Forget the threat of a U.S. recession -- predictions of which have escalated dramatically during the second half of this year. The real bane for high-flying technology stocks right now is revenue slowdown. A lot of factors can contribute to that scenario, but for cybersecurity upstart Zscaler (NASDAQ:ZS), competition seems to be the culprit.

If you're a cybersecurity investor, the rapid pace of change in recent years is no breaking news headline. The rise of cloud computing has been a boon for Zscaler, but it has been for plenty of other start-ups as well. Heavyweights in the industry like Palo Alto Networks (NYSE:PANW) and Fortinet (NASDAQ:FTNT) are cracking the code as well. As a result, it's looking like north-of-50% sales growth for Zscaler is now in the past. That reality is justifying Zscaler stock's more than 40% drop from all-time highs reached over the summer of 2019. It isn't time to sell, but it's time for investors to keep a wary eye on the top line.  

Someone in the background pressing an illustrated lock in the foreground, representing cybersecurity.

Image source: Getty Images.

A strong start to the year

That's not to say that the report card from the fiscal 2020 first quarter was a bad one. Zscaler's revenues came in well above guidance ($93.6 million, versus $89 million to $90 million projected) provided just a few months prior, and management also updated full-year revenue expectations to $405 million to $413 million (from $395 million to $405 million before).

Metric

3 Months Ended Oct. 31, 2019

3 Months Ended Oct. 31, 2018

Change

Revenue

$93.6 million

$63.3 million

48%

Gross profit margin

79.1%

80.9%

(1.8 pp)

Operating expenses

$92.3 million

$59.9 million

54%

Net income (loss)

($17.1 million)

($7.59 million)

N/A

Adjusted earnings (loss) per share

$0.03

$0.02

50%

Pp = percentage point. Data source: Zscaler.  

So what's wrong with 48% top-line growth? For starters, it's another slowdown. Q4 2019 sales notched a 53% rate, and Zscaler's guidance upgrade for 2020 (35% growth at the midpoint) still implies a sharp drop-off at some point this year. Shares were down as much as 10% the day after the news. The bar has been set high, and shareholders have grown accustomed to more robust expansion from the cloud security firm.

Plus, as sales decelerate -- perhaps quickly if management doesn't deliver more big earnings beats in subsequent quarters -- operating expenses are still soaring. 

Operating Expenses

3 Months Ended Oct. 31, 2019

 Change

Sales & marketing

$59.4 million

63%

Research & development

$20.3 million

54%

General & administrative

$12.6 million

25%

YOY = year over year. Data source: Zscaler.  

As a start-up grows, operating expense growth is supposed to moderate relative to revenue growth. That isn't happening here. Granted, included in those expenses is a grand total of $18.4 million awarded in stock-based compensation -- which goes down as a noncash expense. But Zscaler is making changes to its sales team (read: hiring more staff) as CEO Jay Chaudhry said his company is "focused on improving our sales execution to take Zscaler beyond $1 billion in revenue." Investors should thus keep an eye on operating metrics as fiscal 2020 drags on. Growth at any cost probably isn't the route to go at this point with the cloud security market getting crowded.

Priced for years of growth

I'm not writing off Zscaler just yet. Volatility is common with small, fast-growing firms like this, and things can change for the better real quick. Nevertheless, it's important to remember that the stock has years' worth of growth (or much higher growth for this coming year, take your pick) priced in already. Shares are going for 383 times fiscal 2020 expected adjusted earnings per share, so profitability isn't a reliable tool. That leaves us with the highly subjective price-to-sales ratio, and using that puts the stock at an equally lofty 15.6 times expected 2020 revenue.

Given the projected sales trajectory, Zscaler might be fairly valued -- although other cloud firms similarly priced using the price-to-sales ratio like Twilio, The Trade Desk, and Anaplan are expecting to grow faster than Zscaler is. It all hinges on whether the management team surprises investors to the upside as the next few quarters unfold. Investors can at least take solace in the fact that a conservative guidance strategy has been the company's modus operandi thus far, so more revenue beats and full-year updates should be in the cards. Stay tuned.