Not another Zoom meeting...

We use our Watch List to allocate our Research Time. The most believable stock prices, within our thematic purview, get our attention. Believability, at the initial stages, comes down to “revenue growth we can believe”. That’s what our Watch List is about.

The big qualitative reason for wanting to dig into Zoom is the whole WFA (work from anywhere) fad. WFA got a supersized booster in the form of a pandemic. We believe this has legs. Let’s be real – most meetings can bee Zoom meetings, and most corporate trips are totally unnecessary. Zoom has become the de facto WFA tool, and if WFA will become the norm, then Zoom should see a lot of revenue upside. With the recent stock price dip in Zoom stock, we thought there’s a good chance that the market is too pessimistic. Of course, there are qualitative risks as well. But this analysis is more about numbers and estimates that are prerequisites for us to unpack all that qualitative stuff. First, we figure out what we need to believe; then we can proceed to “should we believe it and why”. It’s not quite as simple as staring at a chart and drawing conclusions. That’s astrology.

In the next few sections, we’ll decide whether Zoom is worth our time, primarily from a numerical point of view. We’ll do some “PIEcasting”. PIE is a popular and overused acronym that always makes us hungry. But we’re referring to the one coined by Michael Mauboussin – PIE stands for Price Implied Expectations – which kind of kills our appetite. But it’s a very useful part of our investment process. In the following sections, we will:

1. Estimate “what needs to happen” for us to consider investing in Zoom
2. Estimate what the Mr. Market believes will happen.

What needs to happen?

“Invert, always invert.” – Charlie Munger

We measure “what need to happen” (WNTH) in terms of revenue growth. We invert. We back solve into this from the minimum stock price we’d like to sell at to achieve our minimum return requirement of 50% in less than 5 years. From there we derive the “free cash flow we need to believe”, and then move up the cash flow waterfall to finally arrive at the revenue level. Here’s the result of this process for Zoom:

Looks quite benign to us. For a high growth SaaS company like Zoom, a 14% annual revenue growth looks achievable. But before we commit to spending 40 hours on this, let’s peel this onion a little more.

Top Line Test

Before we even begin with the soft stuff – competitive advantage, economic moat, management strategy etc. – we like to ensure that we’re barking up the right tree. We’d rather spend our energy on investment ideas that are reasonably priced to begin with, or we run the risk of justifying a high price because we love the story (confirmation bias). It’s bit of a chicken-or-the-egg conundrum: for the stock price to be reasonable, we need to know the story, but in order to dig into the story with our limited time, we need to unpack the stock price…

So, we came up with an efficient workaround. We measure believability against what has happened in the past and, if available, data about what management expects out of the business (presumably they know things we don’t). As mentioned earlier, believability to us means “revenue growth we need to believe to consider buying the stock…”. We pitch that against our two barometers to measure believability so we can streamline our list of investment ideas. Here’s how it looks for Zoom:

In this case, we’ve got to take this chart with a grain of salt. But we’re beginning to think Zoom is a bit overpriced, even though we love the story (what we know of it).

What should we believe?

Obviously, we can’t expect Zoom to ever have the explosive 3 years that it had during the pandemic. But what growth rate is believable? We’d veer towards Management’s expectations for the next 12 months. Coincidentally, that’s what the market expects as well…

We flipped our calculations. We punched in different revenue growth rates in our model to estimate a logical, rational price Zoom’s stock. This is what analysts normally do, which we don’t think is the right way to do things. But here it will help us zoom (pun intended) into Mr. Market’s expectations. Here are the main assumptions:

1. Assume a minimum return requirement of 50% over the next 5 years.
2. Assume same gross margin as the last 12 months.
3. Assume R&D expense will increase by 10% per year.
4. Assume Selling, General & Admin. costs will increase by 5% per year.
5. Assume a cash tax rate of 20%.
6. Assume an “exit multiple” of 20 times Free Cash Flow.

It seems to us that paying much more than Zoom’s current price would be risky – that we’d be buying expectations higher than what management expects. It’s 10.5% vs. 14%. Sure, revenue growth could accelerate to over 14% annually over the next few years with new products. But betting on that, to us, is closer to speculation than investment. On the story front, we could probably justify management guidance by extrapolating the company’s growth in Enterprise revenue – it’s been growing fast, in double-digits. It’s one thing being depending on Zoom subscribers like us for revenue; it’s quite another (significantly better and stickier) being dependent on Fortune 1000 companies for recurring revenue in a post-pandemic, work-from-anywhere world.

So, 10-11% annualized revenue growth, to us, is believable. That’s reflected in the current stock price. Management expects it over the next year. We would need Zoom’s stock price to drop to about $80 to expect – rationally – our minimum upside of 50%. For now, we see better deals out there. Case in point: our recent investment in Google.

Appendix: Cash Flow Details

Here’s what we think is a believable scenario for Zoom. If this comes to pass, the current stock price range of around $110 is rational – the growth expectations built into that price are rational.

Enjoy!