2023-03-28 18:56:08 ET
Summary
- Zscaler shares fell sharply in the wake of a recent quarterly report that featured a noticeable deceleration in billings growth.
- The company did actually beat revenue and earnings metrics for the quarter, and raised its forecast for those categories for the balance of the fiscal year.
- Concerns that legacy vendors in the cyber-security space are encroaching on ZS and limiting its share in the zero trust market are overblown.
- ZS continues to have technology advantages that resonate with large and sophisticated users.
- Its security platform now has 4 pillars and an increasing number of users are opting for larger, multi-product ZS deployments.
Zscaler - Still a dominant player in the world of Zero Trust Internet Access
There is an old saying about March coming in like a lion - which is not meant to compliment the weather at the start of the month. The corollary to the saying is that the month is supposed to go out like a lamb. Certainly the reaction to Zscaler’s ( ZS ) latest earnings, which were announced on March 2nd clearly qualify for lion status, and the reaction of the shares was as unpleasant as dealing with a March blizzard. I have owned Zscaler shares years now; my reaction to the earnings report and the share price slide was to increase the size of my position. And I think investors in high growth IT shares should do the same. The noise from the quarter was deafening; the actual change in the business outlook indicated by the quarter was equivalent to the squeak of a mouse.
I have started writing this article in the wake of the latest Fed meeting and interest rate decision. The fact is that Zscaler shares spent that day, and many other days, reacting to opinions about the latest rate setting decision and the perceived hawkishness of the Fed chairman during his subsequent press conference. Zscaler shares are not going to achieve sustained appreciation and improved valuations until investor focus on Fed speakers, pivots, inflation outlooks and a variety of other concerns outside the scope of the company's actual business outlook wanes.
I continue to be surprised that investors believe that Fed speakers will announce a pivot in some credible way before it happens. The Fed, as currently constituted, has proven to be a reactive, and not proactive body. It also exists in a global context, and has to account for somewhat different inflation dynamics in different economies. The board, and its chairman, pointedly noted that the potential exists for the latest banking crisis to have significant negative economic effects, but effects that are not precisely knowable at this point. It is hard for me to imagine that the impacts of this latest banking crisis won't, at least on some level, impact some decisions about capex amongst some companies, at least at the margin. And software purchases are usually considered capex. Zscaler, in particular, has another month until its quarter ends. But this article is not particularly about playing Zscaler shares because they might exceed very conservative guidance, and produce upsides on at least EPS and free cash flow compared to expectations.
Chairman Jay Powell took a hawkish tone with regards to future rates, saying that there was no discussion of a pivot during the meeting. That impacted most stocks, and that included the shares of ZS - at least on Wednesday afternoon before reversing direction the next day. As the week ends, the stability of Deutsche Bank is now under scrutiny. It hasn’t been suggested that the bank, Germany’s largest by some measures, and the 21 st largest in the world, needs a bailout, but the cost of default insurance has spiked significantly. Just how this turmoil in financial markets impacts global business in general, and the business of ZS specifically, is not really knowable at this point. Certainly when the board of the Fed confesses uncertainty and doubt, it probably doesn’t make too much sense for me to claim special insight on the subject. I am guessing that until the stability of the global financial system is accepted, there will be some, although not substantial pressure on global growth.
While there has been almost daily volatility in the market for high growth IT shares, and of course that includes ZS, overall, the valuation of the shares has descended to below average for its growth cohort, and relative to the Rule of 40 analysis. Of course, while I can’t buy every jiggle in the share price, these dips do afford investors attractive entry points. This is an article about the longer term prospects for Zscaler, and not an article that attempts to figure out how to trade the very volatile shares.
This also is not an article that tries to forecast in advance, when Fed governors believe an interest rate pivot is appropriate. They will do so, I imagine, after, and not before, employment trends become visibly negative, and after and not before signs of economic growth consistently under attain. Whether that happens in April, or May or June is not something I will even try to forecast, and thus, I won’t try to forecast the timing on when Zscaler’s valuation starts to return to what I believe are reasonable values.
