ZS - Zscaler: More Pain Ahead Despite Strong Growth

Summary

• Zscaler has underperformed the cybersecurity industry by more than 100%, suggesting that, beyond the tech sell-off, there other underlying issues weighing on the stock.
• The business has been doing well, achieving record revenues in a challenging macroeconomic environment.
• The stock's downside risk is, however, too high right now as the business growth does not justify the stock's insanely high valuation.
• In a market environment where valuation multiples matter more in investors’ decision-making process, ZS will struggle to attract buy and hold investors.
• This will leave it vulnerable to more selling, potentially setting up investors for more pain in 2023.

Zscaler Inc ( ZS ) has in the past 12 months fallen more than 60% amid a sustained sell off in tech stocks triggered by interest rate hikes by the Fed. However, the fact that ZS has fallen more than the overall cybersecurity industry, represented by the ETFMG Prime Cyber Security ETF ( HACK ), suggests there could be other underlying issues weighing on the stock beyond the market's shift away from richly valued high-beta tech stocks. ZS has underperformed the industry by more than 100% as the chart below illustrates.

A stock's long-term performance is usually determined by two factors - the performance of the underlying business and its valuation relative to this performance. I'll look at both factors to determine why ZS has aggressively sold off over the past year and if a turnaround in the stock is in the cards for 2023.

The business is doing well

ZS's underlying business is in the best shape it's ever been. The cybersecurity company closed FY 2022 (July 2022) with record annual revenues of $1.1 billion, a 62% year on year jump. For FQ1 2023 (October 2022), ZS was able to deliver revenues of $355.55 million, 54% higher than the previous year, $14.78 million ahead of analysts' estimates, and also higher than guidance of $339 million to $341 million issued by the CFO in the Q4 2022 earnings call .

What is impressive in my opinion about ZS's performance is its resilient sales process that has enabled it to deliver strong revenues despite tighter spending by enterprises in the past few quarters. Fears over a recession and tighter financial conditions due to rate hikes have led to deals taking longer to close. ZS has circumvented this challenge by producing what the company's CEO and Chairman Jay Chaudhry describes as "CFO ready business cases." This has enabled it to close a large number of multi-year and multi-product deals in recent quarters.

ZS also scores highly when it comes to customer satisfaction, which is important in a highly competitive industry like cyber security where compelling substitutes are readily available. Speaking at the Q1 2023 (October 2022) earnings call , Jay noted that the company's net retention rate had exceeded 125% for eight consecutive quarters and that its Net Promoter Score was more than 2 times the average NPS for SaaS companies.

ZS had 348 customers paying more than $1 million annually in October 2022, up 55% from 224 in the prior year. It further had 2217 customers paying more than $100K in October 2022. Overall, it has more 6700 customers, indicating that it has a diversified base of large established enterprises and small and medium sized businesses.

ZS has a long-term ambition of serving 200 million users across its customer base, according to the CEO. In July 2022 it served 34 million users, meaning it's still in the early innings of growth and the current lack of GAAP operating profits is not a major concern given it has not achieved its optimal scale. This notwithstanding, the lack of profits has weighed on the stock given investors have been more cautious about buying stocks with negative earnings at a time of higher interest rates.

Still too expensive

ZS is growing robustly and is on track to deliver an even stronger FY 2023, with management expecting annual revenue in the range of $1.49 billion to $1.50 billion, representing approximately 37% year-over-year growth.

While this growth is impressive, it's not high enough to justify the current valuation. ZS has never been a cheap stock and the downturn in its share price in the past year has not changed this fact. Despite a 60%+ drawdown, the stock has an insanely high valuation . Its P/E Non-GAAP is 131x for the trailing twelve months and 89x fwd. Likewise, its EV/EBITDA ((FWD)) is 65.11x .

Price/sales is generally more appropriate for a company like ZS which is still investing in its growth. Even here, it is overvalued in my opinion. It has a P/S ((FWD)) of 10.41x. This should be in the single digits given the current macroeconomic backdrop and the fact that tech stocks with negative earnings can no longer command premium valuations in the current market environment.

In retrospect, it was the speculative mania during the pandemic that set up ZS for failure. The stock, like many other tech names, moved too high, too fast. The crash in 2022 has not corrected this overvaluation. This means that even with a great underlying business, it could still struggle to get long-term investors given we are in a market environment where valuation multiples matter more in investors' decision making process. For this reason, I believe that things will get worse before they get better for the stock.

What next?

The silver lining is that ZS's underlying business is doing well. Cybersecurity is also a durable theme and overall demand is unlikely to wane in coming years as more companies make progress in their digital transformation agenda. ZS's growth is strong and, from the look of things, GAAP profitability is on the horizon. This could make ZS a potentially rewarding turnaround play at some point in the future . However, I wouldn't hold my breath for this turnaround as the present valuation suggests there could still be more downside.

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