Zscaler Is Making An Attempt To Ignite Sales Growth (NASDAQ:ZS)

Zscaler (NASDAQ:ZS) is in a prime position for the next generation of threat actors, as the company’s platforms pose as the gateway between outside traffic breaching a company’s data. I believe that the firm is well-positioned in the era of GenAI and, through M&A, will position itself for the future quantum threat actors in the near future. Though the company’s top-line growth is nearing a sub-30% growth rate, as management guided, I do believe that the firm still remains value-rich as management seeks to bolster its sales and marketing department to push full platform adoption. I provide ZS shares a BUY recommendation with a price target of $286.20/share.

Operations

Zscaler reported a strong q1’24, kicking off the new fiscal year running on all cylinders. As the firm seeks to grow into a single-platform security company as do its competitors, Zscaler is emphasizing its three product pillars, ZIA, ZPA, and ZDX, with ZIA and ZPA being the core-adopted products with ZDX as the cross-sell item. ZDX appears to be Zscaler’s solution that’s comparable to Datadog (DDOG) or SolarWinds’ (SWI) network monitoring feature for SaaS application optimization for a better user experience. In addition to these, Zscaler is bringing forward its data protection feature, CASB/DLP, as companies begin leveraging some form of AI/ML in the workplace. Differentiated from other cybersecurity platforms, Zscaler’s core focus is within the web API security realm in which their products secure data traffic between the network infrastructure and the outside world, whether it’s a cloud platform or basic internet browsing.

Zscaler experienced a strong go-to-market in q1’24, with nearly 50% of new logo customers purchasing their three core products, ZIA, ZPA, and ZDX. I believe this single-company solution trend will continue going forward as CIOs effectively seek to reduce multiple vendor exposures and, in turn, reduce costs while maintaining effectiveness. This can be seen across the firm’s federal exposure, with their products being found in 12 of the 15 cabinet-level agencies. As of q1’24, Zscaler ZIA, ZPA, and ZDX were each deployed across 100,000 users at this federal level. As alluded to in their q1’24 earnings call, Zscaler’s DoD exposure still has a long runway as their exposure continues to be rather limited. This can be a huge potential for the firm in terms of government contracts.

As for the GenAI ramp, Zscaler may have a major opportunity with its core products as a way to shield outside traffic from a company’s sensitive data. Being opportunistic, Zscaler upsells its AI-driven features by 20% above its standard advanced bundle. Management noted in their q1’24 earnings presentation that their products have secured over 2b AI transactions per month, posing the risks involved in GenAI and thus proving that its AI-driven features are necessary for the emerging technology. This can also be an opportunity for Zscaler to emphasize sales for their DLP and CASB features. As more companies are potentially exposing their data to the public domain, Zscaler’s product suite can effectively analyze data transfers, predict potential threats, and preemptively act before a threat actor attacks.

The firm’s latest product, Risk360, has hit the ground running with 10+ closed deals and an additional 10+ enterprises evaluating the features. Risk360 is the firm’s AIML product that actively quantifies and mitigates risks in real time. As discussed in their q1’24 earnings call, Risk360:

provides critical insights to CISOs when reporting on cybersecurity risk strategy and governance, particularly in light of new SEC regulations.

Jay Chaudhry

This product can be a critical tool for CISOs to ensure their GRC posture is up-to-date and effectively being enforced.

Financials

Management alluded to the same challenge other security firms are facing in terms of billings. As the cost of borrowing has remained elevated since the Fed pinned interest rates between 5.25-5.50%, contract duration has come down, with fewer firms signing longer-term 3-year deals. Though this doesn’t necessarily impact revenue, it does add a certain level of risk for future periods as contract renewal takes place.

Despite these challenges, billings still grew 34% y/y, though dropped by -37% sequentially. Despite these challenges, the firm did grow customers over $100k in ARR and over $1mm in ARR, each by 4%. Customers over $1mm in ARR have significantly slowed from previous periods where it averaged 9% in 2h23. I don’t believe that this is necessarily a sign of a slowdown per se; however, it sheds some light on management’s guidance for the remainder of eFY24.

Management guided ~31% top-line growth for eq2’24 and ~29% for eFY24. This is a significant slowdown from previous years, with growth of 62% in FY22 and 48% in FY23. Despite this slowdown, I believe that this isn’t necessarily a concern as the firm’s platforms are reaching strong business saturation and are reaching a more normalized growth rate. I believe that we can discern that the company’s “land” growth has reached its peak growth rate and the firm is now more heavily focusing on the “expand” growth rate as companies seek to work with fewer vendors on more of a platform format.

Considering operations, management mentioned that the firm will be open to M&A activity, not for revenue growth but to buy emerging technologies that will bolster the firm’s platforms.

I think you will not see us trying to buy revenue through an M&A. They’re going to see us buying innovative, disruptive technologies that can help us get to market sooner; faster is important.

Jay Chaudhry

My expectation from this verbiage is that management isn’t quite ready to steer the company into the mature phase of growth but is still seeking to enhance its platforms for a broader cross-selling cycle. I believe that this approach to M&A will benefit the Zscaler in the long run as cybersecurity is an evolving front and securing technology that remains one step ahead of the threat actors and is vital for the survival of a security platform. As management at Palo Alto Networks (PANW) had mentioned on their q1’24 earnings call, quantum security remains a ways off but remains a concern for companies as this emerging technology takes shape. After GenAI, I believe this will be the next focus for Zscaler, as the firm’s platforms act as the web gateway for enterprises. I’d anticipate the next deals to be either focused on GenAI or that next step forward into quantum security.

On the note of M&A, management mentioned that gross margins are expected to fall within the range of 78-82% going forward. Management had mentioned that new releases and emerging technologies will have a lower margin as they scale, creating a slight headwind to overall margins. Though I cannot forecast when the next deal will occur, I do anticipate that Zscaler will be on the lookout for new technologies to acquire within the next year or two as GenAI continues to become more popular in the workplace and further as quantum computing advances to production.

In terms of future margins, management mentioned that they will be bolstering their sales and marketing staff, which I believe will create some margin compression in the coming quarters. I believe this factor will allow for revenue to remain rich in growth as the firm seeks to sell across multiple nodes as opposed to one-off components.

Value and Shareholder Value

ZS shares currently trade at 22.79x sales, modestly above most of their cohort but significantly below high-grower CrowdStrike (CRWD). With Zscaler’s moderating top-line growth performance, I do believe a more moderate pricing multiple will be necessary when valuing the firm. Using a market cap weighted approach, the average price/sales multiple is 17.53x trailing sales. I believe this will be a more appropriate target for ZS shares going forward as the firm remains between high growth and maturing operations. My recommendation for the stock is a BUY with a price target of $286.20/share at 17.53x eFY25 revenue.

Technical Analysis

On a tactical basis, I believe that ZS shares may experience a pullback in the near term before setting course towards my fundamental price target of $286.20. Given the stock’s sharp upward route since June 2023, a retracement should be expected and may pull the share price back to ~$186/share. I do believe the stock will route back upwards in time as the market digests this significant price increase. For an active trader, my recommendation is to consider reducing one’s position and buying back in at this lower, sub-$200 price.