Video conferencing software provider Zoom (NYSE:ZM) has become a Wall Street (and Main Street) darling during the novel coronavirus pandemic. As consumers, enterprises and academic institutions have all rushed to use Zoom’s video conferencing software to connect with friends, host webinars and conduct business meetings, investors have taken note of this surge in demand, and pushed Zoom stock up from $70 in late January, to a high of $165 in late March.
Shares have since come crashing down on a plethora of privacy, safety and customer support issues. Today, the stock trades hands at $125. Still, that’s up 80% from pre-coronavirus levels.
All this hype has attracted a lot of retail investor attention. The No. 1 question clients, friends and family have asked me over the past few weeks: when should we start buying stocks? The No. 2 question: Is Zoom stock a buy?
The answer to the first question is a bit complex.
The answer to the second question is not. Zoom stock is NOT a buy at current levels. Here are five big reasons why:
- The recent demand surge is mostly from free users, with management’s own guide implying that paid customer growth is much less robust.
- Amid the surge in free demand, customer support and user experience for paying customers has dropped substantially, forcing some customer churn.
- Privacy and safety concerns are front-and-center, and could stall out the uptick in paid customer growth.
- Video conferencing is an exceptionally competitive market, with a relatively low barrier to entry. It’s also not that big of a market.
- Margins are stalling out, thanks to increasing hosting/bandwidth costs and increasing privacy and safety spend without a corresponding uptick in revenue per client.
Zoom stock — already wildly overvalued in an “everything goes right” scenario — is not priced for any of these aforementioned headwinds. As such, I think the stock actually has tremendous downside potential from current levels.
Free Growth Does Not Equal Paid Growth
The big number Zoom bulls have been quoting over the past few weeks is the huge uptick in daily active users of Zoom from 10 million at the end of 2019, to 200 million in March.
But, as the company’s CFO said on the fourth quarter conference call: “[A] lot of that [up tick in usage] is on the free side. So it’s very early to tell whether that’s going to convert long-term into paying customers.”
In all likelihood, most of those free users won’t turn into paying customers. Most of that uptick is from individuals who are using the platform to video chat with friends, a service which the world has standardized as “free.” Once the world returns to normal, these individuals won’t use Zoom anymore, let alone pay up for premium features.
Management’s guide implies as much. Revenues this year are expected to rise 46% year-over-year. That’s a big number. But, not that big. It actually represents a significant slowdown from fiscal 2020’s 88% revenue growth rate, and fiscal 2019’s 118% revenue growth rate.
So, while demand for Zoom is surging, most of that demand surge is on the free side, and the uptick in paid customers isn’t robust enough to offset a multi-year slowing revenue growth trend.
A Decline in Quality
Amid a surge in free demand, Zoom has had to allocate significant resources to accommodating that free demand. In so doing, the company has apparently allocated resources away from things such as paid customer service.
From a Wall Street Journal piece, which tackles this decline in customer service:
“Daniel Newman, founding partner of Futurum Research, says he started paying for Zoom a year ago to stay in touch with clients, including through a podcast, for his Chicago-based firm that provides strategic advice to tech companies. When he last tried to save his Zoom call to the cloud for distribution, it didn’t show up for days, Mr. Newman said. Emails to Zoom to find out why went unanswered, he said, and when he tried to ask customer service through a live chat service he gave up with almost 600 people in the queue already.”
In other words, in an attempt to accommodate robust free demand growth, the company compromised the quality of its service for paying customers. This has already led to some customer churn — and will likely suppress further growth for fear that Zoom won’t deliver the best customer experience to paying customers.
Privacy & Safety Concerns Are Material
Zoom has been whacked by a series of privacy and safety concerns over the past month, the sum of which are credible enough to force major institutions, organizations and governments to drop and even ban the use of Zoom.
The issues revolve around weak encryption and something called “Zoombombing” (wherein uninvited individuals crash a video call, and post inappropriate images and texts).
