We’ve held DocuSign for over a year although we have not added to this LTBH position for some time. Below, we discuss why we closed the position. Our members must make their own decisions, we simply offer transparency on why we add stocks to the portfolio and why we close some positions. We always remain flexible – even with LTBH. The companies we hold must continually earn a position in the portfolio. We add positions and close positions at our discretion and we offer full transparency because we think it’s the right thing to do with anything related to finance.

We plan to re-allocate more towards Asana, Monday.com and Zoom Video for the productivity/WFH/remote trend. We lump DocuSign into this category as a productivity-based cloud company for agreements and signatures and certainly WFH helps the company. However, we think the addressable market and growth will be stronger on the other three we mentioned.

Thank you! 🙂

DocuSign

DocuSign’s earnings report spooked the market with billings growth of 28% year-over-year and billings guidance of 22.2% next quarter. For the fiscal year ending in January, the billings growth is forecast at 36% year-over-year. The company said this was caused by slowing demand, urgent buying patterns that tempered and also “the environment shifted more quickly than we anticipated, and these were the primary contributors to our billing results in Q3 and our outlook for Q4.”

The CEO also took the blame for the slowing billings growth and stated he was more focused with handling the business that came from the urgency of the shift towards cloud rather than generating new demand. “And we really do believe it’s this core phenomenon of the demand was aggressive and we got focused on meeting that demand. And so, when that demand kind of started to come to — back to normalized, we weren’t ready. We weren’t executing. We hadn’t taken all those new folks that had only joined in the time of that meet demand sort of mode and we didn’t shift fast enough back to a mode of a normal generating demand.” And later, it was stated, “But the real — the underlying story here is that we did not execute in our field the way you should expect us to execute and we got to own that and we got to fix that, and that’s why we’re putting the focus as we talked about at the beginning of the call on that execution.”

Probably where our decision hinges even more is the lack of catalyst for DocuSign as it does not necessarily participate in the hybrid or remote work-from-home trend. I’m referring specifically to the trend where 30% of the workers globally and more than 50% of the workers in the United States will remain in a WFH situation after cities fully reopen, and productivity will need to be progressively maintained across remote workforces. These tools are ideally usage based or based per employee, whereas DocuSign is tied to the number of contracts being signed.

The blockchain could be a catalyst for DocuSign or it could be how the company is will become disrupted. According to management, the blockchain is too costly for the number of agreements that DocuSign facilitates but this could change over time. DocuSign has stated the blockchain can help with identity management, however, and it’s one of the use cases the company plans to pursue although this would ideally happen with a blockchain specifically made for auditing documents and e-signatures rather than native protocols suited for the financial industry or gaming.

It's also important to note that the company pointed towards a lack of cross-sells and upsells as another factor weighing on future bookings growth: “However, what we weren’t as successful at is getting as much of the cross-sell and upsell opportunity.” This is concerning to me long-term as the net retention rate for DocuSign has been in the 112% to 119% range and is currently in the 121% range. Ultimately, I’m not convinced there is enough an up-sell with this product to expand the customers that came onboard during 2020.

One analyst attempted to get a clear sign from DOCU on when a turnaround could occur and it seems at least until the second half of next year.

“And then, because it does feel like given the sales cycles for these larger contracts are at least 6 to 9 months, this could be something that impacts you at least until you anniversary Q3 of next year. So, just get a better understanding of the — how long those elements, I guess.” – Alex Zukin, Wolfe Research

Here was management’s answer which seems to indicate H1 could be better:

“Yes, similar to some of the other commentary, I think the right way to think about it is, again, the things that were toughest for H2 of this year are going to be the areas that were dramatically strong all last year and H1 of this year. And from a geography standpoint, that’s basically the U.S., right? And from a vertical standpoint, that’s going to be healthcare, life sciences, that’s going to be financial services, banks, insurance companies, et cetera, and a little bit on the technology telecom side. So, that’s — we just clearly see that in the data.”

Currently, analysts have full year revenue for next fiscal year at $2.61 billion, or 24.8% growth.

DocuSign technically beat on EPS and revenue in the current quarter and the company is profitable. The guidance for revenue missed with analysts expecting $575.3 million and the company guiding for mid-point of $560 million. The company reported free cash flow of $90 million compared to $38.1 million last year, for a EV/FCF of 73 compared to Zoom at 32. The company has $900 million in cash and cash equivalents.

For digging our heels in on Covid stocks, we are waiting to see what Zoom’s Q1 guide says regarding the company’s post-Covid growth potential. We also like Asana and Monday.com due to enterprise growth as well other reasons outlined in our Forbes editorial and published on the forum here.

Shopify reported Q3 results that came in slightly below expectations as consumers reverted to offline shopping during the quarter. However, growth remained robust as sales grew over 40% and YTD GMV increased to over $120 billion. Shopify also announced it is increasingly expanding into social commerce, which I discuss in greater detail below. We are bullish on Shopify and the company will remain a LTBH position into 2022.

 

Note: Beth Kindig contributed to this analysis

Shopify’s Q3 results

 

Total Q3 sales increased 46% YoY to $1.12 billion, which missed the Street’s estimate by $22 million (2%). Sales were driven by a 51% YoY increase in Merchant sales, which rose to $788 million. Merchant sales were supported by growth in GMV, which increased 35% YoY to $41.8 billion, after increasing 109% in the prior year quarter. Specifically, GMV penetration in Shopify Payments increased from 45% to 49% including from point-of-sale hardware for offline sales.  Shopify’s goal with Merchant Sales was to support both online and offline with the economy reopening. The partnerships with Affirm and Global-E also contributed to this growth.

Here's an excerpt discussing this:

“Just to sort of give a little more color on point of sale because I do think Q3 was our best quarter for the retail business. Retail GMV hit an all-time high. But we are bringing Shopify as a very efficient go-to-market model to the POS industry. We're not leaning on established networks of partners, but rather we're doing this in a really efficient way. … Again, retail GMV is the second largest contributor to overall GMV behind the online store. We also saw point-of-sale with Shopify Payments continue to expand globally… Point of Sale Pro is available now across more devices like Android devices.”

Following the growth in merchant sales, subscription sales increased 37% YoY to $336 million, which slightly outpaced the 33% YoY increase in monthly recurring revenue. According to management, this is being driven by merchants globally adopting the Shopify platform. International is an area where Shopify is investing with currently 28% of purchases coming from international buyers.

While GMV growth has been strong, GMV moderately declined QoQ from Q2, as consumers shopped more offline as restrictions from Covid-19 have been eased and stimulus has dissipated. Through the first nine months of the year, GMV increased to a record $121 billion. In fact, the company pointed out that GMV has doubled over the past 16 months from $200 billion in June of 2020 to $400 billion at the beginning of October. GMV, or Gross Merchandise Volume, represents the total dollar value of orders facilitated on the Shopify platform including revenue-sharing arrangements. It helps to demonstrate the growth of Shopify’s platform and its reach. As of now, Shopify owns 8.6% of the market measured in GMV and is in second place behind Amazon, with a wide lead at 39%. Shopify’s second-place ranking excludes merchant point-of-sale which was a big driver for Shopify this year, so it’s percentage could be higher.

Looking forward, subscription sales will likely continue to be strong given the company’s high levels of deferred revenue. Deferred revenue surged 216% YoY to $378 million, or 113% of three-month subscription sales. However, deferred revenue was skewed by large amounts of non-cash considerations from new partnerships that Shopify has signed. I discuss these partnerships in greater detail below. Nevertheless, after adjusting for non-cash consideration, deferred revenue still increased 42% YoY to $137 million, which represented 41% of quarterly subscription sales, up 100 bps YoY from 40% in Q3 2020. The relatively higher level of deferred revenue positions Shopify for continued growth since it provides balance sheet support for future sales.

