Summary
- Zscaler, long one of the most expensive stocks in the SaaS sector, has fallen 60% over the past year.
- Despite the steep fall, the company still retains a rich ~12x forward revenue multiple, which compares unfavorably to many "fallen angel" software names.
- The company has seen its billings growth decay to a mid-30s growth rate.
- Counterbalancing this, however, is a hefty double-digit pro forma operating margin, still positioning Zscaler as a "Rule of 40" stock.
When it comes to positioning my portfolio for 2023, I'm being incredibly selective about the stocks for which I am banking on a rebound. I'm looking for resilient growth in the face of macro headwinds, profitability or at least a path to it, and a compelling valuation.
Zscaler ( ZS ), the cloud security company that has long been a Wall Street favorite, is down ~60% over the past year. In spite of this precipitous fall, I continue to think there are better deals to be had in the software sector.
I am neutral on Zscaler. To me, I view the company as a mixed bag. On the positive side for Zscaler:
- Zscaler remains a "Rule of 40" company- Though growth is decelerating, certainly on the billings side, 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.
- Large $72 billion TAM and high net expansion rates- Zscaler addresses a huge market for which its current ~$1.5 billion annual revenue run rate is still relatively underpenetrated. The company also has a track record for high expansion rates within its customer base, allowing for profitable scaling as the company grows alongside its clients.
The key downside here, though, is valuation. Zscaler has retained premium valuation multiples even as the rest of the software sector has plummeted to multi-year lows. And though the stock's ~60% trailing twelve-month decline certainly "helps" from a valuation perspective, I think Zscaler's maintenance of its premium removes the safety element of buying this dip.
At current share prices near $113, Zscaler trades at a market cap of $16.06 billion. After we net off the $1.83 billion of cash and $1.14 billion of convertible debt on Zscaler's most recent balance sheet, the company's resulting enterprise value is $15.37 billion.
Meanwhile for FY23 (the fiscal year for Zscaler ending in September 2023), the company has guided to $1.525-$1.530 billion in revenue, representing 40% y/y growth at the midpoint. Note that underlying billings growth in the guidance range of $1.93-$1.94 billion represents a deceleration to 30% y/y growth.
Against this revenue outlook, Zscaler trades at 10.0x EV/FY23 revenue - at a time when double-digit revenue multiples have become exceedingly rare even for the buzziest of pandemic stocks.
My take here: continue to watch Zscaler on the sidelines. I'm comfortable buying Zscaler if it dips to 8x EV/FY23 revenue, representing a $90 price target - but not before.
Q1 download
Let's now go through the results of Zscaler's most recent quarter in greater detail. The Q1 earnings summary is shown below:
Zscaler's revenue in Q1 (the October quarter) grew 54% y/y to $355.5 million, exceeding Wall Street's expectations of $340.7 million (+48% y/y) by a six-point margin. Revenue growth decelerated seven points relative to 61% y/y growth in Q4.
The bigger concern, however, was the sharp deceleration in billings growth. Billings of $340 million in the quarter even lagged revenue growth, and only advanced 37% y/y - sharply indicating that revenue growth is also poised to slow down. As seasoned software investors are aware, billings growth is a better forward-looking indicator of a company's growth trajectory as it captures deals signed in a given quarter that will be recognized as revenue in future quarters. Zscaler's guidance also implies that full-year FY23 billings growth is expected to slow to 30% y/y.
Management notes that the billings headwind was known and driven by a shortening of contract durations (which may not necessarily impact the business over the long run, as long as clients are still renewing. Shorter durations may also give Zscaler more frequent chances to upsell customers; with the caveat again that the opportunity for customers to churn is also more frequent).
Per CFO Remo Canessa's remarks on the Q1 earnings call :
As we expected, billings duration was a headwind to growth this quarter. Our Q1 billings duration was above the midpoint of our normal 10 to 14 months range, but was below last year's higher levels. We estimate that duration negatively impacted our billings growth by approximately 5 percentage points. Normalized for this higher duration, our billings grew 42% year-over-year."
Even without the duration hit, however, Zscaler's ~40% billings growth still doesn't hold up well against current revenue growth rates. The company notes that it ended the calendar year 2022 with a large multi-year pipeline, but that macro headwinds are causing larger deals to drag.
The bright side here is on margins: Zscaler maintained its high 81% pro forma gross margin. Operating leverage on revenue growth also helped the company boost pro forma operating margins by two points to 12%:
The company also expects full-year pro forma operating margins to clock in around 12% for FY23, which represents 150bps of margin expansion versus FY22. Zscaler also generated $128.5 million in operating cash flow in Q1, representing 38% y/y OCF growth.
Key takeaways
Don't get me wrong, Zscaler is still a fantastic company. Few software companies are able to reach a $1.5 billion annual revenue run rate and still grow both revenue and billings in excess of 30% y/y. Even fewer can do so while simultaneously managing a double-digit pro forma operating margin. At the same time, however, it's difficult to be bullish on Zscaler while so many more favorable, beaten-down SaaS investments are up for grabs in the market (my favorites at the moment include Asana ( ASAN ), Palantir ( PLTR ), Zoom ( ZM ), DocuSign ( DOCU ), and Smartsheet ( SMAR )).
Stay on the sidelines here.
For further details see:
Zscaler: Back Off For Now