Zscaler Stock: The Sell-Off Has Created An Entry Opportunity

Summary

• Zscaler is the leading player in zero-trust security.
• Its stock was also battered in the recent sell-off. Moreover, it's still trading at a premium against its high-growth SaaS peers.
• Nevertheless, more aggressive investors can consider adding at the current price level.
• I do much more than just articles at Ultimate Growth Investing: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Investment Thesis

Zscaler, Inc. (NASDAQ:ZS) is the cloud-native, multi-tenant, zero-trust security leader. The company's security platform is developed "on top of a distributed, secure access service edge (SASE) architecture." ZS emphasized that the COVID-19 pandemic accelerated the adoption towards zero-trust security as SVP of cloud protection Rich Campagna added (edited): "The pandemic pushed discussion — and certainly adoption — around zero trust. What's happened in the last two-year time period is that people have started to recognize the security and operational benefits of adopting this kind of model."

ZS is the leader in the zero-trust market. Moreover, it has penetrated just 35% of the Fortune 500. Therefore, the company is still very early in leveraging its $72B serviceable addressable market (SAM).

The company's stock was also pummeled recently as its rich valuation became the focus of the growth stocks sell-off. Despite that, we believe that its free cash flow (FCF) generative capability remains robust and is expected to gain leverage moving forward. Moreover, the company's stock remains strongly supported along its long-term uptrend. Therefore, we believe that the recent retracement has created an opportunity for more aggressive investors to consider adding.

ZS Stock YTD Performance

ZS stock YTD performance (as of 31 December' 21).

Despite its recent retracement, ZS stock managed to finish 2021 with an impressive return of 60.9%, easily outperforming the broad market. Moreover, before the sell-off, its YTD gain almost reached 90%. Therefore, it was still a fantastic year for ZS investors in 2021.

Zscaler Believes It's the Clear Leader in Zero-Trust

The security and threat environment has continued to dominate the concerns of senior infosec executives. "According to a recent survey by Venafi, ransomware attacks spiked by 250% in the first half of 2021 alone." Therefore, the heightened threat environment has led these executives to consider that "ransomware (threats) should be prioritized at the same level as terrorism." Moreover, as more workloads are moving into the cloud, organizations and governments will need a much more robust security framework to deal with these threats. A zero-trust architecture is one of the critical frameworks designed to protect these workloads.

"Zero Trust Network Access (ZTNA) is core to the SASE framework because it's designed to define a personalized security perimeter for each individual, flexibly." A Cisco (CSCO) survey highlighted that 42% of CISOs think that "ZTNA is their top spending priority within (their) SASE initiatives."

Zscaler believes it's the leader in zero-trust security as it has penetrated 35% of the Fortune 500. Zscaler Co-Founder and CEO Jay Chaudhry emphasized (edited):

35% of the Fortune 500 companies have Zscaler. So, 65% are still there. And especially on the high end, we think, we have a chance at owning a very, very high percentage of higher end markets. And, this is just on the user side. The Zero Trust for workloads is a massive opportunity. The number of workloads are growing at an astronomical pace. That's opportunity for us. (Nasdaq 45th Investor Conference)

The company believes that it's still in the early innings of a $72B SAM, where its current annualized recurring revenue (ARR) crossed only $1B recently. The company has also defined a $5B ARR target and therefore is focusing on growth over profitability as it scales to meet its objectives.

Zscaler adjusted gross margins. Data source: Company filings

Zscaler dollar-based net retention rate. Data source: Company filings

The company has tremendous pricing power, as its adjusted gross margins have remained highly consistent over time. Moreover, its net retention rate (NRR) also remained robust in FQ1'22, as it posted an NRR of 125%. Therefore, companies have continued to spend more on ZS's platform. Readers should note that while ZS started with Zscaler Internet Access (ZIA), it has already expanded into three other "pillars." Its second pillar, Zscaler Private Access (ZPA), accounted for 16% of its revenue in its recent quarter. The company also expects its third and fourth pillars to start contributing meaningfully to its top line as it upsells its customers.

Notably, the company recently launched its Workload Communications solution. It aims to help its customers "protect workloads in multi-cloud environments while simplifying connectivity and boosting application performance." The solution is designed to enhance one of its emerging pillars; Zscaler Cloud Protection (ZCP). It's critical for readers to note that the company's ZCP product is cloud-agnostic, making it suitable to protect multi-cloud workloads. Thus, Zscaler is primed to leverage the secular drivers undergirding migration of workloads based on a multi-cloud framework. The new feature also augments the capability of its ZIA pillar. The key is to minimize the size of the attack surface, as Zscaler emphasized (edited):

It’s very easy to do: Just port traffic via a simple Zscaler component that they install in their cloud environment. And what we’re able to do is eliminate dozens, in many cases, of firewalls, VPN appliances, homegrown proxy appliances, and complexity around things like routing and peering across cloud environments. Because we’re not extending network connectivity into these various different cloud environments for workloads, we’re cutting down on the risk of lateral threat movement as well. (SDxCentral)

