Zscaler - A Deep Dive into my notes Part 2

Start of Part 2

Sept 2018 – Post by Tinker
The use of appliances to provide security will be disrupted. The disruptors are the public cloud players and one small player only, Zscaler. The three most desired things by IT chiefs are exactly what Zscaler offers. Yes, it is completely disruptive with no real competition. The cloud titans do not guard your iPad, laptop, server in the bathroom, etc. Zscaler does, with no appliances, nearly zero latency issues, and an architecture that keeps hackers out of the data center to begin with. Zscaler enables the truly data centerless internet as your network, a paradigm that GE pioneered even before ZS came along. GE had to write its own software at the time because ZS was not financially stable enough at the time when they first looked into ZS, but a year or so later they moved everything to ZS to enable the internet as the network. Zscaler (is one of the) most dominant companies from a Competitive Advantage Period (CAP) perspective.

Does this justify the valuation? It does to me on the value of ZS as an acquisition, and the long term value of ZS, without question. As Cisco has stated, Cisco, Symantec, and ZS are in a multi-billion dollar business that will be divided up between them, and as we have seen Symantec’s business is starting to go down the tubes already. This leaves Cisco and ZS, and Cisco is dependent upon appliances.

Either ZS will end up becoming dominant, and taking in billions in 3 to 5 years, and thus blowing away its current valuation, or it will not but it will at least grow into its current valuation. I believe the former scenario is extremely likely.

Zscaler is fundamentally a huge winner. As a world wide monopoly, with hyper growth that should be quite long-term, being the key enabler to at least two enormous secular growth markets (cloud and SD-WAN (65% compounded growth estimates - and why put in an appliance when you can just plug and play your off-premise offices through the internet) that are experiencing in my experience even faster current growth.

Just one example as to how disruptive this is. What happens when a company acquires another company in regard to integrating their data centers and software? With ZS who cares. No need to integrate disparate security systems and protocols. Just put each company on ZS, 100% cloud.

Anyway, I have nothing more to offer on valuation, other than my thoughts above. My thoughts on the fundamentals of the company as expressed above however I believe are spot on and less prone to subjective analysis.

If anyone knows of any real competitor to ZS let us know so we can discuss it. Obviously the cloud titans play a role in this, but they really are not competition for it. As an example, for Microsoft 365, Microsoft is using ZS for security. To the point that at ZS’s first convention called Zenith, Microsoft had two presenters, the CEO and CIO. You do not see that everyday at a small company’s first user convention. GE sent their CIO who gave a great presentation of what ZS is all about paradigm shifting wise. AT&T gave a presentation because AT&T is pushing SD-Wan, and of course Zscaler is the way to go security on SD-Wan.

Unless Zscaler’s fortunes suddenly turn for some reason, it seems incredible to me that I was able to get into what appears to be a possible real Gorilla at just a $3.5 billion enterprise value, with many years of hypergrowth left, with multiple year head start and advantage over the rest of the world, and an industry loaded with legacy company’s dilemmas. The legacy companies need to sell appliances that are expensive, and cannot afford to go software only. Doing so would crush their finances. Thus the legacy players will push the need for appliances in the hybrid world, and ZS will say, so what. Why do you keep unnecessarily complicating your IT.

Sept 2018 – July quarter results
Revenue up 54% and up 14% sequentially, to $56 million
Billings up 72% to $95 million, which was a real outlier, as the previous high quarter was $66 million
Cash of $298.5 million and no debt
Adj operating loss was $2.4 million, or 4% of revenue, improved from $7.2 million, or 20% of revenue.
Adj net loss was $1.4 million, improved from $7.4 million
Adj net loss per share was 1 cent, improved from 7 cents a year ago
Operating cash flow was positive $14.7 million, up from negative $3.7 million.
Free cash flow was positive $11.9 million, or 21% of revenue, up from negative free cash flow of $5.4 million, or 15% of total revenue, a year ago.
Deferred revenue up 70% to $164 million.
Cash was $298 million .

