Please ensure Javascript is enabled for purposes of website accessibility

Take Zoom’s Amazing Free Cash Flow With a Grain of Salt

By Timothy Green – Jun 7, 2020 at 8:30AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Free cash flow is far from perfect as a valuation metric.

Few companies have benefited from the pandemic-driven lockdowns around the world more than Zoom Video Communications (ZM -0.12%). Employers have turned to Zoom's video conferencing tech as working from home became the norm, and consumers have been using Zoom to keep in touch with friends and family.

In Zoom's first quarter, which ended on April 30, the numbers told the story of Zoom's success. Revenue rocketed 169% from the prior-year period to $328.2 million; the number of customers with more than 10 employees jumped 354% to around 265,000; and net income rose from basically breakeven in the first quarter of last year to $27 million.

Beyond the astounding revenue growth, Zoom's free cash flow is getting a lot of attention. The company reported free cash flow of $251.7 million for the first quarter, up from just $15.3 million in the same period last year. Zoom converted nearly 77% of its revenue into cold, hard cash.

But before you start extrapolating the cash flow numbers to justify an increasingly bonkers valuation, it's important to understand what's actually driving Zoom's cash generation.


Image source: Getty Images.

Free cash flow has some flaws

Zoom sells software subscriptions, which means it spends upfront on sales and marketing to acquire subscribers that generate revenue for the company over time. While net income is a reasonable profitability metric for many companies, it tends to understate the true profitability for subscription software companies. If Zoom were to pull back on sales and marketing spending such that it stopped growing, net income would surge as subscribers continued to pay for the service while costs declined.

While net income may understate profitability for a SaaS company, free cash flow tends to overstate profitability, in some cases by a lot. Here's the problem: A subscription company takes in cash from customers in advance of providing services. This shows up on the balance sheet as deferred revenue. If the company is growing its customer count, the deferred revenue balance is growing, and that contributes to the cash flow.

This cash flow is real, in the sense that it represents real cash coming in the door. But it doesn't make sense to treat it as a profitability metric. A company could shift from monthly subscriptions to annual subscriptions, for example, which would boost deferred revenue and thus cash flow temporarily, even if nothing else changed about the underlying business.

Zoom's deferred revenue jumped by $322 million in the first quarter from the prior-year period as businesses flocked to the service. This is the main reason for the massive surge in Zoom's free cash flow. If Zoom were to pull back on sales and marketing spending such that it was no longer growing, this source of cash flow would disappear, since deferred revenue would no longer be growing.

An estimate for Zoom's true profitability lies somewhere in between net income and free cash flow. Zoom is a profitable company by any metric, but it is definitely not as profitable as its free cash flow numbers suggest. As Zoom's growth rate slows, free cash flow will fall back to earth.

Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Zoom Video Communications and recommends the following options: short August 2020 $130 calls on Zoom Video Communications. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Zoom Video Communications Stock Quote
Zoom Video Communications
$74.45 (-0.12%) $0.09

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/25/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.