This article was originally published in my newsletter, The Mirandolan by Joseph Noko, on Substack.

My goal as an investor is to buy a business that, firstly, can earn good returns on invested capital; secondly, is in a capital cycle that is favourable to the pursuit of economic profits, which is to say, it operates in an industry in which either capital is exiting in ways that allow for consolidation of that industry in its favour, or, where the competitive landscape is such that there are robust barriers to entry that protect the business’ ability to earn economic profits; thirdly, is viewed with unreasonable pessimism by the market; and finally, has a management whose interests are aligned with those of shareholders.

Naturally, a business like Zoom is very interesting to me. At a time where there is a dearth of growth, and low interest rates have become the new normal, the stocks of high-growth businesses have been bid up to euphoric valuations and the absence of profitability has been excused as part of a “new paradigm” in a cloud cuckoo land where every major tech startup is assumed to be the one that will rule them all. Often, disruptive innovation, and large, fast growing addressable markets are conflated with the creation of long-term shareholder value, even if the capital cycle of the industry is such that nobody makes any money.

Zoom is that rare, fleet-footed elephant that is a high-growth company earning economic profits and growing free cash flows. It’s $1.75 billion public offering is a good opportunity to discuss the business as a prospective investment. I won’t bang on about its sensational share price appreciation since listing: at present, it is only so much noise, or to quote Benjamin Graham:

“In the short-run, the market is a voting machine but in the long-run, the market is a weighing machine.”

How much does Zoom weigh?

Product Market Fit

In his 2009 post, “The Only Thing That Matters”, Marc Andreessen cited video conferencing as an example of a market so small that, regardless of how good the team or the product was, the startup would fail, because the market is “the most important factor in a startup’s failure.

“In a great market — a market with lots of real potential customers — the market pulls product out of the startup.

The market needs to be fulfilled and the market will be fulfilled, by the first viable product that comes along.

The product doesn’t need to be great; it just has to basically work. And, the market doesn’t care how good the team is, as long as the team can produce that viable product.

In short, customers are knocking down your door to get the product; the main goal is to actually answer the phone and respond to all the emails from people who want to buy.”

Since then, the market for video conferencing has exploded, with the IDC estimating an addressable market of $43.1 billion by 2022 and in this booming market, Zoom has fantastic product/market fit, what Andreessen argued was “the only thing that matters” in determining a startup’s success. Product/market fit essentially measures the degree of resonance a company’s product has with a market.

The biggest consequence of Software-as-a-service (Saas) is that, as Ben Thompson says,

“it makes current use cases more efficient for existing enterprise customers on one hand, and accessible for completely new customers on the other.”

This is because Saas allows the differentiated and varying uses of customers to be met by solutions specific to their needs, through a subscription program, reducing the amount of upfront infrastrucure needed by the user. Consequently, ease-of-use becomes more important than ease-of-integration.

Zoom as a market leader in Meeting Solutions and in Unified Communications as a Service (UCaaS), Worldwide, thrives because of its snug product-market fit. Zoom’s secret sauce is an open secret but one that is hard to make and relies on two features: in-built scalability and a frictionless environment.

Setting up a meeting solution is a major pain point for customers. I encountered this when I had to download a video conferencing app on Google Play and for reasons unbeknownst to me, the download got trapped in a loop and wouldn’t install. I had to switch to an already installed app and ask everyone to move there. With Zoom, setting up is easy. If someone sends you a link to a meeting, you just have to click on that link to join the meeting via your browser. Simple. You don’t have to download any software, or create an account to join a Zoom meeting. Downloading the app is optional, though it does give you greater control over the settings. Microsoft Teams, as an example of a rival, only work if you either download the app or use Teams on Microsoft’s Edge browser. There is an absolute minimum of friction in setting up. If you want to share a video conferencing link, you do have to set up account, which you can authenticate with Facebook, Google or an email address. Cisco Webex is similar in terms of ease of setting up, except when opening an account, Cisco Webex is a bit more involved, requiring you to opt in and out of email notifications. It’s hard to overstate how important this seemingly miniscule feature is, but it is a major reason that Zoom is so widely loved. The only person who ever has to set up an account is the meeting organizer sharing the meeting link.

Payments are just as simple: all you need is a credit card.

Ease of use is Zoom’s calling card.

