ZS

Why Did Zscaler Stock Drop 20% Last Month?

Shares of Zscaler (NASDAQ: ZS) fell 20.4% in March, according to data provided by S&P Global Market Intelligence. Despite delivering impressive quarterly financial results, the cybersecurity stock still slid lower thanks to a combination of pessimism about its outlook, an expensive valuation, and unfavorable market conditions.

Zscaler's quarterly results were solid, but its outlook was less impressive

Zscaler reported quarterly earnings on Feb. 29 after the market closed for the day. The company attained $525 million in quarterly revenue, 4% above Wall Street's estimates and 35% higher than the prior year.

That translated to 108% growth in adjusted net income and a 60% increase in free cash flow. High growth paired with margin expansion is a recipe for success. The company also reported a strong net dollar retention of 117%, indicating high customer satisfaction, product enhancements, and effective sales operations.

A person at a desk looking at a laptop computer with a cybersecurity program on the screen.

Image source: Getty Images.

Those positive results weren't enough to keep the stock from tumbling. The company's forecasts suggest a slowdown to 28% revenue growth, and the full-year guidance implies only 24% annual growth in the fourth quarter. Those fell within the range of analyst forecasts, but the most bullish investors are probably dealing with a reality check.

Zscaler's stock is too expensive to withstand minor speed bumps

The quarterly report was, at worst, a mix of good and bad news. Some analysts remain bullish on the stock, and the new guidance exceeded expectations from some analysts, even if it fell short of the more bullish estimates. That seems at odds with a 20% drop.

Zscaler's rate of expansion is slowing as it matures and saturates its target markets more deeply. Investors often struggle to attach a valuation to companies reporting high growth rates by decelerating. This creates volatility, especially when the valuation ratios are expensive.

Zscaler stock climbed 26% between its last two earnings reports. Its recent 20% drop might not reflect a fundamental shift in expectations but rather normalization after a strong period as some investors take gains off the table.

ZS Chart

ZS data by YCharts.

The stock's valuation ratios expanded in the months leading to the most recent report, and they've since returned to less speculative levels.

ZS PE Ratio (Forward) Chart

ZS PE Ratio (Forward) data by YCharts. PE Ratio = price-to-earnings ratio. PS Ratio = price-to-sales ratio.

Its forward price-to-earnings (PE) ratio returned to 70 after climbing to 90, price-to-sales climbed above 20 before falling back to 15, and price-to-free-cash-flow surged above 75 before settling back to 57. These valuation ratios are still fairly expensive, so it's fair to expect volatility any time there's doubt about Zscaler's future results or the relative outperformance of growth stocks in general. Both conditions were met in March, and Zscaler gave back some of its prior gains.

There's plenty of long-term opportunity for Zscaler shareholders to enjoy impressive returns, but expect more volatility in the years to come as the cybersecurity industry matures and Zscaler transitions from explosive growth to cash-flow generation.

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Ryan Downie has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zscaler. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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