Michael Vi
Zscaler – It is time to bring a Buffett-like mentality to this beaten down leader
The Sage of Omaha, Warren Buffett, has offered many nuggets of wisdom in a long and storied career. One of them is “be fearful when others are greedy, and greedy when others are fearful.” Certainly most investors in Zscaler (NASDAQ:ZS) are fearful. Fearful of all kinds of things, most of them not related to the company. This has not been an easy time in which to invest in high growth IT companies. It really hasn’t been a great time in which to invest in almost every class of financial assets, but I specialize in looking at IT vendors and that has been an especially difficult road to hoe. This is an article recommending the purchase of ZS shares, although not because I can discern some immediate catalyst other than its share price implosion. I hope the shares are near a bottom, but I suppose the same could be said with regards to most other IT stocks. And I would be naive in the extreme to think that ZS shares will be able to show any kind of appreciation when investors are selling any kind of risk assets at the least sign that inflation continues as a problem. At the time of writing this, markets are under pressure because of an uptick in inflation expectations in a consumer confidence survey. Previously, investors had been concerned about issues with regards to the contretemps with liquidity issues stemming from pushback against a UK stimulus package. With that as a backdrop, any kind of risk assets are seeing prices marked down. Just as a stark example, New Relic (NEWR) preannounced an upside compared to prior expectations in conjunction with its announcement of the appointment of Mark Dodd as its Chief Revenue Officer. Despite having fallen by 10% in just 3 days, the positive news has had a minimal (1.5%) positive impact on the shares.
If I were to attempt to list all of the current fears of investors about investing in equities, and particularly investing in high growth IT equities or even Zscaler itself, this article would be long, and it would basically write itself. Inflation, recession, stagflation, social unrest, quantitative tightening, interest rate spikes, valuation, stock based compensation, geo-political concerns, electoral politics, political dysfunction, global warming-I am sure I have missed a few concerns. I certainly don’t want to suggest that these aren’t real concerns, but to an extent they have already led to some of the lowest sentiment indicators on record for both individuals and institutions as well as one of the more significant declines in asset valuations that has ever been seen.
As has been pointed out by others, many of the concerns being cited as animating Fed policies are based on lagging and coincident indicators. This was discussed in a recent article by the chief strategist of MKM Partners, Michael Darda. That said, of course, inflation is a scourge, and until investors see a couple of months of lower inflation prints, stocks, and that includes Zscaler, will be pressured with little likelihood of seeing sustained positive share price trends. .
It can be hard to evaluate individual companies with any degree of dispassion in the midst of such a toxic environment where almost anything positive is seen as a problem. But I can try to look at Zscaler in that fashion, even after its epic valuation implosion.
Even after the market’s big bounce on Thursday, high growth shares still finished with losses, although far smaller losses than they had seen prior to the bounce. ZS shares, even after having fallen precipitously in previous sessions, still wound up the day down a further 1.5%. And whatever bounce was seen on Thursday, dissipated by the close on Friday, with ZS shares falling another 7%. One commentator observed that the chart of Zscaler displays a hammer pattern, which is said to be a technical indication of nearing a bottom. I am not a technical analyst, but hey, any port in a storm. I hope indeed that is the case, but this is a fundamental analysis of the strengths of ZS and its competitive position in the market and the growth of the market that it leads. Right now, those considerations don’t matter, but at some point, investors are going to differentiate between the best and the also-rans in different spaces in the IT space.
This article does make the case, best as I am able as to why this is a better time to consider ZS as an investment than has been the case for several years. So far this year, Zscaler shares have lost about 58% of their value and they are down by 63% since their high point set 11 months ago. (The percentage comparisons are based on prices as of the close of 10/14). While sometime looking at relative losses might be correlated with future positive share price performance, given the universality of the valuation implosion of high growth IT shares, the fall of ZS is not my reason to focus on these shares. What has happened however, is that growth and profitability of ZS has been strongly positive -at the same time that valuation has been shredded. That is what makes this share price implosion of particular interest to me, and the reason to consider adding the shares to a high growth portfolio understanding that ZS shares are not going to achieve positive performance while investors are focusing on inflation, interest rates and other macro risks.
