Companies around the globe are tightening their budgetary belts in preparation for possible turbulence in 2023 -- or, maybe it's just an effort to revamp profit margins after a couple of spending-spree years early in the pandemic. Whatever the reason, the tech world has been feeling the pinch. Even the mighty cloud industry has been dealing with a sharp slowdown in spending as customers take longer to approve new IT projects.
Against this backdrop, cybersecurity has remained a high-flying sub-industry. Why? In an increasingly digital world, leaving operations unprotected just isn't an option. In its latest quarter, Zscaler (ZS 0.30%) clobbered expectations and put up sizzling growth. Nevertheless, the stock still fell after the update and is down roughly 45% over the past year. What's up with that, and is it time to sell?
It's about the guidance, same as always
Zscaler's fiscal second quarter of 2023 (the three months ended in January 2023) was impressive; revenue was up 52% year over year and came in at nearly $388 million. That obliterated the outlook provided a few months ago for revenue to be as much as $366 million. Adjusted net income of $57.6 million also exceeded the guide for as much as $43 million.
So why the glum mood on Wall Street (shares of Zscaler fell over 10% in the days following the quarterly report)? It's about the guidance, which is often treated as more important than what already happened. Despite the robust financial outperformance, Zscaler's full-fiscal-year 2023 outlook wasn't raised that much. Revenue is now expected to be in a range of $1.558 billion to $1.563 billion, compared to $1.525 billion to $1.530 billion before.
The new full-year outlook implies growth of 43% over last year, which is by no means a shabby rate of expansion. But it does imply a sharp reduction in growth from the 54% growth rate reported through the first half of fiscal 2023 (perhaps a mid- to high-30% year-over-year growth rate for the next two quarters). Zscaler said it's still seeing slower time for new deals to get greenlit, much like other cloud companies have reported as of late.
The other half of the equation that has the market miffed
In addition to slowing growth, the market is also likely a bit concerned at Zscaler's slowing pace of some profit metrics. Free cash flow in particular was $158 million in the first half of fiscal 2023, up just 40% from the same period a year ago. Free cash flow can be lumpy from quarter to quarter and even from year to year, but the rapid scaling from no cash flow to robust cash flow (free cash flow more than doubled last fiscal year) seems to be over for now. Management said it is reducing its workforce by about 3% and tightening up on some expenses in response.
Additionally, employee stock-based compensation also ran higher in the last quarter. So far in fiscal 2023, stock-based comp was $215 million, up 14% year over year. Zscaler has chosen not to offset any of this new stock issuance with a stock buyback plan, so it's having a dilutive effect for shareholders on a free-cash-flow-per-share basis.
Data by YCharts.
Even so, it has been an epic run for Zscaler the last few years, and that's what is still keeping me on the sidelines for the time being. Shares are still sporting a very high valuation of 62 times trailing-12-month free cash flow, revenue and profit growth is slowing, and employee stock comp is still increasing. The last two quarters, I anticipated this stock would be a bumpy ride at best, and it has delivered. At this juncture, I don't see that changing given the market's hyper focus on high-profit companies returning excess cash to shareholders.
Still, Zscaler has proven me wrong over the years with resilient growth along with the cloud industry overall. Existing customers continue to spend more with Zscaler (growth is currently skewing toward 60% upsell from existing customers, 40% new additions) as organizations migrate their operations to next-gen IT infrastructure that favors a very mobile, very connected operation. After already enduring a nasty sell-off, now's probably not the time to sell -- especially if you like the direction the business is headed for the long term.
Although I'm not buying just yet, this leader in cloud cybersecurity remains on my watch list.