Fiscal Year Results
Revenue was $190 million, up 51% .
Adj operating loss was $15.4 million, or 8% of revenue, improved from $19.3 million, or 15% of revenue.
Adj net loss was $14.4 million, improved from $19.7 million
Adj net per share was a loss of 13 cents, improved from a loss of 19 cents
Operating cash flow was positive $17.3 million, up from negative $6.0 million.
Free cash flow was positive $2.1 million, or 1% of revenue, up from negative free cash flow of $14.2 million, or 11% of total revenue, a year ago.
Raised $205 million in our IPO in March.

Conference Call
We believe we have the right architecture and are the best choice for securing the cloud world. We are going after a $70.7 billion TAM

Total backlog, or remaining performance obligations, was $398 million, up 81% from $220 million yoy, and up 30% from $305 million sequentially.

Our increased success selling bigger deals up front, which start with the transformation bundle, and faster up-sells within a year, while good for our business can reduce our net dollar retention rate.

Our quarterly operating margin was a negative 4%, improved from negative 20% yoy.

We expect ZPA to gain, to grow at a faster rate than ZIA. But ZIA is growing very fast too. It’ll be very hard for ZPA to catch up with ZIA even though the market TAM of both platforms is essentially the same. In terms of sale cycle, it depends. We have two types of use cases in ZPA:

One is what I call transactional. The customer saying I hate my VPN could you replace it? That’s quick, that’s faster.

The second is more transformational. I want to eliminate the old way of going to cloud. My applications are going to Azure, AWS, and Google. I want to go direct through Zscalar ZPA. Those things take a little bit longer because we have to educate the customer with architectural transformation. And we expect ZPA market share to grow as a part of the overall product mix.

Bert’s Take on Earnings (shortened and paraphrased)
Zscaler reported one of the strongest quarters that is likely to be seen in the enterprise software space for some time. Sure, its shares are priced to perfection. But the quarter reported yesterday WAS perfection, and it provides me the confidence to suggest that you either establish positions or increase your holdings.

I am aware that ZS shares are very highly valued. Looking at the next 12 months the EV/S is probably near 16X. Presumably, that the reason for the significant short interest, 15% of the float last month. But ZS is disrupting the enterprise security space in a major way with unique technology and it will be one of the larger security vendors there is in a few years. I can’t prove that, but the numbers speak for themselves.

ZPA, a relatively newer product, has taken off at a rate seldom seen for a new product in the IT space. Even with the high growth rates ZS reported, ZPA more than doubled its percentage of new business, from 4% to 10%. ZPA will continue to grow faster than ZIA for the foreseeable future, but it is not likely to overtake the revenue of ZS’s initial product in the near future.

Eliminating VPN infrastructure is a long-term desire for many users, and ZPA has been able to provide for that. Its adoption appears to be moving at a very strong rate. I have personally heard about just how unhappy users are with many VPN solutions for years. ZS has solved a long-standing problem in IT and long before anyone else.

Obviously, some readers will want a deeper understanding of the differentiation that ZS offers, and why it is not likely to be duplicated by competitors. Without extending this post to an unreasonable length, the basic issue is that the ZS architecture is obsoleting the traditional way of providing network security and it is economically difficult for the large NS vendors to obsolete their own technology.

I thus suggest than in looking at valuation, it is prudent to look at growth rates reaching to 50% and higher for some years on into the future.

As of today’s closing price of $42 and outstanding shares of 124 million, the company has a market capitalization of around $5.2 billion. It current enterprise value is about $4.9 billion. The available market for Zscaler is so large that it is reasonable to talk about the company exceeding 50% growth for years.

Bert’s Update: (shortened and paraphrased) Our weakest holding in the high-growth portfolio last week was Zscaler. Zscaler is suffering from valuation concerns. Even analysts who don’t like the stock acknowledge its leadership role. Most realize that growth will far exceed the consensus “forecast.” Many share my belief that Zscaler has developed a new paradigm that will disrupt the network security space and will replace, in whole or in part, the rather obsolescent firewall technology. Zscaler continues to execute well.

Part of the strong over-attainment last quarter had to do with a major transaction with the DOD that totaled more than $16 million in bookings. That was a non-competitive transaction because no one else could achieve the performance requirements of the RFP. Not Checkpoint, not Palo Alto etc.

