Summary
- Is it all over for cybersecurity stocks? Okta just dropped another 30% after an already torrid year for the stock.
- CrowdStrike on the other hand has moved up well since its lows in May.
- Zscaler is due to report earnings next week - will it plumb the depths like Okta, or hold up like CrowdStrike?
- We investigate below. Read on!
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First, Some Context - It's A Wonderful Time To Report Earnings, Not
Before we turn to Zscaler ( ZS ) let's consider the market in which the stock sits. This is important, as you'll note later in this article.
Equity markets are rather jittery right now. Zooming out, both the S&P500 and the Nasdaq-100 are following textbook patterns since the 2016 and 2018 lows respectively, but whilst one can take comfort from this at a helicopter viewpoint, the daily machinations of the indices and in particular single stock names is a little less relaxing. In essence we have a number of forces acting upon stocks.
- The Midterms. Sailing into the midterms with poor people getting hammered by inflation, and rich people getting hammered by the Fed's response to inflation, isn't a great way to bolster support for the incumbent flavor of Administration. So this is a bullish force on stocks we believe.
- The Fed. Who can say? Mixed messages aplenty and that's just from its Chairman. July PCI inflation was flat on June; we'll see what August PCI brings vs. July but why the Fed believes that the US can return to a 2% inflation level is beyond us. 2% was viable as a result of the globalizing, deflationary policies adopted by most of the developed world through the 2000s to around 2016-17. Since then, the world is leaning towards less not more liberalization, and with the elevation of both tariff and non-tariff barriers across most economic areas one would have to assume that prices generally are going to run higher, not lower. So whether the Fed is genuinely targeting 2% and will raise rates at a pace that they believe can deliver 2% - or whether this whole game lately is just a statement of intent to set boundaries for markets - who knows. Not us. This week the Fed has been negative for equities, last month it was positive, yet the inflation data is improving not worsening. So let's call the Fed a wildcard, which is always what you want from the world's prime central bank.
- Big Money. By and large, institutions are in our view gunning for stocks to move up. This is a huge broad-brush statement but what lies behind it is that in our detailed stock-by-stock work, we see a lot of names exhibiting institutional accumulation behavior on their respective stock charts - in other words high volumes of trading with the stock price moving somewhat sideways in a defined band. We think that, following Wyckoff , this is likely Big Money building positions in stocks at these low levels to then enjoy a future move up. Big Money's teenage members are however punishing folks day to day by buying big in index puts, which is dragging down the SPY and QQQ around key option expiry dates. But net net we think Big Money is a bullish force.
- Chad. We had a comment recently on one of our notes - "Who or what is Chad?". You know Chad. We all know Chad. Worse, there is a little bit of Chad in all of us, whether or not we care to admit it. Chad YOLOs meme stocks and NFTs, buys at the top because it's all goin' to the moon and sells at the bottom because recession. Chad lives right across the street in his mom's basement, and also lives on your shoulder whispering unhelpful ideas into your all-too-willing limbic brain. Chad is a negative for stocks right now, because Chad is Afraid. Very Afraid. But the Sum Of All Chads still doesn't amount to very much money, so Chad can't move the market. Chad is merely there to give more money to Big Money so that they can become Even Bigger Money.
Taken together and until price action proves otherwise, we believe markets are in an up-trend right now. That the SPY and QQQ are capable of new highs - above the Q4 2021 peaks - before the next big move down. Here's a couple charts illustrating our view on each.
First, SPY. You can open a full page version of this chart, here .
Wave 1 from the 2016 lows to the pre-Covid peak; a textbook 78.6% retrace to the Covid lows; a textbook 161.8% extension up to the Wave 3 peak at the end of last year; and a (so far) textbook Wave 4 drop to between the 38.2% and the 50% retracements of the Wave 3 up. That the SPY fits these standard wave patterns so well is one reason we lean bullish on the outlook. (The other reasons are because we think the midterms trounce the Fed, and we think Big Money trounces Chad).
Next, QQQ - full page version, here .
Same story as SPY except the timeframe is truncated and the moves are amplified - which is logical if you think about it, since QQQ is a more risky asset than SPY. The Wave 3 peak was a bigger extension than SPY - a 2.618 rather than 1.618 extension of the respective Wave 1s - and so the Wave 4 trough has been a bigger retrace too - between the 50% and the 61.8% retrace rather than between the 38.2% and the 50% as for SPY. But, in essence, the same thing just with more risk to the upside and to the downside. So our conclusion - a move towards new highs before a larger-degree move down - is the same as for SPY.
