Zoom Video: In A Class Of Its Own

Summary

• Zoom Video has by far the highest stock valuation in my digital transformation stock universe.
• The company has exceptional revenue growth and free cash flow margin. It scores a phenomenal 106 on the Rule of 40.
• The stock price is benefiting from the coronavirus fear but it is unclear whether the crisis is driving new paid users.
• It is my opinion that the stock price is very overvalued and the stock price may fall once the coronavirus crisis subsides.
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Zoom Video Communications, Inc. (NASDAQ:ZM) is a stock that most investors are drooling over. By all accounts, Zoom Video has a best-in-class video conferencing product. The company's 3-year annual revenue growth is 117%, free cash flow margin is positive at 18% and the company has a significant amount of cash and cash equivalents on the books to the tune of $855 million.

While the company's financials are extremely impressive, I find that the stock price is extremely overvalued based on the forward sales multiple. In addition, the stock price appears to have been inflated during the coronavirus scare as it is one of the few companies that may actually benefit from increased isolation of the population.

Zoom Video has removed limits on the free use of its video conferencing product during this period of crisis. While this action puts pressure on Zoom Video's infrastructure, there is no clear indication that it is resulting in an increase of paid users. The company management has warned that gross margin for the coming months will be negatively impacted as capacity is built up.

Given the very high stock valuation and the likelihood that the stock price will deflate once the fear caused by the coronavirus passes, I am giving Zoom Video a neutral rating. It is unlikely that Zoom Video can sustain this level of revenue growth and stock valuation for the long term. The company has a great product but doesn't have a sustainable economic moat, at least according to Morningstar.

The Rule Of 40

One industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. For a further description of the rule and calculation, please refer to one of my previous articles.

(Source: Portfolio123/MS Paint)

In Zoom Video's case:

Revenue Growth + FCF margin = 88% + 18% = 106%

Zoom Video literally shatters the Rule of 40. I think it is safe to say that this company scores the highest of the 152 stocks that I track. Exceeding the Rule of 40 signifies that Zoom Video has a healthy balance between growth and profitability.

Stock Valuation

The following scatter plot of enterprise value/forward sales versus estimated forward Y-o-Y sales growth illustrates Zoom Video's stock valuation relative to the 152 stocks in my digital transformation stock universe.

(Source: Portfolio123/private software)

A best-fit line is drawn in red on the scatter plot and represents a typical valuation based on next year's sales growth. As can be seen from the scatter plot, Zoom Video commands the highest valuation in my stock universe by far. There is no other company even close to the forward sales multiple for this company. Therefore, in my opinion, Zoom Video is very overvalued relative to its peers.

Recent Stock Performance

The performance of Zoom Video stock has been rather remarkable since the spread of the coronavirus started to affect the stock market. In the last month, Zoom Video was up ~20% while the S&P 500 was down almost 20%.

(Source: Yahoo Finance/MS Paint)

It appears that investors are expecting that Zoom Video will prosper during the coronavirus scare. Certainly, companies, universities, and schools in China have been taking advantage of the video conferencing product since Zoom Video waived the time limit on the free use of the product during the coronavirus crisis. But as the company management pointed out:

we have definitely seen an uptick in usage. But a lot of that is on the free side. So it's very early to tell whether or not that's going to convert long-term into paying customers.

While Zoom Video has benefited from the coronavirus scare, I believe that once the crisis has subsided, the stock price may deflate as the general market recovers. As an anecdotal example, Zoom Video stock was down 4% on Tuesday, March 10, the same day that the markets rose approximately 5%. One would have expected that Zoom Video would bounce along with the rest of the stock market, but it appears to be inversely correlated.

Impact to Gross Margins

The coronavirus scare is resulting in increased usage of Zoom Video applications but this is putting pressure on its infrastructure. The company management has indicated that it must continue to build capacity to ensure that it can support the increased usage, resulting in lower gross margins:

we are seeing impact and if continue to build capacity to ensure that we can support this increased usage. So we are seeing impact on our gross margins, which is why we're guiding you towards the lower end of our range for next year.

Summary and Conclusions

Zoom Video is one of the few companies that hasn't succumbed to the coronavirus scare, primarily due to its video conferencing product and the perception that it is a best-in-class product offering. The superior product has translated into phenomenal 3-year revenue growth of 117% and positive free cash flow.

The company has removed limits on the usage of the free product offering and by all accounts, users are taking advantage of this offer in China. The additional usage is causing Zoom Video to build additional capacity and the company has warned that this will impact gross margins for some time to come. There is no indication at present that the increased usage of the free product will result in additional paid users.

