2023-04-28 07:00:57 ET
Summary
- Zscaler is a cash-flowing operator in cybersecurity.
- The company is finally seeing the impact from the macro environment.
- The company has a net cash balance sheet and boasts 20+% cash flow margins.
- With guidance set conservatively, ZS stock is looking highly buyable.
While many other tech stocks are recouping some losses in the past quarter, Zscaler ( ZS ) continues to see its stock languish. Much of that may be due to valuation, as ZS continues to trade at a relative premium to peers even accounting for this weakness. But ZS has also seen its growth rates decelerate meaningfully in no small part due to the tough macro environment. Still though, ZS represents a cash flowing operator in cybersecurity with a long growth runway ahead of it. The stock is cheap but not necessarily dirt-cheap in spite of a highly uncertain macro environment.
ZS Stock Price
ZS has crashed hard from 2021 highs as its stock valuation was bid up to meteoric levels amidst the tech bubble.
I last covered ZS in February where I rated the stock a buy on account of the resilient growth rates and profit margins amidst the tough macro environment. The stock has since fallen another 29%, helping to further improve the risk-reward proposition.
ZS Stock Key Metrics
In its most recent quarter, ZS delivered 52% YOY revenue growth, powered by a dollar-based net retention rate of over 125%. It is extremely impressive that ZS has been able to sustain such rapid growth rates - the company had actually delivered accelerating growth rates in fiscal 21 and 22.
ZS saw calculated billings growth decelerate to 34%, implying that forward revenue growth rates will eventually decelerate quite meaningfully.
On the conference call , management noted that billings were negatively impacted by customers showing hesitancy at the beginning of the new year, but that these deals were delayed, not canceled, and that they had already closed a few of these deals in February.
ZS has been profitable on a non-GAAP basis and is guiding for some margin expansion to 13.7% non-GAAP operating margins this year. ZS has consistently generated free cash flow margins in excess of 20% - showing the advantages of the subscription software model.
ZS ended the quarter with $1.9 billion of cash versus $1.1 billion of convertible notes, representing a solid balance sheet position.
Looking ahead, it appears that the times of accelerating growth rates has finally come to an end. ZS has guided for 39% YOY revenue growth in the third quarter and only 32.6% projected growth in the fourth quarter.
Management noted that their outlook is quite conservative as they have factored in a "further lengthening of sale cycles" and subsequent "uncertain timing of large deals." Management notes that their pipeline has grown and has more mature deals, but they are nonetheless assuming "a slight deterioration in close rates."
Amidst a period of layoffs across the tech sector, the company reduced their workforce by around 3%, a modest figure relative to peers. As ZS has been profitable on a non-GAAP basis for many years, the company did not have the necessity from a financial perspective to undertake aggressive cost cutting. Management reminded investors that investors should expect less than 300 bps of margin expansion in any year in which revenue is growing faster than 30%.
Is ZS Stock A Buy, Sell, or Hold?
ZS is a cybersecurity operator specifically focused on securing access to applications and data.
ZS provides the following helpful diagram to explain their product positioning. Whereas legacy security products secure the network, ZS's zero trust architecture adds another layer of security by securing individual applications.
Amidst a rapid transition towards cloud computing, I am of the view that ZS' approach is more relevant for today's market.
When you combine the attractive cybersecurity positioning, resilient growth rates, and robust cash flow generation, it is no surprise that ZS continues to command premium multiples.
Based on 25% growth, 30% long term net margins, and a 1.5x price to earnings growth ratio ('PEG ratio'), I could see fair value hovering at around 11.3x sales, implying a stock price of $156 per share over the next 12 months. Unlike my last report when I called ZS "buyable" but cited reservations on there being far more attractive opportunities elsewhere in the tech sector, ZS' recent weakness has greatly helped to improve its risk-reward proposition.
What are the key risks? Valuation remains a risk, as ZS is still trading with some relative premium to peers. If the market sours on the cybersecurity sector or if ZS underperforms what is supposed to be conservative guidance, then the multiple can compress quite quickly. Another risk is that of competition. While ZS has a wide product offering in zero trust, it can arguably be considered a point product if one considers the entire cybersecurity ecosystem. Perhaps some customers might want to purchase their cybersecurity solutions from all-in-one operators like Palo Alto Networks ( PANW ). I retain some skepticism in this regard as I would think that cybersecurity is not something that one should take risks on, but I might be wrong. ZS management appeared to specifically call out PANW on the conference call, stating that they are seeing deal wins from customers who "initially purchased a single tenant SASE solution from their incumbent firewall vendor that failed to deliver in the real world." As stated earlier, I am of the view that ZS' zero trust architecture is built for the cloud computing environment, and cloud computing is a secular growth story that cannot be stopped. But it is admittedly difficult to predict how enterprise customers might change their purchasing habits amidst a tough economy.
I stress that it is highly likely that ZS may disappoint on the guidance front, as results from other tech peers has foreshadowed such disappointment. I view a basket of undervalued growth stocks as being an ideal way to position ahead of a tech recovery . ZS fits right in with such a basket as it offers secular growth with positive cash flows. I reiterate my buy rating.
For further details see:
Zscaler: Finally Looks Cheap But Will Likely Disappoint On Guidance