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Cybersecurity Spending Is Slowing: 2 Top Stocks That Can Weather the Storm

Motley Fool - Sat Dec 2, 2023

The big takeaway from cybersecurity stock earnings reports in recent weeks is that even this pocket of strength in the computing tech industry is getting impacted by higher interest rates and economic slowdowns. Indeed, as important as digital security is these days, organizations are looking to cut costs -- even by slowing their spend on much-needed cyber-software if need be.

Industry pure-play leaders Palo Alto Networks and Fortinet reported cool-offs are coming, and even cloud-native hypergrowth outfits CrowdStrike (NASDAQ: CRWD) and Zscaler (NASDAQ: ZS) have been affected a bit. However, a slowdown doesn't automatically spell disaster for these two younger companies in the cybersecurity world. Here's why CrowdStrike and Zscaler can weather the storm, and a look at whether the stocks are worth buying now.

CrowdStrike: The top dog in cybersecurity in the making?

CrowdStrike burst onto the public investment scene in 2019 with its AI-powered endpoint cybersecurity platform -- designed for user devices and other hardware at the network "edge" -- just in time for blastoff early in the pandemic. But the company has barely skipped a beat, as it has successfully been gobbling up market share of the endpoint market from leaders like Microsoft. Trailing-12-month revenue has gone from just a few hundred million to nearly $3 billion.

Though the trajectory has cooled, the latest earnings update shows CrowdStrike is far from finished, reporting a 35% year-over-year increase in quarterly sales to $786 million in the third quarter of its fiscal 2024 (the three months ended in October 2023). That's not bad at all, especially given that cybersecurity pure-play leaders Palo Alto Networks and Fortinet have been slowing down so much. CrowdStrike could be well on its way to becoming the biggest out there.

CRWD Revenue (TTM) Chart

Data by YCharts.

Of course, it's going to take time for CrowdStrike to continue narrowing that lead, but it clearly has a strong development pipeline to expand its security offerings. A ton of cash and short-term investments ($3.17 billion, with debt of just $742 million) certainly helps. CrowdStrike co-founder and CEO George Kurtz said on the earnings call with analysts that "this was a standout quarter and places us well on the path to $10 billion in ARR [annualized recurring revenue]..."

But best of all, CrowdStrike is knocking it out of the park with its ability to generate free cash flow. FCF was $656 million the first nine months of this year, an exceptional FCF profit margin of nearly 30%. The only complaint I have right now is the valuation is getting a bit frothy again, at 65 times trailing-12-month FCF. As is often the case with high-growth but richly valued stocks, I believe a dollar-cost average plan makes sense for investors who want to own for the long term.

But make no mistake: CrowdStrike stock deserves some sort of premium price, as it has established itself as a next-gen leader in cybersecurity software. It is in tip-top shape to continue outperforming for a long time to come.

Zscaler: Some issues remain, but strong growth isn't one of them

Zscaler has also been off to the races since its 2018 IPO, and like its cloud-native cybersecurity software peer, it's showing few signs of letting up anytime soon. Zscaler reported 40% year-over-year revenue growth in the first quarter of its fiscal year 2024 (the three months ended in October) to $497 million -- also ranking it as one of the largest cybersecurity names around.

As more organizations around the world migrate their IT work to a cloud (be it a public cloud hosted by a tech giant like Amazon or Microsoft, or a private cloud owned and operated by the organization itself), Zscaler sees plenty of opportunities ahead. Its global compute network helps route cloud traffic safely so it doesn't get intercepted by those with nefarious intent.

Like CrowdStrike, Zscaler is also hitting some impressive FCF margins, 45% to be specific last quarter. However, expect these margins to decline later this year as the company makes investments in new personnel to continue its pace of growth.

Additionally, Zscaler also shells out a far higher rate of stock-based compensation (SBC). SBC was $129 million last quarter, 26% of revenue, or about 1.7% of the company's total market cap when annualizing last quarter's SBC. CrowdStrike's SBC was also high at 21% of last quarter's revenue, but only about 1% of its market cap.

This potential for future shareholder dilution aside, Zscaler is putting up impressive figures for far longer than I had expected (or what management has forecast) it could. However, again considering the high valuation (over 60 times trailing-12-month free cash flow), I continue to believe this is best viewed as a dollar-cost average stock, as volatility can be wild for Zscaler.

Nevertheless, Zscaler and cloud cybersecurity peer CrowdStrike are gaining lots of market share and have all the ingredients in place to compound their profitable growth for years to come. After slogging through the ranks of the hypercompetitive cybersecurity market, these standouts should top investors' lists as best places to invest.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients have positions in Amazon, CrowdStrike, Fortinet, and Palo Alto Networks. The Motley Fool has positions in and recommends Amazon, CrowdStrike, Fortinet, Microsoft, Palo Alto Networks, and Zscaler. The Motley Fool has a disclosure policy.

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