Zscaler (ZS 0.01%) stock continues to get clobbered even as the cybersecurity company puts up sizzling sales growth. Investors are dialing back exposure to high-growth-but-no-profit tech stocks during this bear market. Zscaler, unfortunately, matches that description thanks to a high rate of employee stock-based compensation, so the market hasn't cared much about the business's continued momentum.
Share prices fell 65% in calendar year 2022 and ended near multi-year lows. There is talk that things can potentially take a turn for the better in 2023. Does that make now the right time to buy Zscaler stock?
When business strength no longer equals stock price strength
Cloud computing (data and apps housed in a remote data center and accessed via the internet) enabled a new era of work where employees can access data and applications from anywhere there's an internet connection. But it's also exposed new vulnerabilities. To help keep their operations safe from cyberattacks, organizations have been adopting services like Zscaler's that take a zero-trust approach to IT security (one that requires constant validation of parties requesting access to data).
Zscaler finished out its fiscal 2022 (the 12 months ended July 2022) with 61% revenue growth, and reported 54% year-over-year revenue growth in Q1 fiscal 2023 (ended October 2022) to $356 million. Clearly, Zscaler's technology is winning over lots of new customers.
However, 2022 was the year investors stopped focusing solely on revenue momentum when deciding whether to purchase a stock. Zscaler generates positive free cash flow, but it still reports a loss on a GAAP basis (more on that in just a moment). Thus, many investors were solely focused on using the price-to-sales ratio in 2020 and 2021 to assess growth stocks.
Zscaler went from a ridiculous valuation of more than 60 times trailing-12-month revenue in late 2021 to a much more reasonable 13 times trailing-12-month revenue as of this writing. Shares also trade for 65 times trailing-12-month free cash flow right now, so Zscaler still isn't cheap. But clearly, the market isn't buying the company's impressive expansion.
The primary drag on Zscaler's stock performance
Now back to Zscaler's profitability issue. Over the last 12 months, the company reported net losses (on an unadjusted basis) of $368 million. However, free cash flow was a positive $244 million. The primary difference between the two profit metrics is employee stock-based compensation, which is a non-cash expense that gets excluded from the free-cash-flow calculation. Nevertheless, it's this apparent lack of net profitability that has the market down, and the microscope is looking into that high level of stock-based compensation that dilutes non-employee shareholders.
Zscaler's stock-based comp increased 17% year over year in the first quarter of fiscal 2023 to $105 million -- a seemingly outrageous 29% of total revenue. However, a few months ago, I pointed out how this amount of stock-based comp is negligible when compared to Zscaler's market capitalization (currently, annualized stock-based comp in Q1 was just 2.6% of the market cap of $16 billion). On a per-share basis, Zscaler continues to deliver healthy revenue and free-cash-flow growth to shareholders.
Data by YCharts.
Here's the catch, though: As long as Zscaler continues to trade for a premium (which is tied to its pace of revenue growth), the current rate of stock-based compensation is manageable. Of course, Zscaler could also further mitigate this issue by beginning to use free cash flow to repurchase stock and offset at least some of the effects of employee stock compensation. This is what fellow cybersecurity company Palo Alto Networks does.
But that isn't the case for Zscaler yet, and revenue is expected to cool off in 2023. Full fiscal-year 2023 sales are expected to be as much as $1.53 billion, about 40% higher than last year -- implying a significant cooldown from the 54% pace just reported last quarter. If the market continues to sell off Zscaler, that stock-based compensation could begin to have a more dramatic effect on the business as the market cap shrinks.
For now, I'm taking a cautious stance with Zscaler stock as the market is eyeing it critically. The cybersecurity company is making progress toward GAAP profitability, but it still has a ways to go because of stock-based comp. A share repurchase program might change the narrative much more quickly and might change my mind. For investors who like this cybersecurity company's long-term prospects, dollar-cost averaging into a larger position over time is likely the best course of action until the bear market comes to an end.
