I think ZM has >100% upside over the next 4-5 years. While the market is concerned on how mgmt will guide FY22 on the upcoming Q4'21 report, looking further out I see a business in the early stages of building a platform of convergence between communications and collaboration (Zoom Meetings, Phone, Rooms), content (Zoom Apps via integrations with third-party software vendors), and commerce enablement (OnZoom live event monetization). Between growing penetration of these products (especially Phone) and attacking the G2K customer opportunity, ZM has ample levers to pull to show less deceleration this year than consensus expects. This should drive upward estimate revisions. I believe ZM can reach high 60s y/y growth in FY22 and sustain 30%+ through FY24, after which it should report 20s y/y growth through FY26. FCF per share by FY26 should get close to $30, which suggests you are buying the business at
Relevant Business Info
ZM is a subscription revenue business with a free tier used by consumers and small businesses, which is subsidized by paying customers (primarily larger businesses). Subscription revenues are driven by the number of paid hosts to the Zoom Meetings videoconferencing product plus purchases of additional products (Zoom Phone -- i.e. cloud PBX, Rooms, Webinars, etc.). Management doesn't break out revenue by product currently, but the CFO has said that Zoom Phone could one day be 25-50% of their revenue.
Market
Per Gartner, ZM's TAM was $39bn in 2019 growing to $46bn by 2024 (3% CAGR). This TAM aggregates the individual markets of videoconferencing, premises-based video infrastructure, telephony, and messaging. This is mostly a replacement market with large legacy competitors like Cisco and Avaya losing share today. The major "disruptors" include Zoom, Microsoft Teams, and RingCentral. At its Analyst Day in October, ZM disclosed that its TAM estimate for Zoom Phone was an incremental $23bn by 2024. So overall, this is a ~$50bn market opportunity globally.
Growth Algorithm / Financial Model
Pre COVID, ZM was hypergrowing revenue at >100% y/y in FY18-19 and then decelerated to 88% in FY20. Then COVID hit in FY21, causing the business to reaccelerate, first to 169% y/y in Q1, then to 355% in Q2, 367% in Q3, and 392% in Q4. Growth to date has mostly come from customer growth vs ARPU. ZM discloses a few different tiers of customers, but the major split per mgmt's definition is customers with >10 employees and those with <=10 as this separates B2B customers from consumers. Average revenue per customer has understandably seen a headwind during COVID as many smaller customers with lower effective ARPUs (and free users) joined the platform. I expect that total customer count will obviously decelerate sharply in FY22 (I assume 20% y/y vs high 400s exiting FY21) and then more modestly in FY23+. But the key bet I am underwriting is that large customer expansions and upsells of additional products, especially Phone, will cause a positive inflection in effective ARPUs. Consider that within the G2K, only 12% are spending $100k+ ARR with ZM today despite 50% spending $1k+), so the potential for upsell is very real. Revenue per customer should then be a more impactful driver of the model going forward as bigger customers do larger deals and pay for more products. I see ZM as being able to sustain 30%+ topline growth through FY24 as a result.
Mgmt's long-term targets (non-GAAP) given at the last Analyst Day:
Gross Margin 80%
R&D 10-12% of revenue
S&M 30-35%
G&A 8-10%
Operating Margin 25%
These targets are not predicated on a specific LT topline growth rate or a timeframe.
Management
CEO Eric Yuan was a former Cisco engineer who worked on the Webex videoconferencing product. He started Zoom as a way to fix Webex's many shortcomings (poor A/V quality, unreliable uptime, etc.). His stake in ZM has made his net worth balloon to $20bn. My impression of Eric is that he is customer-obsessed and a passionate product guy. I have spent time with the CFO in meetings since the IPO. Her approach to guidance and messaging the Street tends to be conservative, though recently that's understandable given mgmt doesn't want to extrapolate off of what is clearly an outlier period for the business. Mgmt has executed on a strong beat/raise cadence on all key line items since going public.
Why Does the Opportunity Exist?
