My take on Zscaler

Personally I felt like this call had a fair bit of expectation management for investors and analysts. Sure they seem confident in their technology, but growth has really slowed down and they definitely aren’t saying it is going to stabilize or accelerate next quarter. Italicized are slightly edited responses from the call.

Hedging and expectation management

Also, please keep in mind that we had a large upfront billing of $1 million in Q2 of 2019 from a large public sector customer deploying our platform as a private cloud which will pose a tough year-over-year comparison in Q2.

Re: FCF and operating margin
As a result of these payments, we expect our free cash flow margins in fiscal 2020 to be zero to two points lower compared to our operating profit margins. Longer term, we expect our free cash flow margins to be higher than our non-GAAP operating margins.

The point to make is it’s going to fluctuate. It’s a hard metric to really put your finger on. 120% is outstanding but it could fluctuate.

Re: new products driving upside for 2020
there’s nothing we’re planning for, and you shouldn’t plan for anything either. We’re planning to get these products out in the second calendar quarter of 2020. There’s potential for the products as Jay mentioned with the CASB out of band browser isolation user experience in the B2B. We feel that there’s a pretty significant upside for us with these types of products but nothing for this fiscal 2020 should be accounted for.

The following is sort of non-answer about the new CRO and how much impact he and his team is making to revenue. Jay essentially doesn’t answer the question but talks around it.
Yes, Alex. Thank you. This is Jay. Regarding your question about our go-to-market, our CRO. As you know, we have done very well so far bill-to-business to hundreds of millions of dollars. Now, our goal is to take it to $1 billion and plus which means scaling our sales execution. Tony actually is the right guy who is driving a number of these things. Let me give you a perspective of what all he’s driving. So, for execution at scale, I will give you three examples. One, when you have scores of salespeople, it’s one thing; when you have hundreds of salespeople, you need far better sales enablement, far better training. For us, we used to have a small sales enablement team. Dali has come in and built a pretty sizable team, and the team has already rolling out some of the training programs.
Number two; to really scale your business, you need a very consistent and repeatable sales process that may be more refined. And Dali has come in and taken our process and further refined and it’s being rolled out to the whole field. Number three, while we had tools and systems in place to scale to the next level and to have better accountability, better visibility to give us better leading indicator in sales activities, he and the leadership team have started work on many areas. So, a lot of these things are already making a difference, and we’re seeing it. And I think as each quarter goes by, we will see more and more impact of the work being done by Dali and his team. Remo, you want to add anything?

on comparisons
“Also, please keep in mind that we had a large upfront billing of $1 million in Q2 of 2019 from a large public sector customer deploying our platform as a private cloud which will pose a tough year-over-year comparison in Q2”

on previous sale guidance at the last analyst day.
Yes. Our sales tracking for Q1, it’s a little bit behind but our expectation is still to get to that 60%. We are looking 4Q to be a good quarter for us, but it’s all taken into account in our guidance.

On the positive side

Lots of talk about technology, exciting business developments etc. So far though none of that has turned into better revenue growth.

Re: CRO’s 60 day plan they talked about before. How is it going etc
Yes. Good question. I would start seeing basically improvement next year related to, and again the guidance that we gave contemplates the investments we’re making in sales and marketing. Dolly’s 30 to 60-day plan. I mean I’ve worked with the few CROs and watching what Dali is doing here in the first couple of months as he’s moving very quickly and doing an outstanding. I mean he is building the sales leadership in the organization. He’s building, as Jay mentioned, our sales enablement and training.
He is better defining sales responsibility and putting in place the framework for us to be a much bigger company and placing in, putting in place that accountability. In summary, what I see with Dali is doing, he’s putting structured, disciplined leadership and has a passion that he has. Quite frankly, I don’t know when he sleeps. It’s going very quickly, but it is going to take time. So that was the reason for our guidance initially at 42% to 43% billings in the first half and we increased that to 43% increased our billings guidance to 500 and 510. I’m excited working with Dolly. And what he’s doing and looks forward to it.

”our plan is still to be at a 20% plus operating margin once we hit $800 million to $1 billion in revenue. Related to pricing pressure, our discounts are lower this quarter. Our average prices per user are higher. When I take a look at our ARR for customers with greater than 3,000 users, it is higher this quarter. It’s in the high 300,000 range and our churn is down.”

we have been seeing about half the new customers coming for ZPA, sorry half the ZPA deal is coming from new customers and half coming from upsell. So that’s kind of number of customers. But having said that, the ZPA deals are smaller than ZIA deal. As we said before, when ZIA is bought it’s bought for everyone in the company for all employees and ZPA are based on number of applications. So it’s one. GPA is opening more doors for new logos than we had initially thought off. So pleased with that.

Very bullish on it. Remo, can I say that? Good team. I would say, if you asked me a year ago versus today, I feel we are significantly ahead of where I thought it would be

My take

ZS is a company that is in transition. They are trying to highlight the fact that they are making the transition but so far we haven’t seen evidence in the numbers that the transition is having success. I counted how many times they mentioned Dali the new CRO…16 times. The CRO almost seemed a talism against any question that mentioned pain points. Maybe Dali will have a huge impact, I’m sure he is working hard but he has a big job to transform a sales team’s culture and infrastructure. Growth will almost surely slow down again next quarter. There is just too much hedging, expectation management etc unless something surprising happens.

