Once a hot cybersecurity upstart, shares of Zscaler (NASDAQ:ZS) haven't been able to regain much traction since summer 2019. The upstart quadrupled in value in the year following its IPO, but remains down 40% from its all-time high.

ZS Chart

Data by YCharts.

There are reasons to like Zscaler after the big pullback. Cloud computing is still a high-growth industry, and the company's cloud native security services are picking up new customers. However, revenue growth is slowing as the industry gets increasingly crowded, and Zscaler's acceleration in spending is worrisome to me. New products are coming online that could change the narrative in my mind, but the negatives outweigh the positives at the moment and have me staying on the sideline.

Two new cloud-based products on the way

Zscaler has made waves in the cybersecurity industry with just two products: Zscaler Internet Access (or ZIA, which secures users on the web) and the Zscaler Private Access (ZPA, which manages users' access to applications). These two security platforms have been driving double-digit growth for the company for years, helping it ride the wave being made as organizations around the globe migrate their operations to the cloud.

Being an early mover when new trends get rolling has its benefits, and the company is hard at work to be an industry first in developing new products. As highlighted in previous earnings updates, CEO Jay Chaudhry mentioned that four new security services are set to be released by the early fourth quarter of Zscaler's 2020 fiscal year (late spring and early summer 2020). Two in particular were called out: Zscaler B2B to address the connection between business-to-business applications (like suppliers and business buyers), and Zscaler Digital Experience (or ZDX) to help organizations monitor their digital operations from the cloud. Chaudhry expects both to expand Zscaler's addressable market and help accelerate revenue growth.

A hacker in a sweatshirt. The hood is pulled up and face deleted

Image source: Getty Images.

Slowing revenue at higher cost

The new security services are the good news, and as to specifics, management thinks full-year revenue will increase about 37%. That implies sales might pick up pace during the second half of the 2020 fiscal year, as revenues grew 36% during the second quarter and 42% through the first six months of the year.

While neither figure is worth balking at, as per usual when it comes to investing, context is needed. Even after the big tumble in recent months, shares trade for 18.8 times trailing 12-month sales, pricing in at least several years-worth of fast expansion. So Zscaler has been able to deliver, but its growth rates are showing signs of easing up fast.  

Fiscal Year

Revenue

YOY % Growth

2018

$190.2 million

51%

2019

$302.8 million

59%

First-half 2020

$194.9 million

42%

Full-year 2020 outlook

$414 million to $417 million

37%

Data source: Zscaler.

Of course, B2B, ZDX, and other new services could help the company maintain momentum. However, my second concern revolves around expenses. Even as sales have slowed in the last year, costs have not. Most of the increases are for employee compensation as new sales staff is on-boarded to gear up for the next big push. Even when backing out non-cash stock-based compensation (which dilutes ownership for existing shareholders, but isn't a cash outflow on the balance sheet), operating margins are contracting relative to total revenue.

Fiscal Year

Operating Expenses

Operating Profit (Loss) Margin

Adjusted Operating Expenses (backing out share-based compensation only)

Adjusted Operating Profit (Loss) Margin

2018

$186.9 million

(18.2%)

$176.5 million

(12.3%)

2019

$278.5 million

(11.7%)

$235.0 million

2.7%

First-half 2020

$203.6 million

(24.9%)

$164.3 million

(4.8%)

Data source: Zscaler.

Of course, all of this is fine and well if it's a temporary situation and expenses start to level off again. It's also positive that free cash flow (money left after basic operating and capital expenses are paid) is still positive $19.6 million over the last trailing 12 months (versus a 12-month run rate of over $30 million a year ago).  

My concern, though, is that Zscaler's sales trajectory isn't just a function of new innovation and product. The industry overall is slowing down. Palo Alto Networks (NYSE:PANW) recently hit a wall as well -- although it has taken a different strategy and decided to acquire innovation instead of developing it in-house. Fortinet (NASDAQ:FTNT), which has taken a more measured approach to expanding into the cloud (and incidentally my favorite cybersecurity stock at the moment), has temporarily bucked the trend but is in general slowing down in momentum as the years go by too. Basically, what I'm trying to say is that I was more comfortable with where Zscaler was a year ago than I am today. It could always dial back the cash outflow later if things don't pan out, but along the way existing shareholders are also getting diluted at a high rate.

If Zscaler's new services take off and operating expenses moderate again, all this is a moot point. But I'm not biting until I see signs that's the case, as competition in the cloud security market continues to heat up