Shares of Zscaler (NASDAQ: ZS) slid 13.3% in the first six months of the year, according to data provided by S&P Global Market Intelligence . The cybersecurity stock struggled as investors came to terms with the company's slowing growth rate and increased competition. Zscaler's last two quarters were generally favorable, but investors seem to be rethinking its valuation as the cybersecurity industry evolves.
The cybersecurity company's growth rate is slowing while competition heats up
Zscaler has a strong product portfolio in an exciting growth industry. Its phenomenal growth drove investors to accept an aggressive valuation, but that was unsustainable.
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The company's revenue growth rate climbed above 60% in 2022, which is difficult to maintain. As companies increase scale, they generally grapple with market saturation -- fewer potential customers are still unacquainted with Zscaler or one of its competitors.
To maintain a high growth rate, the amount of new sales generated must grow proportionately, too. That means hiring more and more employees for sales, customer service, and new product enhancements. It's usually impossible to efficiently manage enormous staff increases at scale. Growth naturally slows over time -- it's part of the corporate life cycle.
ZS Revenue (Quarterly YoY Growth) data by YCharts
Zscaler beat Wall Street's quarterly revenue estimates in February, notching an impressive 35% growth rate. It updated its full-year guidance, which was in line with the existing analyst forecasts. That sounds like a solid quarter, but the stock moved sharply lower directly following the financial report.
Deceleration can damage a growth stock, and Zscaler's has coincided with greater competition. The latest Gartner report lists Palo Alto Networks (NASDAQ: PANW) and privately held Netskope as leaders along with Zscaler in its core security service edge product offering. Investors should still be pleased with those high marks from an influential product rating service, but it highlights the issues faced by growth stocks with high valuations.
Zscaler's forward P/E ratio was above 80, and its price-to-sales ratio was nearly 20 before its quarterly earnings report on the last day of February. Those are both high and are only sustainable with exceptional growth. The most bullish investors are likely dealing with a reality check, and the market applied more scrutiny to Zscaler's valuation relative to its prospects.
A strong conclusion to the first half
Zscaler exceeded analyst estimates again in its May quarterly report. The company achieved 32% sales growth, it attained quarterly generally accepted accounting principles ( GAAP ) net profit for the first time in its history, and it revised its full-year forecast higher. That's comprehensively positive performance, and it helped the stock recoup some of its prior losses .
The company's growth rate is falling, but it's making up for that with impressive cash flow generation. Zscaler delivered 22% margins for free cash flow and adjusted operating profits.
Those results are well above the minimum threshold for the Rule of 40 , which is an important metric for software companies. It also reported an impressive 116% net dollar retention . The most recent quarter was overall very positive.
Stocks often experience volatility as they shift out of their high-growth phase. Those valuation ratios likely weren't sustainable for a company in Zscaler's position. Investor expectations are coming back to reality.
Ryan Downie has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Palo Alto Networks and Zscaler. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy .
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