Are Zoom Shares a Buy?

Since its listing in April last year, Zoom's share price has risen more than 150%. It has also defied the wider coronavirus sell-off, up 50% since February 20. 

But not all investors are convinced of the company's potential, including Morningstar analyst Dan Romanoff, who cites the free-user model, stiff competition and embarrassing security breaches as reasons to be wary.

“We think the rise in Zoom shares is unwarranted, and our discounted cash flow-derived fair value estimate remains unchanged at $62,” says Romanoff. “Users have spiked from 10 million in December to 200 million in March. We think the company’s funnel is increasing, as so many users are having a trial by fire on Zoom’s video calling application.

However, Romanoff is sceptical that Zoom will be able to convert enough of these free users to fully paid-up members within a reasonable time frame to justify the stock's current valuation. Nor is he convinced that in a post-covid world, we’ll remain hooked up to Zoom.

“In fact, we see consumer and corporate behaviour normalising, just as it did after September 11, 2001, and after the financial crisis, rather than shifting to a Zoom-only world," he adds.

Zoom's Prank Caller Problem

Zoom’s 20-fold surge in daily members since the end of last year has also exposed privacy risks. Zoom chief executive Eric Yuan was forced into damage control following widespread reports of trolls sabotaging meetings by interjecting porn.

Still, there have been some impressive figures. Zoom’s average user numbers in March were nearly three times that of Teams, according to research firm Apptopia. And since the public-health crisis unfolded, Zoom has become the most downloaded free app on Apple’s iOS App Store, ahead of TikTok, DoorDash, and Disney+, according to Bloomberg.

In the US, Zoom’s daily user volumes rose to a record 4.84 million as school children across the nation switched to virtual learning programs and companies asked staff to work from home to contain the coronavirus outbreak.

But the security scare has also robbed it of some high-profile users; Elon Musk has banned Tesla and SpaceX from using it, and the 1.1 million-strong network of New York City schools has also hung up.

Free Model Doesn't Pay

Video conferencing platforms offer video and audio calls, one-to-one meetings, group conferencing, collaboration and productivity apps, and a (usually) secure interface. Slack, Teams and Zoom offer a “freemium” model: a free version with limited features and tiered pricing for paid ones.

Despite increasing his fair value estimate, Romanoff puts Zoom shares at 107% overvalued to their fair value, adding that the stock has no economic moat and a a high uncertainty rating.

Unlike other young companies, Zoom is profitable, has a strong balance sheet and is tipped for growth. But, as Romanoff notes, management concedes the jump in usage from free users during the pandemic has produced no significant boost to revenue.

“Zoom is a recognised market leader in meeting software and is disrupting and expanding the $43 billion video conferencing market with its ease of use and superior user experience,” Romanoff says. “We think Zoom has product and technology advantages, but we do not believe they’re enough for a moat at this stage in its life cycle.”

He sees aggressive growth continuing in the coming years and models total revenue growth of 48% in the current financial year, decelerating to 23% in fiscal 2025. This represents a five-year compound annual growth rate of 30%.

Zoom Meetings is the core platform; it includes individual and group video conferencing, screen sharing, audio conferencing, searchable and archived transcripts, chat, and file sharing. Pricing tiers are based on a per user per month basis and include Basic (free), Pro ($15), Business ($20), and Enterprise for $20 (more features with a volume discount).

Zoom’s focus is squarely on adding as many users as possible. This starts with generating buzz and familiarity with free users, while the direct salesforce sells to enterprise accounts.

In this sense, it relies on viral adoption, whereby an increase in free users eventually leads to a customer signing on to access extra features. According to management, 55% of customers started with the free offering before converting to the paid version.

The company has also expanded its portfolio with the addition of Zoom Phone - the company’s cloud-based phone system that would serve as a replacement for a traditional private phone system. This is available only as an add-on to Zoom Meetings, with pricing starting at $10 per user per month.

Valuation Risks

While Zoom is expected to produce relatively higher revenue growth, the higher absolute valuation offers less room for missteps and therefore carries greater inherent risks. Romanoff says: “At high valuation levels, companies can often become momentum stocks that are punished severely if they do not deliver against expectations, which are regularly higher than consensus.”

And because its freemium model revenue is concentrated among the largest customers, there is also higher churn among smaller customers. “We think this could be exacerbated in Zoom’s case, as the company operates a freemium model, where the number of free users far outpaces the number of paid users," he adds. 

Management does not disclose churn statistics, but Romanoff thinks the nature of the model would dictate higher churn than fully paid enterprise software models. Zoom was actually profitable in the 2019 financial year, and this is likely to continue, which can’t always be said for many young software companies.

And then there is the risk of competition. Cisco (CSCO), Microsoft, Alphabet (GOOG), LogMeIn (9LG) – the list is long and includes a wide variety of smaller niche solutions. Larger companies, such as Cisco and Microsoft, can bundle a number of solutions together with video conferencing and, like Zoom, also offer a free version of their products.

And as the company expands Zoom Phone, Romanoff expects increased competition from legacy and modern cloud-based private phone providers, such as Avaya, RingCentral, and 8x8.

This article first appeared on Morningstar Australia