Zoom’s positioning, future
As I’m writing this, Zoom’s stock price sits at $431, for a market cap of $125 billion. According to the Bessemer Emerging Cloud Index, they have an Enterprise Value/Forward 12 Months Revenue ratio of 35x. That’s a really high multiple! The average for the BVP Emerging Cloud Index is 19.1x EV/Forward Revenue, and that’s already the multiple for a basket of the hottest, fastest growing tech companies. Why is Zoom valued at such a high, historically unsupportable multiple of their forward revenue? If you look at the numbers in a vacuum, the 35x revenue multiple actually seems like a significant bargain. In Q3, they posted remarkable year-over-year growth of 367%, a completely unprecedented number for a company at Zoom’s size. That’s almost 10x the average revenue growth rate for BVP Emerging Cloud companies. And they’re doing that with an also-incredible 33% free cash flow margin, more than 4x the Emerging Cloud average.
So Zoom is growing at an unprecedented pace and doing so while generating incredible cash flows. What’s the problem here? It looks like a really attractive business.
When you consider the context of Zoom’s last year of operations, the picture doesn’t look nearly as attractive. The entire world was constrained to their houses and essentially every school and every business in the country became remote-only. Everyone from kindergarten students to grandparents had to go home and learn how to use this thing called Zoom, and then use it again, day after day, as their primary connection to the outside world. In that context, the fact that Zoom hasn’t been able to capture more value from their users is a bit surprising. The consensus among Wall Street analysts is that Zoom’s 2022 revenue is going to increase about 78% YoY. It’s hard to imagine, assuming the vaccines work and the rollout is effective, that Zoom will be used more in 2022 than it is being used today. I’m sure (or at least I hope) they’ll figure out how to capture more of the tremendous value that they’ve been creating for quarantiners around the world, but the use cases are going to dwindle a lot faster than these projections seem to suggest. Even a significant increase in ARPU (Average Revenue Per User) is unlikely to offset the impending attrition from a partial return to the physical world. The future of remote/hybrid work is interesting, but it doesn’t compare to the widespread adoption that we’ve seen during the pandemic. If I were working at Zoom, I’d be really worried about what happens when the pandemic ends and the triple-digit growth turns to a struggle to avoid customer churn en masse.
Zoom’s valuation suggests a tremendous future of continued growth and increasing value capture. Market sentiment has gotten more than a little wild and risks have almost completely been ignored in favor of starry-eyed projections (electric vehicle SPACs, anyone?) but it’s still tough to pretend that any reasonable assumptions could push a discounted cash flow model of Zoom’s future business to spit out an equity value above $100 billion.
So what do you do when you have incredibly expensive equity and a core business that is unlikely to produce the cash to support current valuations? The answer has to be something and I imagine that Eric Yuan spends a not-insignificant amount of time hearing pitches about strategic alternatives and capital allocation strategies. I’d like to suggest one company that, in my opinion, is better positioned in the future of video over the internet than Zoom. They’re downright cheap relative to Zoom’s valuation - Chinese audio/video API company Agora, Inc.
The future of audio/video and remote work
If you picture a future in which everyone sits in their homes and logs onto Zoom for each of their work calls/classes, you can probably stop reading here, because the stock to own is Zoom. In that case, Zoom should be doubling down and implementing share repurchases because Zoom will be a trillion dollar company and the best possible capital allocation decision here is more Zoom. *Note: I just finished reading The Outsiders, a book about CEOs who were exceptional capital allocators with a penchant for buying back their own stock when it was undervalued, and I’m kind of in a buyback mood. This is probably not actually a very good idea for Zoom, regardless of their future prospects. They should use that money for iterating and investing in infrastructure and stuff - I’m sure they have some available projects with crazy IRRs at this growth rate*
I believe that the future is undoubtedly much more remote than the pre-Covid era, even as some professions return to work and others find a hybrid balance. I also see the rise of remote school as a virtual inevitability - not because remote school is so great, it’s not yet, but because it goes hand-in-hand with the rise of remote work. In a world of remote work and distributed workforces, one of the biggest perks for an employee at a remote-first company is the freedom to live anywhere. In a world in which jobs no longer offer geographic constraints, many parents won’t want to be tied down to the location of their kids’ schools. If the only alternative was the current form of remote school, parents would face a difficult trade off between additional freedom and education quality.
