Zoom Video Communications Inc. (ZM) just reported its latest quarterly earnings smashing expectations with surging sales and firming profits. The stock climbed by as much as 25% after hours on the report reaching a market cap above $115 billion, and up over 500% this year. The momentum here is not surprising as Zoom’s video conferencing and collaboration platform has been a breakout phenomenon with nearly viral user adoption worldwide driven by trends like work from home and the need for virtual meetings during the COVID-19 pandemic.

While recognizing the impressive operational and financial trends, we’re taking a cautious outlook on the stock here based on what we see as a stretched valuation and the current trading action that has likely priced-in much of the near-term upside. This past quarter may have represented the peak of company growth which will be difficult to maintain going forward. In our view, it’s too late for investors to chase the stock and we expect greater volatility going forward as the market consolidates these recent gains.

ZM Q2 Earnings Recap

Zoom Video Communications reported its fiscal Q2 on August 31st after the market close with non-GAAP EPS of $0.92 which was $0.47 ahead of the estimate. Similarly, GAAP EPS of $0.63 was also $0.26 above the market consensus. The story here was really a massive beat on the revenue estimate as the company did $663.5 million, up 355% year over year. This was surprising as the company had previously guided for sales around $500 million during the Q1 earnings release back in June.

(Source: Company IR)

Keep in mind that the company’s fiscal quarter was for the period between May and July meaning that the company had already seen a big boost to user growth in Q1 during the early stage of the pandemic in March and April. The strength in Q2 highlights the ongoing momentum with Zoom not only able to convert more users than anticipated but also to capture large customers into the platform. The company reports that they have 988 customers contributing over $100,000 in trailing 12 months revenue, up 112% y/y. The figure was also a 30% increase from the 769 “enterprise” customers at the end of Q1. Overall, revenue in the quarter essentially doubled compared to Q1.

(Source: Company IR)

In terms of margins, rapid sales growth was coupled with a significant decline in operating expenses which drove the improved profitability. The non-GAAP operating margin which excludes stock-based compensation and acquisition expenses reached 41.7%, up from 14.2% in Q2 last year. The improvement here was driven by a sharp decline in the non-GAAP measure of sales and marketing expenses as a percentage of revenue which fell by 2,871 basis points (28.7 percentage points) consistent with the benefit of increasing scale. Indeed, R&D and administrative expenses all declined as a percentage of sales given the top-line growth dynamic. The result is not only firming earnings but also accelerating free cash flow which reached $373 million compared to $17.1 million in Q2 last year.

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(Source: Company IR)

Finally, the other impressive trend here is the company’s expanding international presence outside of the Americas region. The share of revenue from the Americas at 68.4% in Q2 fell from 80.3% in Q2 2019 which is indicative of a diversifying global reach. Within the total revenue growth for the quarter, the regions outside of the Americas saw faster momentum with revenue up 629% year over year. Management sees a significant opportunity to grow internationally in areas that are still untapped particularly Europe and Asia-Pacific.

(Source: Company IR)

ZM Management Guidance

Considering the better than expected results this quarter, management has revised higher its full-year outlook. Compared to a prior full-year fiscal 2021 revenue target of $1.8 billion announced back with the Q1 results, management now sees revenue in a range between $2.37 billion and $2.39 billion. The non-GAAP EPS estimate of $2.44 at the midpoint has also been revised higher and is now nearly double the previous target of $1.25 per share.

(Source: Company IR)

For the current fiscal Q3, management is guiding for revenue between $685 and $690 million. While this figure if confirmed would represent a year-over-year growth of 312%, the quarter-over-quarter increase represents a relatively tepid 3.5% increase. This implies that the exceptionally strong Q2 which included the bulk of the pandemic dynamic will be a difficult comparable for the company to match going forward. A higher churn in users is expected.

In some ways, this relatively soft guidance for Q3 revenue is the one setback from the entire earnings release and raises questions about the longer-term growth outlook. The implication is that most users that needed to sign up this year already did between Q1 and Q2, and the company is facing a “wall” to climb to accelerate growth from here.

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Analysis and Forward-Looking Commentary

The beauty of the software-as-a-service business model is the ability to generate consistent and recurring revenue from users tied to the platform. Zoom Video can seek to upsell customers into higher tier offerings as an internal growth opportunity while we also expect that the company should continue to see organic growth trends from new users and enterprise customers joining the platform. It’s a powerful business model with simplicity to estimates sales and earnings tied directly to user growth.

With the stock trading at $400 after hours following the earnings release combined with the latest full-year management guidance, we can update current valuation metrics. Considering an approximate market cap of $115 billion, ZM is currently trading at a forward price to sales multiple of 48x. At the upper end of management’s EPS target for the year at $2.47 per share, the forward P/E ratio is 162x. Also, if we annualized the Q2 free cash flow of $373 million to $1.5 billion, the stock is trading at a free cash flow multiple of 77x. These measures are objectively expensive compared to the broader market but potentially justifiable considering the growth trends. Zoom Video commands a high growth premium with an expectation that growth over the next decade will converge to the current valuation.

Through next year, the strong Q2 results will drive a year-over-year tailwind for revenue and earnings momentum to continue. The company will continue to benefit from increasing scale and has new product launches on tap including integrated hardware solutions as future growth drivers. In July, Zoom launched “hardware as a service” essentially offering customers the option to lease video conferencing equipment.

Risks and Monitoring Points

Zoom faced some questions earlier this year regarding the security of its platform along with ties to China. The company publicly responded through a marketing effort by committing to enhance encryption. This is important as some competitors including Microsoft Corp. (MSFT) with its “Teams” platform and Citrix Systems Inc. (CTXS) through its “WebEx” offering are competing for the same enterprise customers which are particularly lucrative. Apparently, these issues did not impact growth in Q2 but will continue to be a theme in the segment.

We sense that the market will begin to look more closely at quarter-over-quarter figures and focus on financial margins. If this last quarter was an effective “jackpot” in terms of growth, the real challenge for the company starts now to meet and exceed a high bar of expectations.

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The greatest uncertainty over the next year is how much variability and user turnover Zoom will face if and when the coronavirus pandemic is contained and regular face to face meeting environments can return to normal. In this scenario, it’s possible that some customers including enterprises might cut back on the use of video conferencing. The risk for the stock is that the market is pricing in revenue growth that is too optimistic given the uncertainty of the pandemic containment. User churn and customer attrition will be key monitoring points over the next year.

Takeaway

A blowout quarter and breakout move higher in the stock lead us to question what comes next. User growth is the most important metric for the company and Zoom will need to keep innovating and enhancing the value proposition to maintain its market leadership position. Considering what remains a competitive market segment with formidable companies fighting for the same market share, we find it too risky to bet on Zoom at the current valuation with an outlook over many years.

Tactically, we expect this latest pop in shares to be matched by some profit-taking and think shares will look to consolidate recent gains through the next earnings release. For now, Zoom remains one of the best growth stories in the market and the positive sentiment is a powerful force working in its favor. While we won’t bet against shares of ZM, it’s likely too late for investors to chase this one higher. We rate shares as a hold and look ahead to the next earnings release where the company will need to prove it can continue to execute.

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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.



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