Funding thesis
My preliminary bullish thesis about Zscaler (NASDAQ:ZS) as of June 2023 aged exceptionally properly, and the inventory has rallied by 78% since then. At this time, I wish to downgrade my score for ZS to “Maintain” as a result of I consider that, given all the developments and valuation evaluation, shopping for earlier than earnings is a really dangerous thought. There have been a couple of adversarial trade developments in current weeks, which elevated ZS’s administration to supply mushy steerage through the upcoming earnings name. My valuation evaluation suggests the inventory is considerably overvalued, and for it to rally after earnings, a large steerage enhance is required, which is unlikely.
Zscaler – Current developments and Q2 earnings preview
Zscaler delivered one other stellar quarterly efficiency on November 27. The corporate topped consensus estimates with a large margin, a strong elementary signal. YoY income progress was very near 40% and the adjusted EPS greater than doubled from $0.29 to $0.67.
The standard of the EPS growth was excessive as a result of it was achieved with the working margin progress, which improved YoY from -19.4% to -9.3%. The levered free money circulation [FCF] improved notably as properly, from $157 million to $270 million. This allowed to fortify the corporate’s monetary place with $2.32 billion in money, nearly two instances larger than the full debt.
The corporate experiences its FQ2 earnings on February 29. Wall Avenue expectations across the earnings launch are extraordinarily scorching, as there have been 35 EPS upgrades over the past 90 days. Consensus estimates forecast quarterly income at $507 million, which signifies a large 31% YoY progress. The adjusted EPS can be anticipated to extend sharply, from $0.37 to $0.58.
A 31% anticipated YoY income progress may look overly optimistic, however ZS delivered above 30% quarterly income progress in nineteen straight quarters. Furthermore, over the past twenty quarters, ZS has all the time met consensus estimates, neither from the income nor EPS. Such a large optimistic earnings shock historical past makes me optimistic concerning the upcoming earnings launch.
Then again, how the market will react after earnings will rely not solely on previous monetary efficiency but additionally considerably on the administration’s forward-looking views and near-term steerage. From this angle, I see a couple of dangers as a result of current developments within the trade. One of many rising cybersecurity corporations and Zscaler’s friends, Palo Alto Networks (PANW) reported its earnings final week. Whereas the previous quarter’s efficiency of PANW was sturdy, the inventory fell off the cliff with greater than a 20% intraday value drop. The sell-off occurred as a result of mushy steerage, regardless of cybersecurity being considered as important spending unlikely to be lower by companies and governments. Subsequently, there’s an elevated threat that Zscaler’s administration’s outlook may additionally be mushy. One other warning signal I see from the current developments is that one other huge participant within the rising cybersecurity trade, CrowdStrike (CRWD), bought a score downgrade from WestPark Capital as a consequence of overvaluation.
Please don’t misunderstand me. I’m nonetheless bullish on Zscaler from a long-term perspective. With income rising at 40% YoY within the newest quarter, it’s obvious that the corporate is quickly increasing its market share and has huge potential to proceed reinvesting in R&D and bettering its choices. In response to statista.com, the cloud safety market remains to be scorching and is anticipated to stay so within the subsequent 5 years. Nonetheless, current adversarial developments demonstrated by trade friends make me very cautious from the angle of the upcoming earnings launch. As a progress inventory, ZS may see an enormous downward motion in case of both disappointing earnings or mushy steerage.
ZS inventory valuation replace
ZS recorded a 76% rally over the past 12 months, considerably outperforming the broader U.S. market. The beginning of 2024 was additionally optimistic, with a 6.2% YTD rally. After delivering such a large rally, I’m not shocked that multiples are excessive and ZS bought a low “D” valuation grade from Looking for Alpha Quant.
However multiples won’t be the best choice to reach at ultimate conclusions, and I’m continuing with the discounted money circulation [DCF] simulation. I’m utilizing a 9.4% low cost fee, a WACC beneficial by valueinvesting.io. I exploit a 5.92% TTM FCF margin for the bottom 12 months and anticipate one proportion level yearly growth. I’ll use the identical WACC and FCF assumptions throughout all my eventualities as a result of, total, I’m bullish concerning the inventory.
Nonetheless, as a result of huge uncertainty relating to the steerage actions, I favor to simulate a number of income progress eventualities to grasp the vary the place the inventory may go after the earnings launch. Income consensus estimates forecast a 22% CAGR for the following decade, with which I’ll begin my first situation.
Below the bottom case situation, even with a 22% income CAGR, very beneficiant FCF growth assumptions, and comparatively low WACC, the inventory is round 27% overvalued. Subsequently, for the inventory to rally after the earnings launch, the administration wants to spice up income steerage considerably. In response to my template, ZS wants a 27% income CAGR for the following decade to justify its present valuation. Given steerage softness from a outstanding participant like PANW, I believe {that a} notable steerage enhance from ZS’s administration is kind of unlikely.
Then again, in case ZS additionally alerts mushy steerage, this could be an enormous unfavorable catalyst for valuation. Decelerating the corporate’s long-term income progress tempo to twenty% provides the enterprise a good worth of $22 billion, 38% decrease than the present market cap.
To conclude, Zscaler’s present valuation can’t be referred to as engaging. In response to my evaluation, large optimism is already priced in, and shopping for the inventory earlier than earnings seems to be like an enormous threat with little likelihood of massive upswing.
Dangers to my thesis
Tender steerage from PANW and the current downgrade for CRWD don’t assure that Zscaler can even present mushy steerage or weak earnings. The likelihood of Zscaler boosting steerage additionally exists, as a result of the corporate is working in a scorching cloud safety trade. Additionally it is vital to keep in mind that world cybersecurity dangers are growing as digitalization penetrates deeper into households and companies.
Additionally it is vital to grasp that Zscaler’s power as a inventory comes not solely from the huge income progress but additionally from its stellar profitability. Subsequently, administration may point out that the corporate’s profitability growth is anticipated to maneuver quicker than anticipated, which could outweigh the income steerage if it’s not upgraded and be a notable optimistic catalyst for the inventory value.
Backside line
To conclude, I’m nonetheless bullish about Zscaler from the secular perspective, however I consider that the present valuation went too excessive. Shopping for the inventory earlier than earnings when it’s already overvalued seems to be like a dangerous thought to me. Subsequently, I downgrade ZS to “Maintain”.