Zoom and the Legend of the Profitable Unicorn

Some say that in the twilight hours just between day and night, if you look at just the right spot in the middle distance, you might see a profitable tech unicorn... like Zoom.

Zoom is planning to go public sometime this year, and on top of the sturdy business model and solid moat, it's already turning a profit. If you feel there has to be a catch, listen to this week's episode of Industry Focus for a deep dive on everything we know about the business so far -- its strengths, weaknesses, risks, advantages, the whole shebang. Host Dylan Lewis and Motley Fool contributor Brian Feroldi tell the Zoom story, what investors need to know about this ultra-rare unicorn, and why you'll probably want to add it on your watch list.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on April 12, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 12. We're talking about a unicorn that's actually profitable. I'm your host, Dylan Lewis, and I've got fool.com's Brian Feroldi on Skype. Brian, what's up?

Brian Feroldi: Dylan, awesome to be back! Talking about another new IPO.

Lewis: We've been pretty spoiled so far in 2019. I think it's going to only continue. We talked about Pinterest a little way back. We're talking about Zoom, another upcoming tech IPO. And that's just the beginning. 2019 is going to be very good for us! The Uber prospectus just came out.

Feroldi: Yeah, I was just reading through the Uber prospectus right before the show. Tons to talk about!

Lewis: That'll be a future episode, Brian. Let's talk Zoom today. This is one that Fools know very well. We use Zoom here at HQ. A lot of folks, though, probably haven't heard the name before.

Feroldi: Zoom is a leader in video communications. Anybody that's familiar with video chatting, Zoom is a competitor in that space. And I have to be honest, when I first heard about Zoom, I didn't even give it a second thought. I thought the video market was already incredible saturated. I didn't understand how any company could create an edge in this market. But the more I dug into the details behind Zoom, the more I realized that I do think they actually have an edge here.

Lewis: Yeah, I think we arrived at this company very differently. You heard about what they did, and then started digging into the financials and were skeptical, then interested. I had seen firsthand the way the product works, and was immediately interested, and was crossing my fingers that the financials also looked good.

Why don't we talk a little bit about how they make their money? While we're talking video chatting, there's an element there of hardware with making sure that all this happens. This is a SaaS company, and this is a business that really follows a lot of the core SaaS metrics investors are familiar with.

Feroldi: Yeah, totally. Zoom is, in many ways, a leader in the software-as-a-service video market. This was a company that was founded about seven or eight years ago by a former executive at Cisco that was in charge of their video offering. He found that what Cisco was offering at the time just wasn't up to par with what consumers needed. I can tell you, the company I worked at before I worked at The Fool, we did all of our communications over the phone. We knew that video communications was a thing, but we didn't have an option that was good enough for us to all use at the same time. Zoom is trying to fill that niche of what enterprises need, and trying to make the software so easy to use and so reliable that companies actually use it.

Lewis: The thing that they come back to over and over again in their prospectus and when they are trying to talk about how they are different than the other players out there is the fact that they're a little bit newer to the game. Because of that, they started out on the cloud. They didn't have to take a whole bunch of old tech and then figure out how to make it happen on the cloud. I think that's huge for them.

Feroldi: Yeah, I totally agree. The cloud is such a game-changer technology. Zoom was developed with the cloud in mind. Cloud is their native hub. A lot of other communications platforms that you see, such as Skype and others, they added video after the fact. They weren't a video-first. Zoom is purely a video-first company.

Lewis: If anyone, after hearing all this, wants to kick the tires and get a sense of what this company looks like, as is the case with a lot of SaaS companies, you can try it for free. They have a nice free tier. There's some limited functionality around meeting length, but it gives you unlimited one-on-one meetings, the ability to add quite a few participants. And then, as you might expect, once you start getting into the paid tiers, you have your Pro, your Small Business, and then ultimately the Enterprise tiers.

They break out their business a couple of different ways. One of the main ways you'll see, though, is meeting hosts. They run $15 to $20 per month. That's a host or per-head license type of thing. They also have Zoom Rooms, which, if you're looking at the enterprise market, is a no-brainer for them.

Feroldi: Zoom Rooms are when you set up a conference room in an office and you dedicate it to using Zoom. Dylan, we actually held a Zoom Room conference before our meeting today because I wanted to see how it worked.

Lewis: Yeah, and I have to say, pretty seamless, right?

Feroldi: Yeah, it was totally easy. You just sent me a website address and a meeting number. I went to the website, typed in the meeting number, boom, we were video chatting.

