Zscaler - A Rising Star In The Growing Cyber Security Universe?

About: Zscaler, Inc. (ZS)
by: Güner Soysal

The digital transformation just begins which opens huge potential for cyber security companies in general.

Zscaler offers innovative cloud security products with high customer satisfaction and accelerating growth rates.

Zscaler is a growth company with a high valuation but even higher growth potential.

1. Introduction

We are in the middle of a digital transformation, which is leading to structural changes in the world of business and everyday life. New challenges and opportunities such as cloud computing, mobility and the Internet of Things require new information security solutions, especially in the corporate world.

While in the past the company's own data centers and servers were the core of the companies that needed to be protected against external threats, nowadays the digital transformation and increasing outsourcing of data and applications to the cloud (e.g. Microsoft Azure, Amazon Web Services, Google Cloud Platform) require new requirements for the protection and access of company data. These are challenges such as:

  • security,
  • reliability,
  • data access at any time and from anywhere,
  • cost efficiency,
  • data transmission speed and
  • ease of use.

In this context, companies such as Zscaler (ZS) come into play. In particular, they offer companies security solutions tailored to the cloud (keyword: 'cloud security').

Old World vs. New World. Source: Zscaler IPO prospectus

Although Cyber Security is a fast growing market, for various reasons I did not have any shares from this sector in my portfolio so far. But then an IT specialist I knew, who works for a large listed and global company, drew my attention to Zscaler. Zscaler was introduced to his company and he was impressed with Zscaler's security solution. So I put Zscaler on the watchlist and put it out of my mind because I had other favorites on the list at the time.

On February 28th I received a push notification from Seeking Alpha with the quarterly results from Zscaler. Wall Street's expectations were beaten. So I looked at the results and the notes of my friend again and did something I don't do normally. I bought the company's shares after trading, even though they had already risen by 15% by that time. On the following day, the share price rose by around 23%. But what was it that impressed me so much that I put the shares directly in my portfolio?

Let's take a look at what Zscaler has to offer. In this context, I look at Zscaler's business model, growth, fundamentals, valuation, opportunities and risks.

2. What is Zscaler?

Zscaler claims to be the largest cloud-based software-as-a-service platform with over 100 data centers spread across six continents. In addition, the company would have more than 2,800 global customers, with a focus on larger companies, of which over 200 are Forbes Global 2000 (e.g. Siemens, Schneider Electric, General Electric, Engie). Zscaler currently has over 950 employees and representative offices in New York, Washington, D.C., Australia, France, Germany, India, Ireland, the Netherlands, Singapore and the United Kingdom.

Zscaler's logo. Source: Zscaler

The company was founded in 2008 in Silicon Valley and is led by founder and CEO Jay Chaudhry. Jay Chaudhry owns approximately 22% of the shares according to the 2018 financial statements. The entire board of directors of Zscaler owns approximately 60% of the shares.

Zscaler provides a cloud security platform that routes all traffic through Zscaler software to apply corporate and security policies (e.g., specific employee access rights), eliminating the need for a variety of hardware and software solutions that were used in the past. At the same time, Zscaler helps its customers securely migrate data to the cloud.

This saves organizations the significant time, complexity and cost they would normally spend implementing and monitoring their network and data security (e.g., hardware, software, IT staff, own data centers, web filtering management, firewall, data leakage protection, SSL inspection).

Using Zscaler's Cloud Security solution requires two things: the Zscaler App and certain software connectors that are attached to each server location. Once the corporate and security policies have been set in the system, Zscaler's Cloud Security solution does the rest. Access is provided via the Zscaler app. It ensures that only authorized employees have access to the corresponding applications in the cloud or on the company's internal server and that no unauthorized third party interventions can take place on internal company data or applications (a corresponding product demonstration can be called up here).

The following chart illustrates Zscaler's Cloud Security solution:

Zscaler's Cloud Security. Source: Zscaler Zscaler Cloud Security. Source: Zscaler

Zscaler went public on 16 March 2018 at an IPO price of $16. The share price more than doubled on the issue date, closing the day at $33. The share closed at $60.54 on Friday and has therefore almost quadrupled since the IPO.

The following chart illustrates the price development of the Zscaler share since its IPO:

Zscaler share price performance since its IPO on 16 March 2018. Source: YCharts

Why the share price has risen so rapidly becomes clearer in the next section.

