Zscaler: Valuation Seems A Bit Excessive Heading Into Earnings

About: Zscaler, Inc. (ZS)
by: Individual Investing Ideas

Revenue growth in Q2 was 65%, which actually accelerated from 59% in the previous quarter.

Management's guidance for Q3 revenue growth of 50-52% growth seems beatable in addition to a profitable quarter.

Despite being a great long-term hold, the stock seems to be a bit excessive with high expectations heading into earnings.

Zscaler (ZS) continues to be one of the higher-valued security names in the market and rightly so. They reported another very strong Q2 earnings report in late February, with revenue growing 65% y/y, an increase from 59% growth in Q1. In addition, ZS also posted EPS of $0.09, which beat consensus estimates for a loss of $0.01. It is remarkable for a company this young and growing this fast to already demonstrate the ability to turn a profit in addition to a massive acceleration in revenue.

ZS promptly traded up over 20% following its Q2 earnings and continued to tread along at a high-teens forward revenue valuation. However, after the strong Q2 performance and pop in stock price, it becomes a little more challenging to justify building a position at these levels. I am confident in the long-term viability of the company and shareholders should be rightfully rewarded for holding onto their positions.

Chart Data by YCharts

Since going public back a year ago in March at $16 a share, ZS has quickly amassed an impressive 4x return. The forward revenue multiple has bounced around from low double digits to over 20x, which is well above the average for comparable SaaS-based companies with similar growth rates. The recent Q2 report reinforces the long-term bull thesis surrounding ZS, however, with a valuation near all-time highs and investors already baking in another beat and raise quarter for Q3, I would be a bit cautious around this name for now.

Q2 Earnings and Guidance

ZS offers two main products, Zscaler Internet Access (ZIA) and Zscaler Private Access (ZPA). ZIA essentially is a secure internet and web gateway solution enabling customers the ability to use the internet through ZS in a fully secure way. ZPA provides customers with remote access to internal applications running on the cloud of a data center, with the applications never being exposed directly to the internet (Company website).

After Q1 earnings, ZS was trading at ~19x forward revenue, which was very pricey considering its growth characteristics and relative valuation compared to other fast-growing SaaS peers. Investors who were able to back up the truck on shares a few months ago when they were trading in the low-$30s have already been rewarded nearly 2x.

Moving into Q2, ZS reported revenue growth of 65%, an acceleration from 59% y/y revenue growth in Q1 and ~51% revenue growth in FY18. Revenue for the quarter beat consensus estimates by ~12%, a very impressive feat. Even more impressive was the billings growth of 74%, which accelerated from 56% in Q1. Billings remain one of the best indicators for the health of the company given ZS's near 100% SaaS-based model. Billings growth remains very healthy and saw a significant acceleration as well as being above revenue growth, which demonstrates continued revenue streams in the next few quarters.

Source: Company Presentation

The long-term growth opportunity is clearly present and Q2 growth rates reinforced this thesis. The company's ability to accelerate revenues from Q1 to Q2 is a testament to its potential market share power. Since the company operates in a largely untapped market and has the advantage of being the only pure cloud-based security provider, ZS has the ability to rapidly increase revenues by expanding its customer base.

ZS also retained its clean balance sheet, with total cash of $67 million and no debt. This balance sheet gives ZS a lot of flexibility in terms of future growth potential either organically or through accretive acquisitions.

For example, in August, ZS acquired TrustPath, an artificial intelligence and machine-learning technology security company. This acquisition will look to "derive intelligence from transactions processed by the cloud to identify anomalous traffic, build user behavioral profiles, compute enterprise risk posture, and detect sophisticated targeted attacks as they emerge" (Source: Company Presentation). In essence, this acquisition will use both AI and ML to improve the efficiency and predictive powers of its cloud-based security solutions.

Source: Company Presentation

Gross margin continued to remain above 80% and operating margin improved from a 4% loss last year to positive 13% for this year. This is impressive given revenue and billings both experienced significant acceleration in the quarter. Typically, when a company accelerates revenue, this comes at the cost of lower operating margins in the form of higher R&D and S&M expenses.

