Zscaler (NASDAQ:ZS) has been one of many hottest shares throughout the 2021 inventory market frenzy. Since then, the inventory worth has plunged virtually threefold. I think about such an enormous selloff unfair, given the underlying fundamentals. Regardless of a difficult macro setting with margins bettering considerably, the corporate demonstrates awe-inspiring topline development. Furthermore, my valuation evaluation suggests the inventory is undervalued. Although, buyers ought to be conscious that the extent of uncertainty concerning underlying assumptions is excessive.
Zscaler pioneered cloud-based cybersecurity options. The corporate’s cloud-native platform supplies safe entry to the web and personal purposes, permitting companies to embrace cloud expertise, cellular gadgets, and distant workforces with out compromising safety. Zscaler is a software-as-a-service [SaaS] firm. The agency is headquartered in San Jose, California, and went public in 2018.
Zscaler’s fiscal 12 months ends on July 31, and the firm operates as a single reportable section. About half of the corporate’s income is generated within the U.S.
The corporate delivered a stellar above 45% income CAGR over the past eight years, which is spectacular given the size of the horizon. Gross margin expanded notably as effectively.
I additionally like that the corporate just isn’t a money burner, producing optimistic free money circulate [FCF] with stock-based compensation [SBC] deducted. Then again, the corporate nonetheless didn’t break even in working revenue phrases on account of huge funding in R&D and SG&A.
The corporate’s steadiness sheet is in fine condition, with strong liquidity and web money place. For me, as a possible investor, administration’s sound capital allocation coverage is an efficient signal.
If we slender it all the way down to a number of final quarters, we are able to see that the topline has grown at a staggering above 50% YoY tempo. It appears to be like much more spectacular, given the cruel macro setting. I additionally extremely admire administration’s efforts to enhance working margin in latest quarters.
I can’t go into deep particulars concerning the corporate’s newest obtainable quarterly earnings since at the moment, ZS reviews its third fiscal quarter. Consensus estimates anticipate quarterly income to be about $412 million, whereas the administration’s steerage is round $417 million on the midpoint. If we examine with the identical quarter within the earlier 12 months, income is anticipated to develop 45% YoY and about 8% sequentially. I think about this a strong dynamic, particularly given the present harsh setting. Final quarter, ZS delivered a 34% development in billings, which indicated development deceleration. Then again, throughout ZS’s announcement in early Could, the administration shared that third-quarter billings are anticipated to develop at about 39% YoY, which means a strong sequential enchancment.
Aside from improved steerage from the administration, I additionally like that the corporate strives to maintain up with the quickly altering technological setting. Not too long ago, Zscaler unveiled upgrades to its AI-powered options. Zscaler has no choices however to innovate to maintain up technologically, and I see that the administration understands this clearly. The rise of AI means not solely huge alternatives for productiveness development but additionally new challenges from the cybersecurity perspective. I’m glad that the corporate addresses these secular shifts proactively.
Zscaler’s market cap peaked in late 2021 throughout the inventory market frenzy fueled by an enormous QE and low Fed funds charges. The corporate’s market cap has decreased greater than two instances since then on account of tightened market situations and plenty of different unfavorable tendencies within the macro setting.
However the enterprise nonetheless delivers huge development, which is anticipated to maintain quickly. Zscaler just isn’t a money burner; the corporate has a sound steadiness sheet, so let me calculate whether or not such an enormous selloff of the previous two years provides us engaging shopping for alternatives.
Zscaler is an aggressive development firm. Due to this fact, I exploit the discounted money circulate [DCF] strategy for valuation. Valueinvesting.io suggests the corporate’s WACC is 8.7%, however I choose to be conservative, so I spherical it as much as 9%. I’ve consensus earnings estimates to make use of to venture future money flows. FCF margin could be tough; to be truthful, I exploit TTM metrics.
My calculations recommend that the FCF margin is 4%. I exploit it for FY 2023 and anticipate it to extend yearly by two share factors. Incorporating all of the above assumptions into the DCF template returns the enterprise’s truthful worth at about $22.5 billion, about 15% greater than the present market cap.
In accordance with In search of Alpha Quant valuation scores, Zscaler has a low “D-” rating, indicating present share costs aren’t engaging. Then again, within the “Financials” part, we noticed that the corporate sustainably delivers over 50% YoY income development, with margins bettering notably. It’s not a shock that Zscaler is traded at a big premium in comparison with sector median ranges. After we take a look at multiples, I choose to check them with the corporate’s historic valuation metrics, which shrank considerably.
To cross-check myself, I additionally check with Morningstar Premium [MP]. In accordance with MP, Zscaler’s inventory worth truthful worth is $170, indicating a 20% low cost. The chart under exhibits how traditionally ZS inventory worth correlated with MP’s truthful worth estimates.
Dangers to think about
On condition that the corporate reviews its earnings at the moment, there’s a threat of a short-term selloff if it doesn’t beat consensus estimates or reiterates its steerage downward. Due to this fact, the inventory is a purchase for long-term buyers who’re pleased with near-term drawdowns.
Subsequent, I see the corporate’s huge spending on SG&A as a threat. Not solely the proportion of revenues invested into SG&A however the development itself. SG&A to income ratio doesn’t exhibit a decline regardless of huge topline development. This might imply that if the corporate decides to lower SG&A expenditures, this may hit the spectacular income development report.
Present inventory worth and my truthful worth calculations worth in aggressive income development. In case the corporate signifies softening income development tempo or fails to enhance FCF margin as I anticipate, the inventory worth will endure considerably.
Total, I consider that the upside potential outweighs the potential dangers. ZS inventory is a purchase for long-term buyers with a excessive short-term volatility tolerance. The corporate’s round 50% income development within the difficult setting signifies strong resilience for me. A optimistic development in margins can be a bullish signal for potential buyers.