Video conferencing software provider Zoom (ZM -5.03%) is grappling with a severe slowdown in growth. The pandemic forced businesses to go remote, and Zoom's easy-to-use software became the default choice to connect employees. This led to incredible revenue growth and massive profits, but the bonanza is very clearly over as the pandemic drags on.
Zoom's revenue grew by just 8% year over year in the second quarter. What's worse, profits plunged. GAAP net income fell 86%, and adjusted net income dropped 22%. Adjusted free cash flow, where Zoom adds back some litigation settlement payments, was cut in half from the prior-year period.
A cash machine, but only if you don't look too closely
A bullish argument for Zoom goes as follows: Even though growth has slowed down and profitability is contracting, the company still generates a ton of cash. That adjusted free cash flow number was $222.1 million in the second quarter, or about 20% of revenue.
Here's the problem: If you back out stock-based compensation from Zoom's adjusted free cash flow, it turns negative in the second quarter. Stock-based comp is not a cash expense, but it is a real expense. If Zoom stopped doling out equity awards, it would need to pay its employees more cash to retain them.
As Warren Buffett said back in 1992:
If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?
If you take Zoom's reported free cash flow at face value, the stock doesn't look all that expensive. With a market cap of $25.5 billion and annualized free cash flow somewhere around $900 million, we're talking about a price-to-free cash flow ratio in the vicinity of 30. That's certainly not egregious.
But if you back out stock-based compensation, you can no longer calculate that valuation metric because free cash flow is negative. Adjusted net income has the same problem as reported free cash flow in that it treats stock-based compensation as something to be ignored. If you take Zoom's GAAP net income from the second quarter, which to be fair does include some other one-time items, you're looking at a price-to-earnings ratio well over 100.
Not a good story
A lot of software-as-a-service companies are unprofitable but growing fast. The story they tell usually involves profits eventually being delivered as they continue to scale up. That's an appealing story. Investors can say things like: "Well, if XYZ keeps growing at 30% and reaches a 20% free cash flow margin in 10 years, the current price is certainly justified."
With Zoom, the situation is reversed. The company already reached impressive levels of profitability during the pandemic. Now growth is slowing, and profitability is contracting. There's more competition, and companies can take their time before deciding on video conferencing providers. Sales cycles are getting longer, which means higher costs for Zoom as it works to close deals.
Slow growth plus no real reason to believe that profit margins will ever bounce back to their pandemic peaks is just not a good story. You look 10 years in the future and see a Zoom that's modestly larger with worse margins. That's a hard sell.
If Zoom can somehow come up with a second act that restarts the growth and profit engine, the stock would be a lot more appealing. But as it stands, Zoom stock just doesn't look like a very good deal.
Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zoom Video Communications. The Motley Fool has a disclosure policy.
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August 28, 2022 at 12:31AM
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Zoom's Real Free Cash Flow Just Turned Negative - The Motley Fool
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