Zscaler looking no-brainer-ish

Investment Analysis Clubs Saul’s Investing Discussions
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I really appreciate @MajorFool20 pointing out the MELI opportunity, and so in turn I’ll mention Zscaler. Though the stock is down 24% ytd for no good reasons that I can surmise, to a market cap of just $27b, look how steadily they’ve grown non-gaap EPS the last 8 quarters:

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I got back in over a month ago, but the additional haircut the last couple weeks inspired me to bump the position higher.

Valuation-wise, ZS’s trailing PE is 66.4, lower than MELI’s! (But to be clear this is very apples to oranges, because ZS’s “E” is non-GAAP and MELI’s is GAAP.) But ZS’s (non-GAAP) net margin is a lot higher, about 21% by my calculation. So their PE is a lot closer to their FCF multiple, 54. Therefore, it’s unlikely ZS’s profit margin will double in short order, but I still think it can expand some, and rapidly growing revenue will be a multiplier, so I see the above chart continuing.

So while MELI’s profit expansion could be more explosive, you’re still getting expansion with Zscaler, and I think with fewer risks. They’re a subscription software business and that will always give me a lot of confidence in the model. And while cybersecurity companies (other than CRWD) aren’t really cool right now, Zscaler is a leader in their space. They’re clearly not trading at anywhere near the premium of CRWD or other leaders (where ZS has traded in the past), so to me this looks like quite a no-brainer right now.

I’ve increased my position over the past couple weeks, but it’s still sub-10%. I’d like to know why in the world the stock is down 24% ytd. There is of course a chance that the growth will slow faster than I expect and the above chart still continues/increases but less and less so, and soon begins to flatten/plateau. I don’t expect that, but I’m not at the point where I want to put 15% or 20% of my eggs in this basket, and probably never would be.

If others have thoughts on Zscaler please add them.

Thanks,
Bear

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Here are the Earnings and Revenue estimates, for ZS, for the next four quarter

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Andy

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I have total faith in ZS and have been adding, started way too soon. It reminds me of when the stock slowly tanked to the 80s last year. I kept buying all the way down and my cost basis was great, until I nearly doubled my position since their last ER, which was stellar. I believe the tank is based on nothing, but if I were to hazard a guess why:

  1. The not-yet-public Netskope is rating higher on Gartner in the same space
  2. PANW is moving up the charts on Gartner in the Zero Trust arena. So is NET
  3. PANW saying they were going to start giving away product for free as they move to platformitization (that the word? platformation? Platypustulization?), making everyone worried about a price war that could affect all companies in the space.

I think people forget about the close relationship ZS has with the best name in the field, CRWD. But all in all, this looks very similar to what happened last year when it plummeted on no news. I wish I started adding now, instead of right after Earnings. But I’m in complete agreement with Bear, like I usually am. This seems like an opportunity to me.

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I think much of ZS’s recent issues have been billings related. Management constantly harps on this metric as its best measure of health, yet guided for a 7% sequential decline for Q3. While a seasonal Q3 decline is normal, 7% is more than double the average of the last four years. It also implies a roughly 55% sequential Q4 jump, which in turn would be the highest in five years.

Management was asked point blank about this discrepancy on the call and reiterated they are comfortable with that breakdown. However, they are also doing this with a lot of recent C-suite shuffling including a revamp of the sales group and departure of the COO. Long-time holders will remember ZS experienced something similar in 2019 or so, and it did take a few quarters to turn it around (ironically led by the COO who just departed).

If management indeed hits those numbers, a buy here should look great. If not, this haircut will end up being justified. Even given CEO Jay Chaudrhry’s stable track record, ZScaler has left itself something to prove. We’ll see.

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Just for context, while this is technically true, the last 5 years the actual Q4 sequential increase has been:
49%
48%
48%
51%
49%

So 55% doesn’t seem like an unattainable reach – more like a slight aberration.

Also, since Q3 will be light, maybe it’s a timing thing with some renews getting pushed to Q4 or something?

