2023-12-23 06:48:45 ET
Summary
- Zoom Video Communications continues to face challenges in the videoconferencing industry, with increasing competition from Microsoft Teams and other established players.
- The company has shown positive developments in AI functionalities, but market share losses and high reliance on stock-based compensation expenses are concerns.
- Despite outperforming expectations financially, Zoom's current valuation does not present a compelling investment case, and the risk/reward profile appears unfavorable.
Investment thesis
I reaffirm my Sell rating on Zoom Video Communications, Inc. ( ZM ) despite the company outperforming my expectations over the last eight months. Despite its recent positive developments, Zoom Video continues to face a challenging landscape in the ever-evolving videoconferencing industry. The initial surge in demand fueled by the work-from-home trend during the COVID-19 pandemic provided Zoom with substantial growth, but as the industry matures and competition intensifies, the company's struggles have become more apparent.
While the overall videoconferencing market is projected to experience low-double-digit growth, Zoom's market share, sitting at an impressive 55%, appears increasingly vulnerable. The emergence of formidable competitors, particularly Microsoft Teams ( MSFT ), equipped with advanced AI capabilities and seamless integration, has eroded Zoom's once-dominant position. While a commendable effort, the company's attempts to enter the productivity market with Zoom Docs may face challenges against established players like Microsoft Office and Google Docs (GOOG) ( GOOGL ).
On a positive note, Zoom has surprised observers with its rapid deployment of AI functionalities, outpacing competitors like Cisco ( CSCO ) and Microsoft. The company's investments in AI, notably through the partnership with Anthropic, have led to the successful integration of AI features like the Zoom AI companion, Zoom Phone, and Zoom Contact Center. These innovations, coupled with the positive adoption rates, enhance Zoom's value proposition and potentially mitigate some of the challenges it faces.
Financially, Zoom has outperformed expectations in 2023, showing resilience in revenue and achieving better-than-expected growth. However, concerns persist, particularly in terms of market share losses, persistent stock-based compensation (SBC) expenses, and the company's high reliance on M&A for future growth. Looking ahead, Zoom's guidance for Q4 reflects a slowdown in growth, indicating ongoing challenges.
Despite an upgrade in financial estimates, the stock's current valuation, trading at 14.5x this year's earnings, does not present a compelling investment case. With an outlook of mid-single digits CAGR for revenue and low-single digits for EPS, coupled with the prevailing risks, the risk/reward profile appears unfavorable. In light of these considerations, the recommendation remains a sell, with the expectation that Zoom is likely to underperform over the next 12 months. Investors are advised to approach the stock cautiously, considering alternative opportunities in the market, especially given the current high-interest rate environment.
Zoom Video – An industry leader facing challenges
It has been a while since I last covered Zoom, the company behind one of the world’s largest videoconferencing platforms, here on Seeking Alpha. I last discussed the stock in April when I rated shares a sell and not without reason. The company emerged as a winner from the COVID-19 pandemic, fully benefiting from the working-from-home trend and rapidly growing demand for videoconferencing tools. However, these tailwinds driving growth for Zoom from 2020 to mid-2021 have eased away, putting pressure on the company as growth is hard to come by, competition is intensifying, and its financials did not align with its new growth profile. Whereas the company fundamentally definitely had potential, I saw too many negatives and headwinds for it to get past to consider this a solid investment.
This was despite the videoconferencing industry outlook actually looking really decent. Looking at the latest data and estimates, we can see that while the work-from-home trend intensity has definitely eased off from COVID levels, it is here to stay. The number of full workdays from home increased from just 6% pre-pandemic to 50% in the midst of the pandemic and has since retracted to 28% since early 2023, still significantly above the pre-pandemic level. This is what has so far allowed Zoom to avoid reporting negative growth. Both consumers and enterprises continue to see value in the company’s offering as remote working remains popular.
For perspective, as of 2023, 12.7% of full-time employees still work from home, while 28.2% work a hybrid model. Furthermore, 98% of workers want to work remotely at least some of the time. As a result, according to a study by Upwork, 22% of all Americans will be working remotely by 2025, which translates to 36.2 million people, up 87% from 2019 levels. This research shows that the remote working trend is here to stay and may only increase going forward, which bodes well for Zoom as demand for its platform will remain and most likely grow over time.
As a result of these dynamics, the global videoconferencing market , from a stable level in 2023, is expected to grow at a CAGR of low-double digits. Looking at the projections of multiple market research agencies, a CAGR of around the 11% mark seems highly likely. This is driven by the growing demand for videoconferencing as remote or hybrid work is here to stay but is also driven by rapid developments and innovations in the platforms themselves, like the integration of cloud and AI capabilities, which increase the value and functionalities of these platforms, increasing both value and usability.
