Zscaler's (NASDAQ:ZS) fiscal third-quarter results, reported in late May, exceeded expectations and management raised its full-year outlook. But since the coronavirus-induced market sell-off in early March, its stock price has increased about 175%, which should encourage investors to consider the cybersecurity specialist's apparently spectacular performance with prudence.

Modest revenue boost from stay-at-home policies

The company has been increasing its revenue at a fast clip over the last several years thanks to its cloud-based cybersecurity portfolio that is profiting from the secular growth of cloud computing.

In particular, Zscaler Internet Access (ZIA) allows users to access the internet and public Software-as-a-Service (SaaS) applications from anywhere in a secure way. And Zscaler Private Access (ZPA), which was launched more recently in 2016, secures remote access to private applications. Management doesn't disclose the individual performance of these products, but the CEO said during the fiscal second-quarter earnings call in February that ZPA grew "from nothing to a pretty significant contributing factor," which implies ZIA still represents the majority of the company's revenue.

Over the last few months, businesses have been implementing these types of solutions on short notice for employees who need to work from home as part of efforts to limit the spread of COVID-19. During the May 28 earnings call, CEO Jay Chaudhry said the company's ZPA service saw a 10 times growth in usage over the last quarter.

As a result, quarterly revenue increased to $110.5 million, up 40% year over year, which exceeded management's revenue guidance range of $105 million to $107 million. Given the strong boost work-from-home policies gave Zscaler's businesses, that overperformance -- 3.3% above the high end of the guidance range -- seems modest, though. In comparison, high-growth cloud vendors Okta and Datadog exceeded the top ends of their revenue guidance ranges by 5.7% and 10.1%, respectively.

A man in a suit holds a magnifying glass over an artist's representation of a cloud and a padlock

Image source: Getty Images.

Losses widened

Despite its strong revenue growth, Zscaler increased its losses under generally accepted accounting principles (GAAP) to $19.3 million in the quarter, compared to $12.2 million one year ago.

Granted, the company had to use Amazon's Amazon Web Services (AWS) and Microsoft's Azure cloud infrastructures to keep up with the surge in demand for its services because of the coronavirus crisis. But the impact of these extra costs on profitability remained limited as gross margin dropped to 78%, compared to 81% the prior-year quarter.

Instead, the company's losses are due to its high sales and marketing expenses, which represented 61.3% of revenue during the last quarter, up from 57.2% last year.

And taking into account all the other costs, such as research & development, Zscaler is still far from reaching profitability as its GAAP operating losses widened to 19% of revenue compared to 17% last year.

Free cash flow excludes significant costs

In contrast with its GAAP losses, Zscaler posted positive third-quarter free cash flow of $9.1 million, up from $4.6 million last year. And with $391 million in cash, cash equivalents, short-term investments, and no debt, the company seems immune from financial difficulties even if a prolonged recession materializes.

But investors should keep in mind free cash flow excludes share-based compensation, which represents a significant cost for shareholders in terms of dilution. During the last quarter, the weighted-average number of shares outstanding increased by 4% year over year, and SBC amounted to $27.8 million, or 25.1% of revenue. If these costs were cash expenses, the number of shares would have stayed flat quarter over quarter, but the company's free cash flow would have been negative $18.7 million.

Also, Zscaler recently acquired cybersecurity specialists Cloudneeti and Edgewise Networks for a total of $40 million. Management indicated that these companies, which have been developing products that protect cloud data centers and cloud applications, would not impact revenue over the next several quarters, as they are in their infancy. Yet despite this expected lack of short-term revenue, these acquisitions make sense. Zscaler can boost the development of these early stage companies and profit from cross-selling opportunities with its existing solutions it has been selling to more than 3,900 customers.

There's no standard definition for free cash flow, but excluding mergers and acquisitions from the calculation has become a common practice among  U.S. publicly traded companies. Thus, the cost of Zscaler's acquisitions will not be reflected in its free cash flow. Yet investors should keep in mind the cash outflow of $40 million that correspond to these transactions represent a real cost for the company to enhance its portfolio.

Not for prudent investors

Zscaler's lofty valuation is another reason for investors to remain prudent.

Based on the midpoint of management's raised full-year revenue guidance range, the market values the company at a lofty enterprise value-to-sales ratio of 32. And assuming the midpoint of the forecast full-year adjusted earnings per share range, the forward price-to-earnings (P/E) ratio of 536 corresponds to phenomenal market expectations. Besides, adjusted EPS doesn't take into account share-based compensation, which will lead to negative fiscal full-year GAAP EPS.

Since Zscaler's lofty valuation doesn't leave much margin of safety, the stock is a buy only for investors convinced the company will keep on posting spectacular revenue growth over the long term while improving its profitability in a meaningful way. Given that level of stellar growth seems difficult to sustain over many years with scale, it's not a bet I'm willing to take.