It’s been bit a bit more than 6 months since I last wrote about Zscaler shares for Seeking Alpha. I thought the shares were on sale then. I guess I didn’t get the memo that the sale would be going on for longer and at lower prices than I had expected. Zscaler shares have done notably worse in performance since that time falling by more than 26% while the (HACK) cyber security ETF has gained about 4% while the (WCLD) ETF has gained about 7%.
The reason for the underperformance is simple. The company’s latest earnings report was regarded as an indication that the company’s ability to withstand macro headwinds was waning and that competitors, particularly, Palo Alto ( PANW ) and perhaps Fortinet ( FTNT ) were catching up in terms of their zero trust architecture. Of course ZS shares have been considered as highly valued for many years, based on an elevated EV/S ratio that has been justified by hyper-growth and lately strongly rising profitability metrics. So any indication that percentage growth was being challenged, and that the company’s competitive position was under siege has had the potential to eviscerate valuations. And indeed, the combination of a sector whose immunity to macro headwinds is less than expected, coupled with the possibility of competitive displacement in what remains a risk-off market environment, has proven to be toxic and has left the shares at a valuation less than average for its growth cohort for the first since I first started following the shares and built a model.
I almost never try to hang recommendations on quarterly earnings reports - and certainly not on a calculated 2 nd tier metric. I have owned various amounts of Zscaler shares for years, and I expect I will continue to do so for some time into the future. When I see a quarterly results which I believe to have been misread bringing on significant valuation contraction, I regard it as an opportunity. But this article doesn’t suggest that Zscaler’s calculated billings, the alleged culprit in the reaction of the shares to the earnings release, will come roaring back to substantially above consensus growth in the next quarter or two.
In my opinion, as I expressed in my prior article, calculated billings is simply not a metric that is of considerable value in forecasting forward revenue growth metrics for this company. It does have a correlation with free cash flow in a given quarter; it really doesn’t have huge value as a forecasting tool. That said, the sequential increase in billings was 45%, certainly not overly disappointing, One analyst said that the beat was not of the magnitude normally expected by shareholders. I will leave that thought unaddressed for now; investors can be fickle in how they evaluate beats. I would be more inclined to look at RPO balances, basically the company’s backlog. The RPO balance grew by 44% last quarter year on year, and slightly more of it was current than in the prior quarter. The company doesn't provide ARR data which is the most objective measure of actual sales performance in a given quarter - it would be helpful to stakeholders if it starts to focus on providing insight into that metric.
Is Zscaler losing its competitive mojo?
That is basically the heart of the negative case being made about the shares at this point. The issue is that Palo Alto, and to a lesser extent Fortinet appear to be growing the parts of their solutions that compete directly against Zscaler at higher rates. It can be a little treacherous to disentangle that kind of assertion.
Before discussing some of the specifics of these assertions, I want to establish a baseline. Last quarter, Zscaler revenues rose by 52%. It is forecasting revenue growth of 38% next quarter, and 32% in the quarter after that. Palo Alto revenues rose by 26% last quarter, and its current projection s are for revenue growth of 23.5% this quarter, and 25.7% in the following quarter.
Fortinet grew its revenues by 33% last quarter and is forecasting growth of 26% and 24% over the next two quarters. As a further bit of complexity, Palo Alto and Fortinet sell hardware as part of their overall offering; ZS does not. Because those companies sell hardware, headline results in terms of percentage revenue growth can see more variability and cyclicality than is the case for companies with a pure subscription revenue model. Hardware revenues are recognized upfront while subscription revenues of course are recognized when billed. While many industry observers believe that the hardware involved with next generation firewalls is likely to become less relevant in the cyber security paradigm, lately both Fortinet and Palo Alto have gotten a growth boost from strong demand for NGFW solutions.
