Zscaler's Stock Retreat Masks Solid Execution, But Margin and Competitive Pressures Linger

What happened

Zscaler's stock has pulled back 22% amid broader software sector pessimism, yet the company continues to demonstrate robust financials with 20%+ growth and operating margins. From the DeepValue report, Zscaler boasts scaled Zero Trust leadership, serving over 40% of the Forbes Global 2000, with FY25 FCF margin at 27% and ARR surpassing $3.0 billion. Management is guiding a transition from hypergrowth to a durable compounder, targeting FY26 revenue of ~$3.27 billion and ARR of ~$3.68-3.70 billion, though GAAP losses persist and gross margin has slightly declined. AI initiatives like AI Guard show promise with AI Security ARR up 80% YoY, and strategic acquisitions such as Red Canary aim to broaden the platform, but integration challenges and intense competition from peers like Palo Alto Networks remain headwinds. Critically, while strong cash generation and liquidity offer downside support, sustained margin erosion or execution missteps against guidance could undermine the investment case.

Implication

Firstly, the stock decline reflects broader market sentiment rather than company-specific weakness, suggesting a possible mispricing for long-term investors. Secondly, Zscaler's transition to a compounder with consistent cash flow and large deferred revenue provides visibility, yet GAAP losses and margin pressures temper optimism. Thirdly, AI and Zero Trust adoption are secular tailwinds, but success hinges on effective product integration and customer uptake amidst rising competition. Fourthly, risks from aggressive peers and pricing pressure could decelerate growth, necessitating close monitoring of ARR and billings metrics. Finally, the balance sheet strength offers a cushion, but sustained deterioration in FCF or gross margins would signal a need for reassessment.

Thesis delta

The positive news reinforces Zscaler's growth trajectory and AI momentum, aligning with the existing BUY thesis by highlighting resilience and strategic execution. However, it does not alter the core risks of margin compression and competitive intensity, which remain unchanged and critical to watch. Thus, while confidence in near-term performance is bolstered, the long-term thesis remains contingent on overcoming these persistent challenges.