2023-07-13 11:14:54 ET
Summary
- Zscaler is a $21.50 billion market cap global cloud security company that anticipated the rise of cloud adoption and mobility and recognized the need for a new approach to network security.
- Despite significant revenue growth, the company has incurred net losses since its inception. But ZS's TTM measured net loss started to reverse lately.
- The CEO Jay Chaudhry noted that Zscaler refined its go-to-market process, engaging with C-level executives earlier and providing more meaningful ROI cost savings justifications.
- Investors are overpaying for ZS stock today compared even to CrowdStrike.
- The market loves to overreact to different things, and in this particular case, it looks like there was an overreaction in Zscaler's EPS forecasts. Many risks are not priced-in.
The Company
Zscaler, Inc. ( ZS ), now a $21.50-billion market cap global cloud security company founded in 2007, anticipated the rise of cloud adoption and mobility and recognized the need for a new approach to network security. They offer 2 main solutions: Zscaler Internet Access, which provides secure access to externally managed applications for users, workloads, IoT, and OT devices; and Zscaler Private Access, which enables access to managed applications hosted internally in data centers or public/private clouds. The company also provides Zscaler Digital Experience, a tool for measuring and scoring user experience across business applications.
They generate revenue primarily through subscriptions to their cloud platform, along with support services. The subscription pricing is typically based on a per-user basis, and the revenue is recognized evenly over the contract duration, usually one to three years. Zscaler has expanded its operations to over 6,700 customers across various industries in 185 countries, serving government agencies and many of the world's largest enterprises.
Despite significant revenue growth, the company has incurred net losses since its inception. For the nine months ended April 30, 2023, their revenue was $1,161.9 million, while their net loss was $171.7 million. But ZS's TTM measured net loss started to reverse lately:
In terms of revenue growth, ZS has few equals - over the last 4 fiscal years, revenue has grown at a CAGR of ~37.75%. In the last quarter, GAAP margins are down slightly, but due to growing sales volume, we see gross profit expanding ~45.14% YoY [Q3 FY23 vs Q3 FY22], while GAAP operating income is up almost 135% YoY. So the GAAP EBIT margin was reduced from negative 30% last year to just -13% in Q3 FY23, which is good news.
In general, Q3 FY23 can be seen as very successful for the company - in fact, all key operating and financial metrics that the market had expected were exceeded with a good margin:
During the latest Global Technology Conference held by Bank of America, the CEO Jay Chaudhry noted that Zscaler refined its go-to-market process, engaging with C-level executives earlier and providing more meaningful ROI cost savings justifications. This approach resulted in better outcomes and a record pipeline.
Chaudhry emphasized that Zscaler's high-touch sales process, involving C-level, CFO-level, and CTO-level engagements, differs from traditional box security companies.
Management sees the addressable market at $72 billion in June 2023, while opportunities for market expansion appear even greater:
The main problem, in my opinion, is the relatively long duration of the mastery of this TAM. What do I mean by this?
Zscaler currently has a valuation of $21.5 billion on TTM revenue of $1.48 billion and is still posting GAAP losses. Growth investors might argue that a P/S of 13.50x for next year is OK when revenue is growing so fast, and I agree. But the market sees it the same way:
Wall Street analysts believe that Zscaler's EPS will grow at a CAGR of ~27.16% over the next 10 years, which of course may be true, but as you can see from the table above, there are no significant drawdowns in the momentum of this assumed growth.
The same is true for projected revenue growth - according to the same analysts, ZS will continue to grow its revenue at a CAGR of ~20.9% annually over the next 10 years.
Do not get me wrong - I do not doubt that the company can grow that fast. But these projections look like ZS has no risks given the competition, market penetration, maturity of the business cycle, and macroeconomic pressures on clients' budgets.
Just a few days ago, Morgan Stanley analysts noted this discrepancy in their brief note [proprietary source] on the cybersecurity sector. They pointed out that the EPS guidance currently priced in by the market for ZS may prove to be too optimistic, especially taking into account the conservatism of ZS's management team.
The Valuation
Again, it is hard to judge whether Zscaler is overvalued or not because its multiples are mostly forward-looking or revenue-based:
If we do a comparative analysis, we will find that ZS seems to be a rather generously valued company, to say the least:
One way to assess the reasonableness of ZS's valuation given the longevity of Mr. Market's priced-in assumptions is to look at future EBITDA growth. YCharts data shows that the consensus expects EBITDA growth of ~38.1% in FY25, roughly in line with CrowdStrike ( CRWD ) and less than Cloudflare ( NET ):
But does it make sense to overpay 20x forward earnings for a company that should only achieve 1.8% more in EBITDA growth in 2 years? So if you look at ZS from this perspective, it turns out that the company is trading at a noticeable premium to most other peers.
The Bottom Line
I like the cybersecurity industry as a whole because it's set to expand by one of the most significant CAGRs in the overall economy. But this is known to all. That's why it's very important to separate the business of cybersecurity companies from their stocks.
Zscaler obviously looks like one of the favorites in its niche. Q3 FY23 showed noticeable growth that exceeded all expectations. Shortly thereafter, the Q3 success was extrapolated to Q4 and beyond, as we can clearly see from the EPS positive revisions. This means that ZS has much less potential to surprise its investors in the coming years. It will take at least another 5-7 years for the company to grow out of its current valuation with consistent top-line growth rates and margin expansion. So far, this is the case - but what will happen to these projections if cheaper solutions come to market or fierce competition forces the company to lower its pricing? What about market saturation?
The market loves to overreact to different things, and in this particular case, it looks like there was an overreaction in EPS forecasts. This has inflated the valuation of the company compared to some similarly-growing companies in the industry.
For that reason, I like the company, but I do not like the stock. Zscaler stock is anything but a Buy, as it could disappoint investors with Q4 FY23 guidance and further EPS revisions from Wall Street.
Thank you for reading!
For further details see:
Zscaler Stock Is Far From Buy