2023-07-13 08:00:00 ET
Summary
- Despite its first-mover advantage and strong growth metrics, Microsoft's entry into the secure service edge market could pose a significant challenge to cybersecurity leader Zscaler.
- ZS stock has declined nearly 16% since its Zenith event, with investors wary of its high valuation and lack of GAAP profitability, despite strong calculated billings and deferred revenue growth.
- The Company must demonstrate more value to safeguard its offerings against Microsoft, as the King of SaaS looks to take share and chart a new growth driver.
- With Zscaler still priced at a steep premium, near-term volatility is expected. I discuss the key levels for buyers to observe closely.
As Microsoft ( MSFT ) heralded its entry into the secure service edge or SSE space, expensive pure-play cybersecurity stocks took a beating yesterday. The King of SaaS also took direct aim against Zscaler ( ZS ), as Microsoft announced Microsoft Entra Internet Access and Entra Private Access.
It demonstrated Microsoft's ability to expand into what Morgan Stanley ( MS ) cautioned is the final piece in MSFT's security jigsaw puzzle. Accordingly, SSE "is potentially the largest and final major cybersecurity market that Microsoft has yet to enter."
With Microsoft ready to take the game to its best-of-breed rivals, it suggests that CEO Satya Nadella & his team are ready to unlock a new growth driver.
Zscaler's leadership and first-mover advantage as the zero-trust leader is well known. It has also helped the company nail down a narrow economic moat primarily built on switching costs and network effects. However, the dynamic cybersecurity landscape suggests that significant R&D and SG&A spending could still be necessary to thwart the advances of its arch-rivals.
Moreover, with Microsoft's entry into Zscaler's traditional battlefield, management needs to demonstrate even more value as it looks to expand further, even as it reported a robust FQ3 release in early June.
Keen investors should recall that Zscaler posted a 40% YoY gain in calculated billings and a 44% growth in deferred revenue. Therefore, it corroborated the confidence of dip buyers who braved significant pessimism at its early May lows, as ZS fell to about $85.
However, ZS's lows also attracted dip buyers to return in force, sending it up more than 90% toward its mid-June highs. However, investors who bought into ZS's momentum spiked as it launched its Zenith conference have been hammered.
Accordingly, ZS has declined nearly 16% since its Zenith event, reminding investors why it's critical to be mindful of unsustainable momentum spikes, particularly as ZS is priced at a steep premium (rated "D-" by Seeking Alpha Quant).
Zscaler Bulls would likely argue that its high-growth metrics (rated "A+" by Seeking Alpha Quant) could defend the argument for a premium valuation, as demonstrated in its recent earnings release.
However, with Microsoft's entry into the SSE market, Zscaler and its peers are expected to fight harder and possibly navigate a more challenging runway toward sustainable GAAP profitability.
Why does it matter? Because Zscaler is still not GAAP profitable, even though it's free cash flow or FCF profitable. Investors concerned about sustainable profitability would likely not be keen to invest aggressively in ZS, which could limit the potential upside from the current levels.
In addition, Zscaler is not projected to post GAAP EPS profitability in the forecast period through FY25 (year ending July 2025).
As such, I believe some dip buyers from its May lows have likely used June's spike to cut exposure. These dip buyers astutely took profits just as late momentum buyers piled into the stock, likely stunning them as ZS's momentum reversed.
The critical question facing investors is whether the current levels could provide a relatively attractive risk/reward profile from a price action perspective?
ZS price chart (weekly) (TradingView)
As seen above, ZS had already topped out in mid-June after a sharp reversal from its May lows.
Therefore, this week's selloff accelerated the distribution zone, indicating that more dip buyers likely took profit. As such, I gleaned that ZS is at a critical juncture, with buyers needing to help defend the decline and holding it above the 50-week moving average or MA (blue line) to sustain its reversal.
However, I anticipate a further decline to the $120 level, which should attract dip buyers to return and defend against a further selloff. While near-term volatility is still expected, I'm still constructive on ZS, but prefer to wait for price action resolution.
As such, I'll let the market action take its course before I assess the next buyable moment for investors who have yet to add exposure.
Rating: Hold (on the watch for a rating change).
Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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Zscaler: Microsoft Wants To Eat Its Share