On the face of it, therefore, it might seem that the relative position of Zscaler, even after considering the current demand for NXGF, is set to deteriorate. But things are not nearly so straightforward, and the thesis that Zscaler is seeing a deterioration in relative advantage in the zero trust space is more a chimera than real. And thus, the CEO responded to questions about the company’s competitive position as follows:
In terms of competitive positioning, we haven't really seen any change. In fact, I would say that on the higher end of the market, we actually feel like we are stronger than even before because we have established that. We actually have the right architecture, right solution with thousands of customers well deployed and very happy customers.
In fact, the other thing we are beginning to see that some of the solutions that are sold by firewall vendors and SASE solutions, and when customers can deploy them, they’re falling apart. I have been asked many times in the past two years, hey, are you replacing some of our firewall-based solutions? Answer I used to give is, I haven't seen very many out there, now beginning to see some of them. The large retailer I mentioned on my call with 20,000 stores tried for over 18 months to deploy a firewall-based SASE solution, so to speak, and eventually gave up, and we are really taking care of it.
There is obviously some noise these days with regards to Zscaler billings and comparison to PANW billings growth. But I think in looking at the specifics of customer engagement, Zscaler’s positioning hasn’t deteriorated and is probably better right now than was the case one year ago. Not everyone buys cyber security solutions based on architecture, and not everyone will wind up believing that they need to have multi-tenant architecture in order to satisfy their requirements for scalability and performance. But the share price of ZS suggests that at least at some level, investors believe that the company no longer has the leadership position in the Zero Trust space, and I believe that is not supported by the preponderance of the evidence.
Zscaler these days is far from a one trick pony. It offers 4 major product types; Zscaler Internet Access ; Zscaler Private Access , Zscaler Digital Experience, and Zscaler Posture Control. The specific competitive issue is basically between ZIA and the comparable product from Palo Alto, Prisma Access. Is Prisma better than ZIA and is it growing faster. I own shares of PANW and ZS; they are different companies in terms of their growth outlook and likely financial performance. So, I have no pre-set mindset. I have linked here to the Gartner competitive evaluation between the two offerings. Not much to choose from, according to this evaluation, really. Ultimately, choice is one of architecture, I believe.
I don’t suggest that I am the leading authority on SASE (Secure Access Service Edge) which is generally how these products are described. I am going to oversimplify things here, and for that I apologize to some subscribers/readers, but this is a subject that is complex, and often that complexity isn’t going to help readers optimize their investment in the cyber security space. But simply put, ZIA is based on a multi-tenant architecture, and Prisma is not. And that has implications in terms of scalability and performance that are significant for some buyers. To an extent, Zscaler was the pioneer vendor in terms of bringing a Zero Trust Architecture into the mainstream. I have linked here to a description of what zero trust is all about.
These days, the subject of cyber security has grown increasingly complex and the details require an inordinate amount of concentrated study to completely understand. Rather than try to utilize my limited expertise on the subject, I think it is better to look at the following quote from the ZS CEO, Jay Chaudhry, in the latest conference call that outlines his take on the architectural differences and advantages offered by ZS compared to the other high-profile zero trust vendors.
We have expanded our business value team to collaborate with customers to create CFO-ready business cases with clear ROI and payback periods that facilitate necessary deal approvals.
In today’s environment, customers can’t afford to risk their mission-critical projects with immature offerings from unproven vendors. We’re starting to see deal wins from customers who initially purchased a single tenant SASE solution from their incumbent firewall vendor that failed to deliver in the real world. These customers were misguided by their flawed message: Keep on buying my boxes and use my so-called cloud service when your users are on the road or in a branch office. A single-tenant architecture, whether deployed as appliances or as virtual machines spun up in a public cloud, will not allow enterprises to fully realize the benefits of secure digital transformation. Every customer we’ve won has lots of firewalls in their data centers; but when it comes to Zero Trust security and digital transformation, they are choosing Zscaler because of our multi-tenant cloud architecture that scales and delivers business agility. Our Zero Trust Exchange is the largest in-line security cloud in the world, processing over 280 billion transactions and preventing 9 billion security and policy violations per day. This massive amount of traffic provides us with more than 300 trillion signals per day to feed our machine learning and AI engines for better detection of user and application traffic anomalies, resulting in superior threat protection.
