A 31 2020 - Wait For The Pullback To Buy Zscaler

Summary

Cybersecurity has been one of the major beneficiaries of the work-from-home economy.

Zscaler has demonstrated overall healthy financials and has increased its full-year guidance.

Cheap capital can prove to be a major positive for Zscaler.

The stock, however, is pretty expensive and is subject to price volatility.

The cloud-based information security company Zscaler (NASDAQ:ZS) has been reaching new heights for the past few months. Ironically, the pandemic caused the stock to plummet and touch its 52-week low of . However, the stock has not only recovered its losses, but has also jumped up 198.41% YTD to close at 1.13 on August 29.

Although Zscaler has reaped the benefits of a superior product portfolio and brand recognition, the company is experiencing decreased growth rates in revenue and calculated billings. Macroeconomic instability and a lumpy sales cycle are some of the reasons for this decline. Then, there is also a higher prior-year base, which also affects growth rates. The company is overvalued and subject to high share price volatility.

In this backdrop, while Zscaler can prove to be a good investment, it is also important that the price is in a reasonable range. I believe that retail investors should wait for a pullback to start with a small position in this stock.

I will highlight how I came to adopt a neutral stance for this company in this article. First, we will see what is working in favor of Zscaler. Thereafter I will highlight the risks involved.

Zscaler's addressable market is evolving and growing

The pandemic has resulted in accelerated digital transformation in all sectors. Companies are forced to adopt work-from-home and hybrid models to keep their businesses up and running. Since employees are working from outside the corporate network, traditional on-premise security has become redundant. The implementation of a remote workforce has resulted in increased cyber-risk for enterprises. Additionally, the threat landscape has dramatically broadened and is constantly evolving. In such a situation companies need to enable employees to work from anywhere securely. Hence, the increased operational risk associated with the digital economy has made cloud-based cybersecurity technologies particularly attractive.

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Zscaler estimates the total market opportunity for internet access and private access technologies to be .3 billion. The company's proprietary cloud-based applications are built for the current distributed-network environment. Hence, the company's cloud-based applications can prove far superior to legacy applications.

Fundamentals show good health, but there are signs of reduced growth for Zscaler

Zscaler saw a healthy rise in total subscribers in the third quarter of fiscal 2020. The company has a highly diversified customer base of over 3,900 customers across 185+ countries.

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We now see the company's existing and new customers increasingly adding new clients to the Zscaler ecosystem. This jump in the upsell activity is a direct result of multiple clients going digital and opting to include ZPA (Zscaler Private Access) service. However, there is a much bigger market to pursue considering that only 32% of the company's Global 2000 customers have purchased ZPA to date.

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The company has shown strong YOY growth for multiple fiscal years. The subscription model lends its high revenue visibility.

Going beyond the business, let us take a look at the company's financial metrics.

Zscaler reported revenue of 0.5 million for the third quarter of fiscal 2020, which is a 9% sequential increase and a 40% YoY increase. The company's revenue is expected to grow 21.4%, faster than the U.S market which is expected to grow 9.7% and the industry which is expected to grow 12.1% in the next one to three years. However, although we are now working with higher bases, there is definitely some deceleration in YoY revenue growth trends.

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Zscaler has guided revenues in the range of 2 to 4 million indicating a 39% to 40% YOY growth. This is a slight improvement compared to the previous guidance of 4 to 7 million, which indicated a 37% to 38% YOY growth. The increased guidance is a show of confidence by the management of the company's continued growth.

Zscaler reported the calculated billings of 1.3 million for the third quarter of fiscal 2020, indicating a 55% rise YOY. Like revenue, calculated billings are working on higher bases and are experiencing a deceleration in YOY growth trends.

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The calculated billings saw a considerable decline in the YOY growth rate for the first and second quarters of fiscal 2020 but significantly improved in the third quarter. Similarly, due to the strong third-quarter performance, the management raised the full-year guidance for calculated billings. The company expects the calculated billings to be in the range of 9 to 1 million, implying a YOY growth rate of 39% to 40%, again higher than the previous guidance of 2 to 7 million, implying a YOY growth rate of 37% to 38%. Increased guidance for calculated billings indicates that the company is expecting a surge in new customers and better cross-selling in the following quarters.

