ZS - Zscaler: Room To Rise After Recent Volatility

2023-09-24 02:54:07 ET

Summary

• Tech stocks are experiencing a dip in the market as investors adjust their long-term interest rate assumptions.
• Zscaler, a cloud-based cybersecurity company, is still showing strong performance despite the drop and has potential for further growth.
• The company's fiscal FY23 results, guidance for FY24, and expansion plans indicate its position as a leading player in the cybersecurity market.
• Though not cheap at ~10x forward revenue, Zscaler's position as a "Rule of 40" software stock justifies its premium multiple and paves the way for further upside ahead.

Markets are dipping again, with tech stocks feeling major pain as investors increase their long-term interest rate assumptions after a hawkish tone set by the Fed during the latest September meeting. It's a great time, in my view, to pick up shares of high-quality tech stocks while they're trading off recent highs.

Zscaler ( ZS ) represents the epitome of quality among growth mid-cap software. This cloud-based cybersecurity company is still up nearly 40% year to date despite the recent drop, but I think there's still plenty of upside left to go.

I wrote a bullish opinion on Zscaler (an upgrade from a prior neutral viewpoint) when the stock was trading closer to the $140s. Now, several new factors have come into play:

• The company has closed out its fiscal FY23, showing incredible strength in billings and large customer momentum despite a soft macro environment
• Zscaler also set guidance for FY24 that showcases continued improvement on margins, solidifying the company's position as a "Rule of 40" company

Note as well that the company recently crossed the >$2B ARR threshold (doubling its ARR in just under 2 years), and has its sights on >$5B in ARR through new product expansions:

The company is leaning on workload expansion as well as new releases to drive the next doubling in ARR. The company expects emerging products to drive 20% of new deals in FY24 (the year the company just began), versus a rate in the high single digits in FY21.

All in all, I remain quite bullish on Zscaler and advocate buying on the dip. As a refresher to investors who are newer to this name, here are the core elements of the bull case for Zscaler:

• New product expansion to drive ARR growth. Zscaler has already made its imprint as the leading cloud-based cybersecurity vendor. As it expands its product portfolio into different workloads, the company has the opportunity to capture more of its massive market.
• Security is recession-proof. We've heard from many companies in the software sector that IT chiefs are delaying large capital projects and that each deal is getting more heavily scrutinized. It's more difficult, however, to delay a critical security infrastructure purchase, and that's why Zscaler has been able to find success in both down and up markets.
• Growth at scale. Despite hitting over $2 billion in annual revenue, Zscaler is still growing its top line metrics (revenue and billings) at a >40% clip, which demonstrates the largesse of its market and its leading competitive position versus other cybersecurity companies.
• Incredibly high gross margin profile. Zscaler's pro forma gross margins in the 80s index very high relative to fellow software companies, and allows for incredible scalability at its more mature stage.
• Zscaler remains a "Rule of 40" company. Though revenue growth is decelerating, the company makes up for it with a rich low-teens pro forma operating margin. Zscaler's plug-and-play profitability makes it a safer bet in a more risk-averse market that has shunned unprofitable tech stocks.

Stay long here and use recent market weakness as an opportunity to buy shares.

Q4 download

Let's now go through Zscaler's latest quarterly results in greater detail. The fiscal Q4 (July quarter) results are shown in the snapshot below:

Zscaler's revenue soared 43% y/y to $455.0 million, obliterating Wall Street's expectations of $430.6 million (+35% y/y) by a large eight-point margin. Revenue growth also kept pace with 46% y/y growth in Q3, and we continue to marvel at Zscaler's ability to drive >40% growth despite its ~$2 billion annual scale - a feat rarely achieved in the software sector, not to mention during a macro recession.

Zscaler's billings also clocked in at 38% y/y growth (versus 40% y/y growth in Q3), indicating that high 30s/low 40s growth is likely to be sustained in the near term. Note that the company's outlook for FY24 calls for $2.050-$2.065 billion in revenue, which represents 27-28% y/y growth. Bear in mind that Zscaler frequently underpromises on its initial outlook and deploys a "beat and raise" strategy throughout the year.

Management notes that Zscaler's high-touch sales process (with reps pushing for deals to close) has helped the company execute well despite a softer macro climate. Per CEO Jay Chaudry's remarks on the Q4 earnings call:

While the macro environment remains challenging, we are executing well. With cybersecurity as a high priority, IT executives are moving forward with zero trust initiatives driving our business. As I mentioned before, we are partnering earlier with CXOs to create compelling CFO-ready business cases with clear ROI and payback periods. As our results demonstrate, refining our high-touch sales process is helping get large deals across the finish line. We have a blueprint for delivering immediate value, which drives faster upsells, often within 12 months of initial purchase. We closed a record number of deals over $1 million ACV in Q4, driven by broad based strength across our key industry verticals."

The company has managed to sustain top-line strength while exerting spending discipline, however. Pro forma operating margins of 19% improved over 700bps y/y (and forget the "Rule of 40", Zscaler achieved a Rule of 60)/

The company expects to generate 140bps of further operating margin efficiencies in FY24 (its 16% margin on top of 27-28% revenue growth still positions the company in the Rule of 40 despite expected deceleration), as shown in the chart below:

Valuation, risks, and key takeaways

At current share prices near $152, Zscaler trades at a market cap of $22.33 billion. After we net off the $2.10 billion of cash and $1.13 billion of convertible debt on Zscaler's most recent balance sheet, the company's resulting enterprise value is $21.36 billion. Versus the company's expected $2.05-$2.065 billion revenue range for the upcoming FY24, Zscaler trades at 10.4x EV/FY24 revenue - which certainly isn't cheap, but for a company currently growing revenue at a >40% y/y pace despite its scale and for consistently hitting "Rule of 40" targets, I'd say there is more room for upside here.

Of course, there are risks at hand that investors should be cognizant of. The first is competition: while Zscaler certainly made a name for itself as one of the first movers in security for cloud apps, there are a swath of legacy cybersecurity companies with deep pockets (like Palo Alto Networks ( PANW )) that could encroach on its territory. Valuation is another key risk: as revenue growth decelerates to the 30s and potentially 20s next year, and if interest rates expectations continue to hike upward, Zscaler may see downside.

All in all, however, I see more reward than risk. Stay long and buy the dip.

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