Lewis: There's a deep irony here in that we're doing this over Skype and talking about Zoom. But I think that this product has really changed the way that a lot of people are looking at video communications. I am always remarking at how crystal clear all the resolution is and how clear the communication is. That's a little different than what I've experienced so far using some of the other competitors' products.

Feroldi: I totally agree. Again, I was initially very skeptical about this company's ability to compete in this market because I knew just how crowded it was. However, the more that I dug into the S-1 and the more I looked at the numbers, the more I think that there is an argument to be made that there is something special about this company.

Lewis: Yeah, the numbers swayed you, Brian. Let's give a quick year by year here. We have revenue of $61 million, $152 million, and just over $330 million for the past three fiscal years. That's pretty incredible growth.

Feroldi: Yeah, that's 149% growth, then 118% growth. More than a doubling two years in a row. $330 million dollars is a pretty sizable number. To put some additional context around that, of that $330 million, 82% of that is based in the U.S. and 18% is international. This is very much a U.S. story at this point. But there's clearly substantial room for growth, both in the international [and domestic] markets.

Lewis: And the shocker of all shockers is the fact that they are profitable, right? We see these gaudy growth rates, and we know this is a company worth over $1 billion, and yet they actually posted some profits. Not just operating profits, real, true profits, for their most recent fiscal year. That's also got people pretty excited.

Feroldi: Yeah, that's incredible! We've talked about unicorns before that are just burning through cash left and right. This isn't a new thing, either. They actually were breakeven about three years ago on $60 million in revenue. As they've doubled, their expenses have grown in lockstep with that, but they still have generated cash each and every year. They had a 5% GAAP operating margin last quarter. On a non-GAAP basis, which strips out stock-based compensation, that was 9%. And, they're free cash flow positive. So very, very respectable.

Lewis: A lot of the headlines that you see with this company are going to focus on top line growth and the fact that they are a profitable unicorn. Two things that really stand out to me is the fact they have that 82% gross margin, which is up from the past couple of years. That's an incredible number. And, the balance sheet is rock solid.

Feroldi: Yeah. $176 million in cash before they IPO, and no debt. And like you said, Dylan, their gross margin is already incredibly high, 82%. That was 78% a few years ago. So, not only is the business' top line growing incredibly fast, but their margins are starting to scale. That's a super potent combination.

Lewis: Right. So many of the IPOs we're seeing in 2019, the growth is there, the interest is there. And a lot of them are consumer-facing, maybe that's part of the reason why. But there's this feeling of, "OK, we kind of need to figure out how to turn this into a viable business," and shareholders, the average investor, people that are just getting in now because the shares are publicly listing, are going to have to pay a ticket to watch and make that happen if they want to be a part of that growth. Not so much the story here.

Feroldi: Yeah, for sure. Just to quickly talk about their margins a little bit more, their data center strategy is, they actually co-locate in 13 data centers. They're running their operations themselves. On top of that, they're outsourcing some of their data work to both Amazon Web Services and Microsoft. So they're taking a different approach than, say, Pinterest, which we talked about a few weeks ago, which is purely running its business on Amazon Web Services. That's an important distinction with this company.

Lewis: You see that play out in the margin number. One of the big things that I think a lot of people are going to wonder with this business is, OK, they were disruptive. They came in, they were cloud-first. There's a lot of legacy players here that have a lot of entrenched interest in making sure that they're in the enterprise market for communications. What's the moat here, Brian?

Feroldi: Yeah, that is a fantastic question! That is the No. 1 thing that I think that investors need to think about when they're talking about this business. Coming up with the idea of what this moat is, is a little bit hard to conceptualize, but there are some numbers that show me that they do have a moat.

First and foremost, with any SaaS company, one of the key metrics is net dollar expansion rate, which is how much money they're earning from their same existing customers from one year to the next. If this number is over 100%, not only are they keeping their existing customers, but their existing customers are spending more. For Zoom over the past 12 months, this number was 140%. That's about as good as it gets in the SaaS space.

Lewis: Yeah, we look at a lot of companies in the software-as-a-service space. This is one of the best numbers I've ever seen. For the most part, you're seeing expansion rates somewhere between 105% and 120%. 140% is like Twilio territory, in terms of being able to build your relationship with your customers, roll out more products that they're clearly interested in, and strengthen the bond that you have and the role that you have in their business.

