2023-08-13 07:47:12 ET
Summary
- Zscaler is a top operator in the cybersecurity sector with a focus on zero-trust solutions.
- After Wall Street expected a big miss to guidance, Zscaler provided a big beat. The cycle is repeating.
- The company is delivering expanding profitability despite the tough macro environment.
- Even after the strong recent momentum, the stock continues to trade at more than reasonable valuations for this long-term secular growth story.
Sentiment is a fickle thing. Amidst a higher interest rate environment, Wall Street can be quick to “shoot first look later.” This appears to have happened after Fortinet's ( FTNT ) latest earnings results , which sent other stocks in the cybersecurity sector plunging in sympathy. Despite not having direct correlation, Zscaler ( ZS ) saw its stock fall as well. That comes even in spite of the most recent earnings report showing that ZS is showing resilient revenue growth alongside expanding profit margins. In general, enterprise tech as a whole has shown robust fundamentals, with cybersecurity shining the brightest. ZS remains highly buyable for long term growth investors.
ZS Stock Price
It is stunning to see the quick reversal in ZS’s stock price over the span of just several months.
I last covered ZS in April where I rated the stock a buy but cautioned that the company may disappoint on guidance. My fear proved too conservative, as the company ended up beating and raising on guidance targets. ZS has been outperforming its valuation and the stock is finally getting rewarded for it.
ZS Stock Key Metrics
In its most recent quarter, ZS delivered 46% YOY revenue growth to $419 million, well ahead of guidance for $398 million.
Unlike many smaller tech peers which are seeing difficulty growing their customer base on account of the macro environment, ZS has somehow been able to continue growing even their larger customers. This plus the high 125% dollar-based net retention rate are a testament to the company’s deep product portfolio and name brand recognition. Management noted that approximately 60% of their new business came from existing customers. I cannot understate this point, as it is often overlooked by investors who might focus on smaller, faster-growing peers.
ZS was able to couple the strong revenue growth with impressive margin expansion, as operating margins expanded 577 bps to 15.3%. The rising interest rate environment may have burst bubbly valuations, but it has also inspired tech management teams to focus on profitability.
ZS ended the quarter with $2 billion of cash versus $1.1 billion of convertible notes, which, together with the robust free cash flow generation, represents a strong balance sheet. Looking ahead, management raised full-year guidance from $1.5 billion to $1.593 billion, representing 46% YOY growth. The fourth quarter is expected to see 36% YOY revenue growth. Based on full-year guidance for 34% billings growth, it is reasonable to expect the next fiscal year to see somewhere between 24% and 28% revenue growth.
On the conference call , management noted that they are continuing to see an “elevated level of scrutiny” from customers due to macro conditions. Management nonetheless called cybersecurity a “number-one IT priority” as legacy cybersecurity products are not capable of safeguarding a “work from anywhere world.” Management credited their strong execution in part due to their go-to-market prowess, which has been undoubtedly helped by their partnership with endpoint market leader CrowdStrike ( CRWD ).
How might ZS thrive in a generative AI world? Management noted that its products can help safeguard against employees submitting “sensitive data to ChatGPT like applications,” which may become a key selling point in the age of AI. Management noted that 15.5% in non-GAAP operating margins for the next year is a reasonable mark, implying further margin expansion ahead.
Is ZS Stock A Buy, Sell, or Hold?
ZS is a cybersecurity operator specializing in “zero trust,” meaning that it secures customers at the application level. This makes it a compelling cybersecurity solution for the modern cloud.
While many tech names have seen rapidly decelerating revenue growth following the pandemic, the cybersecurity sector stands out for seeing resilient top-line growth, which is testament to the mission-critical nature of cybersecurity solutions.
Even after the violent rally from the lows, ZS is still selling for reasonable valuations at around 13x sales.
Seeking Alpha
Based on my projections for 25% revenue growth (lower than consensus), 30% long term net margins, and a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see the stock trading at around 11.3x sales, implying substantial upside after incorporating many years of aggressive growth. I note that ZS arguably deserves a PEG ratio in excess of that 1.5x assumption due to cybersecurity stocks typically earning a rich premium. It is worth noting that ZS appears to be trading at a sizable discount to tech darlings like CRWD, Cloudflare ( NET ), or Snowflake ( SNOW ), but has many of the same characteristics worthy of those premiums.
What are the key risks? The macro environment adds a great deal of uncertainty, and it is possible that near term growth rates will be limited due to customer conservatism. I view ZS as being more insulated over the long term to such risks, as its deep product portfolio and name brand make it a preferred cybersecurity partner. That said, the stock does trade at some premium to non-cybersecurity peers on a growth-adjusted basis and could see considerable volatility as investors attempt to value the sector based on fluctuating growth estimates. Another risk is that of competition - ZS competes against juggernauts like Cisco ( CSCO ) and (more significantly) Palo Alto Networks ( PANW ). While I am of the view that ZS has among the best products, prospective customers may be swayed away by existing relationships or price. I reiterate my buy rating for ZS, as it is offering cybersecurity secular growth at reasonable valuations.
For further details see:
Zscaler: Even The Bulls Were Too Cautious - Top Cybersecurity Pick