2023-06-12 19:12:45 ET
Summary
- Zscaler (ZS) is a leading cybersecurity company providing cloud-based security solutions, benefiting from increasing demand for cloud security services.
- The company's strong earnings report, ongoing cloud adoption trend, and value proposition of cost savings and ROI optimization make it an attractive investment option.
- I initiate on ZS with a Strong Buy rating and a target price of $185 representing a potential upside of 23%.
Company presentation
Founded in 2008 by Jay Chaudhry, Zscaler (ZS) is a cybersecurity company providing cybersecurity services and cloud-based security solutions. Through its platform, ZS helps organizations and individuals to stay safe and secure while using the internet. They do this by offering a cloud-based platform that provides secure access to the internet and protects against various online threats such as malware, viruses, data breaches, and cyberattacks. This approach is particularly attractive as it eliminates the need for traditional hardware or software installations on individual devices.
ZS's panel of products is robust and diversified.
Its main products are:
Secure Web Gateway, providing secure web access for users by inspecting and filtering web traffic in real-time.
Cloud Firewall, helping organizations protect their networks and data by monitoring and controlling incoming and outgoing network traffic.
Data Protection, offering data loss prevention capabilities to prevent sensitive data from being leaked or exposed.
Zero Trust Network Access, ensuring that users and devices are verified and authorized before accessing applications or data.
Distributed across more than 150 data centers around the world, ZS is one of the biggest cloud security platforms. Thanks to its large network, ZS constantly gathers and analyzes data from various sources to identify emerging threats and vulnerabilities. Information gathered are then used to update their security measures and protect customers against new and evolving cyber threats.
ZS's cybersecurity services are employed by a wide range of organizations, spanning from small businesses to large enterprises, operating in diverse industries. By providing a comprehensive cloud-based security platform, ZS enables organizations to embrace digital transformation securely and protect their sensitive information from cyber threats.
Q3 Overview
On the 8th of May, ZS pre-announced earnings results for the Q3. These preannouncements were particularly good as they exceeded the high end of the company's previous guidance range. The main element to consider was the following:
We updated our full-year revenue guidance to a range of $1.587 billion to $1.591 billion, with the low end significantly higher than the high end of the prior guidance of $1.558 billion to $1.563 billion.
This element was remarkable, especially in the current macro context.
Right after that, on the 1st of June, the company reported its full earnings for the quarter. The results were particularly solid, as you can see below.
Here are the main elements that have been mentioned during the earning call that I'd like to highlight:
Revenue grew by 46%, billings grew by 40%, and current billings grew by 44% on a year-over-year basis. On the bottom line, the company's operating income more than doubled on a year-over-year basis, with operating margins now exceeding 15%.
It appears that the company experienced significant growth in new business across various industry verticals. It has also been mentioned that:
Approximately half of the revenues came from outside the U.S.,
This indicates international expansion and diversification.
In an industry where the customer is king, the company boasts a strong and loyal customer base supported by strong investments and rewarded by a high gross retention rate in the high 90s, indicating strong customer satisfaction.
This element is crucial in my opinion to identify whether growth is built to last or not.
It has also been highlighted that:
Economic conditions are getting tighter as customers are increasingly scrutinizing their projects and budgets due to macro conditions.
However, it seems that despite a tough context, market demand for Zero Trust Architecture remains "strong" ($118.7 Billion by 2032, growing at a CAGR of 15.1% according to Future Market Insight ). This strong demand will continue in my view as the workforce is becoming more and more mobile.
This is especially true for an aggregator and differentiated actor like ZS. Indeed, the increasing focus on cybersecurity, driven by the expected rise in all types of cyberattacks and especially ones linked to ransomware and high-profile data breaches, has led IT leaders to seek Zero Trust architecture.
This strong print shows in my opinion that the company's Zero Trust Exchange platform aligns well with this market demand, providing better security, user experience, and cost reduction compared to traditional network security approaches.
The company also points out that:
Traditional network security solutions are inadequate in safeguarding enterprises in the current work-from-anywhere world.
In my opinion, this shift presents an opportunity for ZS, but also indicates a changing landscape that other competitors may target.
Finally, with the current AI wave, it would have been surprising not to see any mention of AI/ML for Cyber Protection. During the call, the company emphasized the use of AI/ML to enhance cyber protection. AI/ML technologies leverage has been mentioned for better detection of attacks, performance optimization, data protection, and policy enforcement, which completely makes sense to me.
