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INITIATING COVERAGE

Zoom may be the true unicorn—a profitable tech startup

REUTERS/Mohammad Ismail
A security flaw has been found with Zoom Video.
Published This article is more than 2 years old.

The term “unicorn” has become synonymous with private companies that are worth more than $1 billion. But with so many companies above that valuation, there’s nothing rare about that designation anymore.

Zoom is a different kind of unicorn. Zoom is worth more than $1 billion and it is profitable. Yes, you read that correctly. A high-growth tech company that makes money is rare if not unique in today’s Silicon Valley. It turns out that while the venture world has fawned all over big money losers, Zoom followed an old school path of building a product that customers love and pay enough for that the company is profitable before going public.

We think Zoom is a company investors should pay close attention to. Here are three things we’re raving over and three things we’re watching out for:

Reason to invest No. 1:

It’s video that just works

As anyone who has ever tried to hold together a long-distance relationship in their personal or professional life knows, video chat has become vital to maintaining connection. Now, as remote and virtual teams become a feature of work, video conferencing plays a critical role in company communications. In a 2017 Gallup poll, 43% of people claimed they work remotely at least some of the time, and many companies have a need to connect people across buildings, cities, countries, and time zones.

Zoom works. Video conferencing can be painful and more often than not, it doesn’t work. Eric Yuan, the founder and CEO of Zoom, experienced all of this firsthand—he had a long-distance relationship and he visited with customers who were unhappy with the performance of video conferencing. He also had a deep technical knowledge of the need for a “video first” architecture that could handle the various communications protocols and hodgepodge of hardware and software that went into internet-enabled video conferencing. So he made a decision to “start from scratch” and design a modern video conferencing solution, with the goal of “increasing happiness,” a somewhat fuzzy and amorphous target.

There’s a lot at stake: employee engagement, retention, and productivity. Google, which says 39% of meetings involve employees in two or more cities, recently released research from the company’s People Innovation Lab that found video conferencing, when used for casual or social purposes, greatly improved people’s sense of connection. Connection is what video is all about. and to that end, Eric Yuan’s mission of frictionless video conferencing that makes people happy is a smart business objective.

Reason to invest No. 2:

Zooming financials

Almost every line in Zoom’s financial statement is going in the right direction. Revenue more than doubled from 2018 to 2019, while costs for service delivery, operating, administration, and research & development remained flat or fell as a percentage of revenue. The company also posted a 2% profit, its first.

The only number that moved in the wrong direction is sales and marketing costs as a percentage of revenue, which increased slightly from 55% to 56%. There are two good reasons for this. First, the company is trying to attract customers in a crowded space with well-funded competitors. Second, in order to grow its business with large enterprise customers, Zoom needs to hire and pay sales people ahead of these new hires being able to generate revenue. Even though the increase in sales and marketing costs makes sense, we think investors should keep an eye on these expenses to see if the additional spending pays off.

Reason to invest No. 3:

An efficient marketing strategy

Zoom is now the hands-down the leader in video conferencing performance. We looked across a number of research providers—who use measures such as employee growth, review growth, social growth, and satisfaction—and they all point to the same conclusion: Zoom is crushing it in a highly competitive and fragmented market. According to G2 Crowd, Zoom is leading a crowded filed of competitors that includes Skype, Blue Jeans, and GoToMeeting in customer satisfaction and adoption.

Zoom has reached this point using a bottom-up/top-down sales approach, viral adoption, and word of mouth. A bottom-up/top-down approach means that a product is designed for consumers, with a focus on user interface design and simplicity, and sales are driven by word-of-mouth. Once a certain level of adoption is reached in a corporation (by individuals inviting others to join meetings and become subscribers), selling to the entire corporation becomes easier, cheaper, and faster. This relatively new and unorthodox approach, popularized by Atlassian, an Australian company that develops software for developers, has now become a preferred sales strategy for many emerging enterprise cloud companies. According to Peter Levine, general partner at Andreessen and Horowitz, in a discussion on this A16z podcast (at the 29 minute mark), “enterprises are looking more like consumers” because vendors like Zoom are trying to sell a single person in an enterprise before going for the whole company.