Feroldi: Yeah, completely. Zoom gets there by a couple of ways. First, their software completely works, and it's usable across basically any device, any operating system, any third-party application that you can think of. They work on Windows, Mac, iOS, Android, Linux, etc. But they also have direct integrations with a number of big-name companies. Atlassian, Dropbox, Google, LinkedIn, Microsoft, Salesforce, all of them have Zoom built right into them. So there is a connection in between there that does provide them, I think, with a little bit of switching costs that are helping to produce that incredible net dollar expansion rate number.

Lewis: Yeah, I don't think they benefit from a moat in the way that a traditional network effect might apply. I think they benefit in the sense that once you get in there as a SaaS provider and you provide people with good service, it tends to be sticky, the switching costs are high. I'm not as convinced that you using means that I'm going to use. Although, they talk quite a bit about how they have this viral marketing strategy, and, like a lot of SaaS companies, they use free users to become advocates, and then hopefully that leads to paid users and enterprise contracts for them.

Feroldi: Yeah, and that strategy is working out brilliantly. People are coming. They are using the free software, and then they are choosing to become paying subscribers down the road. That's how they land, actually, the majority of their clients, including the Fortune 500.

To put up another number about how much their customers like them, this company promotes a net promoter score of over 70. That's when you take, basically, people that promote your brand, and you subtract out people that detract your brand. A number of 70 is just unbelievable. That's a product that is beloved as much as any other product I can think of.

Lewis: Another major thing working in Zoom's favor is the fact that there's some pretty good tailwinds behind this business. You think about where we're going with work, it's increasingly remote, it's increasingly global. This type of technology is exactly what a lot of businesses need, especially if you have a lot of different offices. I think about The Fool in particular. We have HQ here in Alexandria, but we also have another office over in Colorado. We have Fools that are international. There really isn't that much lost by those people being remote when connecting is this easy.

Feroldi: Yeah, when you have a video conversation with somebody, Zoom believes that you build trust faster because a lot of communication that happens between humans is nonverbal. You like to see somebody's face, how they react. Those kinds of things don't always translate over a phone call. But when you can make a video call, that kind of language becomes much, much easier, and it's faster to build trust. Because of that, Zoom likes to say that the payback that companies get for adopting their software is extremely fast, has a huge ROI that this company claims when somebody signs on.

To put some numbers around the potential of the business, Zoom believes that the market size for video communications is $43 billion next year. They think that they're going to be expanding that market number because their product in particular is so easy to use. Again, $43 billion compared to last year's revenue of $300 million. There's a lot of potential upside here.

Lewis: Brian, you mentioned the net promoter score, and the view that people have of this business. I think that's just a small part of the story when we're talking about Zoom. One of the things that really drew me in, too, was the fact that leadership is very well-regarded, and it seems like a truly wonderful place to work. This is a spot that gets glowing reviews from a lot of the employment review outlets out there.

Feroldi: Yeah. One of the things that we always like to do when we're checking in on any company is check them out on Glassdoor. Do people like working there? What's the CEO like? Is the CEO the founder? What kind of approval rating do they get?

The CEO in this case is the founder. His name is Eric Yuan. He actually is the No. 1 ranked CEO of large company in America. No. 1. He is literally a beloved CEO. And he owns 22% of Zoom's stock personally, before the IPO. The company just gets glowing reviews from employees. So this is clearly a great place to work, a beloved CEO, and a very good corporate culture.

Lewis: Brian, we have been pretty complimentary so far of Zoom. I want to take a critical eye to some of the things that we like to run stocks through, especially as they're going public, just to get a sense of what risks might be out there. Looking at the valuation, this is a company that will probably be going public somewhere around $8 billion, because they're going to be pricing at the high end of that $28 to $32 range that they've been shopping around. So, no, it is not a penny stock. That's one of the things that we often check. No, we're good there.

One of the other things I think we really need to keep in mind when we're looking at as-a-service businesses is, what does customer concentration look like? What's the story there?

Feroldi: This company has over 50,000 customers. No individual customer represents more than 5% of revenue. I don't think there's any reason to worry about excessive customer concentration.

Another thing that I always like to look at when I'm thinking about any business is, is this industry that it's in face long-term headwinds? In this case, I think that there's a clear argument to be made that this company has tailwinds behind it, especially with millennials out there choosing to try and work remotely. I think that big push will just put a fuel under the fire for the demand for video conferencing software.

