Zoom Video Communications, Inc. (NASDAQ:ZM) Q3 2021 Earnings Conference Call November 30, 2020 5:30 PM ET

Company Participants

Tom McCallum – Head of IR

Eric Yuan – Founder and CEO

Kelly Steckelberg – CFO

Conference Call Participants

Philip Winslow – Wells Fargo

Bhavan Suri – William Blair

Sterling Auty – JPMorgan

James Fish – Piper Sandler

Meta Marshall – Morgan Stanley

Heather Bellini – Goldman Sachs

Siti Panigrahi – Mizuho Securities

Matthew VanVliet – BTIG

Will Power – Robert W. Baird

Imtiaz Koujalgi – Guggenheim

Walter Pritchard – Citi

Zane Chrane – Bernstein

Brad Zelnick – Credit Suisse

Richard Valera – Needham

Rishi Jaluria – DA Davidson

Alex Zukin – RBC

Ryan Koontz – Rosenblatt

Tom Roderick – Stifel, Nicolaus & Co.

Ittia Kidron – Oppenheimer

Shelby Seyrafi – FBN Securities

Ryan MacWilliams – Stephens

Operator

Hello, everyone, and welcome to Zoom’s Third Quarter Fiscal Year 2021 Earnings Release. I’d like to remind everyone that this call is being recorded.

At this time, I’m going to hand the call over to Tom McCallum, Head of Investor Relations.

Tom McCallum

Thank you, Matt.

Hello everyone, and welcome to Zoom’s earnings video webinar for the third quarter of fiscal 2021. We will start the webinar with a recording from Zoom’s Founder and CEO, Eric Yuan. Then Zoom’s CFO, Kelly Steckelberg will join to discuss the quarter and our outlook. We will then have a Q&A session hosted by Kelly that will end at approximately 3:30 pm Pacific.

Our earnings press release was issued today after the market closed and may be downloaded from the Investor Relations page on the Zoom.com website. Also, on the page you’ll be able to find a copy of today’s prepared remarks and a slide deck with financial highlights that, along with our earnings release, include a reconciliation of GAAP to non-GAAP financial results.

During this call we will make forward-looking statements about our market size and growth strategy, our estimated and projected costs, margins, revenue, expenditures, investments, growth rates, our anticipated financial performance and other future events or trends, including guidance for the fourth quarter of fiscal 2021 and full year 2021, our plans and objectives for future operations and expansion, growth, initiatives, strategies, market position, and the continued impact of the COVID-19 pandemic on our business.

These statements are only predictions that are based on what we believe today, and actual results may differ materially. These forward-looking statements are subject to the risks and other factors that could affect our performance and financial results, which we discuss in detail in our filings with the SEC, including today’s earnings press release and our latest 10-Q. Zoom assumes no obligation to update any forward-looking statements we may make on today’s webinar.

Now let’s hear from Eric

Eric Yuan

Hello, I hope you are all doing well. I am so sorry that I can’t join you all live today but I had a personal conflict arise. As we are in the season of Thanksgiving in the U.S., I want to express my ongoing gratitude for the commitment of our Zoom employees and the support of our customers, partners and investors during these unprecedented times. You all truly inspire and motivate us every day.

Now let me share with you a few recent business highlights. First, revenue grew 367% year-over-year in Q3. Second, with the strong sales execution, our customers with more than 10 employees grew 485% year-over-year. And we are very delighted that, just recently, Gartner Research has named Zoom a Leader in the 2020 Magic Quadrant for Meeting Solutions, as well as a Leader in the Magic Quadrant for Unified Communications as a Service. This is the first year Zoom has qualified for inclusion in the Gartner Magic Quadrant for UCaaS and in the sixth year of Meeting Solutions. We are also very thrilled to welcome Secretary Janet Napolitano to our Board of Directors.

We also had exciting wins in the quarter where customers committed to multiple Zoom products to provide a high-quality experience for their users. First, I would like to welcome Peloton to the Zoom family. Peloton is the leading interactive fitness platform. In Q3, Peloton consolidated to one vendor buying both Zoom Meetings and Zoom Rooms to provide a more feature-rich video communication service to their employees. We are very honored to have Peloton committed to a long term engagement where they will deploy services across all locations and employees.

A global customer increasing their commitment with Zoom is Rakuten. Rakuten is a global leader in internet services with 1.4 billion members around the world. Impressed by the simplicity in the Zoom technology, the ease of facilitating the service and the feature-rich application, Rakuten has committed to the full Zoom UCaaS deployment. They have grown to 42,000 meetings licenses, more than 1,000 Zoom Rooms and are currently deploying Zoom Phones across the globe.

We also want to recognize the Israel Ministry of Education, which oversees public education institutions. The Ministry of Education has enabled about 200,000 teachers and 1.2 million students to use Zoom. The leadership at the Ministry has told me that, Zoom became the most popular app for video meetings in Israel’s schools because of its simplicity, stability and many options for security and privacy.

Thank you for their hard work to provide for children’s educational needs during this crisis. And to all educators around the globe, you are all heroes. Thank you, Peloton. Thank you, Rakuten. Thank you, Israel Ministry of Education. I love you all. Also thank you as well to all other customers. Your trust and happiness energize the entire Zoom team.

Now let me talk about my favorite event of the year, Zoomtopia. In October, we had over 155,000 unique viewers attend Zoomtopia, our premier customer and community event. This year’s event was held virtually on Zoom technology. We also had over 140 customer speakers, ranging from Fortune 50 companies to small businesses, and across all verticals, sharing stories of how they have integrated Zoom into all aspects of their communication and collaboration. We showcased several customers who are not just conducting their business over Zoom, they are re-imagining and delivering new business services over Zoom as well, including the new OnZoom platform.

