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Motley Fool Issues Rare “All In” Buy Alert
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Investors went head over heels for Zoom Video Communications (ZM 1.64%) during the early phases of the COVID-19 pandemic. Rapid revenue growth and work-from-home mandates gave investors reasons to be uber-bullish about the company’s prospects. But now, with social-distancing efforts largely coming to an end and with Zoom experiencing high churn rates, investors have turned bearish on the stock. As of this writing, shares are down 67% over the past year.
But it’s not just the relaxing of peoples’ pandemic behaviors that has the company in a tough position. Zoom Video has an underappreciated problem on its hands that has been weighing on its stock price for some time.
High-quality software engineers and salespeople can be extremely valuable to technology and software companies, which is one reason they tend to pay their employees well. One way they reward their teams is with stock-based compensation in the form of stock options or restricted stock units. The fact that these expenses are non-cash charges makes it easier for a company to generate positive free cash flow, which is a key metric investors look at when valuing a business.
So why is this an issue? Because the stock-based compensation increases the number of shares outstanding, which dilutes the value of the previously circulating shares. Through the first nine months of Zoom’s fiscal 2023 (a period that ended Oct. 31), the company generated $3.28 billion in revenue but gave out $768 million worth of stock options and restricted stock units to employees. That amounted to 23.4% of its revenue. This is much higher than other technology or software companies, which typically spend 5% to 10% of revenue on stock-based compensation.
So even though Zoom Video repurchased almost $1 billion worth of its shares over that nine-month span, the number of shares outstanding has barely dropped. Unless Zoom Video can rein in its stock-based compensation as a percentage of its revenue, it will be difficult for it to generate value for shareholders.
Even though Zoom Video is diluting shareholders with its high levels of stock-based compensation, the business is doing fine. Last fiscal quarter, its revenue grew 7% year over year on a constant-currency basis, even with some headwinds to its individual user numbers. Its enterprise business is outperforming with revenue up 20% and its customer count up 14%. This segment now provides 56% of Zoom’s overall revenue and should drive the majority of growth.
The company’s self-serve or online segment has gone through a tough period compared to its performance in the heat of the pandemic, but it’s showing signs of stabilization. Monthly churn was 3.1% in the fiscal third quarter compared to 3.7% in the same quarter a year earlier. A monthly churn rate above 3% isn’t great, but the trend shows that Zoom’s online business is moving in the right direction.
Even though the narrative on Zoom stock is pretty negative, the underlying business is still growing. Management is guiding for $4.375 billion in revenue this fiscal year, which is up significantly from the $1 billion in annual sales it was doing before the pandemic.
With the stock down so much in 2022, Zoom now has a market cap of just $20 billion. With such high employee stock compensation, its net income has fallen in 2022. The stock now trades at a price-to-earnings ratio of 31.4, which is a premium to the market average.
Data by YCharts.
However, the business is generating a ton of cash, which will put it in a good position relative to a lot of its competitors if the current tough economic conditions get even tougher. If management can remedy its stock compensation issue while still growing enterprise revenue, I think Zoom’s shares could rebound over time. That could make shares a buy at today’s prices.
Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zoom Videommunications. The Motley Fool has a disclosure policy.
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