Zscaler - Qs & As

imyoung · August 31, 2018, 2:19am

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.

Hi Chris,

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.

im
long ZS, long AYX

References:

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…

Diablito · August 31, 2018, 5:56am

Hi imyoung!

I just have a short observation generally about negative PE. It’s best illustrated by an example:

A company with a share price of $100 and EPS of $5 has a PE of 20 (let’s assume there are 1 million shares outstanding, so net income would be 5 million). If EPS is $10 (ie 10 million net income) the PE falls to 10. The lower the PE, the more EPS I get for the share price, ie the cheaper the stock. That’s clear.

Let’s assume the same scenario with a net loss. At $100 share price and $-5 EPS (or $5 LPS) the PE is -20. Net loss is 5 million in total. If negative EPS increases to $-10 (ie losses widening to 10 million) the PE „falls“ to -10. But that’s not better! Now we have 10 million net loss spread over the 1 million shares instead of 5 million, which is clearly a worse situation. So actually a high negative PE ratio is „better“ (cheaper), because there are less net losses in total in relation to the share price.

Not that you should really look at negative PE’s, like you pointed out. But in case of ZS (PE -39.83) and AYX (PE -216.38) - just looking at those ratios - actually AYX should be closer to profitability and thus a cheaper/better investment.

Best wishes,
Niki

tchalla · August 31, 2018, 8:48am

Thanks for your commentary and series of links.

We all have our methods for incorporating or disregarding valuations esp for Saas type companies.

I agree that P/E is hopeless, as most are unprofitable.

I’ve found these a useful way to consider valuations across Saas companies. I put the metrics into a spreadsheet and try to get to a ballpark range of reasonable valuations on LTM YoY growth, NTM estimates, gross margin, etc. Where there is a large deviance from what would be expected, the question is why…

https://catalyst.com/research_item/saas-investors-mind-the-v…

https://catalyst.com/research_item/saas-valuation-redux-sane…

Following this approach, I’ve found it is tricky to justify a EV/Sales current year >15 for companies unless they are growing revs in excess of 55% annually and have margins >90%. There are howeever sometimes,compelling forward looking strategic factors that needs to be incorporated. That may be true for ZS, but I can’t personally justify a 5.25B valuation on 50M-60M quartlerly revs. You don’t have to swing for everything.

When valuations get frothy (and I feel EV/Sales is pretty good to compares between SAAS growth stocks), comes the progressively higher risk of a post ER -20% or greater drop, unless to companies truly excel at ER sequentially. (SQ, AYX, TTD come to mind). See the market response to ZUO - which I can’t help but feel is appropriate.

Buying the high EV/S companies on -25% days could work though.

imyoung · August 31, 2018, 4:12pm

@Diablito,

Thank you for pointing out my careless mistake. Here is your correction:

Let’s assume the same scenario with a net loss. At $100 share price and $-5 EPS (or $5 LPS) the PE is -20. Net loss is 5 million in total. If negative EPS increases to $-10 (ie losses widening to 10 million) the PE „falls“ to -10. But that’s not better! Now we have 10 million net loss spread over the 1 million shares instead of 5 million, which is clearly a worse situation. So actually a high negative PE ratio is „better“ (cheaper), because there are less net losses in total in relation to the share price.

Not that you should really look at negative PE’s, like you pointed out. But in case of ZS (PE -39.83) and AYX (PE -216.38) - just looking at those ratios - actually AYX should be closer to profitability and thus a cheaper/better investment.

The last thing I want to do is lead anyone astray with false information; so yes, in case of ZS (PE -39.83) and AYX (PE -216.38) - just looking at those ratios - actually AYX should be closer to profitability and thus a cheaper/better investment.

@tchalla,

Your references and comments are much appreciated. I will study them and hopefully one day become an expert investor.

As a person without a financial background (who keeps falling asleep on top of two tomes of college accounting books acquired to remedy my deficits), I appreciate any help I can get from all you more knowledgeable posters. To make up for my deficits, I read voraciously and make a list of all the pros and cons of the companies I am interested in. So far, I have done quite well buying stocks but I am still not so good selling them.

As a recent investor in SaaS companies, I have ignored the EV/Sales ratio of all my SaaS stocks but I shall reconsider my wayward ways. However, the cautious side of me has allocated 2% to ZS and 15% to AYX. At this point I am trying to decide if I should buy more ZS prior to earnings on September 5 as I see their revenues increase substantially year on year or if I should wait till after the expiration of the lockup period on September 12. I am still undecided, perhaps I’ll buy a little prior to the earnings report and a bit more after the expiration of the lockup period.

Expected increase in earnings about 80% YoY.


	Q1	  Q2	   Q3	    Q4	       Total       % YoY ? 
			  56.8			
2016	17.1	 18.9	  20.8	   23.6	        80.4	
2017	26.8	 29.4	  33.0	   36.5	       101.9        26.7%
2018	39.9	 45.0	  49.2	   50.7(est)   184.8(est)   81.4%(est)

Thanks again to both of you for the correction and feedback. I shall improve, I promise.

im

tchalla · August 31, 2018, 5:26pm

@ im

I am not trying to correct you, merely offering my own thoughts on an interesting issue.

We all have our own risk/reward profile,time horizons, and analysis process, so please don’t assume what I’m saying is right.
It works for me, but may not be right for you. It’s just an approach that suits my worldview.

Saul is far less interested in valuations than I might be, and I get the sense that Gary Alexander at seeking Alpha is more interested in valuations than I am.

It’s a spectrum, and that is a good thing imho.

