Where Will Zscaler Stock Be in 1 Year?

Zscaler's (ZS -1.49%) stock plunged 11% on March 3 after the cybersecurity company posted its latest earnings report. For the second quarter of fiscal 2023, which ended on Jan. 31, its revenue rose 52% year over year to $387.6 million and beat analysts' estimates by $22.8 million. Its adjusted net income tripled to $57.6 million, or $0.37 per share, which cleared the consensus forecast by eight cents.

For the third quarter of fiscal 2023, Zscaler expects its revenue to rise 38% to 39% year over year as its adjusted earnings per share (EPS) climbs 129%. For the full year, it expects its revenue and adjusted EPS to increase 43% and 120%, respectively. All of those estimates exceeded Wall Street's expectations.

Image source: Getty Images.

Zscaler's headline numbers were impressive, yet the bulls still fled and the stock remains down more than 50% over the past 12 months. Let's see why this hypergrowth stock lost its momentum -- and if it can bounce back this year.

Carving out a high-growth niche in the cybersecurity market

Zscaler provides "zero trust" services which treat everyone, including a company's top executives, as potential threats. But instead of integrating those services into on-site appliances -- which can be expensive and difficult to scale as an organization expands -- Zscaler only offers cloud-native services that can be easily accessed across a wide range of devices.

Between fiscal 2017 and fiscal 2022 (which ended on July 31), Zscaler's calculated billings grew at a compound annual growth rate (CAGR) of 57% as its annual revenue rose at a CAGR of 54%. Many investors had grown accustomed to those breakneck growth rates, but its growth in calculated billings and revenues decelerated slightly over the past year.

Data source: Zscaler. YOY = Year over year.

Its deceleration in calculated billings, which gives us a clearer picture of its overall growth by including its deferred revenue, is worrisome because it suggests the market's demand for its services is gradually cooling off.

Investors should brace for a near-term slowdown

Zscaler expects its calculated billings to increase 31% for the full year, which would represent its slowest growth rate since its IPO in 2018. During the conference call, CEO Jay Chaudhry attributed that slowdown to macro headwinds, which caused organizations to become more "cautious and measured about their spending." He also said Zscaler experienced "additional delays in large deals" in January as organizations exercised "higher scrutiny on budgets" on a month-over-month basis.

To address those near-term headwinds, Zscaler allowed more customers to "ramp into larger subscription commitments" which are composed of lower first-year billings followed by higher second-year billings. Therefore, it's sacrificing some of its near-term billings growth to lock in more customers and generate stronger long-term billings growth. 

But that strategy isn't reducing its gross margin, which actually rose by a percentage point year over year to 81% in the first half of fiscal 2023. Its adjusted operating margin also expanded from 10% to 12% as it "moderated" its pace of hiring. It plans to lay off about 3% of its workforce, or 150 employees, in the third quarter to further optimize its spending.

Zscaler's valuations are still running hot

Zscaler's slowdown isn't disastrous, but its stock isn't cheap at more than 100 times forward earnings and 11 times this year's sales. CrowdStrike (CRWD 0.13%), another cloud-native cybersecurity leader which is growing at slight faster rate than Zscaler, trades at 57 times forward earnings and 13 times this year's sales. Palo Alto Networks (PANW -1.71%), which generates slower but steadier growth, trades at 52 times forward earnings and just eight times this year's sales.

Zscaler is still priced like a hypergrowth stock, but it expects its near-term growth to cool off. That's why the bulls are shunning the stock even though it's still growing in all the right places. Its dollar-based net retention rate, or the ratio of recurring revenues it retains over a trailing-12-month period, even stayed above 125% for the ninth consecutive quarter -- and it will likely generate high double-digit billings and revenue growth for years to come. It's also narrowing its net losses on a generally accepted accounting principles (GAAP) basis, and it could generate stable profits in just a few years.

Unfortunately, I personally believe Zscaler's stock will underperform the market for at least the next 12 months as its valuations limit its upside potential. But over the long term, its stock could head higher again as a new bull market starts.