week, you need that Zoom license for phone, for meetings, for whatever Zoom One. I think that is really a compelling reason for organizations to continue to renew with Zoom.

So first, we believe that the supplemental grant program is really important for the strategy of the company in terms of retaining our employees and keeping them focused and not having to worry about that. The supplemental grants vest over the same period as the underlying grant that they're tied to, so you are going to see this level continue for a few years as those grants are vesting through. Many of them originally were four-year grants, so they have two or three years left in which you're going to see that stock-based comp as those underlying shares are vesting with the stock. If once the stock stabilizes, then you will see less impact or less need for additional grants. So we're hoping that we're at that place and that you're not going to see additional supplemental grants at that same level, but until we get past probably another year's worth, we might have some more. In terms of the repurchase, as you heard, we purchased $991 million, or 11 million shares, so we have a little bit of room with that. Once we've completed that, we'll evaluate whether or not we want to ask the board for authorization. We haven't done that yet.

Yeah, so we've talked about this before. Our online business is a higher margin business as it's largely, not completely, but largely untouched by any person from a sales organization. There are some online account executives that are there to answer questions, but it's minimal compared to our Enterprise sales organization. So we've certainly done a lot of work on modeling what that looks like, and we've taken that into consideration as we laid out our long-term margins that we shared with you at Analyst Day as we looked forward for the next several years and how we think the mix could shift between the online and Enterprise businesses.

Yeah, hi, yeah.

So yes, the answer is yes. There are customers that eventually upsell into Enterprise, which is great because that means they're expanding and they're becoming a bigger customer overall, which we love to see. But that does then, it's not company term, but it looks like it's moving out of the online business into the Enterprise. And in terms of the way we're talking about it, it is a stabilization of online, and we expect that from a dollar perspective to still happen in Q2 of next year based on our current forecast that we're seeing.

So Eric, I know you love to talk about Zoom One. Do you want to talk about it for a second?

And thank you, Eric. I would just add to that that the key customer wins that we saw in Zoom One in Q3 were a pretty balanced mix of new as well as customers that are upselling as they're adding new products to their portfolio. So we're really happy about that. We're seeing traction in both aspects of the business.

Yeah, so the current RPO pressure is largely related to the online customers and the decline that you're seeing in online. The long-term RPO really benefits from the direct or the Enterprise side of our business, which are managed by the direct business and have more annual and multi-year contracts. That's kind of why you see that shift in terms of the overall percentage. I would say, and then the other impact that we're having that is difficult to predict, of course, is FX, right? So you have to consider that, which is more concentrated online than in Enterprise. But you heard in our guidance that we reduced, we said about $14 million of that we believe to be attributable to FX in general. I would say the economics or the state of our business hasn't changed. Our Enterprise business and our Enterprise sales organization is stable. They're continuing to operate in the same way. The online business with the improvement in churn, as well as the way that the majority of it now has shifted out along the fifth beyond the 15 months, is really helpful in terms of our ability to forecast that business. So I think the visibility is the same. There's just some different reasons for all those different components that you're talking about. The deferred is again, the decline you're seeing in Q4 is really due to the front-end loaded nature of our business. The renewals happen at the front end of the year. That's where you're going to see the upswing in billings, the upswing in deferred, and then it gets amortized over the year. So deferred is coming down, and then we have much lower renewals in Q4 as well. The renewals that are filling up the bucket are much, much smaller. So you mentioned very many factors, and there's different reasons for all of those.

Yeah, so first of all, remember our strategy for selling Zoom Phone is selling into the existing install base. So I don't know actually the split between those nine, but I'm sure that the majority of those were existing Zoom customers. And I think there's a focus on the company that, as Eric has talked about, of expanding not just phone, right, but expanding to the full platform. So that's really what we have our team focusing on now. It's Zoom One, it's Contact Center, it's Zoom IQ for Sales now, it's Email and Calendar, and really thinking about that complete platform including Team Chat and the adoption within organization. So for all the reasons we've been talking about in terms of retention, flexibility for organizations to reduce vendors, the cost savings, the total cost of ownership that they see by having that combined, for all of those reasons, that's really becoming the focus of our Enterprise sales organization.

So Eric, do you want to talk about the platform and the value they see?

And just in terms of inorganic opportunities, if we can elaborate on that. Sure, so we continue every day to look at opportunities, and yes, the compression in valuations certainly is not lost on us. What we're always trying to balance, of course, is what would it bring to our customers, what would it bring or the impact potentially on our culture, and then of course the value and the state of the technology. We have a high bar for both talent and technology here at Zoom, so it's been difficult, I would say, today to find something that really meets all of those standards. Eric is a very hard judge, but that doesn't mean that we're stopping, and we continue to look for opportunities every day.