While the issue of billings, and so called ramp deals often are a focus for investors, the most significant debate for long term investors really is market share. I commented in a recent article on a different company, Trade Desk (TTD), that I simply will not recommend stocks if companies aren’t gaining share. In this environment, share is crucial because it buffers macro headwinds. So, here is another answer by the company CEO regarding competition, and market share opportunities.
Gabriela Borges
Yes. Essentially, do you -- you're competing for today, are you getting any signs of feedback from customers saying, we know you're best of breed, but we're not going to prioritize you?
Jay Chaudhry
Yes. Our customers are not looking for best-of-breed point products. They're looking for best-of-breed platform with the right architecture. We can tell you if -- when you talk to the low end of the market, they can live with some of the solutions that are kind of half way. But, when you talk about Global 2000, these customers are generally pretty savvy. The requirements are complicated. And we believe the best architecture will win in the long term
Of course part of the conference call script is meant as a commercial - it would be a surprise if a conference call script wasn’t put together with a view of presenting a company’s technology in a positive light. That said, some parts of script are more or less indisputable. All of the customers ZS has won do have many firewalls, and have had them for years. ZS sells to enterprise customers for the most part, and those customers all have had incumbent cyber security vendors who have to be displaced if ZS makes a sale to a new name account. And these days all of the competitors do have some form of zero trust solutions. So, when ZS wins, it has to displace vendors with firewalls who all offer zero trust solutions and to do that it has to offer performance advantages, and advantages in terms of flexibility and scalability. The fact that Zscaler has been able to achieve so many and such substantial competitive displacements is a significant proof point supporting the company’s architectural advantages for the largest and most performance sensitive users.
Palo Alto, of course, addresses competition differently. It isn’t focused on architecture, but it is focused on vendor consolidation. I think this quote from the latest conference call basically encapsulates the current PANW strategy.
In other cases, we're helping customers adopt SASE and software firewalls, and consolidate their security stack across our consistent set of offerings, driven by hybrid work and securing SaaS apps. A financial service firm recently signed an eight figure deal with us, because they wanted to transform their network and reduce both operational challenges and cost of ownership. They chose us over pure play SASE competitors, because of the breadth of our offering in our comprehensive Zero Trust network.
These days, one of the priorities of the ZS sales motion is to sell large enterprises bundles that it describes as Zscaler for Users . Zscaler for Users includes 3 of the ZS pillars, ZIA, ZPA and ZDX. Zscaler has leveraged its technology quite successfully to sell its users more substantial deployments that include most of the components of a solution. The latest set of security functionality offered by Zscaler is what is described as workload protection . For those interested in the details of what workload protection is all about I have provided a link above.
Workload protection for ZS is a move into an adjacency. It includes elements of identity management and elements of observability as part of the solution, but it is not intended to replace either of those solutions. I expect that over time, it will turn into a significant growth driver for the company.
What did Zscaler report at the start of the month? - Discussing Zscaler’s ramp transactions
Zscaler has had a long track record of beat and raise quarters, and the quarter reported at the start of March, despite the share price reaction was no exception. The company had forecast Q2 revenues of $365 million, non-GAAP income from operations of $43 million, and non-GAAP EPS of $.30. The actual numbers for the period were revenues of $388 million, a beat of 6%, non-GAAP operating income of $49 million, and non-GAAP EPS of $.37. Calculated billings for the quarter $494 million. That was 34% growth, but expectations had been for a larger beat.
The company basically raised all of the metrics regarding revenues and earnings that it forecasts. At the end of the prior quarter, it had forecast full year revenues to reach $1.53 billion, with calculated billings of $1.935 billion. The company is now forecasting full year revenues of $1.56 billion, or a bit more than the sum of the Q1 beat + the prior forecast. The company is now forecasting full year billings of $1,945 million, a modest increase from the prior full year billings forecast of $1.94 billion.
