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Did Zoom Video Communications Make a Big Mistake in China?

By Leo Sun – Jun 17, 2020 at 12:00PM

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Zoom agrees to censor its meetings in China and ban users based on their real-world locations.

Zoom Video Communications (ZM 0.61%) became one of the market's hottest growth stocks as the video conferencing platform gained millions of new users throughout the coronavirus pandemic.

However, Zoom recently courted controversy by agreeing to censor all of its meetings in China after four groups of users assembled online on the 31st anniversary of the Tiananmen Square Massacre on June 4.

An unplugged ethernet cable with a Chinese flag in the background.

Image source: Getty Images.

The Chinese government deemed the meetings "illegal," and Zoom suspended or terminated the host accounts for three of the meetings. Zoom subsequently reinstated the accounts and stated it would introduce new tools to "remove or block at the participant level based on geography."

Zoom claims the changes will enable it to "comply with requests from local authorities when they determine activity on our platform is illegal within their borders." But Zoom also criticized the Chinese government in its press release, declaring "governments who build barriers to disconnect their people from the world and each other will recognize that they are acting against their own interests, as well as the rights of their citizens and all humanity."

It isn't surprising to see Zoom begrudgingly comply with China's censors, since it doesn't want to be booted from the country like other U.S. tech giants. But is it sacrificing its integrity and stumbling down a slippery slope?

With great growth... comes great growing pains

Zoom's revenue surged 88% in fiscal 2020, its adjusted net income rose more than six-fold, and it surpassed 300 million daily active meeting participants in late April.

Its revenue rose 169% annually to $328.2 million in the first quarter of fiscal 2021, which ended on April 30 and bore the full impact of the pandemic. Its adjusted net income grew nearly seven-fold to $58.3 million.

A man seated at a computer using Zoom's video conferencing software.

Image source: Zoom.

For the full year, Zoom expects its revenue to rise 185% to 189%, and for its adjusted earnings per share to jump 246% to 269%.

Those jaw-dropping growth rates explain why the stock soared 140% over the past 12 months to an all-time high, and arguably justify its frothy forward P/E of 185.

But that dazzling growth came with plenty of growing pains. Zoom struggled with attacks on meetings, malware, and phishing scams, and its initial claims of "end-to-end" encryption were proven false. It was also criticized for routing its streams through Chinese servers.

Those missteps caused several countries -- including the U.S., Germany, Australia, and Taiwan -- to ban their government agencies from using Zoom. Big companies like Alphabet's Google and SpaceX also banned Zoom.

Zoom is addressing those issues by hiring dozens of security consultants, securing its platform with services from Crowdstrike and DarkTower, and scaling up its infrastructure via a new cloud deal with Oracle. However, those aggressive investments could eventually throttle its bottom line growth.

What does China mean to Zoom?

Zoom doesn't disclose its exact revenues from China, but it lists the country as a top market alongside the U.S., Australia, and Europe. It generated a combined 19% of its revenues from the APAC (Asia-Pacific) and EMEA (Europe, Middle East, and Africa) regions last year, but nearly 30% of its employees were based in China.

Zoom employs over 700 employees in R&D centers across China, but warned in its latest 10-K filing that a "high concentration" of Chinese employees could expose it to "market scrutiny regarding the integrity of our solution or data security features."

The company says it hires so many employees in China because the personnel costs are "less expensive than in many other jurisdictions." It noted its operating expenses would rise significantly if it were forced to relocate its workforce to another country.

Zoom cites the trade war between the U.S. and China as a major threat, and warns that its competitors might "be better suited to withstand or react to these changes." Zoom's top competitors are mainly platforms from larger companies, including Cisco's Webex, Facebook's Messenger Rooms, Google Meet, and Tencent Meeting.

Did Zoom make the right call in China?

Challenging the Chinese government's demands, as Google did shortly before it left mainland China in 2010, could cost Zoom a large chunk of its revenue and disrupt its Chinese operations. Therefore, Zoom didn't have many options when the Chinese censors came calling.

Its new geography-based bans might placate regulators for now, but the effort also raises troubling questions about Zoom's future privacy and security issues in over 80 other countries. It also indicates the company won't offer end-to-end encryption, which would prevent itself from monitoring meetings, anytime soon.

Over the long run, Zoom might need to temporarily sacrifice its margins to reduce its dependence on China, which could stabilize its business and give it more leverage against authoritarian governments. If it doesn't, its addiction to cheaper labor in China could become a major liability.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Cisco Systems, Facebook, and Tencent Holdings. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), CrowdStrike Holdings, Inc., Facebook, Tencent Holdings, and Zoom Video Communications and recommends the following options: short August 2020 $130 calls on Zoom Video Communications. The Motley Fool has a disclosure policy.

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