Zscaler: spearheading cloud security with high retention (NASDAQ: ZS)
Z-scale (NASDAQ: ZS) is a leading cloud security company that has created its own secure “standard” as a network for security. According to a Markets study, cloud security is expected to grow at a CAGR of 13.7% by 2026, reaching a market size of $77 billion. Zscaler is poised to spearhead this trend, they did their IPO in 2018 and since then the share price has risen an incredible 437%. The stock price peaked at $369/share in November 2021, but high inflation and an expected rise in interest rates led to a 47% downward correction in the stock.
The company has strong retention, strong revenue growth, and a huge market to break into. Let’s dive into the business model, financials and valuation to see if the stock is a buy today.
Technical business model
Zscaler is a cloud security company ranked as a “leader” in security, according to Gartner. Traditional enterprise networks operate with what is known as a “Hub and Spoke” network, which involves a central data center and all traffic is routed through it for applications. However, today business applications are running in different clouds and employees are logging in from multiple locations, such as remotely. So, a new security solution is needed, this is where Zscalers “Zero Trust Network” comes in.
Zscaler operates a network of over 150 data centers that act as an “intelligent switchboard”. While most traditional networks try to secure themselves with a firewall, Zscaler realizes that this is an “attack surface” and therefore secures the data instead, through inspection packets and identity verification in their own data center.
The company’s competitive advantages are its technology, its talent, its partners and its 275 patents (issued and pending). The company maintains close partnerships with major cloud providers such as AWS, Microsoft Azure, and Google Cloud. Microsoft CEO Satya Nadella even posted a video testimonial on his website, which speaks to the company’s credibility. Additionally, they have enabled connection with other cybersecurity platforms such as CrowdStrike through deep API integration.
Zscaler has a high Net Retention Rate (NRR) of over 125%, which is a sign that their “Land and Expand” strategy is working. Customers stay with the company and spend more. They also have a net promoter score of 70, which is above the SaaS industry average of 30. This shows that customers are more willing to recommend their products and are therefore satisfied.
Zscaler was founded by visionary Jay Chaudhry (now CEO). A true “American Dream” success story, Chaudhry grew up in an Indian village without running water before coming to the United States. He founded a series of startups in the computer security industry, from Secure IT in 1996 to VeriSign in 1998. In 2007 he founded Zscaler and it is now worth over $15.4 billion. Today, Chaudhry still owns more than 38% of the company and therefore has “the skin in the game”. Investing in companies run by founders where they have “skin in the game” is one of the key principles of my investment strategy at Motivation 2 invest.
Zscaler grew revenue from $431 million in 2020 to $673 million in 2021, up a rapid 47%. Revenue continued to accelerate in 2022, with $255.6 million reported for Q2022, a 63% year-over-year increase. For fiscal year 2022, they forecast revenue of $1 billion, an accelerated 56% increase from the 47% revenue growth achieved in 2021. This is a good sign to see and shows that the company is on an upward trajectory.
As a SaaS platform, they operate with an extremely high gross margin of around 81% and a positive free cash flow margin of 21%.
The company is operating with a net loss of -$269 million over the last 12 months. However, the company has spent $231 million on R&D over the same period, and its highest spend is on sales and marketing. Zscaler spent $175 million on sales and marketing in the 2022 quarter as the company invests heavily to attract new customers.
Their balance sheet has $409 million in cash and $1.2 billion in short-term investments. I noticed they have $836 million in current liabilities, but the majority of it is non-interest bearing and therefore technically no debt. However, they have $940 million in convertible senior notes, which is debt and can be converted into equity in the company. This may therefore lead to future shareholder dilution, which is a risk.
In order to value the business, I incorporated the latest financial statements into my advanced discounted cash flow model. I grouped the company’s cash and “short-term investments” together because I assume they are short-term treasury bills. In addition, I capitalized the large R&D expenses of the company.
For revenue growth assumptions, I estimated 56% for 2022, which is in line with company guidance, and then 50% for the next 2-5 years. I forecast an increase in operating margin to 25% over the next 4 years as their sales and marketing spend begins to generate a return and their high retention rate remains at a high 125%.
Given these factors, I get a fair value of $193 per share, the stock is currently trading at $216 and is therefore 11% overvalued. I suspect it’s because the market is forecasting higher revenue growth rates for years 2-5, above 55%. Now, while it’s possible, I didn’t include it in my review because my personal style is to be cautious with future predictions. As I think if a stock is “cheap” with realistic/conservative valuations, it gives better chances for the future.
The stock is trading at one of the lowest price-to-sell ratios in company history. The stock is trading today at a forward PS=29 ratio, while in December 2021 the price-to-sales ratio was 49. Historically, the lowest price-to-sales ratio has been ~PS=25. This would be the multiple I would use as a guide for when the stock is “cheap”.
I think the main reason for price compression versus sales is high inflation and rising interest rates, which increase the discount rate and have a much bigger impact on the valuation of “growth stocks “.
If we compare to cybersecurity peers in the industry, Zscaler has always traded at one of the highest multiples. This could be due to accelerating growth rates, but CrowdStrike (CRWD) also showed similar growth and retention.
The EV to EBITDA multiple also shows a similar story with Zscaler having an EV to EBITDA of 218 which is higher than CrowdStrike at 122 which is also high overall.
The stock price is slightly higher than my fair value, but it is also higher compared to other cybersecurity companies such as CrowdStrike. When a stock is “Priced for Perfection” with high earnings estimates priced into the market, it can lead to volatility if the company has a bad quarter.
There has been a lot of insider selling. For example, about $11 million worth of shares were sold by chairman and director Amit Sinha at between $203 and $260 per share. This could be a sign that the stock is priced high and insiders are hedging their bets.
The cybersecurity industry is very competitive, and Zscaler’s main competitors are Palo Alto Networks, Forcepoint, Pulse Secure, Check Point Software, and Fortinet. This can lead to higher customer acquisition costs, slower revenue growth and pressure on long-term margins.
Rising interest rates
A rising interest rate environment tends to compress the valuation multiples of high-priced growth stocks. I think most of that compression has already happened, with the stock price down 47%. However, it may remain subdued until inflation begins to decline.
Zscaler is a fantastic company and a true leader in the cloud security industry. The company has rapidly increased its revenue and has high gross margins. Their high retention and NPS scores indicate that customers love their product and are increasing their spend, while the company’s founder is an IT industry veteran and has “Skin in the Game.” The major problem is evaluation; the stock isn’t expensive right now, but it’s not exactly cheap either. The stock is inherently slightly overvalued, but I suspect it will remain so unless the company has a bad quarter. Either way, it’s a great company for the watchlist and it wouldn’t be crazy to open a small position at the current level.