Zoom Video Communications (ZM 0.05%) posted another exceptional quarter that smashed analysts' expectations and management's guidance. Following these remarkable results, the stock price jumped more than 30% from its previous-week all-time highs, valuing the company in excess of $120 billion. Given that, is Zoom stock still a buy?
Exceptional revenue growth (again)
After a phenomenal fiscal first quarter, Zoom kept profiting from the coronavirus-induced accelerated shift to remote work during its fiscal second quarter, ended July 31. And the extra features and free offerings tech giants such as Microsoft and Facebook announced for their video communication solutions over the last several months didn't seem to have a negative impact on Zoom's business:
- Revenue more than quadrupled year over year to $663.5 million.
- Free cash flow jumped from $17.1 million one year ago to $373.4 million.
- Net income reached $185.7 million, up from $5.5 million one year ago.
The jaw-dropping 355% revenue growth was partly due to the increased use of video communications from existing customers. For the ninth consecutive quarter, the net dollar-based expansion rate exceeded 130%, which means existing customers with more than 10 employees spent 30% more than one year ago. But more remarkably, new customers accounted for approximately 81% of revenue growth.
The spectacular increase in the number of customers with more than 10 employees -- from 66,300 one year ago to 370,200 last quarter -- bodes well for Zoom's long-term growth potential. It also reinforces the company's network effect and cross-selling opportunities between its different video and phone communication products.
And these cross-selling opportunities are growing, too. In addition to the launch of its cloud phone system, Zoom Phone, at the end of 2018, the company announced this quarter two offerings that will facilitate the consumption of its communication services:
- Zoom for Home: a software and hardware offering that is also now available on devices from Amazon, Facebook, and Alphabet's Google.
- Zoom Hardware as a Service: a set of subscription services for audio and video communications hardware.
Given these better-than-expected second-quarter results, management again raised the guidance it had already meaningfully raised during the previous quarter. It now expects full-year revenue to land in the range of $2.37 billion to $2.39 billion, compared to the previous range of $905 million to $915 million in March.
Image source: Getty Images.
Watch the margins
Zoom's huge second-quarter revenue growth had a negative impact on its gross margin, though. As the company used public cloud infrastructure to face the phenomenal demand for its communication services, adjusted gross margin dropped to 72.3%, down from 82.2% in the prior-year quarter. And management anticipates gross margin to remain at this lower level for the rest of the year.
In contrast, scale boosted Zoom's operating margin as operating costs increased less than revenue. Thus, despite a lower gross margin, Zoom's adjusted operating margin reached an astonishing 41.7%, up from 14.2% the year before.
But don't expect that operating margin to stay that high going forward. CFO Kelly Steckelberg indicated during the earnings call the planned increase in expenses for sales and marketing, as well as research and development, will diminish the company's operating margin over the next few quarters. Over the long term, management still estimates adjusted operating margins will decrease to approximately 20%.
Lofty valuation
Zoom's share price now trades at 53 times the midpoint of the forecast full-year revenue guidance range and 185 times the midpoint of the full-year adjusted earnings per share guidance range.
Those lofty valuation ratios indicate the market expects stunning results over the long term, which seems optimistic. Management anticipated quarter-over-quarter revenue growth to decline over the next two quarters. And Zoom's revenue growth remains constrained by its total addressable market.
According to a study from MarketsandMarkets that includes video, telephony, conferencing, mobility, unified messaging, instant messaging, presence, and contact center communications services, the unified communications market should grow at a compound annual rate (CAGR) of 12.6% and reach $74 billion by 2023. Even with that large scope that takes into account contact center solutions that Zoom doesn't offer, Zoom's market cap above $120 billion suggests the company will dominate that unified communications market over the long term.
But even if that outcome materializes, which could happen given the company's recent phenomenal results, Zoom stock's upside potential remains limited while the margin of safety has become nonexistent. With such a challenging risk-reward situation, investors should stay on the sidelines.
