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Zoom Stock Ran Too Far, Too Fast in 2020

By Herve Blandin - Jan 6, 2021 at 7:36AM

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The company's valuation may not take into account the intensifying competition in the unified communications space.

The coronavirus-mandated shelter-in-place orders of 2020 have boosted the need for better digital communications options. And thanks to its easy-to-use solutions, Zoom Video Communications ( ZM 1.04% ) captured a large share of that fresh demand, generating phenomenal results and pushing its stock price upward by almost 400% last year.

However, with that rapid rise, the company's valuation has become too rich, too quickly. It suggests the market expects the impressive results of 2020 to be repeated over the next several years, an unlikely feat given the intensifying competition in the unified communications market. 

Phenomenal results in 2020

Back at the beginning of 2020, before the COVID-19 outbreak expanded into a pandemic, Zoom was showing strong double-digit percentage revenue growth thanks to the quality of its video communication tools, which looked particularly user-friendly in contrast with competitors' clumsy solutions. As the pandemic made video calls and meetings an everyday necessity, growth and adoption significantly accelerated.

Woman wearing headphones and participating in a video conference call on a laptop in a cafe.

Image source: Getty Images.

During the most recent two quarters, revenue growth exceeded 350% year over year, and management expects full-year revenue to land in the range of $2.575 billion to $2.580 billion for fiscal 2021, which ends on Jan. 31. That would amount to 314% growth over the prior year.

And with scale, Zoom's profitability has improved. The company's operating margin increased to 24.7% during the last quarter compared to less than 8% pre-pandemic.

ZM Revenue (Quarterly YoY Growth) Chart

Data by YCharts.

Propelled by these phenomenal results, the stock price surged 396% in 2020 and is now trading at 53 times trailing 12-month (TTM) revenue and 159 times adjusted earnings. That lofty valuation comes with equally lofty expectations regarding the company's future performance.

Intensifying competition in the unified communications market

However, with effective COVID-19 vaccines being deployed worldwide, the need for social distancing will likely decline over the course of 2021, which suggests that last year's surge in demand for video communications will wane.

And the 20%-plus operating margins that Zoom enjoyed during the last few quarters don't seem sustainable. Indeed, management couldn't ramp up operating expenses quickly enough to match the company's stellar top-line gains, as it takes time to hire employees for things like research and development. But CFO Kelly Steckelberg indicated during the last earnings call that operating margins should decrease long term as the company's R&D and sales and marketing budgets catch up to where management wants them to be as a percentage of revenue.

And Zoom will need that extra spending to remain relevant amid intensifying competition. Granted, the company expanded its offering beyond its core video communications business. For instance, Steckelberg indicated Zoom Phone will represent a key growth driver in 2021. The company also created new products such as its online events platform OnZoom to increase its addressable market.

But competitors have also been enhancing their offerings. Individuals and small businesses can now find a number of cheap and feature-rich alternatives to Zoom's solutions. For example, RingCentral released in December its easy-to-use Glip service with many free competitive features, including unlimited meetings of up to 24 hours for up to 100 participants.

On the enterprise side, Cisco Systems has been enhancing its WebEx communications platform, and Microsoft has been doing the same with Teams. Last month, Cisco announced many innovations to be released soon, such as real-time translation, immersive features, and support for huge meetings (up to 25,000 participants compared to a maximum of 1,000 participants in Zoom meetings). And Microsoft is far from standing still in its efforts to position Teams as a platform for collaboration: Teams will integrate with the tech giant's Outlook email solution at the beginning of this year.

Looking forward

Undoubtedly, Zoom will remain a strong competitor in the video and unified communications space. But the market got carried away last year by the company's stellar results, and now, the realization that such growth may not be sustainable has pushed shares of Zoom down almost 40% from their 2020 peak. Yet the tech stock's valuation remains stretched. As the economy reopens and competitors fight for market share, the stock's correction looks to continue in 2021.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Zoom Video Communications Stock Quote
Zoom Video Communications
$185.84 (1.04%) $1.92
Microsoft Corporation Stock Quote
Microsoft Corporation
$326.19 (0.98%) $3.18
Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
$56.96 (1.30%) $0.73
RingCentral, Inc. Stock Quote
RingCentral, Inc.
$199.99 (3.27%) $6.34

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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