Continuing down the income statement, gross profit margin increased 100 bps YoY to 54%, while adjusted operating margin declined 500 bps YoY to 12% as the company ramped investments in sales and marketing expenditures. GAAP EPS surged YoY from $1.59 in Q3 2020 to $9.18 in Q3 2021 while adjusted EPS declined YoY from $1.13 to $0.81, which missed estimates by $0.41. The large disparity between GAAP and non-GAAP was driven by $1.3 billion in unrealized gains from its investments in Affirm and Global-E, which were excluded from earnings. These large gains are a direct result of Shopify’s partnership agreements, which I also discuss in greater detail next.

Shopify expands partnerships into social commerce

Shopify has expanded its reach beyond traditional e-commerce by partnering with and incubating new companies. As mentioned above, Shopify received shares in Affirm and Globe-E last year in return for cash considerations while working as a partnership, which has resulted in over $3 billion in gains in less than a year (note that not all partnerships result in equity awards).

The company has continued this trend and has announced a series of new partnerships that help expand its role into social commerce. For instance, Shopify recently announced partnerships with TikTok, Spotify and Roku ahead of the holiday shopping season. In August, Shopify announced a partnership with TikTok and introduced TikTok Shopping. Business owners will now be able to sync their product catalogues to their TikTok profiles that creates “a mini-storefront that links directly to their online store for checkout … The TikTok community can choose to shop directly from the merchant’s storefront or click a tagged product in a merchant’s TikTok video, which will take them to the merchant's online store for checkout”.

The TikTok partnership could be significant in the future as the platform is one of the fastest growing social media sites with hundreds of millions of users. This partnership should drive demand for Shopify’s merchant solutions, as well.

Shopify also announced a partnership with Spotify in October, expanding further into social commerce. Fans can now purchase merchandise, tickets and even tip artists through a Shopify integration directly on Spotify. Spotify is the largest artist platform with over 365 million global listeners, and this partnership has the potential to grow significantly as fans are increasingly spending more on their favorite artists. For example, the global average music fan increased their spending by 17% from $5.54 in 2019 to $6.49 in 2021. According to Spotify, there are over 8 million artists on the platform, which could be a significant tailwind to Shopify if they begin to set up their own Shopify integrations selling their own merchandise and tickets.

Lastly, Shopify also announced a partnership with Roku in September. Roku is launching an app that allows Shopify merchants to “easily build, buy, and measure TV streaming advertising campaigns. Roku’s addition to Shopify’s marketing solutions will become the first-ever TV streaming app available in the Shopify App Store, opening the door to small and medium-sized businesses to build stronger brands and increase revenue through TV advertising”. This unique partnership allows Shopify merchants with relatively small ad budgets to advertise on television, a medium that has typically been reserved for large companies. Given Roku’s rich user data, they will be able to help Shopify merchants better target their audience. Roku added that a recent poll showed that nearly half of “polled consumers said they have seen an ad on their TV streaming device that caused them to pause their TV and shop for the product online”. Roku’s streaming platform is quickly turning into a shopping platform, and the partnership with Shopify should benefit both companies going forward.

On top of the partnerships, Shopify also makes investments in merchants on its platform. Shopify made $394 million in cash advances and loans to merchants in Q3, up 56% YoY. Shopify Capital has grown to approximately $2.7 billion in cumulative capital funded since its launch in April 2016. These investments help merchants grow, which in turn increases GMV and revenues on the Shopify platform.

Moreover, Shopify adequately provisions for potentials losses with these loans. As shown below, Shopify’s provision for loan losses (which protect against collection risk) have vastly outpaced charge offs in 2021. This signals that Shopify is being conservative and is not using Shopify capital to juice earnings but is instead using the program to foster organic growth at the company.

Outlook

Heading into Q4, Shopify did not directly quantify its guide, which isn’t unusual for the firm as Shopify did not provide a Q4 guide last year. Rather, Shopify stated that it expects to grow revenue rapidly in 2021, but at a lower rate than in 2020 (which was a record year). Furthermore, Q4 is expected to continue to be the largest quarter in terms of revenue generation for the year but due to stimulus in Q1 and Q2, the revenue spread will be more evenly distributed across the four quarters than it has been historically. 

Shopify also expects that its GMV will grow “substantially faster than the commerce market”. On the call, CFO Amy Shapero said that she expects Shopify to continue to take share of the retail market.  Management also guided that it expects costs to slightly accelerate in Q4 as it reinvests back into its business by hiring more engineers to support growth. Despite the acceleration in hiring, the company expects 2021 adjusted operating income to be above the level in 2020.

Following the above description, the Street slightly lowered their Q4 topline estimates by 2% to $1.3 billion, representing a 38% YoY growth rate. However, analyst raised their Q4 estimate for non-GAAP EPS by 8% to $1.32/share. For the year, 2021 sales are expected to increase 56% YoY to $4.5 billion and non-GAAP EPS is expected to grow by 59% YoY and reach $6.34/share. While Shopify hasn’t provided guidance for 2022 yet, the Street expects sales to rise 34% next year and earnings to increase 7%. It is noteworthy that Shopify’s recent expansions into social commerce may not be fully reflected in forward estimates, which provides a potential catalyst for an upward revision in 2022 estimates going forward.

Conclusion

Looking forward, Shopify is expanding its role into social commerce and has partnered with marquee companies such as Roku, Spotify and TikTok. The company’s partnerships have resulted in large gains in the past (ie Affirm and Global-E) and should support growth of Spotify’s merchant platform in the future. The company’s financials have also been strong and Shopify appears to be positioned well to continue to report strong growth going forward. 

We did not touch on the Fulfillment Center, yet this is one of the more exciting prospects for Shopify in the future, as is Shop App and more enterprise-level commerce opportunities. For instance, the company’s Shopify App store is now integrated with ERP systems from Microsoft and Oracle for major, large retailers. This is used for companies like General Mills to launch with Shopify Plus for products like Larabar, and also helps prove the sophistication of Shopify as the company seeks to take more TAM from Amazon and other competitors. We will touch on these developments in the future as more information is disclosed.

Recommended Reading:

We previously discussed social commerce and omnichannel in our Q2 analysis here in August, Shopify Premium Analysis for 2021: Deep Dive, Shopify 2019 Analysis where we discussed why Shopify had a unique value proposition

The reason we think that UiPath has winning potential is that RPA is in its infancy and historically the company’s retention and upgrades are second-to-none. RPA is one of the best ways to participate in the benefits of AI/ML early-on with UiPath’s scalable automation solutions used by early adopters. As the market matures, we think the analyst jitters over a new business model will clear up over time. This is because it’s clear that once customers adopt PATH, they stay and upgrade – which consequently, a lack of upgrades is one reason why we exited DocuSign. My goal is to get you an update on DocuSign by Monday at the latest.

 

UiPath:

 

We’ve covered in the past that UiPath’s annual recurring revenue (ARR) is important to pay attention to and management emphasized again this in the latest call. Prior to the billing change, UiPath’s revenue led ARR growth, yet due to a billing cycle change, this is not the case temporarily. The billing cycle change could be misinterpreted as a sign of weakness, when in reality, it’s is motivated by UiPath wanting to attract a wider range of customers with shorter 1-year billing cycles. If the graph below is any indication, then revenue should normalize in time to where revenue again leads ARR, which is of course, an annual metric unaffected by this billing cycle change.

Here is what the CFO said in the earnings call:

 

 “We have a structured process in place to calculate and report ARR, because it is invoice based, we believe that it is the most accurate and reliable measure of our true business activity. It most closely aligns to long-term cash flow and best aligns to renewals and given our strong dollar based gross retention rate, which was 98% in the third quarter. ARR is most reflective of customer commitment, regardless of deployment model.”

 

The global market size for RPA is at $2.07 billion in 2021, up from $1.23 billion in 2020. UiPath is expected to report $885 million in revenue for fiscal year ending in January. This means UiPath owns up to 42% of the RPA market and we expect this lead to continue given the remarks on the call about market share and competitors.

