When Zscaler (ZS 0.30%) last week released its strong results for its fiscal 2020 fourth quarter (which ended on July 31), it also revealed a potentially troubling shift in its plans.
CFO Remo Canessa announced that the company was postponing its long-term profitability goal to improve its non-GAAP (adjusted) operating margin to the 20% to 22% range when annual revenue reaches the $800 million to $1 billion range. Should shareholders worry about that decision?
Coronavirus-induced boost
Remote workers need the types of solutions Zscaler proposes. The cloud-native cybersecurity specialist's platform allows users to access internet services and private applications in a secure way from anywhere.
Image source: Getty Images.
Thus, the spring's shelter-in-place orders and the widespread decisions by businesses not to bring employees back into offices yet have driven new clients to the company. Its fiscal fourth-quarter revenue increased 46% year over year to $125.9 million, exceeding the guidance range of $117 million to $119 million.
That also suggests the company is gaining market share. The research outfit MarketsandMarkets estimates the global cloud cybersecurity market will grow at a much lower -- yet still attractive -- compound annual growth rate of 14.7% through 2025.
Growth versus profitability
Over the last several years, management prioritized growth over profitability while the company worked to gain scale. Illustrating the results of that strategy, in Q4, Zscaler's losses deepened to $49.5 million, compared to $5.3 million one year ago, as its sales and marketing spending grew to 71% of revenue, up from 57% in the prior-year quarter.
So far, the added scale has failed to improve the company's operating margins because of those high sales and marketing expenses.
ZS Revenue (Quarterly) data by YCharts
However, management had reiterated over the last several quarters that it had confidence in improving profitability, and it put forth the goal of reaching a non-GAAP operating margin of 20% to 22% by the point that the company was generating $800 million to $1 billion in annual revenue. Given Zscaler's strong double-digit revenue growth and based on analysts' expectations, the company should attain that revenue range by fiscal 2023.
But Canessa said during the earnings call he will now aim to hit that non-GAAP operating margin range of 20% to 22% in fiscal 2024 instead, as the company will keep prioritizing growth to capture significant market opportunities.
That shifting long-term goal doesn't alter the investment thesis for this tech stock, though: Zscaler remains a high-growth cloud cybersecurity specialist that prioritizes scale over profitability. However, shareholders should take the update with a grain of salt.
Granted, that extra revenue growth opportunity seems likely to materialize given the better-than-expected top-line growth during Q4. Also, management's fiscal 2021 revenue guidance range of $580 million to $590 million exceeds analysts' prediction of $557.8 million.
But postponing its effort to reach those operating margins means Zscaler will spend a higher-than-expected percentage of its revenue over the next few years to fuel its growth. In addition, management didn't provide a long-term revenue growth target, which leaves hazy the magnitude of extra revenue these higher expenses are expected to bring.
Beyond the non-GAAP operating margin
In addition, investors should keep in mind the company's GAAP operating margin should remain much lower than the 20% to 22% non-GAAP operating margin target.
That's because Zscaler excludes share-based compensation and other expenses from its non-GAAP calculations -- as many companies do. However, share-based compensation represents a real and significant cost to shareholders. Over the last 12 months, the company's non-GAAP operating margin reached 7%, but the GAAP operating margin was negative 26% as share-based compensation equaled 28% of revenue.
Besides, even if you weigh Zscaler based on that inflated non-GAAP operating margin, the valuation remains demanding. Let's assume:
- Revenue in fiscal 2021 matches the midpoint of management's guidance of $585 million.
- After fiscal 2021, revenue will grow annually by 30% -- way above the forecast 14.7% CAGR of the overall cloud cybersecurity market.
- By fiscal 2024, the operating margin will meet the high end of the non-GAAP target range of 22%.
Based on these suppositions, Zscaler stock is trading at 62 times its estimated operating income of $282.75 million in fiscal 2024.
That lofty valuation ratio indicates the market expects the company to gain market share over the next several years in a crowded, competitive environment while significantly improving its margins. And even if that happens, the upside potential of the stock seems limited.
Therefore, shareholders shouldn't focus on the company's shifting profitability long-term goal. Instead, they should realize the market is already pricing flawless execution into this stock no matter how management balances growth and profits, which doesn't leave much margin of safety.
