Should Zoom Video Communications Be On Your Radar?

Zoom Video Communications' (ZM 3.49%) recent growth has been breathtaking. However, there's a legitimate argument to be made that the company's valuation has gotten way ahead of the business's fundamentals.

In this segment from Industry Focus: Technology, host Dylan Lewis and Fool.com contributor Brian Feroldi discuss Zoom's corporate culture, the risks facing the business, and whether investors should be interested in this stock.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on April 12, 2019.

Dylan Lewis: Brian, you mentioned the net promoter score, and the view that people have of this business. I think that's just a small part of the story when we're talking about Zoom. One of the things that really drew me in, too, was the fact that leadership is very well-regarded, and it seems like a truly wonderful place to work. This is a spot that gets glowing reviews from a lot of the employment review outlets out there.

Brian Feroldi: Yeah. One of the things that we always like to do when we're checking in on any company is check them out on Glassdoor. Do people like working there? What's the CEO like? Is the CEO the founder? What kind of approval rating do they get?

The CEO in this case is the founder. His name is Eric Yuan. He actually is the No. 1 ranked CEO of large company in America. No. 1. He is literally a beloved CEO. And he owns 22% of Zoom's stock personally, before the IPO. The company just gets glowing reviews from employees. So this is clearly a great place to work, a beloved CEO, and a very good corporate culture.

Lewis: Brian, we have been pretty complimentary so far of Zoom. I want to take a critical eye to some of the things that we like to run stocks through, especially as they're going public, just to get a sense of what risks might be out there. Looking at the valuation, this is a company that will probably be going public somewhere around $8 billion, because they're going to be pricing at the high end of that $28 to $32 range that they've been shopping around. So, no, it is not a penny stock. That's one of the things that we often check. No, we're good there.

One of the other things I think we really need to keep in mind when we're looking at as-a-service businesses is, what does customer concentration look like? What's the story there?

Feroldi: This company has over 50,000 customers. No individual customer represents more than 5% of revenue. I don't think there's any reason to worry about excessive customer concentration.

Another thing that I always like to look at when I'm thinking about any business is, is this industry that it's in face long-term headwinds? In this case, I think that there's a clear argument to be made that this company has tailwinds behind it, especially with millennials out there choosing to try and work remotely. I think that big push will just put a fuel under the fire for the demand for video conferencing software.

Lewis: Yeah, I totally agree with you. This seems like it's where the market's going. It seems like, broadly, where business is going. I think because of that, because of all these great financial numbers that we've talked about, and because there's a lot pushing this business forward, there's so much enthusiasm around it, one of the risks here is, there's a pretty hefty valuation that this company is going to have to live up to as it goes public. If you do the back-of-the-envelope numbers here, if they're at $8 billion and they did about $330 million in revenue, that puts them at about 25 times trailing sales. That's pretty rich.

Feroldi: Yeah, and that's at the IPO price. That's assuming that you can get shares at what they're actually worth, and this stock isn't going to pop hugely on the first day, like we've seen with so many other IPOs. There's no doubt that, to get in on this growth story, you're going to have to pay an insane multiple on day one if you do. So, the question is, is this business high-quality enough, and is the growth potential strong enough to justify the valuation?

From what I've seen thus far, I think this business is so fantastic that there is an argument to be made that it should be very high on investors' watchlist, even if they have to pay some insane multiple right out of the gate to get on board. But there's no doubt that the valuation is going to make this stock very risky.

Lewis: And because of that, with the quarter-to-quarter results that they've put up as a publicly traded company, if anything misses, if they wind up issuing guidance that is not so rosy, it's going to take a hit. Anything that is valued at 25 times sales is going to wind up having quite a bit of criticism heaped on it if the results aren't there.

Feroldi: Yeah, completely. The other thing for investors to keep an eye on is, what is the competition going to look like in this space? So far, the numbers clearly show that Zoom is a leader in its category, and Zoom is taking market share left and right from people because of its offering. Is there another company out there that could catch up, that could develop the same level of service, that could create a product from the cloud and do it from the ground up? And then, will they be able to compete successfully with Zoom? That's another unknown that could risk their growth rates decelerating. If that happens, look out below.

Lewis: Yeah, absolutely. That's actually something that one of our listeners, I believe Wei, asked us on Twitter. I'd put out that we were going to be talking about Zoom on the show, I just wanted to see what people were curious about. One of the very common questions, we got it from several different people, was, can we highlight the competitors, and what does the moat look like? We touched on this a little bit before, but I do want to read from the S-1 here for a second, just to give you a sense of who they view as their competitors. They said, "We primarily face competition from legacy web-based meeting service providers, including WebEx and Skype for Business. Then you have the bundled productivity solution providers with basic video functionality, including Google, and point solution providers including LogMeIn." So, a lot of the names you might expect. Google Hangouts, you have Skype in there as well. I would also throw Slack in there. I would say, this is a communications business, they are rolling some video into their functionality. That's a thing to watch.

What's nice so far is, they have pretty good partnerships and integrations set up with some of the main players. While Skype is a competitor, they have integrations with Outlook. While Slack is a quasi-competitor, they have some integrations there, I believe, as well. The problem is, when you have all these integrations, you are then somewhat reliant on these platforms for functionality. If that relationship ever sours, that's a risk to be aware of.