Since the start of the bear market, shares of high-growth IT companies have been considered risky. The risk presumably has to do with valuation, since there is no real evidence that IT companies are particularly vulnerable to recessionary headwinds, and certainly there is even less evidence that demand for cybersecurity is cyclical given that it is an essential of most businesses these days.
I have a long history of writing about and recommending Zscaler shares. My interest in the company is mainly a function of the company’s product portfolio which offers an architecture that is considered by many as the gold standard in providing zero-trust security in a web environment. Fact is, that the portfolio has gotten stronger and that the company is now addressing an ever larger TAM in a space that is almost certain to be the most recession resistant component of IT demand. Zscaler’s sales execution, with a couple of exceptions, has seen strong trends as well and at this point, I would point out that both its mind share and a large cohort of influential CSOs (Chief Security Offices) who have used the product and then seek to deploy it when they move to a new job, are additional factors in the continuing success of this company.
I initially wrote about the company in 2018 for SA, and my last article on SA was more than 3 years ago. I have wanted to write about the company and its outlook since then, but its valuation has simply been too high, despite the company’s exemplary growth rate. I sold 2/3rds of my position in early 2021 as the valuation at the time was more than I was comfortable with. But now, in the wake of the valuation implosion of most IT names, and specifically the announcement that the company’s longtime CTO, Amit Sinha is leaving, the shares have a valuation that is at least somewhat reasonable. Not cheap, but reasonable. Reasonable to me is a current EV/S ratio of about 12X, a free cash flow margin of 30%, yielding a Rule of 40 calculation that was above 90 in the last fiscal year, and should still remain above 70 in fiscal 2023, and more likely higher than that.
Before embarking on a discussion of Zscaler and why it is worth considering, I will note the following: The company uses and has used a substantial SBC. Through the end of FY 2022, SBC was significant, at more than 40% of revenue, comparable to levels in prior years. For readers considering SBC levels as a filter, these shares are not for you. Over many years since a GAAP accounting standard was mandated by the FASB, there has been no discernible correlation between SBC expense and valuation. But SBC is a real cost in that it creates dilution. Outstanding shares for ZS rose 3.3% year on year last quarter. I actually have used a share count 5% above current levels, i.e. 149 million to account for the likely dilution over the coming year.
ZS shares did rally notably from May to early September. Part of that was the bear market rally of that time, and part of that was the release of quarterly earnings on September 8th that were well above negative expectations. Since then, more than all of that gain has been surrendered. The company will not be reporting results again until after Thanksgiving, and in this environment, the performance of the shares will be dependent on exogenous macro factors that have nothing to do with the company’s operational outlook.
As mentioned, ZS shares have most recently been pressured by news of the resignation of, Dr. Amit Sinha, who is leaving the company to become the CEO of a privately-held IT company. In fact, Just since 10/7 the shares have fallen more than 20%. Most recently, Dr. Sinha has been the company’s President with responsibility for R&D, Cloud Operations and Customer Support. There is no doubt that Dr. Sinha has been an important part of the ZS management team. He has been the company’s President, since the start of the year, but has been the chief technology officer since 2010. That said, at this point, Zscaler, with about 5000 employees, and a very strong bench, has plenty of talent to backstop the capabilities that Dr. Sinha had brought to the company. I am reasonably sure that the company will thrive in the future as it has in the past. The company founder, Jay Chaudhry and Dr. Sinha’s longtime colleague is remaining, and for a time will assume some of Dr. Sinha’s role.
I don’t really like to speculate on why Dr. Sinha has chosen this time to take up a role as CEO of a pre-IPO company. I obviously can’t know his motivation although I strongly doubt that it was a function of underwater options. The fact is that the opportunities to make a big score in a private company at this point aren’t in the near future. New hot tech IPO’s are just a distant memory at this point and their return is in the unforeseeable future. But given that Dr. Sinha and Jay Chaudhry are contemporaries, my guess is that Dr. Sinha wanted the opportunity to run his own show and decided to join forces with an erstwhile colleague. Nothing dire or sinister.