The throughput requirement of that contract is not typical at this point. It is several times greater than other large installations. But over time, all users are going to want the kind of performance that Zscaler enables. The firewall technology is really no longer capable of being successfully deployed where the frontiers of performance are being tested. The source of growth is that ZS is starting a very long journey to disrupt network security and it should be able to over-attain estimates for years to come. That is the bet one makes in investing in the shares of a company whose valuation doesn’t seem justified.

Brittlerock’s Post - (shortened and paraphrased) ZS provides mission critical functionality with essentially zero competition? The manner in which ZS provides this functionality greatly simplifies the IT infrastructure via the elimination of myriad appliances? Can you understand that while ZS provides vastly improved protection, it simultaneously enhances the user experience?

I spent 30 years in IT. I was not in the security department but I worked with those folks on a regular basis. I am 8 years into retirement and the environment has changed drastically in that time. The threats have multiplied and the sophistication of the attackers has increased dramatically. I can say with a fair amount of confidence that every alternative to ZS has greater vulnerability while simultaneously degrading network performance (that’s why I said that they have no competition). I pretty much understand what they do, I just don’t understand exactly how it’s done. I don’t need to know that to have a high degree of confidence in the company as an investment.

Sept 2018 - Puddinhead’s Post shortened and paraphrased

Both Okta and Zscaler are part of a “zero trust” architecture (trust nothing or no one unless you know who they are, where they are coming from and where they are going).

To me Zscaler seems like it took the place of my old VPN. When I take my laptop home, it is just like being plugged in at work. I see my local MS Outlook and all my corporate share drives. But unlike my VPN it is transparent to me and FAST. I don’t have to login to it each time I go home. I just turn on the laptop and start working. Awesome.

But the big deal is that Zscaler lets my company jetison all the old security hardware. With VPN, I went from home, to the company “ingress” then back out again to a clould, or stayed in on a share drive (which was slow). Now, I go seem to go through the (fast) ZScaler cloud from home. They make sure I am encrypted and protected. Access is fast and easy.

Each Sunday or Monday I have to reauthentic Zscaler. That means pushing the authenticate button, which then presents me with my Okta login. Once I authenticate with Okta, I am send a second authentication request to my phone. I push that, it goes to my OktaVerify app and I press accept again and I am in. It might sound complicated, but it is not. This provides two-factor authentication so even if someone gets your password, they would need your phone and its password to authenticate on the second step.

So back to the hardware aspect. Hardware sucks. We are currently in the process of spending TONS of tax payer money to replace “End of Life” equipment on our customer job (Cisco routers, switches, Dell Pcs, Printers, phones, servers, etc). The hardware still works fine, but the manufacturers no longer provide security updates, so the Gov requires it to be replaced. Nice little game. But the same is true for the stacks and racks of security equipment that Zscaler replaces. That gets old. The processors can’t keep up. The security patches are discontinued. Then your company spends money out of their profit to replace it all and pay the nerds to keep it updated and running smoothly. With Zscaler, no equipment, and only a couple of nerds to keep it running, not an entire nerd herd.

My “new” company had the chance to start from scratch and they chose Okta and Zscaler, … and more. I love how Zscaler simplifies my life. I suspect the company loves how it eliminates all that hardware.

Nov 2018 – Tom Gardner’s Recommendation (VERY shortened and paraphrased)
Let’s talk about the future of cybersecurity. You might not know anything about hacking a network or protecting against a cyberattack, but the idea of building walls and moats for protection goes back to ancient times. That’s essentially what the first generation of cybersecurity did: It protected in-office networks from external attacks. And just as the invention of catapults, battering rams, explosives, and fighter jets made castles and forts vulnerable to new attacks, so too have technological advances forced a new set of security innovations. That’s where Zscaler comes in….

Risks and When We’d Sell

• Zscaler is well aware of the vast group of competitors it’s fighting.… Many of these competitors have better name recognition, more customers, and greater scale. But they also have legacy technology. Perhaps that’s why Symantec is suing Zscaler for patent infringement. As with Arista and Cisco, we don’t expect this to be a material factor in the long term.
• …If hackers managed to penetrate Zscaler’s defenses, then the resulting loss of confidence could cause….
• Finally, it’s essential for Zscaler to maintain good partnerships with other providers of networking services….

