Zscaler's Beer Is Lots Colder Than Some Think

About: Zscaler, Inc. (ZS)
by: Bert Hochfeld

ZS reported its fiscal Q4 results earlier this week.

The guidance provided was considered disappointing and the shares-already down because of concerns about valuation and competition-declined an additional 20%.

ZS, now down about 43% from its high, has reached a valuation level (EV/S) just slightly above average for its growth cohort.

The company specifically refuted the aspersions that have been about its competitive positioning and results.

The company did voice a modest concern about the macro environment potentially impacting large deal sell cycles.

Zscaler - Was the quarter or the guide horrible?

In a single word: NO!

The sector rotation that got underway on July 26th has claimed another victim and created a great opportunity for investors. I don’t think I will try to reprise arguments concerning the rationality, the duration or the extent of that rotation. Nor will I try to evaluate the global economy. There are reports that attempt to tackle both issues on SA and in many other publications. This article is more or less focused on Zscaler (ZS)-although given the specific comments of the CEO about large deals and their possible slippage due to macro factors, I can’t avoid at least some comment regarding the specifics of that statement, and the possible meaning of what was said, or interpreted.

Zscaler is a name that has seen more than a bit of controversy since it went public a little more than a year ago. Only 5 of the 12 analysts who cover the name, recommend the shares-almost entirely a function of valuation concerns, although recently some analysts have expressed concerns about competition as well. Much, although not all, of the controversy has raged about its valuation and there has already been an article on SA suggesting that its valuation is still extended. I have been positive on the name, although a couple of months ago I did trim some of my position as its valuation, based on my EV/S analysis brought it above average for its growth rate.

At this point, and using Thursday's close, the shares are down about 43% since the high they made along with many IT names on July 26. The shares had been buffeted by a downgrade from the OTR brokerage followed by negative reaction to commentary from competitor Palo Alto coupled with sector rotation, and the combination of those 3 events took 31% from valuation using the 7/26 base. The shares are trading down another 20% in the wake of the earnings release.

The culprit, or so the headlines say, is weak guidance-or as I might suggest, guidance that was not as ebullient as some holders (and despite my trim, I am a holder) might have hoped or anticipated. I will discuss the specifics below, but in essence, the company guided in-line for revenue forecasting 34% growth and below the First Call consensus for EPS, forecasting $.12-$.15 compared to the prior consensus of $.19.

Zscaler reported the results of its fiscal Q4 and presented guidance for its fiscal year 2020 earlier this week. The results of the quarter that were reported were a noticeable beat in terms of both EPS and revenues. The growth of billings at 32% for the quarter had been forecast by the company and related to the bookings in Q4-2018 which were driven by one time $16.5 million booking from a single Federal order. The particular billing in question was a multi-year arrangement and there was no comparable transaction this year. Excluding that single transaction, the growth in billings was 58%. The growth in billings for one year payment terms was greater than 50%. Remaining performance obligation as reported grew by 39% to $554 million for the year. Similar to the billings number, the number for RPO was influenced by the one time transaction which added $26 million to the RPO balance in Q4-2018. Excluding that transaction, the RPO growth would have been 49%.

I don’t try to rush to judgement in the articles I prepare. Sometimes that kind of a rush precipitates some factual errors. Such indeed is the case with some of the brokerage reports, including one from a prominent firm, that I have parsed. It is unfortunate when leading firms report such wildly inaccurate data. In this case, the actual performance of apples to apples billings performance in the last quarter did not show the growth deterioration that has been headlined when making appropriate adjustments for one-time events. The company did not miss its billings target, and the quarter to quarter change in actual billings growth and the growth in RPO was quite small when adjusted for year-earlier one-time events. Billings growth was a bit slower than in the prior quarter, which in turn was stronger than the preceding quarter. These changes are typical of a smaller company which can and does sell larger deals to a few customers.

As it happens, the company did see some strong growth in its new customer count this past quarter. The company announced a new head of sales-filling a position that had been vacant for a considerable period. While no doubt, the new head of sales will bring his own twists and predilections to the selling motion, the results this past quarter do not suggest any broken sales model. I think it would be more difficult to sustain a bear case when having to acknowledge that ZS billings rose 50% last quarter. As with most commentary related to guidance, I think the slowdown forecast should best be taken with several large grains of salt.

