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Better Buy: Zoom Video Communications vs. Cisco Systems

By Leo Sun - Sep 5, 2020 at 2:00PM

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Is this a classic matchup between a tortoise and a hare?

Zoom Video Communications (ZM 0.78%) probably wouldn't exist without Cisco Systems (CSCO 5.81%). Zoom's founder and CEO Eric Yuan was previously one of the first employees at Webex, the video conferencing start-up Cisco acquired in 2007.

Yuan subsequently became Cisco's VP of Engineering, and pitched the idea of a new smartphone-oriented video conferencing platform to the company in 2011. Cisco shot down the idea, and Yuan left the company and founded Zoom that same year.

A woman uses Zoom's software in an office.

Image source: Zoom.

Zoom went public last April, and its stock subsequently surged over 1,000% as it dazzled investors with its robust growth in revenue, users, and profits -- which were all amplified by the stay-at-home measures during the pandemic. But Cisco's stock fell 25% during the same period, as the pandemic and other macro headwinds choked its hardware sales.

Zoom initially seems like a superior stock, but past performance never guarantees future gains. Therefore, investors should take a fresh look at both stocks to see if the high-growth darling will stay ahead of the slow-growth networking giant.

Zoom's breakneck growth

Zoom operates a "freemium" business model, which encourages free users to upgrade to paid tiers to remove time limits, host more participants in a meeting, add cloud storage services, and unlock other features.

Zoom's revenue rose 88% in fiscal 2020, which ended this January, and its adjusted EPS soared 483%. In the first half of fiscal 2021, its revenue surged 270% year-over-year as the use of remote work and online education services accelerated throughout the pandemic, and its adjusted EPS grew tenfold. Its operating margin also expanded significantly as its triple-digit revenue growth easily outpaced its rising operating expenses.

For the full year, Zoom expects its revenue to grow 281%-284% with a sevenfold increase in its adjusted earnings. After that big growth spurt, Wall Street expects Zoom's revenue and earnings to grow 25% and 19%, respectively, in fiscal 2022.

Cisco's anemic growth

Cisco generated 55% of its revenue from its infrastructure platforms business -- which sells routers, switches, and other networking hardware -- in fiscal 2020, which ended in late July. Sales of those core products declined as the trade war, COVID-19, and macro headwinds reduced its orders from enterprise and data center customers.

Networking connections across a city.

Image source: Getty Images.

Cisco generated 11% of its revenue from its applications business, which houses AppDynamics, Webex, its Unified Communications platform, and telepresence endpoint solutions. AppDynamics and Webex remained strong throughout the crisis, but weak demand for its on-premise Unified Communications and telepresence endpoint solutions offset those gains.

The only two segments that generated revenue growth in 2020 were Cisco's security unit, which accounted for just 6% of its revenue, and its services segment, which accounted for the remaining 27% of its revenue.

As a result, Cisco's revenue fell 5% last year, but its adjusted EPS -- which was buoyed by buybacks -- rose 4%. Analysts expect its revenue and earnings to decline 2% and 3%, respectively, in fiscal 2021.

Maintaining vs. regaining momentum

Zoom is generating explosive growth, but it's unclear if it can maintain that momentum after the pandemic ends. It could also struggle to securely scale its business to meet the growing demands of its massive audience -- as seen in its previous privacy and security issues.

Moreover, Zoom's growth is convincing its well-funded rivals -- including Cisco's Webex, Alphabet's Google Meet, and Facebook's Messenger Rooms -- to ramp up their investments in their video conferencing capabilities. All these tech giants can afford to undercut Zoom's paid tiers with free and bundled alternatives.

Meanwhile, Cisco is struggling to regain its mojo following three consecutive quarters of year-over-year revenue declines. Cisco's near-term prospects look dim, but its fourth quarter exposed a few bright spots -- including the growth of its security business, the strength of Webex and AppDynamics, its stable gross margins, and its ongoing buybacks and dividends.

In other words, Cisco probably won't start growing again until the macro headwinds wane, but Wall Street's expectations are low, and it can easily tread water with buybacks and dividends until the situation improves.

Bubbly vs. flat valuations

Zoom's stock currently trades at over 170 times this year's earnings and more than 50 times this year's sales. Those are nosebleed valuations, even if it's on track to generate triple-digit revenue and earnings growth this year. If Zoom's growth abruptly decelerates after the pandemic ends, it could struggle to meet Wall Street's soaring expectations.

Cisco trades at just 14 times this year's earnings and less than four times this year's sales. Those low valuations indicate investors aren't expecting much growth, but Cisco's forward yield of 3.4% could set a floor under its stock until the situation improves.

The winner: Cisco

Zoom had a great run, but its euphoric valuations indicate it's becoming a cult stock. The market's momentum could still lift the stock higher, but it will face tough year-over-year comparisons next year -- and even the slightest miss could burst its bubble.

I don't expect Cisco's stock to rally anytime soon, but it's a safer stock and it could eventually recover as the macro headwinds wane. Therefore, it's arguably wiser to bet on the tortoise than the hare in this frothy market.

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 and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, and Zoom Video Communications. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
CSCO
$49.37 (5.81%) $2.71
Zoom Video Communications Stock Quote
Zoom Video Communications
ZM
$103.18 (0.78%) $0.80

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