2023-08-22 03:56:21 ET
Summary
- Zscaler, a leader in security solutions for cloud applications and infrastructure, has emerged as a relatively recession-immune tech company.
- Zscaler's growth potential, high gross margin profile, and profitability make it an attractive investment in the cybersecurity space.
- Despite a tough macro environment, Zscaler notes that cybersecurity projects are a high priority for IT departments, which is reflected in the company's strong billings.
- Though not cheap at just under 10x forward revenue, Zscaler's huge margin expansion justifies a premium multiple today in exchange for later profitability.
The core question for stock investors today: why should we invest in equities when short-term interest rates effectively yield a risk-free 5%? Despite softening inflation data, the coupling of strong economic data makes it unlikely that the Fed will lower interest rates anytime soon, leaving us scratching our heads if the best move isn't to just park everything we have in cash.
We invest in risky assets, of course, for their growth potential. That growth picture has been dented over the past few quarters as tech companies reported weaker earnings and a slowdown in sales cycles. Some, however, have emerged as relatively recession-immune, including and especially Zscaler ( ZS ), the leader in security solutions for cloud applications and infrastructure. Year to date, Zscaler is up roughly 30%, and though it's down in sympathy with other tech stocks so far in the month of August, it has so far avoided any major meltdown.
Earlier this year, I wrote a neutral opinion on Zscaler when it was trading in the low $110s. Yes, I missed out on some gains between then and now: but considering where the market is as well as Zscaler's terrific fundamental performance since then, I'm willing to go long on Zscaler.
My more pessimistic view of Zscaler back then was primarily based on valuation. And while Zscaler certainly remains expensive, the key is that it's one of the few pockets of larger, more mature software companies that are still showing incredible growth rates. On top of this, Zscaler has the "profitable bones" to generate substantial profits, and we'll discuss later in this article how Zscaler's margin profile has dramatically expanded in recent quarters.
Here is my full long-term bull case for Zscaler:
- Security is recession-proof. We've heard from many companies in the software sector that IT chiefs are delaying large capital projects and that each deal is getting more heavily scrutinized. It's more difficult, however, to delay a critical security infrastructure purchase, and that's why Zscaler has been able to find success in both down and up markets.
- Growth at scale. Despite expecting to hit over $2 billion in annual revenue next year, Zscaler is still growing its top line metrics (revenue and billings) at a >40% clip, which demonstrates the largesse of its market and its leading competitive position versus other cybersecurity companies.
- Incredibly high gross margin profile. Zscaler's pro forma gross margins in the 80s index very high relative to fellow software companies, and allows for incredible scalability at its more mature stage.
- Zscaler remains a "Rule of 40" company. Though revenue growth is decelerating, the company makes up for it with a rich low-teens pro forma operating margin. Zscaler's plug-and-play profitability makes it a safer bet in a more risk-averse market that has shunned unprofitable tech stocks.
Of course, much of this strength is already reflected in Zscaler's premium stock price. At current share prices near $143, Zscaler trades at a market cap of $20.83 billion. After netting off the $1.97 billion of cash and $1.14 billion of convertible debt on Zscaler's most recent balance sheet, the company's resulting enterprise value is $20.00 billion.
Meanwhile, for FY24 (the fiscal year for Zscaler ending in July 2024), Wall Street analysts are expecting the company to generate $2.05 billion in revenue, or 29% y/y growth. This puts Zscaler's valuation at 9.7x EV/FY24 revenue.
This certainly isn't cheap: but I'd argue that with Zscaler nearly doubling profitability and cash flow year over year on the back of high double-digits revenue growth, the company still has several years of runway at a premium valuation multiple before it truly needs to prove its earnings clout on a more standard P/E or cash flow basis.
The bottom line here: Zscaler has proven its mettle in a difficult environment for most tech stocks. Any dips here are great buying opportunities. The next catalyst for Zscaler is its fiscal Q4 (July quarter) earnings print on September 5, but I'd look for an entry point ahead of that.
Growth rates aren't showing any wear
The first thing to draw confidence in for Zscaler: the company is still showing fantastic growth rates at scale, as previously mentioned. In Q3 (the April quarter), Zscaler drove 46% y/y revenue growth to $419 million.
Though this represents deceleration from a revenue basis, billings aren't seeing any slowdown at all. As shown in the chart below, Zscaler's billings profile actually accelerated to 40% y/y in Q3, up six points sequentially from 34% growth in Q2. The company also built $63 million of deferred revenue in the quarter on a sequential basis. As seasoned software investors are aware, billings represent the better longer-term trajectory of a subscription software company's growth, as they capture deals signed in the quarter that will be recognized as revenue in future quarters.
Management noted on the Q3 earnings call that despite higher scrutiny on deals, high-priority projects are still moving forward, per CEO Jay Chaudry's prepared remarks:
We are providing increased guidance for the full year, which we believe balances our business optimism and macro-economic uncertainties. A few quarters ago, we noted that customers were increasingly scrutinizing their projects and budgets, due to macro conditions. We are seeing this elevated level of scrutiny continue in Q3.
Nevertheless, we see high-priority initiatives still moving forward. In my conversation with hundreds of IT executives, cybersecurity remains their number-one IT priority."
This solidifies the notion that especially in a down market and tighter economy, cybersecurity is an attractive sub-sector to invest in.
Scalability is starting to show
The second key piece that makes Zscaler such an attractive software investment in difficult times is its profitability potential. This, of course, is driven by the company's sky-high pro forma gross margins of 80%. The company has used the combination of strong revenue growth that has flowed to the bottom line alongside careful expense discipline to drive substantial profitability boosts.
The chart below shows a clear rightward trend of margin expansion across a number of metrics. Pro forma operating margin sin the most recent quarter were 15%, up two points sequentially and six points y/y. Pro forma net income margins, meanwhile, doubled y/y to 18%, and pro forma EPS of $0.48 nearly tripled from the year-ago $0.17.
We're also still quite a way away from hitting Zscaler's margin targets. As shown in the slide below, the company expects that it can hit a 20-22% pro forma operating margin in a steady state, primarily by pushing down opex as a percentage of revenue further than today:
Key takeaways
The combination of double-digit revenue growth plus increasing margin profile by ~50% from today's levels is an incredibly attractive proposition that, in my view, justifies Zscaler's premium multiple. With Zscaler showing that it can deliver results in a tough environment, it's time to go long here.
For further details see:
Zscaler: The Differentiation Factor Is Growth And Scalability (Rating Upgrade)