Nov 17 2020 - Zoom: Misunderstanding Valuation, Guidance, And WFH-Importance
- Zoom shares have pulled back considerably based on news of a vaccine that will hopefully defeat COVID-19 sooner than expected.
- This pull-back is a buying opportunity, although not a massive one.
- Valuation has always been a contentious issue with Zoom, which distorts the important issues for the investment thesis.
- My advice to investors is to focus on other issues than valuation which, ironically, I ignore by writing an entire piece on valuation.
Zoom Video Communications, Inc. (ZM) shares are around 30% below their all-time-high and headed back to levels last seen before the Q2 2021 earnings report. Investors seem to be worried that the COVID-related work-from-home boost will soon be over, which I think is a fallacy. Not because I think that COVID will stay with us longer than the markets sector rotation implies – I have no idea about that – but because I think Zoom has a great business that will thrive with or without COVID-restrictions.
Third-quarter earnings are right around the corner and the recent pull-back begs the question if we are seeing a buying opportunity. For obvious reasons, Zoom has been one of the most contentious stocks in regards to valuation in the market, with most writers on Seeking Alpha taking a bearish stance on that reason alone. As I tried before, I want to challenge that view.
Valuation Remains High But Not Unreasonable
At a current share price of 3.58, Zoom has a market cap of approximately 0 billion and an EV of 8.5 billion. Looking backward, the TTM EV/S multiple stands at 88, which seems extremely high. But judging high growth stocks by TTM EV/S multiples is always wrong and it is especially wrong with Zoom. Using TTM numbers means to include two entire "pre-COVID" quarters (Q3 2020 and Q4 2020, at 7 mil and 8 mil revenue respectively), one "half-COVID" quarter (Q1 2021 at 8 mil revenue), and only one "full-COVID" quarter (Q2 2021 at 4 mil revenue).
As you can see, Zoom's financial outlook has significantly changed since COVID. That's why looking at forward-multiples is so important to understand the valuation picture correctly. It doesn't even cut it, however, to look at full-year revenue for FY 2021, as is usually reported on financial media sites:Data by YCharts
This graph shows the current forward EV/S at 47.11. This forward multiple, however, still includes Q1 2021 that was not fully impacted by COVID.
Thus, to get a true understanding of the current valuation of Zoom, you have to reset your valuation model to start from Q2 2021 onwards. As of Q2, reported in late August, the company had revenue of 4 million in Q2 and guided for 0 million in Q3 and 8 million in Q4 (implied in the full-year guidance). Assuming conservative 2% sequential QoQ-growth from Q4 21' to Q2 22' – which surely will be exceeded – revenue for the next twelve months would be .86 billion, which means that a more accurate forward EV/S multiple is 41.4.
Valuation Levels In Unprecedented Times
A "traditional" investor, used to looking at PE ratios and dividend yields, might find the idea of a sales multiple preposterous on its own. But as I like to note in my takes on valuation, a PE (or PS) ratio tells you nothing about the actual business and very little about valuation, especially looking at high-growth companies. Are earnings growing or shrinking? What about revenue? Is it recurring? Is growth accelerating or decelerating? Is the company growing organically or by acquisitions? Is it highly levered? Are margins expanding or contracting? What can be a reasonable expectation of margins at maturity? What about the market opportunity, market share, competitive advantages, management's ability, inside ownership, and optionality?
Without delving deeper into these topics believe me that Zoom is a poster child in all of the above categories. For example, Zoom has a TTM free cash flow margin of 52%. Let that sink in for a while. I know, this is obviously not normal and the company expects (operating) margins to return back to their long-term target of around 20%. But the fact that Zoom was able to scale as they have with basically every incremental dollar falling to the bottom line is a testament to their strong and very profitable business model.
To be honest, though, a 41 forward EV/S ratio is still a very high valuation multiple especially considering the historical context. Not too long ago a forward EV/S ratio above 20 was considered expensive.Data byYCharts
Nowadays, EV/S ratios in the 30s and 40s have become the "new normal" among the highest growth companies. Is that justified?
Well, first of all, it has to be said that Zoom is not an outlier in terms of high sales multiples. I have included Shopify (SHOP) and DataDog (DDOG) above to show that forward revenue multiples in best-of-breed high-growth companies are very similar. Even if you were to look at lower growth companies like MongoDB (MDB), Okta (OKTA), DocuSign (DOCU), etc. you would also find forward EV/S multiples in the high 20s and low 30s.