Lastly, if they beat in Q3, it would lighten the implicit burden on Q4.

Bear

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In the QnA at GTC, I heard Jensen Huang say that Nvidia has ZeroTrust in all their Data Centers! I asked Grok about this and this is what I received back as an answer:
NVIDIA has developed its own Zero Trust platform, which combines three technologies: NVIDIA BlueField DPUs, NVIDIA DOCA, and the NVIDIA Morpheus cybersecurity AI framework. This platform is designed to bring the power of accelerated computing and deep learning to continuously monitor and detect threats, and isolates applications from infrastructure to limit lateral breaches, at speeds up to 600x faster than servers without NVIDIA acceleration. This infrastructure aims to keep users and data safe, while maintaining a seamless user experience. The NVIDIA Zero Trust platform is a result of NVIDIA’s efforts to enhance security in data centers by leveraging its expertise in accelerated computing and AI technologies.

Hopefully, someone here with some technical chops can break down what this means for Zscaler.

Best

Jason

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I’m not very knowledgeable in this space, but I think it’s interesting to note that both $NVDA and $NET have their own ZT solution.

$NET went so far as to launch its “Descaler” program in early 2023, aiming to lure customers away from $ZS and claiming/touting a quick and simple easy migration path.

That makes me wonder if ZT is on a faster path towards commoditization than other cyber-security components,. OTOH, there is evidence against this notion in that to this point $CRWD and $S are partnering with $ZS, not competing against them.

As tangential a side-note, I also think it’s interesting that $CRWD and $S are also both partnering with $OKTA, which to my knowledge enjoys a dominant position in its cyber-security niche (Identity/Access Management, assignment and enforcement of multi-factor permissions at various component-layers, even as granular as at the individual file level).

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True, though at a much higher scale.

Don’t get me wrong. I think they’ll do better than -7% in Q3. But even at the usual -3% or so ZS would need to add ~$270M in net new Q4 billings versus last year’s record $237M. Every percentage point below -3% would require an extra $12M or so in net new Q4 billings.

It’s very possible significant Q4 federal spending is coming now that the US Executive Order from a couple years ago is hitting the contract stage. However, any softness in Q3 would leave a heavy lift in Q4.

I’m still strong in ZS but don’t want to delude myself on what they need to do even if management didn’t hesitate to reaffirm the numbers when asked directly about it.

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Great discussion. Here are some more data points:

This is a recent note from a Barclarys survey. They found positive spending checks for SASE and greater interest in ZS, which made the bank “feel more bullish on ZS …”

On April 16, ZS announced a partnership with a large real estate company (GLP). GLP has 72 offices in 17 countries.

There have been a couple of positive articles on SA recently about ZS:

https://seekingalpha.com/article/4683662-zscaler-buy-the-dip-as-growth-drivers-and-management-execution-will-drive-upside

https://seekingalpha.com/article/4677735-zscaler-this-is-a-dip-well-worth-buying

The second article is from Bert Hochfeld of tickertarget. He rated ZS as a “strong buy” and recommended buying the shares back on March 12 at $200/share (now they’re about $169). Bert thinks the following are some positives: (1) ZS TAM is growing “by having more data and applications to protect as AI applications are deployed,” (2) he believes ZS is a “share gainer vis-a-vis legacy competitors,” and (3) he thinks analysts overreacted to the seasonal dip in billings (which happens every year to ZS). Bert has a quote from the CFO about the guide being “prudent” and also some quotes from the CEO about the “robust” demand for ZS’s products. ZS’s CEO also said they “added a record number of new logos for our Q2.” New logo adds are a good sign for future growth, imho.

Best,
BTL
@laneylawyer on X.
Long ZS

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For those that follow ZS, there was a posting on X/Twitter that a bad actor had successfully breached a cybersecurity player’s infrastructure.

