2023-03-06 14:23:38 ET
Summary
- Zscaler had a strong beat and raise across the board, with non-GAAP and GAAP operating margins expanding.
- However, the market got spooked by a higher than seasonal drop in Billings growth, but management's "ramp-style" contracts will produce Billing's momentum when they mature.
- The company continues to show resilience in a tough macro environment, and investors have much to like in the coming year, with free cash flow improving.
Cybersecurity is one of my favorite sectors to cover during this uncertain, higher interest rate macroenvironment. It remains one of the most resilient sectors in all of tech, and it's because cybersecurity threats don't care what interest rates or recession odds are - companies must be protected from these second-to-second threats. This is why Zscaler ( ZS ) continues to see impressive revenue growth amid a tightening enterprise and IT budget season. Not only are companies continuing to purchase its products, but its products remain at the top of the list for Zero Trust architecture solutions and implementations. This gives it the advantage of being one of the strongest cybersecurity players in a resilient sector.
Gartner is a trusted name for recommending companies based on their ability to execute and have vision. Zscaler consistently remains at the top of the leaderboard. Its SSE (Security Service Edge) rating is head and shoulders above the competition.
Netskope
Therefore, it's no surprise to see strong earnings for FQ2. Revenue for the quarter of $387.6M came in above guidance of $365M and analyst estimates of $364.9M. Unfortunately, analysts were on the wrong side of guidance, keeping expectations for year-over-year revenue growth at 42.8%. Instead, the company produced 51.7% growth.
Even the guide for FQ3 was well above consensus, coming in at $397M versus estimates of $387.3M. This equates to 38.4% year-over-year growth, but a moderate beat at $410M brings it to 43%. If it can get close to the beat it provided for FQ2, revenue would come in at $420M, good for 46.4% growth.
Making our way toward the bottom line, non-GAAP operating expenses grew less than revenue at 44%, expanding non-GAAP operating margins from 8.4% in FQ2 '22 to 13.1% in FQ2 '23. However, GAAP expenses grew at an even better rate, growing only 29.6% versus the quarter's 51.7% revenue growth.
Financially, the company is doing everything right and pulling all the right levers, and it appears it'll continue over the coming year.
But what about the Zero Trust outlook and the IT-budget environment?
Sales, Cycles, And Outlook
This is where the market is having second thoughts, as indicated by ZS's post-earnings stock reaction.
As covered on FQ1's earnings call three months ago, management noted the sales cycle was lengthening due to the tightening budgets of its potential customers, but it was still closing large-sized deals - they just took longer to close. Interestingly enough, the stock dropped 11% on that news - the same it dropped on Friday - and sunk 31% total in the weeks following. The stock recovered all of that ground leading up to this report, though.
The news was the same in FQ2, where deal scrutiny remained elevated, but the company was still closing deals. This time around, the added color from management included ramping deals over the first year to get customers in the door with less upfront commitment. The rest of the commitment is obligated to "ramp" later in the contract.
This is why the company's Billings guide was weaker than expected for FQ3, declining 9% sequentially. A decline is seasonally expected in its fiscal third quarters, but the rate of decline is slightly higher than last year's 6% decline. However, management did note it's being conservative considering the elevated deal scrutiny seen over the last few quarters.
...there was an elongation of the sales cycle. So, we're basically baking into that to our second half, slightly worse, not a lot but slightly worse than what we saw in Q2. So, a little more conservatism related to our billings guidance than the past.
- Remo Canessa, CFO, FQ3 '23 Earnings Call Q&A
So there's enough baked in where the numbers could be more in line with typical seasonality when the report comes in that management is anticipating with its conservative guidance. So it may not be the usual 6%, but reporting closer to an 8% or 7% decline would be seen as a less-than-feared sales environment.
Investors aren't appreciating Billings will have an additional push from these already signed deals kicking into higher gear when the rest of the ramp comes to the books. And if the macroenvironment is any better a year from now, new wins and upsells will compound the ramp effect. So while the market may be wringing hands over the current situation with less Billings growth, it's just a matter of time before it sees the effect of these entire contracts.
Additionally, the Billings growth it sees a year from now, when these factors mature, will drive revenue growth in the several quarters beyond and potentially stave off the decline in the growth rate - or even show some growth acceleration if the factors are strong enough. It's too soon to say if this will be the case, but the ramp of contracts over the next year may have more than just a bullish one-quarter effect. It really depends on how long this ramp contract style is used this year.
Not A Whole Lot To Say
Zscaler has been showing strength these last two quarters by continuing to add logos and sign contracts. It has plenty of leverage to pull levers and expand margins to keep its balance sheet healthy and marketing division strong. Combined with its ability to generate free cash flow, it adds cushioning to the bull thesis.
Chart mine, data from Zscaler's earnings calls
As the company pulls on profitability levers, FCF growth should continue over the year as it moves past its sales team reorganization and 3% workforce layoff. Considering the increase in FY23 guidance from $1.528B to $1.561B and my expectation for stable or growing FCF margins, the company is already indicating improvements.
Overall, I'm not concerned with ZS's business fundamentals or prospects, even with the slower Billings growth. It's the strongest one in the room in the strongest tech sector, and any short-term inefficiencies in Billings will smooth out when the latter half of these contracts ramp and the macroenvironment eases up.
Its product is an all-in-one solution for growing cloud workloads and edgeless networks (enterprises) and beats any of the firewall competitors' clunky, piecemeal products. ZS may have more significant ups and downs in share price, but its product is number one among customers and will drive it long term.
For further details see:
Zscaler Earnings: Setting Up Future Billings Momentum Amid A Tough Environment