It is no secret that investing in secular growth stories has been a popular winning strategy. Digital payments, cybersecurity, e-commerce, and artificial intelligence are a few such trends that dramatically changed the world.
But robust long-term tailwinds mean nothing if the company is not in good financial health. Hence, it is imperative for investors to also focus on companies with robust revenue-growth potential and improving margins.
Zscaler (ZS 1.28%) and Upstart (UPST 2.76%) are two companies that fit the bill. Let's assess how these companies can prove to be impressive investments for the long-term investor.
1. Zscaler
Cloud-based cybersecurity company Zscaler's shares delivered a lackluster performance in 2022 and early 2023 amid concerns about slowing topline growth and rising employee stock-based compensation expenses.
Amidst increasing fears of a recession, many IT companies have been subject to the pressure of increased deal scrutiny and tighter corporate budgets. Cybersecurity has proved to be an exception thanks to the mission-critical nature of the service. With the annual cost of cybercrime expected to reach a whopping $10.5 trillion by 2025, demand for zero-trust architecture-based (ZTA) security solutions has become strong. All participants are continually verified within a network to prevent unauthorized access to resources.
According to Future Market Insights, the zero-trust security market is estimated to grow annually at a compounded average growth rate (CAGR) of 15.1% from $29 billion in 2022 to $118.7 billion in 2032. As one of the prominent ZTA players, Zscaler has been benefiting from this trend.
Zscaler reported a 46% year-over-year rise in revenue to $419 million in the third quarter (ending April 30). Management expects fourth-quarter revenue to rise by 36% year over year to $430 million.
The company also managed to reduce stock-based compensation expenses. These accounted for 26.6% of the total revenue in Q3, compared to 38.8% a year ago. While not yet profitable according to generally accepted accounting principles (GAAP), Zscaler has also been successful in controlling its mounting losses. In Q3, the company reported an operating loss margin of 16%, far better than 32% a year earlier.
Zscaler is definitely not out of the woods. Management predicted an elongated sales cycle due to the larger size of the deals. While large deals take longer to close (resulting in near-term revenue volatility), they also ensure higher and more secure revenue streams as well as a stickier customer base. The company reported a net-retention rate of over 125% in Q3, confirming the success of an upsell strategy.
Although Zscaler is currently up by nearly 27% so far this year, it is still around 60% below its all-time high level. With cybersecurity spending remaining the top priority of organizations, Zscaler seems well positioned for solid growth in the coming months.
2. Upstart
Consumer loan company Upstart's big data and AI-based platform is gradually challenging the industry standard FICO model (based on five variables) with its technology-based model (based on over 1,000 variables).
Upstart claims that its technology has proven better than traditional lending models used at large U.S. banks in reducing loan-default rates as well as in approving new loans (by accurately gauging the borrower's creditworthiness).
As of March 31, Upstart has serviced over 2.6 million customers and originated loans of more than $32 billion.
While increasing interest rates were challenging for the company (financial institutions and banks have been less eager to make loans), Upstart's focus on expanding the number of lending partners from 50 to 99 should bring in additional loan volume to the company's platform. The company also improved its cost structure by reducing headcount by nearly 30% and identifying opportunities to reduce technical infrastructure costs by $10 million annually.
Upstart is gearing up to diversify beyond its current loan niches (personal and auto loans make up an estimated total addressable market of $171 billion and $775 billion, respectively) in new lending areas such as home and small business loans. Subsequently, the company aims to target a market worth $4 trillion in annual loan originations.
Thanks to these developments, Upstart guided strong revenue and earnings performance in Q2 (ending June 30). Management expects a 31% sequential rise in revenue to $135 million and a $40 million net loss in Q2 (compared to a $129.3 million net loss in the previous quarter).
Upstart is a cyclical business and highly sensitive to macroeconomic challenges. However, the company is trading at around 4.5 times sales, a far cry from its price-to-sales (P/S) ratio of more than 45 times in late 2021.
Given the disruptive nature of the company's lending model, investors can expect a strong recovery in its share prices in a thriving economy. Hence, it makes sense to pick up a small position in this fundamentally strong stock at current discounted price levels and wait for the eventual recovery.