I’m very proud of the Zoom team that delivered this successful event to our user community and at the size and scope that is truly incredible for virtual events. We were also able to demonstrate to the world that you can do this too with Zoom.

In summary, Zoom performed well for our customers and communities during the third quarter. I want to thank our over 3,800 employees who continue to scale our business and truly deliver happiness.

With that, let me turn things over to Kelly, but first here is a look of what our new OnZoom platform has to offer.

[Audio-Visual Presentation]

Kelly Steckelberg

Hello, everybody, we’re so glad you could all join us today. In Q3 we continued to be inspired by the many creative ways our customers have been using Zoom to work anywhere, learn anywhere and connect anywhere.

Let me start by reviewing our financial results for Q3, then discuss our increased outlook for Q4 and the full year FY21. Total revenue grew 367% year-over-year to $777 million in Q3, achieving a $3 billion revenue run-rate. This top line result exceeded the high end of our guidance range of $690 million due to strong sales and marketing execution in both our online and direct businesses, as well as lower-than-expected churn.

For the quarter, the year-over-year growth in revenue was primarily due to subscriptions provided to new customers, which accounted for approximately 81% of the increase, while subscriptions provided to existing customers accounted for approximately 19% of the increase. This demand was broad-based across products, industry verticals, geographies and customer cohorts.

Let’s take a look at the key customer metrics for Q3. We continued to see expansion in the up-market as we ended Q3 with 1,289 customers generating more than $100,000 in trailing twelve months revenue, up 136% year-over-year. This is an increase of more than 300 customers over Q2, the highest number of adds we have had in a quarter. We exited the quarter with a total of approximately 433,700 customers with more than 10 employees. We added approximately 63,500 of these customers during Q3. Year-over-year, we added approximately 360,000 new customers with more than 10 employees, representing a 485% increase. In Q3, customers with more than 10 employees represented approximately 62% of revenue.

We also continued to benefit from significant growth in our segment of customers with 10 or fewer employees, as small businesses and individuals adopted and maintained their Zoom licenses. In Q3, customers with 10 or fewer employees represented approximately 38% of revenue, up from 36% in Q2. Our net dollar expansion for customers with more than 10 employees was over 130% for the 10 consecutive quarter as existing customers continue to support and trust Zoom to be their video communications platform of choice.

Both domestic and international markets had strong growth during the quarter. Americas grew over 300% year-over-year. Our combined APAC and EMEA revenue grew 629% year-over-year and was consistent with Q2 at 31% of revenue. We plan to continue to invest in international expansion to capitalize on our brand awareness and the increased global opportunity.

Now turning to profitability. The increase in demand and strong execution drove net income profitability from both GAAP and non-GAAP perspectives. I will focus on our non-GAAP results, which exclude stock-based compensation expense and associated payroll taxes, charitable donation of common stock and acquisition-related expenses.

Non-GAAP gross margin in the third quarter was 68.2%, compared to 82.9% in Q3 last year and 72.3% last quarter. The impact to our gross margin is partially due to the dramatic increase in usage related to the pandemic, as we are experiencing a higher percentage of free users, including those in over 125,000 K-12 educational institutions that went back to school in the fall. It is also due to the continued higher utilization of public cloud services.

We ended the quarter with an annualized run rate of 3.5 trillion meeting minutes, approximately 75% growth quarter-over-quarter. We are thrilled that a significant percentage of the usage was from both paid and free participants in the education sector, as millions of students and teachers returned to the classroom virtually. With the uncertainty of the longevity of the pandemic, it is unclear how long gross margins will be impacted as we remain committed to supporting the global community. Consequently, we expect gross margins to be consistent with Q3 into the next fiscal year before starting to improve towards our long-term target margin.

R&D expense in Q3 was approximately $25 million, up 80% year-over-year. As a percentage of total revenue, R&D expense was approximately 3%, which was lower than Q3 last year mainly due to the strong top line growth. We are committed to prioritize R&D hiring to drive further innovation, expansion and security into our platform.

Sales and marketing expense for Q3 was $141 million. This reflects an increase of 71% or $59 million over last year primarily due to investments to drive future growth. As a percentage of total revenue, sales and marketing expense was approximately 18%, a decrease from Q3 last year mainly due to strong top line growth and marketing efficiencies from the virtual production of Zoomtopia. We plan to continue to invest in adding sales capacity and marketing programs over the next several quarters to capture market share and to deliver on our growth opportunities.

G&A expense in Q3 was $73 million, up 257% on a year-over-year basis as we continued to scale our G&A functions to support a company of our size. As a percentage of total revenue, G&A expense was approximately 9%, a decrease from Q3 last year. The revenue upside in the quarter carried over to the bottom line, with non-GAAP operating income of $291 million exceeding our guidance. This translates to a 37.4% non-GAAP operating margin for the third quarter. This is an increase compared to Q3 last year’s result of 12.8%, and a decrease from Q2 FY21’s margin of 41.7%.

Non-GAAP earnings per share in Q3 was $0.99, on approximately 299 million of non-GAAP, weighted average shares outstanding and adjusting for undistributed earnings. This result is $0.25 more than the high end of our guidance and $0.90 higher than Q3 of last year.

Turning to the balance sheet, deferred revenue at the end of the quarter was $855 million, up 324% year-over-year. Looking at both our billed and unbilled contracts, our RPO totaled approximately $1.6 billion, up 215% from $517 million year-over-year. The increase in RPO is consistent with the strong demand and execution in the quarter. We expect to recognize approximately 72% or $1.2 billion of the total RPO as revenue over the next 12 months as compared to 64% or $330 million in Q3 last year.

