ZS - It's Always Early In Cybersecurity: We Rate Zscaler At Accumulate

2023-10-11 18:33:14 ET

Summary

• Zscaler is a highly volatile stock that we believe offers high gain potential at the expense of needing careful shepherding.
• The company is a leader in the "zero trust" network protection niche within cybersecurity.
• The fundamentals of Zscaler are strong, with high rates of revenue growth, solid margins, a large order book and a healthy balance sheet.
• We rate the name at Accumulate.

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Preamble: Volatility Also Can Be Good

In a moment we shall get down to business and talk about Zscaler ( ZS ). But allow us this indulgence for a moment, for as you will see, it's a sidebar very relevant to ZS stock prospects.

The context is this: The problem with owning highly volatile stocks is that they have a tendency to swoon, hit the deck, and then dig for the basement even when more sanguine securities have recovered their composure and begun moving at least sideways. And this puts people off owning them, and it particularly puts folks off buying them at the lows.

The wonderful thing about highly volatile stocks is that if you catch them right, they can rip upwards and print you money all day long and make you look like the genius that none of us are. As long as you remember to sell them at the highs.

The poster child for this is, of course, Nvidia ( NVDA ). When NVDA put in a 10x move from the 2019 lows to the 2021 highs, it then dumped around 80% of that value gain in less than a year. Whereupon it was declared by all right-thinking folk everywhere that of course the stock was a scam or a Ponzi or a bubble or a bull trap or a... you get the point. It could never happen again.

Whoops! Since the October 2022 lows , NVDA then delivered a 5x money gain in... less than a year. And this is our point. Volatility can also be good. The sun also rises. Here's NVDA, which is likely to continue to climb, in our view. We had the stock rated at Accumulate between $100-150 last year, as you can see from that link above).

ZScaler, For When You Want To Look To The Stars

Let's now turn to ZScaler. This too is a crazy-volatile stock. From the COVID crisis lows in March 2020 (when the company had recently hit some sales execution problems, so the stock was languishing anyway) to the 2021 all-time high, the stock delivered better than 10x money. $35 to $370/share in less than two years. And then promptly lost around 80% of that gain in the following 18 months or so. When tech in general was bottoming out in Q3-Q4 of 2022, ZS kept looking downstairs, finally bottoming in May 2023. Not an easy one, but then the big winners never are.

The company is a leader in a specific niche within cybersecurity, being "zero trust" network protection. They're a leader in this segment by dint of having coined the term and spun it into a thing which they now dominate. This is product marketing 101 (invent a thing, have everyone conclude that it's an important thing, and be the biggest provider of that thing by default because ... you invented it), nothing new under the sun in that method, but they have executed it well. The new battleground between enterprise buyers and cybersecurity vendors is something called SASE which we can talk about another day. Suffice to say that ZS doesn't have quite the grip on that term that it does on zero trust, but it can likely dominate it anyway.

Cybersecurity is a perennially early stage sector. It never really matures, because bad people are always finding different ways to do bad things using computers. The difficulty of investing in cybersecurity historically is that product cycles tended to be nasty, short, and brutish, so even if you thought you had invested in the hot stock, it soon ran out of opportunity and was steamrollered by suite vendors of yore such as McAfee, Norton and so forth. The advent of cloud computing as the default application delivery mechanism has changed this somewhat. It means that the vendors no longer deliver a static product but can keep updating the product and/or service as the threat environment evolves. This is how Palo Alto Networks (PANW) hasn't simply gone into a slow decline as a legacy box vendor, and it's how we believe ZScaler can remain a go-to vendor even as network architectures and threat vectors change.

The fundamentals are rock solid. Let's take a look.

• Revenue growth of 48% on a TTM basis, on a revenue base of $1.6bn. Growth is slowing a touch - it was +43% in the most recent quarter - but nothing too harmful for the stock in our view.
• Unlevered pretax free cashflow margins of 10% and EBITDA margins of 16%, both on a TTM basis.
• Nearly $1bn net cash on the balance sheet.
• An order book (remaining performance obligation) worth more than 2x the last twelve months' worth of recognized revenue.

Valuation is chunky as you might expect. But we don't think this will get in the way of the stock moving up. Stocks like this one are always "too expensive" and have been since the dawn of time. We don't expect that to change.

And now the part you can lob rocks and rotten tomatoes at. The stock chart.

Here's how we think this crazy-volatile adrenaline-mainlining degenerate name can pan out.

We've had ZS rated at Accumulate between around $85-165. That's a wide range of course, but you have to situate that in the context of the volatility of the stock. We rated NVDA at Accumulate between $100-150 which sounds silly until you see that $500 top-ticked not too long after. We define our Accumulation Zones according to the breadcrumb trail laid by Big Money, whose money is so Big that they can't just YOLO into names like this. They have to take their time buying, lest the stock price start to run up uncontrollably as momentum investors catch a whiff of the game. Those gray volume x price bars on the right hand side of the chart, together with the Fibonacci retracement levels from the 2021 highs down to the 2023 lows, are what set the boundaries of our Accumulation Zone.

Strictly speaking at $173 - the price at the time of writing - we ought to call this a Hold, but what's $8 between friends, right? So we'll repeat that Accumulate rating in this note here.

Technically we think the stock can run to the $600s without any great controversy. It would be imprudent to buy great chunks of the thing in the $170s then sit around waiting for the big six-oh-oh to happen. Even if it does happen, it won't be only-up, and it won't be quick. So you might consider building a stake in this name and using stops judiciously in case it decides to head for the basement once more. Below $85, something has gone very wrong, and most folks don't like a 50% delta to their stop, so you may want to put something nearer than that. (Not too near, as your local stop-hunter will take you out just for yucks.) The hardest part of all is if the stock starts to really climb. How to protect your gains - sell and risk selling too early? Use a trailing stop? How much trail, given the volatility - 10% can be blown in a single day. 20%? These are the hard questions and the pitfalls that must be navigated to really make bank in a name like this one. But we think the opportunity is there for the patient.

Accumulate rating.

(By the way - you can read all our prior Seeking Alpha coverage of this name here .)

Cestrian Capital Research, Inc - 11 October 2023.

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