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By Christopher Gannatti, CFA
So far, 2022 has been a year of the value style of investing outperforming the growth style, and few megatrends in recent years have been more growth-oriented than cloud computing. Big stories and sales growth went from being in favor during 2020 and 2021 to completely out of favor in an environment of higher inflation and interest rates.
However, do we risk painting an entire megatrend with too broad a brush? If most cloud computing companies are trading based more on macroeconomic factors, opportunities can be created because the companies where positive things are happening are being pulled down along with everything else.
Anyone interested in cloud computing and Software-as-a-Service (SaaS) businesses would do well to follow Jason Lemkin’s SaaStr blog. Some of the examples I point out in the text that follows were inspired by his writing, and it is excellent food for thought in finding positive financial developments in these companies.
Zoom Video Communications
It’s possible that the biggest value of Zoom (ZM) is it is a global brand everyone knows. There is even such a thing as “Zoom fatigue”—meaning that the product is used so much there is common language to describe using it too much.
But is this just a “pandemic darling,” or is this a business with a significant future outside the COVID-19 pandemic?
Customer Cohorts Are Changing
Customers that generate more than $100,000 in recurring revenue are the engine for future growth. This group of customers, roughly 2,900 in number, is growing 46% year-over-year. This could be Zoom’s ultimate future, but it will be a journey. Even in 2021, 63% of Zoom’s revenue was still from 10-seat or smaller customers.1
I was fascinated and even surprised to see that Zoom’s sales and marketing spending is around 25% of revenue, having grown a bit from a level of 20%. The reason for the spending expansion is to facilitate Zoom’s transition toward enterprise customers. The typical Software-as-a-Service company is spending something closer to 50% of revenue on sales and marketing, so Zoom is operating at roughly half the scale of the typical SaaS business, at least on the basis of measuring its expenditure this way. This is a big reason why Zoom is able to generate roughly $2 billion of adjusted free cash flow per year. In the current environment, if these stocks start trading less on macroeconomic factors and more on fundamentals, we believe that the capability to transition from revenues to free cash flows to earnings will be prized, and Zoom is doing this2.
Zoom has annual recurring revenue of about $4 billion, and the vast majority of this comes from its core video communications product. However, Zoom’s phone product does have about three million users. We can recognize that Zoom attempted to acquire Five9 (FIVN), which didn’t work out, but it is still seeing growth in its phone product. It will just take time for the phone product to get big enough to materially impact the $4 billion in annual recurring revenue.
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