👋 In today’s update, we’re talking about Zoom.

  • What do they do, what products do they sell, and who are their competitors?
  • Are they an economic franchise or just a business?
  • What’s their ceiling? Risks?

Resources used in this article:

  • Zoom’s S-1: Management’s discussion about their business starts on page 54.
  • Alex Clayton’s breakdown of Zoom’s S-1.

An Overview of Zoom

What do they do?

Zoom was founded in 2011 by Eric Yuan. Eric was a lead engineer for Cisco Systems Webex product (collaboration product similar to Zoom). Zoom helps companies communicate through video. They enable face-to-face communication through video, audio, and chat in a single meeting across different devices (desktop, iPhone, iPad) and different locations. For example, they’ve helped one customer with 1,000 all-remote employees, grow and maintain their culture.

Their goal is simple: To make Zoom meetings better than in-person meetings.

What products/services do they sell?

Zoom offers four products:

  1. Meetings and chat: Their core product. You can use it for free! This is how they hook users. Enables HD video meetings, audio, and real-time messaging and content sharing.
  2. Zoom rooms and workspaces: They help you make any room a conference room. Their software integrates with your existing hardware.
  3. Zoom phone: A phone system that integrates with your existing hardware. You can use their app to make calls on the go.
  4. Zoom webinars: Helps you broadcast virtual events.

Who are their competitors?

Integrated video and phone systems have been around for years. So this isn’t a new market created out of thin air.

A few companies with similar products:

What’s their business model and what do their financials look like?

They generate revenue through subscriptions. They charge based on the number of paid hosts (1 host = 1 license). For example, they charge $19.99/month/host with a minimum of 50 hosts on their enterprise plan.

They offer monthly, annually, and multi-year subscriptions. Larger customers typically pay annually. In fiscal year 18′ and 19′, 65% and 74% of annual recurring revenue (ARR) was generated from annual and multi-year subscriptions.

This is a good thing: Getting money upfront for services rendered throughout the year lets you reinvest quickly, increases payback period (time it takes to recoup your costs of acquiring customers), and increases cash flow.

Revenue

High growth SAAS companies have little in the way of profits (net income). Investors focus their attention on revenue. Their revenue for 2017, 2018, and 2019 was $60.8 million, $151.1 million, and $330.5 million, respectively. That represents a growth rate of 147% and 118% for 2018 and 2019, respectively.

Their metrics

Source: Alex Clayton; Zoom S-1

What KPIs (key performance indicators) do they use to measure the success of their business?

  1. Customers with greater than 10 employees. This makes sense. With larger companies, there is a greater chance for more employees to be exposed to their product and become a paid host. In a way, this is a viral loop and an efficient way to acquire customers without spending additional dollars. Their hope is that their product grows like a virus within an organization. In FY’ 2019, they had over 50,000 customers with greater than 10 full-time employees, up 97% year-over-year.
  2. Customers contributing more than $100,000 of annual revenue. They measure their ability to scale by the number of customers who pay more than $100,000 annually. Again, customers that pay that much have greater potential to increase future paid hosts as Zoom’s product penetrates an organization. These customers are a growing percentage of their revenue. They made up 22%, 25%, and 30% of revenue for fiscal year’s 17′, 18′, and 19′, respectively. In FY’ 2019, they had 344 customers that paid more than $100k in annual revenue, up 140% year-over-year.

Are They an Economic Franchise or Just a Business?

To be an economic franchise, a company needs to answer yes to these questions.

  1. Is their product/service needed or desired? (i.e. have they achieved product/market fit?)
  2. Is this product/service thought by its customers to have no close substitute?
  3. Are they subject to price regulation? (can they price their product/service aggressively in the face of rising competition?)

Let’s take these questions one by one.

Is their product/service needed or desired? (i.e. have they achieved product/market fit?)

A company that has made it to the IPO stage has achieved product/market fit to some degree. It’s reasonable to conclude that Zoom has a product that is needed and desired up to this point.

I think the question of product/market fit is better applied to startups (early stage companies) and companies launching new product lines.