 

With the market expected to reach $7.01 billion by 2025, UiPath’s 40% penetration would equate to $2.8 billion or 3.3X growth. In 2030, UiPath could be reporting as much as $5.5 billion in revenue or 6.5X growth in revenue. This is all while nearing profitability, which is rare this soon after going public. According to other estimates, RPA services will expand the addressable market to $4.3 billion by 2022, which is higher than the estimates previously listed.

 

I think these estimates could be low given the cost savings that RPA offers. Below, we see enterprises saving millions of hours per year with savings in the millions of dollars from automation. Morgan Stanley seems to agree with a note that the RPA market could reach $56 billion with the firm concluding UiPath owns 30% to 32% of the market. Notably, Gartner has also pointed out that UiPath’s revenue growth is higher than overall RPA market growth.

 

We had covered in our original research report that owning Path and RPA is attractive for our portfolio because of the pain point the company solves. Automation is truly unique in terms of the benefits it provides to the enterprise. Here were a few states we had quoted:

 

“The ROI is astounding when you have an error-free employee who works 24/7 and does not tire or need bathroom breaks. To illustrate, a few automations can save 20 minutes of work per person daily and enabling 10K employees with a software robot could save more than $30 million a year (based on an average salary of $35/hour).

 

According to analysts like Forrester, 14.9 million jobs will be created by 2027 to work alongside robots. It’s not clear though how many jobs robots will replace and if the 15 million is actually a deficit.

 

According to McKinsey, $3.6 trillion of work can be automated. The piece of the pie that UiPath is after is the automation of applications for enterprises. The number of applications deployed by enterprises has increased by “approximately 70% over the past four years,” according to Wall Street Journal.

 

According to McAfee, the average enterprise has deployed 464 custom applications and deploys an additional 37 new applications in a 12-month time span. Companies with fewer than 1,000 employees run 22 custom applications while companies with over 500,000 run 788 custom applications, on average. The majority of these applications (58%) are used internally while 36.2% are used by customers, partners and suppliers. These larger enterprises – with the 788 applications on average — are the companies that UiPath is targeting.”

There are a few stats the company gave in the most recent earnings report, as well:

 

·       Hana Bank has applied automation to 80 processes, an estimated saving of around 1.5 million hours per year.

·       Saudi Ministry of Tourism reduced the time needed to collect process and analyze data by 95%, from 30 minutes per record to 40 seconds

·       Toll Group freed up 170,000 hours and they are on track for savings of $1.6 million annually. 

 

On the competitive front, the earnings call was quite direct about UiPath outpacing competitors. The primary competitors are Blue Prism, Automation Anywhere and Microsoft.

 

Microsoft is not building a best-of-breed product and there’s no indication they plan to take UiPath head-on right now.

 

“Our own data, if we take into account the deals where Microsoft is participating versus the deals where Microsoft is not participating, we are not seeing material changes in our winning rate. So right now currently, I can say Microsoft has — doesn't have a meaningful impact on our ability to win customers. What is going to happen in the next couple of years, first of all, I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”

 

Regarding Automation Anywhere and Blue Prism, an analyst said the following:

 

“So Daniel, at your User Conference in Las Vegas, one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs. And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs. And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”

 

The management responded by saying geographies like the Nordics, Canada and the United States are regions where competitors are “withdrawing their presence significantly.” However, management points towards the market being too new for this to be a tailwind (usually this becomes more important in a mature market). Instead, the growth is coming from keeping their current customers happy with the platform and also from new customers for growth.

 

A Note on Cloud …

 

There was some discussion on the forum over UiPath’s ability to perform well in cloud-native environments.

 

We had pointed towards the acquisition of Cloud Elements to expand UiPath from UI-based process automation to also include API-based could be an important competitive advantage for UiPath as it now operates with the same integrations as its competitors yet is more end-to-end. The analyst above is also implying that UiPath is taking market share from Automation Anywhere, the cloud-native automation platform. Here is what management said:

 

“Automation suite enables our customers to leverage the power of the full UiPath platform with the benefit of a cloud native architecture. However they choose, on-prem, public cloud or third-party hosted with the single install on Linux. 21.10 also included the introduction of Linux based software robots, a capability that is required to be a truly cloud native company. This allows our customers to achieve scalability and auto scalability in a cost-effective manner.”

 

The integrations with Crowdstrike, Snowflake, Qlik, AWS, etcetera, also point towards cloud-enabled solutions. Gartner seems to agree that UiPath has no issues competing in the cloud with the following analysis on the company’s weakness:

 

“Web-based development: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”

As far as a decreasing TAM due to on-premises, I don’t see any evidence of this. UiPath’s end-to-end solution across all environments is a strength. The company is seen as a leader in RPA across many reports: Gartner, Forrester, Everest Group, MarketScape, etcetera. You’d be hard pressed to find any product analysis on RPA that doesn’t thoroughly assess UiPath’s product as the leading product across both cloud and on-premise. This is important because RPA may become a winner-takes-all due to scaling complexity.

 

Below is a chart that shows the percentage of interest in RPA as of 2017 compared to the number of companies that had deployed it:

The most recent survey from Deloitte stated that 73% of organizations have looked into automation, up from 58% in 2019. The issue is that very few have reached automation at scale with the far majority in the piloting stage. We think this will resolve over time and this is the primary reason we are invested in UiPath – real demand with high anticipated penetration being consistently reported across analyst firms, yet many companies are stalling out due to the complexity of the solutions, and UiPath leads the category. We also think that as organizations chose UiPath over other vendors, that the high switching costs will be nearly insurmountable.

 

Financials:

 

I agree with the forum comment that the earnings report was unremarkable. The company did beat on both top line and bottom line and increased the forward, yet the market is still trying to factor in the slowdown in growth from previous years which was roughly 127% in fiscal 2019 and 80% in fiscal 2020. Will the slowdown stabilize or continue to meaningfully erode? That’s why the company hasn’t quite won the confidence of Wall Street yet.

 

Regarding my comment on the fact that high switching costs are nearly insurmountable, I can’t give you a clear reason as to why UiPath did not discuss their net retention rate in the most recent earnings reports. In the past, it’s been an industry-leading number of 145%+ and my hope is that it continues to be above minimum the 130% range for the next few years.

 

As stated, the company emphasizes ARR, yet this is declining although still above 50% on the forward guide. The YoY growth in ARR was at 64% in fiscal Q1, 60% in Q2, 58% in Q3 and is expected to decelerate again to 55% in Q4. Despite the beat, the company’s deceleration is being penalized as are nearly all decelerations in cloud from the Q3 reports. 

 

If we read between the lines, we see that Covid had a negative upfront effect on UiPath although Deloitte believes in the long-term, digital transformation will be a tailwind for UiPath. Cost could be one factor as to why we are seeing slowing growth and the other could be that organizations had to prioritize cloud migrations. Regardless, the $3 billion market size is communicating that RPA is early and the slowing growth is not because demand is slowing; rather it may have been paused or de-prioritized. It’s true that investing in Path is a bet that it’ll resume stronger growth in the future.   

 

The key metric that is most exciting from the recent report is that customers with $1 million plus ARR was up 82% year-over-year. The customer category above $100K was up 52% year-over-year. UiPath also plans to be profitable next quarter but this could be lumpy depending on how many investments the company makes. Nonetheless, gross margins remained robust as consolidated gross margin was 85% and software gross margin was 93%.

 

Remaining performance obligations (RPO) increased 80% to $579.5 million, while RPO to be completed in the next twelve months (NTM RPO) increased 11% QoQ to $359 million. Looking forward, NTM RPO represents 33.0% of the NTM revenue estimate, an improvement of 70 bps QoQ. The improvement in NTM RPO relative to forward sales expectations provides a ‘floor’ for future sales, improving the quality of forward estimates.