We ended Q3 with approximately $1.9 billion in cash, cash equivalents and marketable securities, excluding restricted cash. We had exceptional operating cash flow in Q3 of $412 million, up from $62 million in Q3 last year. Free cash flow was $388 million, up from $55 million in Q3 last year. The increase is attributable to strong billings and collections.

For the fourth quarter, we expect to have additional capital expenditures related to the build out of our data center infrastructure. And as a reminder, we will see the semi-annual cadence of net cash outflows from ESPP purchases to occur in Q4.

Now turning to guidance, we’re pleased to raise our outlook for FY21 for both revenue and non-GAAP profitability. And although we remain optimistic on Zoom’s outlook, please note that the impact and extent of the COVID-19 pandemic and its associated economic concerns remain largely unknown. Our higher outlook for FY21 is based on our current perspective of the business environment.

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For the fourth quarter, we expect revenue to be in the range of $806 million to $811 million. We expect non-GAAP operating income to be in the range of $243 million to $248 million. Our outlook for non-GAAP earnings per share is $0.77 to $0.79 based on approximately 306 million shares outstanding. For the full year of FY21, we expect revenue to be in the range of $2.75 [ph] [Sic, $2.575] billion to $2.58 billion, which would be approximately 314% year-over-year growth.

We expect non-GAAP operating income to be in the range of approximately $865 million to $870 million which would be approximately 876% to 881% year-over-year growth. Our outlook for the non-GAAP earnings per share is $2.85 to $2.87, based on approximately 300 million shares outstanding.

In closing, as the world is changing, Zoom is privileged to be a driving force enabling connection and collaboration worldwide with our high-quality, frictionless and secured communications platform. Thank you to the entire Zoom team. With that we open it up for questions. If you’ve not yet enabled your video please do so now for the interactive portion of this meeting. Matt, please queue up our first question.

Question-and-Answer Session

Operator

And our first question is from Phil Winslow with Wells Fargo.

Philip Winslow

Hi, thanks for taking my question, and congrats on another fabulous quarter. I really want to focus in on that customer segment with fewer than 10 employees, obviously strong again this quarter. Really two questions here that I want to focus on. First, you talked about some initiatives over the past couple of calls, to translate more of these customers from monthly to annual contracts, wonder if you can give us an update on that. And then second question is, I wonder if you compare and contrast the trends that you’re seeing in terms of Zoom Phone attach between these small businesses, and then 10% plus — I’m sorry, 10 employee plus segment.

Kelly Steckelberg

So in terms of the activities that we’re doing to convert those monthly customers to annual, those continue. It’s a significant part of the focus of our marketing team. And we have seen movement in that area. It’s not something we’re going to talk about really specifically, but we’re excited about the prospects and people that continue to see the value of Zoom and want to connect to longer term agreement. So that’s great.

And then in terms of Zoom Phone, what’s great about this, we have seen consistent performance across all segments of the business, all the way from small business up to enterprise. In fact, as we continue to see strong performance in Zoom Phone, we once again had our highest deal to date in Q3. So very excited about continuing to see progress there.

Philip Winslow

Great. Thanks, Kelly. And once again, thanks for your support of K-12 education. I’ve been on two Zooms with my daughter’s school over the past few weeks. I thank you for that.

Kelly Steckelberg

Great, thank you, Phil.

Tom McCallum

Next question please, Matt.

Operator

Our next question is from Bhavan Suri with William Blair.

Bhavan Suri

Hey, guys. Let me echo my congrats there. Two quick ones. One, Kelly on linearity in the quarter, was there any — in terms of deals and then really quickly, as you look at the expansion of the product, you’ve built Zoom Phone, you’ve got the PBX work, and you’ve got a global — you’ve gone into various areas, but a natural extension might be something like call center. Love to understand how you think about that opportunity, and what you might — is that an area you might explore, an area you might visit? Or is that sort of too far afield?

Kelly Steckelberg

Yeah, great to see you, Bhavan, thank you. So in terms of Q3 linearity, it was more front end loaded than our traditional seasonality, especially as we continue to see strength in that customer base with fewer than 10 employees, that many of them are buying online. And they’re buying via credit card. What we expect to see as, especially as we move into Q4, that we’re going to start, and as we move more towards fulfillment through our direct sales channel, that it will be more back end loaded and more kind of our traditional seasonality that we saw pre-COVID.

And then, in terms of call center strategy, we agree with you, the call center contact center is a really important part of the strategy around Zoom Phone. And the way we’re approaching that today is through partnerships with many of the great contact center providers that are out there today. And we think that works really well as we have strong integrations with them. And it gives our customers the opportunity to work with the contact center provider of their choice, but to do it with Zoom Phone in a very seamless way.

Bhavan Suri

Got it. Thank you.

Kelly Steckelberg

Yeah, thank you.

Operator

The next question is from Sterling Auty with JPMorgan.

Sterling Auty

Yeah, thanks. Hi, guys. So Kelly, I want to circle back to the customers with less than 10 employees. And specifically, you made the comment that churn was better than expected in the quarter. Was that attributable to the entire customer base, or specifically to these smaller customers?

Kelly Steckelberg

Hi, Sterling. Churn was actually better across all segments of the business. So as I mentioned earlier, the marketing team is very focused on trying to convert monthly to annual customers in that fewer than 10 base. But we’ve also seen, even in the upmarket people that are also expanding, continuing to buy more products, which makes them more integrated into the Zoom ecosystem and makes them more retentive. So we saw that across all segments of the business actually.

