Can Zoom Press a Reset Button?

The Background

Zoom Video Communications Inc. (Nasdaq: ZM) has a great story to tell as an enterprise software company. From FY 2020 through FY 2022, revenue exploded from $623 million to $4.1 billion. This growth trajectory was driven by the unexpected global CoVid-19 pandemic and its mandated quarantines, which led to employees working from home and students being educated via remote learning. This unprecedented quarterly growth progression, magnified by much higher relative valuations for cloud computing companies, led to Zoom's shares hitting $539 per share on 10/27/2020. This share price level was unhinged from any kind of rational financial calculus, but Wall Street analysts, bankers and company managements were not complaining.

By late October 2022, Zoom management had consistently lowered or missed expectations to the point where the balance of the current fiscal year is a non-event. The share price is above its 52 week low of $70.44, yet the story has no cheerleaders. To see how mealy mouthed analysts have become, J.P. Morgan’s analyst has resumed coverage of Zoom with a Neutral rating and an $85 price target, having previously had an Overweight rating and a $295 price target![1] Yet, the analyst likes Zoom's technology, but thinks that corporate customers may be reluctant to renew contracts.

The analyst team at Canaccord Genuity Capital Markets have published their quarterly review of Enterprise Software[2] The analyst whose coverage should include Zoom, does not have it listed in his coverage.?The analyst does like Salesforce, Service Now, Atlassian, and Five 9. The market capitalization of these companies ranges from $161 billion to $4 billion. Service Now and Atlassian were announced by Zoom as new logos a while back; Five 9 was an acquisition target, and the company has just had a CEO transition. Surely Zoom at least deserves a place on the coverage list. What can be done by management to refocus the value creation story and to make the stock appealing to a wider group of institutional investors than cloud index funds and momentum-driven traders?

In addition to Zoom's own growth flattening, those higher relative multiples on cloud computing have compressed. As the tech sector always does, the magic of cloud computing and 'digitization' have been oversold, and their costs have increased sharply; company CIOs are struggling to understand all the things they have moved to the cloud, from commodity functions like storage to corporate workflows, and the recurring costs associated with different vendors. Zoom cannot change this kind of macroeconomic or financial market sentiment, but a good sales and customer service organization can help the customer to buy better and to maximize the benefits of Zoom integrations. A sale should just be the introduction to a long, mutually beneficial relationship.

Low Expectations Are The Perfect Time for a Reset

Expectations for Zoom’s share price performance are at ocean floor bottom. In my experience sitting in a public CFO’s chair, a public board member’s chair, and having heard many hundred quarterly calls from companies over the years, this is a great opportunity to re-examine the business model, the size and structure of the organization, its go-to-market game plan, and its philosophy of communications.?A game developer noted that he liked video games because you can always press a Reset button, whereas life has no such option. However, markets do offer cover for a Reset opportunity when expectations are very low.

Zoom Has Some Key Distinctions From Other Fast Growers

Zoom Founder Eric Yuan developed Zoom’s software product with a team of engineers who got to see his domain knowledge, work ethic, and the commitment to a frictionless user experience firsthand during the eleven years leading up to its debut in 2011. Nine years after its founding, Zoom had its very successful Initial Public Offering.[3]

Another distinction, for me as an analyst, is that Zoom showed GAAP net profits fairly early in its corporate history. This fact distinguished ZM from many of its current larger and smaller capitalization peers in enterprise software, cloud computing, UCaaS, or whatever label one wants to use. At this writing, Zoom has trailing 12 month diluted GAAP EPS of $3.23, a PE multiple of 25x, which can be compared directly to other companies owned in a portfolio which report on this basis, like Microsoft at 24x. To its credit, MSFT regularly returns cash to shareholders via a dividend yield, shareholders are owners because there is one class of stock, and its recent quarter showed strong growth across of range of businesses; so Zoom looks like a "pig in a poke" now. Zoom should be able to get back to generating GAAP earnings, provided make some systematic, well thought out resets. At that point, things could begin to look different.

