2023-11-17 14:54:01 ET
Summary
- In 2019, pundits referred to Zoom as the next verb in the lexicon of the collective consciousness, akin to Google or Kleenex.
- After three years of meteoric growth, during which Zoom 10x'd+ its free cash flow generative sales, growth has slowed, and it's largely been left for dead by investors.
- In the mid-2010s, Apple experienced the same treatment from investors: It generated some of its best returns in a short period of time in the company's history.
- Today, I will highlight the similarities between Apple of 2018 and Zoom of 2023 so as to surface what investors should pay attention to as Zoom reports next week.
- In short, with $6 billion in cash, no debt, multiple rapidly-growing lines of business, and a very large, stable source of free cash flow, I like Zoom and its 8.7% free cash flow yield.
Awaiting Acceleration Day
Zoom (ZM), like so many businesses that were beloved in the private and public markets throughout the 2010s and early 2020s, has been essentially discarded by market participants, as evidenced by its elevated free cash flow yield of 8.7%.
While market participants doted on the business in 2020 and 2021, sending its shares to unsustainable heights, they've ostensibly vanished as the business has found itself at its most attractive valuation in its corporate history.
Zoom Now Offers Its Highest Free Cash Flow Yield In Its Corporate History (8.7%)
YCharts
Recently, I've shared that I believe Zoom to be an attractive investment as it offers such an elevated yield alongside healthy free cash flow margins of 25%-plus and $6B cash hoard and no debt.
Today, I will briefly further elaborate why I believe it's attractive at these levels, then I will share the KPIs (key performance indicators) that I will monitor in Zoom's forthcoming earnings report.
An Attractive Setup
As I've noted, Zoom is reminiscent of Apple (AAPL) circa 2016-2018. I will explore what I mean by this in this section.
I recently shared what I believe to be an attractive investment setup. To wit:
In the interest of maximizing the value of your time, we will dive right in. The setup could be summarized via just three points:
- Stable, profitable legacy business
- Rapidly growing, more dynamic new line of business
- Healthy balance sheet
The stable, profitable business protects downside (what some would call risk, i.e., beta, i.e., volatility), and the rapidly growing, more dynamic new line of business creates "huge upside."
- There is nuance here, of course. For instance, finance academics would define "risk" as "beta," but risk is a matter of product-market-fit, culture, execution, financial realities, etc., and not the volatility of a business' stock price.
Let's now explore a few interesting "attractive setups."
From 2016 to 2018, Apple represented this attractive setup framework perfectly, and, over the last five or so years, its returns have demonstrated what such an attractive setup can create in the way of returns.
Returns Based On Apple's Attractive Setup
Seeking Alpha
Below, I shared the characteristics that Apple possessed that made it an attractive setup, poising it to create such an incredible outcome for its shareholders.
- Stable, profitable legacy business (Apple's hardware business that included the iPhone, iPad, Mac Desktop, MacBook Laptop, and more).
- Rapidly growing, more dynamic new line of business (Apple's services business that included iCloud sales, Apple Music sales, App Store Ads, and more).
- Healthy Balance Sheet (At the time, Apple had just repatriated ~$200B in cash as a result of the Trump Administration's tax cuts. The company announced that it was committed to achieving a "net cash neutral position," which suggested that it would return all of that $200B in the form of buy backs and raise cheap debt, with which it would buy back even more stock, to achieve a "net cash neutral position" such that total cash = total long term debt).
Today, Zoom possesses essentially the same characteristics:
- Stable, profitable legacy business (Zoom's consumer facing Zoom call business, whose churn has stabilized in recent quarters. While not growing, akin to Apple's iPhone business in the 2010s, it does generate healthy free cash flow for the Zoom conglomerate).
- Rapidly growing, more dynamic new line of business (Zoom Unified Communications as a Service, a.k.a., its enterprise business. Zoom Phone is at $500M in ARR and is growing around 30%-50% presently. Zoom Contact Center is also growing rapidly. Management has stated that they believe Zoom Meetings, the aforementioned stable, profitable legacy business, could return to growth in the future).
- Healthy balance sheet (healthy balance sheet genuinely is an understatement for Zoom. "Preposterously giant cash hoard" would accurately describe Zoom's balance sheet, which has ~$6B in cash and no long term debt presently).
The setups are virtually identical, and, to this end, I'd like to share one more similarity before briefly discussing what I'll be looking at in Zoom's upcoming earnings report.
