What a time it’s been for Zscaler. In the past six months alone, the company’s stock price has increased by a massive 69%, reaching $306.95 per share. This was partly due to its solid quarterly results, and the performance may have investors wondering how to approach the situation.

Following the strength, is ZS a buy right now? Or is the market overestimating its value? Find out in our full research report, it’s free.

Why Does Zscaler Spark Debate?

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.

Two Positive Attributes:

1. ARR Surges as Recurring Revenue Flows In

While reported revenue for a software company can include low-margin items like implementation fees, annual recurring revenue (ARR) is a sum of the next 12 months of contracted revenue purely from software subscriptions, or the high-margin, predictable revenue streams that make SaaS businesses so valuable.

Zscaler’s ARR punched in at $2.9 billion in Q1, and over the last four quarters, its year-on-year growth averaged 24.3%. This performance was impressive and shows that customers are willing to take multi-year bets on the company’s technology. Its growth also makes Zscaler a more predictable business, a tailwind for its valuation as investors typically prefer businesses with recurring revenue.

2. Excellent Free Cash Flow Margin Boosts Reinvestment Potential

If you’ve followed StockStory for a while, you know we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can’t use accounting profits to pay the bills.

Zscaler has shown terrific cash profitability, driven by its lucrative business model and cost-effective customer acquisition strategy that enable it to stay ahead of the competition through investments in new products rather than sales and marketing. The company’s free cash flow margin was among the best in the software sector, averaging 27.1% over the last year. The divergence from its underwhelming operating margin stems from the add-back of non-cash charges like depreciation and stock-based compensation. GAAP operating profit expenses these line items, but free cash flow does not.

One Reason to be Careful:

Operating Losses Sound the Alarms

While many software businesses point investors to their adjusted profits, which exclude stock-based compensation (SBC), we prefer GAAP operating margin because SBC is a legitimate expense used to attract and retain talent. This metric shows how much revenue remains after accounting for all core expenses – everything from the cost of goods sold to sales and R&D.

Zscaler’s expensive cost structure has contributed to an average operating margin of negative 4.8% over the last year. This happened because the company spent loads of money to capture market share. As seen in its fast revenue growth, the aggressive strategy has paid off so far, and Wall Street’s estimates suggest the party will continue. We tend to agree and believe the business has a good chance of reaching profitability upon scale.

Final Judgment

Zscaler’s positive characteristics outweigh the negatives, and with the recent rally, the stock trades at 15.6× forward price-to-sales (or $306.95 per share). Is now the time to initiate a position? See for yourself in our full research report, it’s free.

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