Zoom's balance sheet is about as simple as can be for an analyst to pencil through. Finally as Emergence Capital, one of Zoom's larger investors has said, "I trust Eric." Ultimately, somewhere during market cycles, analysts, investors and board members can be disappointed. Trust in the management is critical at these inflection points: it is something intangible, but very, very valuable and hard to regain, once lost.

Walking Through the Model: Questions For a Reset

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1.??????REVENUE. ??Zoom revenues come from two segments, Enterprise and Online. Enterprise are classified as businesses which are large enough to be called on by a dedicated sales effort. Online comprises the individual customers who access Zoom self-service through a browser, either free or with a subscription plan; online also includes small businesses, like a yoga studio for example. Zoom was founded to serve large enterprises, but the pandemic and associated shutdowns created a large online business. In FY Q2 2023, online revenue ?was $500 million, about half the quarter’s revenues, but it was down 9% from the prior year. Churn is much higher for this segment than for Enterprise, and its service has some strong competitors.

From Microsoft’s recent quarterly call, it is very clear that Teams is gaining ground in both Enterprise and online segments. Teams comes in several flavors and formats, from embedded in Office 365 to enhanced versions for corporations which have phones and rooms as part of the package. Verizon is giving away Blue Jeans for its mobile customers, and Google Meets is free with Chrome.?The Online business is for harvesting slowly and should not become a battleground for Zoom's future. The value proposition for individual customers, who got used to free, is not clear.

. Enterprise, on the other hand, in the same quarter above was $599 million and up 27% over the prior year, and suggestions were that “upmarket” enterprise was the most encouraging. This is the story that needs to be told MUCH differently and better. So how would management characterize a three year outlook for revenue growth in Enterprise, specifically upmarket companies??This number should be one which is reflected in the company’s confidential strategic plan and one to which management and others are incentivized in their bonus or option grants.

2.??????HELP ANALYSTS UNDERSTAND SALES CYCLES AND BARRIERS. ?Everyone is reading about CFOs looking to cut expenses, from employees to outside services, for the uncertain economy and regulatory environment in 2024. Analysts will have some of their own checks. Tell them what you are seeing, talk about Zoom’s findings and what new President Greg Tomb is doing about it with changes to sales, marketing, product value upgrades, and account management.?Give perhaps a few metrics which can be tracked going forward.

3.??????ANY FACTORS WHICH CAN AFFECT COST OF DATA SERVICES??Microsoft’s CEO spoke of energy costs in data centers weighing on their gross margins.?Does Zoom see any uncontrollable factors affecting Zoom’s gross margins??What is a normalized expectation for these GAAP margins?

4.??????SALES AND MARKETING EXPENSE?The new President will have had some time to reflect on cleaning up the come-to-market presentation of Zoom’s offering, and he has done that soon after joining via his Zoom blog entry.?How will the truly global enterprise accounts be handled? Medtronic (NYSE: MDT) comes to mind as a great win, but there was “thank you” on a call, but nothing more.?I know from my experience that Medtronic is an incredibly complicated company in the way they do business, e.g. by dealing with a global network of large distributors. The ways in which the EU touches and monitors processes from sales and marketing incentives to patient privacy can be much more intrusive than in the U.S.?Medtronic are simplifying their business with some recently announced divestitures.?Some of the functions they could do much more efficiently seem like they should be in Zoom's product development wheelhouse. If this kind of company were to become a poster child for a great Zoom implementation, there are other similar and larger companies out there like Medtronic who would learn of MDT's success. How are salespeople incentivized? Do they hold back booking an account to maximize variable compensation, as was suggested??

Speaking about geographical expansion, after decades of disappointments there may be a few opportunities in Africa: Rwanda might be one such market. Rwanda hosts remote workers from some innovative tech companies and hybrid, collaborative work in such a large continent has to begin sometime.