 

However, it should be noted that cash support for future sales has declined. For instance, current deferred revenue relative to NTM RPO declined QoQ from 73% to 70%, which lowers the quality of recently reported RPO. However, the billing cycle discussed above may be temporarily skewing this metric, as management is prioritizing one-year deals over multi-year deals. We will be watching this metric going forward and anticipate an improvement as the trend annualizes. Furthermore, current deferred revenue has increased relative to subscription sales for the past two quarters, highlighting that one-year deals appear to be healthy and suggesting the lower cash support is due to the drawdown in multi-year deals.

 

Moving down to cashflows, quarterly cashflows from operations declined from $7 million down to an outflow of -$25 million. The steep drawdown in cashflows is likely a result of the company’s billing cycle change mentioned above, as the upfront cash payments from multi-year deals is being replaced with relatively smaller amounts of upfront cash payments from one-year deals. We should expect cashflows to improve going forward as this trend fully annualizes. Management has discussed that it does not have to sacrifice as much margin (and cashflows) with one-years relative to multi-year deals, so in the long run this change should improve cashflow generation, all else equal.

Conclusion:

 

I’ve heard UiPath called a story stock and I agree. The story here is quite compelling in terms of the percentage of organizations that are pursuing automation (70%+) compared to the number that have scaled RPA solutions (low single digits). I believe there is enough evidence that UiPath is the leader and will continue to lead. I tend to not counter invest in product leadership. The ongoing integrations and partner network also certainly doesn’t hurt which we covered in our original analysis here.

 

Bradley Cipriano contributed to this analysis.

Below, the team looks at Micron – a semiconductor company the I/O Fund has owned in the past. Micron is in third place behind Samsung and SK Hynix. We analyze both product and financials to determine if Micron has what it takes to capture more market share across data centers, automotive/industrial, and 5G smartphones and edge devices. Earnings are on December 20th.December 20th.

Micron is one that we are watching closely but do not own at time of writing. Please reference Trade Notifications archived on the dashboard and the forum for updates. on the dashboard and the forum for updates.

Overview of Micron’s Products:

By Beth Kindig

 

When we first covered Micron, the company’s revenue was two-thirds DRAM and one-third NAND. The company’s most recent earnings report shows a heavier weight on DRAM at three-quarters revenue compared to one-quarter revenue from NAND.

NAND memory saves data even when the power is removed, such as when a cell phone is turned off. Beyond mobile devices, NAND is found in traffic lights, digital advertising panels/displays, and anything with artificial intelligence that needs to store data.

Dynamic RAM, or DRAM, stores memory when a device is on, such as PC processors and graphics cards. DRAM is also used in gaming devices and video game consoles. DRAM is 100X faster than NAND, lasts longer, and is smaller in size. However, DRAM is known as volatile memory which means when power is turned off, it does not store data. The benefit of loading the data into the RAM is that reading the data is much faster than reading it from the hard drive.

According to the CEO of Micron, AI servers will require six times more DRAM and twice the SSDs compared with standard servers. In the most recent earnings report, it was also pointed out that “DRAM and NAND stem share of the semiconductor industry has steadily grown over the last two decades, from around 10% to approximately 30% today.” Today, data centers are the largest market for memory and storage due to the growth driven by cloud.

Hyperscale data centers are growing faster than DRAM supply can keep up with. Due to higher capacities and low latencies, DRAM is being used across health care, the military, automotive, networking systems, and data centers. DRAM is being used in the Internet of Things (IoT) due to low latency with automotive using up to 80GB compared to 5.5GB in PCs and 2.5GB in handsets.

NAND is used to store pictures or music on a mobile device and is also particularly well suited for edge devices because it’s ideal for high data storage density. Although DRAM drives the majority of Micron’s revenue right now, NAND is the growth segment to watch as AI workloads move to the edge and will require NAND for the increased energy requirements, portability, and ability to store massive amounts of data.

According to FiorMarkets, Global 3D NAND Flash is expected to grow at a 32.3% CAGR from 2019 to 2025. 360 Research Reports put the CAGR at 20.6% between 2021-2026. Overall, NAND is expected to grow at 11.05% between 2021-2026. DRAM has a CAGR of 7% between 2020 and 2026.

Micron’s revenue segments

By business unit, Micron saw the most revenue growth from Embedded (EBU) at 108% year-over-year and 23% QoQ growth. This was also the largest growth in the prior year. EBU refers to memory and storage products used in automotive, consumer markets, and industrial applications. In 2019, Micron had expanded its wafer fab facility in Virginia with a $3 billion investment to manufacture 20nm/1xnm DRAM and 3D NAND for automotive infotainment, advanced driver-assistance systems (ADAS), and also industrial automation and surveillance applications. Two years later, the investment and engineering expansion appears to be paying off.

This is a key segment to watch as industry CAGR for automotive processors is expected to be 65% through 2023, according to IDC. This is driven by automation and the memory content per car will increase up to 16GB of DRAM and 1TB of NAND to run AI, supercomputer, and high-def mapping. Micron holds 48% of automotive memory market share and is the primary supplier to Nvidia and Intel.

Compute and Networking (CNBU) grew at 26% growth year-over-year and 15% quarter-over-quarter. This is the segment that serves cloud servers and PCs, plus graphics and networking markets, and this segment is the largest source of revenue and operating income for Micron. Bradley expands more on this in his write-up below.

Mobile Business Unit (MBU) focuses on mobile and smartphones and mobile saw its highest-ever mobile revenue in fiscal year 2021. This is partly driven by the uMCP5 multichip package which allows smartphones to handle data-intensive 5G workloads. Micron has also released low-power DRAM for edge devices in a promotion with MediaTek. Micron offers a combined chip for both NAND flash storage and DRAM for 5G smartphones to extend battery life and increase performance without taking up circuit board space. This segment is also one to watch as the memory in smartphones will increase exponentially with 5G due to large data volumes.

Micron has exposure to PCs. This has been a boon during the past few years yet could also weigh on Micron if consumer spending slows.

3D NAND product update

Last year, Micron released a 176-layer 3D NAND product that has a layer count 40% higher than the nearest competitor, which is Samsung. The new NAND device is 10 times denser than previous 3D NAND devices which allows smartphones and edge devices with capacity limitations removed and increased power efficiency. Cloud storage also benefits due to being data intensive.

According to Micron, this device has the “industry’s highest data transfer rate” of 1,600 megatransfers per second (MT/s). The device is the same height as the 64-layer design with a fabrication technique that removes stack height limitations to provide higher storage capacities. The company uses CMOS-under-array (CuA) to build a multi-layered cell stack for more memory to be leveraged in a smaller space while also decreasing die size.

The replacement-gate (RG) flash technology replaces the traditional floating-gate design, and according to Micron’s whitepaper, helps the device remain competitive in terms of time it takes to program and/or to limit the reduction in performance. Micron points out in the paper that extending the number of tiered stacks creates cell-to-cell capacitive coupling, which leads to lower program times. Therefore, the more tiers or layers that competitors release will not necessarily result in better performance due to design limitations. This performance becomes critical as program algorithms can add to time delays when writing the data.

In this iteration, Micron changed the design to mitigate issues of the “cell-to-cell capacitance structure,” or a reduction of electric field duration and increase in voltage threshold (VT), which results in higher endurance life span, increased power efficiency, increased storage capacity, and doubled speed of write performance. The company also changed the material from polysilicon to metal. These two improvements result in Micron’s RG 3D NAND to perform up to 2X faster than other current 3D NAND devices.

Memory and storage can be very competitive in terms of price, so we want to track incremental product improvements. According to Micron, “current 3D NAND design has begun to reach the limits of its monolithic die-level maximum capacity. It will continue to fall short of the immense system-level storage capacities demanded by future data-driven applications. Cell-to-cell capacitive coupling complications and smaller etch requirements account for many of these limitations.” If Micron is correct, then this could be an opportunity for the company to see more market share on 3D NAND.