Luckily for parents, there is a huge movement of edtech (education technology) that is going to help fill the void of quality remote education. Just like superior remote work tools will ultimately be built, edtech startups will disrupt the current education model and create a remote-first education that rivals the experience in a physical classroom. In fact, remote-first schools have the potential to create significantly better experiences by leveraging “superstar” teachers. In a world where education is occurring almost entirely over video, there’s no reason why lessons can’t be taught by the best teachers in the world, with local teachers/tutors available to answer students’ questions. Joint consumption technologies in edtech will amplify superstar teachers the same way that the record player and music streaming amplified superstar artists and exponentially grew their earning potential. When the tools and platforms are built to allow 10x teachers to leverage their incredible lectures and reach massive audiences, those incredible teachers will unlock new, more appropriate levels of compensation and students around the country and the world will gain access to the incredible resources that is an extraordinary teacher.
On these education-disrupting platforms, students and their teachers won’t leave to go join a Zoom classroom. There’s nothing special about the Zoom experience (as it exists today) for the education vertical. It’s a nascent platform that was in its early innings and catering primarily to early adopters of remote work before the pandemic forced the world into hastily adopted solutions for an unprecedented crisis. Zoom can and likely will build more features on top of their platform to become more attractive to massive verticals like remote education in the future. Still, they might have a tough time competing with platforms whose primary focus is education, especially with the proliferation of video APIs and commoditization of audio/VoIP experiences. These platforms will include built-in video solutions so that students and teachers never need to leave the platform to join their classes. It’s a clear part of the vision of remote classrooms that the video experience needs to be better integrated into the virtual classroom. Edtech startups aren’t going to build their own video software - it’s not a differentiator in that market.
***A quick, important note on APIs***
In the modern API economy, companies don’t build their own software for every piece of functionality that they need. It wouldn’t make sense for every startup that uses video chat to build their own video solution. What they do is incorporate a third-party API (Application Programming Interface) into their businesses. Modern companies are able to focus on the two or three things that differentiate their business, plugging in best-in-class solutions in the form of APIs everywhere else.
Nobody at Doordash or Uber wakes up every morning and thinks about how they can improve the experience of sending messages to customers. If they tried to build their own solutions for sending messages to customers when their food/drivers arrived, they would be unlikely to produce best-in-class solutions. Lucky for them, everyone at Twilio wakes up every morning thinking about how to improve the experience of sending messages to customers. All Doordash/Uber/whoever has to do is write a few lines of code to incorporate the Twilio API and Twilio is able to consistently push updates to their software that improve the experience of a Doordash/Uber customer in real time. Doordash/Uber get a best-in-class solution to messaging and Twilio earns revenue based on the number of times that their API is accessed by Doordash/Uber’s software. By accessing a third-party API, you get to take advantage of both the focus and the scale of the vendors. Twilio is able to develop great messaging software because they focus on messaging every day and they do messaging at a large enough scale that they can make investments and generate insights that Doordash could never make themselves into such a relatively small part of their food delivery business.
Tech companies use APIs in the same way that a car manufacturer buys tires from one supplier and speedometers from another and steering wheels from a third, each of which has deep expertise in their manufacturing niche. The API economy is the modern, tech version of that set of manufacturers. Twilio CEO Jeff Lawson refers to the stack of APIs available as a “supply chain for building software.”
***
Remote school will be done on education platforms that include video, not video platforms being awkwardly adapted for education. I’m using edtech as the example of technology that will grow to support the remote-first environment but the same thing is coming to professional environments. I find the edtech disruption easier to explain than remote workplace software, but the playbook will be similar for remote work startups.
Because video isn’t a differentiator in edtech or in other remote-first solutions, the edtech startups that pioneer remote education won’t build their own solutions. But they likely won’t use the Zoom platform as it currently exists, either. These education platforms will incorporate APIs. The “industry standard” API for incorporating audio/video into a startup today is a Chinese company called Agora, fittingly trading under the ticker API.
Agora (NASDAQ: API)*
I started talking about Agora around Christmas of 2020 as a potential Zoom acquisition target (by talking about it, I really mean annoying my family by repeatedly trying to explain, basically, what I’ve written here.) At that point, Agora traded around $40/share for about a $4 billion market cap. That’s a tiny fraction of Zoom’s size - about 1/30th. Since then, the rise of social audio startup Clubhouse (now valued at $1B after their recent raise from a16z) sent Agora’s stock soaring. Clubhouse, like pretty much every hot startup being built these days, uses Agora’s API for their audio experience. I was actually pretty surprised that Clubhouse didn’t build this one in-house - I would’ve expected audio to be a differentiator for a social audio startup, but I suppose that either Agora’s tech is so good that Clubhouse couldn’t beat it or they’re solely focused on the social aspect of the platform. The Clubhouse founders are serial social entrepreneurs, so I suppose that’s their true focus. The rise and potential of Clubhouse represents a huge potential revenue stream for Agora, but it also hints at the massive potential of a company that is focused on enabling all types of platforms to incorporate a best-in-class audio/video solution. Clubhouse is far from the last unicorn that will use Agora’s API to enable quality audio/video experiences and strip verticals away from the Zoom user base, cutting into the use cases for the Zoom platform.
