Zoom's well-documented fall from grace has left the once high-flying pandemic darling trading at terminal multiples of ~10x forward EV/FCF.
While Zoom is facing intense competition from deep-pocketed rivals, particularly from Microsoft, I think ZM is undergoing a temporary period of digestion in a post-COVID normalization.
Despite tepid growth in Q2 FY2024, Zoom is a robust free cash flow machine, and it looks all set for a growth re-acceleration in the near- to medium-term future.
Introduction
Investing is a marathon, not a 100-meter sprint; however, most individuals fail to realize this simple mantra and end up chasing "the shiniest object" or "the next big thing" at ridiculous valuations. And once the hype fades, these darling stocks get brutally discarded regardless of long-term business fundamentals. Due to such investor psych, many great businesses have seen their stocks go through boom and bust cycles, with massive stock rallies being followed by long periods of underperformance. And in my view, Zoom Video Communications ( ZM ) is a great example.
On the back of hyperbolic revenue growth during the COVID-19 pandemic, Zoom turned into a pandemic darling on Wall Street, with ZM stock rising from ~$60 to ~$594 (nearly 10x) in a matter of months. However, a subsequent collapse in revenue growth rates has driven an incredible plunge in ZM stock, which is now trading lower than pre-pandemic levels.
YCharts
YCharts
While intense competition from the likes of Microsoft ( MSFT ) is a valid concern, I think Zoom is a victim of its own success. The pull forward in demand for remote work solutions in 2020-21 saw Zoom capture a big chunk of its TAM, and it is now undergoing a period of digestion in a post-COVID normalization.
Despite the enterprise video meeting solutions market seems saturated, with Microsoft Teams and Zoom emerging as a duopoly. While Zoom is finding growth hard to come by in the post-pandemic world, the business is a robust free cash flow machine that is likely to generate $1.5-1.8B over the next twelve months. As of today, Mr. Market is pricing Zoom at terminal multiples (forward 12-month EV/FCF: ~10x) due to its tepid growth. However, I believe that a growth re-acceleration at Zoom can easily drive an upward re-rating of ZM stock over the next 12-36 months.
In the subsequent analysis, we will dig into Zoom's Q2 FY2024 earnings report, and then re-valuate Zoom stock using TQI's Valuation Model to make an informed investment decision.
Analyzing Zoom's Q2 FY-2024 Report
In Q2 FY2024, Zoom's total revenue grew ~4% y/y to $1.139B, beating consensus analyst estimates as well as the high end of the management's guidance by ~$24M. This outperformance stemmed from the "Enterprise" segment, which grew by 10% y/y on the back of new customer acquisition (enterprise customer count: 218K, +7% y/y) and higher spending from existing customers (net retention rate for enterprise customers: 109%).
Zoom Q2 FY2024 Investor presentation
Zoom Q2 FY2024 Investor presentation
While Zoom's Enterprise segment is also seeing a sharp deceleration in growth, it is still growing at a healthy clip. During Q2, Zoom's revenue mix continued to move toward the Enterprise segment, which now makes up ~58% of total revenue (up from 54% a year ago). The decline in Zoom's self-serve "Online" segment is well-documented at this stage; however, the average monthly churn of 3.2% is back to pre-pandemic levels as of H1 FY2024, and I think are about to see stabilization (and then positive growth) from this business segment within the next 4-8 quarters.
From a geographical standpoint, Zoom experienced +6% y/y growth in its primary market - the Americas; however, the remote-work software company registered negative growth rates in both EMEA [-1% y/y] and APAC [-3% y/y] markets due to a poor macroeconomic environment in these regions.
Zoom Q2 FY2024 Investor presentation
According to Zoom's CFO, Kelly Steckelberg, revenues in both EMEA and APAC markets would have been approximately flat y/y in the absence of adverse currency impact. And that is somewhat of a saving grace in my view.
While Zoom's top-line performance is nothing to write home about, I see the company making tremendous progress on the profitability front. In Q2, Zoom made solid improvements across various expense categories, boosting its margin profile.
During Q2, Zoom's non-GAAP gross margin improved by +144 bps to 80.3% [from last year's 78.9%], driven by ongoing optimization of its cloud and data center operations. For the full year FY2024, the company anticipates a non-GAAP gross margin of approximately 79.7%. This figure marks a slight moderation from current levels, and management attributed this potential weakness to strategic investments in AI technologies.
Zoom Q2 FY2024 Investor presentation
In addition to higher gross margins, a moderation in operating expenses (as a %age of revenue) is boosting Zoom's operating profits and free cash flow. In Q2, Zoom's non-GAAP Sales and Marketing (S&M) expenses declined by 3% y/y to $276M, representing 24.2% (-176 bps y/y) of total revenue. Further, Zoom's General and Administrative (G&A) expenses fell by 179 bps as a %age of revenue over last year, owing to operational efficiency gains and certain one-time savings.
While S&M and G&A expenses are going down, Zoom's management is increasing their spending on Research and Development (R&D) as they attempt to broaden Zoom's product suite, especially in the realms of Zoom Contact Center and AI. In Q2, Zoom's R&D expenses rose by +6% Y/Y to around $104 million, representing ~9.1% of total revenues (up +25bps from last year).
In an effort to boost growth, Zoom tried to acquire Five9 ( FIVN ) in 2021, but that deal collapsed soon after. Since then, Zoom has pivoted to building a contact center platform in-house, and I think Zoom Contact Center has the potential to drive the next leg of growth at the company. During the Q2 earnings call, Zoom's leadership shared some exciting customer wins for Zoom Contact Center, which has now surpassed 500 customers in just 6 quarters.
