Zoom Communications

We are discontinuing analyst coverage of Zoom Communications.

We will discontinue analyst coverage of Zoom on or about Sept. 11. We provide analyst research and ratings on over 1,500 companies globally and periodically adjust our coverage according to investor interest and staffing.

Our fair value estimate for Zoom is $105 per share, which implies a fiscal 2027 enterprise value/sales multiple of 4 times, adjusted price/earnings multiple of 15 times, and a 6% free cash flow yield.

We believe investors are most concerned with how growth will normalize in a post-lockdown world and if revenue growth can ever return to even the high single digits. We see improved revenue growth in fiscal 2027 as new (or newer) solutions, such as Zoom Contact Center, AI Companion, and Zoom Phone, penetrate. We model a five-year compound annual growth rate of 4% through fiscal 2031. We think revenue will shift more toward existing customers over time, and solutions beyond Zoom Meetings (Phone, contact center, Rooms, and Connector, among others) will increase within the mix. We model non-GAAP operating margin remaining approximately flat over the next five years at 40%. We mostly see stock-based comp declining as a percentage of revenue, weighing down non-GAAP operating margin. Management’s long-term guidance calls for margins of 28% to 32%.

We believe Zoom Phone, Zoom Contact Center, and various AI solutions will contribute to revenue growth over the next decade. We see this substantial market as being able to support multiple winners, but given the covid revenue surge, we are skeptical of a return to double-digit growth any time soon.

We assign a narrow moat rating to Zoom based primarily on switching costs with an emerging moat source arising from network effects. The covid-19 pandemic accelerated Zoom’s growth and provided a massive influx of new users, propelling an already-strong return on invested capital even higher in fiscal 2021 and most likely going forward. We think that many of these new customers, in particular enterprise customers, are sticky and will remain with Zoom for years. Given the company has established itself as a leading communication platform and is expanding its portfolio, we think Zoom’s competitive position will support excess returns throughout the next decade.

Zoom provides a collaboration platform that was initially designed as a video conferencing solution. Zoom Meetings is the core platform, which has grown over the last several years. Initially, Zoom focused on individual and group video conferencing, screen sharing, audio conferencing, searchable and archived transcripts, chat, and file sharing. Now, it has expanded its portfolio to include Zoom Phone, video webinars, events, hardware-as-a-service partners, and a variety of other products. Importantly, in its quest to become a communications platform company, Zoom has introduced the Zoom Apps marketplace and enhanced its development platform with application programming interfaces and an enhanced software development kit.

In our view, switching costs in software are driven by several factors, the most obvious of which is the time and expense of implementing a new software package for the customer while maintaining the existing platform. There are indirect costs along those same lines, mainly lost productivity as customers move up a learning curve on the new system and the distraction of users involved in the function where the change is occurring. Lastly, and perhaps most importantly, there is the operational risk, including loss of data during the changeover, project execution, and potential operational disruption. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs will be.

Through this lens, Zoom often sees little difficulty or incremental expense in initial pilot programs or even in some major rollouts involving thousands of users. Indeed, this is a feature of Zoom’s business model. Zoom employs a hybrid go-to-market strategy, with self-service through its website and a direct salesforce. Potential customers can visit the company’s website, download the software, and be up and running within minutes (in a simple case), reinforcing the “frictionless” message the company espouses. Zoom relies on viral adoption from here, with an internal champion pushing team members to use Zoom. The platform then spreads to new teams and ultimately to new use cases. During the pandemic, users from the biggest enterprises in the world to single-person businesses turned to Zoom to help them conduct something akin to business as usual.

On the surface, this easy and frictionless rollout seems counterintuitive to high customer switching costs. Since simplicity is a core pillar of Zoom’s philosophy, initially, we saw little specialized training or lost productivity as a result of switching video conference calling software platforms. In the simplest of cases, easy to deploy means easy to switch as well, but we see this mainly in small and medium-sized businesses, so some small use cases amounted to nothing more than trials, both before and during the pandemic. Competing platforms like Microsoft Teams are also frictionless and therefore represent competitive threats to Zoom. Further, an organization can easily deploy multiple communication solutions, while users can pick up a headset and work with multiple services. In fact, nearly every organization of commercial size that uses Zoom also uses Microsoft Office, which includes Teams. Slack is another collaboration platform that competes head-to-head with Teams, and Slack management has repeatedly hammered this point home: While virtually all of its customers already used the Office suite, Slack was still used, likely due to more features, better connectivity, and a much more robust set of prebuilt integrations for other applications. We think that while not exactly the same, Zoom’s situation is similar to that of Slack, and customers continue to adopt the solutions despite having Teams already present in their organizations.

While employee preference and inertia can drive switching costs, we do not see a steep learning curve for users among the baseline products in video conferencing on any of these platforms. Despite our views that Zoom is an easy-to-use, reliable, and robust solution, the ease with which users can try the product makes it theoretically susceptible to competition, especially when it comes from large firms such as Microsoft, Cisco, and Google. Then again, easy trial usage is a feature to create a new customer pipeline rather than a bug that results in a competitive threat.

