Turns out I was wrong about Zscaler (ZS +2.50%) stock.
After backtracking significantly in the second half of 2019 on worries its growth trajectory was losing momentum, the cloud-based cybersecurity firm's shares are up roughly 92% from mid-March lows and up 63% year to date in 2020.
To say coronavirus has made anyone a winner wouldn't be fair, but shelter-in-place and work-from-home movements that have ensued to combat the spread of the pandemic have cloud computing in high demand. Just as its larger incumbents Palo Alto Networks (PANW +1.80%) and Fortinet (FTNT +3.44%) got a boost in revenue the first few months of the year, so too has Zscaler.
Stepping on the gas made sense
Just a few months ago (at the end of February and what feels like a totally different world now), Zscaler reported a more than respectable 37% year-over-year increase in sales, but nonetheless a deceleration from the nearly 60% rate of growth in 2019. While anything north of 30% would be an unimaginable expansion for most firms, the cloud computing industry this security company is a part of continues to make fast inroads into organizational operations around the globe. With a price-to-sales ratio of over 20 at the time, Zscaler needed every bit of that growth to justify its valuation.
Image source: Zscaler.
Yet cybersecurity for this new digital age driven by the cloud has gotten crowded. There are other upstarts like Zscaler, and the largest and oldest players like Palo Alto and Fortinet have been successfully transitioning their security suites to address new needs as well. Zscaler's decision to increase spending amid elevated competition and decelerating results -- even if it has ample cash on its balance sheet -- made me uncomfortable. Not to mention there was some troublesome news brewing about a novel viral infection.
As it turns out, Zscaler doubling down on its aggressive strategy was fortuitous. Much of the world went on lockdown, and organizations that have been dragging their feet implementing new digital tools were sent scrambling to put continuity plans in place. The result for Zscaler? Revenue accelerated to a 40% year-over-year pace to $110.5 million in fiscal third quarter 2020 (the three months ended April 30, 2019). Deferred revenue (sales that have been collected but for which service has not yet been rendered) increased 42% to $300.8 million, and free cash flow (revenue less cash operating and capital expenses) doubled from a year ago to $9.1 million -- good for an 8% free cash flow profit margin.
More than a one-time bump?
For the final quarter of its fiscal year, Zscaler expects no less than a 36% increase in revenue. Given its history of under-promising and over-delivering, it wouldn't be surprising to see the figure go much higher as the company helps businesses migrate to challenging times and to a more modern tech infrastructure.
Zscaler is sticking with its plan of plowing cash back into itself to maximize its growth now. Through the first nine months of its current fiscal year, operating expenses less stock-based compensation to employees, amortization, and litigation have increased 39% to $219 million. Much of that is due to rising headcount as the company onboards sales and support staff to accommodate its fast-growing operations. Given the current state of affairs in the world, it's hard to argue with Zscaler's use of funds ($391 million in cash and short-term investments, zero debt). Work-from-home and higher use of the cloud isn't going anywhere anytime soon, and that plays into this cybersecurity firm's hand.
I'm still not quite comfortable with making a purchase. Shares have surged higher on expectations that this accelerating sales story would play out, and the stock now trades for 29.6 times trailing 12-month sales. Nevertheless, keep this one on your radar. Like it or not, the aggressive expansion is paying off as Zscaler's cloud security suite increases in importance.
