Zoom: Risky Business – Zoom Video Communications, Inc. (NASDAQ:ZM) No ratings yet.

Zoom (ZM) is expected to grow its revenue significantly next year and to keep growing at impressive rates, but investing in the company now presents a treacherous proposition with dire downside potential matched by its upside potential at a costly price.

The company is in good financial shape with impressive debt to equity and history of astounding revenue growth in the past couple of years, never the less the price for the stock is too high lowering the upside potential and reducing the likelihood of stable returns.

Those who bought the IPO made a fantastic choice, as the product the company has is spectacular, it was a perfect risk-reward opportunity, and now it might be time to take profits.

Zoom-in

Zoom provides what Microsoft (MSFT) Skype promises and much more. It has an easy to use interface with a variety of simple features that allow it to provide a better experience. An excellent example of this is the autofocus feature that shows which participant is speaking and pulls it forward. This feature is not new; many video conference solutions have provided it for a long time but not for laptop or smartphone conference calls.

Zoom has many exciting or even unique features as well, like creating subgroups and letting admins pop-up in whichever group they choose among others or simultaneous screen sharing that is incredibly useful for complex projects and is rare or unique to Zoom.

Source: Medium

The product is better than its competitors now, but will it be able to keep up? The risk of zoom is that companies like Microsoft or Cisco (NASDAQ:CSCO) finally up their game and improve their products to what Zoom is offering now before it can take a significant chunk of the market.

Zoom is ahead, but I do not see a string moat that can protect them from its competitors when and if they decide to take it as a severe threat. It might have the luck Netflix (NFLX) had and take advantage of the slow pace of the industry to thrive, but unlike Netflix, Zoom has to compete with an existing service and outperform them by enough that it justifies a change.

A better analogy would be AMD (NASDAQ:AMD) and Intel (NASDAQ:INTC). AMD has been offering similar products that Intel at a lower price and because of Intel´s moat and brand recognition it has taken this long for AMD to carve out a significant portion of the market. Unlike Zoom, AMD had a technological edge that located it far beyond Intel, and unlike Microsoft, Intel had internal structural problems that made it hard to move as fast as AMD.

Even with a better product, Zoom needs to find an edge that can help it keep its lead in the market and continue its high grow streak.

Valuation

Projecting that revenue growth probably will oscillate between 37.7% and 61.2%, taking the assumption that gross margin is between 77% and 77.4%, making the assumption that G&A as a percentage of revenue has a minimum and maximum of 60.7% and 55.9%, taking the assumption that R&D as a percentage of Revenue should range 13.9% and 11.2% we have the following chart.

Source: Author´s Charts

These approximations are in line with what the market expects for Zoom in the next couple of years, as the image below shows.

Source: Seeking Alpha

I like to use Peter Lynch’s ratio when valuing a stock. This method uses the ratio between the expected earnings growth plus dividends and the P/E of the stock to determine its fair value. A stock that has a 1:1 ratio is reasonably priced. The higher the number, the more underpriced the stock is.

Source: Author´s Charts

With this valuation, arguably, the stock is at worst overvalued by 95% and at best overvalued by 69%. So the stock is severely overvalued, and despite its impressive growth record and high expectations, it is not worth getting it at this price.

Source: Author’s Charts

Constructing an adjusted Beta Pert risk profile for the long-term prospects of the stock, we can calculate the risk profile for the company.

The risk profile shows there is a 90% probability that Zoom will trade at a lower price than it is today. The upside is a meager 9% yearly return unless the company can exceed the expectations of even the most bullish analysts.

At the $36 price of the IPO, the risk-reward proposition would look very different.

Source: Author’s Charts (Considering a $36 Price)

With a substantially lowered downside and expanded upside, the Beta Pert analysis would make a case for investing in the company.

Source: Author’s Charts (Considering a $36 Price)

Still, with significant risks that the stock could underperform and reduce its price but with the potential of hitting a home run, as the stock has already made. Taking profits might be advisable.

Conclusions

Zoom is a lovely company with a fantastic product. Those of us who missed the IPO have to recognize it and move on, and if the stock goes down, be ready to seize the opportunity.

As for those who invested at the IPO price, it might be a good idea to take profits. Zoom is an excellent company with high growth expectations which make it somewhat healthy for it to trade above its fair price, but right now it is severely overvalued and at risk that if the stock misses expectations slightly, there could be a severe correction.

The company has done a fantastic job, but it is not without risks, and its current price expects nothing short of perfection, which might be difficult to achieve especially when competing against titans like Cisco and Microsoft

If there is anything in this article you agree or disagree with or would like me to expand further; I would sincerely appreciate you leaving a comment. I will address it as soon as possible.

Disclosure: I am/we are long AMD, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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