Zscaler (ZS 1.28%) and DigitalOcean (DOCN 3.30%) represent two different ways to invest in the booming cloud software market. Zscaler is a cybersecurity company that provides "zero trust" services that treat everyone as a potential threat. Instead of installing its tools through on-site appliances like most traditional cybersecurity companies, Zscaler offers them as subscription-based cloud services -- which are cheaper and easier to scale as a company grows. DigitalOcean provides cloud infrastructure services to small businesses. Unlike larger cloud platform providers like Amazon (AMZN 3.43%) and Microsoft (MSFT 1.82%), DigitalOcean offers up smaller "droplets" of servers at lower prices.
Both stocks soared to their all-time highs in November 2021. But today, Zscaler and DigitalOcean trade nearly 60% and 80% below those record levels. The bulls retreated as the macro headwinds throttled their revenue growth, and rising interest rates popped their bubbly valuations. Should investors take a chance on either of these out-of-favor growth stocks right now?
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Zscaler is still priced for growth it can't deliver
Zscaler's revenue rose 62% in fiscal 2022 (which ended in July 2022) and 48% in fiscal 2023. But in fiscal 2024, it only expects its revenue to grow 27% to 28%. That would represent its slowest annual growth rate since its IPO in 2018.
Like many of its cybersecurity peers, Zscaler blames that slowdown on the macro headwinds. Cybersecurity companies are usually resistant to economic downturns since their clients won't lower their digital defenses to save a few dollars, but they can still struggle to gain new customers or squeeze out more revenue from their existing ones.
During its latest conference call, CEO Jay Chaudhry admitted that the "macro environment remains challenging," but the company was still "executing well." As its growth cooled off, its cost-cutting measures boosted its adjusted operating margin from 10% in fiscal 2022 to 15% in fiscal 2023. It expects that figure to dip to 13% in fiscal 2024, but it still believes its adjusted EPS will grow 23% to 26% for the full year.
Zscaler's stock is still richly valued at 72 times forward earnings. Its more diversified cloud-based peer CrowdStrike (CRWD 2.03%), which plans to grow its adjusted EPS by 82% to 84% this year, trades at 65 times forward earnings. That high valuation could limit Zscaler's upside potential until its revenue growth accelerates again.
DigitalOcean faces significant near-term challenges
DigitalOcean's revenue rose 35% in 2021 and 34% in 2022. Those growth rates suggested its niche market of smaller businesses was better insulated from the macro headwinds than larger enterprise-oriented cloud platforms like Amazon Web Services (AWS) and Microsoft Azure. However, it only expects its revenue to rise 18% to 19% in 2023 -- which would also mark its slowest growth rate since its IPO in early 2021.
DigitalOcean attributed that slowdown to the tough macro environment, but two other issues dragged down its stock over the past month: accounting errors that forced it to restate its adjusted EPS in the first half of 2023, and the abrupt announcement that its CEO Yancey Spruill would step down once a successor was appointed.
Those issues overshadowed the fact that DigitalOcean's adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin still expanded from 32% in 2021 to 34% in 2022, and it expects that figure to rise to 38% to 39% in 2023. Those expanding margins suggest it still has pricing power in its niche market and that it can continue to flourish in the shadow of AWS, Azure, and other cloud platform giants.
DigitalOcean trades at just 15 times forward earnings and 13 times this year's adjusted EBITDA. Those lower valuations could limit its downside potential as it restates its financials, finds a new CEO, and stabilizes its near-term revenue growth.
The winner: DigitalOcean
DigitalOcean needs to overcome a lot of near-term challenges, but its lower valuation makes it a more compelling investment than Zscaler right now. Zscaler's stock is still priced for perfection, but the company is delivering imperfect results -- and it probably won't become a more compelling investment until its valuations cool off to more reasonable levels.
