Zoom Video: $1.5B Buyback Is A Game-Changer (NASDAQ:ZM)

Zoom Video Communications (NASDAQ:ZM) reported slowing top line growth in Q4’23, but otherwise had a decent earnings report that caused the share price to increase about 8%. Both earnings and revenues beat consensus expectations and Zoom Video is generating solid free cash flow margins. The video-conferencing company also issued a robust outlook for FY 2025 in terms of free cash flow margins, and the announcement of a $1.5B stock buyback is a game-changer as well. While I believe that the risk profile has improved, I believe the valuation as such remains unattractive for now. Therefore, I am up-grading my rating only from sell to hold!

Previous rating

I worked on Zoom Video in August 2022 and indicated that the company was set for slowing top line growth as the U.S. economy transitioned out of the pandemic: The Growth Party Is Over. Since then, shares have declined by 22% and top line growth did slow down to the single-digits. Given that the company is now solidly free cash flow-profitable and announced a stock buyback in the amount of $1.5B, I believe the risk profile is improving. The valuation, however, remains stretched and holds me back from issuing a buy recommendation.

Continued revenue slowdown, net retention rate challenges

Zoom Video benefited greatly from the COVID-19 pandemic as companies changed their business processes and required video-conferencing technology to establish new communication channels. Zoom Video owns a communications platform that includes video, voice, chat, and content sharing functionality which has seen growing customer uptake, especially in the enterprise market.

After the pandemic, however, Zoom Video’s growth has cratered significantly and the firm only achieved a disappointing top line growth rate of 2.6% year over year in its most recent quarter. Enterprise revenues, which are derived from the largest customers on the Zoom platform, grew 5% to $667M, but overall Zoom Video’s revenue growth has been a major disappointment.

The revenue challenge is compounded by another key challenge that I see and which relates to Zoom Video’s net retention rate, which has rather consistently declined in the last year as well.

Software companies measure their ability to upsell and organically grow their revenues through a ratio called net dollar expansion rate, or sometimes (dollar-based) net retention rate. This figure measures by what percentage a software company has been able to grow its revenues from the same customers year over year.

In the fourth-quarter, Zoom Video reported a TTM net dollar expansion rate/NDER of 101% compared to 105% in the third-quarter. The trend is quite negative, with the NDER trending down consistently every single quarter in FY 2024. In other words, Zoom Video’s ability to upsell its customers has greatly deteriorated: in Q3’21, Zoom Video’s net dollar expansion rate was above 130%, so the company is potentially running into organic revenue growth challenges in the near term.

Free cash flow, improvement in FCF margins

Zoom Video is free cash flow-profitable and achieves decent margins as well. In the fourth-quarter, the video-conferencing company reported $332.7M in free cash flow, showing 81% year-over-year growth. During this time, Zoom Video’s free cash flow margin expanded from 16.4% to 29.0%, chiefly because of the firm’s success with the lucrative enterprise market segment. The enterprise customer base is hugely important to Zoom Video, and the outlook for FY 2025 is a positive one as well.

Outlook for FY 2025, Zoom Video’s $1.5B stock buyback is a game-changer

Zoom Video is guiding for $4.6B in revenues (+1.6% Y/Y growth) which was slightly less than expected ($4.66B), but the company continues to expect a ton of free cash flow in FY 2025. With $1.46B in free cash flow projected this year, the company is looking to achieve a FCF margin of 32% (compared to a 33% margin for FY 2024).

The good news here for shareholder is that they can expect a return of this free cash flow as the company announced a $1.5B Class A common stock buyback yesterday. Although Zoom Video gave no timetable for its stock buyback, the company could return almost all of this year’s FCF to shareholders. At a current share price of $68, the buyback could allow Zoom Video to repurchase about ~7% of its outstanding shares.

Zoom Video’s valuation

Shares of the video-conferencing company are trading at 4.0X forward revenues. In my opinion, a 4.0X P/S ratio is a bit hard to justify given the risks associated with a declining NDER figure and weakening monetization in a low-growth industry. Zoom Video’s shares are also trading at only a small discount of 9% to the 1-year average price-to-revenue ratio. I am using a P/S ratio chiefly because the company has attracted investors based off of its revenue growth prospects in the video-conferencing market in the last couple of years.

A P/S ratio of 3.0X would be more appropriate, considering that the company is not seeing any real top line growth anymore and that it is struggling with its NDER measure. A fair value P/S ratio of 3.0X implies a fair value, for me, of about $50. At this point, I would consider revisiting Zoom Video and potentially buying the shares.

Risks with Zoom Video

Zoom Video’s biggest risk relates to the valuation, in my opinion. Shares are not cheap given the weakness in top line growth. The platform’s business trends are not entirely favorable (free cash flow, however, is) and I would be especially concerned as an investor about the company’s weak net dollar expansion rate trend, which has fallen dangerously close to 100% in the last quarter. A drop below 100% could indicate more severe monetization challenges and result in negative top line growth for Zoom Video (a metric that is worth tracking going forward).

Closing thoughts

Zoom Video is set to generate only low-single digit top line growth this year, and the net dollar expansion rate trend is not great. If monetization of the company’s enterprise customers weakens, then Zoom Video may soon run into real growth problems. An already weak revenue trend and soft monetization together are key issues of concerns that stand against improvements in free cash flow margins as well as the $1.5B stock buyback, which could support the share price in the short term. As a result, I believe Zoom Video is worthy of an upgrade after Q4’23, but the valuation is still too unattractive for me to risk my capital!