Having created a frictionless environment, Zoom have knocked the “quality” ball right out of the park. The quality of the user experience is such that it generates what the company calls, “viral enthusiasm”, with many first-time users of Zoom promoting the product to friends and colleagues. The company’s S-1/A statement explains:

“We have a unique model that combines viral enthusiasm for our platform with a multipronged go-to-market strategy for optimal efficiency. Viral enthusiasm begins with our users as they experience our platform – it just works. This enthusiasm continues as meeting participants become paid hosts and as businesses of all sizes become our customers. Our sales efforts funnel this viral demand into routes-to-market that are optimized for each customer opportunity, which can include our direct sales force, online channel, resellers and strategic partners. Our sales model allows us to efficiently turn a single non-paying user into a full enterprise deployment. For the fiscal year ended January 31, 2019, 55% of our 344 customers that contributed more than $100,000 of revenue started with at least one free host prior to subscribing. These 344 customers contributed 30% of revenue in the fiscal year ended January 31, 2019.”

Anyone who has used Zoom can attest to the ease of use and video quality. Unsurprisingly, the company has a high net promoter score of over 70. Zoom’s product-market fit seems starkly clear, which as Ben Horowitz points out about product-market fit, is actually quite rare.

The Competitive Landscape

As aforementioned, the company cites IDC estimates in forecasting an addressable market (Hosted / Cloud Voice and Unified Communications, Collaborative Applications and IP Telephony Lines segments of the Unified Communications and Collaboration market) of $43.1 billion by 2022. In an earlier post I remarked that a:

“…theory of history -and of the future-, is inherently imperfect: firstly, because of facts and numbers we do not know but which we may come to know, what is known as “epistemic uncertainty”; secondly, because even if furnished with all the experimental data it is possible to gather, every emotion, every glance, all the economic, scientific, and social data imaginable, it would still not be able to explain everything and predict everything, because of the irreducible randomness that is inherent in historical processes, what we call, “aleatory uncertainty” -the union of all sets of knowledge is not equivalent to reality-; thirdly, because our perceptions drive our actions which impact the future, a shoelace process of history, so that the future is a constantly evolving predictive target, rather than a linear chain of fact to fact to fact; lastly, because cognitive biases impede our ability to understand the world regardless of how much information we have.”

So let’s treat that $43.1 billion with a degree of skepticism. My feeling is that the number is, as the company itself says, potentially bigger because as users jump onto the platform, they will evolve novel use cases and expand their use of the platform. An example of this and the uncertainty of the future is Zoom’s evolution in terms of its user base, something which its CEO, Eric Yuang discusses in the 2020 Annual Report:

“Our platform was built primarily for enterprise customers – large institutions with full IT support and established protocols for security and privacy. And in those use cases, we have excelled. … However, we could not have predicted all of the use cases and nuances that would emerge as hundreds of millions of new consumer users adopted Zoom, or the various related questions and issues that subsequently arose out of their use of Zoom’s services. While our platform has always included many features designed to keep users and their meetings secure and private, we have had to quickly adapt to the new global reality and the new uses cases it has created.”

The growth of the market has a genealogy that extends well before the Covid-19 pandemic struck. The pandemic “merely” accelerated a shift toward the adoption of video as the primary means through which people communicate. In 2020, 70% of full-time workers in the United States worked remotely. In 2019, only 16% of full-time workers worked remotely, according to the Bureau of Labor Statistics. Obviously there will be a return to offices as vaccination programs expand, but there are reasons to believe that the reorganization of work will involve a great deal of remote work for at least a substantial portion of full-time workers.

Gardner’s magic quadrant is a good guide as to who the major players are in Meeting Solutions (the first graphic) and UCaaS worldwide (the second graphic):

What’s Zoom’s moat, you ask? Its ability to counter-position against its rivals. In other words, Zoom can do what its rivals cannot, it can attack the market without its rivals being able to fully rise to the challenge, because fundamentally, it is not in their best interests to completely imitate Zoom’s best features, and in other areas, they have technological disadvantages. Zoom is different, largely thanks to the fact that it was developed in the age of the cloud, whereas platforms like Skype, for example, added video after the fact. Zoom was video-first from day one and built for the cloud. As we said above, Zoom is the only video conferencing platform that does not demand its users are within its ecosystem in order to use it. Giant competitors like Facebook and Google may have the capital to subsidize users in order to grow usage, for example, or develop innovative solutions, as Google Meets has done in creating a 16-person grid for meetings, but their models are predicated on remaining within their ecosystem and this limits scalability. Hamilton Helmer discusses counter-positioning in his book, 7 Powers: The Foundations of Business Strategy, saying:

“The barrier for Counter-Positioning seems a bit mysterious: how could a powerhouse (such as Fidelity Investments in this case) allow itself to be persistently humbled by an upstart over such an extended period? Couldn’t they foresee the potential success of Vanguard’s model? Frequently in such situations, naïve onlookers castigate the incumbent for lack of vision, or even just poor management. Often, too, they level this accusation at companies with prior plaudits for business acumen. In many cases, this view is unjust and misleading. The incumbent’s failure to respond, more often than not, results from thoughtful calculation. They observe the upstart’s new model, and ask, “Am I better off staying the course, or adopting the new model?” Counter-Positioning applies to the subset of cases in which the expected damage to the existing business elicits a “no” answer from the incumbent. The Barrier, simply put, is collateral damage. In the Vanguard case, Fidelity looked at their highly attractive active management franchise and concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products.”