NAND is expected to see a 30.8% increase in total bit demand and an oversupply in the second half of next year. Competition is expected to drive a decrease in average sales price (ASP). In the earnings presentation, Micron forecast calendar year 2022 growth of 30% in NAND.

DRAM product update

Moore’s Law states that the number of transistors or processing power on an integrated circuit doubles every two years while the cost is halved. This has led to shrinking the circuits to fit more transistors or memory cells in the limited space. At one point, you could see a transistor and now they are measured in nanometers, which is not visible by the human eye. This helps chips switch faster and use less energy and are cheaper to make, as well. As size decreased, memory chips moved to the Roman and Greek alphabet to name nodes which is why Micron calls their DRAM “1-alpha.’ This provides a 40% improvement over bit density compared to the 1z node and power consumption has improved by up to “20 percent.”

These chips are manufactured without EUV, or Extreme Ultraviolet Lithography. This manufacturing method uses smaller 13.5nm wavelengths of ultraviolet light to etch wafers as opposed to lasers from Deep Ultraviolet Lithography (DUV). You could argue that EUV is a point of weakness for Micron as Samsung is using this manufacturing method while Micron is delayed until 2024.

DDR5 is the company’s increased bandwidth product that will increase core count resulting in up to 85% increase in bandwidth. The double date rate (DDR) product has been primarily focused on more bandwidth while previous generations focused on reducing power consumption to serve the needs of mobile applications and data centers. The performance increase is between 1.36X and 1.87X. This has not been released yet but is expected to be released soon.

DRAM is expected to see a decrease in average sales price (ASP) next year while DRAM bit demand will increase by 17%. This will lead to an oversupply in the second half of the year. Micron is forecasting DRAM revenue to be in the mid-to-high teens.

Being U.S. based, plus MU, lowered exposure to China

It’s very helpful that Micron is the only U.S. based manufacturer of memory during a time when suppliers are relocating to the United States. Micron announced that it intends to invest $150 billion globally over the next decade in “leading-edge memory manufacturing and research and development (R&D) including potential U.S. fab expansion.” The U.S. Senate passed the U.S. Innovation and Competition Act (USICA) which includes $52 billion in federal investments for the domestic semiconductor research, design and manufacturing provisions in the CHIPS Act. Congress is also considering legislation called the FABS Act that would establish a semiconductor investment tax credit. Policy could strategically help Micron compete with Samsung.

The next hurdle for semis long-term is relying on China sales. Micron changed how they report geographic information from ship-to location to customers headquarters. Micron also lost Huawei revenue during the same time period which Keybanc estimates was 7-9% of Micron’s revenue.

Here's a snapshot from fiscal Q4 2018 where “ship-to location” was heavily weighted to China.

If we go on customer headquarters then we see that Micron has about 18% exposure in FY2021 if we include China and Hong Kong.

Competitors

Micron was the first to build and ship a 176-layer NAND last year and SK Hynix was close behind. In early 2020, Kioxia and Western Digital released a 112-layer device and are expected to move to 160-layer soon based on split-gate architecture by stacking two 80-layer structures. By splitting the gates, the cell size is reduced in half and this increase the capacity. YMTC was a new competitor from China that released a 128-layer very quickly by skipping the 96-layer generation. The company uses an expensive copper hybrid bonding technique that enables higher bit density. YMTC is likely to take market share in China across all memory and storage competitors.

According to TrendForce, SK Hynix saw the largest increase QoQ on NAND flash sales with a 25% QoQ increase and Kioxia reported 3D NAND sales of 20.8% QoQ compared to Micron’s 8% increase QoQ. In terms of DRAM, TrendForce reported that Samsung grew it’s lead with 11% growth QoQ while Micron also grew it’s lead with 12% growth QoQ compared to SK Hynix at 8% QoQ.

Micron is Becoming Less Cyclical

By Bradley Cipriano

Micron has reported strong results over the last few years and this continued into 2021. Micron is a key player in the memory market, which is going through a structural change. Demand is no longer dependent on PCs, rather memory demand is now being driven by much stronger tailwinds such as datacenter server growth and the rollout of 5G. This structural change is making Micron less cyclical.

Looking forward, Micron expects these structural tailwinds to continue to drive growth at the company. CEO Sanjay Mehrotra explained it well during the Q4 FY2021 Conference Call when he said that “Industry trends like the broad integration of artificial intelligence into all computing, proliferation of the intelligent edge, continued data center growth, and deployments of 5G networks create new and expanding opportunities for Micron.”

The rise of cloud data centers has led to a structural increase in demand for semiconductor components such as DRAM and NAND memory, which helps smooth out the boom and busts cycles that Micron was historically exposed to. Micron explained the new market dynamic in its 10K when it stated that “data is today’s new business currency, and memory and storage are a critical foundation for the data economy”.

The IDC estimates data creation will explode going forward (pictured below), driven by the rise of cloud computing. Furthermore, the IDC estimates that less than 2% of data is saved today, and that data creation is far outpacing data storage capacities.

Furthermore, the ramp of the metaverse also requires massive scaling. During Marvel’s (MRVL) Q3 Conference Call, the company stated that the metaverse “will significantly accelerate a number of key trends, which are already occurring in the cloud today, including the need to store huge amounts of data”. With Meta (aka Facebook) guiding for $34 billion in capex in 2022 to develop the metaverse, the demand for data storage will likely be strong for the foreseeable future.

We can see the structural change underway by looking at results over the last four years. For instance, aggregate gross margin over the last four years was 44%, well above historical (cyclical) periods, and aggregate operating cashflow margin was ~50% over the same time period. In response to the structural change underway in the memory market, management recently initiated a quarterly dividend ($0.10 per share), which highlights management’s contention that the memory market is becoming less cyclical. I discuss Micron’s recent financial results in more detail below.

New memory technologies keep pace with cloud innovation

To address the issue of exploding data creation, Micron has innovated on some key new technologies that will enable datacenters to capture and retain much more data. Two of these key new technologies are 176-layer NAND and 1-alpha DRAM, which Micron began shipping in volume this year.

Micron stated that the introduction of “176-layer NAND and 1α (1-alpha) DRAM represent major technology breakthroughs for our company and the first time in our history that we have achieved industry leadership across these two flagship technologies”. 176-layer NAND is an extension of 3D NAND, and as the name implies, has 176 layers of cells that dramatically increase memory capacity. Previously, NAND was on a 2D plane with just one layer, and Micron has significantly increased capacity by expanding beyond a single layer of memory. Furthermore, the 1α DRAM memory node was introduced in 2021 and materially improves the performance of DRAM memory (20% to 30% higher yields), which is critical for cloud servers that rely on low latency and high performance.

With the continued development of AI, cloud servers require significantly higher quantities of DRAM, as the number and capabilities of these intelligent edge devices increases, more data is stored, processed and accessed in the cloud.  The demand for storage in the cloud environment is growing exponentially and Micron’s industry leading 1α DRAM nodes should be able to capture market share in this fast growing segment in FY2022. We can see the strength in cloud computing by looking at Micron’s Compute and Networking segment (CNBU) sales, which increased 34% YoY to $12.3 billion during FY2021 and rebounded from an 8% YoY decline in the prior year.

CNBU is Micron’s largest segment (44% of sales) and continued strength here will be rewarded by the market. With that said, there was a deceleration in this segment between fiscal Q3 and fiscal Q4 both YoY and QoQ from 49% down to 26% YoY growth and down from 25% to 15% on QoQ growth.

In Q2 FY2021, Micron also began shipping 1α DRAM nodes for mobile, which improved power efficiency in mobile phones, and allows for memory intense use cases like smart photography. Management explained on the Q4 call that 5G phones have 50% more DRAM than 4G phones, meaning that the continued adoption of 5G phones should be a significant tailwind for Micron going forward.