For example,

Amazon was already a large, diversified company when they launched their Fire phone in 2014. That product was not needed, desired, and did not achieve product/market fit. Some people bought it, but with bad reviews and disappointing sales, it wasn’t worth it for Amazon to continue allocating resources to that product.

Is their product/service thought by its customers to have no close substitute?

THE key question, and the hardest one to answer. Unless you have tried all other options, it’s hard to know which product is the best and what product you would pay for if cheaper alternatives are good enough.

Zoom operates in a competitive space, with companies making similar products. How do you judge the quality and value their product relative to other products? Reviews from comparison websites? How accurate are those? Word of mouth from people you trust? That’s a small sample size.

To help with this question, let’s turn to four characteristics that all economic franchises are likely to have. Or at least have one or a few.

  1. Proprietary technology: This is the greatest advantage a company can have because it makes your product difficult to replicate. Not sure how to judge if their technology is better than its competitors. In my circle, people who have tried other products, think Zoom is better, but again, it’s a small sample size.
  2. Network effects: Don’t think this applies to Zoom.
  3. Economies of scale: This applies to most software companies. After companies spend large amounts of money to build their software, the cost of replicating that software (marginal costs) is zero. This characteristic also applies to their competitors.
  4. Branding: Again, this is hard to measure, but I don’t hear other video communication companies talked about in the same way as Zoom, so there must be something there.

Are they subject to price regulation?

This will be tough to answer without knowing the answer to question two (no close substitutes). If customers see little difference between their product and a competitor’s product, it will be tough to price their product aggressively if good enough alternatives exist at cheaper prices.

To conclude

I’m not sure what to conclude. There are very few economic franchises in the world. Salesforce ($122 billion mkt. cap) is the only SaaS company in the top 100 companies by market cap in the U.S. Does Zoom have the potential to be a top 100 company in a decade? Maybe.

The best thing we can do is watch the two metrics that they use to measure their success and go from there.


What’s Their Ceiling? What Are Their Risks?

Possible upside?

SaaS companies are usually valued at a multiple of their forward revenue (i.e. what their revenue is expected to be over the next twelve months times a multiple).

Here’s a nice chart with a range of potential values (mkt. cap) with different revenue and multiple assumptions.

Source: Alex Clayton

Recent SaaS IPOs like Okta, Atlassian, and Smartsheet have revenue multiples b/w 22-30.

This range put’s their market cap between $13 billion on the low end and $17 billion on the high end, using $578.4 million as the implied NTM revenue (see chart above).

What are some risks?

Three come to mind.

  1. Their product isn’t as great as people think, and other companies figure out how to replicate their technology.
  2. Will companies see their product as a “must have” tool that saves them time and money and helps them meet their business goals? Or, will it be seen as a discretionary item that will be on the chopping block when the business cycle turns down and companies have to cut costs?
  3. The multiples investors are willing to pay for SaaS companies compress. This will happen at some point.

Tough to know the answer to the first one, but I believe we can attempt to answer the second risk with a little digging.

When the business cycle turns down and companies start cutting expenses, we’ll see that in two places.

One: General economic reports like the business investment section from the GDP report (monthly report) will tell us if businesses are increasing or decreasing their spending. Not a perfect measure, but it will give us a clue as to how businesses feel about deploying capital.

Two: In every annual report there is a section called “Management’s Discussion and Analysis of Financial Condition and Results of Operation.” In that section, they tell you how much revenue, expenses, and other items increased or decreased from the previous year and the reasons why.

Since some of their customers are public companies, we can see which companies cut back on operating expenses (which is where Zoom’s products fall). Then we compare that to the two key metrics Zoom said matters to their business. And we can get a rough estimate of how sticky (important) their product is.

Specifically, if the majority of companies are cutting operating expenses and the number of customers who pay more than $100 thousand a year is rising (KPI #2), it’s reasonable to conclude that they view Zoom as a non-discretionary expense and a critical part of their business.

This way isn’t perfect, but it gives us little clues we can add to our puzzle in trying to figure out how durable this business is.


Thanks for reading,

Caleb

Category:
IPOs