Zoom Video Communications: Priced For Perfection

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About: Zoom Video Communications, Inc. (ZM)
by: Hervé Blandin
Summary

Zoom Video Communications released excellent fiscal Q1 results and strong guidance.

The impressive revenue growth doesn't translate into profits.

Considering the high valuation, the execution must be flawless over the next several years.

Zoom Video Communications (ZM) released its fiscal Q1 2020 earnings and communicated its guidance for the rest of the fiscal year. Even with better-than-expected results and strong guidance, the valuation I discussed in my previous article is still demanding.

Following the earnings, the stock price increased by 18.41%. Based on the midpoint of the fiscal 2020 guidance, the corresponding EV/revenue ratio is above 51x. Also, with the midpoint of the expected full-year non-GAAP EPS of $0.025, the PE ratio exceeds 3,760.

Besides the market valuation, let's have a close look at Zoom Video Communications' first quarterly results as a public company.

Man in front of video wall illustrates Zoom Video Communications success Image source: Geralt via Pixabay

Impressive revenue growth and flattish bottom line

During fiscal Q1 2020, revenue increased 103% year over year and reached $122 million. The impressive revenue growth is due to a mix of new customers and extra spending from existing customers.

Total Remaining Performance Obligations (RPO), which is a leading indicator of future revenue, grew in the same proportions. And the expected growth goes beyond the short term as non-current RPO increased 158%.

Zoom Communications fiscal Q1 2020 earnings: total RPO

Source: Presentation June 2019

However, due to the ramp-up of the sales and marketing expenses, the revenue growth doesn't translate into profits. During fiscal Q1 2020, the company increased its operating cash flow, free cash flow, and net income. But the numbers stay modest compared to the $24+ billion market capitalization.

Operating cash flow increased from $3 million to $22 million year over year. Net income turned positive at $0.2 million against a loss of $1.34 million the year before.

Taking into account the midpoint of the full-year guidance, revenue is expected to grow 62%. In contrast, management forecasts the midpoint of the non-GAAP operating income to decline and barely stay positive at about $1.5 million. Last year, non-GAAP operating income was approximately $15 million.

Zoom Communications fiscal Q1 2020 earnings: outlook

Source: Presentation June 2019

As a side note, I'm not a big fan of non-GAAP results. Most of the young tech companies exclude the large real costs that share-based compensations (SBC) and amortization of intangible assets represent. In the case of Zoom Video Communications, the impact of non-GAAP adjustments is less important as SBC represented only about 5.5% of Q1 revenue.

The contrast between the strong revenue growth and the flattish bottom line is due to the sales and marketing expenses that represented 53% of the revenue during fiscal Q1.

Management indicated these efforts will continue due to the planned growth outside of the Americas. The graph below shows that, due to the much smaller revenue base in the rest of the world, the growth potential outside of the Americas is indeed important.

Zoom Communications fiscal Q1 2020 earnings: revenue growth

Source: Presentation June 2019

In any case, the top line performance is impressive. But the company still has to show it can generate comfortable operating margins when it gets closer to its mature phase. Considering the current costs structure, turning to profits must come from lower sales and marketing expenses as a percentage of revenue.

Zoom Communications fiscal Q1 2020 earnings: GAAP and non-GAAP results

Source: Presentation June 2019

Considering the competition, a decrease in the R&D expenses as a percentage of revenue would be risky. But, with scale, I expect G&A expenses to diminish (as a percentage of revenue) over time.

Too much cash?

With these results and considering the guidance, the company doesn't need external financing to fund its organic growth. Even if operating income doesn't match revenue growth, the company is still generating some positive free cash flow.

And with the recent IPO, the company has about $737 million of net cash and equivalent.

During the earnings call, management indicated holding cash to keep options to acquire companies and fund organic growth. There was no indication of any direct return to shareholders in the form of a special dividend or share repurchase. Considering the high valuation, buying back shares would not be the best capital allocation decision anyway.

Thus, Zoom Video Communications has the potential for important acquisitions relative to its size. Considering the cash on the balance sheet and the high stock price, acquisitions based on cash and equity could exceed $1 billion without considering any debt.

But of course, acquisitions represent an extra risk. And with the current generous valuation, the company is priced for perfection. Any disappointing M&A activity will have a strong impact on the stock price.

High valuation

The midpoint of the fiscal 2020 revenue guidance is $537.5 million and the corresponding EV/revenue ratio exceeds 51x. Even when compared to high-growth companies, Zoom Video Communications' valuation is high.

The graph below shows the EV/revenue (forward) ratios stay in the range of 11x to 30x for companies that grew revenue in the range of 34% to 85% during their most recent respective reported quarter. The comparison isn't perfect as these companies operate in different industries. But the point is to highlight Zoom's high valuation compared to other companies with a similar revenue growth profile.

Chart Data by YCharts

Management's guidance for fiscal 2020 corresponds to a 60% revenue growth. And analysts estimate revenue will reach $750.22 million during fiscal 2021, which corresponds to a 40% year-over-year revenue growth.

Zoom revenues estimates

Source: Seeking Alpha

Being optimistic and assuming the company will maintain revenue growth of 40% between 2021 and 2025, revenue will reach $2.88 billion in 2025.

Zoom revenue assuming 40% CAGR over the next several years

Source: Author, based on assumptions

Assuming the number of shares stays constant at 301 million, which isn't a conservative assumption considering the SBC, the EV/revenue (2025) ratio still exceeds 9x.

Management doesn't expect to generate any profit during fiscal 2020. But if we assume a high 20% net margin by 2025, net income will reach $576 million. The corresponding PE ratio will stay elevated at about 49x. This valuation is not even conservative. I didn't discount the 2025 net income to calculate the PE ratio based on the present value of the estimated net income.

Thus, the company will have to grow revenue at a CAGR above 40% over the next several years and eventually generate a net income margin above 20% to justify the current market valuation.

Conclusion

Following the earnings, the market capitalization exceeds $28 billion. The midpoint of the full-year fiscal 2020 revenue guidance is $537.5 million. And considering the expected lack of profits, the company is priced for perfect execution over the next several years.

In this context, M&A activity is an extra risk as any integration challenge will impact the stock price. Also, the company will have to show it can keep on growing while reducing its sales and marketing expenses.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.