Sterling Auty

Should the under 10% of revenue that 38% perhaps fall back as you get in to that end of year budget flush and maybe bigger spend by large enterprise.

Kelly Steckelberg

We think certainly over time that we will move back towards more of our sales and bookings being dominated by our direct sales channel, which then yes, would ultimately eventually drive down that percentage of revenue from the fewer than 10 employee base.

Sterling Auty

Thank you.

Operator

Next question is from James Fish with Piper Sandler.

James Fish

Hey, Kelly. Hope you had a great holiday. I know our focus would be here on Zoom Phone. But just curious on Zoom, it’s still in beta is my understanding. But how has the monetization strategy developed over the last few weeks since Zoomtopia? What Commission does Zoom take? And is there any way to think about the size of this business a few years down the road? And if I can squeeze in a second one, additionally, what percentage of revenue this quarter came from the greater than $100,000 customers this quarter?

Kelly Steckelberg

Okay, hi, James. Great to see you. In terms of on Zoom, yes, it is still in beta at this point. And we have not yet announced what our monetization strategy is around that platform. We’ve certainly been working on internally, but we’re more focused on ensuring that the platform is ready and is meeting the needs of not only the host, but also the customers and making that a really seamless transition or transaction for them. I hope you saw the video, some of the really cool things that are happening on the platform. And if you guys haven’t checked it out, just go look, and you can see the classes and events that are happening there.

We will announce our monetization strategy probably sometime next year. But in terms of how we’re thinking about it, we don’t expect it to have a significant contribution to revenue next year. And we’re really focusing on building out the platform itself.

And then in terms of your second question, that percentage of revenue from customers greater than hundred. Yeah, I need to look, sorry, one second. I just need to look and see exactly what that is. Let me come back to you, James. I have it my stuff. Let me come back to you.

James Fish

Just have Tom or come back to me later. Sounds good. Thank you.

Operator

All right. The next question will be from Meta Marshall with Morgan Stanley.

Meta Marshall

Hi, thanks. So you noted that Zoomtopia, kind of expansion capability or expansion room within the global 2k, given a lot of room to grow within that customer subset. I just wanted to see how do you feel your staff to attack that opportunity? Do you feel your staff out to a tactical about 2k? And then maybe just in terms of, you have a pretty meaningful cash balance at this point. Is there meaningful M&A kind of being discussed in the space? How does that change kind of your viewpoint of how you’re looking at M&A? Thanks.

Kelly Steckelberg

Hi, Meta, nice to see you. So certainly, in terms of addressing how we staff to, serve and take share, continue to take share in the global 2k, international expansion is a huge area of focus for us. And we talked a little bit about this in the past. But with the increase of brand awareness around the globe, it has really created an opportunity for us to hire into markets very quickly, where historically it would have taken us time to seed those markets with marketing spin. And now we’re able to just go in there, because we’re seeing tremendous demand. So we’re excited about the opportunity. And yes, Abe Smith and our international team are growing very quickly to address that.

And then, in terms of cash balance and M&A, we certainly continuously watch for opportunities to do something with that cash, that would be additive. I think we’ve talked about in the past, we would look for opportunities in M&A that could either extend our technology or our talents. And those are the two areas that we’re continuously watching for the right opportunity.

Meta Marshall

Thanks.

Tom McCallum

Hi, this is Tom. Just wanted to point out on the last question that James asked, it is 18% coming from the greater than 100k.

Kelly Steckelberg

Thank you, Tom.

Operator

Next question is from Heather Bellini with Goldman Sachs.

Heather Bellini

Hey, Kelly, thank you so much. I’ve two quick questions. One, just — I guess, just thinking about chat functionality and team-based chat collaboration specifically, given that category has seen tremendous growth during the pandemic as well. And just giving the competitive dynamics there right now, if you guys have any thoughts on how you see that playing out and your ability to compete there. And also just a follow-up, how much Zoom Phone, driving customers over 100,000 were — you continue to have another really big quarter there in terms of adds.

Kelly Steckelberg

So our chat product is a really important part of our overall product suite, especially when you look at Zoom Phone. It’s a very natural tie into it. And as we’ve seen the expansion in Zoom Phone we’ve seen customers continue to ask for more features and functionality and we certainly are committed to continuing to develop and innovate around Zoom Chat. And as a reminder, it does come embedded with our meetings product itself.

And then in terms of how much Zoom Phone is driving customers greater than 100k, I don’t think that we have explicitly called out the number of Zoom Phone customers we have in that specific category. As we said about Zoom Phone metrics, we’ll continue to look at opportunities for milestone metrics along the way. And that could be something we would disclose in the future. We just haven’t done it yet today.

Heather Bellini

Thank you.

Kelly Steckelberg

Thank you, Heather.

Operator

Next question is from Siti Panigrahi with Mizuho.

Siti Panigrahi

Hi, Kelly. Thanks for taking my question. I was wanting to ask about the sales productivity. You added a lot of sales people this year. So could you talk about the sales productivity in fiscal Q3, million dollar up market? And what are you assuming in terms of productivity or expense in the up market segment in your fiscal Q4 guidance?

Kelly Steckelberg

So in Q3, we continue to see strong sales productivity across all segments of the business. But when you care — when you look at the results, from Q1 to Q2 to Q3, they are starting to come down to down to more normalized rates. And when we’re looking forward and thinking about Q4, and into next year, you should think about that our reps are returning to more normalized pre-COVID sales productivity levels. And that’s how we’re thinking about it. We’re still obviously working on our FY22 plan but that’s how we’re thinking about it at a high level.