I think as long as you approach the issue eyes open, then you’re best placed to decide for yourself what works for you

Cheers

XMFBreakerTinker · August 31, 2018, 8:21pm

From the longer Credit Suisse report, which is September of 2017 the gist is not very surprising and is:

The Last Transition in the Stack…
Thinking about enterprise IT architecture simply in terms of storage/compute, applications, and perimeter, it’s clear the traditional stack has been disrupted by AWS and other cloud vendors and that the large applications vendors have been somewhat displaced by SaaS offerings (Siebel to Salesforce). Without mincing words, it appears as if it’s the perimeter’s turn next.

Meaning that the traditional use of appliances to provide security will be disrupted and the new “refresh” cycle that such vendors are looking forward to may not be what they think it will be given this disruption.

The disruptors are the public cloud players and one player only, Zscaler. Zscaler is not even mentioned in the report because it was not yet public. OKTA was and described as an example of the markets hunger for such a disruptive security stock.

On page 33 of the report the 3 most desired things by IT chiefs are exactly what Zscaler offers. Yes, it is completely disruptive. No real competition, and the article itself is a bit short sighted as it is still data center centric instead of user centric. 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, paradigm, that GE, as an example 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.

There are some truly dominant companies s out there. Nvidia, Zscaler, near world wide monopolies, MongoDB (if management’s pronouncements prove true of rarely seeing any other NoSQL at all anymore in their sales (the CEO stating that all other NoSQL are becoming less and less relevant), Nutanix has a world wide near duopoly, Okta s building dominance in its part of the stack, Alteryx is dominant where it has been adopted, and so on.

Zscaler and Nvidia are perhaps the two 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 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 this dominant and taking in billions in 3 to 5 years and thus blowing away its current valuation, or it will not but will at least grow into its current valuation.

I always hate the latte scenario, which is why I believe the former scenario is extremely likely and find the valuation to be more in line with those companies that David Gardner likes as part of his criteria of “considered to be outrageously overvalued” or the like.

My opinion on it anyways. I find that CAP + Growth are the two most important aspects to stock risk/reward, with valuation only relevant in regard to (1) determining if there is a bubble, and (2) as information as to what the market thinks of the company.

Zscaler is fundamentally a huge winner. Whether that translates into blowing away its current marketcap, or simply just (and disappointingly) growing into it, TBD. 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 of premise offices through the internet) that are experiencing and 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, as I said before, I bought at much lower prices than now (when it was still outrageously expensive) and I have nothing more to offer on valuation as it may relate to risk/reward 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 Zs. 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 innovator’s dilemma. They need to sell appliances that are expensive and legacy, 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.

Tinker

SoonerAJ · August 31, 2018, 10:43pm

The cloud titans do not guard your iPad, laptop, server…

Does ZScaler have any consumer products? Seems like there would be a lot of demand for home devices and home internet access also.

-AJ

volfan84 · August 31, 2018, 10:44pm

Well Tinker, I think amongst my football watching this weekend, I might just have to finally get around to diving in to understand ZS. I was a little late getting around to Pivotal and MongoDB semi-recently, but still got in early enough that I already have some nice gains. May as well take advantage of the long weekend a bit and see what DreamerDad and you seem to find so impressive (even with its seemingly crazy high valuation at present).

volfan84
No ZS position (yet)

XMFBreakerTinker · August 31, 2018, 10:52pm

Zscaler has stated that the consumer market does not appear to provide profitable enough opportunities. Zscaler will therefore stay with enterprise market and let someone else figure out how to make money in consumer market.

Tinker

tchalla · September 1, 2018, 4:18am

Thanks for a superb response Tinker

It really outlines why ZS may have a disruptive competitive advantage.

Part of the reason I pause on loft valuations is the opportunity cost vs other companies as investment prospects.

For the reasons you outline, ZS seems like it is extremely well positioned with a differentiated product.

I guess it seems easier somehow for me to imagine an

INST (fwd EV/S 6.15) at 7B or
MIME at 12.5B
as a 5x return
vs ZS at a 28B valuation over a few years.

But i know it happens when then mix is right (SQ)

But ZS looks like a great company. I’ll look to buy on weakness, if/when it happens.

roach1984 · September 1, 2018, 10:46am

I just purchased more; expecting a huge quarter to offset all the average fundamentals described above.

volfan84 · September 2, 2018, 8:16pm

Here is a new article on ZS from Seeking Alpha. For full disclosure, I am merely posting it here within this prior thread rather than its own thread due to the fact that I may want to enter a position on Tuesday morning and suspect that this board by itself has a bit of market moving potential. I haven’t even read the full article yet, but the 38 or 39% revenue growth guidance after 77% billings growth (if I am remembering those numbers correctly) seems like some of the most egregious sand-bagging that I can recall.

https://seekingalpha.com/article/4203668-zscaler-ready-big-b…

Still planning to do a bit more research before deciding for sure whether to open a position, but I think I am leaning that way…may even buy in the pre-market then highlight this article in its own thread.

-volfan84
no ZS position (yet)

XMFBreakerTinker · September 2, 2018, 8:54pm

Management stated that calculated billings was exaggerated due to many customers deciding to pay 3 years in advance instead of one year in advance. That is some rather confident purchasing to pay a full 3 years in advance. The company can only recognize the revenue ratably, and thus a company paying 3 years in advance won’t have month 13 counted until next year for revenue purposes.

Nevertheless, even adjusting for this, calculated billings was up more than 60% YoY. An acceleration over the prior year.

If growth is just 39% then this narrative is a complete bust, fabrication, lie. Thus, in the end, numbers tell the story. I will sell out and move on.

September 5 it is.

Tinker

Jeremy1234 · March 19, 2019, 5:28pm

Seems the pro ZS investors were right.

I am late was not following ZS.

Then when I did, learned of the high valuation.

Internet security is here to stay, so I think I may buy.

Plus from what I read ZS is a disrupt-er and 1st mover.