Micron also began volume shipments of 176-layer NAND for mobile in 2021. On the Q4 call, CEO Mehrotra explained that “176-layer NAND-based mobile product went from just introduction to 1-million-unit shipments in a record time. Fastest RAM in the history of the Company”. The ramp in 176-layer NAND helps put into perspective how much demand there is for Micron’s new technologies. Following this strong demand, Mobile (MBU) segment sales increased 26% YoY to $7.2 billion in FY2021, a record high. The continued roll-out of 5G phones will likely be a tailwind for Micron going forward.

The roll out of these new technologies is just now beginning to ramp. To accelerate the roll out of these new technologies, Micron expects to increase its annual capex by 20% YoY to $12 billion, which follows a 22% YoY rise in capex in FY2021. Micron explained that capex will be driven by its continued transition to 176-NAND, as well as infrastructure support for the introduction of new technologies such as EUV lithography. While increased capex spend does not guarantee increased sales, there are also signs in Micron’s balance sheet that point to heightened demand in the near term, which I discuss in more detail next.

Micron’s financials

Following the roll out of new technologies during the year, Micron reported strong results to end its fiscal year. Specifically, Micron’s Q4 FY2021 sales increased 37% YoY to $8 billion, an acceleration from the 36%, 30%, and 12% YoY increase in Q3, Q2, Q1 respectively. Gross margin increased 1,300 bps YoY to 47%, the highest level since Q3 FY2019. On a rolling four-year basis, gross margin was 44%, highlighting the strong success Micron has experienced in recent years. As shown below, the sustained improvement in four-year rolling gross margin suggests that Micron’s business is becoming less cyclical.

The strong gross margin flowed down into operating margin, which increased 1,600 bps YoY to 36%. On an annual basis, operating margin improved from 14% in FY2020 to 23% in FY2021, while non-GAAP operating margin was 28%, up 1,200 bps YoY. The strong margin performance was driven by pricing increases across DRAM and NAND products and ongoing product transformation. Looking forward, management guided that gross margin would remain strong at 47% +/- 100 bps in Q1 FY2022, as the company continues to benefit from the new product releases (discussed in more detail above).

Continuing down the income statement, GAAP EPS increased 175% YoY to $2.39 and on an annual basis GAAP EPS increased 117% YoY to $5.14. In the last five years, Micron has reported an aggregate $28.94 in GAAP EPS, or nearly five times as much as it had earned in aggregate earnings over the prior 33 years (dating back to 1984). As discussed above, Micron had historically been a cyclical company dependent on PC demand for memory, but tailwinds from datacenter and mobile have structurally changed the demand environment for memory and have made Micron’s business less cyclical and more profitable. Below, we look at the 4-year rolling gross margin to discuss the continued strength in the company.

We can also see this outperformance in cashflows. Micron’s annual cashflow margin was robust at 45%, and FCF margin was also strong at 9%. Annual FCF margin has been positive in all but one year since 2012 and has been positive for five consecutive years. As a result of the strong cashflow performance over the last few years, management initiated a quarterly $0.10 dividend.

CFO Dave Zinsner stated on the Q4 call that “the initiation of a dividend is an important milestone that reflects the structural transformation Micron has undergone over the last several years, and it shows our confidence in the sustainability of our cash flow generation”. He added that Micron expects to return more than 50% of FCF to shareholders through dividends and buybacks going forward. If the memory business is becoming less cyclical, then shareholder returns could be substantial going forward given Micron’s robust profitability and cashflow generation.

Finally, inventory trends also highlight the strong demand for Micron’s products. Inventory declined 17% YoY despite the 37% YoY growth in sales, as Micron has struggled to replenish lean inventory levels in response to strong customer demand. Typically, in cyclical industries, elevated inventory levels can be a sign of concern, so the drawdown in inventory highlights the strong demand for memory in the current environment.

Inventory composition is also bullish, as raw material inventory increased to 11% of total inventory, a three-year seasonal high, while finished goods inventory declined from 19% of inventory to 11% in Q4, a five-year low. The drawdown in finished goods highlights that Micron is shipping its product faster than it can be replaced, highlighting the strong demand it is experiencing. A rise in raw materials and decline in finished goods means that management is quickly selling its product and anticipates that this demand will continue.

Outlook and valuation

However, a risk with the low inventory levels is that Micron will not be able to fulfill the strong demand in the near term. There are also supply chain issues outside of Micron’s control that may impact demand in the near term. CEO Mehrotra explained on the Q4 call that some PC customers are adjusting memory purchases in the near term due to non-memory component shortages. He added that supply chain constraints for IC components will limit some large shipments in the near term.

This commentary helps explain Micron’s Q1 FY2022 forward guide miss. Micron guided Q1 sales to be $7.65 billion at the mid-point, 10% below the Street’s initial estimate at $8.5 billion. Micron also guided Q1 EPS to be $2.10 at the midpoint, or 15% below initial expectations of $2.48. CEO Mehrotra explained that while there are near term supply chain issues, “shipping growth will resume in the second half of the fiscal year, and we're planning to deliver record revenue with solid profitability in fiscal 2022”. While Micron only quantified its Q1 guide, CEO Mehrotra’s statements suggest that growth will rebound in the second half of the year as supply chain issues and low inventory levels normalize.

Looking forward, Micron is expected to report Q1 earnings on December 20th. Q1 sales are expected to increase 33% YoY to $7.65 billion and non-GAAP EPS is expected to rise 169% YoY to $2.10. For the year, Micron is expected to grow sales 16% YoY to $2 billion and to report $9.01 in non-GAAP EPS, which gives it a 9.2x fwd EPS multiple. This is slightly below Intel’s fwd P/E multiple of 9.7 but above Western Digital’s fwd P/E of 6.7x. Furthermore, Micron’s fwd P/E of 9.2x is below the 15.8x level it reached earlier in the year, which highlights that there is room for multiple expansion going forward.

Micron also trades at a slight premium based on trailing earnings. Its TTM P/E multiple of 16x is 45% higher than the peer median of 11x (peers include Samsung, SK Hynix, Intel, and Western Digital). Micron is likely being awarded a premium over its peers due to its current technological lead in key technologies discussed above.

Conclusion

Micron’s sales grew 29% YoY in FY2021 and management expects this growth to continue into FY2022 as demand for memory remains robust. The memory market is becoming less cyclical due to numerous tailwinds that have expanded demand for memory beyond PCs and into more memory intensive markets such as data centers and mobile. Micron is ramping capex to keep pace with outsized demand and has innovated new technologies to keep pace with the cloud environment.

Management also issued a quarterly $0.10 dividend, which further highlights management’s contention that its market is becoming less cyclical. Micron currently trades at 9x fwd P/E, which is near Intel’s and above Western Digital’s multiple. If the company can prove to the market that its business is less cyclical and that its 40% gross margin and 50% cashflow margins are sustainable, then its multiple will likely expand going forward.

This report is a 2-for-1 deal with Beth and Bradley both providing an analysis. Please reference Bradley’s Deep Dive on Financials Below.

This one has been especially challenging in terms of price action. Below, I tell you why we continue to hold the stock and added to it after the earnings report. If the market wants to give me a 15 forward P/S on Zoom, I’ll take it.

Growth is “slowing” because we are lapping extraordinary quarters. Zoom’s situation is very different from a company that put up 60%, then 50%, then 40%. I would call that slowing growth while l would call Zoom’s situation “tough comps.” There is an important difference.

When analysts “downgrade” a company yet set the price target comfortably higher than where the stock is trading at, then it’s meaningless because the analyst will be right no matter what happens. If you’re an institutional analyst, finding a way to be right no matter what happens with Zoom is probably a smart idea. The reason is that Zoom is very complicated to predict as management is offering very limited visibility into next year and because Q4 and Q3 are seasonal low quarters due to a unique billing cycle. We discuss the unique billing cycle in detail below.

