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Zoom Video Communications Cl A(ZM-Q)

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1 Reason to Sell Zoom Stock, and 1 Reason to Watch It and Be Patient

Motley Fool - Sun Aug 27, 8:30AM CDT

Good news: Zoom Video Communications (NASDAQ: ZM) reported better-than-expected earnings for the second quarter of fiscal 2024 (the three months ended in July 2023)! Bad news: The business continues to put up pathetically low growth numbers, all the while still in need of shrugging off more elevated expenses.

In several ways, the pandemic broke Zoom. Years of growth were pulled forward, and now it should be a value-style stock, but it doesn't have the necessary business governance to do ex-growth business things like pay a dividend and repurchase ample amounts of stock.

Investors certainly wouldn't be wrong to sell and move on (if they're still holding this stock), but there was at least one reason to continue being patient with Zoom after its latest earnings update.

One big reason to sell Zoom stock

Zoom did slightly beat its own expectations for its last quarter, but that's not saying much. The slight upgrade to current year guidance implies revenue will grow just 2% year over year to a range of $4.485 billion to $4.495 billion.

Worse still, free cash flow (FCF) growth has stalled out this year too. Sure, FCF can be a highly volatile metric from one quarter and one year to the next. Nevertheless, any hope that this profit metric could keep expanding following record figures during the pandemic has been dashed, at least for now.

ZM Revenue (TTM) Chart.

Data by YCharts.

By certain counts, Zoom stock is cheap. It currently trades for 18 times trailing-12-month FCF. However, the company's key profitable growth rates have fallen below the rate an investor could get from simply owning bonds. Thanks (sort of) to the U.S. Federal Reserve's record interest rate hikes in 2022 and 2023, the Vanguard Short-Term Bond Index Fund ETF now yields nearly 5% a year in income.

As long as Zoom continues putting up growth rates like it just did -- as well as not returning any cash via dividends or stock buybacks -- few investors are likely to suddenly feel like flooding the market with buy orders for the stock. This alone could be a good reason to sell and move on.

If you're keeping score on this, and I think you should, Zoom ended July 2023 with $6 billion in cash and short-term investments and zero debt. It's high time for management to start returning cash to shareholders, one way or another.

One reason you might want to remain patient

Of course, by some measures, Zoom is still managing to put up growth even in a difficult economic environment. Many cloud computing companies have been reporting sharp slowdowns in sales as customers look to conserve cash in 2023. Zoom is no exception. However, stripping away its more volatile individual and small-business customers, enterprise-grade revenue (big business accounts) was up 10% year over year in Q2.

And while it continues to manage through these tough times, management is starting to get a handle on expenses. The result has been fast-improving generally accepted accounting principles (GAAP) net income. Through the first half of the year, net income increased 24% to $197 million. That's notable, and things could improve even more if Zoom is able to turn a corner on its ballooning employee stock-based compensation ($544 million so far this year, up 17% from last year's levels), which gets subtracted from GAAP net income.

For value investors, it's this specific profitability metric that matters most, and Zoom is recovering. The stock now trades for about 26 times price-to-GAAP earnings per share (EPS) if we annualize EPS ($0.59 per share) from the last quarter. This is no great value, but if Zoom keeps making fast progress through next year and maybe picks up just a little steam in the revenue growth department, the stock could finally begin to mount a recovery.

For this reason, you might want to exercise some more patience with Zoom stock if you already own it. It's far too soon for me to label the beaten-up cloud stock a buy, but there's still enough progress being made to keep me from dropping my interest in Zoom completely.

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Nicholas Rossolillo has positions in Zoom Video Communications. The Motley Fool has positions in and recommends Vanguard Bond Index Funds - Vanguard Short-Term Bond ETF and Zoom Video Communications. The Motley Fool has a disclosure policy.

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