I Do Not See SMB Exposure Driving Revenue Churn, But Rather Creating Support & Potential For Expansion
Zoom Video (ZM) has seen a rapid advance in trading levels to the tune of 36% since posting remarkable 2Q21 earnings results. Sales nearly quadrupled on a y/y basis, but more impressive, in my view, was the company’s operating margin of 43%, providing ample runway for future net profit margin expansion and substantial FCF generation. A concerning disclosure which highlighted in a note dated 08/31/2020 from Sterling Auty at JPMorgan (JPM) as a potential risk to forward revenue churn, was the increasing representation of businesses with sub-10 headcounts with the company’s sales. On the contrary, I view the over-sized representation of these small entities at ~36% of sales as a bullish attribute that will drive renewals and expansion opportunities even into the recovery.
Zoom Video is fast on its way to becoming a business utility and frees numerous growth levers for the SMB segment as a whole. Decentralized operations reduce overhead expenses associated with leasing, insurance, onsite amenities, and employee travel, while simultaneously expanding the candidate to pool to a global range. Home-office abandonment could lead to an SMB renaissance led by margin expansion, and efficiency tailwinds resulting from outsourcing opportunities. Additionally, the company enjoys first adopter advantage and brand name recognition, making consumers less likely to adopt rival platforms.
Small Businesses Could See Annualized Savings Equivalent An Additional Employee From Rent Elimination Alone
In my view, far too many analysts emphasize phone & conference up-sells as the primary avenue for customer account expansion. I see a world of possibility in the capital freed by remote work adoption that will likely drive direct reinvestment into the relationship itself. To illustrate this point, I have taken a hypothetical 10 person company and examined the cost benefits from remote office implementation vs. leasing private office space in a WeWork facility in many major business hubs across the US. I selected a 10 person company specifically to address the concerns over churn in this customer group raised by J.P. Morgan Equity Research.
Compared to the Business tier Zoom Video plan, rent expenses for a private office that can accommodate 10 employees were greater than the average salary for an entry-level hire, with the Austin market being particularly egregious. This analysis was very simple and did not account for expenses related to private rentals, office supplies, or commuter benefits. These adjustments would make the true savings much higher as the cost of a monthly parking pass in San Francisco alone could easily run 60k annually for 10 employees. Although these hypothetical savings are impressive, I am much more interested in the possibilities for reinvestment.
Companies Could Score Social Responsibility Points, While Seeing Greater Employee Retention, And Improved Productivity At Reduced Rates
Full adoption of remote work would remove geographic obstacles from labor searches expanding the network of qualified talent, while potentially reducing cost-of-living tailwinds on wage inflation. Small companies located in New York, San Francisco, and even Washington, DC have previously been constrained to only candidates who can currently afford to live locally, and are then forced to compensate them at local market rates. This, especially at the entry level, leads to quick employee turnover as entry-level hires chase salaries that can accommodate rising housing costs. Adopting a fully remote workplace would solve this problem by enabling the company to select the best candidate nationally, if not globally, and by allowing employees to work from lower cost locations relieving financial strain that often drives attrition.
Consider an engineering graduate who lives in a rural community in southwest Virginia. He studied at Virginia Tech, graduated near the top of his class, but he cannot afford to go to the San Francisco Bay area to interview, let alone live on an entry level salary. In many cases, this individual would not be considered on the basis of location alone, but a remote office would enable the company to hire the graduate and employ him from his home across the country. In order to match the quality of life provided by their $50,000 base salary, the company would only have to pay this young man $23,000. This puts leadership in the position to provide him the local equivalent of a six figure salary at their standard rate, or meet him somewhere in the middle providing both an improved quality of life vs. local employers, and a discount to the business vs. local talent.
This prospect becomes increasingly attractive when taken to a global scale. Companies who have grown accustomed to remote collaboration open the door to a global network of talent at much more competitive rates than domestic employees. Historically expensive domestic employees such as financial analysts, software developers, and even sales & marketing can be outsourced to cheaper regions with favorable currency conversion rates and average hourly rates. Additionally, platforms such as Fiverr (FVRR) enable extensive talent networks of contract laborers with a reliable intermediary, allowing the company to further drive cost improvement by avoiding benefit expenses associated with salaried employees.
Imagine a company that reinvests their savings into a full back office staff paid hourly in India or the Pacific Islands. They free time for revenue generated to complete more activities while Zoom benefits from additional licenses. A 10 man company that adds 5 minimum wage contractors could increase the value of the relation for Zoom by 50%. This illustrates my strong conviction that the staggering growth observed today may only be the beginning.
The “Kleanex Effect” Is Setting In And Making The Adoption Of Copycat Services Less Likely, Even With The Potential For Attractive Bundles
Alphabet (GOOGL), Microsoft (MSFT), Facebook (FB), and many other high-profile tech firms have successful products that compete directly with Zoom. Bears tend to believe that these competing services will erode the company’s market share and undermine the long-term growth prospects. If this were to happen, then Zoom’s lofty valuation of ~93x trailing sales would likely unravel. In my view, this is highly unlikely as the brand is becoming synonymous with the service and reaching a level of familiarity and trust that will be challenging to disrupt. In business, you rarely have to worry about educating a counter party in the use of Zoom as they have used it once before, that is often not the case with MS Teams or Google Meet. There is a reason Facebook dating did not destroy Tinder as many feared in 2018, and why Pinterest was not undermined by the company’s similar efforts earlier this year. Generally people are averse to change and do not easily abandon platforms that have reached the level of cultural significance as Zoom.
Addressing The Valuation & Final Thoughts
Zoom is not a value trade by any stretch of the imagination. This is an aggressive and speculative growth thesis that is priced for flawless execution. At 53x forward sales, Zoom Video seems expensive, but with the backdrop of 355% y/y sales growth it is somewhat justifiable. These are rates of growth rarely observed in publicly traded firms, and when combined with a net profit that recently exceeded estimates by more than 100%, it is clear that this is not an ordinary high-flier. This is a stock that has the potential to change the face of business as we know and as such it is given a valuation premium that reflects near unlimited potential. Additionally, I am impressed by the company’s consistently conservative guidance and for these reason Zoom is a very bullish top pick.
Disclosure: I am/we are long ZM. 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.