The 350% revenue growth is a very hard comp to clear because consumers piled into the app unexpectedly. This has placed immense pressure on Zoom’s enterprise segment to carry the growth. Zoom is an enterprise company and the management had no intentions of being popular with consumers. Even now, the company does nothing to grow this segment other than to offer a free and lower priced tier. Zoom’s competition is Teams — not FaceTime.

One of the main reasons we want to continue holding Zoom is that hybrid work-from-home is an important trend for our portfolio. Asana’s growth is participating in this trend and Monday.com is also participating in the productivity tools category with work-from-home tailwinds. When we were down 40% in Asana, the portfolio manager Knox asked about my conviction and I said “we need to have more than Zoom for work-from-home – productivity tools will be winners this year.” The chances this trend wouldn’t carry Asana was low. Now, I’m reiterating “we don’t want to give up on the leader in work-from-home because the trend is not done yet.” On a side note, we will likely revisit Asana OR we will look at Monday.com if these companies get into a buy zone.

According to Gartner, 51% of knowledge workers will be working remotely by the end of 2021 up from 27% of knowledge workers in 2019. Looking forward, Gartner expects that 31% of all workers in the global workforce will be a mix of remote and hybrid with the United States at 53% of its workforce – in other words, not only knowledge workers. The senior research director who worked on the report stated, “Through 2024, organizations will be forced to bring forward digital business transformation plans by at least five years. Those plans will have to adapt to a post-COVID-19 world that involves permanently higher adoption of remote work and digital touchpoints.”

There are 3.3. billion workers in the world, which works out to about 1 billion remote workers.

Here's what is important to consider. On one hand, you could say that Zoom has 50% of the TAM already at more than 500 million users. However, those were many free accounts in the online segment. Instead, it’s important to consider that Zoom has substantial brand awareness yet only has 20% of the Global Fortune 2000.

Regarding productivity tools, Gartner reports 80% of workers are using collaboration tools for work, up from roughly half in 2019. Here’s the main statistic we think adds to our bull case: “Specifically, the use of meeting solutions surged during the pandemic. While workers globally reported that they spent, on average, 63% of their meeting time in-person in 2019, that number dropped to 33% by 2021 as more meetings took place over audio and video-enabled meeting solutions. The shift away from in-person meetings is expected to continue. Gartner predicts that by 2024, in-person meetings will drop from 60% of enterprise meetings to 25%, driven by remote work and changing workforce demographics.”remote work and changing workforce demographics.”

The good news is that Zoom is an enterprise product and always will be so this statistic directly applies (“enterprise meetings”). The consumer or online segment has distracted the market from the company’s core enterprise focus. Even today, Zoom is not attempting to expand on the consumer side or capture any market share here yet Wall Street has deeply discounted based on the drop-off in this segment. I discussed why this reminds me of when the market was deeply discounting Nvidia for fall-off in crypto mining in 2018 when I openly and consistently said crypto mining is not Nvidia’s thesis – rather the story is AI acceleration in the data center segment. Nvidia struggled to keep up with tough comps in Q4 2018 after crypto mining unexpectedly drove record revenue.

Zoom must execute on the enterprise side but there’s no reason in the recent earnings report to think they won’t. Meanwhile, the market is concerned over the wrong part of the story. Let’s talk about Q3 and Q4 specifically.

Why Q4 is Lower

An important factor as to why Zoom has reported lower third quarter (35%) and also low fourth quarter revenue guidance (19%) is because enterprise revenue is billed in Q1 and deferred revenue and billings are lower as the year continues.

So, how did Zoom put up its biggest quarters during Covid in Q3 and Q4? Well, it’s because consumers were piling in and paying monthly. This places Zoom in a predicament because enterprise is where the growth is coming from (and should be coming from) but the billing cycle means enterprise revenue is very weak in the second half at the very point in time that Zoom has high comps to clear.

The analysts covering the stock point towards lower deferred revenue growth as a concern, yet this is also front half-weighted.

“Turning to the balance sheet. Deferred revenue at the end of the period was one point two billion dollars, up thirty nine percent year over year from eight fifty five million dollars, and slightly up quarter over quarter. Looking at Q4, we expect the year-over-year growth rate in deferred revenue to be in the mid twenty. This is driven by the cyclical decline in the average remaining term of our annual customer contracts, which are front-half weighted.”This is driven by the cyclical decline in the average remaining term of our annual customer contracts, which are front-half weighted.”

There was a question from a financial analyst who covers Zoom and yet was not clear on this point. I’ve included the transcript below. I think it’s important to put into context what is contributing to the slower Q4 growth. Candidly, I find it strange that the analyst had to ask again as it’s pretty clear what management is saying. The last analysis I/O Fund published discussed this here when we said: “Please also note, that Zoom has what’s called “front-weighted seasonality” which means contracts renew more in the first half of the year than the second half of the year. This is technically a headwind to Q3 and Q4 although that was already taken into account with the guide.”

Here's the earnings call transcript:

Kyle Keirstead, UBS

“39:21 Okay, Great. Maybe Kelly, metrics like deferred revenues and RPO are certainly not the most important to watch with Zoom, but they can be indicative of changes in the business, so it's still important to keep an eye on them. And you made some color about DR and RPO next quarter that I'd love if you could elaborate. I think on DR you mentioned that it'll grow mid-twenties due to a cyclical decline in average remaining term of annual contracts. I'm not sure I totally understand what that means. So I'd love to ask for a clarification. And then likely as well on RPO, you mentioned that we would see a shift back to long term plans. I'm wondering if you could elaborate on that as well. Thanks so much.”

“40:05 Yes. So for deferred revenue, there's two things to remember, which is the seasonality trend of our renewal is that Q1 is the largest quarter for renewals and Q4 is the lowest. So, in terms of new deferred coming on to the books, Q4 is the lowest quarter because of that, as well as the fact that Q1 is the largest quarter when deferred gets out of the balance sheet, but they are annual contracts, by the time you get to Q4 most of that has already been amortized and recognized. There is only twenty five percent of it in theory about left when you come into the quarter. So the combination of the fact that anything added in Q1 is almost fully amortized and will get refilled and renewed back in Q1. And the fact that Q4 is the lowest renewal quarter, those two things are what's driving this trend of renewals. — Sorry, of deferred, which I know is probably counter intuitive to any other company that you see because of the seasonality that we have.”

Karl Keirstead

41:25 Yes. And so the fact that DR growth would slow to mid-twenties is due to what?

Kelly Steckelberg

41:30 It's due to the fact that Q4 is our lowest renewal period as well as all those annual renewals that came on in Q1, which is the biggest quarter are now almost fully amortized and recognized.

Kelly Steckelberg

41:49 And then this has a strong impact on billings and RPO as well, because the same thing like they are adding to the building of the collections are happening earlier in the quarter and the remaining term is being amortized throughout the year, so there is — it's the short amount of contract left during Q4.

The goal of my analysis is not to sugarcoat the slowing growth in the consumer or online segment that is billed monthly. That growth is slowing – no argument here. Rather it’s to help put into context that the 19% growth is not reflective of enterprise growth. Zoom is and always will be an enterprise story. In fact, the company is so ambitious at the enterprise-level that its goal is to disrupt traditional telecom with cloud communications.

Let’s Talk About the Enterprise Segment

Zoom is returning to an enterprise story with strong growth in customers that spend over $100K. The growth in this segment is higher than pre-pandemic levels at 94% year-over-year. This is on a high base, as well. The law of large numbers states it’s much harder to grow 94% YoY on a base of 1289 customers (2021) than to grow 86% on a base of about 350 customers (2019). The acceleration here is impressive if we remove 2020 as an anomaly and on top of the strong 2020 base.

When you separate the segment of under 10 employees, we can see the effects Covid had on the company with the current quarter being the highest hurdle to clear at 485% growth in the year-ago quarter although Q4 is not much easier to clear in terms of comps with 470% growth. To be honest, the fact the growth isn’t negative in this segment is a miracle. It seems preposterous that any consumer would be getting on Zoom for the first time 18 months into the pandemic – meaning negative growth would be logical. Of course, the growth is probably small teams creating accounts. Don’t forget that any churn in free accounts like K-12 don’t affect revenue growth.