In the future ZS expecst FCF margin to be higher than operating margin although not for 2020. With that in mind we should see 25%+ FCF margin and 20% + operating margin. Those are excellent numbers, the big question is now growth. They seem to be indicating that their new CRO is going to help drive growth but they are being coy about when they think that will happen and what type of growth they expect. At this point there are plenty of good companies with FCF margins and operating margins that are already in the 25+ range with growth that is stable in the 30-40% range. ZS on the other hand has aspirational goals of those margins and slowing growth. When the price spiked before earnings I cut down my position from 14% down to 3.8% . I don’t typically look at turnarounds or “transition” type of investments and to my eye that is what ZS has become. Maybe we will see some positive surprises, Hope is not an investment strategy. I personally don’t feel inclined to increase my position. More thinking ahead.



In the future ZS expecst FCF margin to be higher than operating margin although not for 2020. With that in mind we should see 25%+ FCF margin and 20% + operating margin. Those are excellent numbers, the big question is now growth.

OK, so when they get to $800M - $1B in revenue then they expect FCF margins higher than 20%. Let’s assume 23% with growth still at 40% in 3 years. TTM revenue is at $333M now so it would take them 3 years, growing at an average rate of 45%, to reach $1B. So in 3 years they would have $1B in revenue a growth rate at around 40% still and TTM FCF of $233M.

Using CRM as a yardstick, CRM’s TTM FCF multiple is 30-45 on revenue growth of 25%. By comparison, if ZS still has 35-40% growth then, it might deserve a TTM FCF multiple of 40-60 (someone make an argument why it should be higher???). So this would mean the EV would be in the range of $9.3B - 14B. If shares are diluted at 4% per year then we would have 154M shares which would give us a share price range of $60.40 - $90.90 three years from now. This would give us a CAGR of 7% - 22%.

Seems to me that at this point the market is ZS’s to lose since their competitive position seems really strong. I also reduced my position prior to earnings and sold some more this morning. My position is down to 8.7% down from around 14% a few days ago.



I am going to go back and read the many great thoughts on this topic, it may change my my mind. But I thought I’d toss what my mind is here first from my thoughts the last few weeks through earnings and some discussion on a different forum, Mauser in particular had some great insights.

I was millimeters away from lightening up on Zscaler before earnings yesterday but decided to stick with it. Zscaler of course also has a great narrative, management, paradigm, product etc. But there are a few process rules that I think are more valuable than trying to think one is smarter than the market.

(1) when narrative <>= numbers it is time to stop enjoying the narrative so much. Zscaler may be a rare exception to that rule as we have seen how well they have already done making large sales and transforming organizations. But clearly the numbers don’t equate to this continuing to happen at the same pace. For Zscaler numbers to again equate to narrative customer growth is going to have to pick up again and that require taking enormous organizations that may have little interest in transforming their architecture (the way so many others have done successfully) any time soon. Gartner predicts 2023 as when NGFW appliances start getting kicked to the curb.

So the process is when narrative and numbers don’t equate not good. Stick with process, or give Zscaler that rare exception?

(2) FUD. When FUD is partially based upon real fundamentals then it is not an investable FUD event. For Zscaler there is true FUD around “breaking O365”. Clearly false ad untrue. But there is also declining fundamentals. Compare that to the Alteryx and Tableau FUD event. That involved the false precept that Tableau was an existential threat to Alteryx. Scary but quite investable as so many of us fortunately found out. But at no point were Alteryx’s numbers ever pinged by this. It was purely narrative and not numbers that created that FUD event.

Trying to be smarter than the market hurts. I’m not. Maybe some are. So it is whether to give an exception to the rules of the process or stick with the process. Given alternatives I am sticking with the process. I therefore did reduce my ZS holdings substantially. Nice profit on the back end anyways as ZS made a nice recovery. It has been something I was pondering since the summer to do anyways (And did not do because of tax issues, but I may have to rethink this tax fear - and no one should underestimate the danger of taxes - but perhaps too much on my part in regard).

Following the process I am taking that money and putting it elsewhere (even though Zscaler has done decently well since it bottomed last.

I will read other comments in regard and see if it changes my thinking at all. But I think the process points are important, and it is something I have been considering to do anyways for months, and nearly did so before earnings yesterday.

What keeps us in I think is how ZS has always been so “prudent” in the past, and that yes they have beat all expectations in the past. They may very well recover in the future as well when they get over this stumble, but that is adding “hope” to replace numbers and process. My way of thinking anyways.



Gartner predicts 2023 as when NGFW appliances start getting kicked to the curb. .
If they wait that long to even get started, those companies are already well down the road to failure. You don’t get a decade to fix broken processes anymore. The next recession and/or a reduction in supply of very cheap capital will reinforce this.