KEY POINTS
- Zscaler’s stock price has declined nearly 40% from its all-time high.
- Its core business continues to fire on all cylinders.
- Its stock is still richly valued relative to its comparable peers.
This cloud-based cybersecurity company is still priced for perfection.
Zscaler's ( ZS -2.32% ) stock price hit an all-time high of $368.78 last November. But over the following four months, the broad sell-off in growth stocks caused the cloud-based cybersecurity company's shares to pull back to the mid-$230s.
Should investors consider investing in Zscaler after that steep decline, especially as cybersecurity becomes a more pressing issue for both private companies and government organizations?
Image source: Getty Images.
What does Zscaler do?
Zscaler's cloud-native security platform doesn't require the installation of on-premise hardware appliances, which can be expensive and difficult to scale as an organization expands. It specializes in "zero trust" safeguards, which treat everyone -- even "trusted" employees -- as potential threats.
Zscaler might initially seem similar to CrowdStrike ( CRWD -0.65% ), which also aims to disrupt on-premise appliances with cloud-native cybersecurity services. However, Zscaler's services mainly monitor an organization's internal and web-based traffic, while CrowdStrike's Falcon platform protects endpoint devices like servers, PCs, and mobile devices.
How fast is Zscaler growing?
Zscaler currently serves more than 5,600 customers worldwide, including a quarter of the Forbes Global 2000. At the time of its IPO in 2018, it only served roughly 2,800 customers and about 10% of the Global 2000. That's why the company has grown like a weed since its public debut.
Period | FY 2018 | FY 2019 | FY 2020 | FY 2021 | 1H 2022 |
|---|---|---|---|---|---|
Revenue (in millions) | $190.2 | $302.8 | $431.3 | $673.1 | $486.1 |
Growth (YOY) | 51% | 59% | 42% | 56% | 62% |
Data source: Zscaler. YOY = Year over year. FY = fiscal year. 1H = first half.
Zscaler has also been gaining more large customers. It ended the second quarter of 2022 with 251 customers that generated over $1 million in annual recurring revenue (ARR), which was up 85% from a year ago. Its dollar-based net retention rate, which gauges its year-over-year revenue growth per existing customer, has also stayed above 125% over the past year.
For the current year, Zscaler expects its revenue to rise 55%-56%. Analysts expect its revenue to grow 56% in 2022 and 36% in 2023.
Stable gross margins with rising operating margins
Zscaler's adjusted gross margins have consistently remained above 80% since its IPO. Its adjusted operating margin, which was initially negative, has also climbed to double-digit levels over the past 18 months.
Period | FY 2018 | FY 2019 | FY 2020 | FY 2021 | 1H 2022 |
|---|---|---|---|---|---|
Gross Margin | 80% | 81% | 80% | 81% | 80% |
Operating Margin | (8%) | 8% | 7% | 12% | 10% |
Data source: Zscaler. Non-GAAP. FY = fiscal year. 1H = first half.
Analysts expect Zscaler's adjusted operating margin to dip to 9% in fiscal 2022 as it ramps up its spending and prioritizes its top-line growth. But in 2023, they expect its adjusted operating margin to expand to 11% again. That gradual expansion indicates that economies of scale are kicking in.
But mind its losses, high valuation, and ongoing dilution
On a generally accepted accounting principles (GAAP) basis, Zscaler remains deeply unprofitable. But on a non-GAAP basis, which mainly excludes its high stock-based compensation expenses, it's remained profitable since fiscal 2019.
Period | FY 2018 | FY 2019 | FY 2020 | FY 2021 | 1H 2022 |
|---|---|---|---|---|---|
Net Income (in millions, GAAP) | ($33.6) | ($28.7) | ($115.1) | ($262.0) | ($100.4) |
Net Income (in millions, Non-GAAP) | ($14.4) | $30.3 | $40.8 | $75.7 | $19.2 |
Data source: Zscaler. FY = fiscal year. 1H = first half.
Investors shouldn't fret too much over a high-growth company's GAAP losses so long as its top-line growth and gross margins are healthy.
Zscaler's free cash flow also jumped 87% year over year to $112.8 million in the first half of 2022, and it ended the second quarter with $409.8 million in cash and equivalents, with $1.21 billion in short-term investments.
That liquidity indicates it won't run out of cash even if its losses continue to widen. However, its high debt-to-equity ratio of 3.5 indicates it could be tough to borrow more cash at favorable rates as interest rates rise.
NASDAQ: ZS
Another issue is Zscaler's valuation. The stock trades at more than 400 times its forward non-GAAP earnings and 32 times this year's sales. CrowdStrike, which generates comparable top-line growth, trades at about 200 times forward earnings and 24 times this year's sales. CrowdStrike also ended its latest quarter with a much lower debt-to-equity ratio of 2.5.
Lastly, Zscaler's liberal use of stock-based compensation (39% of its revenue in the first half of 2022) to subsidize its salaries has caused its share count to rise about 20% over the past four years. That ongoing dilution will make it even tougher for Zscaler's valuations to cool off.
Source: YCharts
Should you buy Zscaler today?
Zscaler is one of the cybersecurity sector's fastest-growing companies, but it's still too pricey at these levels. Its core business is healthy and it has plenty of room to grow, but it's tough to recommend buying the stock when CrowdStrike has lower leverage and trades at more reasonable valuations.
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