Summary
- Zscaler's President steps down. It may not be because stock-based compensation is now worth less. But I believe that it would be naive to pretend this wasn't an issue either.
- Zscaler has seen its share price go nowhere in 2 years.
- Zscaler is growing at a rapid clip, with profit margins improving. This is a very difficult feat to accomplish at scale.
- Turns out that secular growth companies are not immune to the macro environment.
- All that being considered, Zscaler may not be as expensive as seems on the surface.
Investment Thesis
Zscaler ( ZS ) is down 50% since the start of the year. As we approach tax loss season, we should expect indiscriminate selling to pick up as investors look to take losses to offset any gains they might have elsewhere.
Going into Q4 earnings I wrote an article about Zscaler where I stated:
And this is exactly the same problem here today. The stock has continued to slide because investors continue to push back against its expensive valuation of 123x next year's non-GAAP EPS.
And that's the overarching theme. Investors that have a diversified portfolio would do well to seek cybersecurity names, such as Zscaler, but its valuation isn't so compelling .
Also, I put forward the question of stock-based compensation and management retention issues.
Simply put, there's a broad consensus that this is a good company. Yet, it's priced as an excellent company.
In sum, I remain tepidly bullish on this name.
What's Happening Right Now?
The inflation report came in largely the same as the consensus. And the market rallied. Why?
- Perhaps investors believe that there was a lot of near-term pessimism already priced in.
- Or perhaps, there's the hope that the economy is going to break, meaning that Fed will be forced to pivot and drop rates.
- Or perhaps, there's the expectation that the Fed has already done a lot of the heavy lifting and that there was no incremental new news out from the report.
- Or perhaps, stocks go up and down, sometimes without justification?
Anyone that can claim to know exactly how things are going to unfold from here is misguided in my opinion.
Secular Growth And Macro, Could These Now Go Hand in Hand
The reason why investors are interested in Zscaler is that it's supposed to do well in all environments. It is highly valued as a secular growth story so growth investors don't need to overly think about the macro environment.
By focusing on the micro, investors can simply focus on topline growth. That's the theory, at least.
And that worked extremely well in the past, but with Zscaler down approximately 50% this year, I believe that it's important that investors now think a little more broadly.
Next, let's discuss some bullish considerations.
Profitability Profile Set to Improve
Presently, Zscaler's guided fiscal 2023 non-GAAP income from operations margin points to 12%. That's a substantial improvement from fiscal 2022, which ended at 9%. That means that there is a 200 basis point profit margin improvement expected over the coming twelve months.
Although, realistically, there's likely to be some level of caution baked into this guidance, which could ultimately translate into a 250 basis point profit margin y/y.
Consequently, believe it or not, not only is Zscaler still reporting strong growth rates , which few investors would sneeze at, but it's growing at a rapid rate while improving profitability. And that is a very challenging feat to accomplish, and should be awarded a premium valuation!
Thus, they are clearly delivering all around. The only problem here is with investors' expectations.
ZS Stock Valuation -- Priced at 123x Forward non-GAAP EPS
For fiscal 2022, revenues increased by 62% y/y. Impressive, no doubt. But what's less impressive is that for revenues to leap this much, stock-based compensation was also up 58% y/y.
And this naturally forces the question, with Zscaler's stock down so significantly, if Zscaler wants to retain executive talent, will they be able to sustain the same level of stock-based compensation payout?
Or will they have to increase the amount of stock-based compensation , to compensate and retain executive talent?
And I'm not going so far as to ascribe that the only reason why Zscaler's President left was to do with the fact that executive compensation was now worth less. But it would also be quite naive to pretend this wasn't a meaningful consideration.
And so, we are forced to confront the issue in the room, is stock-based compensation a real cost? And how much will shareholders, asides from founder Jay Chaudhry tolerate rapidly rising compensation while the share price continues to slide?
The Bottom Line
Is a company that is GAAP unprofitable an unprofitable business? Or can we continue to pretend that management works for free? And I simply don't know the answer.
If we can assume, that at some point over the very long term high-quality businesses end up priced somewhere around 20x to 25x GAAP earnings, we are clearly very far from that multiple today.
On the other hand, there's the argument to be made that SaaS businesses could in time end up being priced like Salesforce ( CRM ) on a non-GAAP basis, at very approximately 25x non-GAAP earnings.
On yet the other hand, if we were to believe Zscaler can continue to compound at close to 35% CAGR for 5 more years, together with some level of profitability improvement, Zscaler could end up priced at approximately 30x its fiscal 2027 non-GAAP EPS.
This would clearly imply that Zscaler today at $145 is less expensive than it seems at first glance. Thus, I remain tepidly bullish on this name.
For further details see:
Zscaler: Compensation Could Become An Issue