Galeanu Mihai
Taking a look beyond the headlines of this high growth IT casualty
This is an article recommending the purchase of ZoomInfo (NASDAQ:ZI) shares-the other Zoom. This article has nothing to do with Zoom Video (ZM). The company’s earnings report of 11/1 was poorly received and the shares imploded by almost 30% the next day and drifted lower. Even after the buying tsunami of Thursday and Friday which lifted ZI shares a bit more than 14%, the shares are just marginally above the levels they reached the day after the earnings report. And that is far worse than other high growth IT shares. Even the 10% jump of last Thursday was worse than average; the WCLD ETF was up by more than 13% that day.
It is hard to write about just about anything related to investing on the Friday after, without acknowledging the buying tsunami that engulfed the market, and particularly the high-growth IT stock segment on Thursday and Friday, 11/10/11/11 after a far better than expected monthly CPI report. It changed the calculus for so much. At some level, IT shares had been so oversold and subject to so many real and FUD headwinds that a material reaction was inevitable.
I am not writing here about what to expect next on the macro front. The inflation dragon will return to its lair, but not all at once. It usually takes some time to cure inflationary expectations so they return to a “well anchored” state. The Fed will probably overshoot as it most often does. Some Fed speakers like Chris Waller will continue to make hawkish noises, long after those noises cease to be really justified. Other Fed speakers, like the Vice Chair, will be a bit more realistic in their comments. Bond traders will also likely overshoot the Fed’s terminal rate as is often the case. I will bottle up my inner electrons on that score. Was the price action of 11/10/11/11 a bear market rally, or the start of a sustainable trend toward less compressed valuations? Of course I hope the latter, but no guarantees other than to comment that the premium for future growth is at historic lows.
Even with the potential for a Fed pivot in the next several months, lower inflation and a bit less angst about the prior feeling of hopelessness amongst growth stock investors, I don’t expect high growth IT stocks to take off and become highly valued in the next several months. But that doesn’t have to happen for many members of the cohort to produce superior returns, just as they have produced disastrous drawdowns over the past year. These companies are still growing, many of them are generating lots of free cash flow and all of them are focused on growing profits even at the expense of some growth.
There have just been so many casualties in terms of valuation and share price implosion that it would be tiresome to mention all of them. It is as though it took this current earnings season to convince IT investors that demand in the space has always had a cyclical component, regardless of demand drivers such as digital transformations and the broad acceptance of AI. And, as has been the case for many decades, investors have overreacted to that insight and essentially have chosen to sell most everything IT related.
I am as guilty as the next writer in using some overworked expressions. So, while it is appropriate to comment about not crying over spilled milk in terms of looking at ZoomInfo and its imploded valuation, I will advert to trying to find that proverbial silk purse made from a sow’s ear when reviewing what is really going on at ZI, really, the questions aren’t about milk or purses or about just how horrible IT stocks have been, but which IT stocks have the best outlook and the most reasonable valuation when current macro headwinds abate. And that is why I have chosen to focus on ZI which used to be considered expensive, and which has now been battered such that it is valuation, looking at a combination or EV/S and free cash flow margins are noticeably below average.
I have been asked more times than I can think of about a single stock on which to focus. That kind of focus is hardly easy to make with any degree of analytical rigor when there are just so many beaten down IT equities whose valuation have imploded for various reasons. But I think the implosion of ZoomInfo shares is one of the least “deserved” of the various casualties that have marked this now waning earnings season. I also believe that the company is misunderstood and has never really garnered the kind of recognition that is consistent with its market opportunity and its competitive moat.
I last wrote about ZoomInfo on SA as long ago as April 2021. The shares were $50 then and are 1/3rd lower. Not a happy record. Of course, that performance is actually a little bit better than average for cloud stocks as measured by the WCLD ETF, and a little worse when compared to the performance of the IGV Tech/Software ETF. Over that span, the relative valuation of Zoom has gotten substantially better in terms of almost all valuation metrics, and I contend its outlook now is just as positive as it was all the way back in April 2021 when I last wrote about the shares.
As for the Blue Light special in the title-back 20 years ago when there was a K-Mart, and omni-channel push marketing had yet to be developed, shoppers in a physical store would hear those magic words, there is a blue light special in aisle X and a physical blue light would flash to show customers where they could find the particular item that had been placed on sale. It is much easier to find sale items these days-for most of us they will be in our inboxes, and of course, it is easier still to find ZI shares.
