Summary
- I initiate Zscaler with a neutral rating based on rich valuations but, in my view, the long-term prospects and competitive positioning of the company looks strong.
- The company can pull multiple levers to manage growth and profitability.
- Near-term, there will be increasing budget scrutiny, but its deal velocity remains resilient.
- Zscaler's multiple pillars and emerging products are also registering strong growth as demand continues to be solid.
- My target price is $160, implying 13% upside from current levels.
Investment thesis
I initiate Zscaler ( ZS ) with a neutral rating mainly on rich valuations in an uncertain market in the near-term, but I like the company's long-term prospects and competitive positioning. Zscaler, in my view, is in the top tier of growth software companies as it looks set to continue to operate above the Rule of 40 as it benefits from strong margins and growth. With its strong competitive position as a leader in the Security Service Edge segment, as well as a large addressable market and the flexibility to use multiple levers to manage both growth and profitability, the company looks set in the long-term. My target price is $160, implying 13% upside from current levels.
Overview
Zscaler is a cybersecurity company incorporated in 2007 that pioneered what it calls the Zscaler Zero Trust Exchange, its very own cloud platform. It leverages on the cloud to bring new value add to traditional perimeter security methods and the company pioneered a unique way to securely connect devices, users and applications using business policies rather than the network. With the use of Zscaler's Zero Trust Exchange, this will help its customer eliminate the need for traditional on-premises security appliances. These are typically tough to maintain and have compromises that needs to be made with the user experience, cost and security.
Zscaler's platform, the Zero Trust Exchange, has 3 core products that helps its customers to connect and secure users, workloads as well as Internet of Things or Operational Technology devices. First, there is " Zscaler for Users ", which uses Zscaler Private Access ("ZPA") for users to have Zero Trust Network Access to internally hosted applications regardless of the location, network or device, while Zscaler Internet Access ("ZIA") helps users access the internet, including SaaS applications securely and reliably. Second, there is " Zscaler for Workloads " that secures workloads and provides secure and fast app-to-internet using ZIA and app-to-app using ZPA. Lastly, there is "Zscaler for IoT/OT", helping to lower cyberattack risks and data loss while providing zero trust security for connected IoT and OT devices.
Increasing budget scrutiny while deal velocity remains resilient
Management mentioned that there was more budget scrutiny in the recent quarter. This resulted in their business being more backend loaded. I think that management is embedding this higher level of budget scrutiny into their guidance for 2023. Furthermore, I think that the higher level of budget scrutiny is warranted given what we are seeing with the uncertain macroeconomic environment. That said, I would expect Zscaler to continue to see strong demand for its offerings as the higher valuation it commands today is only justified if this strong demand persists in uncertain macroeconomic conditions.
That said, deal velocity for the recent quarter remained resilient as Zscaler was still able to close large multi-year, multi-product pillar deals in the quarter helped by its business value assessments. These business value assessments continue to support the case for Zscaler's platform with the strong return on investment profile with it often reaching above 200% as it brings value in improving cost, risk and productivity. As Zscaler uses more business value assessments for contracts it is negotiating, the deal velocity could continue to remain resilient even as budget scrutiny continues to persist.
Multiple levers to balance growth and profitability
For the full-year 2023 fiscal year, Zscaler expects revenue to grow at 37% year on year while billings to grow between 30% to 31%. Implied operating profit margins are around 12% based on the $173 million to $176 million operating profit expected for the fiscal year. With the full-year revenue guidance, there has likely been conservatism incorporated into the guidance for FY2023 as budgets will mostly be set in the second half of the fiscal year.
Zscaler has multiple levers to pull to balance both growth and profitability by altering its investment framework respectively. When pursuing high growth, the priority will be to invest in the business. As such when Zscaler is growing revenue faster than 30%, there will be less than 300 basis points of margin expansion in the year. However, when the company sees an uncertain and difficult macroeconomic environment, they have the flexibility to use multiple levers to prioritize operating profitability. The company remains confident in being able to achieve the long-term operating margins target of 20% to 22%.
For those wondering where they will be able to adjust to improve operating profitability in uncertain times, the picture below illustrates this clear. The company spent between 47% to 49% on sales and marketing in the past 4 years as it continued to produce strong growth in the business. This can be dialed down when the priority shifts from growth to profitability in more uncertain times.
