This post is in answer to Chris who raised the questions below on this thread: http://discussion.fool.com/zscaler-a-second-look-33158877.aspx?s…
The company [VS] is not profitable so I am using an EV/Sales ratio as a starting point… After backing out the net cash, I get an EV of $5109 287M = $4822M… TTM revenue was $171M so the EV/Sales ratio is a nose bleeding 28.3!!!
However, I look at a company like AYX which has higher margins (90% vs 81%), a slightly higher growth rate (53% vs 51%), a very strong competitive position (essentially no competition according to management), and a MUCH lower EV/Sales (19.8 vs 28.3), how can I not STRONGLY prefer a company like AYX to ZS. ZS’s EV/Sales ratio in a year will be where AYX’s is today.
Here is my answer to your dilemma. I too used to fret over terrible numbers (PE, EV/S, etc) when using conventional metrics and ratios to evaluate young non-profitable companies and sat on the sidelines for a long time before taking a tiny position in them. Slowly, I have come to the realization that especially for disruptive young SaaS companies, conventional metrics are useless. Would I evaluate a Ferrari the same way as a horse-drawn carriage where I not only have to assess the carriage but also the horse? Of course not, so why should I use the same conventional methods to assess the valuation of these young, revolutionary companies that are reshaping whole industries, including the established stalwarts within it? But that’s what most rating services do. I find most of their ratings useless. Of those services available to me, for the evaluation of disruptive companies, I like Credit Suisse the best. They are more in tune with the latest IT developments. In September 2017 they initiated coverage of the Infrastructure as Software sector and have published one of the best evaluations of Cloud Security, a very detailed 255-page treatise. It’s the best I have seen so far and can highly recommend it for anyone interested or invested in cloud companies.
How woefully inadequate conventional ratios are is evident from the PEs of my holdings. The company with the best PE of 12.29, Nektar Therapeutics (NKTR), has done worst, i.e. break even but the company with the worst PE of -505, Square (SQ), has done the best, followed by AYX with a PE of -216.38. SQ by the way has been rated by Schwab as F, strongly underperform, since May of this year. ZS, PE -39.83, acquired at ~$35 and $39, has already risen by nearly 30% in 30 days. It has been rated a Strong Sell by CFRA for months.
Judging from the PE alone, ZS (PE -39.83) should be a better investment than AYX (PE -216.38). I do share your enthusiasm for AYX, a position I trimmed recently when it ballooned to above my comfort level (no position higher than 15%) but in my view, AYX is not as disruptive in data analytics as Zscaler (ZS) is in the cloud security sector that is still in its infancy and where ZS is first mover. In addition, the data analytic space is more crowded and AYX has more potential competitors than ZS. I also make allowances for the age of the companies. AYX is almost a year older than ZS. Its gross margins have steadily risen from 2014-12 to 2017-12: 77.5%, 80.5%, 81.3% and 83.4%, respectively. ZS’ gross margin of about 80% is excellent considering the lower revenue. It should improve.
As far as the EV/Sales ratio is concerned, I agree it is high. But isn’t that usually seen with a disruptor? Rated overvalued, overpriced with insane ratios by most analytic services. I have started to look for a better way to determine the value of SaaS companies and how to compare them. I came across two methods commonly used by venture capitalists: 1. The Rule of 40 and 2. the Bessemer Efficiency Score but I haven’t had the time yet to compile the data and create the tables. I will place references at the end for inquiring minds who want to know.
The 40% Rule, according to Brad Feld who was first to report it, “is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%.” This simple calculation lets you compare a company growing at 100 percent with -60 percent profit margins to a company growing at 40 percent at break-even or a company growing 10 percent but with 30 percent profits. The Rule of 40 is probably the best first pass filter for us growth equity investors to determine whether a business might be a good investment candidate. The rule was designed for companies of at least 50M ARR (Annual Recurrent Revenue) and can therefore be applied to both Zscaler and Ateryx, Inc.
Note that the rule of 40 doesn’t work for early stage companies with revenues at or above 1M, see Sundeep Peechu of Felicis Venture for details.
The Efficiency Score, “measures a company’s efficiency by taking the sum total of a company’s percent growth + percent free cash flow (FCF) margin. This simple calculation quantifies the growth efficiency of a given cloud business. At different stages of a company’s life cycle, their Efficiency Score changes. But for the average public company a few years after IPO, an Efficiency Score above 40 is considered great,” according to Epstein & Harder.
Is there any strong evidence that ZS’s revenue growth will go up dramatically?
I am certain that ZS’ revenue will go up, but I don’t know how dramatic it will be, judging by the so far relatively slow adoption of the cloud and the even slower adoption of cloud security despite an exponential increase in cyberthreats. Zscaler is in an advantageous position and will profit for the reasons below while the security stalwarts that use hardware will become less relevant and some may actually cease to exist.
1. ZS is first mover in the disruptive cloud security market. Its architecture is cloud-based, there is no hardware, no need for VPN (virtual private network) and Zscaler currently defines the market it leads. There are many indications that with growing adoption there will be a shift away from appliance-based choices from companies like PANW, CHKP, FTNT and BlueCoat owned by SMC.
1.1 As leader, ZS is a highly strategic acquisition target for the legacy companies like PANW, CSCO, CHKP, and even SYMC, the latter despite the pending lawsuits.
1.2 Zscaler, significantly cheaper to implement than the security stalwarts mentioned above, will benefit from the disconnect between cloud spending and cloud security spending. According to Gartner, cloud spending was 14% of the IT budget in 2018 while the spending on cloud security as % of the security budget was only 10% in 2018. The divergence is estimated to increase. By 2020 the IT budget percent cloud spending are estimated to be 19% and cloud security as % of the security budget are estimated to be 11%.