Dec 2018 – Oct quarter results
• Revenue up 59% to $63 million
• Calculated billings up 56% to $65 million
• Deferred revenue up 68% $165 million
• Adj net income of $2.0 million improved from a loss of $7.5 million.
• Adj op income was 2% of revenue or $1.2 million, improved from a loss of 19% of revenue or $7.4 million.
• Adj EPS was 1 cent, improved from a loss of 7 cents
• Op Cash Flow was 17% of revenue or $11.0 million, improved from a loss of 11% of revenue or $4.4 million
• Positive free cash flow was $5.2 million, or 8% of revenue, improved from negative $8.9 million, or 22% of revenue
• Deferred Revenue: $165.3 million, up 68%
• Cash $314 million, up $15.5 million and no debt.
• Named a leader in Gartner Magic Quadrant for the 8th year in a row.
• Zscaler Private Access (ZPA) became the first zero trust architecture to achieve AWS Security Competency status.
It is one of four cloud service providers selected to pursue Joint Authorization Board (JAB) FedRAMP certification, at the High Impact level, through the FedRAMP Connect program. This sets the stage to further expand its growth within the Federal market.

Conference Call
While we are pleased with our profitability ahead of schedule, we’ll continue to aggressively invest for growth. We believe we have a unique opportunity to disrupt and to capture a large market opportunity. We plan to achieve sustained profitability and positive free cash flow sometime in fiscal 2020.

I’ll tell you an interesting dialogue I had with a CIO of Global 2000 company. I went to see him. I said, hey, thank you for making time for me. I know I’m a very tiny fraction in your overall IT budget. He interrupted me and he said, “Stop! You may be a small piece of my IT budget but I don’t have a cloud strategy without you. So I want you to come and see me every six months.”

Saul: My overall take: Awesome quarter!!!

Bert’s Take - Zscaler disrupting cyber security at an accelerating pace (Shortened and Paraphrased)

Zscaler showed again just how disruptive its technology is in the cyber-security space. The numbers alone are enough to show just how its technology is making inroads against the traditional paradigm of firewalls and overly complex network management. Revenue growth was far above the consensus, reaching 59%. More important perhaps was bookings growth of 56% which compared to prior consensus estimates of 44%.

And, in the wake of particularly strong revenue numbers, it was able to report its first ever profit, a year earlier than schedule, and it also was able to generate positive free cash flow.

I think hyper growth is likely to continue on into the future. Zscaler has achieved the success that it has is because it offers a radical departure from the security offerings of all of the well-known firewall vendors. Its solution has a lower cost, it is far easier to install and manage, and it is more effective, overall. At some point, competitors will have to adopt the Zscaler technology. Until they do, and can show that their solution works at least as well, Zscaler will be able to win new customers and take market share at substantial rates. That is why you should own ZS shares.

One win that was highlighted in the conference call relates to a Fortune 100 conglomerate that simply replaced its entire security infrastructure with Z-Scaler across what are called local internet breakouts. It is the kind of deal that Z-Scaler would have been unlikely to close a few quarters ago when CIO’s would be less willing to move to this technology in one bite.

A large component of the positive commentary on the call was relating to its ability to sell these large deals, that are not totally greenfield opportunities.

A more typical deal reported on the call was the upsell of Zscaler within a large food and beverage company which went from using the technology as part of a mobile network that had 50,000 users to using it for the entire employee base and deploying the transformation bundle.

My guess is that Zscaler will continue to over attain in terms of earnings, and cash flow as well.

Dec 2018 - Bert’s Short Post (Shortened and Paraphrased)
… I strongly believe that ZS has developed differentiated technology to secure cloud networks, and to replace appliances and VPN’s. Indeed, I see that happening already. Those who find the shares over-valued simply don’t understand the product differentiation and the disruptive power of this technology. The shares remain at levels that simply do not reflect the disruptive potential of the technology.

