Zscaler Stock: Major Rally In Store (NASDAQ:ZS)

Make no mistake, innovative technology stocks have been absolutely decimated in the last year. In 2022, these stocks saw even more pressure as the dollar became stronger, and interest rates have risen. This hurts tech stocks, as the underlying companies have to pay more to borrow, or see more pressure on international sales due to currency issues. However, with many of these stocks being down 50% or more, some stocks are set up for success. Zscaler (NASDAQ:NASDAQ:ZS) is a good example of a stock that has been crushed. The sector it is in has also been crushed, and Zscaler operates in a really competitive space. It is a cybersecurity play to put it simply. The technology it offers helps customers to be more agile, efficient, resilient, and secure. Its products are used by thousands of customers to prevent losses from cyberattacks. It prevents data loss by securely connecting users, devices, and applications on its cloud. Each quarter the company continues to enhance its customer’s experience with innovation and cutting-edge security. It is a solid company, despite the stock being cut in half in a year.

The thing is, even after the massive pullback, the stock is disgustingly expensive, at least on traditional valuation metrics. This adds risk because the company must operate strongly and deliver exceptional results or the stock could suffer more. That said, Zscaler is rapidly growing, and the performance of the company suggests it can grow into the valuation. We think shares are setting up for a strong rally following the release of the company’s Q4’22 earnings report.

So how well is the company actually performing? Pretty strongly. In companies like this, we look for growth in sales and cash flow and on these metrics, Zscaler is winning. In Q4, Zscaler saw a strong 61% increase year-over-year in revenue to $318 million. The company has a near $27 billion market cap, and sales are on pace to be well over $1 billion next year, so this is priced 18x FWD sales. Not nearly as expensive as say a year ago, but still expensive at least from an actual metric value. Priced for delivering growth and it is delivering. It is worth pointing out that these revenues were ahead of already bullish consensus projections by $13 million.

The earnings, and specifically a price-to-earnings ratio, are almost laughable. You have to look longer-term. Right now it is simply uninformative. Adjusted EPS was $0.25, beating by $0.04 by the way. The fact that the company is earnings positive puts it ahead of a lot of the competitors in the tech sector that are growing revenues like wildfire. If the company manages to earn $1.00 in earnings for 2023, then at $188 per share, we are trading at ‘just’ 180x FWD EPS.

So you really cannot value the company on these traditional metrics. To value the stock and what an investment means, you need to look at where the company could be in five years. The company is rapidly growing bookings. They have major customers as they are partnering with major companies to strengthen cybersecurity offerings.

We like to look to cash flow. This is another way to value the name. Cash provided by operations was $103.1 million, or 32% of revenue, compared to $44.7 million, or 24% of revenue a year ago. Further, free cash flow was a very strong $74.8 million, or 24% of revenue, compared to $27.7 million, or 14% of revenue, in last year’s comparable period. So free cash flow nearly tripled. Winning. We like that. It is worth noting the company also has $1.731 billion in cash and equivalents. Very strong.

As you can see with the pace of revenues, cash flows, and earnings expansion, the company is not surprisingly growing billings tremendously. In fact, calculated billings grew 57% from last year. Deferred revenue is also up markedly by 74%, and stands at nearly $1.02 billion. Jay Chaudhry, Chairman and CEO of Zscaler stated:

We delivered outstanding results for the fourth quarter with 61% revenue growth and 57% billings growth year over year, while driving operational efficiency across the company and delivering on Rule of 80 for the quarter and for the full year… Our customers are realizing immense value from the new, innovative services and advanced capabilities being integrated into our Zero Trust security platform. Despite the uncertain macroeconomic landscape which continues to evolve, we continue to see favorable demand for our Zero Trust Exchange platform because it makes businesses more secure, simplifies IT, and reduces cost.

The Zero Trust type security is a winner. As we possibly head into a small recession, the fact that Zscaler can help companies reduce cost is a catalyst. But there is no guarantee they will spend. In a recession we often see capex spending by companies, as well as government spend decline, particularly on innovative tech solutions. So the stock is not without risks. Recession is a risk. A bad market is a risk. While valuation is silly, with the stock being so incredibly overvalued on traditional metrics, it is priced for absolute perfection. One mistake, one bad quarter that does not show beats, could send the stock spiraling back lower. The short interest is also moderately high here in the high single-digit percentage, which can be a negative. A pricey stock in a shaky market can lead to high short interest that could lead to short attacks sending the stock far lower on bad news. Other possible risks operationally include some type of big data breach to a customer using their software or cloud solutions could be a headline risk that sends shares lower. Another risk is the huge amount of competition for cybersecurity. While the moat is quite strong, the fight for market share is real. Further, the earnings are positive, but if there is margin erosion or the company slips back to losses, the stock will be quickly revalued lower.

Final Thoughts

While there are risks here, and despite the stock being cut in half, valuation is still sky-high. That valuation has attracted a high short interest, and we would not be surprised to see further short covering on this report. But the outlook is strong, with management guiding ahead of consensus, and looking for earnings of $1.16-$1.18 in fiscal 2023. The company is growing into the rich valuation, and we see growth continuing. We think, barring a horrible market correction, this rally continues.