ZoomInfo – Just what did the company report to send the shares crashing by 39% in the wake of earnings?
It seems appropriate to actually look at just what ZoomInfo reported that might have precipitated the rerating of the shares. Just for the record, the company didn’t miss, it didn’t reduce guidance, and reported that it closed two of the largest deals in its history. This just isn’t a sick company, although it did indicate to investors that it had some macro issues that would constrain growth.
ZoomInfo, in my opinion, is really the leader in sales force automation in the B2B space. No, it doesn’t compete with that other Salesforce (CRM) or even Pega (PEGA) or Microsoft (MSFT) Dynamics. Its solutions have nothing in common, basically, with what those companies, and others who are considered to be sales force automation leaders actually sell to their users. What it does, however, is to significantly automate some of the tasks that enterprise sales people and their managers do while helping to drive the productivity of a B2B sales force.
Many commentators believe that Zoom’s service is all about prospect/contact lists-what is most often described as sales intelligence. And of course Zoom started out as a pioneer in the space, and became the leader in that space. Its co-founder basically was one of the inventors/developers of the space and his educational background has provided him with a grounding on how the marketing process actually has worked. But as this article will discuss, the simple sales intelligence solution has long ceased to be the driving element of the company’s business, although it certainly still a crucial component of the company’s overall offering.
The TAM of the sales intelligence market is not huge and its projected growth rate of 12% is not nearly as high as some other business software markets. The fact is that the TAM for the totality of what ZI sells is far greater than the $4 billion the linked study suggests because of the various definitions of the market, and the multiplicity of tools that ZI actually sells as part of its stack.
Last quarter, the company’s revenues grew by 46% and exceeded the prior forecast by about 4%. The company’s non-GAAP operating margin had been forecast to be 40%; it actually was 41%. So far so good. The company also closed its largest land deal in the history of the company, and its largest expand deal, the latter apparently greater than $10 million. That said, the 46% revenue growth is a bit of an optical illusion. Some of it is not organic, and some of it relates to the number of billing days in the quarter. The sequential growth in daily revenues was about 7%, and that translates into annualized revenue growth of a bit greater than 30%-slightly more than that in constant currency.
The company provided guidance for its current fiscal quarter that has revenues growing by just 4% or about 5% in terms of the company’s average daily revenue, the metric this company uses to evaluate sales performance. The actual expectation for revenues in this current quarter is now $300 million, compared to the prior consensus of $298 million. That kind of minimal raise was considered to be an issue by many auditors on the call and was part of what drove the shares down 30%.
Despite the revenue growth slowdown, the company is still forecasting 41% non-GAAP operating margins this quarter. The company cut its guidance for free cash flow for the year by about 2%; basically a function of assumptions about the cadence of customer prepayments/deferred revenue. And the company talked about lengthening sales cycles, and its sales reps having less time to spend on driving incremental upsells, and as a result, the company has forecast that its DBE ratio will fall from recently higher levels.
In addition, the company’s billings growth was just 20% year on year. That is also a confusing metric, and one the company has suggested is less relevant in terms of forecasting future revenue growth. In this case, in the year earlier period, the company completed 2 acquisitions, Ring Lead and Chorus. The acquisitions caused the deferred revenue balance to rise. Billings is a calculated number-thus the 20% calculation, which does not include the impact of the acquisition, yields a number that is not really comparable to other billings numbers. Adjusted for the impact of the acquisition, the comparable increase in billings was a bit greater than 30% year on year. I personally almost never look at calculated billings in any event, as so much of the change in the metric has to do with deferred revenue balances, and in turn, that has to do with customer preferences for prepayments and for other terms in a given contract.
The company didn’t provide guidance for its revenue growth expectations for 2023. That said, most analysts, based their published expectations on the kind of growth that the company has forecasted for Q4, i.e. around 25%. This actually was not very different from what analysts had previously published, although I imagine most observers had thought there would be upside compared to what they had formally projected. In any event, the 2023 EPS forecast is basically unchanged over the past 2 weeks despite the cautionary language on the company’s conference call.
Given the tenor of company management on the call, and the current environment where everything IT, except for cyber-security is under increased scrutiny, it seems prudent to accept the company’s forecast as provided. I have used that forecast in preparing my valuation analysis.