Dec 2018 – Excellent article by Niki Schranz (shortened and paraphrased)

Zscaler: don’t miss it because of valuation concerns. I think it is getting more and more obvious that Zscaler is in the process of accelerating growth. Strong business momentum should drive shares for two reasons: In the short term, estimations will be revised to the upside regularly. At the same time, there are major long-term tailwinds from their disruptive approach to cybersecurity, and their competitive advantage as first mover and market leader, giving them a very long runway.

What could keep stock appreciation in check at the moment is its steep valuation, which has been a “problem“ since the IPO. However, explosive growth of the business reduces the downside risk considerably. I think Zscaler should definitely be in the portfolios of innovation focused investors. I expect it to generate significant alpha in the years to come.

To understand what Zscaler does on a high level, you must be aware of two basic trends that are happening right now: First, company applications and data are migrating from company networks to the cloud. And second, employees are becoming more mobile and need secure access to company resources from any location and device.

However, the current IT security paradigm is not very well suited for this changing environment. For legacy network security, imagine a company network like a castle and a moat. To enter the castle, organizations created internet gateways (protected by firewalls) that provide a drawbridge across the moat. These gateways separated the internet from users, data and applications.

Furthermore, companies typically built their networks as hub-and-spoke architectures. This means having large, central network headquarters, through which every IT-traffic has to flow. No matter from where or from which device an employee or third party wants to access apps and data, he has to get access to the network first through the HQ. The network HQ is the center of gravity of all IT in the company. Even if not all company applications are located in the HQ (but for example in the cloud instead), it is always involved.

There are many inefficiencies in this picture. One of the biggest problems is that you create huge traffic through the network HQ. Handling this traffic is very complex, expensive, and often causes bad user experiences. It is a classic example of a bottleneck and makes a wonderful target for hackers trying to do harm (single point of failure). Until now, companies have responded to security threats by adding complexity to make it harder for hackers to infiltrate their systems. But this hasn’t stopped them from hacking. On the contrary, this dynamic has caused a rat race, as increasingly complex security threats led to ever more complex and expensive network security solutions.

The challenge of today’s cybersecurity is that employees are increasingly embracing the opportunities to work from outside the office, while applications and data that used to live in the network HQ are slowly moving into the cloud. And here lies the paradigm change in a nutshell: While the center of gravity for the companies’ IT moves from the companies’ HQ to the cloud, the internet becomes the new corporate network. Zscaler is in the lead to secure the new corporate network based on the internet.

When a ZScaler sales representative comes up to an IT department of a customer nowadays they can promise the following:

• Your applications will be more secure.
• We will help with your migration to the cloud and make it easier.
• Your apps will be more accessible to users (employees).
• You will save money (potentially millions of dollars per year).

More security, more user-friendliness, lower cost and you will help me migrate to the cloud? That’s a heck of a sales pitch.

Competition - Cybersecurity has has attracted a long list of possible competitors. However, Zscaler doesn’t have too much to worry about in this regard for the moment. Recently, it was named a leader in the Gartner Magic Quadrant for Secure Web Gateways for the 8th consecutive year in 2018.
Judging from this report, Symantec (through their Bluecoat acquisition) and iboss appear to be the biggest direct competitive threats for Zscaler at the moment (in terms of comparable technology). However, Symantec is going through big operational struggles at the moment, which most likely will limit their ability to stay on par with Zscaler, and iboss currently lacks the scale to really hurt Zscaler.

Obviously, you shouldn’t disregard big players in the cybersecurity space like Checkpoint, Palo Alto Networks, or Cisco either. It was rumored that Cisco actually tried to acquire Zscaler before the IPO. It is safe to say that these companies are aware of the disruptive nature of Zscalers products and will be tough competitors going forward.

In my view, Zscaler should do well regardless of the competition as the cybersecurity space is large enough for many players to do well. Zscaler’s other advantages are that they are solely focused on their disruptive cloud-security products and have a head-start to everyone else. Not to mention various patents that protect their technology (although some are currently challenged by competitor Symantec) and their global cloud, comprised of more than 100 global data centers on six continents.

Are shares grossly overpriced? - At a share price of $41, Zscalers market cap stands at $5.5 billion. If you take my optimistic revenue projection for FY 2019 of $300 million, we arrive at a forward PS ratio of 18.5. If you back out cash from the market cap the forward EV/S is 17.4. That’s not cheap.