Looking at the competitive landscape, we believe that enterprise software companies compete on features and functionality rather than price. Pricing among Microsoft, Cisco, Zoom, Slack, and others is generally similar, with tiered versions from free to $20 per user per month (list price). The exact features included in each tier vary and make precise comparisons challenging, but they are generally consistent with one another. At the large-scale end, competition includes mainly Microsoft (Teams) and Cisco (Webex), while in the midmarket and SMB area, we see LogMeIn (GoToMeeting), BlueJeans, Google (Workspace), Slack, and a variety of bundled and point solutions from the likes of RingCentral and Five9. Ultimately, we do not believe that enterprises will adopt an inferior solution just to save a few dollars per employee per month. We think simplicity and a better user experience are allowing Zoom to take customers from legacy providers, and ultimately, Microsoft and Zoom are best positioned over the next several years. We also think stepped-up investments by Cisco will help stem recent market share erosion from Webex’s substantial installed base.

Despite a variety of competitors, including products from a handful of tech giants, the collaboration software market is growing rapidly, and we envision Zoom capturing its fair share of new customer wins and seat expansion in the decade ahead, all of which should lead to excess returns on capital. We believe that the various remote work and workflow solutions ultimately result in a market opportunity in excess of $100 billion annually. In its S-1 filing, the company sized the unified communications and collaboration market at $34 billion in 2019, but Zoom now sees it expanding to $91 billion in 2025, based on data from a variety of sources, including Gartner and IDC. We’re pleased to see other estimates increasing to meet our own, but our larger point is that the market for Zoom’s solutions is enormous and growing rapidly. Thanks to the pandemic, modern converged cloud-based solutions that solve a variety of communications needs will capture the most market share, in our view. Zoom’s products would need to devolve from leading solutions into clearly inferior ones in the decade ahead for the company to surrender its share of growth and profits awaiting in this massive market opportunity.

Moreover, we do not see a scenario where an organization uses Teams for a year, then freely switches to Webex, then switches again to Zoom based on discounted pricing or some other random factor. We believe that collaboration software, including Zoom’s solutions, becomes stickier in an organization once the paid version is implemented, as Zoom has more touch points and becomes more ingrained in the organization’s workflows. At some point during the process, we see smaller organizations typically converting from the free version to a paid version, depending on the features they need. Larger, enterprise customers are unlikely to begin as free users but might trial the software on a specific group and therefore keep the cost nominal. Regardless of product pricing, rolling out a platform across an entire organization takes time and effort, so organizations are unlikely to switch away from an implemented solution in order to indiscriminately try other software. If other solutions were being considered, they would likely be used on a trial basis within a small group as well. However, Zoom’s massive enterprise growth has not come from a wave of these small trials, but rather, more involved enterprisewide rollouts.

According to management, 55% of customers started with the free offering, which is not the same as a conversion rate but certainly reinforces the power of viral marketing. Zoom is not the first company to use a free version to quickly and cheaply gather users in a high-level funnel. Within Morningstar’s technology coverage, we count HubSpot (narrow moat), Atlassian (narrow moat), VMware (narrow moat), Okta (narrow moat), IBM (narrow moat), and Oracle (narrow moat) as offering completely free versions for some of their solutions. Additionally, we see at least a dozen other software companies covered by Morningstar that have either a wide or narrow moat that also offer free trial periods for their software. For larger and strategic accounts, Zoom employs a direct salesforce to generate leads and a customer success team to service clients. We think these teams help establish and maintain customer relationships and therefore boost switching costs as well.

When we launched coverage in 2019, our initial no-moat rating stemmed from two concerns: easy rollouts (users are easy come, easy go) and a relatively highly competitive threat. Since that time, the world and video collaboration tools have witnessed profound changes. We believe these concerns were more relevant when video conference calling was a niche luxury technology, but such tools quickly became a necessity. Even as employees return to offices, the model going forward is clearly going to be a hybrid of remote and in-person work, where these tools will remain essential. In 2020, with the covid-19 pandemic, we saw the obvious and mandated rise of remote and hybrid working arrangements. This shift required not just the business need for robust collaboration tools, but greater integration of such tools into business workflows. In turn, switching to a different set of collaboration tools today would be more disruptive than it was just a couple of years ago.

Over the past two years, we believe that initial installations at many enterprise customers are complete, but those customers are likely thinking more strategically and are more tightly integrating Zoom more formally into their workflow in order to maximize the value provided by the solution. Back-end integration means the solution is tied into other applications and core systems at the code level, which makes a software solution hard to change, even if there are potentially better solutions available. For example, a company might use both Salesforce and Zoom, and there is a high likelihood that, directly in the Salesforce app, there is a button to initiate a Zoom meeting. Similarly, if an enterprise uses Adobe’s Digital Experience and Digital Marketing clouds, an obvious case would be to have Zoom Video Conferencing or Zoom Phone embedded into the workflow management portion on the creative side so the creative team could quickly meet, complete with whiteboard functionality to brainstorm, and then have the ability to bring members on the campaign management side into the meeting in order to have a real-time analysis of the efficacy of the last marketing campaign the company just ran—all without leaving the Adobe dashboard. Again, Zoom might be easy for employees to use by picking up a headset, but the back-end integration is harder to implement, so organizations are less likely to switch without a pressing need.

