Zoom’s real free cash flow just turned negative

video conferencing software provider Zoom (ZM -5.03%) is struggling with a significant slowdown in its growth. The pandemic has forced businesses to move remotely, and Zoom’s easy-to-use software has become the default choice for connecting employees. This has led to incredible revenue growth and massive profits, but the windfall is very clearly over as the pandemic drags on.

Zoom’s revenue grew only 8% year-over-year in the second quarter. Worse still, profits plunged. GAAP net income fell 86% and adjusted net income 22%. Adjusted free cash flow, where Zoom adds back certain litigation settlement payments, was cut in half from the prior year period.

An ATM, but only if you don’t look too closely

A bullish argument for Zoom is this: even though growth has slowed and profitability is shrinking, the company is still generating a ton of cash. That adjusted free cash flow figure was $222.1 million in the second quarter, or about 20% of revenue.

Here’s the problem: if you take stock-based compensation out of Zoom’s adjusted free cash flow, it becomes negative in the second quarter. Stock-based compensation is not a cash expense, but it is an actual expense. If Zoom stopped handing out stock rewards, it would have to pay its employees more money to retain them.

As Warren Buffett said in 1992:

If options are not a form of compensation, what are they? If remuneration is not an expense, what is? And, if expenses were not to enter into the calculation of income, where should they go?

If you take Zoom’s reported free cash flow at face value, the stock doesn’t look that expensive. With a market cap of $25.5 billion and annualized free cash flow of around $900 million, we’re talking about a price to free cash flow ratio of around 30. That’s certainly not glaring. .

But if you cancel stock-based compensation, you can no longer calculate this valuation metric because free cash flow is negative. Adjusted net income has the same problem as reported free cash flow in that it treats stock-based compensation as something to ignore. If you take Zoom’s second-quarter GAAP net income, which, to be fair, includes other one-time items, you’re looking at a price-to-earnings ratio well over 100.

Not a good story

Many software-as-a-service companies are not profitable but are growing rapidly. The story they tell usually involves the benefits eventually being delivered as they continue to grow. It’s an attractive story. Investors may say things like, “Well, if XYZ continues to grow at 30% and achieves a 20% free cash flow margin in 10 years, the current price is certainly justified.”

With Zoom, the situation is reversed. The company has already achieved impressive levels of profitability during the pandemic. Today, growth is slowing and profitability is shrinking. There is more competition and companies can take their time choosing video conferencing providers. Sales cycles are getting longer, which means higher costs for Zoom as it works to close deals.

Slow growth and no real reason to believe that profit margins will ever rebound to their pandemic peaks is simply not a good story. You look 10 years into the future and see a slightly larger zoom with worse margins. It’s hard to sell.

If Zoom can somehow come up with a second act that restarts the engine of growth and profit, the title would be much more attractive. But as it stands, Zoom’s stock just doesn’t seem like a very good deal.

Timothy Green has no position in the stocks mentioned. The Motley Fool fills positions and recommends Zoom Video Communications. The Motley Fool has a disclosure policy.

About Myra R.

Check Also

Are investors undervaluing Aker Solutions ASA (OB:AKSO) by 35%?

In this article, we are going to estimate the intrinsic value of Aker Solutions ASA …