Zscaler’s share price was hit under a cloud of suspicion but on investigation reported that it was in the clear. If it is true and it isn’t ZS but another cybersecurity player one can assume a share price rebound but also potential business opportunities for ZS and negative consequences for said player.

https://trust.zscaler.com/zscaler.net/posts/18686

Don’t forget that latest regulatory requirements are for almost immediate public reporting of breaches as well as potential liability consequences.

Ant

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I’m resurfacing this thread in the interest of revisiting previous thinking and some of the discussions over the past few years about how valuation metrics fit into the overall evaluation of a stock.

Zscaler caught my attention again after the CRWD event and the sizeable sell-off in cyber-security. (I was in CRWD, but exited completely.) ZS is now back below the April 20 levels - the date of the original post. A lot has happened over the past 5 months, but from a growth and forward PE perspective, you could make the case that if it was a no-brainer ~170 that it’s more attractive now at ~160.

Bear - this isn’t meant to call out a mistake. In fact, if you keep a close eye on price and a consolidated portfolio allows enough time to follow each stocks closely, ZS has been a winner: there have been several opportunities to follow your lead - get in ~170 in April and get out (due to higher valuation/changes in the sector/reevaluation of the thesis) at ~200.

But in your most recent update you shared that you were out of ZS and probably wouldn’t get back in because of the lack of future upside.

FWIW, here’s the Fool’s latest:

I’m most interested in learning how/when you go back to picks of the past and specifically if you have any current interest in ZS.

Thanks to you and Saul for all you do.

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No offense taken – I think looking back is a great idea. And like you go on to say, it has actually been over $200 recently, so the call worked out if you got out at the right time. But a lot has happened since April, so how should we update our thinking on the company/stock?

One thing I called out in April was their rapidly increasing non-gaap EPS. It’s a pretty trend that seemed like it would continue for another year or two. Eventually it won’t, and the stock won’t have much upside at that point, IMO. I mentioned in the April post:

Unfortunately, we already saw that this most recent quarter (earnings through July). That’s not why I sold (since I sold before the quarter was announced) – I sold because at around $200, I saw more downside than upside. But here’s what we got.

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88 cents in the quarter ending April 2024 was fairly on track, but the flat sequential EPS in the July quarter (88 cents again) was disappointing, and I think a big part of why ZS sold off.

The overarching theme here is that this is a company that has somewhat durable growth because of subscription revenue, but that growth rate is absolutely slowing. We see that in a lot of SaaS. It’s not a great recipe, when growth gets low enough and the price is still high. ZS closed at ~$162 yesterday which is still a trailing PE of ~51 and a trailing PS of ~12. That’s not cheap. It would be a no brainer if ZS had a couple more years of 30%+ growth ahead. I don’t think it does now.

Full disclosure, I did buy back a small position as shares were falling, before I had really processed the report. I’ll probably keep the shares for now, as I do think it’s pretty reasonably priced. It’s just not growing fast enough to be exciting. That’s why I had said in my August portfolio summary that I probably wouldn’t even trade it anymore (I should have said, “barring a big sell-off”.) But even after the sell-off, I don’t see it as having as much upside as I did in April, so therefore I don’t see it as no-brainer(ish).

Hope that makes sense.

Bear

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Zscaler raised its non-GAAP effective tax rate assumption to 23% for fiscal year 2025 (effective Aug 1). Without that, EPS guidance would have increased, not decreased for FY25. This had to do with the sunsetting of losses carried forward and should be a one-time adjustment to tax rates and how they effect EPS growth.

I’d also suggest that cybersecurity companies are generally viewed as having a longer runway of growth than most SaaS companies (i.e., we only see the criminals activity growing, not waning) and thus Cybersecurity companies have tended to get a bit of a valuation bump. 100% based on the thought that revenue growth will be more DURABLE than most.

I thought it was a good quarter and the street did not. But I do have some concerns that their GTM strategy overhaul is a bit of a risk to growth and I’m reducing slowly from a top 3 pick to a mid-level holding.

