A lot of companies have great starts on Wall Street. But, few have had as successful of a Wall Street debut as Zoom Video Communications (NASDAQ:ZM). ZM stock has been on a straight line up since its debut last week.
The hyper-growth video conferencing company originally priced its IPO in the $28-$32 range. Investor demand was so high at those prices that the list price range for the Zoom IPO eventually moved north to $33-$35. The IPO was finally priced above that already-increased range, at $36. Then, Zoom stock soared more than 80% on its public debut to above $60. The stock kept moving higher the next day, and today, it trades at $67, nearly 90% above the already twice-boosted IPO price.
Why the huge demand? Plain and simple, Zoom is a great company. The company is in the right space, with 100%-plus revenue growth rates, a healthy long-term outlook, and sky high gross margins. Oh, and the company is already profitable, with only $330 million in revenue last year.
All in all, Zoom is simply a really good company. The huge success of the Zoom IPO reflects that.
But, Zoom was a hypothetical $30 stock a few days ago. Now, it’s nearly a $70 stock. After such a huge rally, one has to look at the underlying fundamentals, and see if the valuation today is worth it.
When you do that, it becomes obvious that ZM stock is very richly valued — perhaps too richly valued. Even under aggressive long-term growth assumptions, I think today’s valuation is slightly stretched. While the Zoom IPO was a huge success because its a great company, I’m in no rush to buy Zoom stock today. Instead, I think there’s a pullback coming around the corner and investors can afford to wait for better entry points.
Zoom Is A Great Company
In a nutshell, Zoom is a great company oozing with long-term profit growth potential, and that’s why the IPO was so successful.
First and foremost, the company is in the right space. Video conferencing is a huge growth market in the enterprise world. There are so many tailwinds at play here. The enterprise world is more connected than ever, and as such, communication between offices around the globe is not only possible, but necessary. Video is considered the tool-of-choice when it comes to digital communication.
Further, you have this massive shift from on-site work to remote work, which has been enabled by technology trends and empowered by the gig economy. Also, employee work forces are getting younger, and as a result, want to see all these up-and-coming trends play out at the office.
Second, Zoom is a leader in that market with rapidly expanding market share. Next to Cisco (NYSE:CSCO) and Microsoft (NASDAQ:MSFT), Zoom is the other large player in the video conferencing market. But, the company has grown revenue at a consistent 100%-plus rate for several quarters. If the company keeps that up, Zoom will be the number one player in this market soon.
Third, Zoom has sky-high gross margins. For the past several years, gross margins have hovered around 80%, and management’s made gradual improvements. These robust gross margins allow for robust profit potential at scale.
Fourth, Zoom is already profitable. Unlike other hyper-growth companies, Zoom isn’t spending an arm and a leg to sustain that big growth. Instead, the company’s opex rate sits below 80%. With gross margins around 80%, that combination produced profits last year.
The Valuation Is Stretched
Although Zoom is a great company with a ton of long-term potential, it increasingly looks like that all that potential is more than priced into the stock today.
Consider this: The Zoom IPO was supposed to price around $30 per share. Today, the stock trades near $70. That’s a 100%-plus increase in just a few days and it’s stayed there. For most stocks, such a move higher absent a monumental catalyst would be a sure-fire sign of overbought conditions. Investors aren’t applying the same logic to the Zoom IPO because it’s an IPO. But, my numbers say they should.
The video conferencing market measured roughly $11 billion in 2017. With revenue of $150 million, Zoom had just over 1% market share. That market share grew in 2018, likely to somewhere around 3% (assuming the video conferencing market grew at the projected 10% rate). Over time, as Zoom continues to prove out its competitive advantages, the company should continue to expand its foot print. From this perspective, I think 10-15% market share by 2025 is very doable.
Current estimates peg the video conferencing market at $20 billion by then. That seems light to me. IDC forecast the unified communications and collaboration market as being worth nearly $45 billion over the next few years, and video should command the lion’s share of that market given secular trends towards video adoption. As such, I think video conferencing will measure closer to a $30 billion market by 2025.
A 10-15% market share on that implies $3.75 billion in revenue, at the midpoint, by 2025. Assuming 85% gross margins and a fairly regular 40% opex rate, that flows into roughly $1.7 billion in operating profits. Taking out 20% for taxes, you’re left with $1.35 billion in net profits. Based on a growth average 20x forward multiple, that implies a reasonable 2024 valuation target of $27 billion. Discounted back by 10% per year, that equates to a 2019 market cap of just under $17 billion.
That’s roughly the market cap of Zoom today, and it’s April 2019. As such, upside in the near term seems limited by a stretched valuation.
Bottom Line on the Zoom IPO
To recap, the Zoom IPO was a huge success because Zoom is a great company, and at $30 per share, the stock was way undervalued considering the company’s long-term growth potential.
But, after a huge IPO pop, Zoom stock now seems fully valued. Near-term upside is capped by what is already a stretched valuation. As such, while ZM stock is a long-term holding, investors can afford to wait for better prices to enter for that long haul.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
