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Is Zscaler Stock a Buy Now?

The Motley Fool
The Motley Fool
 2022-12-04

Zscaler 's (NASDAQ: ZS) stock tumbled 11% on Dec. 2 in response to its latest earnings report. For the first quarter of fiscal 2023, which ended on Oct. 31, the cloud-based cybersecurity company's revenue rose 54% year over year to $355.5 million and beat analysts' estimates by $14.7 million.

On a non-GAAP ( generally accepted accounting principles ) basis, its net income rose 110% to $44 million, or $0.29 per share, which also beat expectations by $0.03. On a GAAP basis, its net loss narrowed from $90.8 million to $68.2 million.

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Image source: Getty Images.

For the second quarter, Zscaler expects its revenue to rise 42%-43% year over year and for its adjusted EPS to increase 123%-131%. For the full year, it expects its revenue to rise approximately 40% (compared to its prior forecast for 37%-38% growth) and for its adjusted EPS to grow 78%-81% (versus its previous outlook for 68%-71% growth).

All of those estimates exceeded Wall Street's expectations, yet Zscaler's stock still slipped and remains down nearly 60% for the year. Let's see why Zscaler failed to win back the bulls -- and if its stock is still worth buying.

Its growth has been cooling off

Many cybersecurity companies install on-site appliances to power their services, but that hardware takes up lots of space, requires constant maintenance, and can be expensive to scale as an organization expands. To address those challenges, a new generation of cybersecurity companies -- including Zscaler and CrowdStrike (NASDAQ: CRWD) -- provide cloud-native services that don't require any on-site appliances. CrowdStrike provides a broad range of endpoint security services, while Zscaler provides "zero trust" security services -- which treat everyone (including a company's CEO) as a potential threat.

The market's demand for Zscaler's services has been booming since its IPO in 2018. At the end of fiscal 2022 (which ended on July 31), it served over 6,700 customers, compared to 3,250 customers at the end of fiscal 2018. Here's how rapidly its billings and revenue grew during that period:

Period

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Calculated billings growth

51%

51%

41%

70%

59%

Revenue growth

65%

59%

42%

56%

62%

Data source: Zscaler.

However, this table also explains why Zscaler's latest earnings report failed to impress the bulls. Its outlook for 30% to 31% calculated billings growth and 40% revenue growth in fiscal 2023 is still robust, but those would also represent its slowest top-line growth rates since its public debut.

Investors might have cared less about that slowdown if Zscaler's stock were cheaper. But with an enterprise value of $18.8 billion, it's still valued at 12 times this year's sales. Based on the recent post-earnings declines in other similar growth stocks , investors don't seem eager to pay more than 10 times sales for companies with cooling growth in this tough market.

But its core business still seems healthy

Yet Zscaler's other growth metrics still look fine. Its adjusted gross margin held steady year over year at 81% in the first quarter, while its adjusted operating margin rose 2 percentage points to 12%. Its net retention rate, or the percentage of recurring revenue it retains over a trailing-12-month period, also stayed above 125% for the eighth consecutive quarter.

During the conference call , CEO Jay Chaudhry admitted that Zscaler faced "broader macro challenges and economic uncertainties" -- but that it was still "seeing an increase in large multi-year commitments for multiple product pillars" and its federal government clients experienced less of a macro impact than its enterprise customers. Those comments seem more upbeat than CrowdStrike CEO George Kurtz's grim warnings of "increased macroeconomic headwinds" and "elongated sales cycles" during the company's latest conference call on Nov. 29.

Zscaler's business should continue to grow for the foreseeable future. Its deferred revenue, which gauges the forward demand for its services, rose 55% year over year to just over $1 billion during the third quarter. Analysts expect its revenue to rise 39% this year and grow 30% in fiscal 2024.

Is it the right time to buy Zscaler?

The main problem with Zscaler is its valuation. Just like CrowdStrike, which is still growing rapidly but trades at 10 times next year's sales, Zscaler will remain out of favor as long as rising interest rates cast dark clouds over pricier growth stocks.

Zscaler might attract more attention if it generated stable GAAP profits like its larger peer Palo Alto Networks , but that probably won't happen anytime soon (since its stock-based compensation expenses still consumed nearly 30% of its revenue during the first quarter).

I personally believe Zscaler is still a great long-term buy. However, its gains will remain limited for at least a few more quarters as the macro headwinds persist -- and investors shouldn't be surprised if it underperforms the market next year.

Leo Sun has positions in CrowdStrike and Palo Alto Networks. The Motley Fool has positions in and recommends CrowdStrike, Palo Alto Networks, and Zscaler. The Motley Fool has a disclosure policy .

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