ZM has round-tripped since September and is down almost 30% from its peak as the market fears the "tough COVID comps" narrative into the Q4'21 print/FY22 guide. While I appreciate the controversial setup, I believe the market is missing the forest for the trees -- ZM is a high quality business with a frictionless land through newfound brand recognition, viral expansion motion, best-in-class growth/profitability profile, ability to sustain 130%+ net expansion for the next several years, and a high-caliber mgmt team. The transition from a point product (Meetings) to a suite (Phone etc) should drive a more positive narrative on the stock as the company executes on quarterly earnings as this year unfolds.
Bear Case
Bears say ZM will see headwinds to topline growth from tough comps in FY22 while mgmt messages that they will also need to reinvest meaningfully on R&D and S&M. COVID clearly benefited topline but it also made it difficult for mgmt to spend on opex effectively and right-size the organization for key growth initiatives like Zoom Phone. The result was an "overearning" period for ZM in FY21, which bears believe will get a hard reset this year. 38% of ZM's revenue in Q3 came from the <=10 employee customer tier (vs 20% pre COVID), and at one point 50% of sales came from these subs paying monthly (vs annual for business users). Bears believe a substantial portion of this revenue will not convert to permanent paying subs post COVID. Gross margins also already took a hit over the last year from the large number of free Meetings minutes running through the company's data centers and reliance on public cloud vendors, which has now resulted in mgmt guiding to several quarters of pressure well below the LT 80% target. While mgmt has indicated that Phone will be a key product area for FY22, bears contend that this space is more competitive than core videoconferencing with MSFT Teams and RNG as notable competitors with a more robust channel presence, which has traditionally been a key go-to-market motion for selling phones. How all these puts/takes show up in the upcoming FY22 guide is the subject of intense debate right now. Bears think the FY guide will imply that revenue could come in below expectations for Q2-Q4 given lapping hypergrowth y/y. A guide below would be used to justify a lower terminal multiple on a "COVID pull-forward" thesis, indicating that perhaps ZM LT topline growth rate could just be structurally lower than bulls think.
Why the Bears Are Wrong
My variant view comes from surveying 20+ customers over the last 2 quarters and reading various other sources of channel checks. I'm not going to rehash all the fieldwork here, but the punchline is that G2K customers are planning on spending A LOT more with Zoom in the next 12 months. Most said 30-40% more while stating that could end up being conservative; some said spend could grow 100%+ y/y albeit off of a small base in CY20. The most often cited reasons for the bigger y/y spend is due to adding Zoom Phone, more Meetings seats, and Zoom Rooms, which many larger businesses are finding a useful solution in planning a return to the office. I find the checks on Phone especially encouraging as this is central to my bet on the stock for the current fiscal year and is where most of the noise on competition is. Even more encouraging was that large customers found Microsoft Teams to be too clunky. In many cases, customers noted that MS Teams required a hardware/server implementation vs ZM's seamless integration leveraging the same architecture as Meetings but adding an extra icon on users' devices. As another data point, along with ZM's $1.75bn equity raise last month, mgmt announced that Phone exceeded 1mm seats. I think Zoom Phone will easily hit mgmt's view of 25%+ of revenue within the next few years and validate the business as more than just a COVID pull-forward story.
Select quotes from Zoom Phone checks:
"It just works. It's easy to provision; it was just a couple mouse clicks to add the Phone icon to our users' desktops and devices, and we were all set. We rolled it out to everyone who has a Zoom video license already. The whole process just took a couple of weeks [including the time to put together a rollout plan]. After that it was maybe a couple of days to get everyone on it." - Customer with 3,000+ (and expanding) Meetings seats
"[Microsoft] Teams is definitely not even a phone system. They're just a dial pad with what I call like a cellphone-like subscription service, unless you bring your own trunks, and who wants to support that. They're also not in the international spaces that I specifically need."
"Zoom has some work to do on building up the channel for Phone, but I think it'll get there. It's a better solution than RingCentral or Microsoft Teams. Those two have a lead on the channel right now, but Zoom didn't put a lot of muscle into the Phone go-to-market during COVID. I think that's changing now since more people will go back to physical offices later this year. They probably don't need to put more work into the videoconferencing app anymore with that happening, but I'd bet they start really pushing Phone and Zoom Rooms."