Ben Thompson posits another reason for why Zoom’s rivals have been vulnerable:

“The challenge for incumbents, including Microsoft and also other competitors like Citrix, Cisco, etc., is that years of building their business on leveraging their existing relationships with enterprises left them vulnerable to a company like Zoom singularly focused on delivering a superior product, at least once a SaaS architecture made distribution so much easier. Make no mistake, enterprise software still requires a sales force, but it is far easier to start with customers that have already discovered and tried the product on their own than it is to sell something without any sort of pre-existing relationship.”

So whatever the actions of its rivals, Zoom’s competitive advantage is durable. It has the ability to defend its profitability. In an earlier post I defined what Warren Buffett calls as “moat” as:

“the set of competitive advantages that support economic earnings, defying the tendency of ROIC to sink below the cost of capital in a process of mean reversion.”

Based on the above, I think we can say that Zoom has a moat. Readers who want to explore this further should read what I think is the best book on investing through capital cycles, Edward Chancellor’s book, Capital Returns, a compilation of reports written by Marathon Asset Management’s portfolio managers.

Financials

I used New Constructs’ platform to arrive at the following analysis. Zoom is a near-perfect growth story. It earned economic profits of $3.14 million in the 2018 fiscal year, $3.46 million in 2019, $10.43 million in 2020 and $423.39 million for the twelve trailing months (TTM).  

During that time, operating revenues swelled from $151.48 million to $1.96 billion, doubling in every year of the last four years. Gross margins have bounced around a tight band of between 79.68% and 81.54%.

This beautiful balance of revenue growth and profitability is not the love child of the global pandemic, rather, it predates it, and that really makes this company special.

Free cash flows were negative until the the TTM period: -$19.37 million in 2019; -$37.16 million in 2020; and $641.42 million for the TTM period. Yuang and his team have been exceptional capital allocators. Zoom has a “ROI-focused business model” and the results of their capital allocation decisions can be seen in their consistently rising returns on invested capital (ROIC): 9.4% in 2018; 10.2% in 2019; 13.6% in 2020; and 2,122% for the TTM period. Investors can be assured that the company will create value for shareholders. Negative free cash flows prior to the TTM period are, to my mind, are a reflection of investments made to grow the company, rather than of a fundamental flaw in the business model. In all that time, Zoom has always generated returns above its cost of capital.

Free cash flow yield was -0.2% for both 2019 and 2020; and is 0.6% for the TTM period. One wants to buy growing free cash at an attractive price and at 0.6%, Zoom’s free cash is not attractive, which is not to say it is unattractive. In this climate, free cash flow yields would have to rise to 3% before one could consider them attractive.

Limited Margin of Safety

As we said above, in discussing forecasts, the future is not a straight line from today. Assuming stable margins in a high growth business strikes me as foolishness. This is not to suggest that revenue growth will slow down or collapse or that margins will fall, it is to say, “nobody knows”. If we catastrophize Zoom’s results, the company still looks good if gross margins are halved, and revenue growth continues to double or falls to something like 50% a year. So an investor buying now has a margin of safety in a world where revenue growth is maintained and margins hold; or where margins plunge and maybe even revenues. The investment is protected in the near-term either way. Preservation of capital is the most important thing. It seems obvious to me that the business can earn a good return on invested capital even if we dismiss the TTM ROIC as an absurdity born out of a once-in-a-century crisis. I am happy to take 15% ROIC, which. The quality of the business is such that it can survive an assault on its profitability and continue to earn economic profits for its shareholders.

Here’s the rub! Everything but the price is perfect. Zoom has a price-to-economic-book-value (PEBV) of 10.3, versus a PEBV of 3.2 for Invesco QQQ, an ETF that tracks the Nasdaq-100 Index, or a PEBV of 3.2 for the S&P 500. The share price of $373.01 implies that the company will grow revenues at 6.3% a year for more 100 years, all the while earning an economic profit margin of 606%. The PEBV and the growth appreciation period are the point at which Zoom becomes very unattractive.