But this is an unforgiving environment, and obviously some investors believe that there is more to the departure of Dr. Sinha than is apparent, or that he is an irreplaceable talent. As I will discuss, the company has a well-defined product roadmap, and it remains the leading vendor in zero-trust cyber security architecture with a broadening footprint and a growing TAM. The company really does have an extensive group of senior executives who are focused on maintaining Zscaler’s technological leadership in its space, and in expanding its space. The company’s COO is Dali Rajic who runs go-to-market operations. It has a chief innovation officer, an EVP for Business Development and Corporate Strategy, an EVP of Customer Experience and Transformation, a Chief Technology Evangelist, and a Senior VP of Product Management. Dr. Sinha is no doubt a visionary and has a strong record of innovation. But Zscaler has a very strong bench in terms of technology leadership, and its CEO is certainly one of the luminaries of the cyber-security space. At the end of the day, I doubt that Dr. Sinha’s departure will slow successful innovation at Zscaler, or disrupt the operations of its data centers or in any way diminish its growth rate from what otherwise might be anticipated.
The fact is that in evaluating the kind of growth Zscaler is likely to achieve in the next couple of year, the two keys are the company’s sales execution capabilities, and its product portfolio. Dr. Sinha has not been directly involved in the ZS sales process, and the current product portfolio has been described by a leading analyst as “sizzling.” There is little danger that Zscaler will not continue to be the leader in its part of the cybersecurity world over the next 12-24 months, and probably longer.
Just how strongly has ZS performed lately
In a world where even the leading IT companies are seeing challenged sales momentum, Zscaler, along with a few other cyber-security vendors stands out. Last quarter, the company grew revenues by 61% year on year, and by 11% sequentially. The company’s deferred revenue balance grew by 62% year on year, and by 25% sequentially (it was a fiscal Q4 so some of that growth was seasonal). While the company’s CFO as well as some investors and analysts focus on calculated billings, at the end of the day, that metric is a function of deferred revenues, a metric not totally congruent with actual sales momentum.
When available, I prefer to look at RPO balances, or committed backlog. The company’s RPO balance grew by 68% in the quarter reported in September, and at $2.6 billion, represents 1.57 years of projected revenues. That is an unusually high ratio for just about any company, and suggests the strength of the company’s sales momentum. The RPO balance rose by 18% sequentially; it might be noted that the RPO balance does not include a $45 million contract the company has signed with a Federal agency even though the commitment is contractual. Including that unusually large order, the RPO balance would have risen by almost 20% sequentially.
The company has secured what is called FedRAMP high and IL5 certifications. Indeed, its ZPA and ZIA offerings have both secured FedRAMP high, and it is the only company that has two products with that level of certification. These certifications are driving very high levels of growth in the Federal vertical for this company, and that vertical is most unlikely to be subject to cyclical perturbations.
The company’s DBE ratio has been above 125% for almost 2 years. The company’s cohort of large customers rose by 62% year on year last quarter. While ZS operates in what might appear to be a highly competitive market, it has demonstrated a significant level of pricing power, and gross margins continued to increase, reaching 81.6%, up almost 100 bps on a year over year basis last quarter.
The company entered the current fiscal year with a record pipeline according to its CFO, and its land/expand strategy has been successful for years. The company has a broader set of solutions to sell to its users, and users are increasingly adopting the platform approach in their deployment of cyber security solutions with Zscaler being the zero trust platform of choice.
That said, management noted that it saw more deals receiving a higher level of scrutiny than had heretofore been the case, although this scrutiny did not impact overall quarterly results. The company has a sophisticated process of producing business value assessments for its users, and these assessments are apparently resonating and were a factor in the strong results of the latest quarter. As a result of this increased scrutiny, DSO rose, although again, some of that is seasonal, and that in turn put some pressure on the quarterly free cash flow margin although it still was still a very healthy 24%.
As a result of concern regarding macro headwinds, the company provided more conspicuously conservative guidance than usual. Currently, consensus expectations, essentially a mirror of the company’s guidance, call for revenue growth of just 39% this current fiscal year, with sequential revenue growth forecast to be 7%. On the other hand, projected EPS growth of 75% does reflect significant margin improvement. I might normally not place overwhelming reliance on this kind of conservatism, but it is self-evident that these are not ordinary times, and forecasting torrid growth for this company, and for almost any company at this point, is probably a stretch too far. As it happens, this level of growth was considered to be very positive and was the major cause for the share price rally after the release of earnings.
No one can really know at this point how a recession will wind up curbing or not curbing demand for different classes of software. What can be suggested, however, is that cyber security will remain an IT spending priority through a recession meaning that Zscaler should show even stronger relative growth than most other IT companies.
