Time for a Change: Why I’m Downgrading Zscaler (NASDAQ:ZS)

Zscaler (NASDAQ:ZS) has been one of the strongest tech stocks as of late. It isn’t hard to see why: the cybersecurity company has posted top-notch fundamental results over the past year in spite of a tough macro environment, generating best-in-class growth rates and showing expanding operating margins. While the stock is no longer dirt cheap as it was one year ago, the company has arguably earned a premium valuation. ZS maintains a net cash balance sheet and appears on the verge of inflecting on GAAP profitability. That said, the current stock price does not appear to be offering enough potential reward for the current risk profile, even if we assume strong top and bottom line growth rates over the next decade. I am downgrading the stock to a neutral “hold” rating.

ZS Stock Price

It’s funny how quickly sentiment can change. It was just less than a year ago when the market seemingly had all but given up on ZS, thinking that growth rates would be heading lower. ZS has proven the doubters wrong, and those who stuck by the stock have been rewarded handsomely.

I last covered ZS in November where I reiterated my buy rating on account of generative AI being a potential tailwind for cybersecurity stocks. The stock is up substantially since then but may have run a little too far and a little too fast.

ZS Stock Key Metrics

In its most recent quarter, ZS generated 40% YoY revenue growth to $497 million, smashing guidance of $474 million.

The company paired that strong revenue growth with 34% YoY billings growth.

On the conference call, management noted that the current remaining performance obligations (‘cRPOs’) grew 3.5% QoQ and 32.7% YoY. Between the strong billings and cRPOs growth, I expect ZS to sustain rapid top-line growth over the coming year.

ZS has benefitted from its wide product portfolio, as the 120% dollar-based net retention rate was a key driver of the aggressive top-line growth. ZS has somehow also delivered on aggressive customer growth, an impressive achievement given the increased scrutiny on IT expenses.

ZS also delivered solid profitability gains, with non-GAAP operating margins rising 622 bps to 18.1% and non-GAAP EPS coming in at $0.67, smashing guidance for $0.49.

It is worth noting that ZS is now very close to achieving GAAP profitability. The higher interest rate environment has helped lead to a surge in interest income, but even excluding interest income, ZS would need to generate only a 31% incremental operating margin to achieve GAAP profitability (assuming 30% forward growth). In actuality, at some point I expect ZS to begin generating incremental operating margins in excess of 75% or higher as operating leverage takes hold. This is a company that could show GAAP profits whenever it chooses to.

ZS ended the quarter with $2.3 billion of cash versus $1.1 billion of convertible notes. These convertible notes carry a 0.125% interest rate, which helps to explain the high net interest income. These notes mature next year.

Looking ahead, management has guided for the second quarter to see up to 31% YoY revenue growth. Consensus estimates have the company coming in at the middle of revenue guidance at around $506 million and at the high end of earnings guidance at $0.58 in non-GAAP EPS. Management raised full-year guidance to see up to 30% YoY revenue growth and 26% YoY billings growth.

On the conference call, management noted that the macro environment remained challenging though “customer sentiment seems to be stabilizing.” Given commentary from Microsoft’s (MSFT) recent earnings call that cloud optimization headwinds have eased dramatically, it is possible that ZS may benefit from an improving macro environment moving forward. The tough macro environment had impacted ZS’ business through slowing headcount growth at its customers (even if ZS still generated strong results). As typical, Wall Street has invested ahead of the fundamental news as this optimism is being priced into the stock.

Is ZS Stock A Buy, Sell, or Hold?

ZS is a cybersecurity stock that is disrupting the traditional firewall protection model. ZS’ zero trust architecture protects data and apps at the user level, leading to strong security in a cloud-driven world.

Generative AI may benefit society, but it may also increase the prevalence and sophistication of cyberattacks. That should accelerate demand for new-generation cybersecurity companies like ZS.

As of recent prices, ZS was no longer trading “dirt-cheap” as it did for much of 2023. The stock recently traded hands at around 17x sales.

Consensus estimates call for ZS to show strong operating leverage over the coming decade.

Management has given long-term guidance for around 22% in non-GAAP operating margins, though consensus estimates call for 25% non-GAAP net margins by 2033.

I’m of the view that ZS can get to 25% to 30% GAAP net margins over the long term given the high 80+% gross margins. I can see ZS trading at around 30x earnings by 2033, equating to a valuation of 7.5x to 9x sales. That implies 11.7% to 14% compounded annual return potential over the next 9 years. That would likely beat the broader market, and consensus estimates do not look too aggressive. However, given the lack of GAAP profitability, I am of the view that these prospective returns are not high enough to justify buying the stock over the broader market index. I would prefer a prospective return potential of 14% to 18% for a name of this kind of risk profile. If the company can execute on generating sustainable GAAP profitability and begin rewarding shareholders with share repurchases, then I would be more inclined to lower my hurdle requirements.

While ZS continues to fire on all cylinders, I am downgrading the stock to a neutral rating and selling out of my position, as the current valuation is not constructive to reliable market-beating returns.