And yet, while growth in the videoconferencing industry is looking solid, the significant competition and disappearing moat for Zoom mean it might not be there to fully benefit. This is what I concluded back in April:
Zoom emerged as one of the winners of the COVID-19 pandemic as its share price skyrocketed to over $500 per share. Today, the share price has come down to around $70 per share as investors realized that the COVID-19 tailwinds boosting growth for Zoom were not here to stay, resulting in a somewhat weak growth outlook for the company. And this is reflected in its FY23 results and FY24 outlook with growth of just 7% and 1%, respectively. The company seems to have entered a mature stage in which growth is expected to remain in the mid-single digits and management should focus on profitability and its shareholders. Yet, the company reported SBC expenses of $1.3 billion in FY23, resulting in it only barely making a GAAP profit.
In addition to this, I believe the current impressive market share of above 55% in the videoconferencing industry is not sustainable for Zoom as it will quickly be overtaken by its big tech competitors which appear much stronger in advanced AI capabilities that are expected to drive new features and growth in this industry. Furthermore, whereas Zoom operated the best platform during the pandemic, focusing on simplicity and meeting features, competition has caught up, resulting in a weakening moat for Zoom. As a result, I am projecting weak growth for the company going forward, with it underperforming the videoconferencing industry and its competitors, driven by market share losses, making this a tricky investment opportunity with a weak risk-reward profile.
Clearly, the company is operating in a challenging environment and struggling to grow revenue and earnings. This is also reflected in the stock price performance. Whereas we have seen many technology stock prices skyrocket so far in 2023, Zoom stock is up just 7% YTD. Furthermore, shares are up just 2.5% since I last covered these in April, underperforming the SP500 index significantly as this one is up 14.5% over the same period.
This is despite the fact that Zoom is, in fact, one of the companies that could significantly benefit from the AI boom and has actually shown quite some promising developments over recent months. I must admit that the company has done better financially and fundamentally in terms of development than I anticipated in April. However, this does not mean that crucial issues have entirely disappeared.
Therefore, let’s dive into the most important developments from the last eight months, both positive and negative.
Zoom shows positive developments but will continue to struggle
As discussed earlier, the outlook for the videoconferencing industry is very solid, with growth at a CAGR of low-double digits. Yet, I did not expect Zoom to be able to fully benefit from this growth. I still don’t, which is essentially a result of the significant competition it faces from Microsoft with its Teams platform, Zoom’s weak moat, and its financial disadvantage.
Remarkably, as of the end of 2022, the company holds a very significant market share of 55% in the industry, far ahead of its closest peer, Microsoft, at 21%. However, I do not view the market share as anywhere close to sustainable.
Whereas Zoom offered the best platform during the pandemic thanks to its head start, focusing on simplicity and meeting features, competition has caught up, with Microsoft’s Teams platform offering very similar features to that of Zoom. For most meeting requirements, both will probably do the job, and as a result, Zoom has seen its moat disappear rapidly over recent years.
Of course, its moat was never really strong. Apart from the first-mover advantage and the fact that enterprises are unlikely to switch platforms due to costs, Zoom has had very little going for it. The platform is in no way unique, which is confirmed by Gartner's research, which gives both Zoom and Microsoft Teams very similar ratings and places on its magic quadrant.
Within the videoconferencing industry, there are just three real factors to leverage as a way to set your platform apart from the competition, and these are features, costs, and compatibility. In each of those, Zoom has had trouble fighting Microsoft.
Whereas in terms of cost, there is little difference between the two, on the compatibility front, Microsoft has the benefit of Teams being integrated into its office package, giving customers seamless integration between Teams and programs like Excel, Word, and PowerPoint. With this software being used by millions of individuals, governments, institutions, and businesses worldwide, this gives Microsoft a very powerful advantage, one Zoom can’t fight or match.
This has been one of the key reasons why Microsoft has reported faster user growth in recent quarters and years. At the end of 2021, Microsoft reported 270 million users of its Teams platform, growing to 300 million by the end of 2022 and 320 million as of the most recent financial report . This includes over 1 million organizations and 91% of the Fortune 100.
Furthermore, while hard to determine, some analysts believe Teams is about to reach $8 billion in revenue in 2023. This is up from $6.8 billion in 2020, when, of course, usage was much higher. One way or another, it is safe to say that Microsoft continues to close the gap and is gaining on Zoom.
However, positively, Zoom is now, in fact, looking to fight Microsoft on the compatibility front by entering the productivity market to compete with Microsoft office and offer what Microsoft is able to offer through Teams and Word with its Zoom Docs powered by AI. While Zoom is not about to fully compete with Microsoft, it is simply trying to match the functionality of having a program to create documents, track projects, manage tasks, and many more, with excellent compatibility with the Zoom platform to make it more competitive on the productivity front. The company will introduce the program in 2024 to go up against Microsoft Office and Google Docs.