Zscaler maintained a high dollar-based net retention rate for the third quarter. The company reported a 119% dollar-based retention rate for the third quarter of fiscal 2020. This compares well to 118% reported in the third quarter of fiscal 2019 and 116% last quarter. The increased retention rate can be attributed to the current COVID economy. Existing ZIA (Zscaler Internet Access) customers opted to include ZPA (Zscaler Private Access) service to their platform. Thus, increased cross-selling improved the dollar-based retention rate for the quarter.

Zscaler has maintained a high non-GAAP gross margin YOY. The company reported a non-GAAP gross margin of 80% in the third quarter, 2 percentage points lower than the second quarter of fiscal 2020. Additionally, the company expects gross margin to be in the range of 76% to 77% in the fourth quarter of fiscal 2020 and 78% in the first quarter of fiscal 2021. This decline in the gross margin is primarily due to the increased traffic for the company's ZPA (Zscaler Private Access) service. To meet this increased demand, the company is using AWS and Azure which runs at a significantly higher cost compared to their own data centers. However, the company expects its gross margins to return to 80% by the end of the second half of fiscal 2021.

Zscaler has reported positive non-GAAP EPS of .07, beating the consensus by .05. However, according to the analysis done by Simply Wall St., the company is expected to remain unprofitable for the next one to three years.

The company has increased its R&D expenditure by 20% sequentially and 39% YOY to .1 million. Increased R&D in higher levels of technology can directly boost the company's growth in future quarters.

Zscaler has reported a positive cash flow of million for the third quarter of fiscal 2020. The company's cash and short-term investments have grown to 1 million while the company has a total debt of .85 million as of 30th June 2020.

However, the company has announced convertible senior unsecured notes offering worth  billion priced at 0.125%, due July 1, 2025. Although the new offering would significantly increase the company's overall debt, one should note that the interest charged on this borrowed money is negligible. The money comes at exceptionally low risk for the company and hence is lucrative. This offering will allow the company to invest even more into its business and ensure more growth.

To wrap it up, the overall financial performance appears to be significantly strong for the company. The revenue and the calculated billings YOY growth rates have shown a slight decline, but nothing too alarming. Particularly, management seems positive to attain higher growth in future quarters.

Zscaler is pretty expensive

Zscaler is trading at a remarkably high P/S multiple of over 45x and a P/B ratio of over 50x and hence is exposed to significant share price volatility.

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According to the analysis done by Simply Wall St., the stock is 53.2% overvalued compared to the fair value that it has estimated. The fair value estimate is based upon the cash flows the company is expected to generate in the future. This analysis makes it clear that in the case of market correction, the stock will lose a considerable amount of its gains.

Similarly, according to the analysis done by Seeking Alpha, the stock would experience a reduction in the forward P/S multiples in consequent years. This analysis is based on multiple analysts' projections for the company. Seeking Alpha estimates that forward P/S multiple for the stock will reduce to 30x with average sales of 6.56 million in fiscal 2021 and 24x with average sales of 0.43 million in fiscal 2022.

Thus, we can assume that the stock price is more likely to go down in the future aftermarket correction. However, investors seem highly reluctant to adjust to this reality.

What is the verdict?

Zscaler is highly favored by multiple Wall Street analysts. Most notably Citi analyst Walter Pritchard has upgraded the company from neutral to buy with a price target of 2 from on July 9th. Similarly, the analyst from Morgan Stanley Keith Weiss upgraded the stock from underweight to equal weight with a price target of 4 on June 18th.

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So overall we can see that analysts are very bullish for the stock and expect good results from the company in ensuing quarters

To sum it up, Zscaler has outperformed consensus expectations in most of its quarters. It has shown a progressive growth in revenue and maintained high revenue visibility. Although the company is expecting a decline in the growth rates of annual revenue and calculated billings for the current fiscal year, it is not a matter of concern as the management is confident of its future growth. However, the concerning issue is that the company is overvalued. This valuation is making the stock very volatile and investors are subjected to higher risk.

So, in my opinion, retail investors should wait for a pullback from Zscaler and take a position when the stock is reasonably valued with a time frame of at least one year.

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