Zscaler: A Clear Leader
Sep. 24, 2018 1:31 AM ET
About: Zscaler (ZS), Includes: SYMC
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Summary
Zscaler is a leader in the web-gate security market.
The company's stock has stagnated even though its last quarter's performance was sublime.
Zscaler is an expensive company, but its competitive positioning warrants the premium valuation.
Investment Thesis Zscaler (NASDAQ: ZS) reported one of the best quarters I’ve ever seen, and the stock’s response has been rather muted. Therefore, the valuation has become more tolerable.
Introduction This article will be a look at Zscaler’s latest quarter and its competitive positioning. If you want more of the nitty-gritty business model, see here.
In short, Zscaler’s software allows people to connect directly to applications and the internet rather than a network. Gone are the days of logging into a VPN - Zscaler has done away with those. This decreases complexity and costs and increases security. Seems like a pretty good value proposition.
Disrupting Firewalls The late Phil Fisher, author of the book Common Stocks and Uncommon Profits, was a legendary growth investor. He had a checklist of 15 points that he used to narrow down companies he wanted to look at. The first of these 15 points is the company must have a market big enough to grow into for many years. Zscaler definitely checks this box. The company estimates a TAM of $71 billion, since it seeks to replace perimeter security appliances.
Seeing as its revenue was less than $200 million for the past twelve months, it looks like Zscaler will not run out of market anytime soon.
Limited Competition Not only does the company have a sizable market, it also doesn’t have a whole lot of competition. If you check out the Gartner report, you can see that there are only two companies placed in the leader quadrant. It’s one of the loneliest Magic Quadrants out there.
(Source: Gartner 2017)
Of course, in this context, lonely is good. But you can see how Symantec (NASDAQ: SYMC) became a leader - it acquired Blue Coat. Below is the Magic Quadrant for two years ago.
(Source: Gartner 2016)
Symantec bought Blue Coat in June 2016 for $4.6 billion. Interestingly enough, that is right around where Zscaler’s enterprise value is today. That may or may not be a coincidence, but it seemingly does give investors a backstop, knowing that Zscaler may at least be that valuable.
So here we are, two years later, and one might assume that Symantec is firing on all cylinders. Well, not so fast. According to last quarter’s press release, the company’s revenue decreased 5%. Yes, decreased. Of course, it has more products than just Blue Coat’s, but that dynamic creates a conflict of interest. Symantec’s business includes a lot of network appliances, which Zscaler is successfully disrupting. It would take a massive effort for Symantec to pivot to cloud-only products.
One interesting note in the Symantec earnings call was how its management talked about winning a big deal against a cloud-only competitor (definitely Zscaler). The CEO said this customer went with Symantec because of its hybrid architecture. I am not convinced that this space will work like hyperconverged infrastructure (HCI), where the hybrid cloud has become so pervasive. If cybersecurity is cheaper in the cloud, the industry will head in that direction.
So this seems to be one of the main points of contention. Will a hybrid structure win out? Let me put it this way, what is more valuable, AWS (NASDAQ: AMZN) or Nutanix (NASDAQ: NTNX)? Nutanix might be best of breed, but there is no denying the power of a cloud-native platform. Hopefully, Zscaler will be the AWS to Symantec’s Nutanix.
Incredible Quarter With all that said, the proof is in the pudding. And Zscaler’s pudding is delicious.
Gross margins stayed pretty still at 79%, while billings shot up 72%, or 74% sequentially on a very tough comp. Deferred revenue grew 70%, while free cash flow went from -14% in the fourth quarter of last year to 21% of revenue this year - a 35% improvement.
Moreover, non-GAAP net losses shrank from -20% of revenue to -4%. The CFO even commented how he and the CEO, Jay Chaudhry, are two of the most frugal people out there after an analyst asked about potential profitability. That’s important because it signals how much demand there is in the market. On the last two earnings calls, the CEO noted how “the market is coming to us.”
One thing I was a little worried about was how the expansion rate decreased year over year, from 121% to 117%. It’s not that big of a deal, but fortunately, management commented on it. They said that this quarter, the company saw customers start with bigger, more expensive transformation bundles, including implementation of ZPA, where people can connect directly to applications. This is what has led to such strong billings and deferred revenue growth.
Another thing that may have worried investors was the conservative guidance. The company’s 2019 revenue growth estimate was 34% - a big deceleration from 54% in the latest quarter. However, management noted that Zscaler has a backlog of $398 million, of which 53% will be recognized as revenue. This means the company is already guaranteed to have $211 million in 2019 revenue. To hit its guidance, only $44 million in additional revenue is needed. It would be surprising if that target was not easily attained.
Risks and Valuation Right now, it seems like Zscaler’s market to lose, judging by its lead. Therefore, the real risk is overpaying. As evidence, the company's great quarter has pretty much left the stock price unchanged after a couple weeks of wild undulation.
Using management’s conservative estimates, Zscaler could have $255 million in revenues for 2019. Today’s market cap is about $4.7 billion, and the company has $300 million in cash on the books. This results in just over 17x sales. This is still not cheap by any means, but it is a testament to how strongly the market believes in its competitive positioning.
Of course, there are always other risks, like a recession which could limit IT spending, but we can’t control those things. All we can do is take a good hard look at a company and its prospects and then make strategic investments, keeping in mind the opportunity costs.
To End I’m constantly torn between crawling back to my value investing roots after growing up on Buffett and Howard Marks and believing in the power of technology and how it is so hard to value these hypergrowth stocks. In the end, if there is too much priced into a stock, no matter how great business performance is, the stock price will stagnate.
At the same time, Zscaler is no ordinary company. It virtually owns this huge market, and it checks all the boxes I look for. I recommend buying shares or starting a position if you haven’t.
Author’s Note: Please scroll up and hit the big, orange "Follow" button so you can get these articles before they hit the paywall. Thanks so much for your time, it will never be taken for granted. Have yourself a fantastic day and happy investing! Check out my links in the profile as well if you want even more.
Disclosure: I am/we are long ZS, NTNX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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