Zoom Video Communications Is Undervalued

In late 2020, I looked at Zoom Video Communications, Inc. (ZM) and quickly determined shares were grossly overvalued.

A few days ago, someone asked me for my opinion of the company. With the release of Q2 and YTD2024 results after the August 21 market close, I now revisit ZM.

NOTE: ZM is NOT to be confused with ZoomInfo Technologies Inc. (ZI). ZI is junk. Even S&P Global and Moody's agree ZI is junk given the assigned domestic long-term debt ratings of BB and Ba3.

Business Overview

ZM is a communications technology company founded in 2011 by Eric Yuan, previously a manager of WebEx at Cisco, which acquired the video conferencing company in 2007. He left Cisco in April 2011 with 40 engineers to start ZM (originally named Saasbee, Inc.).

It provides videotelephony and online chat services through a cloud-based peer-to-peer software platform used for video communications (Meetings), messaging (Chat), voice calls (Phone), conference rooms for video meetings (Rooms), virtual events (Events) and contact centers (Contact Center), and offers an open platform allowing third-party developers to build custom applications on its unified communications platform (Developer Platform).

In the years following ZM's 2019 initial public offering (IPO), the business grew rapidly as ZM expanded from a video communications tool to a full collaboration platform. The company's trajectory was forever changed during the pandemic. Within 24 months of the onset of the pandemic, ZM grew significantly in size

Following FYE2023, ZM announced a restructuring plan intended to reduce operating costs and continue advancing the company's ongoing commitment to profitable growth. This plan included a ~15% reduction in the workforce.

In addition, ZM recently announced a structured hybrid approach. Employees who live within commuting distance must now attend their local office at least twice a week. ZM is purpose-built for hybrid work and by introducing this structured hybrid approach, management expects its team members will be able to have a better understanding of what ZM's customers are experiencing in their hybrid journeys.

A business overview is accessible in Part 1, Item 1 in ZM's FY2023 Form 10-K.

Risk Factors

Investors should review the risk factors presented in a company's Form 10-K. This section immediately follows Item 1 - Business.

The market for communication and collaboration technologies platforms in which ZM competes is competitive and rapidly changing.

Certain features of ZM's current platform compete in the communication and collaboration technologies market with products offered by:

• legacy web-based meeting providers, including Cisco Webex and GoTo;
• bundled productivity solutions providers with video functionality, including Microsoft Teams, Google G Suite and Meet products;
• UCaaS and legacy PBX providers, including Avaya, RingCentral, and 8x8; and
• consumer-facing platforms that can support small- or medium-sized businesses, including Amazon, Apple, and Facebook.

Other large established companies may also make investments in video communications tools.

As ZM introduces new products and services into its platform, and with the introduction of new technologies and market entrants, the expectation is that competition will intensify in the future.

Despite formidable competitors, ZM's annual revenue has risen from $61 million in FY2017 to $4.4B in FY2023. It expects to generate ~$4.5B in FY2024.

Legal Proceedings

As I compose this post, ZM's Q2 2024 Form 10-Q is unavailable. Page 18 of 73 in the Q1 2024 Form 10-Q, however, provides details of commitments and contingencies that include details of legal proceedings.

ZM has been vigorously defending itself against multiple class actions that were filed against it in various U.S. federal district courts and state courts relating to its alleged privacy and security practices. A trial is scheduled for May 20, 2024.

ZM has had discussions with the lead plaintiff’s counsel regarding a potential settlement of this matter. Although no binding agreement has been reached, and there is no assurance that a final settlement will be reached or that a settlement, if reached, will be approved by the Court, the discussions are ongoing.

ZM had accrued an estimated legal settlement charge of $7.5 million during FY2023. Based on subsequent discussions, however, it recorded an additional estimated legal settlement charge of $52.5 million as a general and administrative expense in the Q1 2024 financial statements. ZM currently estimates the maximum loss in excess of the amounts accrued is ~$90 million.

Management anticipates that some or all of any final settlement paid will be paid by its Directors and Officers (D&O) liability insurance; this insurance coverage is intended to protect individuals from personal losses if they are sued as a result of serving as a director or an officer of a business or other type of organization. It can also cover the legal fees and other costs the organization may incur as a result of such a suit.

