Zoom Video Communications Stock: Miscommunication (NASDAQ:ZM)

Shares of Zoom Communications (NASDAQ:ZM) have seen a retest of the lows around the $80 mark as the latest set of quarterly results, including a poor margin outlook, set investors up for a new disappointment.

In March of this year I believed it was time to call as the downfall in the shares of Zoom made that shares fell to their double-digits, as I thought that valuations have been de-risked in quite a major way, making that appeal was slowly starting to emerge.

Some Background

Zoom went public in 2019 and shares traded around the $60 mark soon after the offering, actually hitting the $100 mark, as this was a time when the company was much smaller of course. The company has been a poster child of the pandemic as shares hit the $500 mark in October of the year with the $3.5 billion sales run rate for the year being roughly 4 times the original revenue guidance!

The company guided for 2021 sales to rise in a modest fashion to $4.0 billion and unlike so many technology names (at the time) the company was hugely profitable with GAAP profit margins exceeding 20%, still translating into a 100 times earnings multiple, with the business supporting a hundred billion valuation at the time on the back of a 25 times sales multiple.

Optimism fueled Zoom into pursuing a $14.7 billion deal for Five9 last summer as it all went downhill from there, even as that deal fell through, and the company continued to hold a very substantial net cash position. Shares kept falling amidst a normalization of valuations, retreat of the pandemic, and fears of competitive pressure, with names like Microsoft (MSFT) offering cheaper similar services as well.

Valuation Reset

By March shares fell to the $100 mark, down 80% from the highs, as that move is even an under reaction given the net cash position held by the company. Early in 2022, the company posted its fourth quarter results with revenues up 21% to $1.07 billion, with GAAP operating profits of $252 million being strong. Non-GAAP earnings came in at $1.29 per share, yet adjusting for stock-based compensation expenses, I pegged realistic earnings closer to $3 per share.

For the upcoming fiscal year of 2023, the company guided for revenues at a midpoint of $4.54 billion, suggesting modest growth from the $4.10 billion in revenues reported in the fiscal year 2022. Adjusted earnings are set to rise from $3.34 per share to $3.48 per share, yet after backing out stock-based compensation I see realistic earnings closer to just $2.50 per share.

The 306 million shares valued equity of the company at $30 billion in March, or $25 billion if I factor in net cash. This still comes in at 5-6 times sales but low thirty times realistic earnings multiple. These multiples are quite demanding in order to get upbeat on the name and while revenue numbers looks reasonable, the margins were deteriorating.

While this was largely a pandemic play, its services would still be used in a post-pandemic world, as there were many balancing acts including a more modest valuation, but on the other hand fierce competition and potential for M&A as well.

What Now?

Since my take in March, shares have largely traded in an $80-$120 price range, now trading towards the low end of the range following the latest quarterly results. In May, Zoom posted a 12% increase in first quarter sales to $1.08 billion. That was about the good news as GAAP operating margins took a beating, with GAAP operating profits down from $226 million to $187 million.

Following some losses on investments, the company saw GAAP earnings cut in half to $0.37 per share as non-GAAP earnings fell thirty cents to $1.03 per share, excluding stock-based compensation expenses which doubled. While a more than $3.70 per share guidance in adjusted earnings sounds upbeat, stock-based compensation is on the increase, so that is not that meaningful to me.

In August, Zoom saw sales growth decelerate to 8%, although a strong dollar is hurting the business, all while margin pressure is only on the increase. Second quarter operating profits fell from $295 million last year to just $122 million, with quarterly stock-based compensation expense increasing to just over a quarter of a billion, allowing adjusted earnings to come in at $1.05 per share.

The 307 million shares have now fallen to $80 per share, for a market valuation of just over $24 billion, as the operating assets are valued at around $19 billion here. This reduces the sales multiple to 4-5 times, even if the full year sales guidance has been cut by $150 million to $4.39 billion.

Non-GAAP earnings are seen between $3.66 and $3.69 per share and given that adjusted earnings already totaled $2.08 per share in the first half of the year, severe margin pressure is seen in the coming two quarters, with earnings seen around $1.60 in the second half of the fiscal year. This reveals that GAAP earnings are likely seen flattish in the near term.

Caution – Given The Margins

After believing value was near to be found at the $100 mark in March, I have to take a much more cautious stance here 20% lower. This comes amidst the much worsening margin pressure here. Not only is the gap between GAAP and non-GAAP earnings growing because of rapidly increasing stock-based compensation expenses (equal to about a billion, or 25% of sales here). The other issue is that the full year guidance implies no realistic earnings to be seen for the second half of the year, and that is after backing out these incentive expenses.

All of this makes me extremely cautious as the thesis of profitability has gone out of the window, making it hard for the stock to find fundamental support with competitive pressures apparently rapidly on the rise.