This therefore is the backdrop, the assumptions, the cognitive bias, whatever, against which our Zscaler assessment should be considered. If we're wrong on the market we're likely wrong on ZS. You will, as always, reach your own view.
One thing we can be fairly sure of is excessive earnings reaction, be it to the upside or the downside. Q2 earnings season in the stocks we cover has seen hardly any "meh" responses from the market. For a moment there NVDA looked like "meh" but then China and Jackson Hole and just like that, it was gone.
So Will Zscaler Moon Or Bomb?
If we look at the two most direct comparators - because, one, they both operate in the cybersecurity sector and, two, they both have January year ends and so reported their Q2 numbers very recently - CrowdStrike ( CRWD ) and Okta ( OKTA ) can give us some guard rails as to what may happen when ZS reports.
CRWD printed a very good quarter on fundamentals - not so much the headline numbers, which continued to show declining revenue growth rates and also declining unlevered pretax free cashflow margins - but beneath the waterline, specifically the deferred revenue growth, which moved up a lot. Deferred revenue is, as you know, the total amount of prepaid, yet-to-be-delivered customer contracts; a big move up in deferred revenue growth, if deferred is a big % of TTM revenue (which it is at CRWD) is a signal that recognized revenue growth may also tick up in the near future. This was clearly a bullish signal and the market responded initially with a big move up. But then came the last couple days' worth of general dumpage, and that was that. Full page chart, here .
OKTA printed a solid quarter on fundamentals and actually raised guidance - we had to triple check this given the stock response! - despite which the stock was utterly hammered into the ground. If you'd like to understand why that happened, you might read this . Very curious self-flagellation by the CEO on the earnings call by the way. Full page chart, here .
So we have had: good results, stock whacked ( CRWD ); good results but general M&A malaise underneath the hood which will likely rear its head in the future, stock whacked ( OKTA ).
As we said above - great time to print earnings. Not.
Zscaler fundamentals are supported by a large deferred revenue balance and an even larger Remaining Performance Obligation book. As you will recall, RPO = the total forward customer contract book of yet-to-be-recognized revenue, comprising both prepaid contracts (= deferred revenue) and not-yet-paid contracts.
Here's the numbers up to and including Q1.
Zscaler Fundamentals (Company SEC filings, Cestrian Analysis, YCharts.com)
Nags last quarter included a flat rate of revenue growth - acceleration is always the best bet to get a stock moving up - and a weak cashflow quarter which really dragged down TTM unlevered pretax FCF, from 13% to 9% margins in one quarter. Deferred revenue growth and RPO growth also slowed. So the scene is set for a further slowing of the forward growth indicators and even if the company has been prudent with cash, an increase in margins won't in and of itself compensate for any material slowing on the revenue line. Given what looks like a general easing of urgency amongst enterprise customers to ramp software spending - even in cyber - we aren't hugely confident of rockstar fundamentals from ZS this quarter.
The valuation is, er, punchy, so the risk of a drop on a weak print is obvious.
ZS Valuation (Company SEC filings, YCharts.com, Cestrian Analysis)
The chart however offers a more positive outlook, and since stocks run ahead of the news (as CRWD evidences - it has been moving up fast since the June lows when lo and behold the August earnings print revealed a big bump in prepaid orders - amazing coincidence!), we tend to lean towards believing the chart not the fundamentals at this point.
You can open a full page ZS chart, here .
Here we start the count at zero, which may seem odd - it is odd but then all chart voodoo is odd - but we find this works quite well for recently IPO'd stocks. We get a Wave 2 down troughing at the Covid lows with a 61.8% retrace (that's a little shallow for a Wave 2 by the way, setting ZS up for a deep Wave 4 correction), Wave 3 peaking at around the 3.618 extension of Wave 1 (so, way riskier than the S&P or the QQQ) and Wave 4 bottoming so far at between the 61.8% and 78.6% retracement of that huge Wave 3.
We rate ZS at Accumulate, in the range $108-$166, defined by those last two Fibonacci retracement levels. Below $108, something bad has happened, hence the 'stop zone' and in fact a tighter stop would be simply beneath the May lows in the high $120s.
The chart says this can make a new high in a year or two. That looks rather overconfident to us but that is what the chart says, and these Fib/wave charts have a tendency to surprise us by coming true more often than can be coincidence. But that is what the chart says, and as you know we lean bullish on the market, so, Accumulate rating it is.
Just remember to buy a tin hat in case rubble starts raining down on earnings day!
Cestrian Capital Research, Inc - 2 September 2022.
For further details see:
Will Zscaler Crater Like Okta?