Making sense of Zscalers premium valuation - Their product, is really disruptive. While Palo Alto basically improved the way firewalls work, Zscaler is totally reinventing the cybersecurity space by ultimately rendering the companies IT-network and traditional firewalls useless.

• Their total addressable market seems to be bigger. And they expect that number to “increase substantially“ due to the opportunities to deliver additional services and expand their platform to smart and connected IoT devices.
• Zscaler has mostly recurring revenue.
• Zscaler’s deferred revenues of $165 million were 77% of TTM revenue of $214 million.
• Their gross margins, were 81.7% last quarter, and they are not even trying to maximize that yet.
• Zscalers revenue growth looks to be accelerating. Wall Street typically loves accelerating growth and so should we as individual investors.
• Zscaler is founder-led and has considerable inside ownership. Founder and CEO Jay Chaudhry holds more than half of the companies shares directly and through trusts. Chaudhry has a lot of skin in the game…

Closing thoughts - If you are a fan of disruptive, founder-led companies Zscaler is definitely one to add to your shopping list. Disclosure: I am long ZS.

Feb 2019 – Jan quarter results This is their most recent quarter!
• Revenue up 65% to $74 million. Up 17% sequentially.
• Calculated billings up 74% to $115 million
• Deferred revenue up 73% to $206 million
• Total backlog up 69% (Remaining Performance Obligations) was $461 million up from $273 million a year ago.
• Adj net income of $11.6 million up from a loss of $2.8 million a year ago
• Adj operating income was $10.0 million, or 13% of total revenue, up from a losss of $2.7 million , or 6% of total revenue, a year ago.
• Adj EPS was 9 cents, up from a loss of 3 cents a year ago.
• Operating Cash Flow was $15.7 million, or 21% of revenue, up from a loss of $1.1 million, or 2% of revenue, a year ago.
• Free Cash Flow was $12.0 million, or 16% of revenue, up from a loss of $4.6 million, or 10% of revenue, a year ago.
• Cash, was $340 million and No Debt.
• Achieved FedRAMP authorization for Zscaler Internet Access™-Government (ZIA™-Government), becoming the first secure internet and web gateway solution to earn FedRAMP certification.

Saul: My Take – It looks great!

Conference Call
Imagine 80% of the luggage passing through airport security unchecked. You can’t, because that would be unacceptable, but this is exactly what happens when organizations attempt to use next-gen firewalls.

Operating Margin was a positive 13% up from a negative 6% margin a year ago.
Net income in the quarter was $11.6 million or adj earnings per share of 9 cents.
Free cash flow was positive $12 million in the quarter compared to negative $4.6 million for the same quarter a year ago

Looking forward, our plans are not to maximize profitability or to generate additional operating leverage, but to invest aggressively in our business to pursue our significant market opportunity. I want to remind you that historically Q2 and Q4 have been our strongest billing quarters with sequential declines in Q1 and Q3 quarters respectively. This sequential decline will be accentuated by the multiple greater than one year billings we had in Q2, including $11 million from the public sector customer.Also keep in mind, that we had a large upfront billing of $16.5 million in Q4 of 2018 that will pose a tough year-over-year comparison in Q4.

Bert’s Take on earnings (shortened, etc)
Zscaler reported another outstanding quarter. Growth of revenues and bookings actually accelerated, with bookings growth over 70%.

It reported strong operating leverage - adj margins were about 15% and the op cash flow margin was above 20%.

It continues to achieve extraordinary success capturing large new customers and selling more seats, and more transformations, to existing ones.

It doesn’t have any competitors at this point that can match its overall capabilities, although there are a number of entrants in the broadly defined space.

Zscaler’s Excellent Quarter - ZS shares have appreciated since the earnings release, rising by almost 22% before pulling back a little since that recent high point. They trade at an EV/S of perhaps 17X on a forward basis - even after adjusting for the exceptional operational performance that the company achieved this past quarter and its revised outlook over the next several quarters. Can a reasonable case be made for holding these shares or should investors take their profits and go home?

I think the risks, other than market risks, are over-rated. Zscaler’s valuation is high if one believes that its growth is slowing. Its valuation is far less extended if one believes that its results are representative of its potential. There simply aren’t that many businesses that have recorded 3 quarters in a row in which bookings growth exceeded 70%.