The company had forecast full year non-GAAP income from operations of $180 million, with non-GAAP EPS of $1.24. It is now forecasting non-GAAP income from operations of $215 million and non GAAP EPS of $1.53. The company doesn’t forecast cash flow metrics. Through the first 6 months of the year, the company’s operating cash flow margin was 29%, compared to 29% in the prior year. The issue with billings is most visible in terms of operating cash flow performance. The increase in deferred revenues fell from $130 million to $91 million in the last 6 months, and was $76 million vs. $112 million last quarter. Most of the company’s growth in cash flow is because its GAAP loss has declined noticeably; given that trend, and what the company has forecast, I am estimating that ZS will have a free cash flow margin of 28% in the current fiscal year. That yields a Rule of 40 metric of around 60. The company is forecasting that its capex, mainly a function of investment in expanding its data center capacity will be in the high single digits percent of revenue for the full year, significantly greater than the prior year and above the rates seen so far in fiscal 2024.
Why is this decline in percentage billings growth happening, and what does it mean for the outlook?
The company CEO explained the issue this way.
With macro concerns weighing on business leaders, more organizations are being cautious and measured about their spending. In January, we saw a higher scrutiny on budgets compared to December, resulting in additional delays in large deals. These deals haven't gone away, and customers are taking longer to make decisions and requiring additional approvals. In select instances where timing of budgets was a hurdle for new customers, we enabled them to ramp into larger subscription commitments. These strategic deals lowered our first-year billings, but will grow into a higher annual run-rate level in the second year. We typically have some ramped deals each quarter, but in Q2, the impact of ramped deals on our billings was higher. These ramped deals position us to expand the customer relationship over time to create long-term value.
As we enter the second half of fiscal 23, we are expecting customer cautiousness to continue. We have accounted for further lengthening of sale cycles and the uncertain timing of large deals in our outlook. Even though our current pipeline has grown and has more mature deals, we are assuming a slight deterioration in close rates.
Zscaler sells large deals to enterprise customers. Some of its deals are amongst the largest in enterprise software. For example, even in the environment of the last quarter, Zscaler closed a 400k seat deal. That kind of a deal would typically be for $10+ million of new ARR. There are large deals, they are getting done, but they take longer to do, and many customers want to “chunk” deals by contracting for a deployment ramp that impacts year 1 billings and leads to greater billings thereafter. These ramped deals are based on contractual commitments.
These days, as mentioned, Zscaler has 4 main pillars in its offerings, and the preponderance of its customers are choosing at least two of these offerings. It is often the case that users deploy these modules serially rather than all at once. The company has offered ramp alternatives for large deployments for several years. The proportion of ramp transactions increased moderately last quarter and apparently reduced reported calculated billings by 200-400 bps. But adjusted for these ramp transactions, the growth in calculated billings was roughly comparable between fiscal Q1 and fiscal Q2.
Overall, the company is forecasting a slightly greater than normal decline in billings in Q3, by about 9% sequentially compared to an historical average of 6%, The company is also forecasting billings growth of 46%-48% sequentially in Q4, more or less in line with the historical average.
This is a recessionary environment for IT purchases and has been for some time. Essentially all IT vendors are feeling the cold macro headwinds. It is harder to sell large deals to new customers, and even installed customers want to expand their deployments at a more measured cadence. The fact that this is happening to Zscaler is neither surprising nor alarming. What might be surprising to some is that the company has been demonstrating an ability to improve margins as percentage growth has moved to a lower level.
Taking a look at Zscaler’s business model - it is improving quite rapidly
Like more than a few other high growth IT companies, ZS has chosen a strategy in this period of stressed demand growth, to focus on improving operating margins as a priority. Given that the company is still growing at a rapid rate, it is a strategy that probably requires fewer sacrifices and trade-offs than is the case for other companies in the space with lower percentage revenue growth. That said, the company has announced a 3% layoff at the start of the quarter, although it is still hiring selectively for certain roles.
