2023-08-23 12:04:05 ET
Summary
- Zscaler is a SaaS cloud security company which did really well until 2022.
- The stock has dropped over 60% and it is still expensive relative to peers and our DCF model.
- We expect revenue growth to drop significantly, which will cause the stock to get re-rated to the downside.
Investment Thesis
Zscaler ( ZS ) is a SaaS cloud security company. Their offerings encompass two primary solutions. Firstly, Zscaler Internet Access ensures a secure gateway to externally managed applications, catering to users, workloads, and both IoT and OT devices. Secondly, Zscaler Private Access facilitates entry to internally hosted managed applications, whether in data centers or across public or private clouds. As you may imagine, these types of companies are the ones investors are willing to pay a premium for.
Despite this, the stock is more than 60% down from its all-time high, but has been performing relatively well recently. However, we don't think the weakness is over. ZS is still an expensive stock whose growth is slowing down, which in turn will lead to a steep decline in the stock's value.
Financials
In this analysis, we will solely focus on the numbers. ZS reported Q3 F2023 results on June 1 . The first impression is that revenue growth has been slowing down the last few quarters and will fall even more next year. Analysts estimate that ZS will bring in $2.05 billion in revenue in F2024, which would only be up 28% YoY. This would be the slowest YoY growth since it became public.
On the other side, they seem to have been able to control their cost base, given that they all grew less than revenue in the last couple quarters. As a result, the operating margin improved from -32% a year earlier to -18% in the latest quarter.
What really caught our eye is the difference between net income and free cash flow. Why is this? There is one primary answer: stock based compensation. Stock based compensation was nearly $400 million in the last year, and although many people don't consider it an expense, it is. Instead of paying employees in cash, they give out stock and dilute shareholders. In other words, they've been increasing shares outstanding by ~4% every year.
Nonetheless, the strong free cash flow generation has allowed ZS to build a big cash position, which is crucial during these times. Interest income went from virtually $0 a year ago to ~$20 million in the latest quarter.
Moreover, the $1.14 billion of debt, in the form of convertible notes, only bears a fixed 0.25% interest rate per year till maturity. This must have been one of the best deals a company like this has done in 2020. The notes mature on July 1, 2025.
Valuation
ZS is an expensive stock. It is currently trading at 12.5x P/S, 83.4x P/E and 53x P/FCF . All of these ratios are +50% higher than the average of its peers. With revenue slowing down significantly, we don't know how much longer it will be able to keep these high multiples.
Author
We also decided to do a DCF model. We assumed double-digit revenue growth and that operating cash flow will represent ~30% of revenue(in line with historical averages). We also assumed a WACC of 10% and a TGR of 5%.
Author
With these assumptions, we arrived at the conclusion that shares are overvalued, even though the case model is on the bull side(we believe). Shares would have to decrease ~17% to trade at fair value according to our estimate. With only a small change (11% WACC and 4% TGR) the implied price to share drops to $88, a 38% drop from current levels.
Takeaway
The cybersecurity sector presents an enticing arena of growth, but investors shouldn't be willing to pay anything for this type of stocks. In ZS case, the company is on the verge of facing a significant drop in revenue growth, while shareholders continue to face dilution due to stock based compensation.
To all this, we should sum the fact that the stock is trading at premium multiples relative to their peers, and our DCF model confirms this as well. Overall, we don't dislike the company, but we don't think the stock is a good investment at current levels. That is why we rate ZS a SELL .
For further details see:
Zscaler: Slower Growth Ahead And Overvalued