The solid earnings release and guidance update appear to have surprised many investors that are coming back to a stock that has been heavily penalized, even though the firm never ceased to deliver.
Disinterest in software / IT stocks in a tough macro environment characterized by high inflationary pressures and rising interest rates has played in the disfavor of the stock.
However, many catalysts remain and there is still room in my view for substantial upside.
Cloud Adoption: It's Just The Beginning
Cloud security involves the implementation of various procedures and technologies to safeguard businesses against both external and internal security threats. As organizations embark on their digital transformation journey and integrate cloud-based tools and services into their infrastructure, the need for cloud security becomes crucial.
However, while embracing the cloud infrastructure and transitioning to cloud-based environments, organizations face the challenge of striking the right balance between productivity and security. Even if modern technologies enable operational optimization beyond on-premises infrastructure, a secure approach to cloud migration is essential to mitigate potential implications.
The cloud adoption trend has been accelerated by the COVID and there is still a lot of progress to be made, implying a larger TAM ($1.5 trillion) and an even higher potential for ZS.
That is what is suggested from this study made by Accenture where it is highlighted that:
Over the past two years, there's been a surge in cloud commitment, with more than 86% of companies reporting an increase in cloud initiatives.
Cloud adoption has in my view still a long way to go.
Legacy Network Cannibalization: Cost Savings and ROI Optimization
In a recent Bloomberg interview, Jay Chaudhry, ZS's CEO (19% stake in the company) insisted on ZS's unique value proposition and its capacity to improve cost savings initiatives while maximizing firms' ROI through its solutions. That is in my view what makes ZS a top pick to consider in the cybersecurity industry.
Indeed, as ZS, is a cloud-native platform, it is better-positioned than anyone else to disrupt the legacy networking industry while addressing key client concerns related to cost reduction and ROI optimization. Legacy networks are characterized by on-premises infrastructure, complex management, and lack the scalability and agility required by modern businesses. In this logic, ZS's cloud-based approach eliminates the need for on-premises hardware, reducing upfront capital and ongoing maintenance costs.
By streamlining network operations through simplified management and centralized control panels, organizations can lower operational expenses. The scalability and pay-as-you-go model allows cost optimization by scaling services based on demand. ZS's consolidated security services eliminate the need for multiple security products, reducing licensing, maintenance, and training expenses. With their global network presence and optimized routing, ZS minimizes bandwidth costs, while the unified cloud platform reduces complexity and integration expenses.
Valuation
I choose ZS peers that aren't profitable yet such as CrowdStrike (CRWD), Datadog (DDOG), Cloudflare (CN), Snowflake (SNOW), ServiceNow (NOW).
Combining consensus growth expectations for 2023 and mine for the year 2024. I arrive at a 23% potential upside, implying a $185 target price.
My growth rate expectations are conservative and based on companies guidance that I choose to revise down should 2024 to be a tougher year on the macro side.
Risks
Risks that have to be considered are the following:
- A macro environment tighter than expected cloud imply a slowdown in cloud transition and Cybersecurity spending.
- Stronger competition than anticipated, characterized by M&A deals and industry concentration.
- Evolving cybersecurity threats that could put pressure on industry actors.
- AI disruption has now become a key concern but also an opportunity for many tech companies. It will be important to follow that closely.
- Higher interest rates might put the firm valuation under pressure.
Conclusion
ZS represents in my view a compelling investment opportunity with major positive factors supporting its potential. The company is an underappreciated leading player in the cybersecurity industry, offering cloud-based security solutions and benefiting from the increasing demand for cloud security services.
Its strong earnings report, with robust revenue growth, billings, and customer base expansion, indicates the company's ability to deliver and capitalize on market opportunities. I expect that to continue in the long run.
The ongoing trend of cloud adoption and digital transformation provides ZS with a significant growth opportunity. As organizations continue to migrate to cloud-based infrastructure, the need for robust cloud security becomes crucial, and ZS's cloud-native platform positions it well to address this demand.
Furthermore, ZS's value proposition of cost savings, ROI optimization, and disruption of legacy networking infrastructure adds to its appeal. Jay Chaudhry, founder and CEO of ZS, understood the importance of that and is very focused on these elements, which in my opinion is crucial in terms of differentiation.
Finally, the company's strong financial performance, expanding customer base, and alignment with market trends make it an even more attractive investment option in my view.
I initiate on ZS with a Strong Buy rating and a TP of $185.
For further details see:
My Cybersecurity Top Pick: Zscaler, Revolutionizing The Landscape Of Cybersecurity