Cybercrime

Global cybercrime damages are predicted to cost up to $10.5T annually by 2025. It is not surprising, therefore, that in a paper published on August 3, 2023, researchers determined that an AI tool could decipher text (including passwords) from keystroke sounds recorded over Zoom.

An AI model developed by these researchers showed a 93% accuracy rate in deciphering keystrokes from a recording of a Macbook's keystrokes made over ZM's video conferencing software; this accuracy rate rose to 95% when keystrokes were recorded using an iPhone 13 mini.

One of ZM's risk factors states that its security measures have been compromised in the past and may be compromised in the future. If its security measures are compromised in the future or if its information technology fails, this could harm ZM's reputation, expose it to significant fines and liability, impair sales, and harm the business. In addition, ZM's products and services may be perceived as not being secure. This perception may result in customers and hosts curtailing or ceasing their use of ZM's products, the incurrence of significant liabilities, and significant harm to the business.

These risks, however, are not unique to ZM. Its competitors disclose similar risks in their respective Form 10-Ks.

CEO and NEO Compensation

I think CEO and NEO compensation is often obscene relative to all other employees. However, I own so few shares in the companies in which I have exposure that my shareholder votes are irrelevant. I must resign myself to being unable to effect any changes to the compensation structure of senior executives, and therefore, must determine if the compensation structures of CEOs and NEOs align with my long-term interests.

If the long-term incentive component makes up a large percentage of the CEO's and NEOs' compensation structures, I envision they will make decisions that align with my interests.

Based on my review of their compensation structures, it appears they are incentivized to position ZM to succeed over the very long term; I reference the Compensation Discussion and Analysis component of ZM's 2023 Proxy Statement that commences on page 32 of 71.

Eric Yuan, President and Chief Executive Officer, and his family are on the Forbes List of Billionaires (2023) and the Forbes 400 (2022). A significant percentage of Mr. Yuan's net worth appears to be his ownership stake in ZM.  When ZM was ridiculously overvalued in 2021, it is estimated his net worth was $14.9B. Now, his net worth is ~$3.4B. This suggests Mr. Yuan is incentivized to ensure ZM's continued success.

Financials

Q2 and YTD2024 Results

Refer to ZM's Q2 2024 Earnings Release, accompanying Earnings Presentation, and Prepared Remarks.

The following is a snapshot of ZM's Q2 2024 results and YoY change.

At the end of Q2, ZM had ~$1.38B of cash and cash equivalents and ~$4.648B of marketable securities for a total of ~$6.028B of liquidity; the marketable securities generally consist of high-grade commercial paper, corporate bonds, agency bonds, corporate and other debt securities, U.S. government agency securities, and treasury bills.

ZM's TOTAL liabilities amount to ~$1.921B. Of this amount, ~$1.349B is deferred revenue. Deferred revenue is advance payments received for products or services that are to be delivered or performed in the future. As ZM provides these services, this amount reduces and ZM records the corresponding value as revenue.

If we exclude deferred revenue, ZM has $0.572B of liabilities versus ~$6.028B of liquidity.

Deferred revenue at the end of Q2 was ~$1.37B (includes ~$20.5 million non-current). Although this is down ~2% from Q2 2023, it is in line with the high end of the expectations management shared on the Q1 earnings call. For Q3, management expects deferred revenue to be down 4 - 5% YoY. This is partially driven by shorter billing frequencies on Enterprise deals arising from the high-interest rate environment.

An encouraging trend is that ZM's Remaining Performance Obligations (RPO) continue to grow. RPO consists of both billed considerations and unbilled considerations that ZM expects to recognize as revenue.

RPO increased 9% YoY to ~$3.5B. ZM expects to recognize ~59% of the total RPO as revenue over the next 12 months versus ~61% in Q2 2023 which is indicative of the lengthening of contract durations on a YoY basis.

FY2024 Outlook

With the release of Q2 2024 results, ZM has increased its FY2024 outlook for the second time following the release of its original FY2024 outlook in February.