Lewis: Yeah, I totally agree with you. This seems like it's where the market's going. It seems like, broadly, where business is going. I think because of that, because of all these great financial numbers that we've talked about, and because there's a lot pushing this business forward, there's so much enthusiasm around it, one of the risks here is, there's a pretty hefty valuation that this company is going to have to live up to as it goes public. If you do the back-of-the-envelope numbers here, if they're at $8 billion and they did about $330 million in revenue, that puts them at about 25X trailing sales. That's pretty rich.

Feroldi: Yeah, and that's at the IPO price. That's assuming that you can get shares at what they're actually worth, and this stock isn't going to pop hugely on the first day, like we've seen with so many other IPOs. There's no doubt that, to get in on this growth story, you're going to have to pay an insane multiple on day one if you do. So, the question is, is this business high-quality enough, and is the growth potential strong enough to justify the valuation?

From what I've seen thus far, I think this business is so fantastic that there is an argument to be made that it should be very high on investors' watch list, even if they have to pay some insane multiple right out of the gate to get on board. But there's no doubt that the valuation is going to make this stock very risky.

Lewis: And because of that, with the quarter-to-quarter results that they've put up as a publicly traded company, if anything misses, if they wind up issuing guidance that is not so rosy, it's going to take a hit. Anything that is valued at 25X sales is going to wind up having quite a bit of criticism heaped on it if the results aren't there.

Feroldi: Yeah, completely. The other thing for investors to keep an eye on is, what is the competition going to look like in this space? So far, the numbers clearly show that Zoom is a leader in its category, and Zoom is taking market share left and right from people because of its offering. Is there another company out there that could catch up, that could develop the same level of service, that could create a product from the cloud and do it from the ground up? And then, will they be able to compete successfully with Zoom? That's another unknown that could risk their growth rates decelerating. If that happens, look out below.

Lewis: Yeah, absolutely. That's actually something that one of our listeners, I believe Wei, asked us on Twitter. I'd put out that we were going to be talking about Zoom on the show, I just wanted to see what people were curious about. One of the very common questions, we got it from several different people, was, can we highlight the competitors, and what does the moat look like? We touched on this a little bit before, but I do want to read from the S-1 here for a second, just to give you a sense of who they view as their competitors. They said, "We primarily face competition from legacy web-based meeting service providers, including WebEx and Skype for Business. Then you have the bundled productivity solution providers with basic video functionality, including Google, and point solution providers including LogMeIn." So, a lot of the names you might expect. Google Hangouts, you have Skype in there as well. I would also throw Slack in there. I would say, this is a communications business, they are rolling some video into their functionality. That's a thing to watch.

What's nice so far is, they have pretty good partnerships and integrations set up with some of the main players. While Skype is a competitor, they have integrations with Outlook. While Slack is a quasi-competitor, they have some integrations there, I believe, as well. The problem is, when you have all these integrations, you are then somewhat reliant on these platforms for functionality. If that relationship ever sours, that's a risk to be aware of.

Yeah, completely. Having all those partnerships in place is both a benefit and a potential long-term risk if they decide to become competitors. One thing I will throw out there for the competitive question is, it's important to note that the CEO here was actually one of the very first employees at WebEx back in the late 1990s. He stayed with that business all the way through until it was acquired by Cisco. Then he worked at Cisco for another five years before founding Zoom. And he founded Zoom because he saw that the offerings that Cisco was offering were not what customers needed, and they were not using the products. And then he went on to convince 40 of his fellow engineers to abandon ship and join him at Zoom. So there are competitors that need to be watched here, but the management team and the engineering team are all deeply talented and know this space extremely well.

Lewis: Yeah, I look at the legacy competitors and I almost think that they are more in a position to buy Zoom at some point down the road. I think the bigger risk is someone coming out and saying, "We're going to be cloud-first, too. Also, we're going to access this market and slowly eat away some of the share that you're enjoying right now as the first mover in that space." I'm doubtful, because they've laid out such a good product, and because I've used it and I know how strong it is,. But, it's something to be aware of.

Brian, another one of our followers, Seth, asked us, how well does the product actually work? I think we touched on that one. Then he said, is there any optionality with the business other than video calls? This is a great question!

Feroldi: Yeah, completely! When you think about optionality with growth stocks, it's the ability for them to add on new services or enter new markets down the road. That's a little bit of a tricky thing to talk about in this case. In Zoom's case, they have rolled out Zoom Meetings, and they just rolled out a Zoom Phone offering. So you can argue that there is optionality within the video communication space. But another way to think about it is, the market for their core market offering is so enormous that optionality isn't necessarily something that they need right now.

