EUR 850.00 For Business Accounts Only

Morningstar | Secular Shifts Continuing to Facilitate Zscaler Disruption; FVE Up to $67

Narrow-moat Zscaler delivered another stellar quarter, exceeding our expectations as well as consensus estimates on both the top and bottom lines. The beat-and-raise cadence of past results persisted, with management raising full-year guidance higher than even our above-consensus estimates. Enterprises continue to adopt external SaaS applications and public cloud infrastructure for IT agility and efficiency, with the attendant traffic and security implications driving demand for the firm’s platform. We continue to see evidence supporting our positive moat trend rating, which we maintain, and raise our fair value estimate to $67 per share from $62 to reflect the time value of money and modestly higher near-term growth assumptions. Shares were volatile during after-hours, but we continue to see them as fully valued and would recommend prospective investors await a wider margin of safety before committing capital to this cybersecurity disruptor.

Fiscal third-quarter revenue came in at $79.1 million, representing a year-over-year increase of 61%. ZPA, which we view as a structurally stickier solution, continued to see strong sales momentum with more upfront deals as opposed to upsells. While management demurred with regards to giving specifics, we believe ZPA is growing materially as a proportion of the firm’s overall mix.

Zscaler performed admirably on the margin front, with adjusted gross and operating margins widening by 100 and 1360 basis points to 82.2% and 7.7%, respectively. We were particularly pleased with the sales and marketing spending which, while up materially in absolute dollars, decreased on a GAAP basis to roughly 57% of revenue from 61% a year ago. While management has indicated that they remain focused on reinvesting in the business to fully penetrate the market opportunity, in lieu of expanding margins, we still expect the leverage inherent in their business model to be evident longer-term.

Management continued to call out legacy cybersecurity competitors that are trying to pivot to a more cloud-centric strategy, with CEO Jay Chaudry derisively referring to them as “cloud imitators.” While we are sure their commentary is exaggerated, we agree with the overarching premise that Zscaler’s approach to security is fundamentally differentiated in the marketplace. Legacy appliance vendors that offer solutions delivered from or intended for cloud environments do so in a disjointed way, blending together expensive appliances and single-tenant software. While this serves the needs of many customers today, we believe this approach will be increasingly ill-suited as cloud adoption proliferates. In our view, Zscaler is advantaged in an increasingly cloud-centric world, because its globally distributed colocation footprint allows for a multitenant, software-defined approach to security. Given the increasing reliance on the Internet, with DNS servers all over the globe, we believe this type of architecture is increasingly necessary given the need to inspect traffic and enforce policies anywhere.

We don’t view these current competitive dynamics as immutable, because Zscaler’s architectural approach can certainly be replicated. Still, we view the switching costs that arise from the multiple touchpoints across which the firm’s platform is being deployed, and the mission-criticality of the workflows it secures, as structural advantages that underpin our narrow moat rating.