Report
Mark Cash
EUR 850.00 For Business Accounts Only

Morningstar | Scales Tip in Zscaler's Favor as Cloud Shift Continues: Raising Moat and Trend Ratings and FVE. See Updated Analyst Note from 22 Apr 2019

We remain impressed by Zscaler's security-as-a-service offering, and while the firm’s business model and security approach are in their early innings, we see a long runway for growth in an addressable market worth tens of billions of dollars. We are raising our moat rating to narrow from none, as well as our moat trend rating to positive from stable, as we believe the company benefits from customer switching costs as enterprises adopt the capabilities encompassed by its two flagship solutions: Zscaler Internet Access and Zscaler Private Access. We are also raising our fair value estimate to $62 per share from $35, driven by improved long-term top-line assumptions. We are lowering our uncertainty rating to high from very high, as we have more confidence not only in the company’s ability to execute on its strategy, but more important, in the secular tailwinds facilitating the firm’s success. Despite the appreciable increase in our estimate of Zscaler’s intrinsic value, we view the shares as fully valued today and would recommend prospective investors await a wider margin of safety before committing capital to this cybersecurity disrupter.

Zscaler wagered heavily on the secular trend of cloud computing and the ways in which this shift would upend the previous paradigms of network and application security. The firm’s bet has paid dividends, as it has leveraged a distributed cloud to deliver a multitenant security platform that offers security capabilities traditionally sold as purpose-built appliances. Zscaler’s software-as-a-service business model and the benefits that accompany this mode of software consumption, combined with an innovative product suite and a differentiated channel sales model, are all factors that we think will facilitate continued success winning enterprises that are building out significant cloud footprints.

Zscaler offers two umbrella solutions encompassing capabilities across the security stack: Zscaler Internet Access and Zscaler Private Access. These two solutions represent innovative approaches to network security, in our view. ZIA offers capabilities, such as a cloud firewall and sandbox, that have historically been sold as purpose-built physical or virtual appliances. It stands between an organizations users and devices and the Internet, inspecting traffic and enforcing policies, thus representing the conduit through which users access popular web-based applications and Internet destinations. This allows enterprises to securely send web traffic directly to the Internet, in lieu of the traditional hub-and-spoke model. Under the traditional model, an organization had to purchase an expensive multiprotocol label switching connection from a service provider and route the traffic from a regional office, for example, to a centralized data center for security scanning before reaching its destination. ZPA connects users to internally managed workloads, like a SQL database, and uses capabilities such as application segmentation to expose only the authorized application to the user’s device. This stands in contrast to traditional virtual private network connections, which typically give a user access to an entire corporate network, thus exposing the network to vulnerabilities particularly on the user’s end of the connection.

We contend that switching costs have manifested for Zscaler along two primary dimensions: the number of customer touchpoints across which the firm’s products are being deployed, and the heightened risk aversion that we think will persist whenever enterprises consider switching solutions that secure mission-critical data and workloads. The firm has consistently been able to deepen relationships with its customers even as it expands its base, thus becoming more embedded across the users, devices, and workflows of large enterprises. This is supported by quantitative evidence in the firm’s results. For example, the company’s average annual contract value has been increasing at a greater than 30% CAGR over the past few years, a trend we expect to continue. Dollar retention has remained at or above 115% since 2015, implying that the average customer has increased its spending by 15% or more annually by licensing more seats, more capabilities, or both.

Zscaler faces entrenched competitors as well as a legacy appliance-based approach to security that is prevalent in the IT ecosystems of current and potential customers. Still, we think the firm will be able to sustain and augment its competitive positioning in a fragmented security vendor landscape. The secular trends of cloud and mobility have given rise to structural shifts in data traffic paths and volume. We believe that, in lieu of multiprotocol label switching, enterprises will continue to leverage the Internet, an open network rife with security vulnerabilities, for critical workloads. In turn, we believe they will find value in the Zscaler’s offerings.

We model Zscaler achieving midcycle gross margins of 86% by fiscal 2028, an increase from roughly 80% in fiscal 2018, as it leverages its growing footprint in colocation data centers to serve an increasing number of customers deploying multiple Zscaler capabilities. We expect sales and marketing expenses to grow appreciably over our explicit forecast as the firm faces entrenched competitors but lag sales growth as it further penetrates its addressable market. This results in sales and marketing spending being 30% of revenue in fiscal 2028 versus roughly 60% in fiscal 2018, and Zscaler’s ability to leverage this line is a major crux of our valuation thesis. The firm has a differentiated go-to-market approach, with roughly 92% of sales derived through channel partners, and roughly 50% through service providers and system integrators specifically. This is a stark contrast with traditional security vendors, which sell primarily through distributors and resellers. Service provider/system integrator sales imply a deeper commitment from customers, in our view, as they are reorienting their infrastructure for network and application access. These channel relationships may necessitate less reinvestment over time, which could allow the firm to win large deals at a lower cost. These dynamics, combined with a maturing direct salesforce and a product offering increasingly consistent with the cybersecurity zeitgeist, should be additive to the operating leverage inherent in the SaaS business model. On the research and development front, we similarly model growth in this line lagging sales growth, bottoming out as a percentage of revenue at 15% in fiscal 2028 versus 20% in fiscal 2018. All in, we model material operating margin expansion, with the firm achieving operating margins of 34% by 2028.
Underlying
Zscaler Inc.

Zscaler is a cloud security company that developed a platform incorporating security functionalities needed to enable users to safely utilize authorized applications and services based on an organization's policies. The company's solution is a purpose-built, multi-tenant, distributed cloud security platform that secures access for users and devices to applications and services, regardless of location. The company delivers its solutions using a software-as-a-service business model and sells subscriptions to customers to access its cloud platform, together with related support services. The company conducts business worldwide, with presence in North America, Europe and Asia.

Provider
Morningstar
Morningstar

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.

Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.

We have operations in 27 countries.

Analysts
Mark Cash

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