Morsa Images/DigitalVision via Getty Images
Morsa Images/DigitalVision via Getty Images
Zoom Video Communications (NASDAQ:ZM ) was one of the high-flying, pandemic-favourite tech stocks. Eventually, the stock price started to decline in the second half of 2021 and has already lost more than 75% of its market value since its peak. Although the hypergrowth expectations have been already forgotten and the stock is out of favor now, we believe the firm's operations and financials are still solid. Further, while a decline in EPS is forecasted in the near term, moderate growth may still be expected in the longer term.
We believe the firm is approaching value territory, but the bottom for the stock has not yet been reached and therefore we believe that it's not yet a buy at current valuations. To understand this thesis, we need to take a look at the financial position of the firm, need to evaluate the firm's strategy going forward and last, but not least understand the current valuation metrics. To close off we will highlight the most significant risks to the firm.
ZM has reported solid financial results for FY22. They have achieved a 55% revenue growth Y/Y and an adjusted free cash flow margin of 38%. The revenue growth in the fourth quarter was 21% year-over-year, reaching more than $1 billion. The main driver of the growth was the Enterprise business, while the demand for Zoom Phone was also high. Zoom Phone achieved a record quarter, growing by more than 550.000 paid seats.
Total revenue (in millions) (Zoom Video Communications)
Total revenue (in millions) (Zoom Video Communications)
Important to note that 14% of the revenue growth Y/Y was actually attributable to existing customers. In our view, it is important that ZM does not only grow by acquiring new customers, but they are also able to retain their customers and even increase their revenue from the already existing user base. We believe this could have a potentially positive impact on the business going forward, as it could have a favourable effect on the margins.
The firm also managed to expand their customer base, and currently have more than 2700 customers contributing more than $100,000 on a trailing twelve-month basis. Let us focus now briefly on the Enterprise customers, as they were the main driver for growth.
Enterprise customers and revenue share by customer category (Zoom Video Communications)
Enterprise customers and revenue share by customer category (Zoom Video Communications)
The number of Enterprise customers have increased by 35% compared to the year ago quarter, increasing the contribution of Enterprise revenue to 50%. The firm expects the contribution of Enterprise to become more dominant in the years ahead. ZM also made the remark that they aim to continue investing in the growth of the online channel, as it is more attractive from profitability and cash flow point of views.
In our view, the competition in the online channel space is very high. Users have a wide variety of choices to communicate and collaborate with each other. The cost of switching to different platforms is also low. Therefore, we do not see a competitive advantage of ZM in this segment and expect the slowing growth of the online channel to continue.
Further, in order to stay competitive, innovation, new products and marketing are vital. We can see in ZM's Q4 financial figures that they indeed had a strong focus in these areas. Sales and marketing expenses increased by 58% Y/Y, while R&D expenses increased by almost 100% Y/Y reaching 6.7% of the total revenue. These increased expenses however, inherently cause a decreasing margin in the short term.
Q4 FY22 financial results (Zoom Video Communications)
Q4 FY22 financial results (Zoom Video Communications)
Zoom pointed out that they are aiming to find a balance between growing and maintaining their margins in the years ahead. We see finding the balance a difficult challenge, as the cost of acquiring new customers is increasing, and the faster growing Enterprise segment is less attractive from a profitability point of view than the online channel.
To sum up, currently ZM's business looks healthy from a financial point of view, with impressive growth figures. Going forward, however we can potentially expect slowing growth and contracting margins.
In order to understand Zoom's potential performance in the future, we need to take a look at the strategy that they have defined.
ZM has presented a strategy, which aims to propel future growth. The three defining elements of this strategy are unified communications, hybrid work and business workflows.
We definitely agree, that in order to survive in this competitive environment, there must a unified platform, enabling not only video conferencing, but also planning, chat and phone functionalities. However, there are many other products on the market, which can compete with ZM's platform. As of now, we do not see the competitive advantage of Zoom in this segment.
The firm has just recently announced the general availability of their Contact Center, as a key part of the UC stack. The results related to the Contact Center will give us an indication, whether the strategy is viable.
The trend of a more flexible working routine, both in terms of location and time, is clearly visible now. Zoom aims to provide a consistent experience for its customers, to make sure that the users are able to collaborate effectively, regardless of where they are. They specifically point out Zoom Rooms and Zoom-connected devices are enablers.
Again, as already highlighted in the first point, we do not see a moat or a competitive advantage for ZM's business in this element either. There are other, more established firms in the space, who could provide similar products and experiences.
ZM aims to partner with other tech firms to integrate Zoom into their platforms to enhance communication and collaboration. One recent integration is the Zoom-DocuSign integration. This enables the parties to review and approve their documents during a Zoom Meeting.
We see potential in partnering with other tech firms and integrating Zoom into other products. However, we are yet to see, how well the firm will be able to monetise on these kind of integrations.
All in all, we are not convinced about Zoom's strategy going forward. There is potential, but there is significant uncertainty, whether Zoom will be able to create a competitive advantage and moat to grow its business or maintain its market share successfully.
Despite the dramatic drop in the share price and the relatively low price multiples, Zoom still appears to have more downside risk.
Currently, ZM is trading at a P/E multiple of 16.7x, which is slightly below the sector median of 17.3x. Further, the current P/FCF multiple of 15.8x is also below the sector median of 18.4x. On the other hand, both price-to-sales and EV/EBITDA of Zoom are significantly higher than the respective sector medians.
Moreover, analysts estimate the earnings per share for the next four quarters to be in the range of $3.27 to $4.38, while ZM expects $3.45 to $3.51 per share based on 312 million shares outstanding for the same period. Both of these estimates are significantly below the EPS of $5.08 achieved in the last four quarters.
In our view, the uncertain growth potential of the firm, the declining EPS in the near term, the lack of competitive advantage as of now, and the contracting operating margin do not justify these multiple. In order to have a more appealing risk reward profile, a higher margin of safety is needed.
Last, but not least, Zoom has also been diluting its shareholders in the last few years by constantly issuing new shares, which essentially eroded value for the investors. This quarter the firm announced a $1 billion repurchase program, which is planned to be executed in the near future.
We believe that ZM's decision to buy back shares is a good way to return at least some value to investors, who have been sticking with the stock so far. However, we would like to see a consistent and continuous share repurchase program from the firm in the future, to be able to rely on it as value creation.
ZM also does not pay dividends.
We find it especially important to highlight two of the risks listed in Zoom's annual report, filed in March 2022. These are:
We believe competition is the highest risk Zoom is currently facing. Other companies like Microsoft, Google, Cisco are all present in the communication market and have a much larger, already existing ecosystem and customer base.
The restrictions introduced during the pandemic are gradually disappearing. Although the way we work and collaborate has significantly changed, and we believe some trends are here to stay, more and more people are wishing to conduct face-to-face meetings, due to the "Zoom fatigue". This could eventually result in a declining demand for Zoom's products.
The financial position of Zoom is sound, but slowing growth and contracting margins create an uncertain future.
Competition is fierce in the communication space with competitors including Microsoft, Google and Cisco.
We do not see a competitive advantage or moat on Zoom's side.
There may be further downside risk for the stock.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: Past performance is not an indicator of future performance. This post is illustrative and educational and is not a specific offer of products or services or financial advice. Information in this article is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. This article was co-authored by Mark Lakos.