In the S-1 document Zoom filed with the SEC, the company states, “Employees are increasingly the primary force for IT modernization at work as they bring the latest technologies from their personal lives to their jobs. According to a 2017 report from Salesforce Research, 71% of employees want their companies to provide the same level of technology as they use in their personal lives.” However, there are reasons to believe this approach has a natural limit and that, eventually, Zoom will hit it and need to employ a more conventional sales approach.

Our first concern is that while Zoom has been very successful selling to smaller companies, they have yet to prove their model in large companies. Among video conferencing providers, 45% of companies choose either Zoom (roughly 26%) or Skype Business (18%) over all other options, according to a report by Owl Labs, which makes a 360-degree video conferencing device. Zoom’s usage, however, is highly skewed to smaller companies; 64% of companies with 500 or more employees use Skype for Business while 72% of companies with 500 or fewer use Zoom.

Secondly, there is evidence that recruiting larger companies simply take more sales effort. A recent article (paywall) in The Information discusses Atlassian’s move towards adopting “conventional tactics as its growth has slowed.” Zoom’s sales and marketing costs as a percentage of revenue (55%) is 2.6 times that of Atlassian’s, but its revenue growth is 2.9 times that of Atlassian’s as well. We expect Zoom’s sales and marketing costs as a percentage of revenue to decline over time but it’s unclear whether it will normalize around the more top-down sales oriented companies like Salesforce.com or the more bottom-up companies like Atlassian.

Things to watch out for No. 1:

Competition

Zoom’s technology seems to give it a leg up against its competitors. But the list of its competitors starts with Google (which offers Hangouts), Microsoft (Skype), and Cisco (Webex)—all formidable technology competitors in any category. While Zoom’s technology and its sole focus on video conferencing makes its service superior to Hangouts, Skype and Webex, in our experience, no one should dismiss the competitive threats of companies with such scale and reach.

We think investors should also be watchful of companies like Slack, which offers video chat within its collaboration system. Although video isn’t Slack’s primary focus and its video technology isn’t as strong, the convenience of video chats within Slack could reduce the need for people to use a separate system like Zoom.

Things to watch out for No. 2:

Big company customers

While Zoom has users at more than half of the companies in the Fortune 500, many are still small customers. As we’ve mentioned, Zoom’s ability to start with a single user and then scale up to a full enterprise gives it a very cost-efficient way of growing its customer base. But the big wins of signing large companies to full enterprise licenses takes time and effort from expensive sales people. Zoom is spending more on sales to help grow its business with these big customers, and we think investors should be watchful of the company’s success. We don’t know yet if the company will announce big customer wins on its quarterly earnings calls but we think such disclosure would help investors understand how well the company is moving into the big leagues.

Things to watch out for No. 3:

Governance

It’s easy to look past dual-class share structures that give founders voting control over their companies because it’s become so common. But we don’t think this is a good thing for investors or for companies in the long term. In Zoom’s case, the company’s class B shares, which are owned by insiders, are tied to Eric Yuan’s employment as CEO. For the next 15 years, the class B share owners will have control of the company unless Yuan leaves the company, at which point class B shares convert to normal class A shares. Yuan has done a remarkable job building a high-performing company and there’s no reason we can see that he won’t continue to do so. But we think one of the principles of public stock ownership is that investors have the ability to shape how the company is governed in case the leaders prove ineffective in the future. Investors won’t have any say in how the company is run until Yuan decides to let them.

Zoom is one to watch

Overall, we’re a fan of Zoom as a company and as a stock. The company is a leading player in a market we think will continue to grow as companies become more geographically diverse and allow more remote work. Zoom has proven that its product and business model work, and it makes a small, but solid, profit that gives investors a basis for valuing the business. Even though Zoom faces daunting competition, its bottom-up/top-down sales model and strong technical advantages have created an unlikely success competing against the biggest companies in the world. We don’t like dual-class shares but if investors are willing to take a passive ride with Yuan, Zoom seems like a smart way to invest in the future of remote work.