Zoom FQ3 2020 – Great company, terrible stock pt. II.

Great results but uncertain outlook.

• Zoom produced excellent Q3 2021 results but the burden of free users has finally hit profitability which together with an admission of slowing growth calls into question the extreme valuation.
• I think Zoom is a great company that provides the best video conferencing offering and has a management team that has executed exceptionally well through the very difficult circumstances it faced during the pandemic.
• I just can’t stomach the valuation of the shares.
• Zoom reported excellent Q3 2020 revenues / EPS of $777.2m / $0.66 ahead of estimates of $693.0m / $0.50 as demand remained strong across the board.
• This is a particularly good performance as Microsoft is pushing very hard with Teams which is bundled as part of Office365 and effectively comes for free for Office users.
• As a user of all video conferencing systems and a customer of Zoom, I am a typical user who values Zoom’s user experience advantage despite having Teams included as part of my Office365 subscription.
• The key risk to Zoom is that Microsoft manages to catch up in terms of the user experience of Teams and Zoom has to cut prices to keep its customers.
• However, given Microsoft’s execrable performance when trying to improve the user experience of Skype, I think Zoom has a large time gap and remain unconcerned with this risk in the short term.
• Key to Zoom’s growth has been new customers with big customers generating over $100K per year growing 136% YoY and small customers growing by 485% YoY to 360,000.
• Small customers are growing their share of revenue making up 38% of revenues compared to 36% in Q2 2020.
• However, profitability was somewhat problematic with gross margins falling to 67% from 81% in Q3 2019 as a result of a big boost in free users.
• Total usage increased 75% QoQ to 3.5tn minutes meaning that Zoom had a much bigger cloud bill to pay which dented gross margins.
• Education was a large part of this increase as students returned to online learning and Zoom expects this to normalise when students return to school full-time.
• Zoom would not be drawn on this is going to occur but I am pretty hopeful that many institutions will return full-time in January with the vast majority back by the middle of Q2 2021.
• This is because most evidence is pointing to the SARS-Cov2 being highly seasonal like all coronaviruses meaning that even without vaccines, the caseload will drop dramatically as the weather begins to warm up.
• If vaccines are available in volume, then the northern hemisphere has 6 months to get everyone vaccinated before SARS-Cov2 makes its inevitable return in the autumn of 2021.
• Hence, my scenario for next year is that gross margins go back up but at the same time revenue slows down.
• This is for two reasons:
  • First, usage: With education returning to in-person full time, Zoom’s free usage will return to a lower percentage of the total meaning that gross margins should normalise.
  • This is in the absence of increasing competition which I think remains pretty far away from being able to put pressure on Zoom’s pricing.
  • Second, the economy. Once the pandemic is largely over, all eyes are going to return to the ruin that has been made of the Western economy.
  • Global indebtedness has increased by $15tn as a result of COVID-19 and taxes look almost certain to rise substantially in a vain attempt to pay for the lockdown.
  • Hence, the recovery is going to slow and painful as high indebtedness and increasing taxation will both act to slow the recovery down.
  • This is because they both will drain resources that could otherwise be used to reinvest for recovery.
  • It’s the smaller companies that will feel the brunt of the pain as government support ends and they have to stand on their own two feet.
  • This could cause smaller companies to cut costs and Zoom may be seen as a luxury as people increasingly come back to the office and as Microsoft offers something inferior but usable as part of an existing subscription.
• Zoom’s valuation is predicated on its growth and under this scenario, consensus of 32% YoY over and above 2020 may be hard to achieve.
• Zoom is currently trading on 2021 EV/Revenue of 54.1x and a 2021 PER of 176.9x which I continue to believe is too high.
• The market seems to be assuming that people are going to work from home forever and that Zoom will completely dominate the video conferencing market.
• Both of these are big asks and are already priced into the shares.
• Great company but I have no interest in getting involved.