Thomas Barwick
Investment overview
I give a buy rating for Zscaler (NASDAQ:ZS), as I think the business is going to see growth accelerate in the near term, sustaining growth above >30%. ZS has proven that its products are a better alternative to peers’ offerings as it continues to win market share. The additional growth drivers, like Fed spending tailwinds and the shift in the GTM model to focus on upselling, should further support growth ahead. With growth expected to grow faster than peers, I believe ZS should continue to trade at a premium.
Business description
Zscaler is a cloud-based provider of enterprise and network security, offered via its key products such as Zscaler Internet Access for secure access to internet and SaaS applications (offers both outbound and inbound web and network protection via the company’s edge servers, which serve as proxies that direct and filter traffic between internal users and external untrusted sources), and Zscaler Private Access for secure access to internal applications (creates a private portal that enables trusted users to access a company’s internal network resources and data, replacing traditional VPN functionalities). Zscaler is a crucial enabler of secure SD-WAN and helps enterprises move to a cloud-direct network architecture. The reality is that cybersecurity is only going to get more important, and this is a massive long-term tailwind for ZS. Throughout its relatively short history as a publicly traded company, ZS has consistently reported very high growth rates, north of 40%, reaching as high as 59% in FY19. The business is also profitable, generating an adj. EBIT margin of 15% as of FY23.
Growth acceleration is in sight.
I think the key debate for ZS is how much growth will decelerate and whether it can sustain itself at >30% levels. Over the past few quarters, growth has seen consecutive decelerations from 40+% in 4Q23 to 35% in 2Q24, and this has driven share prices downward from $250 to $184. The underlying concern is whether businesses will start to reinvest in cybersecurity given the tough macro-condition: while cybersecurity is important, ensuring business survival is more important (i.e., having cash). I think we have reached a level of stability where businesses are no longer tightening budgets like they did last year. Management noted that they are not seeing incremental signs of spending fatigue or pricing pressure for their products. In fact, I think the current macro environment has created a favorable situation for ZS to capture share from legacy vendors, where businesses are now scrutinizing whether they need all the products that have been in the bundle. In the past, when times were good, businesses did not scrutinize this because there was no urgency to cut costs or optimize spending. However, now that times are bad, I expect businesses to look for alternatives, and this opens up the pathway for ZS to step in and offer a better product, which seems to me to mean that ZS is winning share as they saw steady execution on upsell and new customers, where they recorded multiple customers with ARR (annual recurring revenue) of more than $10 million and more than $100k in 2Q24. Lastly, the fact that management raised the billing outlook is a positive sign as it implies a step up in sequential growth for 2H24, which I take as a sign of growth acceleration.
Additional growth drivers to continue support >30% growth
There are two key drivers (catalysts): Fed spending and the new go-to-market [GTM] model. Regarding Fed spend, although Palto Alto Networks (PANW) is calling out that Fed spend is a headwind to growth, this seems to be the opposite for ZS, as Fed spending contributed to the growth in 2Q24. In fact, the growth was significant as ZS managed to double their number of users in the Fed agency, which led to a 2x increase in ARR. This tells me that ZS is winning share in this space, and importantly, the growth runway is extremely long given that ZS is less than 15% penetrated.
As Nikesh mentioned, we saw weakness in the U.S. federal vertical related to some specific programs. This U.S. federal weakness was a meaningful headwind to our billings in Q2 after we saw a slow start in the year to Fed. PANW 2Q24
we have been investing in the federal market for quite some time. We got the highest FedRAMP certification. And we are doing very well, in fact, we are heavily engaged with all federal agencies, including DOD, 12 of the 15 agencies are our customers. In my prepared remarks, I talked about the federal deal, here we doubled the number of users, and we double that ARR to approximately $5 million and even with this less we’re than 15% penetrated in the agency in terms of number of users, which means there is an 85% wide space to go up there. We feel good, we keep on investing in it and I think it’s a strong area for us. Remo? Company 2Q24 earnings
The next driver is the change in the GTM model, now with a focus on increasing vertical sales programs by adding more domain experts to drive vertical-specific sales strategies. ZS should be able to execute this GTM strategy well given that it has already seen success within the Fed space and healthcare. To give a sense of the opportunity in upselling, note that ZS has a double-digit number of customers with more than $10 million in ARR as per the call, and the average ARR per customer disclosed back in FY19 was only $74k. While this number is slightly dated, even if you assume 100% gain over the past 4 years, blended ARR is still only ~$1.2 million (still ~10x lower than $10 million). This is in line with the management comment that there is still a six-fold upsell opportunity in their customer base.
In fact, even today, as we said in our current customer base, we can literally take our ARR by 6x if we sold all of these user products to our customers, so even I would even say we have no lack of product to sell. Company 2Q24 earnings
Valuation
May Investing Ideas
Based on my research and analysis, my expected target price for ZS is $212.
- Revenue should sustain at >30% for the next 2 years, 31% in FY24 at the mid point of guidance, and 31% for FY25 as growth sees support from macro recovery, Fed spending, and new GTM model
- Stock should trade at 11x forward revenue multiple as growth continues to stay above 30%. At 11x, ZS is trading at a premium relative to peers which I think is warranted given that ZS is the fastest grow, by 2x, vs. other cybersecurity players like PANW (mid-teens growth outlook), Fortinet (mid-teens growth outlook), Okta (low-teens), and Splunk (mid-teens) who are trading at mid-to-high-single digits forward revenue multiple.
Risk
Growth could actually dip below 30%, which will be viewed very negatively by the market as growth continues to decelerate. This could happen if the shift in GTM model is not well executed; most of Fed spending only materialize in FY25; macro flips into a recession that forces more businesses to cut back on cybersecurity investments.
Conclusion
I give a buy rating for ZS as I expect the business to continue showing growth exceeding 30% for the next two years. Importantly, ZS offers a superior product compared to competitors, evident by its continuous market share gain. Favorable tailwinds such as Fed spending and the strategic shift to upsell existing customers further support this growth. Relative to peers, ZS’s strong growth outlook should continue to justify a premium valuation.
