Is Zscaler Stock a Buy Now?

Zscaler's (ZS -1.00%) stock price surged 12% during after-hours trading on Sept. 8 following the release of its fiscal 2022 fourth-quarter earnings report (for the quarter ending July 31). The cloud-based cybersecurity company's revenue rose 61% year over year to $318.1 million, which beat analysts' estimates by $12.5 million, as its billings rose 57% to $520.4 million. Its adjusted net income increased 79% year over year to $36.4 million, or $0.25 per share, which also cleared the consensus forecast by four cents.

Those headline numbers were impressive, but should investors still buy Zscaler's stock in this challenging market for hypergrowth stocks? Let's review its business model, growth rates, and valuations to decide.

Image source: Getty Images.

Carving out a niche in next-gen cybersecurity services

Zscaler provides "zero trust" tools that treat everyone -- including a company's most trusted employees -- as potential threats. It provides these tools as cloud-based services instead of bulky on-site appliances, which take up a lot of space and can be difficult to scale as a company expands.

That cloud-native approach makes Zscaler comparable to CrowdStrike (CRWD -1.18%), but CrowdStrike provides a much wider range of endpoint security services, while Zscaler primarily focuses on its zero-trust niche. Zscaler's early mover's advantage in that niche has enabled it to grow like a weed since its public debut in 2018.

Data source: Zscaler.

For fiscal 2023, Zscaler expects its calculated billings to grow 30%-31% and for its revenue to increase 37%-38%. Those would represent its slowest annual growth rates since its IPO, but that deceleration is due to the recent macro headwinds rather than any fundamental problems with its underlying business.

Ambitious long-term goals

At the end of fiscal 2022 (which ended on July 31), Zscaler's platform secured over 34 million users for more than 6,700 customers. That's more than double the 3,250 customers it served at the end of fiscal 2018. Its number of customers that generated over $1 million in annual revenue also rose 62% year over year to 327 at the end of fiscal 2022.

Zscaler is also generating more revenue from its existing customers. Its net retention rate, or the percentage of recurring revenue it retains over the previous 12 months, has exceeded 125% for seven consecutive quarters.

Zscaler believes it can secure 200 million users over the long term, which suggests its business will grow more than six times larger. That's a fairly reasonable target -- even if Zscaler's growth cools off to a more moderate compound annual growth rate (CAGR) of 30% over the next five years, its annual revenue would still nearly quadruple from $1.1 billion in fiscal 2022 to more than $4 billion in fiscal 2027.

Stable gross and operating margins

Zscaler's non-GAAP (generally accepted accounting principles) gross margins have consistently stayed above 80% since its public debut. Its non-GAAP operating margins also rose from the single digits to the double digits over the past two years.

Data source: Zscaler. Non-GAAP. FY = fiscal year.

Zscaler's stable gross margins indicate it still has plenty of pricing power in its niche market, even as more diversified cybersecurity companies like CrowdStrike and Palo Alto (PANW 1.43%) launch similar zero-trust services. Over the long term, Zscaler expects its gross margins to stay between 78%-82%, and for its operating margins to rise to 20%-22%.

Zscaler is still unprofitable by GAAP measures, but those losses could narrow quickly once it reins in the stock-based compensation expenses that consumed a whopping 38% of its revenue in fiscal 2022.

But a lot of growth is already priced in

Zscaler's business is clearly firing on all cylinders. But at $173 per share, it's still valued at more than 17.9 times this year's sales. CrowdStrike, which is growing at a similar rate as Zscaler, trades at 20 times this year's sales.

Both of those cloud-native cybersecurity stocks look pricey compared to Palo Alto, which is growing slower but trades at 8.2 times this year's sales. Unlike Zscaler and CrowdStrike, Palo Alto expects to stay profitable by GAAP measures this year.

Zscaler still looks like a good long-term buy right now. However, investors should expect its premium valuation to cap its near-term gains as rising interest rates drive investors toward more conservative investments.