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How are you getting that the trailing P/E ratio is 51 for ZScaler? Are you using adjusted earnings and then calculating yourself?

Asking because the standard notation for P/E is GAAP earnings and ZScaler has -58M of net income on that bottom earnings number for the last 12 months, so it doesn’t have a P/E ratio.

One of the main reasons I’m not interested in ZScaler is even with the scale they are running at, they are still not profitable. This is in contrast to companies of similar size like Datadog and Crowdstrike which are profitable.

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Yes! Very important habit, IMO. As Saul says in the knowledge base:

Of course, you’re not interested in CRWD or DDOG either, right? I’m not either. And even ZS is only interesting because the market (maybe due to GAAP profitability) doesn’t give it nearly as high a multiple as other SaaS and cybersecurity companies. None are growing at 40% and even the ones growing at 30% will be more like 20% soon…so from my perspective none are super interesting long term unless that 20% growth holds for like a decade. I don’t think there’s any reason to think it will.

Bear

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I think you should at least be writing “adjusted PE ratio” because this is misleading to write just “PE ratio”. No brokerages list this metric adjusted PE ratio, and when someone writes PE ratio everybody understands that to be a GAAP number. This isn’t an apples to apples comparison to the generally accepted way to use the term. If I go to Yahoo, Schwab, Etrade, Robinhood or anywhere else the P/E (TTM) for ZS is listed as “–” or negative.

For example if I wrote the PE ratio for PANW is 48, would you assume I was just pulling the standard number that everybody uses to mean PE, or that I had calculated adjusted PE ratio myself? How would we know which one we are talking about?

I get Saul’s point about using adjusted numbers because of how stock based comp works, and how if we trust management then we’d prefer to rely on the adjusted numbers. I just don’t think we should be mixing up terms because it’s not an apples to apples comparison of our companies then.

At the same time I am considering that many of the SaaS companies from the 2020 class of IPOs paid out extremely generous pay packages which they are still on the hook for.

Of course, you’re not interested in CRWD or DDOG either, right?

I’m more interested in these companies than ZS because they are being run more efficiently which is evidenced by their better profitability. The primary factor for why I’m not interested in almost any of these SaaS companies right now is their growth have gone down and now they can only talk about “durable” growth which seems to be a term SaaS companies coined recently.

My philosophy has evolved a lot since the SaaS crash and I’m preferring companies which are growing both top line and bottom line growth well. Right now of the eight companies I own they are all growing above revenue 40%, and only one is not profitable on a GAAP basis. Of course, they are all profitable on an adjusted basis though and even more so.

Updating with contrasting the example Saul provided in the Knowledge Base and how that compares to ZScaler. Here’s what was mentioned above,

For those who think that GAAP are the only valid earnings, and that Non-GAAP are just “cheating,” these were the latest PSIX results, at the time I wrote this back in 2015:

GAAP earnings: 68 cents
Adjusted earnings: 39 cents

So this company PSIX actually revised earnings down because of one time issues.

And here’s ZScaler,

GAAP earnings: -0.10
Adjusted earnings: 0.88

Here’s Datadog,

GAAP earnings: 0.12
Adjusted earnings: 0.43

We should at least be questioning with an open mind why such a large adjustment for ZScaler is needed every quarter. Datadog doesn’t need such a big adjustment as ZScaler is using. Although Datadog has more shares outstanding, it’s still a smaller proportional adjustment, and Datadog is profitable without adjustments.

SaaS seems to be the only business model which has these huge adjustments which are always in favor of the company earning more, and in many cases like with ZS, it crosses over the negative to positive threshold, meaning ZScaler is unprofitable without the adjustments.

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That isn’t really true. ZS is a very profitable company irrespective of the adjustments you discussed. Look at the cash flow. That tells the whole story.

Actually, it takes adjustments to get to the GAAP PE. Stock based compensation does not cost the company anything. But that’s been discussed above.

AJ

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That isn’t really true. ZS is a very profitable company irrespective of the adjustments you discussed. Look at the cash flow. That tells the whole story.