So, I think that your assessment, we're not giving FY24 guidance on this call, we will do that obviously at the Q4 call, but your assessment in the way you're kind of thinking about the top-line growth is right in line with how we're thinking about it right now. And in terms of from an operating margin perspective, the way we're thinking about it is, as we're working on our FY24 plan, we are being very, very thoughtful about prioritization of investments. That's how I would say it. As you noted, we have grown our expenses and we've hired a lot this year, and so being very thoughtful about ensuring that they're focused on the right things, that we are prioritized internally. We are committed to continuing on innovation and meeting our customers' needs, as well as go-to-market expansion. Those are really the top priorities that we have, and making sure that we have resources in the right areas for that. I guess that's what I would say.

Yeah, so we think based on the share purchase program that we currently have in place, we've done a good job of being able to offset the dilution from the supplemental shares. We want to be very thoughtful about our cash flows. We just talked about M&A, for example. So especially as we're focusing on our FY24 plan, we're balancing the opportunity for managing dilution as well as earnings on that cash and M&A opportunities. So all of those are being considered as we look forward for FY24, and that's really what we have to say today. We'll have more to talk about when we come back for the Q4 call.

Yeah, so really happy with the progress we've seen with Zoom One, with Zoom Phone, and the strength in Zoom Rooms in Q3. We also certainly see potential in Contact Center and Sales IQ. They're just so early, you know, we're seeing progress there and excitement, but it's early stages. In terms of what they're contributing overall to the dollar amount, it's minimal at this point, but we are seeing growth in terms of quarter-over-quarter expansion in those products, so that's really exciting to see.

So yeah, Todd, Catherine's referring to Todd who joined us a couple quarters ago. He's great. At Zootopia, he hosted our first Partner Connect with over 400 partners there, so that was super exciting to see. And while there are lots of opportunities, I think one of the biggest areas of opportunity is international partner expansion. We've done a good job over the last few years of building up master agent and carriers here in the U.S., but it's still relatively nascent outside the U.S., so that will be a big area of focus for sure.

Yeah, so in terms of our reps, we are constantly looking at opportunities to help make them more productive. As we were just talking about, we've hired a lot over the last few years, and as we look forward to FY24, we'll be making many fewer hires. So we're really looking for how do we enable the reps, how do we make sure that we have the right overlay teams in the right places to support them. As a reminder, we have specialists that are selling Contact Center and Phone, and that's a really important aspect of making sure that everybody is aligned on serving our customers in the best way possible, so that is a big focus. We also have a new president, Greg Tom, that you all met last quarter, and he's been spending a lot of time helping us think about that, especially as we're moving up in the Enterprise stack, and that's his experience, his background. And really focusing on making sure that our comp plans align. That's another thing that we're taking a look at for FY24 as well.

Yeah, I think it's very similar to Zoom meeting licenses in the aspect of as long as you have a hybrid workforce, you need the right technology in your conference rooms to ensure that you have this inclusive experience that we've all become so accustomed to. And we continue to listen to our customers and work on innovations to ensure that we provide that. But I don't think it's going to go away. We'll see what happens with commercial real estate, however, Zoom Rooms and the importance of those in a hybrid workforce, I just can't stress enough the importance of that. And that's really what our customers are seeing as well as they're in some sort of state of a hybrid work environment.

Yeah, so in the online segment of the business for Q4, we expect churn to be pretty much in line with Q3. It's likely that number is going to bounce around a little bit quarter to quarter, and that's going to all be visible to you now as we report it, but we're not forecasting any dramatic changes there. And then in the Enterprise segment, I would say the biggest change that we're seeing is just continued push of deals to the back end of the quarter. So that linearity, over the last few years we had a much more balanced linearity in our Enterprise segment, and what that leads to, of course, is deals contributing to revenue in the quarter, and we're seeing much less of that as these deals are going back to the more traditional back end, really back end of the quarter. Now we have the benefit in Q4 of having kind of the two periods of December 31st close and then the January 31st close, but we are expecting the linearity more consistent with what we've seen in Q3 than what we saw a year ago.

Carl, I should have said this earlier. As a reminder, we don't guide to billings. We never have because we don't think that they are a good indicator for us because of the large percentage of our customers, especially in the online segment of the business, that are on monthly contracts. And so because they bill and they pay us monthly, they don't show up in that number, and that's why it isn't really a good proxy for you to use.

Nothing significant. It's really the timing. The deferred revenue specifically is really about the seasonality of the renewals. I can't stress that enough for everybody. Remember, it's the two factors. It's the fact that they bill in Q1, and then so you're going to see an uptick in billings and deferreds and collections, and then that amortizes over time. And then the billings in Q4 are just a lot smaller, so you have this double impact of now you've amortized a lot of the deferred that was picked up in Q1, so we're down at the lowest period in Q4, and the billings in Q4 are the lightest period to refill that bucket. So this is going to be a phenomenon that we're going to see for years to come, as I talked about, until over time we start to see more and more of our bookings happening in Q4, but that's going to take a long time.