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Morningstar | Zscaler Excels for its Fiscal Year End; Raising FVE to $35 per Share, but Shares Look Expensive

Zscaler reported solid fourth-quarter results for its fiscal 2018 and we are raising our fair value estimate to $35 per share. Overall, we continue to believe Zscaler will grow very quickly, benefiting from underlying trends, such as its ability to upend the traditional VPN paradigm. However, we think on a valuation basis, with shares trading on an enterprise value/revenue multiple of approximately 22 times, Zscaler shares appear expensive and will need to experience accelerating revenue growth to justify that multiple. For context, Zscaler’s EV/revenue multiple makes it more expensive on a fundamental basis than nearly ever enterprise software firm in our coverage. We posit that part of that multiple may be due to a baked-in acquisition premium. Ultimately, even with aggressive revenue growth and margin expansion assumptions, our fair value is still modestly below where shares have traded since the IPO and we would recommend to investors to await a wider margin of safety before jumping into this name.

While we see Zscaler’s technology as potentially disruptive, our long-standing view is that it is difficult for cyber security businesses to establish economic moats as "innovative" technologies seem to be mimicked by peers over time. Zscaler’s tangential competitors on the endpoint and firewall side, almost exist in a Hobbesian state of nature, where new technologies and price wars make the environment fiercely competitive, which compels us to maintain our no-moat rating for Zscaler at this time, but we concede that Zscaler is not susceptible to the refresh cycle replacement risks of those peers.

The firm reported solid revenue of $56 million for the quarter and $190 for the year, with billings growth of 54%. Guidance for fiscal 2019 sat at $255 million at the midpoint and we track modestly above that range. Thus, we have raised our fair value estimate to $35 dollars per share, giving Zscaler greater credit for deferred revenue growth and margin expansion.

We had the opportunity to talk with Jay Chaudhry, the CEO of Zscaler, on our management callback with the firm. We were impressed that Zscaler indicated that a large enterprise, identified as a top 10 bank, used ZIA (Zscaler Internet Access) in one office, but were expanding across the company, demonstrating that ZIA and ZPA (Zscaler Private Access) continue to gain traction. Mr. Chaudhry indicated that this is an exception and not the norm, since the vast majority of enterprises purchase ZIA in bulk for their users. Zscaler Private Access, or ZPA, which allows users to access AWS or Azure, is typically purchased for a fraction (say 20% of enterprise's customers) and expanded on from there. Thus, the upsell opportunity remains more on the ZPA side, which only represents 10% of annual recurring revenue. While we have been bearish on valuation for Zscaler, we note that we are coming around to the idea that Zscaler is less a product and more a platform, evidenced by their Transformation Bundle sales. Instead of customers purchasing Zscaler to fulfill a function, as they would a traditional firewall, they are subscribing to a system, that does not need to be replaced.

In terms of our fair value increase, Zscaler demonstrated notable growth among enterprise customers. The firm grew its share of the global 2000 cohort to 300 customers, from 200 a year prior. Additionally, Zscaler reported dollar-based net retention of 117%. These results made us more comfortable with revenue and margin expansion for Zscaler.