The company reported that its dollar based net retention rate rose to 118%, slightly above prior levels. The CFO suggested that initial orders are running larger than in the past as the company sells a greater percentage of its Transformation Bundle (43% vs. 35% a year ago) which has a tendency to reduce that metric, one often studied by analysts.

The company hired a new president/CRO, Dali Rajic. Mr. Rajic was most recently the head of sales at AppDynamics before that company was sold to Cisco on the eve of its IPO. The company has been without a head of sales for some time. In the wake of this hire, the company marginally reduced 1st half bookings guidance, giving Mr. Rajic some breathing space to ramp up the sales engine. Part of the earnings guide-down relates to a stepped up cadence of sales and marketing expense in conjunction with Mr. Rajic’s hiring, and the hiring of some other VP positions in the sales organization. While I will explore the issues of guidance and expectations later in this article in a bit more detail, it would strike me that very few businesses would step up their investment in sales and marketing spend on a percentage basis and expect that the investment would not produce something positive in the way of sales growth.

Competitive Moats and Competition

Many headlines and some analysts have proclaimed that ZS has lost its competitive edge and that is why it produced what is considered to be mediocre guidance. I simply do not believe that this was the case or indeed that it will be the case. I do not propose to try to explain the advantages that ZS offers to its users in any great detail. I have linked to the Gartner Peer Access report for those interested, although the number of survey respondents is not large enough to be statistically valid. I have also linked to the latest Gartner MQ on the subject, although at this point, the study is 10 months in arrears and some people would say it doesn’t encompass the latest offerings from PANW. Should I interpose my own judgement into an evaluation. Simply put, there is a preponderance of straight-forward evidence that might suggest why ZS is winning, and will continue to win the market share struggle. against PANW.

At this point, ZS offers two services, ZIA which is the core of the company and is based on a secure web gateway and a cloud sandbox. The company also offers ZPA which is the company’s private access solution set. At this point, ZPA is about 14% of revenues and growing faster than ZIA. There is less controversy that ZPA really is a better solution than legacy VPN, so I will not focus on it. ZIA grew by more than 100% last year, and its growth cadence is likely to continue at that level because of its ability to replace VPN’s which typically do not offer a great user experience.

Within the broad security space, for many years, Palo Alto (PANW) has been considered to be the most dynamic force with many innovations to its credit. It dramatically disrupted the industry and overtook erstwhile leader Checkpoint (CHKP) along with a host of other cyber-security vendors. It pioneered NGFW technology. Its solution essentially involved the sale of appliance hardware to facilitate firewalls in many data centers operated by its customers. These days, it also offers a host of applications that run on those appliances. But to a greater or lesser extent, having firewalls as a first line of cybersecurity defense is no longer adequate in a cloud-centric environment.

The fact is, firewalls were never meant to try to encompass the complexity inherent in modern networks, and users very often are dealing with multiple vendors for different applications, and with architecture that is almost impossible to decipher. The ZS solution with its own data centers, and 100% inspection as well has produced better experiences for users, at least so far as I can determine.

I do not want to pretend to be an expert in cyber-security. There are almost certainly readers of this article who have professional skills with regards to that discipline. I do believe that this company’s CEO, Jay Chaudhry is well versed in the technology of cyber security-and is really one of the thought leaders of the industry. And I certainly believe that Gartner, while certainly not the end-all/be-all of consultants, has more than a bit of domain expertise. Gartner has produced a study which can be accessed on the ZS web site that discusses the evolution of cybersecurity from an appliance based security world to a world where security is in the cloud through what they describe as a Secure Access Service Edge.

When ZS initially reached some scale and became a public company, its principle market opportunity was that of competing when users developed new networks. In the past year or so, as the cloud continues to grow and users migrate legacy applications to the cloud, ZS has started to displace legacy installations-from vendors such as PANW but other security competitors as well. It is that phenomenon, I believe, that has lead to the rather abrasive commentary that PANW management has offered with regards to ZS.

Has PANW displaced some ZS applications as its CFO proclaimed at a recent analyst meeting? I won’t doubt that it has happened although I observe that the instances cited in the presentation that so impacted investors, showed ZS coexisting with other security vendors in the displaced installation. Many users have determined to reduce the number of vendors providing security solutions, and given the size of PANW it is not surprising that some of the displacements that they have reported most likely resulted from the desire of users to standardize on a single vendor regardless of the performance or ease of use factors. I once again would say that the churn reduction reported by ZS ought to put paid to competitive concerns.