Zscaler’s fiscal quarter ends at the end of October. In analyst interviews just prior to the start of its “quiet period”, the company has said it hasn’t seen any erosion of its business. Management continues to say it is presenting a cautious outlook because it assumes a recession over the next year and that will probably result in constrained IT budgets, and perhaps could result in pressures on cyber-security spend even though it hasn’t seen such a trend thus far.
Why is Zscaler achieving its success
There are basically two reasons. One is that the company only sells cloud cyber security solutions. While most market research focuses on the entire cyber security space, with growth rates projected in the low/mid teens, Zscaler’s focus is just on cyber security for cloud based applications. That market is seen growing at a 20% CAGR over the next 5 years. Zscaler is growing much faster than that, because its technology, based on a zero trust architecture, is replacing what are called next generation firewalls, which are have usually been based on physical appliances scattered in many remote offices, as the preferred topology for modern enterprise networks.
The success of ZS, and its market place momentum is mainly based on the architecture of its offerings. I don’t want to attempt to suggest that I have the expertise to evaluate cyber-security offerings and make judgments as to which offering is better. While not intending to quibble about the meaning of the word “BETTER” it can be hard to define when it comes to performance in the world in which Zscaler competes. Cyber-security is a complex space with lots of competitors, and as the threat landscape changes and enlarges, the competitors have to respond with new ways to thwart cyber-criminals. And no solution is truly impenetrable.
These days, many companies claim to have zero-trust solutions, and essentially all of the significant cyber-security companies have evolved software solutions that are in some ways comparable to what Zscaler offers. While there continues to be healthy demand for next generation firewalls, and the appliances that facilitate those solutions, solutions patterned on the ZS model have become the focus of most of the competitors in the space.
So what differentiates ZS and its offerings. I have to rely on 3rd party evidence and look at the preponderance of the evidence. And looking at 3rd party analysis, it seems reasonable to conclude that Zscaler’s success is simply because of the company’s superior technology as well as its platform approach which is resonating with its users. Since Zscaler pioneered what it describes as zero-trust architecture there have been a plethora of competitive offerings. It would be hard for cyber security vendors to remain relevant without zero trust architectures. But most of these, constructed in haste, lack the architectural refinements, and hence the scalability and performance that Zscaler offers. Zscaler has been evaluated by Gartner to be the leader in two categories. One of these is Security Service Edge. It is not terribly surprising that ZS is seen as the leader in the category since it essentially pioneered that kind of functionality. Gartner describes the Zscaler as “the leading cloud-native security provider.” It says it has generated a strong mindshare in the market. I believe this quote from the Gartner report is most relevant.
“Zscaler has a solid track record of innovation and continues to invest before its competitors in efforts to provide interesting innovations in the SSE market. For example, it was the first to introduce DEM, which enables it to collect and analyze end-user experiences wherever its agent is installed.”
The major caution Gartner identifies is price. Zscaler has continued to increase prices, particularly when users renew as the company has changed its pricing model to enhance its gross margins. While ZS products are premium priced, the total cost of ownership for ZS offers users significant savings. That is the basis for the detailed, CEO ready presentations mentioned earlier. Most users find that paying more for software is an excellent investment. Rather than me try to illustrate the point, I will let this quote from the CEO speak for itself:
Jay Chaudhry
We have actually many, many customers who have publicly stated in our conferences that the number of resources needed to one, operate Zscaler service is much sold. Often it’s kind of — fit all what it takes to run appliance companies, firewall companies and the like. So, that’s part of the operational cost that you talk about. There are four pieces of cost that customer looks at from reduction from Zscaler. Operational is obviously one part of it. Cost savings from elimination of point products is an important area. You won’t believe so many security products are sitting at any large enterprises. And one CISO called it appliance for peak.
Our third area is improved business productivity, which is linked to user experience. It is interesting as users are working from everywhere accessing very critical information out in the cloud, users are very, how should I say, intolerant of any slowness and store experience. And fourth thing is risk reduction. It’s hard to quantify risk, but our customers are looking and saying, “What’s the cost of breach? What’s the cost of downtime and the like?” So, we have always had a good business value assessment process. It has short book. And also when we work the C level and the C level becomes sponsor of the process, it helps us show them savings and it helps us get our deal done.