How Walled Garden Ecosystems Create Huge Shareholder Returns
In addition to the above-mentioned similarities, Zoom and Apple have another fascinating and noteworthy similarity, and that's their product and platform strategy.
In past months I've written to you often about the strategies businesses employ via which giant businesses and correspondingly rapidly appreciating share prices are created. Specifically, I've discussed the framework in which a company fields an initial product, uses that product to capture customers, then upsells those customers over time on more products. The company then weaves those products into one seamless ecosystem that both serves to "lock in its customers" and create consumer surplus for those same customers.
Apple's Walled Garden Ecosystem has been both vilified for locking its customers into using exclusively Apple products and praised for its ability to create one of the most formidable embedding/switching costs moats the business world has ever seen.
In addition to these effects, it's also allowed Apple to "go to market" in a more diversified manner while also, ultimately, achieving a better LTV/CAC.
That is, because Apple can go to market with its iPhone, MacBook, iMac, iPad, headphones, mouse offerings, and more, it has many different avenues to wedge into new customers' wallets. Then, over time, upsell these customers on new products, until, at some point, they cannot escape from the ecosystem and an embedding/switching costs moat is built.
This allows Apple to be more aggressive in marketing spend (as measured by CAC) in that it knows its customers' LTV will be very high over time as it upsells and locks customers into its Walled Garden Ecosystem.
Applying these ideas to Zoom, it has quietly begun building a Walled Garden Ecosystem of its own via a series of growing products, each of which serves as an avenue for Zoom to go to market.
In the same way that Apple has built a very large franchise via this business strategy, Zoom is attempting to gradually expand its product set and weave each of these products into one, unified ecosystem that creates both embedding/switching costs moats and greater consumer surplus.
We can see Zoom's execution of this strategy in the way it's begun to articulate its platform to customers:
Zoom One Platform
Zoom.com
With these ideas in mind, here's what I'll be monitoring for Zoom's Q3 2023 report:
What To Watch
It's no secret that Zoom's growth has collapsed following a period in which it 10x'd+ its sales in about 36 months.
YCharts
And, of course, Zoom's flat growth has been priced into its valuation already.
And this is important to note: The market has priced Zoom such that it will not accelerate growth in the future, so, should it begin to accelerate growth, its valuation should re-rate materially higher, bringing its share price with it.
Furthermore, should the market begin to believe in Zoom's ecosystem strategy, the nuances of which I detailed for you just above, it will likely re-rate Zoom's valuation, as it did for Apple in the late 2010s as the market came to appreciate the overall ecosystem as well as the faster growing properties within the ecosystem.
In the case of Zoom, I will be watching the growth rates of Zoom Phone, which could scale to beyond $1B in ARR in the years ahead, and of Zoom Contact Center, which management has hinted could be as large as Phone over time.
Both of these properties, like Apple's services sales in the late 2010s, are growing rapidly presently, though they have not hit sufficient scale to push upward on the total sales growth metric for Zoom in a meaningful way.
Additionally, Zoom's stable, profitable legacy business could return to growth, as has been the case for Apple's iPhone business in certain recent years, which would really supercharge the entire conglomerate's growth rate, which should lead to valuation multiple repricing, and, by extension, Zoom's share price should appreciate.
Concluding Thoughts: Here's What Needs To Happen For The Thesis To Play Out
In short, I will be looking for sustained elevated growth from these lines of business:
- Zoom Phone
- Zoom Contact Center
- Zoom One, i.e., how well Zoom sells its holistic ecosystem
In addition, I hope to see Zoom Meetings return to growth, though this isn't entirely necessary, but it would certainly add to the rocket ship that could be Zoom's valuation multiple re-pricing were it to happen in the quarters ahead.
And, should these metrics satisfy (not necessarily in this quarter but in the quarters and years ahead), the market will realize:
- Zoom can accelerate growth.
- Zoom's ecosystem is more durable than recently thought.
And both of these factors will serve to push upward on Zoom's valuation multiple, and, by extension, its share price.
Of course, the primary risk to all of this is:
- Zoom fails to innovate internally and/or acquire adroitly whereby growth accelerates via new products and services.
But, so long as Zoom continues to execute as it has over the last couple years (it's been quietly building huge properties in Phone and Contact Center), and so long as it uses the $6 billion net cash hoard wisely, I believe Zoom will eventually experience a substantial valuation re-rating upward.
Thank you for reading, and have a great day.
For further details see:
Zoom's Q3 Earnings Preview: Stock At An Attractive Valuation