For a variety of reasons, at this point PANW has not developed a grounds-up technology with which to compete against ZS. There are certainly ZS competitors out there and the Gartner MQ report lists some of them. But really, like many other larger legacy vendors with substantial installed bases, it has proven difficult for PANW to develop a strategy that does not strand its legacy users but offers acceptable performance for new networks.

Do I have the domain expertise to suggest that the appliances and the hybrid solutions that PANW is offering do not represent the leading edge of technology in this space? Not really. But the concept that is being sold is not one that resonates easily. The message of buying appliances but use a cloud service for remote and branch office applications is hard just to understand from a commonsense point of view.

In any event, it really doesn’t matter what I might think about the logic of competing services; either readers believe the CEO or not when it comes to his commentary about the performance of ZS last quarter in terms of competition. In the prepared script, the CEO talked about the fact that the competitive environment remaining favorable, with high win rates and a strong net dollar retention rate. And specifically, and despite the commentary from PANW’s CFO a couple of weeks ago, the CEO talked about a decline in customer churn both year on year, and quarter on quarter. It is hard to reconcile that specific fact with a deterioration in competitive positioning. And despite the downgrade by one brokerage (OTR) based on their “survey” of 14 channel partners, large system integrators continue to grow as a percentage of this company’s business with over 50% of revenue now coming from global service providers and integrators who apparently were not amongst the 14 survey respondents that precipitated the brokerage downgrade.

One area of contention relates to what is called proxy architecture. ZS uses it; PANW doesn’t. The conference call featured one set of queries on the subject-without debating the point, the answer of the ZS CEO and his examples on the part of users would seem to be dispositive. For the sake of clarity, here is the key part of the response of the ZS CEO with regards to this concern amongst some analysts:

“In fact, I know of a very large bank that has spent ten of millions of dollars on a next-gen firewall and deployed them all over. And this bank is still depending upon a proxy technology to inspect to clear traffic for threats. That's one piece. Two, if you look at any vendor, who is doing any meaningful thing even sitting in front of servers like Akamai’s of the world. They all have proxy-based technology because without proxy, you have little or no control. Lastly firewall, which is a pass-through device was a good thing before the SSL world when traffic was not encrypted. Today in most of the cases, 90 plus percent of the cases, it's SSL traffic, TLS traffic. Firewalls were never designed to inspect SSL, proxy technologies needed for SSL, if you really don't inspect the traffic, it is like your luggage passing through an airport inspection check post without inspecting. That's not a good thing. So I think. These statements are meaningless, they mislead customers, they give them false sense of security and do a disservice to the security industry.”

Investors shouldn’t really be committing funds to company’s whose CEO’s are not credible. There is nothing I really can add to this point beyond the comment of Mr. Chaudhry regarding the company’s competitive position:

“Yeah, if I may add, I mean as we compete out there, we almost win every deal, very low situations where we don't win. So very comfortable with our differentiated technology, very comfortable with our sales process [Indecipherable]. We just need to make sure we can keep on scaling it as we set our targets for bigger and bigger numbers.”

Win rates that are very high, declining churn and strong dollar based net retention-it sort of puts a spike in the argument that ZS is losing its competitive edge. When I try to evaluate companies, I do so by looking both at their reported numbers and guidance but also at their strategies and competitive position. I will discuss guidance, this company’s business model below, but when it comes to the opportunity, I more or less have to accept a credible management supported by the preponderance of the evidence at its face. I have seen many examples in IT where the David disrupts and ultimately upends the Goliath. It is hard not to see the parallels here and to focus on those opportunities as opposed to having what might seem to be a myopic view of traditional numbers.

Some thoughts on valuation

Is ZS valued at an appropriate price for investors? I think it is. There are many ways to approach valuation. The typical one seen in many brokerage reports is to construct some DPV model. In my experience as an analyst, I used such techniques on many occasions. I don’t like them since they are based on an assumed discount rate that is, of course, subject to change and require assumptions about terminal value that are almost always completely implausible. So, I rarely use price targets-and in valuing higher growth companies, I think price targets do investors far more harm than good.

In the wake of the quarterly numbers from ZS, essentially all analysts who cover the name reduced their price targets because the company is going to spend more money on operating expense, and that in turn reduces the free cash flow number that is part of most DPV formulas on valuation. To be sure, price targets are usually based on 12 months expectations-and I expect-and indeed strongly believe-that ZS will spend more money on opex, and have a lower free cash flow than that which was in many models before this earnings release. The price targets ratchet down by rote, almost without any qualification that spending more on opex usually results in faster growth in future periods-else why do it?