After the pandemic, the portfolio continues to grow, and the installed base is now a multiple of what it was just two years ago. More solutions employed by a customer make switching more difficult. In the last two years, Zoom introduced a variety of key new products and significantly enhanced existing solutions. For example, it launched hardware as a service, partnering with various hardware suppliers to provide approved and often unique hardware appliances to meeting rooms to smoothly offer Zoom solutions. Further, while the acquisition of Five9 was terminated, we see the early 2022 launch of Zoom Video Engagement Center as filling an obvious hole in the portfolio for a contact center solution, and we expect strong cross-selling traction not unlike what Zoom Phone enjoys.

We see the time, expense, and complexity increasing as large customers also elect Zoom Phone and any number of the other solutions in the growing portfolio. Zoom Phone, in particular, has gone from test cases two years ago to more than 2 million seats by April 2021, meaning that customers are adopting more solutions from Zoom’s portfolio and therefore tightening their bond with the company. By comparison, it took narrow-moat RingCentral 20 years to capture 3.5 million seats as of June 2021, so the adoption of Zoom Phone within the enterprise has been rapid and impressive, in our view. Training and employee learning curves are not the main source of switching costs for Zoom, in our view, but increasing complexity likely leads to higher training needs as well.

Lastly, the pandemic has proved that flexibility is imperative, and the remote work capabilities that Zoom provides are absolutely essential. As video conferencing has gone from nice to have to a necessity in a hybrid environment as workers return to their offices, we see higher switching costs. We stress this point, as companies are clearly opting for hybrid work environments to have a permanent presence in their organizations going forward.

The data shows Zoom continues to enjoy viral adoption once it has an initial use case, with trailing 12-month net dollar expansion rates of 130% or better in each quarter since July 2018, which is a very strong absolute level and a remarkable run over three years--one which we think we continue over the next several years. We also see larger deals growing well in excess of the corporate average. We believe this data suggests that when companies deploy Zoom, they overwhelmingly pay for it and push it out to additional departments and use cases, which we view as supportive of our high customer switching costs argument.

Zoom’s momentum has continued even as the lockdowns have eased and employees have begun returning to the office. Revenue growth remained strong in calendar 2021, even against the very challenging comps in calendar 2020, as revenue spiked due to the start of the pandemic-related lockdowns. This top-line performance has clearly been besting Zoom’s main competitors. Non-GAAP operating margins more than doubled in just one year compared with prepandemic levels. These unparalleled financial results have pushed ROICs to more than double from already excellent levels. We expect growth to moderate and ROICs to recede to prepandemic levels but remain strong over the longer term. The financial model has clearly changed as a result of Zoom scaling in one year rather than 10 years.

Regarding the network effect, we see several factors combining to create an emerging one. The most obvious indicator of the network effect, in our opinion, is the viral adoption model Zoom has employed, whereby a paying customer can have a video conference call with a nonpaying customer on any device. Given the ease of use and high quality of the basic solutions, users quickly get a simple trial and often move into a paid version, where they, in turn, host calls for other nonpaying users. This flywheel effect continually draws in new users. Zoom has launched an updated software development kit to make it easier for developers to integrate its solutions. The company has also created a marketplace where developers can distribute their own Zoom-related solutions; there are in excess of 50 products available already. Lastly, Zoom launched a $100 million venture fund to invest in companies that develop technologies involved in the ecosystem. We see these factors as creating a network effect that we envision expanding over time.

We see the pandemic as permanently changing the need for video calling and other solutions that enable remote work. We think the massive jump in the installed base is a game changer for Zoom, and the expanding portfolio represents cross-selling opportunities that deepen ties and increase complexity. The data support this view, and we therefore see Zoom as generating strong financial results and high and durable ROICs over the next decade.

Zoom’s user base and revenue surged during the pandemic. In the couple of years that followed, metrics were generally declining but have since stabilized and even shown signs of improvement.

Zoom is leaning into its substantial installed base to offer solutions beyond its original disruptive Zoom Video Meetings product, including Zoom Phone and contact center software.

Zoom’s low-touch, low-friction model helps drive strong margins, which we expect to continue.

Zoom has gone from being a product of necessity during covid lockdowns to trying to sell additional solutions that may not need to be replaced to its existing customer base.

Cisco and Microsoft are prominent in the video conferencing market and can bundle a broad array of solutions in response to a competitive threat from Zoom.

Growth was pulled forward during covid and remains depressed. It is not clear that revenue can accelerate meaningfully from current levels on a more durable trajectory.