Zscaler operating expenses structure (Zscaler investor presentation)
As a result, I like the opportunity that Zscaler has to use multiple levers to adjust the business as conditions change. It makes the business so much more flexible. With changing business conditions and uncertain times, the best companies are the ones that are able to move nimbly to balance profitability and growth.
Emerging products with strong growth
The company is executing well on its emerging products, Zscaler Digital Experience ("ZDX") and Zscaler Cloud Protection ("ZCP") as the two businesses made up almost 14% of new business in FY2022 and the company expects the contribution from these emerging businesses to be in the high teens.
According to my estimates, these 2 emerging businesses contributed almost 5% of revenues in FY2022 and that means that ZIA is still growing steadily at 50% growth rate. On the other hand, ZPA was 27% of the company's total new business in FY2022.
I think that all of Zscaler's pillars are positioned for strong growth given the large opportunity set available. With a serviceable market of $72 billion today, this comprises of a $49 billion user serviceable market and $23 billion serviceable addressable market for workloads, this presents ample opportunity for Zscaler to expand into and continue to grow.
Serviceable market of Zscaler (Zscaler investor presentation)
As long as Zscaler continues to expand its portfolio and innovate, it will continue to strengthen its leadership position in the Zero Trust security market.
Leadership position
According to Gartner Magic Quadrant, Zscaler is regarded as a leader in the Security Service Edge segment as it has a strong competitive advantage that puts it ahead of peers. The company continues to invest in a large sales organization, which has enabled it to grow revenues quickly by growing new customers at a rapid pace. Its market message is strong as it appeals to customers looking for a cloud-native security provider, further cementing its leadership position as customers frequently think of Zscaler for cloud-based options. Lastly, Zscaler brings a strong innovation track record and does not hesitate to innovate, thereby bringing advantages over competitors and being the first to roll out new products.
Gartner Magic Quadrant for Zscaler (Gartner Magic Quadrant)
Valuation
I expect that with the guidance given for FY2023, Zscaler is able to grow at a CAGR of 32% in the next 3 years. I use the EV/S/G ratio to value Zscaler, with a ratio of 0.4x assumed and an exit multiple of 10x FY2025 EV/S. My target price is $160, implying 13% upside from current levels.
I use a growth-adjusted EV/S ratio to my forecasts to generate the target price and this ratio accounts for qualitative factors like the quality of the company, competitive positioning, execution and profitability expansion. I think that a premium multiple is warranted given the company's strong competitive positioning and strong demand for its products. The company continues to maintain its status as a company being able to maintain its Rule of 40 standing as it continues to bring growth and FCF margin to the table. This puts Zscaler among the top tier of growth software names, further defending the premium valuation.
Risks
Rich valuation
With Zscaler trading at such a premium valuation, there is a risk that the stock sells off as a result of poorer execution or results than expected. With this risk, it could lead to multiple compression as the market prices in a lower multiple for Zscaler as it no longer warrants a premium multiple
Departure of executives
With the appointment of Dali Rajic in 2019, he brought accelerating business momentum into Zscaler and is seen as a key man for the business. If he were to leave, this could cause the markets to have reduced confidence in such a growth trajectory. Amit Sinha recently resigned as president and there is a risk that others may follow suit.
Competitive and pricing pressures
As a result of the gold rush phase for cloud workload protection, this could lead to the sector being competitive and increasingly fragmented. This could result in Zscaler having a lower pricing power and lower stickiness as there are increasingly more options available from other players.
Conclusion
Zscaler looks set to benefit from increasing cloud adoption as a cloud-based cybersecurity platform. As illustrated earlier in the article, the company is regarded as a leader in the Security Service Edge segment and has strong competitive advantages that ensure that peers are unable to compete meaningfully with it. The company has a strong addressable market that brings long-term opportunity for growth while being able to be flexible in managing both growth and profitability as it has multiple levers to do so. While the company faces near-term budget scrutiny, the deal velocity remains resilient and Zscaler looks set for continued strong growth in the future. My target price is $160, implying 13% upside from current levels. I initiate the stock with a neutral rating on valuation but I like the company given its strong long-term fundamentals.
For further details see:
Zscaler: Leaders Tend To Be Expensive