Investors were generally pleased with the fiscal third-quarter update from Zscaler (ZS 1.28%), which covered the period ended April 30. The cybersecurity specialist is on a stronger growth path right now, despite pressure on IT budgets around the world. This success confirms the mission-critical nature of its market niche while implying good returns ahead for patient shareholders. But a Zscaler investment also comes with some big risks for investors.
Let's take a closer look at Zscaler's latest operating update, both the good and the bad.
The green flag: Rising contract values
Less than two years ago, Zscaler counted roughly 200 customers who had committed to over $1 million of annual contract spending. That figure passed 400 in early 2023 after this growth segment expanded by 39% on top of the prior year's 77% spike.
Many factors went into this success at attracting more large contracts, including strong growth in Zscaler's overall business. The company has also built a more robust platform that is especially useful for cloud-based businesses that need to protect their data from bad actors.
This tilt toward bigger contracts is being amplified by a rising commitment from Zscaler's customer base in general. Average order renewals occurred at 125% their previous value in Q3, which confirms that the company is delivering plenty of value to existing clients. "We have a strong and loyal base of customers," CEO Jay Chaudhry said in a recent call with investors.
The red flag: More net losses
Executives in early June highlighted Zscaler's improving finances, with non-GAAP (adjusted) operating profit margin rising to 13% of sales over the past nine months compared to 10% of sales in the prior-year period. Yet the company continues to gush red ink when it comes to earnings under generally accepted accounting principles. Operating losses landed at 16% of sales through the first three quarters of fiscal 2023 compared to a 32% loss a year earlier.
ZS Operating Margin (TTM) data by YCharts
Those losses look a bit riskier given the shaky economic environment. Zscaler is seeing longer lead times for contract closes as enterprises become more cautious in their spending. That shift was a key reason why the company is predicting a weaker close rate in the fiscal fourth quarter despite a strong pipeline of negotiations, management said.
Still bullish on Zscaler
The good news outweighs the bad for Zscaler right now, though. Solid demand trends in recent months show how enterprises are prioritizing spending on digital security and identity management even as they pull back in other areas. Zscaler's market share gains in this attractive industry suggest it can grow sales in tougher selling environments, with growth likely accelerating during a cyclical upturn.
Cautious investors might want to watch the business over the next few quarters for evidence that it has finally broken into sustainable positive profits. If current trends continue, this shift might occur as early as late 2023.
If you're more comfortable with risk, you might consider putting Zscaler in your portfolio right now. The stock has rallied this year but remains far below its all-time high. And its last few quarterly reports show encouraging progress in areas like contract size, profitability, and renewal rates.