In addition, ZS reported its fourth consecutive quarter of positive FCF with a margin of 16%, improving from a 10% loss in the year-ago period. As the company continues to scale and management is able to better control its expenses, we should continue to see FCF to increase. According to the software Rule of 40, ZS's 65% revenue growth and 16% free cash flow margin for Q1 resulted in a score of 81, a very exceptional score.

Source: Company Presentation

Q3 revenue guidance of $74-75 million remains somewhat conservative and implies a 50-52% growth (compared to the Q2 growth of 65%), and EPS of $0.01 appears achievable given the past two quarters of positive bottom line. I believe the company will be able to beat their revenue guidance for the quarter and will likely raise guidance for the full year. For the full year, revenue guidance of $289-291 million (was raised from $268-272 million) largely reflects the strong Q2 beat. The full-year guidance is also likely to be raised by a similar amount as the potential Q3 revenue beat. Management is likely to remain conservative of revenue growth given how fast the company is growing.


The challenging part of this name is valuation. I have been very skeptical at times because of their valuation and just when I think valuation has stretched a bit too far, ZS beats the quarter, raises guidance, and watches their multiple expand. However, I think this time it is a different story. It is very challenging to find any company with scale in the market trading at a multiple comparable to ZS.

They continue to have a significant long-term opportunity to massively disrupt the cloud-based security market, beating legacy players such as Cisco (CSCO) and Symantec (SYMC). Over the long term, ZS will become a must-own security name with investors willing to pay up for its value. How much investors will be willing to pay up for the name will always be a difficult question to answer.

Comparing ZS's valuation to other security companies is largely unfair due to its much higher growth rate and disruption ability. For this reason, I used other fast-growing SaaS-based companies. My selected peer group includes Atlassian (TEAM), Okta (OKTA), ServiceNow (NOW), Workday (WDAY), Twilio (TWLO), and Zendesk (ZEN). All of these names have revenue growth rates of 25%+ and trade at premium revenue multiples compared to the market.

Chart Data by YCharts

However, even in my quest to find the highest revenue multiple companies in the market, I could not find one at scale that has a multiple in the same zip code as ZS. The company trades at nearly a 7 turn premium to TEAM, the closest peer in the above chart.

The average forward revenue multiple of the above peer group is ~15x, well below ZS. To calculate ZS's revenue multiple, I assumed the midpoint of management's FY19 revenue guidance range of $289-291 million. With a current price of ~$68, this implies a market cap of ~$8.4 billion. The net cash balance of $67 million results in an enterprise value of ~$8.3 billion, resulting in an FY19 revenue multiple of ~29x (different than the chart above because ZS is not on a calendar fiscal year basis).

Even if we were to expand their revenue growth out another year and use a FY20 revenue growth of 40%, this would result in ~$400 million of revenue in FY20 and a revenue multiple of ~21x. Essentially, this means investors are more comfortable paying for FY20 revenue number for ZS (albeit, my $400 million estimate could be conservative) than a FY19 revenue number for the above peer group.

Investors are very bullish around the name, especially in the past few weeks. The valuation chart above clearly shows the revenue multiple expanding significantly after their recent earnings. Heading into Q3 earnings, I would be a bit cautious picking up shares at these levels. I think investors are expecting another large beat for the quarter and another guidance raise.

Over the long term, I continue to believe ZS will maintain its leadership position and will grow market share in the cloud-based security industry. Its SaaS operating model will continue to drive a premium valuation and superior growth rate and improving free cash flow margins demonstrate the strength and potential profitability of the company.

However, after the big run-up in Q2 and sentiment remaining very bullish around the name, ZS seems to have been a safe-haven heading into the quarter where investors put their money in a very strong growth name. Other names in the security software space have not fared as well as ZS, which has caused the multiples to diverge a bit more. Even with a beat and raise quarter, it is challenging to believe the multiple will expand to north of 30x.

Risks to ZS include competition from new players or legacy security providers. Its revenue multiple also poses a risk as these fast-growing names typically correct the most when the market begins to turn.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.