After Earnings, Is Zscaler Stock a Buy, Sell, or Fairly Valued?

Zscaler ZS released its fiscal fourth-quarter earnings on Sept. 5, 2023, after the market close. Here’s Morningstar’s take on what to think of Zscaler’s earnings and stock.

Key Morningstar Metrics for Zscaler

• Fair Value Estimate: $183.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

What We Thought of Zscaler’s Q4 Earnings

The overall results were positive. We believe strong customer additions and guidance reflects Zscaler’s business’ strength despite macroeconomic pressures, which have been a big worry for investors as of late. Encouragingly, spending from large customers seems to be tracking in a positive direction. We have seen similar commentary from other security vendors where they have noted that large customers are easing up on their optimization plans.

While the macroeconomic environment remains uncertain, there is still weakness in small/medium-size businesses, but we were impressed by Zscaler’s ability to close a record number of deals with an annual contract value of more than $1 million. As we look ahead, we expect Zscaler’s products to remain top-of-mind for companies and so forecast robust growth for the firm over the next decade as investments in cloud-native security solutions ramp up.

The firm’s shares traded slightly down after the earnings report, and we view them as marginally undervalued.

Overall, this is a moaty business with a strong track record of deploying capital judiciously and effectively, which should help it execute and gain from these tailwinds within the security space. Zscaler’s sales for the fourth quarter clocked in at $455 million, up 43% year over year and more than $20 million above the high end of management’s prior guidance. Forward-looking metrics such as billings and deferred revenue also showed signs of continued strength, growing 38% and 41% year over year, respectively. Further, management provided strong billings guidance for fiscal 2024, indicating that Zscaler has a strong business pipeline ahead of it.

Fair Value Estimate for Zscaler’s

With its 3-star rating, we believe Zscaler’s stock is fairly valued compared with our long-term fair value estimate. Our fair value estimate for Zscaler is $183 per share, implying a 2023 enterprise value to sales multiple of 12.5 times.

We forecast Zscaler’s revenue growing at a 28% compound annual growth rate over the next five years. As enterprises increasingly shift network traffic routing directly to cloud applications, we see massive greenfield opportunities for the firm to take advantage of and grow its business. Additionally, we think Zscaler’s “land-and-expand” model will continue to bear fruit. The firm has shown great success in upselling its existing customers by either offering additional modules within a platform or cross-selling its Zscaler Private Access after initially landing with its Zscaler Internet Access offering. Going forward, we project continued up/cross-selling activity for the firm.

Read more about Zscaler’s fair value estimate.

Zscaler Historical Price/Fair Value Ratios

Ratios over 1.00 indicate when the stock is overvalued, while ratios below 1.00 mean the stock is undervalued.

Economic Moat Rating

We assign Zscaler a narrow moat rating owing primarily to strong switching costs and secondarily to a network effort associated with its offerings. We believe Zscaler’s industry-leading zero-trust security solutions will continue to see robust enterprise adoption, allowing the firm to both retain and expand its footprint within existing organizations, while also allowing the company to land new customers. As a result, we forecast Zscaler to generate excess returns over invested capital over the next decade.

As we look at the broader cybersecurity space, we believe the complexity and intensity of threats are ever-increasing. Enterprises continue to adopt software-as-a-service solutions, undergo digital transformations, and migrate to the cloud, all while employees continue to work remotely part-time. In turn, we see the number of attack vectors (or entry points for nefarious players) rapidly growing. Similarly, the intensity of digital threats is also on the rise, with higher costs of a data breach, including punitive fines, for any customer data theft.

These trends have rendered the traditional castle-and-moat version of enterprise cybersecurity obsolete. Traditionally, firewalls have stood guard outside corporate networks, inspecting traffic entering and exiting the network. However, with enterprises increasingly using cloud-based solutions (whether it be SaaS applications like Salesforce or public cloud vendors like AWS), the need for hardware firewalls to inspect network traffic is significantly reduced. Instead, enterprises have increasingly shifted to cloud-based solutions that provide a robust way to secure network activity stemming from and traveling within the cloud.

In this shifting landscape, Zscaler’s zero-trust infrastructure allows enterprises to not only maintain a robust security posture but also eliminate areas of excessive IT spend by reducing reliance on costly hardware appliances. While the need for hardware firewalls still remains, we think that the market buying activity has heavily tilted toward cloud-based solutions such as Zscaler. We believe that the shift away from hardware firewalls is part of a broader convergence of networking and security (with Zscaler’s products materially benefiting from it).

Read more about Zscaler’s moat rating.

Risk and Uncertainty

We assign Zscaler a High Morningstar Uncertainty Rating because the firm competes in the ever-shifting cybersecurity space.

While Zscaler has positioned itself well to benefit from secular tailwinds such as a shift to zero-trust security and the convergence of networking and security, the cybersecurity space is known for its rapid pace of development. With this in mind, large incumbents such as Zscaler that have performed exceptionally well in particular verticals stand to be disrupted by upstarts that could offer better performance in key modules. To stay ahead of the pack, Zscaler has invested a great deal of capital in building out its ZIA and ZPA solutions. However, a shifting demand landscape coupled with newer products that affect Zscaler’s competitive positioning are a risk for the firm.

Read more about Zscaler’s risk and uncertainty.

ZS Bulls Say

• Zscaler has strong secular tailwinds behind its back, as the convergence of networking and the security market is in its early innings.
• Zscaler has market leadership and high enterprise penetration through its offerings related to secure web gateways and zero-trust network access.
• Consolidation of security vendors should benefit Zscaler, which has a wide array of solutions across an enterprise’s network security stack.

ZS Bears Say

• Large public cloud vendors often offer their own cybersecurity solutions, which could hamper Zscaler’s growth opportunities.
• Zscaler faces competition from vendors like Palo Alto and Fortinet that have increasingly made investments in the key areas where Zscaler has a market-leading position.
• There always remains a risk that Zscaler may miss out on the next big technology, thereby allowing its competitors to catch up.

This article was compiled by Monit Khandwala.