Zoom Video: In A Class Of Its Own

Mar. 10, 2020 11:26 PM ETZoom Video Communications, Inc. (ZM)30 Comments8 Likes

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.
  • Looking for a portfolio of ideas like this one? Members of Digital Transformation get exclusive access to our model portfolio. Get started today »

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.

Zoom Video growth rate and free cash flow margin

(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.

Scatter plot of fundamentals, 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%.

Zoom Video stock chart

(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.

Panning for gold is so much work, and so last millennium! There is an easier way. Sign up for Digital Transformation, a Seeking Alpha Marketplace, and learn all about investing in the 21st century.

Tap into three high-growth portfolios, industry and subindustry tracking spreadsheets, and three unique proprietary rating systems. Don't miss out on the digital revolution.

Start your 2-Week Free Trial Now!

This article was written by

Steve Auger profile picture
6.65K Followers
Invest in high growth software stocks now!

I have been trading stocks, commodities, and options for more than 25 years. I have honed my skills in quantitative analysis and various stock investment tools for 15 years at Portfolio123 and offer services as a consultant in stock portfolios. I also own the financial data service Equity Analytx which provides aggregated fundamentals for a wide range of industries.

Follow

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.

Recommended For You

Comments (30)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.