My case for making a commitment to Zscaler, is that it has opened up an enormous first mover advantage in what is called the Secure Web Gateway space, and that the technology it is selling has the potential to replace much in the way of IT security infrastructure that has come before. But there is no real visible analog in trying to evaluate Zscaler because essentially what the company is offering has not been done before. That is the bet one makes in investing in this kind of name - and while it is not for everyone, I think it is a reasonable opportunity based on all I know about the space.

Why has Zscaler become so successful and can its advantage be maintained? It ought to be apparent that what ZS does is highly disruptive to an industry that has essentially been built on selling a consistent architecture to users for more than two decades.

ZS remains the leader in the area of Secure Web Gateways. That doesn’t mean there aren’t alternatives to Zscaler’s offering or that ZS wins every competition. Zscaler is the segment’s only pure cloud delivered gateway that requires no hardware investment on the part of users. That is a major difference when compared to all the other vendors that have been reviewed, and one that is most often dispositive for the large enterprise customers that ZS is targeting.

My belief is that as a practical matter at this time, it has limited competition for the solutions it offers. That is even more so in its product area that is called ZPA, or Zscaler Private Access, which is the fastest growing segment of the company’s business. ZPA has reached about 15% of the company’s bookings at this point and is likely to become an increasingly greater proportion of the company’s business.

It would be surprising if the legacy security vendors didn’t seek to offer users some alternative for the services offered by ZS. But there is an obvious problem for legacy vendors because in doing so, they risk cutting into the highly profitable business they have in selling appliances and all that goes with those appliances. So, they continue to sell users firewalls based on appliances for some data from some applications, while using an alternative architecture to inspect data that is routed through their purpose-built data centers for data from some devices, and for some applications.

The problem is that what the legacy vendors are offering is a disjointed solution. The concept of a hybrid security offering for the web is flawed in a multi-cloud world. I imagine there are others who will disagree regarding the efficacy of a hybrid approach when it comes to security, but the concept of ZIA simply seems to resonate with users who want to abandon the highly complex advanced firewall technology that has been around for basically 25 years or more.

The issue differentiating ZS offings from those of its competitors can also be one of performance. Part of the vision of Zscaler has always been its ability to … well scale. And so, it won the sole source procurement with an unnamed Federal agency that has so far resulted in almost $27 million of bookings and is supposed to grow to an ultimate deployment worth at least $50 million and perhaps significantly more. That is a pretty substantial piece of business for a company whose revenues are just now crossing a $300 million year run rate. The reason for ZS success is that it was the only competitor who could fulfill the requirements of the job.

One substantial tailwind for this company has been the broad scale adoption of Office 365. Office 365 is going to require substantial investments in hardware and administration because it pushes substantially greater traffic to the web. Using a secure web gateway makes the migration much less onerous than is otherwise the case. The hub and spoke architectures that have historically been used to implement security using appliances can add substantial latency and degrade the performance of Office 365; Microsoft recommends a direct internet connection and that is best accomplished, apparently, using the Zscaler approach.

I am not going to argue here that appliances and firewalls and VPNs (virtual private networks) are ready for the dustbin of history. What can be concluded is that both secure web gateways and Zscaler’s Private Access solution are the leading technologies that users are acquiring these days that have the flexibility and capacity to replace firewalls and appliances, and which have been purpose built to serve modern cloud deployments.

ZS does not offer what appears to be a low-priced solution when compared to firewalls and appliances or even compared to other secure web gateways at this point. On the other hand, since it is a service and not hardware, the cost of product refreshes and network management disappear in a ZS deployment, in whole or part. Obviously, the zero-trust solution may improve the security performance of an enterprise, and valuing that is impossible. But in terms of typical cost analysis, outsourcing security to a 3rd party, the Zscaler paradigm is inevitably going to save money when it comes to indirect costs such as admin, power, A/C and real estate. And the requirement for back-up in terms of hardware and other infrastructure required in traditional deployments is not an insubstantial cost consideration.