But the fact is, that if ZS can reclaim its growth status-and I believe it will-those price targets will go out the door and the share price will climb to valuations that will be decried by many. I prefer to use valuation expectations based on looking at EV/S vs. a trend-line based on growth and also incorporating an analysis of free cash flow vs. growth. Those measures are by no means perfect. The “fit” of the EV/S line only accounts for about 50% of the valuation differences between various IT names. In the wake of the earnings, and guidance, I obviously made adjustments, both to a 3 year growth rate projection, and the raw numbers to calculate the EV/S. I use a revenue expectation modestly greater than the consensus/guidance and I have reduced a 3 year growth expectation to 39%.

Using those inputs, ZS shares, which for some months had been huge outliers, are now close to the average in terms of valuation for growth rate indicia. Not a bargain, but not mispriced either.

So, why recommend the shares? The simple reason is that while credible 3 year growth expectations greater than 40% are not supportable based on the results and guidance, most investors and this writer believe that the technology on offer from ZS will continue to take market share from legacy vendors leading to many years of growth much greater than is forecast by the consensus.

Looking at it another way, ZS these days has an enterprise value of about $6.6 billion, and revenues have been forecast to be a bit over $400 million for the next 12 months. Palo Alto has an enterprise value of around $20 billion, with estimated revenues of a bit greater than $2.1 billion. Will ZS ultimately overtake PANW-and if so how long will the process take? That is really the valuation bet one makes in evaluating the shares, and not all of the other quantitative measures that are used by many observers. It is not an easy question to answer, to be sure, because there are lots of moving parts. And obviously, no matter what I write and others say, there are shades of grey here, not 50 perhaps but many. And there are many differing opinions as well about the competitive wars that will rage between the various security vendors. But it is this writer’s opinion that the opportunity that ZS has to close the gap with PANW in terms of market share that supported its valuation in the past, will become evident again going forward

What about that earnings guidedown

If you own, or contemplate owning ZS shares, you are a growth stock investor by definition. Oh, you might be a trader playing for a bounce or speculating on a quarter, and if so, this article is not really for you. But if you are a growth stock investor, than the course that ZS has announced in accelerating its investment in both sales and marketing and in research and development is one that is prudent and logical and should be viewed as a positive. Very specifically, the CEO said that this company rarely loses when it competes-the obvious conclusion from that is the company needs to compete in more opportunities and it needs the opportunity to sell more products. So, it makes sense to dramatically increase the scope and depth of its sales coverage and to flesh out its product offerings. Its users have shown an increasing propensity to buy a broader set of solutions from ZS, both upfront and over time. To exploit that opportunity means to deepen sales coverage and to extend the product line. It would be illogical for the company not to address those opportunities.

As mentioned, the company has been operating without a chief revenue officer for some time now. It has appointed an individual with star qualities-the track record of AppDynamics in terms of sales growth was such that it was able to secure a huge valuation when it got bought by Cisco (CSCO). With a CRO/President in place, and with some other sales management positions recently filled, the strategy of accelerating sales and marketing spend is one that can be executed with prudence and should lead to visible impacts on growth over coming quarters.

The real question is the issue of the company’s rather mediocre revenue guide. I do not get the chance to cross question CFO's about the guidance they provide. But I have to ask the question, why bother with the exercise when the results simply defy common sense. This company has forecast that it will grow revenues 41% this quarter and 34% for the year. That must mean, that it will exit the year growing at less than 30%, despite a sharp acceleration in the rate of sales and marketing growth that it has announced. Basically, the company intends to raise its sales and marketing spending growth to something in excess of 40% as non-GAAP operating margins, which were 8% last year are supposed to fall to fall to about 3% this year.

Those relationships do not seem terribly likely, and lead this writer to conclude that the company is most likely to see faster growth, and higher levels of EPS and cash flow than those that constituted its guidance.

One comment that alarmed some investors, and is a counter to this line of reasoning was the portion of the script that suggested that the company had seen sales cycles lengthening for some larger deals, possibly based on macro conditions. Spending on cyber-security is self-evidently not really a discretionary expenditure. Users spend on cyber-security more or less because the alternatives are so much worse and there are so many requirements for privacy and data protection. The last recession experienced in this country spanned the end of 2007 through part of 2009. At that point, the cybersecurity space did not exist in the form that it has now assumed. There were no next generation firewalls. Palo Alto was 2 years old at that point and shipped its first product in 2007. So, there really is no experience as to the cyclicality of the cyber-security space. While the cloud existed at that point, the migration of applications was a gleam in the eyes of a few technologists.

