Edwin Tan/E+ via Getty Images

Edwin Tan/E+ via Getty Images

Zoom Video Communications, Inc. (NASDAQ:ZM ) is a poster child for the group of stocks that benefited from the early pandemic boom but ultimately faced a reckoning over the past year with the shifting market cycle. Indeed, ZM rallied by as much as 800% at its peak during 2020 fueled by the trends in remote working and virtual learning, only to reverse nearly all gains with the ongoing "return to normal" forcing a reset of expectations. The stock is currently down about 40% year to date and a humbling 80% from its all-time high.

The good news is that the deep correction has brought Zoom's valuation back down to Earth supported by overall solid fundamentals. The company just reported its latest quarterly result which beat expectations with positive operating metrics. At the same time, we highlight some ongoing growth concerns against what has evolved into a more competitive operating environment, particularly as Zoom looks to branch out into new business segments beyond just video. The stock likely has some upside in the near term but will continue to face long-term uncertainties so caution is warranted.

The company reported its fiscal 2023 Q1 earnings on May 23rd with non-GAAP EPS of $1.03, $0.16 ahead of the consensus estimate, but down 22% from $1.32 in Q1 last year. Revenue at $1.1 billion climbed 12% year-over-year which favorably contributed to a higher adjusted gross margin at 78.6% compared to 73.9% in Q1 fiscal 2022. By region, revenues from the Americas climbed 15% while APAC led growth with 20% higher y/y sales. On the other hand, the geopolitical conflict in Europe pressured the EMEA region which was flat compared to fiscal 2022.

The lower bottom line this quarter considers what has been a new effort at investments and spending to support the next stage of growth. For example, research and development expenses climbed 120% y/y, or up 358 basis points higher as a percentage of revenue to 7.9% on an adjusted basis from 4.3% in the period last year. Similarly, sales and marketing efforts have also seen a big jump as part of the strategy to expand internationally. The result is an impact on profitability as the non-GAAP operating margin at 37.2% is down from 41.9% last year. Nevertheless, the reported level of free cash flow at $501 million is up 10% in Q1 2022.

Even as the top-line growth this quarter was modest compared to trends last year and in 2020, it's worth pointing out that revenue is up 226% on a 2-year stacked basis compared to $328 million in Q1 fiscal 2021 at the start of the pandemic. Through the subscription model, the strength here is the recurring business with a move towards longer-term plans and a larger total of billions per customer.

The number of customers contributing more than $100,000 in revenue over the past year at 2,916 is up 46% compared to Q1 2022. Anecdotally, the corporate and enterprise-level customers as a group generating this much sales are likely those that have chosen Zoom as their preferred video communications service provider and utilize the platform as a necessary day-to-day tool. Our interpretation is that this metric adds a layer of quality to Zoom financials as the company becomes less dependent on smaller individual users that are less predictable in terms of month-to-month renewals.

Another key financial metric for the company is the remaining performance obligations (RPO) which is defined as the combination of unbilled and deferred revenue yet to be recognized. The total RPO at $2.99 billion, up 44% y/y, provides confidence for a continued growth runway through the rest of the year.

Finally, we note that Zoom ended the quarter with $5.3 billion in cash and cash equivalent along with a large portfolio of marketable securities, against zero long-term financial debt. The balance sheet position has always been a strong point of the company's investment profile and now represents nearly 16% of the company's $33 billion market value. A question among investors that often gets brought up is how the company intends to utilize that proverbial war chest.

On this point, into Q2 in May, Zoom announced the acquisition of "Solvvy", a leading artificial intelligence-based customer support platform. The thinking here is that there are synergies between Zoom's core unified communications product and customer experience solutions. Major companies already using Solvvy include Vimeo, Inc. (VMEO), Under Armour (UAA), and HelloFresh SE (OTCPK:HELFY). While the deal terms were not disclosed, it's likely the value of the transaction was only a small part of Zoom's liquidity, suggesting there is room for more corporate actions down the line. The deal also enhances other Zoom initiatives and new product features discussed during the earnings conference call:

A key part of our strategy is to enable more and more business workflows within our platform, and I am super excited about our recent launches of Zoom Whiteboard and Zoom IQ for Sales. Zoom Whiteboard is arming teams with the power of continuous collaboration in an easy-to-use solution that provides a virtual space to collaborate before, during, and after a meeting.