Hi-growth/Hi-value IT shares crashed the week of November 4th in response to some poor guidance by a variety of companies including this one, Twilio (TWLO). Atlassian (TEAM) and BigCommerce (BIGC). Was the crash justified by the facts in this case of ZI? Basically, Zoom’s forecast probably led to an additional 15%-20% of share price depreciation, beyond the average decline for almost all IT growth stocks. And even with its 14% bounce, it has still lost 15%-20% of its valuation on a relative basis.
I think overall, it is hard to justify the magnitude of the decline. Based on the company’s forecast, a metric I use to try to determine trough valuation, free cash flow yield has now reached 3.8%. There are very few companies with this kind of growth opportunity that have sold with that kind of free cash flow yield for any extended period. (Valuations and prices are based on the close as of Friday, 11/11).
The ZoomInfo competitive moat-how it has transformed a commodity list offering to a sophisticated sales automation platform!
ZoomInfo is probably not the best known IT name-it has just recently crossed the $1 billion/ yr. revenue threshold. It is best known as a company that supplies businesses with extensive contact information with regards to customers, specific decision makers within an enterprise, corporate events and corporate profiles-the company calls much of what it provides to its customers as signals. In other words, an updated, customized and automated list of leads.
There are many companies who provide leads; what they don’t provide and cannot provide is these intent signals which mark a leading differentiation between Zoom and the rest of the companies in this market. Many of the smaller competitors often offer much lower prices for somewhat similar content when compared to ZI. I have linked with a list of the prominent ZoomInfo competitors. It is basically impossible for any outsider to determine who has the most extensive list, or whose list is most up to date, or whose list has other data that is useful for customers. ZI has a process the company uses to collect data from many thousands of enterprises regarding information about purchasing decision makers and other corporate signals that might indicate purchasing requirements. The company probably outspends its rivals by a several times multiple in terms of the investments it makes to amass data and other relevant signals. Based on anecdotal evidence, i.e. asking a few friends in the high tech space, the breadth of the ZI tool is worth it for some, and not worth it for others. It really depends on the specifics of an enterprise deciding about the priorities for their investment in this space.
While the Zoom service is considered to be expensive by some users, many enterprises want to work with a market leader whose sale intelligence data is considered the most extensive, accurate and up to date. While a list may seem like a list, accuracy, and other buying signals that are cleansed and routed to the right individual in an organization are important for ZI customers, and less important for users who choose vendors whose services are less sophisticated and comprehensive.
But the fact is that while the core of the company’s business has been and will remain providing users with digital leads for sales calls, the company has built an offering that is quite unique, and which is a key factor in driving demand and differentiating the company’s offerings from those of company’s whose offerings who are limited to lists.
I often write about the importance of platforms as part of the sales arsenal for various IT companies. Essentially, that was the thesis I propounded in writing about Microsoft and why I believed it was underestimated by many investors. That really is the same thesis for ZoomInfo.
Zoom calls its automation technology Marketing OS. Marketing OS is essentially a set of functionality that launches targeted display and social advertising campaigns that are directed at prospects based on their job title and management level. The functionality is quite similar to that which some companies use in their consumer marketing effort but the key here is the integration of the prospect lists and the marketing efforts which is quite different than what is offered in the niche in which ZI competes. It has become the fastest growing component of the ZI stack, although it is still just a small component of the company’s overall revenues.
The company bought a small vendor called Chorus last fall. Chorus offers what is called a conversation intelligence service. Essentially, the technology, which is based on machine learning, optimizes conversations that sales people have with their prospects and customers. It is designed to be used with ZI’s lists, and it is used to analyze calls, meetings and emails to optimize the sales process. A bit spooky at some level, but a great tool for enterprise sales people.
A few years ago, ZI bought a vendor called Tellwise. It has since been rebranded as Engage. Engage is an automation platform. It looks at potential buying signals and reacts to those that make sense with prospecting, campaigns and social interaction.
The combination of these capabilities has been branded by Zoom as its RevOS platform which also includes a recruiting module. Essentially, what Zoom tries to sell these days is RevOS, rather than just its lists. Last quarter, about 30% of total annual contract value came from what Zoom calls advanced functionality. Most of the company’s larger expansion deals are including advanced functionality, and the company’s largest deal last quarter, which aggregated more than $10 million in ACV was primarily an expansion from the company’s SalesOS to a whole platform deployment.