Outlook With The Release Of Q2 2024 Results

Outlook With The Release Of Q1 2024 Results

Outlook With The Release Of Q4 and FY2023 Results

Free Cash Flow (FCF)

In FY2017 - FY2023, ZM generated FCF of (in millions of $) $4.54, $9.69, $20.88, $113.67, $1,385.36, $1,459.66, and $1,186.4 while it generated Net Income of (in millions of $) ($0.01), ($8.23), $7.58, $21.75, $671.53, $1,375.06 and $103.4.

In the first half of FY2024, ZM generated $0.686B in FCF.

Credit Ratings

ZM has no debt, and therefore, no rating agency covers it.

Dividends and Share Repurchases

Dividend and Dividend Yield

ZM does not distribute a dividend.

Share Repurchases

In November 2018, ZM implemented a dual-class common stock structure. The Class A common stock is entitled to one vote per share and the Class B common stock is entitled to 10 votes per share. The Class A and Class B common stock have the same dividend and liquidation rights.

Details of ZM's Stockholders’ Equity and Equity Incentive Plans are found in Note 10 (commences on page 89 of 145) in the FY2023 Form 10-K.

In February 2022, ZM's Board authorized a stock repurchase program of up to $1B of Class A common stock. During the year ended January 31, 2023, ZM purchased and subsequently retired 11,170,907 shares of its Class A common stock for an aggregate amount of $1B.

ZM's weighted average shares outstanding in FY2017 - FY2023 are (in millions of shares) 269, 269, 269, 254, 298, 306, and 304. The diluted weighted average shares outstanding in Q2 2024 is 306.

No shares have been repurchased in the first half of FY2024.

Valuation

In FY2020 - FY2023, ZM generated $0.09, $2.25, $4.50, and $0.34 in diluted EPS and $0.35, $3.34, $5.07, and $4.37 in adjusted diluted EPS; the following provides a GAAP to Non-GAAP Reconciliation.

ZM's most recent FY2024 guidance is for adjusted diluted EPS of $4.63 - $4.67. Using the $4.65 mid-point and my $64.58 purchase price on August 22, the forward adjusted diluted PE is ~13.9.

Broker guidance is likely to change over the next several days. Using my purchase price and the currently available adjusted diluted EPS estimates, however, ZM's forward adjusted diluted PE levels are:

• FY2024 - 31 brokers - mean of $4.66 and low/high of $4.28 - $5.08. Using the mean estimate, the forward-adjusted diluted PE is ~13.9.
• FY2025 - 29 brokers - mean of $4.52 and low/high of $4.28 - $4.87. Using the mean estimate, the forward-adjusted diluted PE is ~14.3.
• FY2026 - 17 brokers - mean of $4.62 and low/high of $3.52 - $6.27. Using the mean estimate, the forward-adjusted diluted PE is ~14.

In the first half of FY2024, ZM generated $0.686B in FCF. Being conservative, I assume ZM generates ~$0.514B of FCF in the second half of FY2024 for a total of ~$1.2B in FY2024.

Management's most recent guidance is for the FY2024 weighted average number of diluted shares to be 308 million. We get an FCF/share value of $3.90 and a P/FCF value of ~16.6 using my ~$64.58 purchase price.

These valuations suggest ZM is undervalued given its growth potential and impeccable balance sheet.

Final Thoughts

With a 40.5% non-GAAP operating margin in Q2 2024 (vs 35.8% in Q2 2023) and 39.4% in the first half of FY2024 (vs 36.5% in the prior year period), I do not know how much margin expansion we can expect going forward; headcount reductions contributed to this margin strength.

While margin expansion may be difficult to achieve, ZM is expanding its product offering and it continues to add new business (upsell and new customers). It also has a very strong Balance Sheet and it generates impressive FCF.

It operates in a highly competitive market but considering it expects to generate ~$4.5B of total revenue on a constant currency basis in FY2024 when it had virtually no revenue in FY2017, it must be doing something right.

It is beyond me as to why investors would have paid upwards of $550/share in October 2020. Now, however, the pendulum has swung in the opposite direction and ZM shares are undervalued. I, therefore, initiated a 400-share position @ ~$64.58 on August 22 in one of the 'Core' accounts within the FFJ Portfolio.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long ZM.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.