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Even as It Hits All-Time Highs Is Zscaler a Buy?

Nicholas Rossolillo, The Motley Fool

Cybersecurity outfit Zscaler (NASDAQ: ZS) has been on a tear. Since its IPO priced at $16 in March 2018, the stock has doubled several times over and currently trades for about $83. Revenue is growing at a torrid pace, and the company has rocketed to a market cap of over $10 billion -- a huge feat considering it was founded in 2008.

Yet because of its meteoric rise, not to mention lack of profitability, some investors may shy away from this stock. It certainly isn't one for the faint of heart. But ignoring this up-and-coming technologist would be a mistake.

The company and the sandbox it's helping to protect

Zscaler's cybersecurity suite is a cloud-based service, built specifically to protect the cloud. Organizations around the globe are migrating from computing on-premises (like a local network at an office building) to offloading their software and computing power to a remote data center. Among other things, the switch to the cloud helps simplify operations and eliminates the need for as much on-site hardware and local software upgrades.

The migration to the cloud has reached epic proportions. Tech researcher Gartner expects global spending on cloud-based computing to grow 17.5% year over year in 2019 to over $214 billion, with a third of software providers going cloud-only instead of offering a hybrid of old and new software. By 2022, Gartner thinks the market will be worth over $331 billion a year.

Zscaler thinks it's on to something with its cloud-only software geared toward protecting organizations' cloud-based operations and transitions to new IT capabilities. As Zscaler itself was built from the ground up on just such a platform, it has an advantage of capturing new business as it moves off old legacy systems and into a data center.

Some of the cybersecurity firm's peers -- like Palo Alto Networks (NYSE: PANW) and Fortinet, for example -- have been investing heavily to make the transition to the cloud themselves. Thus, Zscaler has had its foot on the gas pedal to add as many new customers as possible, seeing an opportunity to be on the lead lap in the massive and fast-growing cloud industry race.

An illustrated cloud with a bank of computers hooked up to it, representing a data center.

How to decide if it's a buy, and for whom

As a result of these efforts, business is booming for the upstart cybersecurity company. Total revenue has been growing well north of 50% for quite some time, catapulting Zscaler into the category of the largest security software companies.

Metric

Nine Months Ended April 30, 2019

Nine Months Ended April 30, 2018

YOY Change

Revenue

$216.7 million

$134.0 million

62%

Gross profit margin

80.5%

80.3%

0.2 pp

Operating expenses

$201.8 million

$134.3 million

50%

Net income (loss)

($23.4 million)

($26.7 million)

N/A

Adjusted earnings (loss) per share

$0.16

($0.29)

N/A

YOY = year over year; pp = percentage point. Data source: Zscaler.

The epic numbers are responsible for the stock more than doubling in the last year alone. Investors have chosen to focus on top-line growth -- and still-improving lucrative profit margins over 80% on services sold -- rather than skyrocketing operating expenses and the resulting net losses. Management stated during its last quarterly update that this is by design. Investing money heavily into marketing, research, and development to capture new revenue is the name of the game right now for this industry segment; profits will be a concern down the road.

It is worth noting that Zscaler did recently become free-cash-flow positive (meaning it had money left over after basic operating and capital expenses were paid for, excluding stock-based compensation and other noncash expenses). At this point, though, it's a paltry $32 million over the last 12 months, not enough to accurately assess the true value of the company. As revenue continues to grow and expenses moderate in the years ahead, this metric will become more useful.

For now, top-line growth seems to be the primary focus for investors. The price-to-sales ratio (which compares a company's market cap to revenue) doesn't value Zscaler cheaply as the stock currently trades for over 37 times the last 12 months' sales total.

The cybersecurity outfit fetches a lofty valuation because of its massive expansion, not to mention those exceptionally high gross profits. The price tag is par for the course for cloud software companies, though. Fellow cybersecurity upstart Okta (NASDAQ: OKTA) reported 50% year-over-year growth in its last quarter with gross profit of 72%. In a similar financial situation as Zscaler, Okta trades for over 33 times the last year's revenue. That means Zscaler trades at a premium, but the higher profit margins and faster rate of growth compared with similar companies like Okta may make it a worthwhile buy.

Nevertheless, it's important to bear in mind that the cybersecurity stock will be an especially volatile one. As the business grows in size, sales will moderate and focus will gradually shift to profitability. As investors adjust their expectations, that can cause some wild moves in the stock. I'd point out security leader Palo Alto Networks again as an example of how this will play out, as the stock has gyrated in value in the last year as the company tries to balance growth with the bottom line.

Zscaler therefore isn't for everyone. Investors who can't afford extreme fluctuations in their portfolio or don't have the ability to deploy cash and buy the inevitable dips should steer clear. But for those with at least a few years to allow the company to develop and can gradually build out a position in the stock with multiple purchase points, Zscaler looks like an especially promising way to play the cybersecurity industry -- even at all-time highs.


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Nicholas Rossolillo and his clients own shares of Fortinet and Palo Alto Networks. The Motley Fool owns shares of and recommends Okta, Palo Alto Networks, and Zscaler, Inc. The Motley Fool recommends Fortinet and Gartner. The Motley Fool has a disclosure policy.