The other thing I would point out is, great corporate cultures tend to be creative and tend to create new products. One way to bake in optionality if you can't think of it now is to buy into a corporate culture that praises people that think outside the box, and praises people that can use their talents to create new products. I think that there's an argument to be made that Zoom has that. But, I can't see anything myself that says, "Boy, this business has a ton of optionality in it right now."

Lewis: Yeah, I really sat on this question for a while, trying to work through it. I got to a very similar point that you did. I think if you're looking outside of video communications, I don't see the next immediate vertical for them. In terms of optionality in that sense, I'm not quite there. But, if you look within video communications, a lot of that conversation right now is focused on traditional enterprise. We're talking about business-to-business or people working within a business and communicating across offices or something like that. Where I do think they have some optionality is in the application of the video communications. They've already started doing some things in education and healthcare. I could see them doing something in entertainment as well. This is another space where I think the tailwinds are there. If their tech is that good, they will find pretty good ways to apply it.

Feroldi: Yeah, I completely agree.

Lewis: Brian, big picture, your outlook for this business. I think it's going to be going public at some point in mid-April. How are you feeling about it?

Feroldi: I'm extremely interested in it! The numbers that jump off at this page at me are just fantastic! It is very rare that you see a company that has been profitable at their early stage, that has such a great corporate culture, that is throwing up amazing margins that are expanding. There is a lot to like about this business. I plan on following this company very closely right out of the gate. I may even purchase shares at some point, even though I know that I'm going to have to pay some insane multiple in the early days to get my hands on it. How about you?

Lewis: I'm in the same boat. This one immediately went to the top of my watch list once I started really digging in, getting a sense of what the numbers looked like. I will, if I ever wind up buying shares, be doing it in small increments over time. Really, I think that with any IPO in the first six months, you need to be super mindful of fact that they're going to be putting out results that haven't been nicely manicured and put together. They're choosing when they go public. People always have to remember that. So you're going to be seeing maybe some lumpiness in the results. You want to see all management handles being publicly traded. Also, you want to make sure that when insiders have the chance to sell their shares, you aren't being stuck with a massive selling spree that really hits your shares. You don't want your position tied to any one spot and time. Something to keep in mind, especially with a stock like this.

Feroldi: Yeah, totally! When companies come public, things change. The culture can change. Management now has a number that they have to hit. They have to get their records out to everybody. Competitors have a bigger eye on them. There are a number of things that change. But to me, the thing I always start with is, is this company so high-quality that it is worth following, and it could be worth betting on? From what I've seen, I think the answer is yes.

Lewis: Well, we're in agreement there, Brian. Thanks for hopping on today's show! Anything fun going on this weekend?

Feroldi: Hey, I'm heading down to D.C. this weekend! It's my kids' vacation next week, so we will be at HQ next week!

Lewis: Yes, you will be! We'll be doing some shows while you're in town. Excited to see you, excited to see the kids, as well! Our producer, Austin Morgan, what are you up to this weekend?

Austin Morgan: This weekend is the first of the meat smokes for me. I got my pellet smoker in the mail yesterday, put it together. So this weekend, we're going to try to make a brisket.

Lewis: Listeners may remember that when we did our year wrap up, and we were talking about some resolutions for 2019, Austin has set his sights on developing a hobby that was not physically taxing. I'm very, very eager to see, and maybe even taste, the results of your new interest.

Morgan: This is one that I can do while recovering from my rotator cuff surgery.

Lewis: [laughs] And that's the key. Will you post some of your results on Twitter? Maybe we can retweet that from The Motley Fool Industry Focus account.

Morgan: We'll see how it comes out.

Lewis: If they go well.

Morgan: If it goes well.

Lewis: Although the pictures might be better if it doesn't go well.

Morgan: That's true! My man Malcolm Reed from HowToBBQRight, that guy looks like he knows what he's doing. I trust him!

Lewis: Hey, you have to start somewhere, right? Alright, Brian, thanks for hopping on today's show! Austin, excited to see what happens with the barbecuing! Listeners, that does it for this episode of Industry Focus! If you have any questions or you want to reach out and say hey, you can shoot us an email over at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or check out videos from the podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Brian Feroldi owns shares of Amazon, Microsoft, and Twilio. Dylan Lewis owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Atlassian, Microsoft, Salesforce.com, Twilio, and Twitter. The Motley Fool has a disclosure policy.