Alex Henderson
The question, just to be clear, was, has there been a change in that environment that has then amplified the benefit of those four factors?
Jay Chaudhry
Yes. Probably the direct answer would be, it is more and more need to do a strong assessment, quantification and commitment to delivering those results. Absolutely, yes.
I have linked here to an interesting article that details far better than I can, just how transformative it is for companies to switch from legacy technologies to Zscaler. I have also linked to an article outlining historical issues in using Zscaler. And here is a listing of competitors for the core ZS technology. There are plenty of competitors, and Zscaler is not going to win every competitive engagement or displace every legacy vendors en masse. But the market dynamics shown in the linked articles above really illuminate the opportunities which the company is addressing.
The company expanded its sales and marketing staff by 54% last year, allowing it to increase sales capacity significantly. It offers its products through the marketplaces maintained by the cloud hyperscalers and that channel saw a fivefold growth last quarter. It is also just now getting started with a major effort with VARs and SIs.
The company spends 18% of its revenues non-GAAP on research and development. It continues to introduce new products that become demand drivers. The latest two significant offerings are ZDX and Zscaler for Workloads. The company also announced Posture Control for public clouds which essentially develops correlations that can identify vulnerabilities and risks across user deployments.
One of the major issues these days is the performance of digital experiences. When companies embark on a digital transformation journey one of the principle issues they need to address is the management of the performance of their applications. There are many different kinds of observability solutions, and I can’t say that what ZS sells is better than what is sold by Datadog (DDOG) or Dynatrace (DT). ZDX has been identified by company management as one of its pillars for future growth.
Zscaler for Workloads is the new moniker for what used to be called Cloud Protection and is a service that helps users to develop and run secure cloud applications. Again, there are other technologies in this space – Gitlab (GTLB) is addressing the same problem. That said, and part of the reason for the strong growth that Zscaler has been able to achieve, relates to the desire of large users to simplify and consolidate vendor relationships. This isn’t the case during times of IT budget growth, but during periods of budget constraint, users tend to believe they can maximize the value of their spend by partnering with vendors such as ZS that can provide multiple solutions form a single platform.
Last year, the company’s emerging products contributed 14% to the company’s new business and continue to grow faster than the company’s core ZIA and ZPA solutions. In turn, ZPA, which is the Zscaler alternative to Virtual Private Networks and which has substantial benefits in terms of security and performance, is now 27% of new business, continuing to grow more rapidly than ZIA, the company’s internet access edge solution.
As signs of an impending recession multiply, the uncertainties of forecasting demand for most businesses, and specifically enterprise software increase. Those uncertainties should be less for cyber-security whose deployment is not really optional. But this company, in terms of its guidance has chosen to adopt a cautious stance, and indeed, it is forecasting deceleration of percentage bookings growth in the 2nd half of its fiscal year. On the other hand, it has not slowed the cadence of its hiring in either sales or research and development roles.
I certainly don’t want to claim specific insight on how enterprise software demand, and demand for cybersecurity offerings plays out when and if a recession begins, I think the fact that cyber security isn’t an optional expense, and that deploying Zscaler typically helps to eliminate many point solutions and other operational costs is likely to buffer the impact of constrained IT budgets. Equally, I think it is fair to state that the preponderance of the evidence continues to suggest further market share gains for Zscaler for the foreseeable future.
Reviewing the ZS business model and recapitulating its investment case
Just to recapitulate, Zscaler has a high ratio of SBC, in part because its rate of hiring has been so substantial. The SBC formula is such that when an option is granted to a new hire, the entire value of that option is recognized immediately, even if the new employee is likely to have a multi-year tenure. So, when this company increases its employee base in the mid 50% range as it has in the past couple of years, the level of reported SBC is elevated.
As mentioned, thus far ZS has not seen any demand deterioration, and thus its hiring continues at robust levels. All of the metrics below are calculated based on non-GAAP calculations. This is not an article to discuss the merits of SBC exclusion; the fact is there is not now a discernible correlation between SBC levels and valuations, nor has there been since the FASB started mandating the presentation of GAAP earnings a dozen years ago.