What we have seen in the last years is an increasing appreciation by the market of the secular growth trends in cloud computing and the SaaS business model that provides recurring revenues, high margins, and great visibility – which is warranted in my opinion.
On top of that, the low-interest-rate environment that we currently live in is a logical driver of valuation multiples. It is a simple mathematical fact that in a DCF-valuation model, which are standard tools in finance and on Wall Street, valuations rise as the discount rate shrinks. This effect is further multiplied in high-growth stocks because of their high beta.
I also think sometimes investors fail to appreciate the magnitude of a change from 3% to 1% in the risk-free rate and how this affects all other assets. As a simple thought experiment just imagine how many years it would take you to double your money with a fixed rate of 3% compared to a 1%-rate. I will spare you the calculation: It's 24 years (3%) vs. 70 years (1%). Yes, a two percentage point difference almost triples the time to double your money here.
Do you need any further explanation of why every asset class seems to be in a "bubble"; or why growth is valued more by the market than has historically been the case; or why in Q4 2018 when interest rates seemed to be destined to rise, stocks went into free fall; or why after the Fed clearly committed to keeping interest rates low for a very long time (what else are they supposed to do?), stock valuations have soared again?
My goal as an investor, however, is not to call macro trends or the interest rate. I try to find businesses that will be successful and growing regardless of what the Fed does or does not do. So let's return back to Zoom and one more reason why I believe the valuation might not be as scary as many think: conservative guidance.
Who Still Believes Zoom's Guidance?
Everyone knows that high growth companies like to give conservative guidance. Zoom is no different which is why I expect actual numbers to be much higher than forecasts. This will make the forward EV/S multiple we are looking at today much smaller in retrospect.
How much will Zoom surprise to the upside? I don't know. What I do know is that Zoom exceeded its top-line guidance by 7 million in Q1 2021 and by 3 million in Q2 2021. That means that in both quarters they actually beat their guidance by more than the amount of revenue they made in the previous year's quarter (2 and 6 million respectively in Q1 and Q2 2020). While I don't expect Zoom to continue that trend (they would have to beat by 7 million, i.e. land at 7 million revenue in Q3), I am reasonably confident that they will beat by a wide margin when they report results two weeks from now.
This has been the theme all year: Investors updating their expectations during the quarter bidding up the share price, just to end up being completely dumbfounded by the actual – much better – results reported by Zoom, pushing shares even higher. I tried to explain that (mostly to myself) in my previous article on Zoom when shares were trading around 0, 66% lower than the current price after the recent pull-back.
Admittedly, as shares continue to rise the air for further upside will get (and is getting) thinner. Also, analysts expect Zoom to grow revenue to .13 billion in FY 2022, representing roughly 30% YoY-growth, which could make it difficult to justify Zoom's premium valuation next year. Thus, there is a risk that the valuation multiple will compress if the growth outlook disappoints. This is an understatement, though. Even if Zoom substantially beats .13 billion in FY 2022, it still trades at a very high multiple at today's prices. Thus, to remain bullish on Zoom there is no way around loosening your rigidity on valuation methods and increasing your investment horizon (while at the same time, keeping in mind the sometimes underappreciated impact of low-interest rates on valuation multiples).
In any way, I think that as long as Zoom keeps on delivering results far above expectations the shares will keep climbing. Furthermore, I believe Zoom's business is set up for long term success, even without COVID and WFH. Time will tell if my prediction is accurate but in my eyes, Zoom is not really a -3 billion revenue company. It has the potential to grow to , , maybe billion in annual revenue in the future – at very high margins. Yes, growth rates will invariably drop considerably in FY 2022. And yes, the shares will be volatile, especially if we return to a more "normal" world post-COVID. But I find it wrong to be fearful of an imminent deceleration of growth rates considering that at the moment all evidence is pointing to a company that is firing on all cylinders – and especially considering that, as a small individual investor, I have the luxury to sell at any time when the facts or my opinion changes.
I personally used the current COVID-related sell-off to buy some additional shares. I want to be clear, however, that I do not see this current price drop as a massive buying opportunity. After all, the shares are back at levels last seen in mid-September, around two months ago. Nevertheless, I believe that Zoom shares still have upside potential, and this pull-back right before earnings might be a good time to nibble at some shares.