June 7, 2018 10:40 AM GMT Morgan Stanley: "Zscaler Inc 3Q18 Results: Sprinting Out of the Gate"
[admittedly, some of the sections below are a bit tricky to read, but this is the best I could do]
Billings up 73% YoY and margins up 920 bps YoY for ZS's first
Q as a public company likely well exceeded already high
expectations. Forward ests move higher but leave room for
beat/raise, particularly in light of ZS's growing mkt
momentum. Increase PT to $31.
WHAT'S
CHANGED
Zscaler Inc (ZS.O) From To
Price Target $26.00 $31.00
Very Strong Start as a Public Co. ZS's first public earnings delivered a big beat
across all growth metrics, with upside flowing through and driving margins
significantly above expectations. Billings came in at $54.7M vs. us at $44.6M,
delivering growth of 73% YoY. Even normalizing for higher contract durations,
short-term billings growth of 61% YoY accelerated from 47% last Q. With a net
retention rate of 120%, ZS is benefiting from dual drivers of growth: 1) strong
customer adds given a favorable competitive positioning, particularly amongst
the legacy web proxy appliance vendors; and 2) strong upsells/cross-sells into
the base, with enterprises looking to consolidate security spend, particularly in
cloud-based and/or subscription models like Zscaler's. These trends likely
continue for the next few years, which will likely prove our forward revenue
estimates (30% CAGR through FY20) as too low. Top-line upside in FQ3 flowed
through to operating income / FCF, highlighting the inherent leverage in the
model. We raise our PT from $26 to $31 on higher estimates and a recognition
that investors will pay for growth, but with ZS at ~14x CY19 revenue, we're
awaiting a more attractive entry point.
What We Liked:
Zscaler Inc ( ZS.O, ZS US )
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Billings Growth Accelerates. ZS posted FQ3 billings of $54.7M, +73% YoY,
an acceleration from 49% YoY in FQ2. Management noted slightly longer
contract durations which illustrates that customers are making long term
bets on ZS. However, short-term billings (ex-LT deferred) accelerated as
well up 61% YoY vs. 47% last Q. Management noted a solid net retention
rate at 120% (vs. 122% last Q), with the ARR of enterprise customers (3K
seats) at "a little over 300K" in FQ3, up from "high 200K" in FQ2.
Gross Margins Improve. ZS' gross margins came in at 81.2%, up 210 bps
YoY, with the company seeing leverage from greater scale in its cloud
1
What We'll Be Watching:
Estimates Move Higher for FY18 and Beyond. Given better than expected Q1
performance, we raise our FY18/FY19 revenue estimate from $179M/$230M to
$185M/$246M. Our FY20 revenue numbers also move up by 6.6%. We now look
for FY19 billings of $296M, +26% vs. prior of $275M. We see upside to our FY19
billings estimate, which implies new billings per productive sales rep down
meaningfully (-36% YoY). Better than expected profitability in Q1 also drives our
op margin estimates higher by ~680bps in FY18/ FY19/FY20 and now have ZS
reaching operating margin profitability in FY20.
Raising our Price Target. Higher top-line and profitability raises our longer term
FCF estimates, with our CY28 FCF estimates moving from $244M to $293M. Our
base case moves from $18 to $31 on the back of higher estimates as well as a
higher multiple (30x CY28 FCF vs. prior of 21x) to account for our greater
conviction in the scale and durability of ZS's LT growth profile. This multiple is at
a premium to the average of large cap software at 23.5x FCF, but in line with the
average of growing subscription-based large cap software names at 30x FCF. As
such, our Price Target now moves in line with our base case at $31 (vs. prior PT of
$26). Our PT of $31 implies 13.5x EV/CY19e Sales and 0.39x growth adjusted, a
premium to SaaS security peer average at 0.34x that we think is appropriate
given conservatism in estimates.
platform.
Operating Income / FCF Profitability Upside: FQ3 operating income was
($2.9M), $6.4M ahead of our estimate to and well ahead of the $3.4M
upside to our revenue estimate. This drove operating margins of -5.9%, well
ahead of our estimate of -20.3% and up 920 bps YoY. Upside in billings
and strong expense discipline drove material upside to FCF with FQ3 FCF at
$3.7M vs. our model at ($13.2M).
Tougher Comp Ahead. Management noted a difficult billings comp coming
up in Q4 with several large deals in Q417. As a result, we expect billings
growth to decelerate in FQ4, which may be a first blush disappointment.
We look for FQ4 billings of $71.8M, +30% YoY, which leaves room for the
more difficult compare.
Pocket of Sales Leadership. As announced on May 2, 2018, former COO
William Welch resigned from the company effective May 14, 2018. Solid
FQ3 results suggests his departure is likely unrelated to ZS' fundamentals.
However, the position remains unfilled, with management noting it is
currently interviewing replacements. While we believe CEO Jay Chaudhry is
actively involved in the management of the sales organization, he will need
to delegate this responsibility in order to effectively scale. This pocket of
sales leadership as well as the risk around changes with a replacement
could drive disruption. However, management noted strong regional sales
leaders which mitigates the disruption risk.
2
Price Target $31
Bull $44
Base $31
Bear $11
Investment Thesis
Compelling growth name. Zscaler has
emerged as one of the most compelling
secular growth stories in security software.
