Zscaler Stock: Fast Growing Cybersecurity Operator (NASDAQ:ZS)

The cybersecurity sector soared to the stratosphere during the pandemic. While the valuations were hard to understand, the reasons for that directional move made sense – cybersecurity combines the attractive unit economics of software businesses with a compelling long term secular growth story in protecting customers from cyber-attacks. Zscaler (NASDAQ:ZS) is a dominant operator within the cybersecurity sector, helping to protect data and applications at the user level. The stock has not traded cheaply for a long time and even after the steep crash from all-time highs, still trades at a rich valuation. Yet the company has a net cash balance sheet, is flowing cash, and has highly visible forward growth prospects. The stock is quite buyable here for those looking for a higher quality pick amidst the tech crash.

ZS Stock Price

ZS peaked above $365 per share in late 2021 but has since fallen around 63% since then. What a fall!

I first warned on the valuation in September of 2021 when the stock was trading close to $300 per share. After a fall, I last recommended the stock in November on account of the more reasonable valuation and resilient growth rates. After a further fall and recent rally, the stock is down 5% since then, helping to slightly ease valuation which seems to be the only remaining concern.

ZS Stock Key Metrics

After growing revenues by 62% last year, ZS has continued to grow at a rapid pace, reporting 54% growth in the latest quarter. It is incredible to see the company sustain rapid growth in spite of tough comparables and a difficult macro backdrop. Not all tech companies are created equally – as a top operator within cybersecurity, ZS appears more insulated than others to the macro environment.

Billings grew by a slower 37% but normalized for a higher billings result from a year ago, billings grew by 42%. While that represents some deceleration, it is still a solid result considering the market environment.

ZS reported greater than a 125% dollar-based net retention rate, its 8th consecutive quarter with such a high achievement. Like cybersecurity partner and fellow tech darling CrowdStrike (CRWD), ZS benefits from having a wide product portfolio within which it can upsell existing customers. ZS estimates that it can increase revenues by 6x just through upselling through existing customers alone. On the conference call, management noted that the split between new and upsell revenues was approximately 50-50 in the quarter but will likely be more like 40-60 moving forward.

ZS ended the quarter with $1.82 billion of cash versus $1.1 billion of convertible notes. That net cash position is already a clear positive, but I should note that these convertible notes bear interest at 0.125% annually and mature in 2025. ZS also generated $44 million in non-GAAP net income in the quarter – I have no fears regarding financial solvency risk.

Looking ahead, ZS has guided for $366 million in second quarter revenues, representing 43.5% YOY growth, and $1.53 billion in full-year revenues, representing 40.4% YOY growth. That represented a raise from the prior $1.5 billion guidance. On the conference call, management noted that the raise was lower than prior quarters mainly due to the macro backdrop. Management aimed to “derisk” their guide based on some macro uncertainty and noted that their recent sales reorg to focus on smaller enterprises also played a role.

Is ZS Stock A Buy, Sell, or Hold?

ZS is helping to protect enterprises as they undergo a digital (and more specifically, cloud) transformation. Previous cybersecurity products might only protect an individual network. But as enterprises use more cloud applications themselves, how do they continue to protect their data?

Enter Zscaler. ZS offers a complete cybersecurity platform aimed to protecting data and applications on a user level. In contrast, the aforementioned CRWD protects endpoint devices. ZS is a clear market leader with 40% of the Fortune 500 as customers.

The cybersecurity sector has retained a significant premium as compared to tech peers, perhaps due to the greater resiliency in the fundamentals. Within that sector, ZS has also commanded a relative premium due to its wide product offerings. The theory is that it is easier to upsell existing customers than onboard new customers in tough macro conditions.

At recent prices, ZS traded at just over 13x this year’s sales.

Based on 30% projected medium-term growth, 30% long term net margins, and a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see ZS trading at 13.5x sales, reflecting a stock price of $182 per share and 38% potential upside over the next 1.5 years. ZS might outperform that projection as it has typically commanded multiples in excess of the assumed 1.5x PEG ratio.

What are key risks? Valuation is a good starting point. Because ZS trades at a relative premium to peers, one should not be surprised to see some mean reversion. I could see ZS trading down 30% at least just to trade in-line with peers on a growth-adjusted basis. Another is that of competition. Cybersecurity has seen strong growth in recent years but competition and market saturation may eventually lead to steep deceleration in growth rates. It is unclear if and when exactly that may occur, but ZS stock would likely see some multiple compression in such an outcome. Another risk is that of macro – it is possible that ZS may not perform to expectations. With the stock trading as richly as it is, the company will need to perform very strongly just to meet expectations and any stumble may lead to multiple compression. As discussed with subscribers to Best of Breed Growth Stocks, the best way to take advantage of the tech stock crash is by investing in a portfolio of undervalued tech stocks. ZS can fit in such a portfolio as a higher quality allocation though one could make a strong argument that capital may be better placed in more undervalued peers. I rate ZS a buy as I expect the fundamentals to remain resilient through a choppy future.