While Zoom Video is an exceptional company with a promising future, I believe that the stock price is extremely overvalued. It won't be able to maintain its high double-digit revenue growth forever and the forward sales multiple will have to come down. I also believe that once the coronavirus scare passes, there will be some price deflation. Therefore I am giving Zoom Video a neutral rating.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Skordo]

TeleDoc uses Vonage video API's. CEO stated that the company has streamed over a billion minutes of video within the last three months.

[Sober319]

There are a few things to consider about Zoom . Yes, Microsoft and Cisco use their own video conferencing software , along with some bigger companies , however , imagine all the small businesses, churchs, legislative meetings, Alcoholics Anonymous meetings , the list goes on . 

Finally , ZMs overall income and revenue will catch up to the share price .
Business is business . Demand is high . Zoom is growing .

[oakreed]

Once the Corona virus dust settles, ZM will crater back down to a more reasonable valuation. No company, now matter how disruptive, or growing at lightning speed can sustain valuations or 50X revenues multiple.

[rishabh2]

Does the $11 per new user account for education pricing? Seems like that might go up a lot with schools using Zoom during the virus

[Richard Saintvilus]

I added to my Zoom position this morning. Companies are increasingly mandating employees to work from home. I think Zoom will be one of the beneficiaries of this trend. Their Q1 numbers and guidance will crush even the most-bullish estimates.

[dill323]

Yes, but Zooms userbase is largely small business and schools. Large Fortune 500 Companies such as the one I work at use Microsoft versions bc it comes w the suite of office products that we already pay for.

[CarsonChamp]

Can confirm my local university is now using Zoom for lectures. Additionally my Big 4 Accounting firm rolled out zoom firm wide yesterday.

[guessco]

Love ZM, it' far better than TEAM, SKYP, etc.

[dangerski]

Where did you get the Next Year Revenue Growth Estimate of 33% for ZM in the chart? That sounds extremely low to me. I believe their last 7 quarters YoY revenue growth was 122%, 127%, 120%, 108%, 103%, 96%, and 85%

[Steve Auger]

seekingalpha.com/...

[Ernesto H]

In the past I have used Skype and WhatsApp for teleconferencing and sharing documents. Both services have been improving quality and have strong parent companies (Microsoft and Facebook) which should support future expansion and improvement of the service. These services represent strong competition for the ZM platform. I have been unable to identify what ZM brings to the table to warrant 40x sales multiple for its shares.

[masondomino]

College Classes

[jjsirek]

Zoom brings a unique (and superior) architecture to the table. No other product is built like Zoom.

[guessco]

Having used TEAM, Skype, etc and then had a supplier use ZM, I was blown away with the quality, consistency...hmmmmm consistency for Skype/TEAM not so much - did I mention QUALITY. Then there is the Ease of use for ZM...and in a nutshell that's it. Once there is uptake, I believe it will take off and then when you go back to try and use SKYPE/TEAM, it's like going back to school after a fantastic summer vacation...MEH.

[EriCoin]

I don't understand why Microsoft is not promoting Skype for conference calls? They were too slow to combat the threat of Slack with TEAMS. I think the same is happening now. By the time they understand & challenge ZOOM with Skype conferencing, ZOOM will be a household name globally.

[nathanlane]

The answer is the cloud.

[jjsirek]

Skype is not fit for business use and Skype for Business is being sunset. They are moving people to Teams. So, they are unlikely to promote Skype or Skype for Business against anything at this time.

[guessco]

Well, they have an uptime, quality, and basic functionality and design problem. TEAM is slightly better in some ways and worse in others.

[jupp]

And what about zoom phone. That could be a very promising product

[guessco]

Can't wait for that and just hope they don't sell for years to come so that the biggies with worse plats don't destroy it.

[greendeath]

@steveauger
Correlation is not causation and you made a weak one at that. ZM has been moving well before CoViD when it was in the $60s. The current epidemic merely highlights why ZM’s time has come; another year will bring another menace and now we have issues with planes falling from the sky so why not make your keyboard fingers do the flying? Valuation very high but there are solid fundamentals underlying.

[damiller0520]

everyone seems to be downplaying zoom. they have government user and once the government uses a system they are reluctant to change. zoom is a $150 stock at worst. free cash flow and international growth. will push price higher. if zoom takes on new users on a free app, and the users love the service, why would they not switch to the payed version?

[EriCoin]

Competition.

[damiller0520]

from who, Microsoft or cisco? think acquisition.

[EriCoin]

CISCO, SKYPE, HANGOUT, SLACK..

[turkeystand]

nice article. agree with your thesis c-v is boosting the sp. who knows if this is the wave of the future ('social distancing' in all its' forms). i looked at zm and tdoc, and felt tdoc was a little stickier simply by being in the medical field.