Why Investors Should Avoid Zscaler

The cybersecurity company reported strong fiscal first-quarter results and raised its guidance, but its stock price corresponds to higher expectations.

Zscaler (NASDAQ:ZS) posted strong fiscal first-quarter results, and management raised guidance. Yet the stock price dropped by 6% after these better-than-expected earnings. And even with a 43% drop from its peak price a few months ago, the company's valuation remains too high.

The fiscal first quarter beat expectations

The cybersecurity vendor continues to profit from the secular growth of its cloud-based security market. And its customers are increasingly using both of its main products: Zscaler Internet Access, a cloud-based gateway to the internet; and Zscaler Private Access, a solution to provide secure access to private networks from anywhere.  

As a result, Zscaler's fiscal first-quarter revenue of $93.6 million exceeded the guidance range of $89 million to $90 million, up 48% year over year. And the company posted a non-GAAP (adjusted) operating income of $2.9 million versus an expected loss. In addition, management raised its full-year revenue forecast from a previous range of $395 million to $405 million to an updated range of $405 million to $413 million. And calculated billings, a leading indicator of revenue, are also expected in a higher range of $500 million to $510 million compared with the previous range of $490 million to $500 million.

Revenue growth deceleration

Despite this raised guidance, management's forecasts correspond to a growth deceleration after annual revenue growth of 50% over the last three years. Taking into account the midpoint of guidance, next-quarter revenue growth would drop to 33% and full-year calculated billings would increase by only 29.5%.

Management highlighted the challenging comparison with the second fiscal quarter of last year because of significant nonrecurring revenue from a large customer. But calculated billings, which go beyond next-quarter comparisons, confirm Zscaler's growth deceleration.

The company's increasing revenue base explains a part of the challenge to keep up with its impressive revenue growth. But the intensifying competition in the cloud-based security market represents another risk that could further reduce growth.

For instance, the giant tech vendor Cisco has developed its security portfolio beyond its traditional firewalls, and it now proposes cloud-based security solutions such as Cisco Umbrella that compete with Zscaler's web gateway. Also, the legacy on-premises vendor Symantec has adapted its security offering to address the cloud-based security market.

Profitability seems far away

Zscaler's management also highlighted that it would ramp up its investments in sales and marketing and technology to support its growth, which means expenses will increase.

But as is the case with many high-growth tech stocks, marketing already represents a significant part of the company's expenses. During the last quarter, Zscaler's marketing costs even increased to 63.5% of its revenue compared with 57.7% a year ago.

As a result, despite its non-GAAP operating profits, Zscaler still generated GAAP losses. During the last quarter, GAAP net income was negative $17.1 million, a record loss since the company's first disclosed quarterly results ending in October 2016. The difference between GAAP and non-GAAP results was mostly due to the exclusion of $18.4 million of share-based compensation. But since such compensation represents a real cost to shareholders, investors should ignore non-GAAP earnings and focus on GAAP results instead.

Thus, given the company's GAAP losses and its planned higher expenses in marketing and technology, profitability seems far away.

Looking forward

Despite the decrease in Zscaler's stock price to below $50, the market still values the company at a high price-to-sales ratio of 19.1, which corresponds to strong revenue growth expectations and improving margins. But given the increasing competition from stronger players and the higher forecast expenses, prudent investors should stay on the sidelines.