The company's cloud-based security platform
is well positioned in light of modern
computing architectures, which have enabled
rapid share gain in its core web security
market with expansion opportunities to
capture the broader $18B in annual network
security spending. This sets up a long runway
of sustainable 25%+ growth for the next
several years, in our view, with attractive unit
economics supporting 20%+ operating
margins long-term.
Most upside already priced in. While we
are optimistic about the long-term growth
potential, we believe ZS' valuation well
reflects this outlook. ZS trades at 13.5X
EV/CY19 Sales and 0.39x on a growthadjusted
basis, a premium to security peer
group average of 0.38X, which we believe
already reflects model conservatism and
optimism around the sustainability of growth.
We See Shares Trading Between our Base
and Bull cases or $31, reflecting an attractive
business model (100% SaaS), faster revenue
growth and room for upside in our near-term
estimates. Our Price Target of $31 implies a
premium to EV/sales/growth multiples of
SaaS security peers (0.34X), which we think is
warranted given greater room for positive
revisions at ZS.
Key Value Drivers
Faster than expected share gain in broader
network security market
Higher net dollar Retention from existing
customers expanding to higher value bundles
Improving sales productivity as new sales
hires ramp
Potential Catalysts
4Q18 Earnings
Risks to Achieving Price Target
Upside risks: Accelerating customer adds;
greater than expected traction with its
Premium Valuation Justified by Premium Growth Trajectory
$31.00 (+1%)
$30.65
$11.00 (-64%)
$44.00 (+44%)
0
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20
25
30
35
40
45
50
Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19
$
WARNINGDONOTEDIT_RRS4RL~ZS.O~ Price Target (Jun-19) Historical Stock Performance Current Stock Price
Source: Thomson Reuters, Morgan Stanley Research
In line with our base case.
30X Bull Case CY28 FCF of $436M
Next Gen Network Security Platform. Zscaler garners a leading market position
within web security and captures more of the full network security stack (~$18B
in annual spend today). This drives revenue CAGR of 26% through CY28, with
operating margin expanding to 20% on greater revenue scale. Applying a 30x
multiple to our estimated CY28 FCF of $436M yields our bull case DCF value of
$44, after discounting back at 9.9% WACC. This multiple is in line with the
fastest growing large cap enterprise software platforms, including TEAM, CRM,
NOW, VEEV and WDAY.
30X Base Case CY28 FCF of $293M
Next Gen Web Security and Beyond. With less than 2% TAM penetration today,
our base case DCF for Zscaler assumes that the company is able to garner ~6%
share of estimated $23B in market spend by CY28 (~$18B today), implying a
20% CAGR over the next 10 years to reach revenue of $1.4B in CY28. Attractive
unit economics drive op margins from (14%) in CY17 to +21% in CY28e and FCF of
$293M. Applying a 30X EV/FCF multiple against our CY28 estimate and
discounting back at 9.9% drives our $23 Base Case. This multiple is in-line with
the average of growing large cap enterprise software platforms, including
TEAM, CRM, NOW, VEEV and WDAY.
15X Bear Case CY28 FCF of $194M
Niche Web Security Replacement. Zscaler faces intensifying competition from
legacy web security vendors like Blue Coat and Cisco, while the company's
efforts to expand meaningfully in network security fail to materialize. Growth
slows faster than expected, to 16% rev CAGR through CY28, with margin
expansion is less than hoped given limited operating scale, and Zscaler exits
CY28 with 18% operating margin. Given the lower growth profile, ZS trades at
15x EV/FCF in CY28, yielding a $11 share price in CY19, assuming 9.9% discount
rate, with a multiple in-line with the median of security software peer group.
3
Transformational suites which includes the
replacement of network firewalls; faster than
expected traction with ZPA; a pick up in the
pace of M&A activity in the software and/or
cybersecurity space.
Downside risks: Execution risk as the
company grows at a very fast pace, slower
customer adds with limited traction in selling
into higher end enterprises, including the
government; increased competition from
legacy vendors as their cloud-based solutions
mature; limited traction in extending its
solution beyond web gateway replacements;
higher spending due to greater competition; a
negative outcome in patent litigation up to
and including an enjoinment, most notably
with Symantec.
4
Analysis
Exhibit 1: Model Changes
Source: Thomson Reuters, Company Data, Morgan Stanley Research Estimates
Exhibit 2: FQ3 Billings Came in at $55M, +73% YoY, 23% Ahead of our Estimate and an
Acceleration from 49% YoY in FQ2
Source: Company Data, Morgan Stanley Research Estimates
5
Exhibit 3: Our FY18/FY19/FY20 Estimates Move Higher by ~7% But Still Remain Conservative,
with 33% Revenue Growth in FY19, 26% YoY in FY20
Source: Company Data, Morgan Stanley Research Estimate
6
Financials
Exhibit 4: ZS Income Statement
Source: Company Data, Morgan Stanley Research Estimates
7
Exhibit 5: ZS Revenue Drivers
Source: Company Data, Morgan Stanley Research Estimates
Exhibit 6: ZS Balance Sheet
Source: Company Data, Morgan Stanley Research Estimates
8
Exhibit 7: ZS Cash Flow
Source: Company Data, Morgan Stanley Research Estimates
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