It’s true there’s a long standing debate on the best way to measure profitability whether that is net income, adjusted EPS, EBITDA, FCF, or operating cash flow. There’s an argument to be made that cash flows represent the true health or liquidity of the business over net income.

One of the reasons I prefer the combination of net income and EBITDA over cash flow based metrics is that this information is easy to look up on every single company. However, not every company is reporting adjusted EPS, or operating cash flow in their earnings reports. I get that there is a way to calculate the operating cash flow but I want to be able to do simple comparisons between my companies. I want “apples to apples” comparisons which is why I’m challenging the premise of using adj EPS for one company, and GAAP for another which was done in the original post using adj EPS for ZScaler and GAAP EPS for MercadoLibre.

It’s also extremely hard for a company to hide results behind both net income and EBITDA. Usually when companies do have one of these tax one offs, they mention it in the earnings call too, so it’s not hard to track down.

If a company is reported adjusted earnings on their earnings call, I’ll favor that assessment of the business over GAAP numbers. If the company reports FCF or operating cash flows each quarter I’ll look at those numbers and try to understand the trend.

Actually, it takes adjustments to get to the GAAP PE. Stock based compensation does not cost the company anything. But that’s been discussed above.

This is where I do not agree with the consensus on the board that stock based comp has no impact. I’ve seen it written that it’s only diluting the stock by ~3% per year. Looking at the adjustments that Zscaler makes they pay out about 600M in SBC per year, or 100k per employee which is roughly within industry standards, so it’s nothing unusual for ZScaler.

What I’ve seen working in software is that companies is 2020 and 2021 were giving out massive SBC based packages. For example, I know from personal experience that Affirm and Coinbase were giving out 500k+ of RSUs vesting over four years on ordinary engineering positions. Of course, not every employee is going to reach the four year cliff, and some will have left the company especially after their stock options lost a lot of value.

What I am pointing out is the competition for talent in the software industry is huge and to attract top talent the companies need to make huge pay packages to attract employees. This is in contrast to other industries where total comp for a experienced employees might be 200k per year, and SaaS companies may be paying out 400k+ per employee yearly when you factor total comp of salary, bonuses, health care and RSUs.

Many of us on the board are critical of mutual funds which charge a 1-2% yearly fee because that destroys compounding over years. Yet a 3% dilution on SaaS companies is considered standard.

I see Snowflake as the best example of a company with broken promises and excess stock comp. On a GAAP basis Snowflake has net income of over -1B. This is a company which promised once they reach scale their profits would be massive. Yet here we are many years later where revenue growth, NRR, and almost every other metric is way down and the stock has gone from heights years ago of $400 to $120 now. During the height of SaaS, there was one post I looked up on this board where someone was projecting cash flows of Snowflake out to 2029, and pointing out what a bargain Snowflake is.

Something simply is not working with the SaaS business model right now to provide superior returns. I’m looking with a critical eye at SaaS companies which seem to be the only class of companies which need adjusted EPS, while many of other companies in different industries don’t even report an adjusted EPS number.

Like many others on this board I lost 70% or so of my portfolio in SaaS crash, and I’m still trying to put together the puzzle pieces of what went wrong then. Many of the assumptions we had about how these businesses work, and the actual durability of these businesses was completely wrong.

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I couldn’t agree more. Imo, SAAS is over as an under-appreciated (by the general market) segment. Even for the handful of companies that remain solid 20-30%'ers, they are no longer flying under the radar.

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One needs to make a distinction here. “No impact” in this context means neither cash in or out at the time of issuing, despite the fact that GAAP specifies that one must subtract it from GAAP income. Of course, it does have an impact eventually, diluting the stock … when the stock option is exercised, not when it is issued. And, of course, when it is exercised, it actually provides a small amount of cash in. There is no guarantee it will ever be exercised … but then, if the options are not being exercised, you probably don’t want to be invested in that company.

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