Is It Finally Time to Buy Zscaler Stock? | #hacking | #cybersecurity | #infosec | #comptia | #pentest | #ransomware

After a couple of years of brutal treatment from the market, it looks like Zscaler (ZS -2.73%) stock is making a comeback. A rapid rally in recent weeks has sent the cloud security software company’s shares from a negative trailing-three-year return to a more healthy looking 47% increase over the last 36 months.  

Why the sudden change? Up until recent earnings updates, Zscaler had been reporting slowing revenue growth (an inevitable effect as the company grows larger), but rising employee stock-based compensation. With this most glaring issue getting gradually fixed, is it finally time to buy Zscaler stock?

Sales growth certainly isn’t an issue in cyberland

Pressure is mounting on businesses as the global economy slows in 2023. Some worry a recession is here already. Even the high-flying cloud industry has been experiencing a slowdown as companies tighten their financial belts.

Recession or not, though, cybersecurity is a mission-critical service. Zscaler and some of its peers have said deal scrutiny has increased, but not so much that it has throttled growth by too much. Zscaler revenue was up 46% year over year to $419 million during the company’s fiscal third-quarter 2023 (the three months ended April 2023).  

Revenue expansion will slow in Zscaler’s fourth quarter (the three-month period that will end in July 2023). Management forecasted sales will be up “only” about 36% to $430 million. However, let’s not blame the economy. As a business gets bigger, it’s entirely normal for revenue hypergrowth to cool off a bit.

Similar resilience in sales expansion was reported by Zscaler’s larger peers like Palo Alto Networks and Fortinet

What was eating Zscaler stock?

Despite the coming slowdown in revenue growth, something clearly changed as of late in the market’s perception of Zscaler. The upstart cloud security company not only had an unsustainably high valuation the last few years, but expense growth — including stock-based comp (SBC) — was growing at a high rate and limiting Zscaler’s ability to generate a healthier profit margin.

But after some organizational reshuffling, some of these issues are getting under control. Revenue growth has begun to handily exceed operating expense growth, as should be the case for a healthy software business model.

Data by YCharts.

Even SBC is coming down. While SBC for fiscal 2023 to-date is still up 6% from the same period in 2022 to $331.5 million, SBC was actually slightly reduced to $111.3 million in Q3 (compared to $111.6 million a year ago).

If Zscaler can keep it up, profitability on all fronts is poised to rocket higher in the coming years — even if revenue growth continues to moderate. As a rough initial guide, Zscaler said fiscal 2024 adjusted operating margin should be in the 15.5% to 16% range. For reference, through the first three-quarters of the current fiscal year, Zscaler’s adjusted operating margin was 13%.

Time to buy Zscaler stock?

Given this improvement in Zscaler’s profitability, is it time to buy the stock? Not so fast.

After the rapid rally in recent weeks, some of the high premium valuation has come back too. Shares trade for 74 times trailing 12-month free cash flow, and 50 times Wall Street analysts’ expectations for next year’s free cash flow.

Of course, if this cybersecurity platform can keep its momentum going into fiscal 2024 and beyond, a high premium is warranted. If you like Zscaler for the long haul, consider a dollar-cost average plan to smooth out some of the inevitable bumpiness that comes with high-priced growth stocks.

Either way, don’t forget other cybersecurity businesses. This industry is enjoying a secular growth trend, and there are a lot of great names in which to invest in this space.

Nicholas Rossolillo has positions in Fortinet and Palo Alto Networks. The Motley Fool has positions in and recommends Fortinet, Palo Alto Networks, and Zscaler. The Motley Fool has a disclosure policy.


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