Siti Panigrahi

Great, thank you.

Kelly Steckelberg

Thanks, Siti.

Operator

Our next question is from Matt VanVliet with BTIG.

Matthew VanVliet

Hi, thanks for taking the question. Can you [technical difficulty] dig in a little bit more on the international side of the business? How are you seeing the sort of difference in terms of what the U.S. looks like? And then secondarily, are you have any markets that are — were a little bit more difficult to penetrate, whether it’s from security or infrastructure elements that are now either being invested in or you’ve sort of gotten past those impediments to start?

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Kelly Steckelberg

Yeah. So let me talk about the second part of the question, first, in terms of security and privacy, we’ve obviously focused a lot on this as a company on a global basis over the last nine months. And all of the initiatives that we have taken certainly have borne fruit. As we’ve continued to invest as well as putting teams in local markets, that helps a lot with also building the trust and confidence of the customer base there. So certainly we’ve seen the progress there. And then, in terms of what was the question, how is the US different in terms of — did you ask about minutes usage, is that what you asked?

Matthew VanVliet

No, just mix of, are you seeing larger customers, whether it’s our [ph] customers, are there more kind of individuals there, any differences?

Kelly Steckelberg

Yeah. Again, we’ve seen strength across all segments internationally. You remember, I think it was last quarter, our largest customer in the quarter was an international customer. So we’re really excited about the progress we’re continuing to make there.

Matthew VanVliet

Thank you.

Kelly Steckelberg

Thank you, Matt.

Operator

Our next question is from Will Power with Baird.

Will Power

Great, thanks. Yeah. Kelly, you noted the really strong usage growth, I guess, sequentially. You cited 75% usage growth. Anyway to kind of help frame how much that was driven by education versus broader verticals. I guess the other way to kind of cut that would be to kind of look at any color, you could provide around, free growth generally versus we’re seeing in terms of paid growth. And I’ve a second question.

Kelly Steckelberg

So as I said in the prepared remarks, a large percentage of the growth in the usage was from education, but both free and paid. And paid is certainly an elevated percentage of our total usage. Education continues to be one of our strong verticals. It was the second fastest growing vertical again in Q3. So really excited about the progress we continue to make there as well.

Will Power

Okay, and then my second question, you noted the record number of 100,000 [ph] customers in the quarter, which was great. Anything you’d point to with respect to key drivers that — were there any particular verticals that stood out among that largest cohort, geographies and stood out, any changes in go to market? Kind of what kind of drove the improvement there?

Kelly Steckelberg

No, I think that it was really diversified across all markets, all segments and all verticals as well. I think it’s more about the continued expansion in our sales organization as well as the increased brand awareness. And as companies are continuing to think about the extension of this remote working and ensuring that they are keeping their employees productive as well as safe during this time.

Will Power

Thank you.

Operator

Our next question is from Taz Koujalgi with Guggenheim.

Imtiaz Koujalgi

Thanks for taking my question. I had a question on the average deal sizes. If you look at the number of new customers you’re adding every quarter that has gone down, which is expected. But can you comment on the average deal sizes for new consumers? Has that changed at all, the last few quarters, the initial land sizes?

Kelly Steckelberg

We haven’t seen a significant change in our overall deal size. If you remember, land and expand is still a very important part of our sales strategy. And we see customers doing it. We also see customers that are starting with for example, Zoom Meetings, and then add on — two of the customers we talked about today, Peloton and Rakuten, that added on Zoom Phone later. So not really a significant change in the overall deal size, especially at the start.

Imtiaz Koujalgi

Thank you.

Operator

Our next question is from Walter Pritchard with Citi.

Kelly Steckelberg

Hey, Walter.

Walter Pritchard

There we are. Okay. Sorry about that. You noted that churn was below what you expected. But I’m wondering within that — of the customers that did churn, did you notice any trends or commonality that seemed to be coincident or causing the churn that you could help us understand?

Kelly Steckelberg

No, it’s — the churn correlate somewhat to the overall pandemic. And so as we continue to see uncertainty in terms of markets, locations, with shutdown, or shelter in place orders, we see variance. We see the most volatility, of course, in the segment of customers with 10 or fewer employees. But even that was at an improved level than what we were originally forecasting. As I talked about before that’s due in part to these actions where we’re having success. It’s definitely converting customers from monthly to annual contracts.

Walter Pritchard

Thank you.

Kelly Steckelberg

Yeah.

Operator

Our next question is from Zane Chrane with Bernstein.

Zane Chrane

Hi, Kelly, thanks for taking the time. I was wondering if you could explain to us what portion of business customers are on the active host pricing model versus a named host pricing model? And why do you make that distinction? What does it mean for you in terms of strategy, adoption, overall growth? And then I have a quick follow up.

Kelly Steckelberg

Sure, hi, Zane. So in terms of the approach, and why we have active hosts versus named hosts is because it allows customers that aren’t sure exactly what their uses are going to be, to come in and buy Zoom at a level that feels comfortable to them, and then grow into that. So it’s a very effective mechanism for maybe somebody that’s newly adopting video communications, or expanding and extending it to a part of their organization that may not have used it before. And it’s a great way for them to have the opportunity to assess what that level of usage is going to be.

In terms of what percentage comes from that, that’s not something that we disclose. It’s really a mix, depending on the customer segments, and how those customers want to buy.

Zane Chrane

That’s helpful. And as far as the customers that are on the active host pricing model, how long is the lag? Or how should we think about the relationship between revenue and usage? Is it a one month lag between monetization versus usage? Is it a quarter? Is it a year? How should we think about that in general?

