How Does Zoom Video Communications Make Money?

Zoom Video Communications (ZM -0.92%) recently went public. This software-as-a-service business is rapidly taking share in the video conferencing market. But how does this company differentiate itself from legacy providers?

In this segment from Industry Focus: Technology, host Dylan Lewis and Fool.com contributor Brian Feroldi discuss how Zoom makes money, how it stacks up against the competition, and the massive opportunity ahead of the business.

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

This video was recorded on April 12, 2019.

Dylan Lewis: 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.

Brian 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's 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%. One hundred forty percent 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.