1.3 Increased adoption of common enterprise cloud applications such as Microsoft Office 365 will strain network capacity. MSO 365 Outlook alone increases a company’s network traffic by 28%. Zscaler can reduce network strain and reduce infrastructure cost as the FCC’s switchover to ZS showed, saving the agency 70% in security costs. Other companies showed similar high savings.
1.4 ZS will benefit from increasing employee mobility. A 2016 Gallup poll found 31% of respondents spend more than 80% of their time working remotely, up from 24% in 2012. I am sure the numbers are higher now and was surprised that 50% of FCC employees work from home.
1.5 1.5 Acquisition of stealth security startup, TrustPath, including their development team and their market-leading artificial intelligence (AI) and machine learning (ML), allowing ZS to analyze their 50 billion transactions processed daily at peak periods by its cloud. AI and ML will allow the company to “identify anomalous traffic, build user behavioral profiles, compute enterprise risk posture, and detect sophisticated targeted attacks as they emerge.”
2. The Management. Founder and CEO Jay Chaudry owns about 23% of the company and the rest of his team also owns a significant percentage, so management interests are aligned with ours. In addition Mr. Chaudry has a proven record of founding successful companies that were eventually acquired (AirDefense, CipherTrust, SecureIT, CoreHarbor, Air2Web). Note that the Chief Operating Officer William Welch recently left the company to assume that same position at one of the fastest growing cybersecurity companies, Duo, located in Ann Arbor, MI. I have not seen an announcement of a new COO appointment.
3. The Business Model ZScaler’s architecture consists of ZIA (Zscaler Internet Access) and ZPA (Zscaler Private Access). They sell their services as bundles with increasing functionality: professional (proxy gateway), business (proxy gateway plus SSL inspection, advanced threat protection, bandwidth control, cloud application control), transformational (all of the business bundle and the cloud firewall and sandbox). The top service is the combined ZIA and ZPA Bundle. It allows a Zscaler to initially sell a small bundle to a segment of a business, like a subsidiary, a business unit, a unit located in a different location. A company unit may subscribe to the business bundle, initially for remote offices only, then notice the increase in ARR and expand it to the entire corporation and eventually move up to the transformational bundle and the combined bundle of ZIA and ZPA. Credit Swiss estimates that roughly 80% of the recurrent revenue comes from the professional or business bundles. So there is a lot of potential for ZS to sell higher and more expensive services.
4. The Financials. See diablito’s excellent summary. I like the dollar-based net retention rates of 122%, a gross margin of over 80%, accelerating revenue and billings growth. Judging from other companies that received FedRAMP Certification, like NOW, Federal contract value will be highest in the first year and revenue from it was also highest in year one, tapering off thereafter. I expect it to be similar for ZS in the coming year.
To me there is no question that ZS will do well but each investor has to find their own level of comfort with the ratios and numbers. They will without doubt improve and that includes EV/S.
I hope some of this is useful. The CreditSuisse links may not work properly. If I paste them into the browser, they work fine. If they don’t work, please contact me and I will email them.
long ZS, long AYX
A. The Cloud and Cybersecurity
CreditSuisse, The Cloud Has No Walls, 2017-09-05. 225 pages and the most comprehensive work on the shift to the Cloud and Cybersecurity, https://plus.credit-suisse.com/rpc4/ravDocView?docid=V7ZdKB2…
CreditSuisse, Gartner Agrees the Cloud Has No Walls, 2017-12-17, 45 pages, discusses shift from firewall architecture to cloud-based security, https://plus.credit-suisse.com/rpc4/ravDocView?docid=V7aqiR2…
See also Bessemer’s State of the Cloud Report, https://davidcummings.org/2017/02/12/bessemers-2017-state-of…. earslooking</> has posted their data several times. Bessemer Venture Partners (BVP), trace their roots to the Carnegie Steel Empire. If you, like I, have missed great opportunities, read their The Anti-Portfolio and you’ll feel better. Its a collection of all the great companies they did NOT invest in, https://www.bvp.com/portfolio/anti-portfolio
B. The Rule of 40% used by Venture Capitalists
1. Brad Held’s Blog FeldThoughts, The Rule of 40% For a Healthy SaaS Company, 2015-02-03. Held was the first to report the rule used by venture capitalists to value young growth companies with an ARR of at least 50M, https://feld.com/archives/2015/02/rule-40-healthy-saas-compa…
2. Sundeep Peechu of Felicis Ventures (they backed SHOP), Re-imagining the Rule of 40 for Early StageStartups: The 70% Growth Efficiency Heuristic, 2017-02-09. Modification of Rule of 40 for tiny companis, https://medium.com/@speechu/re-imagining-the-rule-of-40-for-…
3. Dave Kellog (tech executive), The SaaS Rule of 40, 2017-07-25.
It has two excellent graphs which include SaaS companies mentioned on this board: LGM, CRM, VEEV, NOW, PAYC, ZEN, HUBS, MULE, NEWR, OKTA and AYX, https://kellblog.com/2017/07/25/the-saas-rule-of-40/
4. Thomasz Tunguz (Venture Capitalist at Redpoint), The Data Behind the Rule of 40, 2018-02-11. Short article with two nice graphs, http://tomtunguz.com/rule-of-40/
5. Jeff Epstein, Josh Harder, How to estimate a company’s health without really trying, 2016-11-28. It discusses the Bessemer Efficiency Score and has a couple of explanatory graphs, https://techcrunch.com/2016/11/28/how-to-estimate-a-companys…