For the record, last quarter SBC expense grew by 39% year on year, while revenue growth was greater than 60%. On a sequential basis, SBC expense grew by 6% while revenues grew by 11%. Presumably these declines in the SBC ratio have more to do with the formula used to calculate the valuation of option grants rather than any decline in hiring, although share awards may have moderated in a less competitive hiring environment.
As mentioned, the company has been able to increase its gross margins steadily. Last quarter, non-GAAP gross margins reached 82%, up about 85 bps from year earlier levels and up a similar amount from the prior sequential quarter. Gross margins for Zscaler were both impacted by price increases as users switch to different, more comprehensive solutions, but also by the level of revenue compared to expectations. The company had forecast fiscal Q4 revenues of $305 million; actual revenues were $318 million. The company has 150 points of presence these days and the greater the utilization, the higher the gross margin.
As has been typical of this company for some years, the CFO continues to caution analysts to use a lower gross margin expectation in forecasts as new products, at least initially, can negatively impact gross margins. So far that has not happened.
Overall operating margins rose a couple of hundred basis points year on year and by 300 bps sequentially. Sales and marketing expense was about 49% of revenues last quarter, compared to 47% of revenues the prior year. As mentioned, the company had a huge order of $45 million in its Federal vertical which did not impact revenues, billings or RPO balances. But obviously closing the deal meant that sales people had to be paid, and that caused the increase in the sales and marketing expense ratio last quarter.
As mentioned earlier, Research and development spending was 14% last quarter, compared to 13% in the year earlier quarter. General and Administrative expense was 6% of revenue last quarter, compared to 7% of revenues the prior year.
The company’s long term goal for operating margins is 20%-22% compared to the 12% achieved in the full year of FY’22. It has forecast a 150bps improvement in operating margins this current fiscal year. Again, as the CFO has said for years, if growth opportunities are less than forecast, the company will alter its spending plans, and achieve greater than average operating margin growth.
Should readers buy ZS shares? Just to be clear, the accounts I manage have a small position in the shares-a bit less than a 4% weighting. Owning any high growth IT shares at the moment is a bit of a contrarian call in that almost nothing short of an acquisition has any current ability to generate significant positive alpha. I don’t suggest that I have some unique ability to call a bottom; when I read that stock prices have reversed direction because a survey of consumer confidence had higher inflation expectations, in turn based on the reversal of gasoline prices, I have to confess that my ability to forecast the track of stock prices in the short term is considerably constrained.
That said, I intend to take advantage of this latest share price implosion in Zscaler to add to its weighting in the portfolios I manage. I acknowledge that on an EV/S basis, even the current level of that metric for ZS shares, which I calculate to be about 12X is still above average. But when I look at ZS on the basis of its Rule of 40 metric which incorporates growth as well as free cash flow margins, the shares are actually valued less than average. And I think that companies in the cyber security space, where demand is far less cyclical, should command a premium and not a discounted valuation.
ZS is likely to continue to achieve market share gains in the company’s spaces both because its current customers continue to add additional components of the company’s solution to their deployment, but also because of its ability to attract new name accounts at a significant pace. Part of this relates to the continued expansion of the company’s sales capacity, part of it relates to substantial mind-share gains, and part of it relates to the ability of the company to demonstrate to prospective customers its substantial ROI and TCO advantages. The overall size of the market that ZS addresses is so large that even with the presence of additional substantial competitors such as Palo Alto (PANW) and Fortinet (FTNT), has not really impeded either close rates or cycle times for the company.
While the company acknowledged that some large deals were seeing more scrutiny and in some cases extended sales cycles, it wound up with a very strong quarter for bookings which grew 60% year on year, and by about 20% sequentially when adjusted for a mega-order in the Federal vertical that was not counted in reported numbers.
This latest down leg for ZS was precipitated by the resignation of the company’s president who is joining a start-up, apparently outside the cybersecurity space. While Dr. Sinha has been a major factor in the growth and success of ZS, the company has a very adequate management team, with lots of talent who will continue to foster innovation and growth. This has been as toxic an environment for high growth IT stocks as any I can recollect, and that is particularly so since unlike the two last periods of sustained underperformance, companies such as this continue to grow at elevated rates with high levels of free cash generation. Eventually, although I can’t forecast when, investors will pivot from macro concerns to evaluating companies. When they do, I believe that ZS shares are poised to generate copious levels of positive alpha.
Be the first to comment