Few companies have benefited from the pandemic-driven lockdowns around the world more than Zoom Video Communications (NASDAQ:ZM). 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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.