Summary
- Zscaler, Inc.'s fiscal Q2 billings didn't live up to investors' expectations.
- Zscaler's customer adoption curve appears to be slowing down.
- Zscaler's valuation wasn't a problem when it was growing very strongly. But as it starts to ever so slightly slow down, investors are going to become more cautious.
Investment Thesis
Zscaler, Inc. ( ZS ) put out a fiscal Q2 2023 earnings report that took me by surprise. As I headed into this earnings report, I was bullish on this stock.
My mistake is that I didn't give enough consideration to the rapidly evolving macro environment. Essentially, it now appears that macro impacts are starting to percolate and affect some companies more than others.
Right now, it appears that rather than having a blanket view that's positive on the ''cyber sector,'' investors have to be more discerning. In essence, it appears that in the end, it's a market of stocks, more than a stock market. We have to be more selective and conscientious on valuations.
All that being said, if I owned Zscaler, I would not sell my stock. Hence, I rate this stock a hold.
Revenue Growth Rates Weren't The Problem
As you can see here, Zscaler stock continues to plow forward with strong growth rates and guidance. Awesome right?
Well, this is the problem. Fiscal Q2 2023 had billings of 34% y/y. Recall, billings are a forward indicator of future revenue growth rates.
If billings remain level with the current guided revenue growth rates, the business will continue to press ahead at those revenue growth rates.
However, if billings substantially dip below the current revenue growth rates, in the coming few quarters, that will lead to a substantial gap in revenues . And the last thing you want if you are investing in a growth stock, with a growth multiple, is to see slowing revenue growth rates.
When a stock goes ex-growth, that's problematic. Why?
Because investors that own the stock under the premise of owning a growth stock suddenly start to have doubts and move on to other, more promising cybersecurity opportunities.
For instance, to my paid subscribers, I've been recommending Palo Alto Networks ( PANW ), so I'm biased in my assessment. But what you see here is that it pays to be a little patient and value-conscious. Why?
It's not that Zscaler isn't growing massively faster than PANW. But rather, PANW's business model is seriously focused on driving down costs for its end user.
And in a tougher economic environment, where budgets are tighter, that allows PAWN to gain market share. And provided investors' expectations are not too high, you as an investor can be a little patient and stay for the ride, and get rewarded over time, as your business compounds in intrinsic value.
Does this make PANW a better investment than Zscaler? Not necessarily, it's just that PANW suits my investment temperament.
I'm happy to take things a little slower and get rewarded over time. I like investing in the underdog. Well, to be fair, PANW is hardly an underdog, as I believe that in the coming couple of months, PAWN is going to get upgraded to the S&P 500 Index (SP500). Perhaps, I should have said, PANW was a contrarian bet.
So, What's Next for Zscaler?
During its earnings call , Zscaler, Inc. alluded to the more challenging economic environment. Here are some excerpts:
Billings were impacted by new customers being more deliberate about their large purchasing decisions at the start of the calendar year [...]
With macro concerns weighing on business leaders, more organizations are being cautious and measured about their spending. In January, we saw a higher scrutiny on budgets compared to December, resulting in additional delays in large deals.
These insights are echoed in the figures. Case in point, customer growth in fiscal Q2 2023 was up 33% y/y, compared with up 41% y/y six months ago in its fiscal Q4 2022 results.
That's an 800 basis point slowdown in customer adoption over 6 months. That's a material step function change in the customer adoption curve.
The Bottom Line
Ultimately, investors are more than willing to pay very high multiples for companies that are rapidly growing. And, for what it's worth, I'm willing, too, for that matter. The problem, though, is when a company goes from rapidly growing, to when the visibility dims and customers aren't quite as eager to embrace a company's offerings.
To be absolutely clear, I'm not saying that everything is doomed for Zscaler, Inc.! My assertion is more nuanced than that. I'm arguing that the market is forward-looking. And if we are seeing customers' growth rates decelerating in a period of 6 months, the market is looking ahead to the next 6 months, and thinking if that's how things are right now, what will they be like in 6 months' time?
Will Zscaler once again be posting stronger customer growth rates in 6 months or slightly weaker? Particularly given the challenging macro environment that enterprises presently face.
Yes, we are told that cybersecurity is resilient to the economic downturn. But the facts coming out appear to point to a different narrative.
In essence, the trick here is to have a very strong view in answering those questions. Or to put it another way, investors need to have a contrarian view and be more right than the market. That's really the game. However, Zscaler, Inc. turns out for you, good luck.
For further details see:
Zscaler: Outlook Dims Down