The rise in Agora’s valuation makes this a bit less of a no-brainer deal for Zoom, but the relative valuation is still way too low for Agora to represent anything but a slam dunk of an accretive acquisition from a long-term perspective. As of this writing, Agora’s market cap is $9.55B, and their last 10-Q didn’t show any debt so their enterprise value should be ~$9 billion (subtracting $600m in cash from equity value, for a quick back-of-the-napkin calculation.) Acquiring Agora would cost about 10% of Zoom’s enterprise value (including acquisition premium) for a company that I believe is both more than 10% likely to present an existential threat and possessing a greater potential for future cash flows. That’s the type of deal Zoom’s newly-hired corporate development team has to be modeling with more than a little curiosity.
Why Zoom needs Agora
{Why can’t Zoom just build their own API and compete with Agora? They’re a huge company solely focused on audio/video - surely they can outcompete their smaller Chinese competitor.}
In a pre-Covid world, Zoom was a well-run, hot tech company with a bright future toward which they were methodically building. The remote world was coming - maybe a decade or two down the line, it might begin to gain widespread adoption. Early adopters were using the product and it looked promising, with a market that had massive growth potential as technology continued to improve and remote work gained cultural acceptance. Then an unprecedented pandemic hit, and the S-curve of technology adoption in remote work tools turned into more of a J-curve, with everyone adopting the nascent technology at the same time. While Zoom showed absolutely ridiculous growth in 2020, this insane, rapid adoption hurt them in a few ways. First, because the product is still early and still of a quality where it is mostly fitting for early adopters, the tech just wasn’t ready to “cross the chasm” and gain widespread acceptance. People everywhere are getting tired of Zoom calls (“Zoom fatigue”) and the collective mental image of Zoom is not as much of an incredible, breakthrough technology that is enabling work-from-home as it is a laundry list of complaints and a direct association with the greatest catastrophe of the early 21st century. As unfair as it may be to see people everywhere criticizing a technology that is both impressive and innovative, it’s hard to change perceptions and the perception of remote work and Zoom in their current form is not stellar. Second, Zoom’s infrastructure was in no way prepared for the 10+ sigma event that has been its rise to complete cultural dominance in 2020. Instead of continuing to iterate and improve the product methodically and slightly ahead of its competitors, Zoom was forced to focus the entirety of their attention on infrastructure and security concerns that have been brought about by the proliferation of remote work. While Zoom struggles to keep up with demand (as any company growing this quickly would), and sees the occasional mishap along the way, other internet audio/video companies are able to build superior products and focus on marketing to verticals that will still exist as a customer base post-pandemic, or to focus on widespread adoption in other platforms through APIs, like Agora. My understanding is that Zoom actually does have an API available - it’s just that startups aren’t plugging into the Zoom API. Zoom spent so much time trying to keep up with a once-in-a-generation influx of users that they missed out on the true long-term opportunity in audio/video solutions. An Agora acquisition would hedge against the future scenario in which video experiences are distributed across platforms (inevitable, in my opinion) and it would acquire a team that has proven they can focus on improving the audio/video experience while Zoom tries to catch up on the infrastructure/privacy side. One great thing about an uncontrollably surging stock price is that you get to go out and make great strategic acquisitions with minimal dilution for existing shareholders that allow you to grow into the company the market expects to see.
Today, the market has decided that Zoom is an order of magnitude more valuable than Agora. If anything, I would argue that the opportunity for Agora, as the leader in video APIs, is an order of magnitude larger than the opportunity for Zoom as a leading video platform. Plus, Agora’s business model is simpler and more obvious in the long run. They can profit through a SaaS API transaction-based model (earning revenue each time their API is used) as opposed to Zoom’s “pay us a subscription fee and you can hold longer meetings or whatever” revenue model. I’d love to see Zoom make a play for the real future of audio/video over the internet so they can continue something resembling their stratospheric growth post-Covid.
I’m wholly unqualified to speak to the potential CFIUS risks of this transaction but I feel confident that it would be OK from an antitrust perspective with Microsoft Teams and Vimeo both owning substantial positions in the market.
*For full disclosure, I have a small position in Agora
Resources for further exploration:
BVP Emerging Cloud Index (Really cool resource for comparing basic data on the most interesting software companies in the public markets)
If you’d like to learn more about APIs and the API economy, check out:
Packy Mccormick’s Not Boring post about APIs
a16z’s fantastic interview with Twilio CEO Jeff Lawson (I can’t recommend this enough. At least the first few paragraphs/minutes. Comes in both article and podcast form)