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Zoom-Five9 Merger, Can Zoom's Valuation Break Higher?

Matthew Chapter 19 verse 14 states, "Jesus said, Let the little children come to me, and do not hinder them, for the kingdom of heaven belongs to such as these."


As a parent, I often watch my son and all that he does as he grows mentally, physically, and spiritually every day. It is always fun to watch how unaffected he is when it comes to having fun and what anyone else thinks. The simple aspect of having fun, and not being concerned with what others think is a direct connection to how my belief and faith in Jesus Christ is supposed to be. Being bold, unshaken, seeking advice and instruction, guidance and correction, are all important qualities to remain throughout one's life.


For investing, it's always important to continue to focus on the fundamentals, and structures of company analysis, especially as it relates to investment opportunities. In essence, there are always key items that remain with respect to valuation and the connection with managing investment returns.


By now anyone with an interest on Zoom Video Communications (ZM) is aware of the announced acquisition of Five9, Inc. (FIVN). But the remaining questions I have are, 1) does this appease recent growth concerns for Zoom from a competitive perspective, and 2) does this increase Zoom's growth over the mid-term enough justifying the valuation and corresponding investment opportunity?


What I'd like to do upfront here is take a moment to highlight a couple scenarios that I've developed. First, I've included a scenario where Zoom's forecast is simply combined with Five9's. Second, I've included a scenario where the combined companies realize greater synergies leading to a higher forecast. I will also show my baseline scenario where I was modeling Zoom prior to the announced deal.


Baseline Scenario



Prior to the deal announcement, I was modeling Zoom to generate just over $9.1 billion in Revenue over the mid-term, while maintaining a nearly 50% Operating Cash Flow, OCF, margin. I feel that this baseline scenario is fairly robust and actually more aggressive than what many Wallstreet analysts were looking for. That being said, the issue I've had with Zoom based on this forecast is that the company needs to be valued a 25 and 55 times EV/Revenue and OCF/share respectively, justify a Stock Price, SP towards $610.


Zoom used to be a top ten holding within the portfolio, but I sold the entire position around $325 per share. Soon after, I decided to rebuild a smaller position buying back in at $303. Assuming the company's trajectory prior to the deal announcement, I would have been looking for a pull-back towards $300 or lower from the current $359/share, to accumulate, as over the mid-term, I was expecting an annualized return of 15% per this scenario and SP near $300. Without any pull-back after my re-initiation, I've simply continued to hold the much smaller position, waiting for stronger growth and/or a changed SP to find a better investment opportunity. As of the current SP, this scenario only assumed an annualized return potential at 11.5%.


Combined No Synergies Scenario



Let me just caveat that the combined no synergies scenario is primarily for illustration purposes to help create transparency and deconstruct the fundamentals. If both companies were assuming no synergies, then it would be a highly questionable move to merge. Regardless, I feel that a similar valuation multiple for the mid-term, 25 and 55 times EV/Revenue and OCF/share is going to need to be maintained. As such, the key takeaway here is that the addition of Five9 simply from the sum of the parts will improve both the combined company's Revenue and OCF/share, despite a lowered OCF margin. This does improve the investment opportunity, but it's still a little low of a trajectory from where I like to have an individual holding.


Combined Synergy Scenario



The combined synergy scenario is predicated on not only both companies seeing sustained financial performance through the combination, but also witnessing increasing synergies leading to further increases in Revenue and corresponding performance. I feel that this scenario is still fairly conservative from a post-merger perspective so it reflects a pretty good aggressive option. In this scenario, Zoom is projected to achieve an estimated $11.7 billion in Revenue over the mid-term, translating to $5.5 billion in OCF. Using similar valuation multiples, the SP is poised to grow towards $805 per share.


For this scenario, I would be comfortable considering accumulating Zoom towards $325-335 per share. At a unit cost of $303, the annualized potential return stands north of 21%. Accumulating towards $335 or lower would still generate an independent 19% or higher potential annualized return, and an ability to still possibly see 20% or so.


Valuation


Valuation is the name of the game. But I obviously cannot predict it perfectly by any means. Right now, Zoom is trading 31 and 60 times EV/Revenue and OCF/share respectively. The combined synergy scenario is essentially assuming that Zoom would modestly grow into a lower EV/Revenue multiple, while remaining fairly flat with respect to OCF/share.


I think there's two major things to think about here. First, it's clear that Wallstreet has been turning more negative on Zoom coming out of the pandemic. Investors need to recall that for Zoom's Fiscal Year 2022, and during the back-half of 2020, Wallstreet was reducing Price Targets, PTs, justifying it based on slowing growth. From Zoom's SP peak in mid-October 2020 at $588 intraday, the SP proceeded to drop by 42% to less than $340 by late-December 2020 as a result. During this time, Wallstreet PTs for Zoom's Revenue, were much lower on average than today's $4 billion. During 2021, Wallstreet's been playing catchup. I'm not trying to take credit, but my Revenue estimates have been pretty stable throughout all of 2020 at $4 billion or so.


Investors also need to consider in a post-merger world, to what degree will Wallstreet increase expectations, and how does this compare to their original mid-term thinking. It is to this point that I feel that my mid-term baseline of $9.1 billion in Revenue was higher than what Wallstreet was thinking, especially as the transition from 2020 into 2021 is shaping up to be much more robust. I see a similar theme playing out over the mid-term.


The second consideration relates to the logic behind valuing Zoom. To this point, I see some risk related to OCF margin contraction. That being said, I feel that Zoom has a strong chance to see OCF margin bottoming towards 30-35%. I also think there's a chance that margins remain very robust as the company continues to scale. It's a question of customer service and contract growth. Before the pandemic, Zoom was trading 33 and 140 times EV/Revenue and OCF/share, with a 24% OCF margin and just less than $625 million in Revenue.


Moving forward, I will continue to prioritize the Cash Flow multiple as it is the core driver for a return on any investment. Assuming that Zoom is able to scale towards $12 billion over the mid-term post-merger, and I feel that an OCF/share multiple at 50-75 times is justifiable. This type of Revenue growth performance would equate to annualized performance of 35% and 27% respectively for fiscal year 2021 and 2022 Revenues of $2.7 billion and $4.6 billion (post-merger estimate).


Conclusion


When the announcement was made by Zoom and Five9, to be honest my reaction was on the nervous side. But after revisiting my financial models and taking a deeper look at Five9, it appears that this deal has the potential to improve Zoom's competitive position. The future opportunity in the unified communications market is a great fit for the inclusion of Five9's omni channel contact center focus.



From a growth perspective over the mid-term, and short-term, Zoom sits atop the competitive landscape. RingCentral's (RNG) reaction was very negative initially, but has recovered all that was lost over a matter of days, but the reaction clearly is indicative of Zoom's move being perceived positively. For what it's worth, many Wallstreet reactions were also positive.


Based on my assessment, I think that this deal has improved Zoom's investment return potential. That being said, I'm in no hurry to rush and add to the position, as Zoom will still need to command a strong premium. As such, I will take a more measured stance on trading activity, however, I may begin buying in the event it drops back below the $340 level. My goal will be to timely build the position opportunistically towards a unit cost average of $325 per share.


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