Zscaler (NASDAQ:ZS) Surprises With Strong Q2 But Stock Drops

Cloud security platform Zscaler (NASDAQ:ZS) announced better-than-expected results in the Q2 FY2023 quarter, with revenue up 51.7% year on year to $387.6 million. Guidance for next quarter's revenue was $397 million at the midpoint, 2.45% above the average of analyst estimates. Zscaler made a GAAP loss of $57.5 million, improving on its loss of $100.4 million, in the same quarter last year.

After successfully selling all four of his previous cybersecurity companies, Jay Chaudhry's fifth venture, Zscaler (NASDAQ:ZS) offers software as a service that helps companies securely connect to applications and networks in the cloud.

The Zscaler Internet Access platform works as a door to the internet through which their customers route all their web traffic and Zscaler ensures malware and viruses doesn’t get in and internal data doesn’t get out. Their Private Access product creates a secure tunnel between a user and an internal application, so the data transferred is never put on the public internet.

Almost every company is slowly finding itself becoming a technology company and facing cybersecurity risks. The migration of businesses to the cloud and employees working remotely in insecure environments is increasing demand modern cloud-based network security software, which offers better performance at lower cost than maintaining the traditional on-premise solutions, such as expensive specialized firewall hardware.

Cybersecurity is a competitive space and Zscaler is competing with companies like Palo Alto Networks (NYSE:PANW) and Cisco (NASDAQ:CSCO)

Sales Growth

As you can see below, Zscaler's revenue growth has been exceptional over the last two years, growing from quarterly revenue of $157 million in Q2 FY2021, to $387.6 million.

This was another standout quarter with the revenue up a splendid 51.7% year on year. But the growth did slow down a little compared to last quarter, as Zscaler increased revenue by $32.1 million in Q2, compared to $37.5 million revenue add in Q1 2023. So while the growth is overall still impressive, we will be keeping an eye on the slowdown.

Guidance for the next quarter indicates Zscaler is expecting revenue to grow 38.4% year on year to $397 million, slowing down from the 62.6% year-over-year increase in revenue the company had recorded in the same quarter last year. Ahead of the earnings results the analysts covering the company were estimating sales to grow 29.2% over the next twelve months.

Profitability

What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. Zscaler's gross profit margin, an important metric measuring how much money there is left after paying for servers, licenses, technical support and other necessary running expenses was at 77.4% in Q2.

That means that for every $1 in revenue the company had $0.77 left to spend on developing new products, marketing & sales and the general administrative overhead. Despite the recent drop, this is still a good gross margin that allows companies like Zscaler to fund large investments in product and sales during periods of rapid growth and be profitable when they reach maturity.

Cash Is King

If you have followed StockStory for a while, you know that we put an emphasis on cash flow. Why, you ask? We believe that in the end cash is king, as you can't use accounting profits to pay the bills. Zscaler's free cash flow came in at $62.8 million in Q2, up 113% year on year.

Zscaler has generated $276.9 million in free cash flow over the last twelve months, an impressive 20.5% of revenues. This extremely high FCF margin is a result of Zscaler asset lite business model and strong competitive positioning, and provides it the option to return capital to shareholders while still having plenty of cash to invest in the business.

Key Takeaways from Zscaler's Q2 Results

With a market capitalization of $18.5 billion, more than $1.91 billion in cash and with free cash flow over the last twelve months being positive, the company is in a very strong position to invest in growth.

We were impressed by the exceptional revenue growth Zscaler delivered this quarter. And we were also excited to see strong free cash flow. On the other hand, there was a deterioration in gross margin. Overall, we think this was a strong quarter, that should leave shareholders feeling very positive. But investors might have been expecting more and the company is down 7.86% on the results and currently trades at $123.6 per share.

Is Now The Time?

Zscaler may have had a good quarter, but investors should also consider its valuation and business qualities, when assessing the investment opportunity. We think Zscaler is a good business. We would expect growth rates to moderate from here, but its revenue growth has been exceptional, over the last two years. On top of that, its bountiful generation of free cash flow empowers it to invest in growth initiatives, and its impressive gross margins are indicative of excellent business economics.

Zscaler's price to sales ratio based on the next twelve months of 11.1x indicates that the market is certainly optimistic about its growth prospects. There is definitely a lot of things to like about Zscaler and looking at the tech landscape right now, it seems that it doesn't trade at an unreasonable price point.

The Wall St analysts covering the company had a one year price target of $165.7 per share right before these results, implying that they saw upside in buying Zscaler even in the short term.

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