3. Growth

Revenues in the final quarter (Q2 2019) rose 65.2% year on year to $74.3 million. What is impressive is that the company is recording accelerating sales growth. Sales growth was 58.8% in Q1 2019 and 45% in Q4 2018.

For fiscal 2019, the company issued guidance of $289 million to $291 million. This would represent revenue growth of at least 52% compared to fiscal 2018.

The following chart illustrates Zscaler's annual revenue growth:

Source: Morningstar

Two other key indicators to measure the success of software-as-a-service companies are Billings and Deferred Revenue. Deferred revenue refers to payments invoiced and received that cannot yet be recognized as revenue because the service has not yet been provided or is due. This is the case, for example, when services are paid for on an annual basis in advance (invoicing on an annual basis is Zscaler's standard procedure). Billings are the services invoiced within the corresponding billing period.

Also in these two cases, Zscaler is experiencing impressive and accelerating growth. Billings rose 74% year-on-year to $115 million. Deferred revenue increased 73% to $206 million, which could be seen as an indication of accelerating revenue growth in future periods.

In addition, despite the impressive revenue growth, ZScaler is profitable on a non-GAAP basis for the second quarter in a row (i.e. excluding, among other things, the inclusion of stock-based compensation, which does not impact cash flow). The GAAP loss was halved from $0.06 to $0.03 compared to the previous quarter. The projections for the coming quarter and fiscal year 2019 also provide for minimum non-GAAP earnings per share.

It is further impressive to note that Zscaler is also improving its gross margin as it grows, which in turn may support a highly scalable business model. Gross margin has improved from 73.13% to 80.18% over the past four years (see chart below).

Source: Morningstar

The gross margin is therefore better than for other "high flyers", such as Shopify (SHOP) (55.6%), The Trade Desk (TTD) (76.1%), Square (SQ) (39.5%) and MongoDB (MDB) (72.3%), regardless of industry classification. Symantec (SYMC) (78.7%) and Palo Alto Networks (PANW) (71.6%) also have a lower gross margin as direct competitors in the cyber security sector, although these companies are currently much larger than Zscaler.

From a qualitative point of view, the CEO spoke in the earnings call about the fact that further top-class customers were acquired across all sectors in the past quarter. Among other things, he spoke of a bank with 100,000 employees that was dissatisfied with the performance of the former Internet security partner and an automobile manufacturer from the Fortune Global 500 (i.e. the 500 companies with the highest revenue in the world). In addition, Zscaler would have outsmarted a potential customer due to its more innovative solution (see following excerpt).

CEO Jay Chaudhry at the earnings call on Zscaler's competitive advantages. Source: Earnings Call Transcript

4. Fundamental situation

In terms of the company's balance sheet quality, it is striking that Zscaler had a debt-free balance sheet as at 31 January 2019 with cash and short-term investments of around $340 million. Cash and cash equivalents account for approximately 65% of assets and have a better ratio of cash and cash equivalents to assets than Facebook (FB), for example. In my opinion, Facebook also has a very high balance sheet quality (see following figure).

Cash and cash equivalents vs. assets as at 31 January 2019. Source: Zscaler Q2 2019 Earnings Report.

With regard to cash flow, it can be stated that the company generated a positive free cash flow in the last quarter and in the last six months. On the one hand, this suggests that the business is scalable and that free cash flow could increase with increasing sales. On the other hand, it could be concluded that Zscaler could finance its growth organically thanks to its comfortable cash situation and potentially increasing cash flow (see following figure).

Free cash flow as at 31 January 2019. Source: Zscaler Q2 2019 Earnings Report.

5. Valuation

In terms of valuation, it makes sense to draw a comparison with other software-as-a-service providers. As already mentioned, Zscaler is not yet profitable on a GAAP basis. For this reason, I draw the comparison based on revenue with companies that have a similar level of revenue or a maximum of $1 billion in revenue (see figure below).

With regard to the price/sales ratio, it is noticeable that Zscaler is very generously valued in a peer group comparison. While the peer group has a price/sales ratio of 13 to 16, Zscaler's price/sales ratio is just under 26 (see figure below).

An additional consideration of the enterprise value-to-revenue ratio also does not change the valuation ratios (in addition to market capitalization, enterprise value also takes into account the debt and cash holdings of the company; see the following figure).