Zscaler does use stock based compensation, although the percentage level has declined noticeably as hiring has slowed. Last quarter, stock based comp was 29% of revenues, down from 41% of revenues in the year ago period. Stock based comp was flat sequentially. In computing valuation, I use the change in weighted average shares which is, in my opinion the real cost of stock based comp., rather than the calculated value shown in GAAP. The company has recently switched to “as if converted” method of calculating average shares, which adds the dilution from currently outstanding incentive awards and the shares that would be issued if the convertible notes are converted. Like most shareholders, I would love to see the convertible notes converted at the strike price of $151. Using the new methodology, outstanding shares rose by 0.3% sequentially. Based on that level of dilution, I have used 156 million outstanding shares outstanding over the next year, consistent with management’s forecast for that metric.
Last quarter, the combination of revenue growth above the company’s forecast and constrained expense growth led to a strong gain in non-GAAP operating margins. The company’s non-GAAP gross margins have ranged between 80%-81% over the last several quarters at this point.
Last quarter, the non-GAAP sales and marketing expense ratio was 46%, down from 50% in the year earlier period. On a sequential basis, non-GAAP sales and marketing expense rose by just more than 3%, while the sequential growth in revenues was 6%. There is obviously lots of room to whittle away at the sales and marketing expense ratio, and that is where much of the company’s increased operating margin target is likely to be realized.
Last quarter, non-GAAP research and development expense was 14.4% of revenue, compared to 15% of revenues in the prior year. On a sequential basis, non-GAAP research and development rose 14%. There probably is much improvement available in research and development expense ratios.
The General and Administrative expense ratio was 6.7% of revenue last quarter, up from 6.6% of revenue in the prior year period. On a sequential basis, non-GAAP general and administrative expense rose about 4%. While minor improvements in this ratio might be possible as ZS scales, it is not going to be a significant source of future margin expansion.
Overall, non-GAAP operating margins were 13% last quarter, compared to 9% in the prior year quarter. On a sequential basis, non-GAAP opex rose by a bit less than 5% last quarter. The company, as mentioned, announced a modest 3% layoff at the time of the conference call. Basically, the company guidance calls for a 2.5% increase in sequential revenues, and about a 1% decrease in operating expense. Last year, sequential revenues rose by 12.5% in this quarter. It seems likely, again based on the overall set of comments by the CFO, that the revenue forecast is more than typically conservative for this company, something seen almost universally amongst IT companies in the last couple of months, and reflects a continuing slowdown in estimated closure of large deals because of lower close rates from the pipeline, and more deal chunking as well. Despite these well-known headwinds from macro conditions, this appears to me to be a more than decent set-up for ZS to produce a significant earnings and cash flow beat .
The recent increase in short term rates, coupled with the healthy cash balance of ZS has had the impact of increasing its net interest income levels noticeably. Net interest income came to about $0.07/share last quarter, which was about 25% of the overall improvement in profitability the company achieved year on year.
As mentioned, mainly because of the strong improvement in profitability, the company’s operating cash flow margin was able to be maintained at 29%, despite the headwind from the decline in the growth of deferred revenues. Despite the impact of the so-called ramp deals, the increase in deferred revenue was still 42% of the company’s operating cash flow for the first half of the year (more than 100% in fiscal Q2). There will be a balancing act, as the company’s cash flow margin might be further pressured by a rising proportion of ramp deals in its sales mix, while the company sees further non-GAAP operating margin enhancements. The structure of the ramp deals is such that they will start to add to the growth in billings a year from now. Balance sheet items were a modest tailwind to operating cash flow margins last quarter.
The company’s balance sheet affords it the flexibility of making smaller, tuck-in acquisitions which seem likely given the dearth of VC financing now available for smaller point solution cyber security companies who have no realistic path to an IPO and would have to accept massive dilution to secure VC financing, if it is even available.