The ZS business model: one that can support hyper-growth and a positive investment conclusion
Last quarter, on a GAAP basis, ZS operating expense grew by just 8.4% sequentially, compared to the sequential increase of 17% in revenues. That kind of progression is very unlikely to happen again in the near future. In particular, the sequential growth of 6.5% in S&M expense, regardless of the timing of its major customer event, seems just not likely to be seen again. It also seems likely that it will increase its spend on R&D faster going forward than it has in the last couple of quarters. ZS spends less on R&D than many other hyper growth vendors and it would not surprise me to see that spend ratio tick up noticeably. Stock based comp is in-line with other IT vendors seeking to hire rapidly.

What could go wrong and what should investors do with ZS shares. Of course there are risks, and it makes sense to point them out again. Most important, are the risks related to competition. There are plenty of competitors in the Secure Web Gateways space. I think that there is a huge difference between ZIA and its competitors and one that is resonating well with customers. Competition is and is likely to remain less of a factor in ZPA.

Another risk is one of execution. Any company growing at 50%+ is performing a high wire act. Selling the ZS paradigm shift and getting users to buy transformation bundles is a major undertaking. Not all sales cycles will be successful. As mentioned, ZS is building up an executive suite to take the company to the next several levels - but inevitably, that remains a work in progress.

A real risk is that this company has a record of booking large deals of a size far greater than might be typical for a company of this magnitude. That means that some performance metrics will be lumpy and from time to time will disappoint some investors.

All of that said however, the opportunity to invest in a technology that is replacing one of the foundations of IT is not one that happens frequently. My guess is that in a few years, the battle between the legacy solutions of appliances and firewalls and secure web gateways will be over, and that the kinds of solutions that ZS offers will become the industry standard. My conclusion is that ZS shares, even at 17X+ EV/S, are not nearly as expensive as they look. I expect that they will continue to provide investors with positive alpha for a considerable period of time to come.

Saul: My Take - Why is Zscaler’s revenue growth accelerating like that instead of slowing down by the law of large numbers? Well their revenue last quarter was only $75 million. It’s a small company. And they aren’t selling something trivial like Docu or Zoom. For a big company to trust Zscaler with the family jewels of its security system requires an act of faith. Therefore, as Zscaler has grown and signed up more and more large companies, prospective companies now see a listed company, with considerably more revenue than before, and more large company references, and large company prospective customers feel better and better about trusting them. So it snowballs, and it gets easier and easier to sign large customers as they grow, and they seem to have passed that inflection point.

**Jan	 Apr	  Jul	   Oct	          Fisc July Yr**
**2016: 	          19	 21	  24       27	         	  80**
**2017: 	          29	 33	  37       40	         	 126**
**2018		  45	 49	  56       63        		 190**
**2019		  74** 

**% Increase**
**2017: 	          56     59       55      49	 		  57%**
**2018		  53	 49	  54      59           	          51%**
**2019		  65**

Notice how the rate of revenue increases was gradually decreasing up to their IPO in March 2018, and has markedly accelerated sequentially each quarter since. The reason (as I wrote above) is that as they have grown bigger, and IPO’ed, and as they have more very large enterprises as happy customers, that makes other large enterprises more willing to trust them with the family jewels. They seem to have passed an inflection point and are taking off. Note that this fiscal year (July 2019) will have a growth rate of 61%, up from 51%, if January’s rate of growth holds, and in the high 50’s even if it slips a little.

**2016: 	         29	 31	  33       25	         	  96**
**2017: 	         44	 32	  55       42	   		 156**
**2018	         66	 55	  95       65        	         258**
**2019	        115** 

**% Increase**
**2017: 	         54      49       65      65	 		 63%**
**2018		 49	 73	  72      56           	         65%**
**2019		 74**

How often do you see a company with over 70% increases in billings for three quarters out of the past four. If you don’t have a position yet in Zscaler, where the heck have you been the last year?



A link to the Knowledgebase for this board is at the top of the Announcements panel that is on the right side of every page on this board.

For some additions to the Knowledgebase, bringing it up to date, I’d advise reading several other posts linked to on the panel, especially “How I Pick a Company to Invest In,” and “Why My Investing Criteria Have Changed,” and “Why It Really is Different.”