On the education front, the New York City Department of Education and the Clark County School District in Nevada both banned the use of Zoom. On the corporate front, Elon Musk’s SpaceX has dropped Zoom. So has NASA. Meanwhile, the entire country of Taiwan has barred all official use of Zoom.
Management acknowledges that they have taken missteps surrounding privacy and security. They are currently in the process of solving these issues. But such issues won’t have implementable solutions for a few months.
Thus, over the next few months when demand for video conferencing software is highest, Zoom will be in market with a product that has significant privacy and security flaws. That might not scare away consumers who are using the platform to chat with friends. But it will scare away big companies, and that’s a problem, because big companies pay for Zoom (while most consumers don’t).
Video Conferencing Hype Is Overdone
Zooming out, bulls will argue that video conferencing and virtualization tailwinds are so strong, that Zoom will breeze past all headwinds and continue to report rocket-ship like growth.
That’s true — to an extent. But it’s worth mentioning that: 1) video conferencing software demand won’t be this big forever, 2) the market is insanely competitive and 3) the addressable revenue opportunity isn’t that big.
On the first point, humans like physical experiences. Most consumers like to physically hangout with friends. Most teachers like to teach with students in the classroom. And most businessmen like to conduct in-person meetings. Thus, once the coronavirus pandemic fades, consumers, organizations and enterprises will return to doing things in-person. Demand for video conferencing software will fall off.
On the second point, Zoom is one of many video conferencing solutions in the market. Microsoft (NASDAQ:MSFT) offers Skype and Teams. Cisco (NASDAQ:CSCO) offers WebEx. LogMeIn (NASDAQ:LOGM) has several competing solutions. RingCentral (NYSE:RNG) just launched its own video conferencing product. So did Tencent (OTCMKTS:TCEHY). Adobe (NASDAQ:ADBE) is in the market, too, with Adobe Connect.
Meanwhile, this market really isn’t that big. The video conferencing market measured about $6 billion in 2019. It’s expected to grow to over $10 billion within the next few years, and maybe $20 billion by 2030. That’s not very big when you consider Zoom already has a market cap of $30 billion.
Margin Headwinds on the Horizon
One of Zoom’s most positive attributes pre-coronavirus was the company’s tremendous profitability. With 80%-plus gross margins and rapidly rising operating margins, the company had a clear pathway towards huge profit growth at scale.
Despite the recent demand surge, this pathway towards huge profit growth has become less clear over the past few weeks.
Free demand is surging. Higher free demands means higher hosting and bandwidth costs, without a corresponding uptick in revenue. That means lower gross margins. Meanwhile, Zoom has clearly under-spent on privacy and security. Going forward, management will spend an arm and a leg on privacy and security, which will cause opex rates to rise (see Facebook (NASDAQ:FB) in 2018 and 2019).
Thus, there are some significant margin headwinds on the horizon. Profit margins will get hit twice, once from lower gross margins and once from negative operating leverage.
Again, management’s guide speaks to this problem. Operating margins were 14.2% last year. This year, they are expected to fall to 12.6%.
Bottom Line on Zoom Stock
Is Zoom stock a buy? All things considered, no.
The stock is wildly overvalued. My long-term model — which aggressively assumes that Zoom will go from approximately 80,000 customers today to over 600,000 customers by 2030, grow revenues by 25%-plus per year during that stretch and grow profits by 35%-plus per year — pegs the fair value of ZM stock today at $85 (based on $10 in 2030 earnings per share, a 20-times exit multiple and a 10% annual discount rate).
Thus, even in an “everything goes right” scenario, Zoom stock is overvalued today.
The bigger problem? Everything won’t go right. A fall off in customer support coupled with privacy and safety concerns could cause paid growth during this very important time to disappoint. Competitors could gain ground. Margins will fall.
Zoom stock isn’t priced for any of those things. That’s why I wouldn’t chase the rally up here.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he was long MSFT and ADBE.