Wrapping up - Reiterating the case to buy Zscaler shares
Zscaler shares fell sharply in the wake of a beat/raise earnings report. The fall was precipitated for the most part by concerns that the company’s billings metric was not the normal size beat, and that the company only marginally raised its outlook for full year calculated billings. In turn, this data caused some analysts to opine that Zscaler’s leadership in providing zero-trust cyber security solutions was being successfully challenged by Palo Alto and possibly Fortinet who both have entries in the space.
I think just looking at specific growth projections for the next quarter or two is a vast oversimplification of the competitive state of play in the market. I think Zscaler continues to enjoy some specific advantages in terms of its architecture, which in turn have led it to provide users with more scalability and performance than its rivals. Of course, its rivals have the advantage of very broad cyber security platforms, and in this era of budget stringency, some users may elect to modernize their cyber security infrastructure with the largest platform vendor, consolidating all of their solutions from a single vendor.
It is highly unlikely that there is going to be a single winner and a flock of also-rans in the market for providing secure internet access. This is a huge market, currently said to be worth more than $70 billion, and its likely CAGR is well above 20%. I believe that both Palo Alto and Zscaler who are often compared are likely winners, and that group should also include Cloudflare (NET). But if I were making a fresh money buy today, and looking to maximize percentage returns over the next 12 months, and probably longer, ZS would be top of the bunch in my estimation based on the combination of growth opportunities, margin expansion and yes, current valuation.
In addition, Zscaler has significantly expanded the scope of its offering beyond providing secure internet access. Its offering is now based on 4 pillars, and most of its larger customers will buy at least two, and some will buy all. So, the competition between Zscaler and Palo Alto is far more nuanced then might be suggested by simply looking at forward revenue growth estimates for the next couple of quarters.
Much of the growth rate decline in Zscaler’s bookings has to do with what have been described as ramp deals. In these deals, users buy large deployments of ZS solutions, but phase the commitment over a couple of years. This decreased calculating billings last quarter, but will add to what is likely to be an increased level of bookings 12 months from now. These are contractual commitments, just ramped, rather than taken at a single point in time.
Despite the slowdown in revenue growth in this environment of extreme macro headwinds blowing in the overall IT space, and a gentler zephyr impacting demand for advanced cybersecurity solutions for the internet, Zscaler is growing margins significantly. Indeed, the company’s mantra for as long as I can remember is that it would emphasize margin growth in environments during which its growth moderates. The company announced a layoff at the time of its last earnings release, and it had been moderating expense growth for the last couple of quarters before that. It is now forecasting a 2.5% sequential growth in revenues coupled with a 1% decline in sequential opex. That is a set-up for another quarter of exceeding prior estimates by a significant level.
Zscaler, along with its other highly valued peers in the IT space, is not likely to show sustained appreciation until a risk-on sentiment becomes pervasive and sustained. Despite some rallies based on particular economic metrics, and the dialogue of Fed speakers, that hasn’t happened yet.
But Zscaler’s valuation metrics have improved significantly on a relative basis, and are at the most attractive levels since the company went public more than 5 years ago. Currently, the EV/S ratio for 12 month forward revenues is about 9.2X. Not cheap on a relative basis, but far cheaper. Because of the rapid growth in the company’s free cash flow margin, since the first time since the company has been public, and since I have been tracking this kind of metric, ZS shares are valued below average when considering the combination of growth and free cash flow margins. ZS, based on the current consensus data, has a Rule of 40 metric in the mid-50-60 range, and that is likely to expand in any kind of economic recovery scenario.
It is not often to be able to invest in a category leader - indeed a category leader in one of the most important categories - at a below average valuation. While the next months are likely to be bumpy for many IT companies as the possible impact from the latest banking crisis percolates through the economy, I think ZS shares are ones that make sense when looking to invest in winners as the economy emerges from macro headwinds. While I am not looking for raised guidance any time in the near-term, I believe that margin gains will support the current valuation, and growth will substantially reaccelerate in a less toxic environment. I think the shares will produce substantial positive alpha over the next year.
For further details see:
Zscaler: The Leader In The Internet Security Pack