Will it be able to compete? Outside of making notes within the Zoom platform, I don’t think so. Microsoft Office and Google Docs have very strong user bases with great compatibility and accessibility with other apps and platforms of those companies.
Furthermore, despite my overall negative view so far, Zoom has also positively surprised me over the last eight months in terms of feature developments and the integration of AI functionalities in particular. In my April article, I explained how I expected Zoom to fall behind the competition on this front as it has to compete with big tech peers like Cisco and Microsoft with superior financial resources and much more experience in AI. And yet, Zoom has proven me wrong over these last few months, with the company rapidly rolling out new features and beating Microsoft and Cisco to the feat.
Zoom has invested in AI start-up Anthropic in an effort to boost its AI offerings. The company is leveraging Anthropic's large language model, known as Claude, across its platform, including its call center and the company’s AI companion. I must admit that Zoom’s fast roll-out of AI functionalities has impressed me as the company, in several areas, seems to outpace the competition with these innovations, adding to the attractiveness of the Zoom platform.
The company’s AI companion, which is now available to paying users at no additional cost, is a differentiator to other AI assistants, with those of Microsoft and Google, both costing up to $30 per month . As a result, the AI functionalities have seen great adoption in the first three months since the release, with over 200,000 accounts enabling it and 2.8 million meeting summaries having been created by the assistant.
Apart from strong growth in these AI functionalities, the company has also seen strong adoption of other new functionalities, with Zoom Phone reaching 7 million paid seats, Zoom Contact Center reaching 700 customers, and the Zoom Virtual Agent reporting a quarter-on-quarter doubling of customers. Clearly, Zoom customers are eager to adopt the new functionalities, adding to Zoom’s value per customer, which can become a strong growth driver over time, especially if it continues to struggle to add new customers.
These new integrations are crucial for Zoom as these next-generation technologies are crucial in winning over customers and maintaining them. As I said before, within the industry, better or more extensive features are one of the best ways to set yourself apart, and this is precisely what Zoom is doing, giving it a better chance at fighting the competition and maintaining its market share.
While this does not change my belief that Zoom is unlikely to expand its market share and will most likely continue to lose share, I do believe it softens the situation and shows that Zoom does still stand a chance to fight its larger, financially superior peers, making me slightly less bearish on the potential market share losses for Zoom. The company has outperformed my expectations in terms of development, allowing for some careful optimism in my eyes. However, I do still expect a slight market underperformance from Zoom.
Zoom outperforms financially, but weakness persists.
Growth so far in 2023 had turned out much better than what management had guided for at the start of the year when it had guided growth of just 1%. In Q3 , total revenue came in at $1.14 billion, up 3% year-over-year, bringing the YTD growth to 3.2%, a slowdown from the 7% growth reported in its fiscal FY23. Still, this is better than I anticipated, primarily due to the business showing to be stickier than expected and management’s rollout of new features, adding new revenue streams.
Still, Zoom continues to face a slowdown in the underlying industry, mainly driven by a slowdown in growth in the enterprise segment, which was up just 8% in Q3, down from 24% growth in fiscal FY23. This reflects the depressed IT spending we currently see among enterprises and does not surprise me. This was further highlighted by a weakening net retention rate, which came in at 105% in Q3, down from a 115% level in fiscal FY23, reflecting a lower demand environment. This is in line with my expectations.
Nevertheless, Zoom reported a 5% growth in Enterprise customers in Q3. Enterprise now accounted for 58% of revenue, up from 56% in the same quarter last year. Also, the business remains relatively sticky, with churn decreasing YoY to 3% from 3.1% one year ago, and continues to grow RPO, although at a slower pace of just 10% compared to 30% in fiscal FY23, resulting in an RPO of $3.6 billion as of the end of Q3. So far, there are not many surprises.
Moving to the bottom line, the company has also performed much better than anticipated, driven by the resilient top-line performance and the optimization of usage across the public cloud, partially offset by investments in new AI technologies. The gross margin in Q3 was 79.7%, up 20 basis points YoY and slightly below the level achieved in the first half of the year. Still, considering weakness, this is a strong gross margin performance.
The resilient gross margin, combined with cost efficiencies and some one-off benefits, allowed Zoom to improve the operating margin to 39.3%, up 470 basis points YoY. This resulted in a non-GAAP operating income of $447 million, up 17% YoY.
This big margin improvement also boosted EPS growth, up 21% YoY to $1.29, bringing the YTD EPS growth to 20%, far above my start-of-the-year estimate of an EPS decline. Cash flows also grew strongly, with FCF up 66% YoY to $453 million, bringing the YTD total to a significant $1.14 billion, representing an FCF margin of 34%. This increase was driven by stronger collections, targeted expense management, and higher interest income. This allowed Zoom to further strengthen the balance sheet as it ended Q3 with a total cash position of $6.5 billion, up a little over a billion from the start of the year. Meanwhile, the company has no debt on the balance sheet, leaving it in excellent financial health with plenty of cash to invest or use for acquisitions.