In terms of guidance, management expects top-line growth in the 9% range for the current Q2 while EPS around $0.91 represents a decline of -35% compared to Q2 fiscal 2022. Again, the trend here reflects higher investment spending with a lower operating margin. For the full-year fiscal 2023, the revenue target ranges right around $4.54 billion, if confirmed, which would represent an increase of 11% y/y. The 2023 outlook for EPS in a range between $3.70 to $3.77 compares to $4.50 in 2022.

Since Zoom reported its Q1 earnings, the stock has gained momentum, rallying from a low of $79.00 in May to a $111 currently, an impressive 40% move higher. If anything, the recent financials are strong enough to brush away fears of an unraveling operating environment or any concerns that customers were abandoning the platform. The context here also considers the broader market trading action with stocks and tech names getting a bounce in recent weeks against what has been extreme volatility all year. The NASDAQ-100 (QQQ) is up 12% from its cycle low.

There's a lot of ground to cover before really making a dent on year-over-year losses, but there is a sense that the sentiment has turned more positive. At the macro level, commentary from U.S. bank CEO's suggesting consumer spending is resilient despite the record inflation levels supports some optimism that the economy can move through the Fed's rate-hiking cycle.

There are also some signs that inflation could be peaking, opening the door for flexibility in monetary policy through 2023. Simply put, from the doom and gloom scenarios that dominated headlines for much of the year, the narrative is starting to change and ZM can benefit from that simply through market beta over the near term.

The longer-term question for Zoom is more complicated. This is a company that in the span of just a few years has become a household name revolutionizing the way business and online communications are done online. At the same time, the next stage of growth is going to depend on a new driver and business line. Zoom crossed $1 billion in quarterly sales for the first time in Q1, but we believe the next billion will be incrementally much more difficult.

The bet the company is making is that it can leverage its success in the video communications platform with the ancillary business services like contact center and even areas like customer experience with the Solvvy acquisition. Our take is that the company has not yet shown how successful those initiatives can be.

Even with the core platform, Zoom faces intense competition from tech giants like Microsoft Corp. (MSFT) which offers the alternative "Teams" platform built around a more collaborative video-based workspace environment. Zoom's response with "Whiteboard" converges many of the same features but it's clear the market share for incremental new business will be challenged. So what we're left with here is otherwise fundamentally strong that will need to keep proving itself into long-term uncertainties.

We mentioned that ZM's valuation has narrowed significantly to the current forward P/E of 28x based on the consensus EPS for this year of $3.77 which is in line with management guidance. This is a bargain compared to the earnings multiple above 500x at one point in 2020. That being said, the annual growth outlook for ZM now in the 12% range through 2025 is a far cry from the momentum the company saw in its heyday. The consensus for EPS growth in the single-digit range between 2024 and 2025 is hardly something to write home about.

That can be a problem when we start sizing up ZM against other tech leaders that are more diversified with an entire ecosystem of products and services while ZM is dependent on its single app. Curiously, MSFT trades at a similar forward P/E of 29x while the company is presenting higher top and bottom-line growth this year. In other words, it's hard to make the case that ZM is "cheap" even following the stock price crash.

We rate ZM as a hold with a price target for the year ahead at $120.00 representing a 32x multiple on the current consensus full-year EPS. In our view, one of the challenges for ZM is that the core business has become "boring" for lack of a better word. We know the level of enterprise-level customers and the implied growth runway based on RPO, so it leaves little room for the company to outperform current expectations which would be necessary for the stock to break out much higher.

One action that could make the stock more interesting would be the initiation of a regular dividend giving it more of a value appeal. The only way to justify ZM's valuation is with some conviction that its initiatives with contact center and customer experience will really take off which are still unproven.

The biggest risk here is that the operating momentum loses traction. Signs that customer growth is slowing or an alternative solution is gaining market share would force a reassessment of the long-term outlook and open the door for another leg lower.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.