Zscaler: From Going Astray To Acceleration
Summary
- Zscaler went from deceleration to acceleration since the pandemic, sending shares up more than 4 times since the lows.
- The growth problems I highlighted after Q2 2020 are completely behind it. The question remains how long accelerated growth might last after Q2 2021.
- Guidance looks quite prudent but Zscaler should manage to keep growing above 50% for the next quarters. Billings, RPO, and deferred revenue growth suggest it.
- Valuation is stretched and the stock is by no means a bargain. But Zscaler's strong fundamentals combined with a strengthening competitive position make it a buy.
One year ago, on March 4th, 2020, I asked the question if there are More Troubles Ahead for Zscaler? There, I highlighted the growth deceleration that has been going on for some quarters, the sales problems mentioned by management, discussed the possible reasons and consequences of these growing pains, and concluded that it would be wise to not add to the shares at the moment. I was wrong.
The main reason that I was wrong was not that I misjudged the company at the time but that I was completely unaware of a little thing called coronavirus. Here is what I wrote in my first Zscaler-article in December 2018:
To understand what Zscaler does on a high level, you must be aware of two basic trends that are happening right now: First, company applications and data are migrating from company networks to the cloud. And second, employees are becoming more mobile and need secure access to company resources from any location and device.
This kind of put Zscaler (NASDAQ:ZS) in the sweet spot during the pandemic, right? On top of that, it seems to me that the fact that Zscaler was running into sales execution problems and already took multiple steps to address these issues well before the pandemic put them in an even better position to handle the increased demand in the last twelve months. As a result, Zscaler is firing on all cylinders again and should be considered a buy even after the huge run-up in the share price.
From Deceleration To Acceleration
Since I wrote my March 2020 article (when I was very alarmed by revenue and billings growth decelerating all the way down to 36% and 18%, respectively) the company has made a complete U-turn. From Q3 2020 to Q2 2021 revenue growth accelerated to 39.7%, 46.2%, 52.4%, and 55% and billings growth jumped to 55%, 54.9%, 63.9%, and 71.3% (billings are seasonally the strongest in Q2 and Q4).
As I wrote in the past, accelerating growth and improving profitability are attributes the market shows a lot of appreciation for. And if a company manages to go from deceleration to acceleration you will see it in the share price.
Data by YCharts
Zscaler's share price has skyrocketed, but this goes hand in hand with very strong and improving fundamentals. Just to point out two additional metrics that I liked from the last earnings release:
First, look at the dollar-based net retention rate which reached 127% in Q2 2021, the highest rate ever on Zscaler's record. (Pre-IPO dollar-based net retention rate was at 115% and it never reached above 122% before the last quarter. If you consider that management already "warned" in Q4 2018 – when retention was at 117% – that selling larger transformation bundles would result in a lower retention rate over time, you should be even more impressed about this acceleration.)
Second, there is TTM Free Cash Flow. It was at $19.7 million in Q2 2020. Fast forward to Q2 2021, and that metric stands at $80.2 million – more than a quadruple in a year. Free Cash Flow Margin was at 14.96% in Q2 2021 – also the highest percentage on record going back to Q4 2016.
Prudent Guidance – As Always
As Cestrian Capital Research pointed out recently this acceleration should continue for the foreseeable future:
Deferred (prepaid, yet-to-be-recognized) revenue growth accelerating - faster than recognized revenue growth - that means the flywheel is spinning up, not down, and since deferred represents fully 83% of TTM recognized, the flywheel has enough heft to spin up the rest of the machine. Meaning, the deferred growth rate is a clue that recognized growth should continue to accelerate.
In this context, one should not be bothered by the conservative revenue growth guidance in my opinion. Management guided to 4.5% sequential revenue growth which is way below their typical growth rate (their worst sequential growth on record came in Q3 2019 when they grew 6.5%) and represents "only" 48.4% yoy-growth. If we factor in a normal revenue beat, they should come in at around 55% yoy-growth or higher in the next quarter.
Apart from a history of regular guidance beats, the jump in Remaining Performance Obligations (RPO) also makes me confident that Zscaler can grow above 55% in the next quarters. RPO totaled $1.025 billion in Q2 2021; up 68.3% over the last year and 18.6% sequentially. $543 million of that RPO will be recognized in the next twelve months. If we were to assume these $543 million will be recognized evenly – which probably is not the case but let's make this assumption for simplicity's sake anyways – $271.5 million are already in the bag for the second half of 2021. The current revenue guidance for the full 2021 ($638 million) calls for additional revenue of $338.4 million in the second half of the year. Thus, they may already have closed deals in the amount of approximately 80% of the guided revenue in 2021. In other words, they should easily beat their guidance by a good margin.
Competitive Position Improving
What is even more encouraging is that Zscaler's competitive position seems to have improved over the last two years. Just look how lonely Zscaler is at the top of the Magic Quadrant for Secure Web Gateways for 2020:
And now compare that to the Magic Quadrant from 2018:
As you can see, according to Gartner, the competitive landscape as a whole has not changed dramatically in the last two years. As expected, Symantec, who used to be one of Zscaler's toughest competitors, lost a lot of ground due to internal struggles. And also, as expected, Netskope made an impressive entry into the list. According to the report, Netskope "has quickly grown its SWG business since its introduction in 2018. Gartner has observed significant interest in Netskope over the past year. It is increasingly being added to shortlists for SWG vendors, especially in cases where clients are looking for strong SWG and CASB integrated products."