Minimizing or eliminating the attack surface is one of the fundamental tenets of the zero-trust security architecture. And, the company believes that its proprietary Zero Trust Exchange "cannot" be replicated easily by the legacy on-premise players, which ZS aims to disrupt. CEO Jay Chaudhry articulated (edited):

What do the firewall guys do for access to applications from remote places? VPN. And everyone knows that VPN is the biggest security risk for any enterprise. Now they're taking VPN and spinning that VPN in the cloud and trying to hide the name of VPN. I was talking to a customer, this is a small company, a few weeks ago. They said, "Oh, we are now doing zero trust in the cloud, and we no longer have VPNs." And so what do you have? They said, "GlobalProtect." I said, "Wow, whatever you call it, it's still VPN." So I think marketing hype only goes so far. You have to protect the customers. You saw how we eliminate attack surface. And then we do in-line malware protection. As attacks are getting more and more dangerous, customers are waking up to realize that they may be having a false sense of security with legacy devices. They need to embrace true zero trust. (Barclays Global TMT Conference 2021)

It's obvious which company Chaudhry referred to: Palo Alto's (PANW) GlobalProtect product.

So, is ZS Stock a Buy Now?

Zscaler revenue and adjusted EBITDA margins mean consensus estimates. Data source: S&P Capital IQ

There's little doubt that the consensus estimates point to a moderation in revenue growth moving forward. ZS is estimated to increase its revenue at a CAGR of 38.3% over the next three years. Notably, ZS registered a YoY revenue growth of 56.1% in FY21. Moreover, the company is still expected to maintain robust adjusted EBITDA margins moving forward.

Nevertheless, ZS stock is trading at a significant premium if we compare it against its high-growth SaaS peers. Its EV/NTM Revenue multiple of 40.9x is way above its peers' median of 16x. But, as mentioned, its FCF profitability remains robust. Its adjusted FCF margin was 36% in FQ1'22. Therefore, we believe that it may be helpful for us to conduct a DCF framework to evaluate its valuation better.

DCF Valuation Metrics	Estimates
WACC	7%
Revenue estimate FY26	$2.96B
Adj. EBITDA estimate FY26	$492M
Adj. EBITDA margin FY26	16.6%
Unlevered FCF estimate FY26	$515M
Revenue exit multiple	20x
ZS stock implied fair value estimate	$324.61

Click to enlarge

ZS stock DCF valuation model. Data source: S&P Capital IQ, company filings, author

We incorporated reasonable assumptions into our estimates and derived an implied fair value of $324.6, based on a revenue exit multiple of 20x. We believe it's an appropriate multiple, given the strength of its topline growth and adjusted EBITDA margins. Thus it's still trading within +/- 10% within our fair value zone, which we think is reasonable.

ZS stock price action.

Moreover, the stock has a solid long-term uptrend that has consistently been supported along its 20-week or 50-week moving average. Investors who would like a reasonable margin of safety due to potential inflation risks moving ahead might want to wait for a deeper retracement. However, we wish to highlight that such a retracement may have already taken place recently, and the selling pressure was well absorbed by the dip buyers.

Therefore, if you are more aggressive and have high conviction over ZS's zero-trust growth story, the current price level could offer a potential opportunity to add.

As such, we rate ZS stock at Buy for aggressive investors only.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of ZS either through stock ownership, options, or other derivatives. 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.

Comments

[bhanusutraye]

Thanks. Zs is a solid company. The valuation metrics are still high. PS of 40+ vs growth of 40% +

What is your thumb rule ? Do you observe rule of 40 for SaaS stocks?

[Misseditagain]

Why was the plug pulled on ZS today. picked up 100 shares at 302, since I couldn’t find any reason to be down some $20 bucks. ? Was that a dumb move….anyone?

[Michael Clark]

@Misseditagain Still a bull. Be patient.

[Misseditagain]

@Misseditagain … after today…it was a dumb move. ☹️

[Michael Clark]

CGTS. ENTRY POINT was May 18 2020. Up 335.35% since.

1 Short 60 07/30/19 10/23/19 +43.590 +51.48 Exit Short Rule
2 Short 18 02/21/20 03/18/20 +4.340 +7.96 Exit Short Rule
3 Long 408 05/18/20 12/31/21 +247.520 +335.35 Open

Still no top.

[Cgain]

Crowdstrike a much better buy at the moment imo.
Much higher sales, earnings, and a faster growth rate. Yet it has the same market cap as zscaler. It should be much higher imo.

[JR Research]

@Cgain CRWD is a good company. ZS is certainly more expensive. But, ZS and CRWD are quite different even though both are in cloud security. Nevertheless, CRWD buy point looks solid too.

[decoder2]

@JR Research CRWD has had a couple of earnings missteps; management somewhat of a question mark. need to see more consistency.

[JR Research]

@decoder2 That is true. But, the stock's valuation seems to have been punished for it.

[Roger Thaat]

Valuations don’t matter?

[Hudson Investments]

@Roger Thaat Yes valuations definitely do matter. ZS consistently beats earnings by 50%, that’s what I like about ZS, and am buying some today.

Their main customer is the US DOD, as you know. That means something significant.

[Hudson Investments]

This is what you call an aggressive bet.