Kelly Steckelberg

Yeah, so the active host model is most prevalent in our up market customers. And the typical structure — of course, again, we’re focused on delivering happiness to our customers. So these are all things that are negotiable. The typical structure of a deal would be, they would have access to a certain — a set number of licenses. They would pay for some fraction of that for the first year. And then after a year, we would look at where their high watermark was of usage for those hosts. And that would be their true up then for the next year.

Zane Chrane

So should we interpret that as meaning customers that have not hit that one year anniversary? Those may be in Q1 or Q2, that have expanded significantly in the last year, we should still see improved monetization of those in Q2, Q3 next year maybe?

Kelly Steckelberg

There’s absolutely the potential in that scenario, that yes, there’s a step up for those customers if they’ve expanded through where we started them in their minimum commitments at the beginning of their contract. Yes.

Zane Chrane

Super helpful. Thank you very much and congrats again.

Kelly Steckelberg

Thanks Zane.

Operator

Our next question is from Brad Zelnick with Credit Suisse.

Brad Zelnick

Great, thank you so much. Hi, Kelly. Hey, Tom. How are you guys doing?

Kelly Steckelberg

Hi, Brad. I’m good. How are you?

Brad Zelnick

Very well. Thank you. I echo my congrats. Just a question, following up on an earlier question about geographies, seems healthy growth all around. But if I look at EMEA, only 5%, growth sequentially, just — any reason to call out why it would be a little bit weaker relative to the Americas or Asia-Pac?

Kelly Steckelberg

No, nothing significant there to call out. Some of these regions are just impacted by larger deals in the quarter, and otherwise nothing significant really happening that’s of note. Again, some of the growth across these regions is dependent upon where these markets are from the pandemic sort of cycle. And if you look back to Q3, I think at the beginning of Q3, Europe was in a very optimistic situation. And unfortunately, we’ve seen sort of some of that reverting as we’ve gotten to the back half of Q3. So it’s a little bit variable with what’s happening in the overall pandemic itself.

Brad Zelnick

Great. If I could throw in a follow-up for you, just on the channel strategy, any updates that you can share? What’s the measure of success there? And how are you performing against that?

Kelly Steckelberg

Yeah. So first of all, the channel continues to be important part of our long term strategy, especially internationally and around Zoom Phone itself. And the way that we measure it internally, or one of the ways that we measure it internally is by looking at the percentage of revenue that is touched, is touched — come through the channel or is touched through the channel. That’s not something that we’ve disclosed publicly in a long time, but it might be something that we continue to evaluate for potential disclosure in the future.

Brad Zelnick

Great, thank you so much for taking the question.

Kelly Steckelberg

Thank you, Brad.

Operator

Up next we have Richard Valera with Needham. Hey Richard, can you unmute?

Richard Valera

Sorry about that. Sorry. Hi, Kelly. Sorry about that.

Kelly Steckelberg

Hey, Rich.

Richard Valera

Yeah, so question on operating margins. You looked like this quarter, you finally started to see expenses catching up with revenue. And you had that expected decline in op margin. You’re guiding for another one in the fourth quarter. I think last quarter, you said you expected several quarters of decreasing operating margins. And I know that kind of takes us into fiscal ‘21. Can you talk about how you think about that trajectory of expenses versus revenue and op margins for the next few quarters?

Kelly Steckelberg

Yeah, so I think if you look across some of our areas of functional spend, we want to continue to invest in R&D. That is an area we’re absolutely focused on prioritizing, hiring at 3% of revenue. We would really like that to be closer to our long term target margin of 8% to 10%. And then, of course, in sales as well, focusing on adding sales capacity, and also spending a little bit more around marketing, as we think about promoting Zoom Phone and some of the other new products and platforms like on Zoom.

So those are the areas that we’re thinking about investing in. And that’s over — as we said over the long term, why you should expect to see that margin continue to decrease.

Richard Valera

Got it, just a quick follow up, if I could on phone. You’ve added a lot of functionality to that product over its short lifetime. And I guess most recently really expanded the international footprint. Where are you now in terms of where you want that product to be? And where you need to be competitively Are there any major outstanding features or functionality you think you need to add to phone to complete it?

Kelly Steckelberg

Yeah, we think we’re very well situated from a competitive feature and functionality perspective. And as you said, we announced last quarter that we’re in 44 markets from a native Zoom Phone deployment perspective. So really feel great about the progress we’ve made around that and are excited about the continued progress that we’re seeing in Phone.

Richard Valera

Great. Thanks, Kelly.

Kelly Steckelberg

Yeah, thank you.

Operator

Our next question is from Rishi Jaluria with DA Davidson.

Rishi Jaluria

Hey, Kelly, thanks so much for taking my questions. Nice to see continued strength in the business. Just wanted to touch on gross margins again. Look, I think the rationale of free users makes a ton of sense, especially given you’re enabling K-12. And you’re doing some very customer friendly things like removing the free limits on Thanksgiving, so people don’t have to travel, which, we all appreciate you doing those things? Can you help us I think directly understand how big of an impact is that — is there? And since you’re talking about this impact going into next year, is there a point at which it makes sense actually start to break down the cost associated with free customers?

And then just along — a follow up on the Zoom Phone side, apologize if you already mentioned this, but how many only Zoom Phone seats you added within the quarter? Thanks.

Kelly Steckelberg

So hi, Rishi, thanks to you too. In terms of the gross margin, as we [technical difficulty] also looking on the holidays like Thanksgiving, and we’re really excited about the opportunity for us to do that. At this point, we aren’t prepared to give you a change in the outlook around gross margin and for the foreseeable future, you should expect it to be in this range, for at least several quarters before it eventually starts moving again back towards our long term target.