QI-ANXIN Technology Group is the other new entrant on the chart but as it is based in China and only targets Chinese enterprises, it can be ignored by Zscaler shareholders for now. What was surprising to me was that Cloudflare (NET) was not mentioned in the Gartner report at all. Instead, they named Palo Alto Networks (PANW), Fortinet (FTNT), and Bitglass (not publicly traded) as vendors to watch in the future.
Zscaler, meanwhile, has both increased its ability to execute and completeness of vision, making them the clear market leader in the Secure Web Gateways market.
Moving Into Smaller Enterprise Customers
Gartner also highlighted some risks in their report that are worth considering for investors. First, Zscaler's success in increasing its market share in the SWG market, makes it a target for competitors. Furthermore, Gartner sees a risk that Zscaler’s expansion into adjacent markets (such as CSPM and DEM) could lead to the company losing focus on existing products. Lastly, Gartner alluded to the reverse side of Zscaler's focus on larger enterprises. They saw "frustration in dealing with the Zscaler sales cycle, especially if they are a midsize organization typically with less than 3,000 seats".
These business risks, or "Cautions" as Gartner calls them, should probably not be overemphasized, though. As to the first two, these are general risks that apply to all successful businesses – if Zscaler runs into problems here, we should easily spot it in the numbers. The last one is more concrete and a bit more concerning. You don't want to see customers being frustrated with the sales cycle, especially in a company that already experienced revenue growth problems for that reason in the past. It appears, however, that this issue is already being addressed. As CEO Jay Chaudhry noted in the earnings call:
During the quarter, we achieved a milestone of over 5,000 customers, including over 500 of the Global 2000. Our strategic decision last year to increase our investments across all areas, particularly the expansion of our go-to-market and R&D teams, is yielding strong results. We drove increased wins in our enterprise segment, as we begin to pursue smaller enterprises with 2,000 to 6,000 employees.
This statement is encouraging for two reasons: First, Zscaler's bread and butter customers, the large Global 2000, are penetrated by 25% which leaves a lot of room for expansion. Second, the pursuit of smaller enterprises seems to address what Gartner has been criticizing. To that end, Zscaler is adding more sales reps, adding and expanding channel partners, and directing its marketing programs to support the segment of smaller enterprise customers.
Source: Zscaler Analyst Day Presentation 2021
Valuation Update & Conclusion
The last issue I want to touch on is valuation. According to YCharts, Zscaler is currently trading at an EV/S of 56.16.
Data by YCharts
At that valuation, it is in good company. CrowdStrike (CRWD) has a higher multiple, but considering CRWD's much higher growth rate they are relatively undervalued compared to Zscaler. Cloudflare that is growing at a similar rate to Zscaler is trading at a slight discount, probably because it does not have the same acceleration tailwinds. The same probably applies to DocuSign (DOCU) and Okta (OKTA), who, in addition, are perceived a bit more mature by the market, warranting a lower EV/S ratio.
It is funny to reread how passionately I defended Zscaler's forward EV/S of 18.5 growing at 60% in late 2018. There I calculated a hypothetical PEG ratio of 1.2 – a real bargain, and it turned out to be true as the share price went from below $40 to above $200. Today, this exercise is yielding much more stretched multiples at a forward EV/S of 35.7 and 55% expected growth for the next year and a hypothetical PEG ratio of 2.59 (again assuming 25% net margins at maturity), i.e., not a bargain anymore (but not out of this world expensive either – albeit still very hypothetical regarding the PEG ratio).
One thing is clear: You cannot expect past performance to be repeated in the future; this stock will not quadruple any time soon again. I understand that people are getting worried where growth stocks will go after the pandemic is over, especially those that have been beneficiaries of COVID. The way I see it, and this is only a guess, is that we are looking at a period of consolidation in 2021 for the stock prices of many SaaS/cloud-stocks, including Zscaler. Could it consolidate even longer? Of course. That is why I think it is a principal requirement for stock market investing to only invest money that you do not need in the next five years.
For what it is worth, I do not think that we are in the tech-bubble 2.0 right now, although I admit some parts of the market do feel a bit "bubbly". But this comes from the guy who wrote an article worrying about the growth prospects of a remote work enabling tech company twelve days before his government decided on a complete lockdown. So, take it with a grain of salt.
All I know is that it pays off to hold great quality companies for the long term as long as the fundamentals warrant it, and Zscaler is (again) checking all the boxes in that regard. The recent acceleration in revenue growth and improved profitability certainly helps. CEO Chaudhry believes that Zscaler is on the right track to capture a material share of a $72 billion serviceable market (which is a big jump from the TAM of $20 billion cited at the IPO). And, Zscaler is far and away the leader in its core market. I think it is still a buy.
This article was written by
Analyst’s Disclosure: I am/we are long ZS, CRWD, OKTA, NET. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (8)
Was it planned five months ago?
Did they need the funds for family health issues?
Is either in a divorce situation?Maybe you don't know, and their selling has ZERO to do with the prospects of the stock (I mean, did they sell ALL their shares, just some, maybe a tiny fraction)? Maybe?
You long NET. In your mind, is FSLY a dead investment relative to NET? Thanks
Be careful.