Zoom’s Challenges
Zoom’s offerings are focused on enabling B to B sales forces, and in a recession, many businesses choose to constrain their marketing spend and cut back on investing in their sales force. Almost any marketing expenditure is going to receive extra scrutiny and require approvals from higher levels of management as company’s look to optimize spend. For many companies, the choice is between investing in ZI software, or in maintaining sales resources. Sometimes that decision goes to software, optimization and automation, and other times, retaining individual sales people gets prioritized. And of course, Zoom’s business is based on a seat based pricing model. In past recessions, it has not been infrequent to see layoffs target sales and marketing activities. If total marketing spend declines for a given enterprise, it can be awfully difficult to expand its ACV with ZI. And some of that is happening now.
One concern with regards to Zoom is that its customers wind up continuing to use the services, but with fewer employees in marketing, growth in ACV could be negative. Another concern is that while during flush times it is typical for users to buy more seats than they need at a given point in time, these seats for yet to be hired employees get returned or serve to reduce the level of expansion in ACV.
During the conference call the Henry Schuck, the company’s CEO addressed that particular concern and maintained that the company was reasonably certain that its users were not carrying extra, unused seats as part of their commitments. But at the least, during a recession, it would be highly improbable to see employment in sales and marketing actually grow. While the company doesn’t explicitly forecast its expansion ratio, the CFO talked about the DBE ratio returning to pre-pandemic levels, or in other words going from the high teens above 100% to the high single digits above 100%.
The company’s CFO said that gross retention was as high as it has ever been-in the mid 90% range. Renewals continue to happen. The company has continued to acquire new users at a reasonably consistent cadence. What isn’t happening at the levels of the recent past is the upsells in terms of seats that had been a factor animating growth over the past couple of years. It is a cyclical phenomenon, rather than a change in the long term demand trajectory.
One concern that many investors have, and have had relates to competition which can be significant in the market for prospect lists. Many of ZI’s competitors are much smaller companies with limited resources. There are probably too many companies in the space with rather basic, commodity like offerings. In this environment, according to ZI’s CFO, the company is seeing competitors pulling back on the resources that they are pushing into the market and thus ZI win rates, already strong, are rising. ZoomInfo’s most significant competitors are LinkedIn and Dun and Bradstreet. Choosing ZI or someone else is usually a function of whether users want the extra features and accuracy that Zoom offers, and in addition, whether they buy into the company’s platform approach which is not really offered by any other competitor.
In a recession, Zoom’s growth is going to be lower than it otherwise would be. It is not something that the company can control, or should be expected to control. That is a challenge, although one most software businesses will be facing and have talked about. The question, I think, is how much the implosion of the shares accounts for that recognition.
Zoom’s Business Model
Zoom has been able to achieve some of the highest margins in the enterprise software space, and despite the growth slowdown being forecast by the company, it seems likely that non-GAAP margins and free cash flow will continue at high levels, and that free cash flow will continue to grow in absolute terms. As mentioned, Zoom subscriptions are relatively expensive. And this has enabled the company to achieve a high level of non-GAAP gross margins. Last quarter, non-GAAP gross margins were 89%, up from about 87.5% in the prior year. The company has a highly efficient mechanism to collect, classify and report data which has been a feature of its business model over the years.
The company has a lean sales effort, which is one of the factors that is a component in its sales capacity which has been stressed by longer and more detailed deal scrutiny. Last quarter, non-GAAP sales and marketing spend was 27% of revenues, down from 28% the prior year. Sales and marketing expense was actually flat sequentially.
The company’s non-GAAP research and development spending is growing rapidly. It was 13% of revenues last quarter, up from 12% of revenues in the prior year, and up about 9% sequentially. As the company focuses on a platform approach, which by its nature is more software intensive, I expect that the company will see this cost ratio rise gradually.
The company’s general and administrative expense was 8.3% of revenue last quarter compared to 9.4% of revenue in the preceding year. On a sequential basis, general and administrative expense grew by 4%.
Overall, the company’s non-GAAP operating margins were 41% last quarter compared to 39% in the year earlier quarter. 41% was the strongest level of margin performance in the past year, as the company has integrated its three largest acquisitions which had a minor, but still visible impact on operating margins. The company has forecast that non-GAAP operating margins would remain at the elevated levels of Q3 into Q4 and probably beyond.
