- Among software stocks, Zscaler has been one of the few to hold onto an incredibly rich premium valuation.
- Though it has lost more than 50% of its value this year, Zscaler is still trading at a ~14x multiple against next year's revenue.
- Though growth is still tracking well above >50% y/y, Zscaler has seen its billings growth rates decelerate consistently over the past several quarters.
- With few fundamental catalysts to take Zscaler higher, it's better to sit on the sidelines here.
The market just can't seem to pick a direction these days. Each week, we're vacillating between big ups and downs, and earnings season so far has been very mixed as well. In these uncertain times, however, I'm focused on buying beaten-down growth stocks that are now trading at compelling valuations.
Zscaler ( ZS ), strangely, has been one of the few high-flying SaaS stocks that has been able to retain a massive valuation premium. Now, it has certainly lost a good chunk of its value since the start of the year - down more than 50% - but to me, that was a much-needed correction to bring one of the tech sector's most overvalued stocks down to earth. The question for investors now is: is it time to buy the dip here?
This is a watch list stock, but not an immediate buy the dip play
While Zscaler is certainly going on my watch list, I would caution against buying this stock now. I remain neutral on Zscaler. Since I last wrote on the company several months ago, the stock has collapsed dramatically, but growth rates have also come down. In addition, the fact that every other SaaS stock has also taken a deep tumble means there are many more value-oriented alternatives to go for.
Now, to Zscaler's credit, this is still a great company for the long term. Zscaler estimates its total addressable market at $72 billion, meaning its current ~$1.1 billion annual revenue run rate is only about 1.5% penetrated into the overall market.
The fact that Zscaler is still growing revenue north of >50% y/y is a testament to the company's very strong execution in a greenfield market. The secular tailwinds here make absolute sense - as more and more companies move workloads and applications into the cloud, traditional on-premises firewall and security solutions will no longer make the cut, and Zscaler is the prime name-brand in cloud-first security.
It's also highly profitable, which is rare for a company at its growth rate. Over the long run, the company intends to more than double its current pro forma operating margin of ~10% to the low/mid-20s:
Here's the thing to be aware of, though: all this strength is already priced into Zscaler's stock, even after the recent fall. At current share prices near $145, Zscaler trades at a market cap of $20.58 billion. After we net off the $1.66 billion of cash and $954.6 million of debt on the company's most recent balance sheet, Zscaler's resulting enterprise value is $19.87 billion.
For the next fiscal year, FY23, meanwhile (the fiscal year for Zscaler ending in June 2023), Wall Street analysts have a consensus revenue target of $1.47 billion for the company, representing 36% y/y growth (data from Yahoo Finance ). Against this revenue estimate, Zscaler trades at 13.5x EV/FY23 revenue.
During the "boom" times of 2020 and 2021, this would be a fine forward revenue multiple. But now, with Zscaler's growth rates decelerating, and other "superstar" SaaS stocks falling below double-digit multiple thresholds, I'm not so keen to buy the dip here.
I'd be a willing buyer of Zscaler at 10x FY23 revenue, implying a price target of $109. Above that level, I'm content to watch this stock from the sidelines.
Q3 download
Let's now go through Zscaler's latest quarterly results in greater detail. The earnings summary for Q3, which for Zscaler is the quarter ending in April, is shown below:
Zscaler's revenue in Q3 grew 63% y/y to $286.8 million, beating Wall Street's expectations of $271.4 million (+54% y/y) by a nine-point margin. Revenue growth also kept pace with Q2's 63% y/y growth rate.
Where the concern is, however, is in billings. As software investors are aware, billings represent a better indicator of a company's long-term growth potential because it captures deals signed in the quarter that will get recognized as revenue in future quarters.
Zscaler has gone through two straight quarters of billings deceleration, down to 54% y/y growth in Q3 (five points weaker than 59% y/y in Q2). This is a leading indicator that revenue growth is soon to come down as well.
The good news is, in spite of the decelerating billings numbers, the company so far has seen little impact from tightening macro conditions on its ability to close deals. Per CEO Jay Chaudhry's prepared remarks on the Q3 earnings call:
In closing, in spite of uncertain macro conditions, we continue to see strong demand for our services. We are in a strong financial position, and we will continue to aggressively invest in our business. We are focused on hiring and developing talent and creating a culture that rewards innovation at all levels. We have grown our global organization to approximately 4,500 employees who are energized by our shared mission to secure the hyperconnected world of cloud and mobility. We grew our total sales and marketing headcount by 54% year-over-year, and we remain focused on investing in our go-to-market machine. In today's competitive hiring market, Zscaler is a destination for top talent. To drive continued growth in hiring and to build on Zscaler's high-performing hybrid-work culture, this month, we welcomed Brendan Castle, Google's former global head of talent acquisition, as our new Chief People Officer. Brendan has proven experience in building highly motivated and productive teams at scale."
This aggressive sales hiring, however, has cut into Zscaler's margins. Pro forma operating margins in Q3 fell to 9%, four points weaker than 13% in the year-ago quarter:
The fear here is that Zscaler is entering into a period of both deceleration as well as ramped expenses. The company's recurring revenue model and high net expansion trends (above 125% this quarter) should help the company scale profitably over time, but in the current profit-focused market, this margin reduction will be a major cloud over sentiment.
Key takeaways
Zscaler remains the same story as ever - high quality for a very high price. In today's market, there are many high-quality growth stocks that are trading at fire-sale levels, including Coupa ( COUP ), Asana ( ASAN ), Palantir ( PLTR ), and DocuSign ( DOCU ) - in other words, there are far better places to deploy your capital than Zscaler. Keep this stock on your watch list, but don't rush in to buy just yet.
For further details see:
Zscaler: Extremely Expensive For This Market