5.??????EXPENSES SHOULD HAVE SOME BENEFITS ?If I recall a large center was built in Bangalore and in another country.?What kind of work is being done there??These were called out for increases in expense ratios in prior quarters, but what benefits will be enjoyed and on what line of the income statement??Similarly for expenses related to the EMEA sales organization.?Surely, this too must have some benefits going forward with the penetration into leading global firms located in EMEA.?Talk about the positives of these investments.

6.??????DON'T BUY BACK SHARES?Unfortunately, Zoom is a two share-class issuer. The A class shareholders have no dividend prospects ever, and they have so say in board appointments or on organizational matters and governance.?Investors may buy shares from time time to time, but clearly they have trouble valuing the shares. Even professional fund managers, with large teams of analysts, such as at T. Rowe Price have caught the knife with a sharp downturn in value. Warren Buffett has written for decades about only buying back company shares if they are selling below the intrinsic value; Zoom's intrinsic value is unknown to Wall Street. Let the program expire unfulfilled. Salesforce announced a similar program, which gives no comfort or encouragement to investors: it's just grandstanding. Reinvesting in the core business should be the best strategic use of funds.

7.??????ARE THERE TOO MANY ZOOMERS? ?I believe I heard Zoom had about 8,000 employees on the last conference call. The increase has been high double digits for a few years now. When the company had to respond to triple digit quarterly growth in revenue, it had to react in an expensive labor market: business continuity was paramount. Now, is that total number and the mix of talent what is required going forward? If there are changes to be made, going into the fourth quarter of the current fiscal year is a good time to make the kind of announcement which Alphabet, Microsoft and many others have already been making proactively.?

8.??????STRENGTH OF THE MANAGEMENT TEAM?

Zoom's management team facing conference call audiences and broker Analyst Days has been the CEO and CFO. Now, the President will be added to that group, perhaps but not at every class of event. What about senior executives on the technology platform who might be able to give some color on why Zoom's technology and product development are better than its competitors? Serious analysts dig into these issues, and investors ask them about the management team also. Take a different approach here?

Conclusion

With the current fiscal year being one of little or no growth, all the ratios from revenue to pre-tax income are out of whack. Salesforce notes that it, among its chosen competitors Microsoft and Oracle, was the fastest to achieving $5 billion in revenue; Zoom should comfortably beat Salesforce's pace to this benchmark. If Zoom were to grow from $4.1 billion to $5 billion or thereabouts, and if it were to get a much richer mix of sales through higher Enterprise sales, particularly upmarket enterprises, and if it were to rationalize its sales and market forces and back office support, could Zoom earn a diluted $5.00 per share in GAAP earnings? If this were to become visible, Zoom could be viewed as representing a GARP stock (growth at a reasonable price); suddenly, the market for longer term investors could open in quality and quantity.

REFERENCES

1. Chacko, Eapen (2020), “The Founder of Zoom Shares What’s Next.”?Entrepreneur & Innovation Exchange. Published online at EIX.org on April 02, 2020, DOI:10.32617/497-5e860bce625a0

2.?Chacko, Eapen (2020), “Eric Yuan’s Leadership Lessons for Building Lasting Enterprise Value.” Entrepreneur & Innovation Exchange. Published online at EIX.org on July 27,2020, DOI:10.32617/549-5f1ee2944152

[1] See “Zoom Faces Risks in Enterprise Contract Renewals, J.P. Morgan Says,” Eric J. Savitz, writing in Barron’s online, Oct. 7.2022.

[2] “Full Stack v1.0: The Inaugural Canaccord Software Quarterly,” Hynes, Crane, Walkley et al, 24 October 2022. Canaccord Genuity LLC (US).

[3]??????Salesforce’s recent Investor Day presentation is here. https://s23.q4cdn.com/574569502/files/doc_presentations/2022/FY23-Salesforce-Investor-Day-2022-Sept-21-(1).pdf