Feroldi: Yeah, completely. Having all those partnerships in place is both a benefit and a potential long-term risk if they decide to become competitors. One thing I will throw out there for the competitive question is, it's important to note that the CEO here was actually one of the very first employees at WebEx back in the late 1990s. He stayed with that business all the way through until it was acquired by Cisco. Then he worked at Cisco for another five years before founding Zoom. And he founded Zoom because he saw that the offerings that Cisco was offering were not what customers needed, and they were not using the products. And then he went on to convince 40 of his fellow engineers to abandon ship and join him at Zoom. So there are competitors that need to be watched here, but the management team and the engineering team are all deeply talented and know this space extremely well.

Lewis: Yeah, I look at the legacy competitors and I almost think that they are more in a position to buy Zoom at some point down the road. I think the bigger risk is someone coming out and saying, "We're going to be cloud-first, too. Also, we're going to access this market and slowly eat away some of the share that you're enjoying right now as the first mover in that space." I'm doubtful, because they've laid out such a good product, and because I've used it and I know how strong it is,. But, it's something to be aware of.

Brian, another one of our followers, Seth, asked us, how well does the product actually work? I think we touched on that one. Then he said, is there any optionality with the business other than video calls? This is a great question!

Feroldi: Yeah, completely! When you think about optionality with growth stocks, it's the ability for them to add on new services or enter new markets down the road. That's a little bit of a tricky thing to talk about in this case. In Zoom's case, they have rolled out Zoom Meetings, and they just rolled out a Zoom Phone offering. So you can argue that there is optionality within the video communication space. But another way to think about it is, the market for their core market offering is so enormous that optionality isn't necessarily something that they need right now.

The other thing I would point out is, great corporate cultures tend to be creative and tend to create new products. One way to bake in optionality if you can't think of it now is to buy into a corporate culture that praises people that think outside the box, and praises people that can use their talents to create new products. I think that there's an argument to be made that Zoom has that. But, I can't see anything myself that says, "Boy, this business has a ton of optionality in it right now."

Lewis: Yeah, I really sat on this question for a while, trying to work through it. I got to a very similar point that you did. I think if you're looking outside of video communications, I don't see the next immediate vertical for them. In terms of optionality in that sense, I'm not quite there. But, if you look within video communications, a lot of that conversation right now is focused on traditional enterprise. We're talking about business-to-business or people working within a business and communicating across offices or something like that. Where I do think they have some optionality is in the application of the video communications. They've already started doing some things in education and healthcare. I could see them doing something in entertainment as well. This is another space where I think the tailwinds are there. If their tech is that good, they will find pretty good ways to apply it.

Feroldi: Yeah, I completely agree.

Lewis: Brian, big picture, your outlook for this business. I think it's going to be going public at some point in mid-April. How are you feeling about it?

Feroldi: I'm extremely interested in it! The numbers that jump off at this page at me are just fantastic! It is very rare that you see a company that has been profitable at their early stage, that has such a great corporate culture, that is throwing up amazing margins that are expanding. There is a lot to like about this business. I plan on following this company very closely right out of the gate. I may even purchase shares at some point, even though I know that I'm going to have to pay some insane multiple in the early days to get my hands on it. How about you?

Lewis: I'm in the same boat. This one immediately went to the top of my watchlist once I started really digging in, getting a sense of what the numbers looked like. I will, if I ever wind up buying shares, be doing it in small increments over time. Really, I think that with any IPO in the first six months, you need to be super mindful of fact that they're going to be putting out results that haven't been nicely manicured and put together. They're choosing when they go public. People always have to remember that. So you're going to be seeing maybe some lumpiness in the results. You want to see how management handles being publicly traded. Also, you want to make sure that when insiders have the chance to sell their shares, you aren't being stuck with a massive selling spree that really hits your shares. You don't want your position tied to any one spot and time. Something to keep in mind, especially with a stock like this.

Feroldi: Yeah, totally! When companies come public, things change. The culture can change. Management now has a number that they have to hit. They have to get their records out to everybody. Competitors have a bigger eye on them. There are a number of things that change. But to me, the thing I always start with is, is this company so high-quality that it is worth following, and it could be worth betting on? From what I've seen, I think the answer is yes.

Lewis: Well, we're in agreement there, Brian. Thanks for hopping on today's show! Anything fun going on this weekend?

Feroldi: Hey, I'm heading down to D.C. this weekend! It's my kids' vacation next week, so we will be at HQ next week!

Lewis: Yes, you will be! We'll be doing some shows while you're in town. Excited to see you, excited to see the kids, as well! Our producer, Austin Morgan, what are you up to this weekend?

Austin Morgan: This weekend is the first of the meat smokes for me. I got my pellet smoker in the mail yesterday, put it together. So this weekend, we're going to try to make a brisket.

Lewis: Listeners may remember that when we did our year wrapup, and we were talking about some resolutions for 2019, Austin has set his sights on developing a hobby that was not physically taxing. I'm very, very eager to see, and maybe even taste, the results of your new interest.

Morgan: This is one that I can do while recovering from my rotator cuff surgery.

Lewis: [laughs] And that's the key. Will you post some of your results on Twitter? Maybe we can retweet that from The Motley Fool Industry Focus account.

Morgan: We'll see how it comes out.

Lewis: If they go well.

Morgan: If it goes well.