Valuation
Consensus Estimates / Q4 Setup
Most sellside analysts are modeling revenue growth decelerating to the 30s in FY22; buyside bulls are well ahead. I am modeling 68% y/y. My variance comes from my customer checks, reports on better than expected churn at the low end of the market, and Zoom app store rankings (consistently #1 in business apps). ZM has indicated more opex and capex spend in the near term, but if they beat on revenue this won't matter much as the flow-through should still be meaningful.
In terms of how mgmt will guide on the upcoming print and what will be viewed as "good enough", it's very tough to say. Mgmt certainly won't guide close to my estimated 68% y/y. I think as long as the FY guide comes in at the high 30s y/y, the stock should work. Q1 should still see hypergrowth given we are still in lockdown and Q1 LY has the easiest y/y comparison. While I expect Q2-Q4 to be guided in the 30%+ range out of prudence against the 300%+ y/y comps, I think this will be viewed as conservative and will likely give bulls confidence to buy the stock as they understand this sets up for a beat/raise as the year progresses.
While short interest appears low overall at 3.7% of the float, this is a $120bn+ market cap; many short-term oriented funds are positioned short on fears around the FY22 guide and given the high liquidity of the stock. Hedge funds who own it are thoughtful long-term shareholders (Hillhouse, Coatue, etc.). The sellside is mostly underweight (11 Buys, 15 Holds, 3 Sells). given the tough tactical setup, leaving ample upgrade capacity if ZM executes over the coming quarters.
Entry Point
ZM is trading at 34x NTM EV/S, in-line with the average of 35x since IPO. While this makes sense due to the impending growth deceleration, the long pitch here isn't based on multiple expansion, which makes the current entry point attractive.
What Is It Worth?
I have ZM doing $4.5bn of revenue in FY22 (current fiscal year) per my 68% y/y growth. By FY26, I assume revenue decelerates to 26% y/y and grows to $14bn. This implies the stock trades currently at $9bn in FY26. This implies an FCF margin of >60% in FY26. I have diluted share count growing from 306mm in Q4'21 to 340mm exiting FY26. On a per-share basis, FCF should get close to $30 by FY26.
My base case assumes 30x on my FY23 sales for a $649 stock in the next 12 months, or 56% upside vs today. I think it's reasonable to assume modest multiple compression given the puts/takes right now in the model this year. My upside case assumes the multiple compresses to 20x on FY26 and gives me a $922 stock, or 121% upside. If I'm wrong, I assume the multiple goes to 30x on NTM Street numbers, which I believe are too low. This gives me -17% downside to $346, approximating the 200DMA of $349. If ZM badly whiffs on the Q4 print, we could see the stock de-rate to 25x NTM on Street numbers which would be 30% downside, obviously a disastrous outcome.
Risks
- The biggest structural risk is competition. While its videoconferencing leadership has let Zoom Meetings become a runaway success, the Phone TAM invites intense competition from MSFT and RNG. While customer checks suggest that MSFT Teams is hampered by architecture (requiring customers to spin up servers) and RNG gets a lot of help from a channel-driven sales motion, ZM may have to invest meaningful resources into the GTM for Phone. If this happens at the same time momentum in the existing business hits a wall, it could drive both downward estimate revisions and multiple compression.
- There is also the relevant and unresolved question of what steady state video penetration looks like post reopening and whether there is really "Zoom fatigue". ZM has been aggressive in its message of converging voice/video into one solution and has helped customers get back to the office with solutions like Zoom Rooms to hedge against this. While that might help, there is still a downward risk to estimates if a meaningful number of subs churn off the platform once the economy reopens (and even worse, if they never reactivate because they associate the Zoom brand with the pain of living through COVID). Importantly, if ZM is unsuccessful in expanding with the G2K and big deals can't offset the churn from the low end of the market (recall this was 38% of revenue in Q3), then there will be an air pocket in revenue growth during FY22. This will prove the bears correct and the stock will implode.
- It is clear to me that ZM will do M&A at some point. While I think this could be a net positive for the long-term share gains / TAM expansion thesis, it could be perceived negatively as "buying growth" if ZM announces a deal at the same time the core business is inevitably decelerating off of a peak from last year.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.