Notably, we are going through a hard stretch for enterprise account growth in terms of comps with 156% growth and 160% growth to clear from the year-ago quarter of Q4 and Q1. The last two quarters Zoom has done an excellent job of maintaining and pacing growth here. I’m expecting Q4 to be lower in enterprise growth while hoping Q1 will resume strength again here.

What was Zoom’s valuation when it was fully understood to be an enterprise story? At its lowest point, it was at 30 P/S and at its highest point it was at 60 P/S in 2019. Once we lap the consumer growth and clear it out, which is weighing on Zoom’s enterprise story, then we should see these valuations again.

The I/O Fund thinks Zoom is oversold at these levels.

Bradley also pointed out on the forum that enterprise is showing strength in long-term deferred revenue, which grew 30% year-over-year compared to 26% growth in the year-ago period. This could be a return-to-normal after concessions were made during Covid (Datadog also moving in this direction), yet it shows strength to lengthen a contract period. He does a deep dive on the financials below.

The one thing that bothers me about the Zoom earnings report this quarter is the Zoom Phone Acceleration slide disappeared as did the numbers for account growth over $1 million. This could indicate the company is not disclosing the growth rates because they were weaker than expected. This is what we got last quarter that was missing from this quarter’s presentation:

Does Zoom Have a Catalyst on the Horizon?

The catalyst for Zoom remains the transition to hybrid and remote work. What makes a market is demand and Gartner predicts strong demand through 2024. Zoom Phone also remains a catalyst with one analyst on the call pointing towards the addressable market of 400 million business phones on legacy technology. AR/VR is a catalyst as Zoom will likely release an avatar and other augmented features. You likely saw that Facebook “Meta” is now integrated with Teams. There are technically integrations already with Zoom and Meta, as well, and Facebook worked with Zoom on Portal. As you know, I don’t think Facebook is actually leader in this space and Zoom could easily acquire a startup for avatars or AR/VR features. Hybrid events is another catalyst that we’ve covered in the past on our LTBH webinar.

Bringing video to the contact center as the video engagement center is not something I would shrug off although it does require more time to build a solid solution. Zoom is also spending its cash to encourage developers to build on its platform, which is a tried-and-true approach to innovation.

Where this Leaves Zoom Investors

There is certainly some suspense here as there is no visibility into Q1 at this time. Q4 tells us essentially nothing about how Q1 will perform. Again, this is partly due to the unique billing cycle and partly due to unusually high comps this year. Management is not willing to discuss guidance more than a quarter out. The combination of tough comps and seasonally low Q3 and low Q4 has beat up the price quite a bit. I/O Fund is willing to wait another quarter as the guidance for Q1 will start to show us what post-Covid Zoom truly looks like.

Deep Dive into Financials

By Bradley Cipriano

Zoom’s Q3 sales increased 35% YoY to $1.050 billion, which came in ahead of the Street’s estimate by $31 million (3%). Q3 also marked the 14th consecutive quarter that sales increased on a sequential basis. It is impressive that Zoom has been able to continue to grow sales every quarter even after its blockbuster 2020 results. Looking forward, management raised their guidance and now expects that total FY2022 sales will increase by ~54% YoY to $4.080 billion at the mid-point, which also implies another quarter of sequential growth.

Management also provided guidance for bookings, which is a key metric used by investors to gauge the sustainability of future topline growth. On the call, CFO Kelly Steckelberg stated that the company expects deferred revenue to increase around “mid-twenty” percent YoY in Q4. This implies a bookings growth rate of just 7%, which seems low, but is due to tough comps as bookings had increased 320% YoY in Q2 FY2021. Furthermore, the company’s bookings have become more seasonal and are now front-loaded to the beginning of the year. As a result, Q4 bookings will be relatively depressed while Q1 FY2023 bookings will be more robust. Nonetheless, the relatively low bookings guide may have spooked investors.

The soft bookings guide was offset with strong trends in RPO and net deferred revenue. RPO represents contracted sales that have yet to be fulfilled and can be used as a proxy for forward growth. RPO increased 51% YoY to $2.5 billion, while RPO to be completed in the NTM increased 39% YoY to $1.6 billion. Stated differently, long-term RPO increased 80% YoY to $821 million, which highlights Zoom’s strength with enterprise customers. Enterprise customers signing long-term deals is a favorable trend as it showcases their commitment to Zoom’s products. We can also see this in deferred revenue trends, as long-term deferred revenue increased 30% YoY, the fastest pace of growth since Q2 2020.

However, despite the strength in enterprise, small customer accounts do represent a headwind to growth in the near term. CFO Steckelberg explained on the Q3 call that small/online accounts represent a headwind that has been incorporated into the Q4 guide. She added that online churn in Q3 performed better than they had initially expected at the beginning of the year, but that online/small accounts are more impacted by the holidays than enterprise customers, leading to temporary increases in churn. This churn should reverse in FY2023, leading to stronger growth in future quarters. Furthermore, small accounts fell YoY from 38% of total sales to 34% of total sales in Q3, highlighting that this customer cohort is not as significant as enterprise customer strength.

Even with these temporary churn headwinds, forward looking metrics remain strong. For example, the growth in NTM RPO was also strong and grew 39% YoY and NTM RPO represented 38% of next twelve-month sales, up 751 bps YoY. The increase in NTM RPO as a percentage of forward sales signals that Zoom has more contractual support for future sales, which improves the quality of forward growth (Zoom is more likely to meet or exceed its sales targets).

Trends in deferred revenue also highlight the quality of recently reported sales. Net deferred revenue (which is total deferred revenue less accounts receivables) increased 41% YoY to $808 million, which was faster than the 35% YoY increase in sales. Looking forward, net deferred revenue represents 27% of NTM sales, which is up 309 bps YoY. The increase in net deferred revenue provides balance sheet support for future sales, which improves the quality of forward sales growth. So, while bookings may be slowing, the quality of the company’s forward sales is improving. In our opinion, analysts are likely being conservative with their forward sales estimates.

Continuing down the income statement, gross margin increased 750 bps YoY to 74%, while non-GAAP gross margin increased 774 bps YoY to 76%. Non-GAAP R&D and S&M expense margin increased 320 bps and 444 bps YoY to 6.4% and 22.6%, respectively, while non-GAAP G&A expense declined 163 bps YoY to 7.8%. It is great to see that management has kept G&A under control despite the surge in sales during the last two years. Following these trends, non-GAAP operating margin increased 173 bps YoY to 39.1%, and non-GAAP EPS also increased 12% YoY to $1.11, which beat by $0.02.

Finally, cashflows also remained robust during the year. In the LTM, free cashflow increased 60% YoY to $1.7 billion, which followed a 1,019% YoY increase in the prior year quarter. Relative to TTM sales, TTM FCF margin fell 1,063 bps YoY to 42%, but this remained well above the pre-covid levels of 17% (in Q3 FY20). Zoom’s valuation also does not appear to correctly reflect the company’s strong cashflows. As shown below, Zoom’s EV/FCF metric is well below other SaaS peers, yet Zoom is growing nearly 2x as fast as the peer median.

In all, Zoom beat top and bottom -line estimates and raised its sales guide for FY2022. However, trends in bookings may have spooked investors as they are expected to grow just 7% YoY next quarter, which could signal that sales may slow down in FY2023. However, this is offset with a rise in both contractual and balance sheet support for future sales as NTM RPO and net deferred revenue increased YoY relative to forward sales estimates. This increase in support for future sales improves the quality of forward estimates and suggests that sales estimates are conservative. Furthermore, gross and operating margins improved YoY while cashflows remained robust and increased YoY despite tough comps. Zoom remains a high-quality company with strong growth and cashflows and also appears to be undervalued relative to other SaaS companies.