And then in terms of breaking out the free, I don’t think we’re going to want to break out. We really value our free customers, our free hosts, and we think they’re a very — they continue to be a very important part of this ecosystem. So I think of it as if we weren’t — if we didn’t have them sitting in our gross margin, they would be sitting in sales and marketing in terms of those expenses. So this is just the way that we’ve chosen to build our go-to-market and that’s just what the trade-off compares to other companies why you might see a difference in those functional spend.

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Rishi Jaluria

Thank you. I’m sorry, just in terms of Zoom Phone seats out in the quarter, did you…?

Kelly Steckelberg

Sorry, yeah, we don’t disclose — we’re not disclosing exactly the number of seats added in any quarter. I will tell you as I said, we had the highest, the largest deal to date in Q3 and other record setting deals. So very excited about that.

Rishi Jaluria

Wonderful. Thank you, Kelly.

Operator

The next question is from Alex Zukin with RBC.

Alex Zukin

Hey, Kelly and Tom. Thanks for taking the question, and congrats on a good quarter. I guess Kelly, we haven’t talked a lot about next year. I know you’re not guiding to next year. But you can imagine the question we get all the time from investors is, how does Zoom grow post-pandemic, was this a pull forward? And as people go back to work, do they turn — school, do they turn off their Zoom?

So given the commentary that you that you talked about with respect to churn rate for the business being better than you expected, given the commentary around Zoom Phone attach? Again, not asking for specific guidance, but at a high level, how would you think — how would you kind of talk to us about calibrating growth for next year? Is it more going to be swung by churn, is it more going to be swung by Zoom Phone attach, any clarity you can provide, I think would go a long way.

Kelly Steckelberg

Sure, I think a couple of things. First of all, the remote working trends that started pre-pandemic have certainly accelerated during this period of time. And while we all hope for a vaccine as soon as possible, I think that remote work trends are here to stay. And we’re excited about some of the features and functionality that we announced at Zoomtopia, for example, to enable this and to support customers and employees that are thinking about potentially going back to work likely in some sort of a hybrid work environment.

So these are things like Smart Gallery, which are really meant to enable better communications when people — some of the employees are working remotely and some of them are in the office. So we’re really looking towards supporting an environment like that, and believe that our — especially our up market, customers are going to continue to want to provide that flexibility to their employees.

And then, in terms of key growth drivers, absolutely. Zoom Phone is one of the key drivers for next year. It was absolutely the fastest growing product in Q3. So excited to see that momentum. And if you think about this significant base of Zoom meetings customers that we’ve acquired in Q1, Q2 and Q3, they are there to continue to support our strategy of selling into our install base. And we absolutely expect that to be a key driver for next year.

Alex Zukin

And then just as a follow up Kelly on churn, right, if you think about the cohorts and breaking down those churn rates, and particularly on the consumer cohort, what is the assumption for Q4 and then as you go now — as you start to go into a more vaccine-led world, again, even when you do give guidance, it’s not like you’re going to have great — you are seeing some engagement trends globally from some regions that are in a different stage of the pandemic today. But what’s going to give you the confidence around that — those churn assumptions for next year?

Kelly Steckelberg

Yeah, I mean, we are taking an approach where we can’t predict the pandemic and so we are taking what we believe is a prudent approach. We do assume that the churn in the mass market, so the customers with fewer than 10 will continue to be elevated compared to both, the pre-pandemic level that we saw, as well as extremely elevated compared to the up market segment of our customer base.

So our — overall, like the relative assumptions haven’t changed. We’ve just seen slight improvements from what we were expecting. I think that’s due to many factors we’ve already talked about, people continuing to see the value in Zoom, people embracing this remote work and assuming this is how this is going to be for a very long time, as well as the efforts that we’re making to help people see the value and convert from monthly to annual.

Alex Zukin

Great, thank you so much. Stay safe.

Kelly Steckelberg

Thank you, Alex. Thank you, you too.

Operator

Our next question is from Ryan Koontz with Rosenblatt Securities.

Ryan Koontz

Hi, great. Thanks for the question. Can you expand a little bit in your relationship with the Lumen Technologies, former CenturyLink, a little bit there? And do you envision that’s something that you would expand the DSP market, potential channel relationships? How do you frame that up? Thank you.

Kelly Steckelberg

Yeah. So as I mentioned earlier, channel continues to be an area of focus and an opportunity for growth for us. We don’t really comment on specific relationships, because we love all of our channel partners equally. But certainly this is an area that will be a driver — an area driving growth for next year.

Ryan Koontz

Helpful, thank you.

Kelly Steckelberg

Yeah.

Operator

Our next question is from Tom Roderick with Stifel.

Tom Roderick

Yeah. Thanks, Matt. Hi, Kelly, great to see you. Thanks for doing this. So I want to go back — the one question before was sort of on operating margin and the leverage in the model, and obviously, the investments in sales and marketing, we all get that. Very interesting to see R&D be down sequentially, especially with all of the advancements, enhancements that we’ve seen in the product. Can you talk a little bit a bit more about just structurally R&D? How much more do you need to throw at it for Zoom Phone on Zoom? We’ve seen a lot of developments just with the numbers where they’re at.

And then, as they come back to structurally, geographically does R&D just rise over time as you disperse geographies or help us think about that as we go into next year.

