Zoom (NASDAQ:ZM) stock surged to all -time highs in early September after the enterprise video conferencing company reported blowout second-quarter numbers which were about as strong as you could imagine.
Customers rose 458% in the quarter. Revenues rose 355%. Operating margins tripled. Net profits rose more than ten-fold.
It was, by all metrics, an unprecedentedly strong quarter. And ZM stock reacted as one would expect. It surged higher by about 40%, bringing ZM stock price to $450 before a pullback to $425.
Remember, before the Covid-19 pandemic, this was a $70 stock. Indeed, Zoom is now a $120 billion company that is slated to do less than $2.5 billion in revenues this year.
I’m all for the video conferencing megatrend. I also believe that Covid-19 has permanently changed the world, especially the enterprise world, where hybrid work will become the global norm. In that world, video conferencing software like Zoom becomes ubiquitous.
But I also think of all that is more than fully priced into ZM stock today.
This is a bubble. And the bubble is getting out of control.
Here’s why.
Zoom’s Strong Earnings
Zoom’s second-quarter earnings report was quite literally as strong of an earnings report as I’ve ever seen.
I’m talking triple-digit customer growth, usage growth and revenue growth. Quadruple-digit profit growth, huge margin expansion, a great guide, bullish commentary from management on the conference call and tons of analyst upgrades following the earnings report.
Some of the most important takeaways from Zoom’s earnings include:
- Usage growth isn’t slowing. The number of Zoom customers with 10 or more employees rose 458% in the quarter (better than Q1’s 354% growth rate), while the number of Zoom customers with $100,000+ contracts rose 112% (better than Q1’s 90% growth rate). In other words, although Covid-19 hysteria faded in the second quarter, the business transition to video conferencing and Zoom’s software accelerated as businesses leaned into the “new normal” of hybrid work.
- Free usage is converting into paid demand. A big question mark surrounding Zoom was whether or not the company could convert all this interest in video conferencing software into paid demand. Zoom is doing just that. Average revenue per customer fell 10% in the quarter, much better than the 15% erosion in Q1, and a sign that unit revenues are stabilizing amid this demand surge.
- Economies of scale is kicking in. While Zoom’s revenues rose 355% in the quarter, adjusted operating expenses rose “just” 100%, meaning that the company is benefiting from economies of scale (wherein revenues rise more than expenses). This drove operating margins to essentially triple year-over-year and rise above 40% for the first time ever.
- Big growth is here to stay. The guide calls for third-quarter revenues to rise more than 300% and implies a fourth quarter revenue growth rate of nearly 300%. Thus, management is strongly saying that today’s big growth is here to stay for at least the next six months.
All of these favorable takeaways are largely why investors pushed up ZM stock by 40%.
Zoom Stock is in a Bubble
The painful reality is that ZM stock is in a bubble today.
Yes. I understand and fully believe in the bull thesis here. The days of office centricity are over. Hybrid work is the future of work. In a world dominated by hybrid work, video conferencing software becomes necessary and ubiquitous. Zoom is the No. 1 provider of video conferencing software in the world. As such, the company’s software has a reasonably good opportunity to be incorporated into most businesses and offices across the globe one day.
But all of that (and then some) is priced into ZM stock today.
There are only 3 million businesses with 10 or more employees in Zoom’s core addressable markets of America, Canada, Europe and Oceania. It’s very likely that, by 2030, nearly all 3 million of them have some form of video conferencing software. But Zoom won’t have 3 million customers. This is a highly competitive market with RingCentral (NYSE:RNG), Microsoft (NASDAQ:MSFT) Teams and many more.
In that competitive market, Zoom should be able to leverage its best-in-market video quality to nab 30% market share, or about 1 million customers. Assuming average revenue climbs towards $15,000 per year (from $9,000 per year in 2019) and that operating margins rise all the way to 45%-plus, my modeling suggests that at best, Zoom does about $15 in earnings per share by 2030 (consensus estimates sit at $8 for 2025).
Application software stocks historically fetch an average forward earnings multiple of 35. A 35x multiple on $15 in 2030 EPS implies a 2029 price target for ZM stock of $525. Discounted back by 8.5% per year, that implies a 2020 price target of $250, which is miles below the ZM stock price today.
Low Rates = Sky Is the Limit?
If ZM stock is so overvalued, then why does the stock keep rallying?
One answer: low rates.
Low rates inflate growth assets by dragging down the cost of equity and boosting the net present value of future cash flows and earnings. All the growth in the world today is in the technology sector, with a big portion of it in the virtualization technology sub-sector. Thus, low rates are inflating the asset prices of technology stocks and virtualization stocks, like ZM stock.
Can this party last forever?
For the foreseeable future, yes. Low rates are here to stay. So long as they stick around, tech stocks will continue outperform. That’s why I’ve broadly continued to say stick with the growth/tech trade.
But there are some outliers here. ZM stock is one of those outliers. Mostly because the valuation has reached a point where even low rates don’t justify the current price tag.
Take the 2029 price target for ZM stock of $525. You would need to use a 2% cost of equity to justify the current price tag. That means just 2% return per year over the next nine years.
That’s anemic. And it makes Zoom stock not worth chasing at these elevated levels.
Bottom Line on ZM Stock
Zoom is on fire. But ZM stock is in a bubble that’s being propped up by low rates.
It’s tough to see this bubble getting popped unless low rates go higher, which won’t happen. Still, it’s equally tough to justify chasing this stock with such limited long-term, fundamentally supported upside potential.
As such, I say stay away. Don’t go long. Don’t go short. Just avoid the name because it’s dangerous both ways.
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 best stock pickers in the world 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 did not own a position in any of the aforementioned securities.
