Sometimes a stock is cheap for all the right reasons. Sure, Wall Street is often too focused on the short term, and that pessimism can create attractive buying opportunities for patient investors. But in cases where a stock's plummeted from its highs, the slump could be tied to negative and potentially enduring changes in the company's earnings outlook.
The main challenge for investors seeking a bargain is being able to separate those stocks that are being penalized for temporary issues from those being penalized for the more permanent variety.
But which category applies to Zoom Video Communications (ZM 1.57%)? This video communications specialist enjoyed massive growth during the early phases of the pandemic. Now it's trailing the market by a wide margin. Is this a temporary or permanent situation? Let's take a look.
Where will Zoom's future growth come from?
Growth stock investors can be too preoccupied with the question of where the next phase of growth will come from. But in Zoom's case, they are right to worry. The company saw declining subscriptions for its online platform in recent quarters, and it's not clear when that segment will return to growth.
The enterprise division is faring much better, having expanded at a 10% pace year over year in the most recent quarter. It's also good news that this segment accounts for nearly 70% of Zoom's business.
But investors can find much faster growth in other software-as-a-service (SaaS) businesses. Okta (OKTA -0.69%) grew year-over-year sales by over 20% last quarter. Microsoft (MSFT 1.82%) increased its cloud services revenue at about the same blazing rate. In contrast, most Wall Street pros forecast nearly flat overall sales for Zoom in the current fiscal year.
Cash flows are a plus for Zoom
Zoom does have an unusually strong financial footing, though. Operating cash flow is solidly positive and expanding as a percentage of sales. Compare Zoom's cash flow rate of 29% of sales this past quarter to Okta's 10% figure for confirmation that this business can easily fund its own growth investments.
Zoom is also profitable, although just barely. Investors have better options on this score. Microsoft is the industry leader with operating margin of over 40% of sales. But cybersecurity specialist Palo Alto Networks (PANW 0.91%) is making big strides toward double-digit margins, potentially reachable as early as 2024. The good news is that investors don't have to worry about Zoom surprising them with big annual losses. But the company isn't expanding quickly enough to ensure impressive profit margins right now.
Zoom's price is discounted and its outlook attracts hesitancy
Zoom's stock is priced at a significant discount to most of its enterprise services peers. Shares are valued at 4.6 times annual sales, while both Microsoft and Palo Alto Networks are valued at around 12 times sales. Okta, which is growing about as quickly as Palo Alto Networks but lacks its profitability, is trading for over 6 times sales. Clearly, Wall Street is more pessimistic about Zoom than many of its peers. And it can be a good strategy to buy stocks that are temporarily out of fashion among investors.
The problem is, Zoom hasn't demonstrated that it has a path back toward robust sales growth. That makes the stock more of a watch than a screaming buy, even though it looks cheap based on some metrics like price-to-sales.
Zoom could work its way back into Wall Street's good graces as it builds out its communications platform and works to expand contract sizes for its new and existing customers. But investors are right to follow a "wait-and-see" approach with this stock right now.
