Wait for the Dip When Zoom Shares Hit Friction

As the novel coronavirus pandemic swept across the globe over the past six months, it has had different impacts on different companies. Leading the pack of companies seeing business boom is video teleconferencing giant Zoom (NASDAQ:ZM). Early on during the pandemic, Wall Street immediately recognized Zoom as a winner in a world where offices are closed and business people aren’t traveling. Since then, ZM stock has taken off like a rocket ship.

zoom (ZM) logo on a building
Source: Michael Vi / Shutterstock.com

Year-to-date, ZM stock is up 310%.

This rally is overdone. Yes, Zoom is on fire. Every trend in the world favors big growth at this company for a lot longer. But Zoom stock is overvalued. All of that big growth is already priced in.

As such, I wouldn’t chase the rally here. While it may seem like ZM stock will simply go up forever, it won’t. Covid-19 hysteria will fade. Demand trends will slow. Valuation friction will rear its ugly head. And the stock will drop.

Here’s a deeper look.

Fundamentals Are Strong

It’s tough to argue against Zoom’s fundamentals. They are rock solid.

Offices are closed. Business people aren’t traveling. But business still needs to happen. And people like to see each other when conducting business, especially for big meetings. Naturally, then, demand for video teleconferencing software has surged amid the Covid-19 pandemic. In this space, Zoom consistently provides the highest quality video stream, and has therefore become the gold standard across enterprises.

The numbers speak for themselves. In the first quarter, the number of Zoom customers rose 354% year-over-year and revenues rose 169%.

Sure, the Covid-19 pandemic won’t last forever. But office virtualization tailwinds will stick around long after the pandemic passes. That’s because the internet has enabled an entirely new era of work, wherein high levels of productivity can be achieved without needing to pay huge office and travel expenses.

Thus, video teleconferencing software seems well on its way toward reaching ubiquity over the next five to 10 years. Over that stretch, Zoom likely maintain leadership in the market through its singular focus on enterprise video solutions. As it does, Zoom will see its customer base grow from less than 300,00 today to potentially a million or more by the end of the decade.

Revenues will soar. The highly scalable software business model with big gross margins will drive significant operating margin expansion. Profits will soar doubly.

All of that means ZM stock should head way higher in the long run, right?

Overpriced ZM Stock

Huge long-term profit growth is already priced into Zoom stock.

I have two scenarios for Zoom. First, the base case, which assumes:

  • The company adds roughly 50,000 to 75,000 new customers per year into 2030 (versus a cadence of ~30,000 before the pandemic), leading to just over 1 million total customers by 2030 (out of an addressable market of over 3 million total businesses in developed economies).
  • Revenues grow at a 25%+ compounded annual growth rate to ~$10 billion by 2030.
  • Operating margins scale above 40%.
  • Earnings per share coming in at $10 by 2030, versus $1.30 projected this year.

Based on an application software sector-average 35-times forward earnings multiple and a 10% annual discount rate, $10 in 2030 earnings per share implies a 2020 price target for ZM stock of about $150.

Second, there’s the bull case, which assumes:

  • The company adds 100,000+ new customers per year into 2030, and grows to 1.3+ million total customers by 2030.
  • Revenues grow at a 30%+ compounded annual growth rate to ~$15 billion by 2030.
  • Operating margins scale toward 45%.
  • Earnings per share in 2030 wind up around $15.

Based on the same math, this bull case lends itself to a 2020 price target for ZM stock of $225.

Either way, Zoom stock is overvalued.

Downside Catalysts Coming Up

It’s true that overvalued stocks can ignore valuation friction for long periods and keep going higher, so long as the story supporting the stock remains favorable. That’s especially true today, because rates are at zero, meaning investors have the patience to play the long game with a bunch of growth stocks.

But I think the Zoom growth story is going to start showing cracks over the next six to 12 months.

I fully expect a Covid-19 vaccine to be approved and start being administered over that stretch. If so, then within the next 12 months, the world will take a huge step toward normalizing. Offices will reopen. Business people will start traveling again.

Sure, office virtualization tailwinds will remain. But they’ll moderate. So will video teleconferencing demand.

Zoom’s red-hot Q1 numbers, which included triple-digit customer and revenue growth, will cool. As they do, the story will start to lose some clout. If the story does lose some clout, valuation friction will rear its ugly head and ZM stock will drop.

Bottom Line on ZM Stock

Zoom is a great company, with a ton of long-term growth potential.

But don’t let the fear of missing out push you into the right stock at the wrong price.

Instead, exercise patience. Let this meteoric rally in ZM stock run its course. Let the hype fade, and the stock cool. Wait for better prices. Then buy the dip, to protect yourself against what could be sizable near-term, valuation-related losses.

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 recognized as 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. 


Article printed from InvestorPlace Media, https://investorplace.com/2020/07/wait-for-the-dip-when-zoom-shares-hit-friction/.

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