Zscaler (NASDAQ:ZS) is a leading Cloud security company which has created its own secure “switchboard” like network for security. According to Markets research, Cloud security is expected to grow at a 13.7% CAGR between now and 2026 reaching a $77 billion market size. Zscaler is poised to spearhead this trend, they had their IPO in 2018 and since then the stock price is up by an incredible 437%. The share price reached a high of $369/share in November 2021, but high inflation and a forecasted rise in interest rates have caused the stock to correct downwards by 47%.
The company has high retention, high revenue growth and a huge market to penetrate. 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 which is ranked as a “leader” in the security edge, according to Gartner. Traditional Corporate networks operate with what is called a “Hub and Spoke” network, which involves a central data center and all traffic is routed through this for applications. However, today business applications are run in various different clouds and employees are connecting from multiple locations, such as being remote. Thus a new security solution is required, this is where Zscalers “Zero Trust Network” comes in.
Zscaler operates a network of over 150 data centers which act like an “Intelligent Switchboard”. Whereas, most traditional networks try to secure themselves with a Firewall, Zscaler realizes this is an “attack surface” and thus secures the data instead, through packet inspection and identity verification at their own data center.
The company’s competitive advantages are their technology, talent, partners and 275 patents (issued & pending). The company has deep partnerships with the leading cloud providers such as AWS, Microsoft Azure and Google cloud. Microsoft CEO Satya Nadella even has a video testimonial on their website which is a testament to the company’s credibility. In addition, they 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 their “Land and Expand” strategy is working. Customers are staying with the company and spending more. They also have a net promoter score of 70, which is above the SaaS industry average of 30. This shows customers are more willing to recommend their products and thus are satisfied.
Zscaler was founded by the visionary Jay Chaudhry (now CEO). A true “American Dream” success story, Chaudhry grew up in an Indian village with no running water, before coming to the US. He founded a series of startups in the IT Security Industry from Secure IT in 1996 to VeriSign in 1998. In 2007 he founded Zscaler and he’s now worth over $15.4 billion. Today Chaudhry still owns over 38% of the company and thus has “skin in the game”. Investing into founder-led companies where they have “skin in the game” is one of the key tenets of my investment strategy at Motivation 2 invest.
Zscaler grew its revenues from $431 million in 2020 to $673 million in 2021, up a rapid 47%. Revenue continued to accelerate into 2022, with $255.6 million reported for Q2022, an increase of 63% year-over-year. For FY2022, They are guiding for $1 billion in revenue, an accelerated increase of 56% over the 47% revenue growth achieved in 2021. This is a great sign to see and shows the company is on an upwards trajectory.
As a SaaS platform, they operate with an extremely high gross margin of ~81% and a 21% positive free cash flow margin.
The company is operating at a net loss of -$269 million in trailing 12 months. However, the company has spent $231 million on R&D over the same period and their highest expense is Sales and Marketing. Zscaler spent $175 million on Sales and Marketing in Q2022 as the company invests heavily to capture new customers.
Their balance sheet has $409 million in cash and $1.2 billion in short-term investments. I did notice that they have $836 million in current liabilities, but the majority of this is non-interest bearing and thus not technically debt. However, they do have $940 million in convertible senior notes, which is debt and can be converted into equity in the company. Thus this may cause future shareholder dilution which is a risk.
In order to value the company, I have plugged the latest financials into my advanced discounted cash flow model. I have grouped the company’s cash and “short term investments” together as I’m making an assumption these are short-term treasury bills. In addition, I have capitalized the company’s large R&D spend.
For revenue growth assumptions I have estimated 56% for 2022 which is in line with the company’s guidance and then 50% for the next 2 to 5 years. I have forecasted an increase in operating margin to 25% in the next 4 years as their Sales & Marketing spend starts to make a return and their high retention rate stays at a high 125%.
Given these factors, I get a fair value of $193 per share, the stock is currently trading at $216 and thus is 11% overvalued. I suspect this is because the market is pricing in higher revenue growth rates for years 2 to 5 over 55%. Now although this is possible, I haven’t included this in my valuation as my personal style is to be conservative with future forecasts. As I believe if a stock is “cheap” with realistic/conservative estimates then that gives better odds for the future.
The stock is trading at one of the lowest price to sales ratios relative to the company’s own history. The stock trades today at a forward PS ratio = 29, whereas in December 2021 the price to sales ratio was 49. The lowest price to sales ratio historically has been ~PS = 25. This would be the multiple I would use as a guide for when the stock is “cheap”.
I believe the main reason for the compression in the price to sales multiple is high inflation and the rising interest rate environment, which increases the discount rate and impacts the valuation of “growth stocks” much greater.
If we compare to Cybersecurity Peers in the industry Zscaler has consistently traded at one of the highest multiples. This could be due to accelerating growth rates but CrowdStrike (CRWD) has shown similar growth and retention also.
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 in general.
The stock is priced slightly higher than my fair value but is also higher relative to other cybersecurity companies such as CrowdStrike. When a stock is “Priced for Perfection” with high revenue estimates baked into the market price this can lead to volatility if the company has a bad quarter.
There has been a large amount of insider selling. For example, approximately $11 million in shares were sold by the President and Director Amit Sinha between $203 and $260 per share. This could be a sign the stock is richly priced and insiders are hedging their bets.
The Cybersecurity industry is very competitive and Zscaler’s top competitors include Palo Alto Networks, Forcepoint, Pulse Secure, Check Point Software and Fortinet. This can lead to increased customer acquisition costs, slower revenue growth and margin pressure long term.
Rising Interest Rates
A rising interest rate environment tends to compress the valuation multiples of richly priced growth stocks. I believe the bulk of this compression has already taken place as the stock price has pulled back by 47%. However, it may stay subdued until inflation starts to decline.
Zscaler is a fantastic company and a true leader in the Cloud Security industry. The company has grown revenues rapidly and has high gross margins. Their high retention and NPS scores indicate customers love their product and are increasing spending, while the company’s founder is a veteran of the IT industry and has “Skin in the Game”. The major issue is the valuation; the stock isn’t expensive right now, but it’s not exactly cheap either. The stock is slightly overvalued intrinsically, but I would suspect it will stay this way unless the company has a bad quarter. Either way, this is a great company for the watch list and it wouldn’t be crazy to open a small position at the current level.