I certainly do not know that there will be a recession-I have my doubts. But if there is a recession, and IT spending growth is impacted, my guess is that cybersecurity spending will see less of an impact than areas such as apps and infrastructure. The impact of a breach is no respecter of where we are in the business cycle, and CIO’s that don’t act to prevent breaches preemptively are taking huge risks with key assets of a company. While I can readily believe that a company such as this might have issues with sales execution, the concept of cyclical cyber security spend is not one I find totally credible.

ZS does not close a huge number of large deals over the course of a year-perhaps 100 or so, so it may be that what it has seen is not a trend but random-or perhaps is related to sales execution. But it is something of which to be aware. The issue is whether or not the 45% in share valuation since the recent peak reflects some of that uncertainty.

The company’s business model

In this last fiscal year, ZS achieved a rather substantial level of profitability-some of it probably unplanned, and some of it because it has operated without a CRO and wound up hiring less and spending less money on sales and marketing than should have been the case. That was particularly evident in this past quarter, a Q4 in which sales and marketing expense, in a quarter in which lots of commission accelerators were paid, grew by only 6% sequentially.

The company has reported rather consistent gross margins in the range of 80% for some time now, and presumably this is a level of be anticipated for the next several years. Last quarter, GAAP sales and marketing expense was 57% of revenue, but as mentioned the growth decelerated from earlier in the year. For the full year of fiscal 2019, sales and marketing expense came to 56% of revenues, which compares to 61% the prior year.

Inevitably some will question this level of sales and marketing spend, and it is high simply because of the huge competitors the company meets in the market. The company spent 20% of its revenues on research and development last quarter, up about 6% sequentially and up by 67% year over year. The company has a small amount of net interest income and in aggregate, its GAAP operating loss of 9% of revenues, is relatively small for its size and growth rate.

Stock based comp trebled over the prior year period in the latest fiscal quarter and actually fell sequentially. Overall stock based comp at 14% of revenue is consistent with the average for companies of this scale and growth in the IT space.

The company had a strong growth in operating cash flow which more than tripled in the year. The primary drivers of the increase in operating cash flow were the sharp rise in stock based comp coupled with strong growth in deferred revenues. Overall, the single largest component of this company’s operating cash flow remained the growth in deferred revenue balance which came about 160% of total operating cash flow.

As mentioned, this company operates 150 data centers at this point, and it will continue to build out points of presence to manage latency and insure availability for its network. Latency is a big deal for users and is frequently advertised by competitors. Overall, capex almost doubled last year and that growth accelerated last quarter. Part of this growth relates to the company’s move to a new headquarters facility and the spending of a few million for tenant improvements. The company reported a free cash flow margin of about 9% for the year.

Next year, the company is forecasting that its free cash flow margin will be noticeably lower than the results of fiscal 2019-as best as I understood the presentation, the company anticipates free cash-flow margins in the range of 3%-4%, but beyond fiscal 2020, it anticipates that free cash margins will be above non-GAAP operating margins.

Wrapping Up

There appears to be a certain level of glee surrounding the share price implosion of ZS, and that glee apparently extends to evaluating the merit of making an investment decision at this point. I have no great desire to try to argue the case for or against the valuation of high-growth shares. That said, with a 43% share price reaction from a recent high, the outlier status of the shares has disappeared, and they are close to average on an EV/S basis for their high-30% growth cohort.

The company has put forward what I believe to be a persuasive case as to why its is not losing its competitive edge. It has stated it wins competitive engagements at very high rates and that churn is falling, deal sizes are rising and it dollar based net expansion has ticked up despite larger initial deal sizes.

It has hired a star quality CRO-and between products and personnel my guess is that current guidance will be handily exceeded. The cyber security space is unlikely to prove cyclical-if indeed there is a business cycle to track.

I have suggested that readers/investors need to move beyond the confines of an analysis based on what I consider to be a myopic fixation with certain metrics, and try to consider opportunities holistically. I assume that the company will make that case far better than my poor keystrokes can do when it has its analyst meeting next week. I plan to increase my holdings of this name on an opportunistic basis over the coming weeks.

Disclosure: I am/we are long ZS. 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.