Kelly Steckelberg

Yeah, sure. So in terms of the dollar decrease that you mentioned, from Q2 to Q3, that’s due to the fact that there was a pretty significant consulting agreement in Q2, related to continuing to build out security and privacy on the platform. And that’s why you see that decrease from a dollar perspective, quarter-over-quarter. And then long term, our target R&D is to be 10%-ish. That’s really where we want that level of investment to be. And your point is exactly right. It will start to increase naturally, as we diversify our talent pool, in terms of geographic locations and hiring. We’re really focused on hiring the best talent wherever they are. And working remotely has really enabled us to do that and define great talent in multiple locations in the U.S., and also continuing to expand as we’ve talked about previously in India, as well.

So all of that will help us not only increase our spending, as it diversifies our talent pool and opportunity for hiring, but also to give us this 24/7, follow the sun development approach as well.

Tom Roderick

Yeah, and I’m glad you mentioned the consulting agreement. So just really quickly as a follow-up, I mean, you got the end to end encryption, really, quite quickly. What’s been the feedback from corporate clients on that? And how has the performance of the overall system held up relative to keeping that an option for all customers out there and not just paying?

Kelly Steckelberg

Yeah, so just to clarify, it is available today for all free and paid customers with up to 200 participants in their meeting. So far we are in this state of — it’s generally available but in technical review. So taking feedback from our customers, and so far, that has largely been positive. And we haven’t seen any impact that would indicate that we need to approach our go to market any differently with it.

Tom Roderick

Great. Congratulations. Thank you.

Kelly Steckelberg

Thank you. Thank you, Tom.

Operator

Our next question is from Ittia Kidron with Oppenheimer.

Ittia Kidron

Thanks. Hi, Kelly. Thanks again, great results. Just a clarification and a question for me as a clarification regarding Alex’s question on churn, just to make sure I understand your churn change assumptions heading into the fourth quarter. Are you assuming the same assumption that you made heading into the third quarter or you’re taking the churn assumption that actually transpired in actual in the third quarter?

And then my question is about the vertical depth — I’m sorry, the Federal vertical, it is a September quarter that you ran for the vertical. So it fell within your October quarter. How did God behave and how does the pipeline look around that vertical going forward.

Kelly Steckelberg

Yeah. So as we are looking into Q4, we continue to assume that the churn assumptions that we’re using are more consistent — we’re using modeling are more consistent with how we were thinking about it as we came into Q3. And not necessarily assuming that we see that improvement that came to actuality in Q3. And then in terms of the verticals heading into Q4, I mentioned early education was one of our strongest growing verticals, government was actually our strongest growing vertical quarter-over-quarter in Q3. So excited about the progress that team is continuing to make.

Ittia Kidron

That’s great. Thanks.

Kelly Steckelberg

Yeah, thank you, Ittia.

Operator

Our next question is from Shelby Seyrafi with FBN Securities. Hey, Shelby, are you there?

Shelby Seyrafi

Can you hear me?

Operator

Yeah, here we go.

Kelly Steckelberg

There you are, hi, Shelby.

Shelby Seyrafi

Yeah, hi. So on the gross margin, which was pressured in Q3, and you’re lowering the outlook for the near term. Was the bigger factor, the free usage or the public cloud, increase?

Kelly Steckelberg

They are both having about the same impact honestly. It’s a pretty comparable split between the two.

Shelby Seyrafi

Okay. And the second one I have for you, is we’re in the middle of a brutal second wave. And obviously, last time when the first wave hit, you guys benefited a lot. So I’m just trying to see if, over the past month or two, you’ve seen some inflection point higher than the typical trend over the past six months, because of the second wave?

Kelly Steckelberg

I wouldn’t say that we’ve seen an inflection point like we experienced in Q1.

Shelby Seyrafi

No, I know that, but just slightly higher, because of the second wave, any kind of positive effect.

Kelly Steckelberg

It’s really early. I think that — I mean, whichever way you’re describing of when you’re characterizing the second wave is happening, some of that would be falling into Q4. And thus that would be reflected in the guidance that we just gave in terms of what we’re currently seeing around the business environment that we’re seeing based on what we understand to be true around the pandemic.

Shelby Seyrafi

Okay, thanks a lot.

Kelly Steckelberg

Yeah.

Operator

All right. We have time for one more question. So our last question is from Ryan McWilliams with Stephens.

Ryan MacWilliams

Hey, Kelly. Thanks, guys for squeezing me in once again.

Kelly Steckelberg

Hey, Ryan.

Ryan MacWilliams

One thing we haven’t talked about recently is Zoom Rooms, and maybe I’m taking an optimistic approach here. But hopefully as things return to normal into next year, are you seeing enterprises starting discussions now about rationalizing their office footprint and video enabling more Zoom Rooms, and just talk about how that’s changing? Thanks.

Kelly Steckelberg

Yeah, we actually are. So we’re seeing customers that are taking this opportunity while their offices are empty to update or put in Zoom Rooms. And especially thinking about how this is going to work if they potentially go back in a hybrid environment and how they’re going to create an inclusive environment, if they have an employee workforce that is now split between remote and people working in the office. That’s why I’m so excited about for example, Smart Gallery, which is really going to enable and empower an experience that’s beneficial, and really maintains this — I will call the democratization communication that’s been created as we’re all working from home, right. All of our squares the same size on this screen.

And so Smart Gallery is going to enable companies to continue to provide that to their remote workers when we eventually start to go back in some sort of a hybrid approach.

Ryan MacWilliams

Thanks for taking the question. Congrats on the results.

Kelly Steckelberg

Yeah, thank you, Ryan.

Operator

That was our last question for today.

Kelly Steckelberg

Okay. Thank you, Matt. And thank you all so much for joining us. We appreciate your support during Q3, and thank you again to all of our Zoom employees that made our quarter possible.

Tom McCallum

Thank you, everyone.



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