Is It Too Late to Buy Zscaler Stock?

Zscaler's (ZS 1.93%) stock jumped 5% on June 2 after the cybersecurity company posted its latest earnings report. For the third quarter of fiscal 2023, which ended on April 30, revenue rose 46% year over year to $419 million and exceeded analysts' estimates by $7 million.

Adjusted net income more than tripled to $75 million, or $0.48 per share, which also cleared the consensus forecast by a nickel. Those growth rates were impressive, but is it too late to buy Zscaler's stock after its year-to-date rally of nearly 30%? 

Image source: Getty Images.

Its growth rates are stabilizing

Zscaler's "zero trust" services secure an organization's network by treating everyone -- including top executives -- as potential threats. Instead of installing on-site appliances and software like older cybersecurity companies, Zscaler only provides cloud-native services -- which are cheaper and easier to scale as an organization expands.

Zscaler's cloud-based approach has enabled it to grow like a weed ever since its IPO in 2018. Between fiscal 2017 and fiscal 2022 (which ended last July), calculated billings increased at a compound annual growth rate (CAGR) of 57% while annual revenue grew at a CAGR of 54%. The stock has surged more than 400% over the past five years.

But over the past year, Zscaler's growth in calculated billings and revenue has gradually cooled off. Like many other cybersecurity companies, it attributes that slowdown to macro headwinds, which have caused many companies to rein in their spending and scrutinize big software deals over the past year. 

Data source: Zscaler. YOY = year over year. 

However, Zscaler's year-over-year growth in calculated billings actually accelerated in the third quarter. Billings still dipped 2% sequentially from the second quarter, partly due to macro and seasonal headwinds, but CFO Remo Canessa said on the company's latest conference call that the quarter-over-quarter drop was still "better than our normal seasonality." 

Zscaler expects its revenue to rise 35% year over year in the fourth quarter, which exceeds analysts' expectations for 34% growth. For the full year, it expects its calculated billings to rise 33%-34% as its revenue increases 46%. That's also slightly higher than Wall Street's expectations for 45% growth.

Its margins are holding steady

As its growth cools off, Zscaler has been locking its customers into larger subscription commitments, which consist of lower first-year billings followed by higher second-year billings. Yet that strategy isn't reducing its adjusted gross margin, which held steady year over year at 81% in the first nine months of fiscal 2023. Its adjusted operating margin also expanded from 10% to 13% as it streamlined its business with layoffs (for 3% of its workforce) and other cost-cutting measures.

Zscaler expects its adjusted earnings per share to rise 96% year over year in the fourth quarter and 136%-138% for the full year. Both of those estimates surpassed Wall Street's expectations.

But the stock still looks pricey relative to its peers

Zscaler's growth rates look healthy, but analysts expect its slowdown to continue with just 28% revenue growth and 22% adjusted earnings growth in fiscal 2024. That means it could grow slower than its cloud-based peer CrowdStrike and only slightly faster than the diversified market leader Palo Alto Networks.

Furthermore, Zscaler is still deeply unprofitable by generally accepted accounting principles (GAAP) measures, mainly due to the stock-based compensation expenses that consumed 28% of its revenue in the first nine months of fiscal 2023. By comparison, CrowdStrike generated a slim GAAP profit in its latest quarter, while Palo Alto Networks has stayed profitable on a GAAP basis over the past four consecutive quarters.

The bears will also tell you that Zscaler's stock looks pricey at 68 times forward earnings and 10 times next year's sales. CrowdStrike trades at 70 times forward earnings and 11 times this year's sales, but it's growing a lot faster than Zscaler. Palo Alto Networks trades at just 45 times forward earnings and 10 times this year's sales.

Is it too late to buy Zscaler?

Zscaler's core business is healthy, but its decelerating growth, lack of GAAP profits, and premium valuations could all limit its near-term gains in this tough market. I'd rather stick with CrowdStrike or Palo Alto Networks for now and wait for Zscaler's valuations to cool off to more reasonable levels before I consider buying it as a long-term investment.