Zoom (ZM 0.37%) grew like gangbusters during the first two years of the pandemic as businesses big and small had little choice but to adopt videoconferencing software. That growth has slowed as the world gets back to normal. In the just-reported third quarter, Zoom's revenue rose by just 5% year over year.
Even with slower growth, Zoom is still wildly profitable, at least according to the company's adjusted figures. A non-GAAP operating margin of 34.6% in the third quarter looks great, and non-GAAP net income of $323.3 million on revenue of $1.1 billion is downright impressive. Free cash flow totaled $272.6 million, down year over year but still solid.
Beyond the glitz
For the most part, tech companies report non-GAAP profit metrics so they can back out stock-based compensation. It's a non-cash expense, after all. Non-GAAP metrics make sense when there are one-time items that aren't expected to recur. In that case, they can give investors a better idea of true profitability.
But stock-based compensation is a recurring expense. It's non-cash, but it's still an expense that shows up each and every quarter. Stock-based compensation wasn't a huge deal when Zoom was booming. In fiscal 2022, which ended Jan. 31, the difference between GAAP and non-GAAP net income wasn't all that meaningful. GAAP net income of $1.38 billion and non-GAAP net income of $1.55 billion on revenue of $4.1 billion looked good no matter which number you preferred.
But as Zoom's stock has crashed, stock-based compensation expenses have exploded. That's not too surprising -- getting paid in stock is much less appealing for employees and executives when the stock price is tumbling. Zoom has had to grant additional equity to retain employees, and that's getting expensive.
In the third quarter, Zoom's stock-based compensation totaled $303 million, nearly tripling from the prior-year period. GAAP net income was just $48.4 million, 85% below the non-GAAP figure. Free cash flow would have been negative if stock-based compensation were backed out.
Some people surely believe that largely ignoring stock-based compensation because it's non-cash is totally fine. But in Zoom's case, the company is effectively converting that non-cash expense into a cash expense with its buyback program. Want to show higher adjusted profits and cash flow? Turn on the stock option printing press, then buy back shares to offset the dilution.
Over the past three quarters, Zoom has spent $991 million buying back its own stock. The diluted share count declined only slightly in that time, from 306 million to 302 million. Zoom effectively paid around $250 per share, far above the stock price at any point over that time frame. A big chunk of these buybacks simply offset the dilution caused by Zoom's excessive use of stock-based compensation.
Buybacks are a financing cash flow, so they don't show up in any of Zoom's profitability metrics. But it's hard to argue that Zoom's stock-based compensation is truly a non-cash expense.
Zoom's real profits are tumbling
GAAP net income is not a perfect number by any means, but in Zoom's case, it's certainly a better reflection of true profitability than the metrics the company wants you to use. GAAP net income plunged 86% year over year in the third quarter as costs, including stock-based compensation, exploded. Research and development expenses nearly doubled, and sales and marketing spend shot up by 45%.
For the fourth quarter, Zoom is calling for non-GAAP earnings per share of $0.78 at most, down from $1.11 in the third quarter. If the stock-based compensation situation looks similar, it's very possible that Zoom's GAAP net income will drop into negative territory. Zoom is on the cusp of becoming an unprofitable tech company, something that would have been unthinkable a year ago when the company was flying high.
Zoom's revenue growth has stalled, and its real profits are falling off a cliff. Meanwhile, the company is painting a much rosier picture with its non-GAAP metrics. Don't fall for it. Zoom's costs are out of control, and with little growth on the table, cost cutting seems inevitable.