Management has already indicated that it is not planning to leverage its significant cash position to buy back shares. Management is entirely focused on investing in the business and is likely to look at smaller tuck-in acquisitions and larger ones.
While I am in favor of this strategy on many occasions, I am not sure in this situation as it leaves investors highly exposed to the significant levels of SBC. SBC in Q3 was $259 million, down 14.5% YoY. However, YTD SBC is still up 4.6%, outpacing revenue growth. Furthermore, as a result, GAAP EPS remained much lower at just $0.45, indicating that SBC continues to take up 66% of non-GAAP net income, which is significant. YTD, this increases further to 70% of non-GAAP net income, with SBC of $813 million. Overall, SBC will be down slightly from fiscal FY23 levels but remain elevated.
For a company that has entered a relatively mature stage with no rapid growth expected over the next decade, this kind of profitability and SBC is simply unacceptable to me as it barely makes a real profit and massively dilutes its shareholders. To me, this is one of my biggest concerns regarding an investment in Zoom, as management does not seem to care and continues to dilute shareholders.
Overall, I must, nevertheless, admit that I am quite impressed by Zoom’s fiscal FY24 so far, as the company has shown the ability to roll out features much faster than peers, maintain existing customers, and continue to attract new customers. Yes, Microsoft’s Teams platforms seem to be growing slightly faster, but Zoom’s market share losses seem to be less significant than I anticipated eight months ago. In addition, management is able to improve margins and cash flows even as revenue growth keeps slowing down, which is remarkable.
Simply put, I have underestimated the company. However, this does not mean all weaknesses have disappeared, with the company still losing market share and continuously diluting its shareholders. Including SBC, the company can still barely report a profit with a GAAP net income margin of just 10%, which raises concerns.
Outlook & Valuation – Is ZM stock a Buy, Hold, or Sell?
For Q4, management has guided revenue to be in the range of $1.125 billion to $1.13 billion, up just 1% at the midpoint of the range, indicating that growth continues to slow down. However, management has been very conservative in its guidance over recent quarters, so these estimates probably have some upside. Management further guides for an operating margin of around 36.5%, up 30 basis points YoY. This should result in an EPS of $1.13 to $1.15, down 6.5% YoY.
This should result in fiscal FY24 revenue of $4.506 billion to $4.511 billion, up slightly from management’s prior expectations and up 3% at the midpoint. Furthermore, the gross margin is expected to be approximately 80% for the entire year, and operating income in the range of $1.74 billion to $1.745 billion, representing an operating margin of approximately 39%. Finally, this results in an EPS estimate of $4.93 to $4.95, up 13% and far above my $4.20 estimate from the start of the year.
Taking into account the company’s better-than-expected YTD performance, the rapid roll-out of new features, and the Q4 guidance laid out above, I upgrade my financial estimates for Zoom and turn slightly more bullish on its long-term potential, even as I continue to see a significant number of headwinds. I have increased both my revenue and EPS estimates through the company’s fiscal FY27. However, from a solid base fiscal FY24, this still represents very disappointing revenue growth of a mid-single digits CAGR and EPS growth at a low-single digits CAGR as the company is facing a very tough comparison with the current fiscal year, rising costs, and increasing competition and investments. I expect the company to have reached a peak in its margins and these to ease slightly in the upcoming years. These expectations result in the following financial projections.
Based on these expectations, Zoom shares are currently trading at 14.5x this year’s earnings, which is a slightly more favorable multiple compared to the 16x it traded on in April, but the current share price of $72 is still above my latest target price of $66. Furthermore, I still don’t view shares as trading at a discount in any way, as the growth outlook remains somewhat depressed and risks remain significant, even as the company has shown some positive and surprising developments in recent quarters.
The company’s growth outlook is not looking very inspiring, it continues to lose market share and barely generate a GAAP profit due to significant SBC, and management is desperately looking for M&A opportunities to boost growth, which will bring risks of its own. Simply put, based on the current growth expectations and risks involved with accelerating growth, I believe investors should not be willing to pay much of a premium for this company, if anything at all.
Even if I maintain my 15x fair value multiple, the slightly higher EPS expectations only allow for a minor target price increase to $73 per share, based on my FY25 EPS projection. This leaves pretty much no upside potential over the next 12+ months, which is why I reconfirm my sell rating on Zoom, despite some positive developments and outlook upgrades.
The risk/reward profile remains unfavorable for investors, especially as interest rates remain high. At the current time, I believe there are much better opportunities available on the market, and I expect Zoom to keep underperforming over the next 12 months.
For further details see:
Zoom Video: Why I Maintain My Sell Rating