The company’s operating cash flow margin through 9 months was 36%, compared to 43% in the prior year. Deferred taxes were lower along with other deferred costs. In addition, the company’s deferred revenue balance grew more slowly than in the past. The company indicated that some of its customers decided not to prepay at rates consistent with past experience, perhaps due to macro conditions. In any event, the CFO, in looking at trends in terms of customer decisions regarding prepayments, forecast that free cash flow in Q4 would be about 5%-7% below prior expectations for that quarter. At the reduced levels being forecast, the company’s free cash flow yield is about 3.8%.
The company’s SBC expense ratio through 9 months was 17%. It is GAAP profitable at this point. SBC has risen substantially year on year, but was flat sequentially. If hiring slows, as the CEO and the CFO implied during their conference call comments, then SBC expense is likely to decline over time, although past hiring is going to continue to show up in reported SBC expense.
Valuation/Wrapping up/Conclusion
This has been a difficult year in which to be an investor in high valued IT growth stocks. Of course most of those high valuations are history at this point. Investors, in an environment of rising rates, have been less willing to pay for growth. And higher rates have brought on slowing demand growth for most IT companies, and that includes ZoomInfo. Essentially a perfect storm for IT investors including this writer.
ZI shares, down by 57% over the past year, reflect those twin trends. The EV/S has fallen to 10X, still high, but far less elevated than in past periods. On the other hand, when considering the company’s 37% free cash flow margin coupled with its growth, the shares are valued at noticeably less than average.
ZoomInfo sell sales productivity software in the B to B space. It is a leader in that space, both because its core technology is more sophisticated and more accurate and more comprehensive than competitive offerings, but also because it has developed a platform approach, not really on offer by competitors. Many investors tend to write off Zoom as a purveyor of prospect lists with a belief that there is minimal differentiation in what it does. The reality is quite different. Not only are its lists, or what it calls its SalesOS more comprehensive and more accurate than competitors, but they come with what many users consider to be useful information, which are called signals in terms of hiring, enterprise trends, new products, and many other indications of potential buying intent. The result of this is that ZoomInfo can charge premium prices for its core offerings, and this has enabled the company to operate at a high level of sales productivity. The company’s continuing pivot to offering additional services as an adjunct to its sales contact information is a factor both in differentiation the offering and in augmenting future growth. At this point, about 30% of the company’s ACV is coming from advanced functionality services, and that percentage is continuing to increase.
The fact that a company such as ZoomInfo is subject to macro headwinds shouldn’t be terribly surprising, or really terribly alarming to investors. It sells B2B solution aimed at enterprise sales people. While some businesses will opt for ZI software as opposed to hiring or retaining sales people, that doesn’t mean that macro pressures don’t exist or won’t exist. But those pressures should be considered in context. In the current difficult environment for enterprise software sales, ZI is expected to maintain a 25% growth rate and 40% operating margins with about an 85% cash conversion ratio. When macro headwinds abate, I expect the company’s growth rate to return to 30%-40% and free cash flow conversion to tick back up to around 100% or perhaps a bit higher.
This has no doubt, been one of the more difficult years in which to invest in the IT space. The carnage has simply been horrific. But with carnage come opportunities. ZoomInfo is the leader in its space, and last quarter’s results or its forward guidance do nothing to change that. The company has an exceptionally profitable business model based on its unique ability to assemble and classify information and signals that are of significant use to enterprise sales people. And its move into advanced functionality, which is further building differentiation, has been well received by customers.
At this point, the company is one of those in which the baby has been thrown out with the bath water of macro headwinds. That affords investors the opportunities to acquire shares at what will, in time, be seen as exceptionally attractive levels.
I don’t think that any commentator really knows when the Fed will actually pivot, or move to lower rates. And further, even when rates are lowered, demand reacceleration for IT services will take place with some lag. When will investors start to discount a return to higher growth for this company and for others in the IT space? No one really knows.
During the last cycle, stocks turned up long before growth estimates and earnings showed positive trends. I simply don’t have the level of pre-knowledge that would allow me to make a prediction regarding when investors will show similar enthusiasm for growth equities as was the case in 2009. And of course, until investors start to believe in a recovery, and accept that growth will reaccelerate, I don’t expect that ZI shares will come close to being valued based on their growth and profitability.
All of that being said, the reaction of ZI shares to the company’s revenue and cash flow forecast was, even on a relative basis, a major overreaction. Even after the rally of Thursday and Friday the shares simply don’t reflect the company’s position in large and emerging markets or its exceptionally profitable business model.
I have owned the shares for years and intend to take advantage of this current valuation anomaly to augment my position. Over the course of the next 12 months, I expect the shares to generate positive alpha.
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