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Zoom Profits From Coronavirus Policies, but Only in the Short Term

By Christine Williams – Jul 1, 2020 at 9:16AM

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Can this wildly popular tech company keep up with its high valuation?

Working-from-home policies have caused increasing reliance on videoconferencing technology, and well-known video communications company Zoom (ZM -0.97%) has profited greatly. With seamless communication as a goal, Zoom has experienced great popularity for its ease of use. However, scandal and concerns have plagued the company of late, and these issues cast a pall over its future viability. 

Two women talk to each other through their computers via videoconferencing.

Image source: Zoom Video Communications.

Revenues race higher and higher

At face value, Zoom posts drool-worthy numbers. The company reported in April 2020 that its revenues more than doubled year over year, and that current customers with more than 10 employees increased by 354% in the same time period. FY21 Q1 revenues were a whopping $328.71 million, up 169% from $121.99 million the year before. 

Financial statements also revealed $251.4 million in Q1 free cash flow (FCF), a more than 16-fold increase from the prior-year period, with annual FCF margin averages around 40% -- above the average of 26% posted by similar large rivals. This indicates that not only is Zoom growing rapidly, but it also is generating enough cash to further prop up its business and potentially reward investors. 

Hacking reports and uncertainty bring Zoom to a pause

However, reports of cybersecurity issues have cast uncertainty as to whether the company is safe for enterprise clients, who form the core of its monetization strategy. 

Further raising doubts, The Verge reported at the end of April that Zoom claimed usage had grown to 300 million daily active users, but that the numbers were quickly corrected to read "300 million daily meeting participants." The difference is subtle yet important: Daily active users count the number of unique users, while meeting participants can be counted multiple times in the same one-day period. 

What does this mean? Zoom does not provide a count of its daily active users, so the exact drivers of its revenue growth are yet unknown. Is the company adding more subscribers? Or is it upgrading existing accounts? When data is not secure, clients may choose to not upgrade, especially given all the alternatives with comparable services.

The problem with videoconferencing technology is its low switching cost for users. Zoom is easy to use and offers useful integration tools for a bevy of cross-platform preferences. But other than setting up an account, there are few stumbling blocks that prevent users from flocking to another convenient platform. And Zoom had a fatal security flaw that exposed sensitive user data: weak, almost nonexistent encryption. Now, after public backlash, Zoom is finally beginning to roll out upgraded GCB encryption, but the damage has already been done.

In fact, work-from-home policies have increased reliance on video communications platforms across the board. In an April 29 phone call with investors, Microsoft (MSFT -0.04%) CEO Satya Nadella stated that on its own communication platform, Microsoft Teams, usage has increased to more than 75 million daily active users. Google (GOOGL -1.02%) CEO Sundar Pichai announced that Google's Meet service is now adding about 3 million users per day. So Zoom, with its hacking vulnerabilities and big-name competition, is currently facing a pivotal moment in its short history.

Falling short of high expectations

As a company, Zoom offers a fantastic customer experience, which may explain why its popularity continues to increase--especially among free account users. But weighed down with increasing expectations carried by its high stock price, the company faces undeniable challenges in the long term. 

Revenues have been increasing, but so have its expenditures. Indeed, 2019 revenues and costs increased nearly in lockstep. Furthermore, as it added computing capacity to handle a sudden surge in users, its gross margin fell from 82.7% in the previous quarter to 68.4% in its most recent one. Zoom has converted a number of free accounts to paying clients, but it still needs to assume the cost of providing service to its growing numbers of users, most of whom continue to use the service for free. 

Unfortunately, Zoom has a P/E ratio around 1,400 -- compared to Microsoft at roughly 33 -- and its current valuation is significantly higher than its current earnings can justify. Thus it appears its valuation is built on high expectations for enterprise subscription growth. The only snag in this, however, is that companies may not be willing to shell out money to a company that offers little in comparative value to its competitors. 

Overall, Zoom's user-friendly interface has won its place in many a customer's heart. It continues to earn money, and short-term prospects for the stock are positive. Nevertheless, Zoom needs to overcome its negative security publicity in order to convince more and more paying customers to subscribe. Is there still room for the company to innovate further? How far can a video communication platform go alone? These questions need to be answered by management before Zoom can be declared a good value for its high price. 

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Christine Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Microsoft, and Zoom Video Communications and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, and short August 2020 $130 calls on Zoom Video Communications. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Zoom Video Communications Stock Quote
Zoom Video Communications
ZM
$75.40 (-0.97%) $0.74
Microsoft Stock Quote
Microsoft
MSFT
$247.49 (-0.04%) $0.09
Alphabet (A shares) Stock Quote
Alphabet (A shares)
GOOGL
$97.46 (-1.02%) $-1.00

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