Zoom Video (NASDAQ:ZM) will report Q3 earnings on Monday, Nov. 20 after market close. I will give my thoughts on the company’s potential and how things have changed since I last covered the company in May. The company has reported much better numbers since my last coverage, with greatly improved GAAP margins than what I modeled earlier. Therefore, I’m upgrading the company to a “hold” rating, and I would like to see these improvements persisting going forward.
Briefly on previous coverage
ZM is down around 4% since my sell recommendation back in May, compared to the S&P 500’s 9% gain. In the article, I said the company has a few good catalysts in play that can help propel the company forward, like the Zoom One bundle and the Zoom Phone Service, but was facing tough competition from the bundled MS Teams with the MS Office Suite. Furthermore, the company has been very liberal with its stock-based compensation, and I didn’t like that at all as it tripled in one year.
GAAP margins were too low to make the company a buy, while AI initiatives are promising too, however, it was too early to tell. The announcement of layoffs was going to help margins, but I didn’t like that kind of cost-cutting measure.
What happened since the last coverage
So, what has happened since then? Quite a bit happened. Treasury yields shot up from around 3.5% to 4.5%, inflation has come down significantly, however, it’s still very sticky, and interest rates will have to stay higher for longer.
In terms of the company, revenues are beginning to see some sort of growth, however, it’s still nowhere near the pandemic highs, and I don’t think it’ll ever come back to such numbers again. Q2 Enterprise revenues saw around 10% growth, while GAAP operating margins stood at 15.6%, and the number of customers contributing more than $100m in revenue increased by around 18%. These are decent numbers, but it’s still quite below pandemic levels.
What to expect from Q3
Q3 revenue is slated to be in the range of $1.15B and $1.120B. Non-GAAP income from operations and diluted EPS, which I don’t like when companies focus on these numbers too much, is expected to be between $400m and $405m and $1.07 and $1.09, respectively.
I will be looking to see if the company is lowballing these estimates and will be able to beat these expectations, as it has beaten EPS 10 out of the last 10 quarters while missing 2 on revenues.
I also will be looking for how the AI initiatives managed to make the company money or at least make everything more efficient. At the company’s conference, ZM’s CEO said that the AI companion already had 30,000 customers using it a month after it launched, which is quite impressive, however, the companion is free to all customers, which doesn’t add to any revenue growth. What it can do if it’s as good as it looks on paper (it can summarize meetings and provide smart recordings), may entice more enterprises to sign up for their service, so it can be a great growth catalyst going forward.
CCaaS and Docs
The two recent initiatives look to be very promising, however, it’s too early to tell how well they will manage to attract paying customers. CCaaS (Contact Center as a Service) was announced back in August, while Zoom Docs was introduced in October, however, it’s slated to be available for the general public in 2024, so right now we don’t know how successful this initiative will be.
CCaaS does seem like a good addition to Zoom’s portfolio given that it’s a one-trick pony, and the more customers can do with the platform the better. The CCaaS market is poised to grow at 18% CAGR through 2030, and now that Zoom is in the running, I can see it capturing quite a decent growth in the segment.
Margins and SBC
The biggest gripes I had with the company back in May were the very low GAAP margins and the company’s liberal use of stock-based compensation, which brought down the margins massively. In my financial analysis, I modeled similar GAAP margins as it had in FY22 to be more conservative, however, in the latest quarter, GAAP margins more than doubled, which is quite impressive.
This can be attributed to the company reducing its stock-based compensation in the last two quarters. I would like to see this trend continue going forward and would like to see non-GAAP margins slowly but surely converging with GAAP margins, as that is the way I prefer to look at a company, rather than how the management thinks about the “true value of the company.”
As I mentioned earlier, a lot has changed since my last article, so I had to update my analysis accordingly. I maintained the same growth in revenues as before mainly because I still think these are good enough estimates. Below are my assumptions for the three cases, the base, conservative, and optimistic.
What I did change were the margin assumptions as the company has proved it can be more efficient and profitable, especially when SBC is decreasing. Below are my estimates for GAAP margins and EPS.
Also, treasury yields changed by 100bps since May, so I had to take that into account. Furthermore, I used a 10% discount for the DCF analysis and a 2.5% terminal growth rate.
I kept the same margin of safety of 25% to be on the conservative side because I would rather sleep well knowing I didn’t overpay for a company. With that said Zoom’s intrinsic value is $56 a share, which means it’s still trading at a premium to its fair price.
The company is very close to its fair value, and the volatility of earnings may bring it down to my PT, at which point, if the long thesis is still intact, I may pick up some shares and hold on for a couple of years to see what the outcome will be. I believe the company is going to survive in the long run because of all the initiatives it has recently introduced to stay relevant. Unbundling of MS Teams is going to be beneficial for ZM and will make it much more competitive in the long run.
I wouldn’t be surprised if sometime in the future, the company finds itself in merger talks with someone, but that is just speculation.
If we see continual improvements in margins for the next year or so, I will certainly have to update my analysis as the company would be worth much more, for example, if GAAP operating margins were to reach non-GAAP levels, which is around 40%, but with this company, I like to keep it on the conservative end and focus on GAAP metrics for that extra margin of safety.