However, it should be noted at this point that Zscaler's revenue growth is also exceptionally high compared to the peer group. While Zscaler's revenue growth is 65% quarter-on-quarter, the peer group's figures are below 60%. Only Twilio (TWLO) can stand out with a growth rate of just under 77%. The graph also illustrates Zscaler's accelerating revenue growth, as evidenced by the steep blue line (see figure below).

6. Opportunities and Risks

As already mentioned at the beginning, we are only in the early stages of digital transformation. According to the Gartner Magic Quadrant Report 2016, Cloud Services have grown 35% per year over the past five years. According to an article in Forbes, cloud computing is expected to grow at a rate of around 30% per year to $264 billion by 2027. This would give Zscaler the potential to grow disproportionately in the tailwind of cloud computing (see figure below).

Source: Forbes.

In addition, Zscaler is partnering with market leaders such as Microsoft and Amazon, enabling the company to take advantage of their monopoly position in customer acquisition (it is worth noting that other cloud security companies are also partnering with these two companies).

In addition, Internet of Things ('IoT') is another potential growth market for Zscaler and Cyber Security in general. According to another article in Forbes, the IoT market is expected to double to up to $520 billion by 2021. In addition to smartphones, tablets and computers, cars, motorcycles, bicycles and household appliances will increasingly be networked with the Internet and data centers, which will require additional security measures. Taking Zscaler's "mobile first" strategy into account, there is tremendous potential in this area as well, provided the company remains innovative and invests in its growth.

Despite the high peer group valuation, an investment in Zscaler could also be rewarding due to takeover speculation. Companies such as Microsoft, Amazon and Google are increasingly expanding their cloud security portfolio. With a market capitalization of just $7.5 billion, Zscaler would be an easy takeover target for these companies.

7. Conclusion

'In this business, if you’re good, you’re right six times out of ten.You’re never going to be right nine times out of ten.'– Peter Lynch

First of all, what impressed me most at Zscaler was the accelerating growth and simplicity of the product in a highly complex area like Cyber Security.

I visually compare Zscaler's solution with the departure at the airport. Passengers have to be checked at baggage screening, passport control, body scanner and the last check-in before departure. From a company's point of view, this process requires high costs for software, hardware and staff. Zscaler's solution enables companies to reduce these costs by eliminating many of these steps. Passengers also benefit from this solution because they enter the airport, check in once and then look forward to their flight.

The high level of customer satisfaction and ease of use means that customers remain loyal to the company and new customers can be acquired easily. On Zscaler's homepage there are testimonials from customers (e.g. Siemens, Schneider Electric) who praise the ease of use, simplicity and cost savings.

Second, Zscaler has a high balance sheet quality, generates a positive free cash flow despite the high growth, and is profitable on a non-GAAP basis. In addition, it is noticeable that the gross margin is improving despite the strong growth, which speaks for a highly scalable business model. With increasing growth, the company could therefore also operate profitably on a GAAP basis in the near future.

Thirdly, I like the fact that Zscaler is led by the founder and CEO who owns more than 22% of the Zscaler shares. As a result, he has an increased interest in the company's success. He is also an experienced cyber security manager, having previously founded and managed several cyber security companies. In addition, he appeared to be very skilled and capable in the earnings call and in various videos.

A handicap of investing in Zscaler is its high valuation. On the other hand, quality and growth have their price. I think it's better to pay a little too high a price for a good company than to buy a company without growth (and growth potential) at a supposedly low price. There are plenty of examples of companies that are currently plummeting on the stock market in this context.

Since Zscaler is a growth stock with a high growth rate, volatility is to be expected. For example, profit taking, analysts' comments, news from competitors or a slowdown in growth can lead to stronger fluctuations from time to time.

In summary, Zscaler is still a small fish in a potentially very large pond, the extent of which cannot yet be quantified at the present time. Cloud computing, mobility and IoT are growth markets in whose tailwind Zscaler can grow. Innovations and the development of new business areas could also promote growth. For example, who would have expected that Netflix would change from a DVD provider to a streaming provider? Or Amazon would transform into a cloud services provider?

Disclosure: I am/we are long ZS, FB, TTD, TWLO, ZEN, SQ, MDB. 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.