In Q2, Zoom Phone reached roughly $500 million in annualized run rate revenue and it continues to grow rapidly. In my view, Zoom Contact Center can replicate this success, and eventually emerge as a significant growth driver for Zoom's business.
Zoom is a best-in-class platform for hybrid work; however, Microsoft is a tough competitor due to its bundling power. And competition is probably the biggest bear thesis for Zoom at this point. With Microsoft offering Teams for free as a part of its Office 365 suite, Zoom has an uphill task to retain customers. However, according to Zoom's CEO, Eric Yuan, AI innovations like Zoom Scheduler and Zoom Clips continue to improve the already-rich value proposition for Zoom's platform.
Here's what Yuan said on the subject of generative AI monetization:
Zoom still growing revenue is a testament to its platform's robust value proposition, and I think it is only a matter of time before this business re-accelerates. Delivering greater customer value by offering AI innovations at no additional cost is bad for margins; however, I think it will drastically improve customer satisfaction and eventually boost retention rates.
Zoom Q2 FY2024 Investor presentation
Now, as of Q2, Zoom's RPO stood at $3.5B (up 9% y/y), with deferred revenue declining marginally (~2% y/y), and unbilled revenue under contract rising 18% y/y. Deferred revenues of $1.37B were in line with the upper end of management expectations from Q1; however, the Q3 guidance points to an anticipated decline in deferred revenue of 4 to 5% y/y. During the earnings call, management ascribed this weakness to shorter contracts on Enterprise deals, which is a direct result of ongoing macroeconomic uncertainties.
What Is The Future Outlook For Zoom?
For Q3, Zoom management guided for 1% y/y growth in revenue and flat EPS. While these numbers are undoubtedly tepid, they are pretty much in line with expectations. Amid a tough macro environment, Zoom is set to struggle for growth in the second half of FY2024.
Zoom Q2 FY2024 Investor presentation
The near-term business outlook for Zoom remains uncertain, and a potential growth re-acceleration is far from guaranteed. Only time will tell if the Zoom growth story has another chapter or two; however, investors can remain rest assured that Zoom is likely to remain a free cash flow-producing machine for several years to come.
Zoom Q2 FY2024 Investor presentation
In Q2, Zoom generated ~$289M (up 26% y/y) in free cash flow, growing its cash balance to $6B. And as we know, Zoom currently has little to no debt. With a massive net cash cushion, Zoom has a robust liquidity position.
In light of Q2 FY2024 earnings, Zoom's re-acceleration story is looking cloudy despite strong growth of non-core offerings like Zoom Phone and Zoom Contact Center. Historically, Zoom has preferred to build while choosing between "build vs. buy"; however, I firmly believe that at some point, Zoom's management will utilize this $6B cash cushion for M&A activity to boost sales growth, i.e., re-accelerate the business. As I see it, Zoom shareholders may need to exercise patience for a few more quarters and allow Eric Yuan and Co. to find the next leg of growth for Zoom. The Q2 report was somewhat mixed, but there are ample reasons to hold ZM stock patiently.
Let us now re-evaluate Zoom using TQI's Valuation Model.
Zoom's Fair Value And Expected Returns:
According to our latest valuation model, Zoom's intrinsic value stands at $74.69 per share (or $23B in market cap). All assumptions used in this model are shared below:
TQI Valuation Model (TQIG.org)
Assuming a conservative exit multiple of ~20x P/FCF, I see Zoom's stock rising from ~$72 to ~$170 by 2028-29. And this 5-year price target implies a CAGR return of ~19% from current levels.
TQI Valuation Model (TQIG.org)
Considering our investment hurdle rate of 15%, I think Zoom's long-term risk/reward is still quite attractive. Hence, I rate Zoom stock a buy at $71.72 per share.
Bottom Line: Is Zoom Stock A Buy, Sell, Or Hold?
With a net cash of ~$19 per share or ~$6B (~26% of its market value) and an annual FCF generation capacity of ~$1.5-2B per year, Zoom has very little downside risk from current levels. Trading at ~10x forward EV/FCF, Zoom is an absolute bargain, and I feel comfortable holding Zoom here, giving management more time to find that next leg of growth for the company.
A re-acceleration in sales growth is not guaranteed; however, Zoom's leadership has ample resources to drive growth organically and in-organically. In my view, it is only a matter of time before Zoom's revenue growth re-accelerates, and the stock gets re-rated higher.
The stock market is a device for transferring money from the impatient to the patient.
- Warren Buffett, CEO at Berkshire Hathaway
Patience is key to successful long-term investing. Despite Zoom experiencing tremendous fluctuations in market value over recent years, I am putting my faith in the company's strong fundamentals and astute leadership team to drive a redemption arc over the long term.
Key Takeaway: I rate Zoom stock a "Buy" in the low $70s.
Thanks for reading, and happy investing! Please share your thoughts, questions, and/or concerns in the comments section below.
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2024-07-24 05:35:00 ET A lot has changed for Zoom Video Communications (NASDAQ: ZM) since its explosive pandemic-era growth. Even as remote work and video conferencing remain critical for businesses globally, disappointing trends from the cloud-based collaboration platform have been...
2024-07-20 07:00:00 ET Shares of enterprise software company Zoom Video Communications (NASDAQ: ZM) are down 90% from their all-time highs. The shares continued falling during the past year, declining 19% -- a stark contrast to the S&P 500 's 24% gain in that same time frame...
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