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

Zscaler ZS released its first-quarter earnings report on May 30. Here’s Morningstar’s take on Zscaler’s earnings and the outlook for its stock.

Key Morningstar Metrics for Zscaler

• Fair Value Estimate: $213.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

What We Thought of Zscaler’s Q1 Earnings

• We were impressed by the company’s results. It showed strength in the emerging products category, which we are monitoring closely, as it will probably determine Zscaler’s growth trajectory. Part of the strength here can be traced to customers wanting to consolidate their security spending.
• We think Zscaler is undervalued. Investors may underappreciate the firm’s true market opportunity, as zero-trust security architecture continues to drive demand toward its cloud-native approach to network security.
• The upcoming quarter will be important. The firm noted some sales team turnover (which will impact the fiscal 2025 topline) but didn’t give explicit guidance. In the next quarter, management will provide a better idea of Zscaler’s growth longevity and ability to grow its business as it becomes a larger player.

Fair Value Estimate for Zscaler

With its 4-star rating, we believe Zscaler’s stock is undervalued compared with our long-term fair value estimate of $213 per share, implying a 2024 enterprise value/sales multiple of 14 times.

We forecast revenue to grow 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 and grow its business. Additionally, we think Zscaler’s “land and expand” model will continue to bear fruit. The firm has shown great success at upselling its existing customers by either offering additional modules within a platform or cross-selling its Private Access offering after initially landing them with Internet Access. We project continued up/cross-selling activity for the firm.

Read more about Zscaler’s fair value estimate.

Economic Moat Rating

We assign Zscaler a narrow moat, owing primarily to strong switching costs and a network effort associated with its offerings. We believe the company’s industry-leading zero-trust security solutions will continue to see robust enterprise adoption, allowing it 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 always 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 rapidly growing. Similarly, the intensity of digital threats is on the rise, with higher costs for a data breach, including punitive fines.

Read more about Zscaler’s economic moat.

Financial Strength

We view Zscaler’s financial position as healthy. The firm ended fiscal 2023 with around $1.3 billion in cash and liquid investments. While it does carry debt of around $1.1 billion, we believe the firm’s cash reserves, coupled with its ability to generate healthy cash flow, will be sufficient to cover its commitments over our explicit forecast.

While the firm has not posted GAAP profitability, Zscaler’s free cash flow to equity margins have been in the black since 2018 and reached 23% in 2023. We expect the firm’s cash generation to improve as it increases its operating leverage by toning down some of its research and sales expenditures. Going forward, we do not expect to see a material change in Zscaler’s capital structure. In a tight macro environment, if the need arises, we expect the firm to raise capital by issuing more equity.

Read more about Zscaler’s financial strength.

Risk and Uncertainty

We assign Zscaler a High Uncertainty Rating due to the ever-shifting cybersecurity space. While the company 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 rapid development. Large incumbents like Zscaler 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 in building out its ZIA and ZPA solutions. However, a shifting demand landscape and newer products that impact Zscaler’s competitive positioning are a risk.

Read more about Zscaler’s risk and uncertainty.

ZS Bulls Say

• Zscaler has strong secular tailwinds, 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.
• The 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 Networks PANW and Fortinet FTNT, which have increasingly made investments in the key areas where the firm has market-leading positions.
• There always remains a risk that Zscaler may miss out on the next big technology, allowing competitors to catch up.

This article was compiled by Leona Murray.