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Cloud-based cybersecurity company Zscaler (NASDAQ: ZS) continues to exceed all revenue growth expectations. The upstart security software provider just wrapped up its fiscal 2023 (which ended in July) and once again knocked it out of the park. Full-year sales were $1.62 billion, up 48% compared to 2022, well above management’s guidance for as much as $1.59 billion provided just a few months ago.

Zscaler stock has been in rally mode — up over 40% so far in calendar 2023 — but is still down nearly 60% from its all-time peak in late 2021. With a new Zscaler fiscal year starting, is it time to buy the stock?

The market is still skeptical about this item

Zscaler’s revenue growth has been impressive. In addition to its great 2023 closeout, its guidance for fiscal 2024 is for revenue of as much as $2.065 billion, implying growth of 28% over 2023. Zscaler has a habit of sandbagging, often exceeding its own guidance and raising the bar during each quarterly update. So perhaps the company can do this again in fiscal 2024.

However, long gone are the days (2020 and 2021 were peak cloud-computing craze) when revenue growth alone could propel a stock higher. These days, the market is more concerned about the growth of profitability and, more specifically, profit growth on a per-share basis.

You see, cloud software-based companies like Zscaler have had to pour a great deal of money into their salesforce to keep growth going. One key component of that expense is employee stock-based compensation (SBC), which rewards employees by issuing new stock to them as a part of their paycheck. (Zscaler shelled out $445 million in SBC last year, about 1.9% of the current market cap, a manageable sum.)

While it also conserves a growing company’s cash to reinvest elsewhere, like in research and development, the drawback is that existing shareholders get diluted. And that’s been the rub for the last couple of years as Wall Street has shifted its focus from all-out cloud growth to the bottom line.

By some measures, Zscaler has been making good progress on this front. Operating income, based on generally accepted accounting principles (GAAP) has finally started heading for breakeven as SBC expense has slowed. And free cash flow (FCF) has gone from nil just a few years ago to robustly positive. That’s been a very positive development. However, FCF on a per-share basis, which includes the effect from new stock issued as SBC, hasn’t been quite as good.

Data by YCharts. TTM = trailing 12 months.

This problem is set to continue in fiscal 2024, with adjusted operating margin (excluding non-cash expenses like SBC) expected to rise only to about 16% to 17%, up from 15% last year. And the additional rub is that SBC is still rising even as revenue growth slows, which will throttle profit-per-share growth.

The company’s fully diluted share count is forecast to grow more than 3% again in the next fiscal year. This explains why Zscaler’s rosy outlook for 2024 didn’t send the share price headed dramatically higher.

Will Zscaler’s “secret sauce” boost the stock?

Granted, Zscaler can continue to outrun these issues if it keeps expanding at a healthy pace. Up to now, it’s been able to do so because it was early in building out a cloud-based network for security — a platform known as SSE, or Security Service Edge. This unifies multiple cloud-based security services run through Zscaler’s network of infrastructure housed in data centers located close to end users worldwide.

The company is facing stiffening cybersecurity competition, though, both from fellow cloud-native upstarts, like CrowdStrike, as they build out more robust security platforms, and from big incumbents like Palo Alto Networks and Fortinet. In addition to generating ample FCF, Zscaler has a stellar balance sheet with over $2 billion in cash and short-term investments, offset by convertible debt of just $1.1 billion. This is a really solid business.

However, though I could argue that Zscaler’s enduring growth proves it has a winning formula that’s scoring lots of new customers, its first-mover advantage is clearly losing some steam as expected sales growth dips below the 30% mark in the year ahead.

All told, my issue isn’t with the business, but rather the price for expected profit growth — as of this writing, some 70 times trailing-12-month FCF and 70 times management’s guidance for adjusted operating income in fiscal 2024. With profitable growth moderating, the price tag remains too high for me.

For investors who still like the long-term prospects, which by all counts appear to remain very good, a cautious dollar-cost-average plan is probably the best way to handle this stock.

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Nicholas Rossolillo and his clients have positions in CrowdStrike, Fortinet, and Palo Alto Networks. The Motley Fool has positions in and recommends CrowdStrike, Fortinet, Palo Alto Networks, and Zscaler. The Motley Fool has a disclosure policy.

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