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Friday, January 15, 2021 1:22pm

Zscaler: More Troubles Ahead? – Zscaler, Inc. (NASDAQ:ZS)

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Is The Investment Thesis Still Valid?

When I first wrote about Zscaler (ZS) a bit more than a year ago I had a clear investment thesis:

Zscaler was seeing explosive and accelerating revenue growth while also showing great profit margin potential. At the same time, the company seemed to have major long-term tailwinds from its disruptive approach to cybersecurity. Their competitive advantage as a first mover and market leader indicated a very long runway of growth.

At the time of my article (in December 2018), Zscaler was trading around $40 a share and had just come out of a quarter (Q1 2019) growing revenue at 59%, billings at 55% and deferred revenue at 68%.

Subsequent quarters showed an acceleration of revenue growth to 65% (Q2 2019) and 61% (Q3 2019) which catapulted the shares to an all-time high around $88 a share in late July 2019.

Since then Zscaler was hit by a combination of broader market turbulences in the Cloud/SaaS-space (which has already abated but seems to be picking up steam again as I write this) and weakness in business performance. What started with the company admitting to lengthening sales cycles in Q4 2019, culminated in the recent Q2 2020 earnings report where the company reported year-on-year revenue growth of only 36% and billings growth of 18%.

This steep deceleration in top-line growth metrics needs further discussion. Should investors be patient and wait this out or move on?

Could There Be More To The Problem Than Management Makes Us Think?

If you read or listen to the opening statements of the recent conference call without knowing the numbers and their context you might be surprised to see the stock drop more than 15%. CEO Jay Chaudhry started the call saying: “We delivered solid Q2 results while making tremendous progress in important areas of our business, particularly with our go-to-market initiatives. In Q2, our revenue grew 36% and billings grew 18% year-over-year…

I must admit this start stunned me a bit since there were not too many „solid“ or „tremendous“ aspects of the report in my opinion. Zscaler should hold itself to different standards and it is obvious that they are not performing according to expectations at the moment.

I don’t want to create the impression that Zscaler’s management is not aware of the fact that there is a problem. Sales problems combined with some comparability issues related to one-time billings and sales in the previous year have been identified as reasons for the recent trend of decelerating growth. Management was quick to point out that they are working hard on solving sales execution issues and that they are already seeing many improvements. In fact, these topics took up most of the time at the conference (which will be discussed a bit more later).

However, this is not really the main issue that is concerning to me as an investor. As the famous saying goes, it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

What if management is focusing too much on sales execution issues when the problem might lie elsewhere? Even worse, what if there is a problem they can do nothing about?

In my last article on Alteryx (AYX) I argued that having the best product is rarely the only reason for market success: you need superior sales & marketing execution (which Zscaler is admittedly struggling with) and you also have to get the timing right (which is normally out of your control).

The problem is this: Yes, Zscaler might have the right architecture and the best product. They might also overcome their sales issues. But what if their product is simply too disruptive to gain mainstream adoption in the enterprise? Or, conversely, what if the (perceived) additional value of Zscalers cloud products does not justify a fundamental change of the cybersecurity architecture? What if hybrid cloud solutions provided by “legacy” cybersecurity providers like Palo Alto (PANW) are “good” enough for most clients? What if competitors like Cloudflare (NET), who seems to be selling very similar solutions to Zscaler, are heating up the competitive battle?

How do you reconcile the idea that Zscaler is disrupting the industry when they just posted quarterly billings growth of 18% while still being a relatively small company with revenues of less than half a billion dollars?

Zscaler had a great use case example of GE who completely changed its security infrastructure. Analyzing that use case it was easy to imagine Zscaler landing similar customers; large customers who are willing to abandon their network architecture for something entirely new and better. The story looks great, but do the numbers still fit?

Source: Author’s table (numbers from Zscaler’s earnings press releases). Q3 2020 and full-year numbers are based on the high-end of guidance provided by management in Q2 2020.

Zscaler has seen revenue growth declining since Q2 2019 when they hit a record growth rate of 65%. The 36% year-on-year growth rate achieved this quarter is by far the lowest number on deck. Both year-on-year and sequential growth numbers have seen notable declines.

If you look at the absolute year-on-year and sequential dollar-additions (in millions), the picture doesn’t look that bleak (but also not great):

Source: Author’s table.

As you can see, the company added around $27 million in revenue in Q2 2020, which is the least since Q1 2019. They added $7.7 million sequentially, which is the second-highest sequential addition in the companies history but also cannot compare to the $11 million sequential dollar-additions achieved in Q2 2019.

The takeaway here should be twofold:

  1. The company had an exceptionally good second quarter in FY 2019, which created difficult comparisons in this quarter. Therefore, the deceleration-issue might be a bit overstated.
  2. Clearly, the company is struggling to scale but is also not completely busted which seems to confirm the narrative told by management.

Is Zscaler Stuck In The Chasm?

In my view, the issue of revenue growth has to be the main focus of investors right now. Decelerating revenue growth, especially for younger companies, is more often than not a harbinger of future problems. These could be that the addressable market is not as big as projected, that competition is causing troubles, or that there are internal issues.

One way of looking at this problem of lacking revenue growth is through the framework of crossing or being stuck in “the chasm”. Geoffrey A. Moore coined this term in his book Crossing the Chasm where he argues that there is a chasm (gap) between the early adopters of a product and the early majority (there are five main segments in the technology adoption lifecycle: innovators, early adopters, early majority, late majority, and laggards). Crossing that chasm is the most difficult step in developing a high-tech market. It’s when a company manages to transition from an early market dominated by a view visionary customers to a mainstream market dominated by pragmatists. If you cannot make that jump, you (or maybe better: your investors) might be in trouble.

So, is a company that has seen growth slow from 65% to 36% in only one year stuck in the chasm? There is no easy answer. Analyzing if a company is crossing or stuck in the chasm is not exactly a science. After all, this is economics, not physics (even worse, it’s marketing). There are no direct causalities that could be studied. The best you can do is to examine case studies, look for patterns and try to combine the dots based on experience. As such, it would be interesting to have a discussion on that topic in the comments section.

Grow Fast Or Die Slow

One obvious pattern to indicate if a company has successfully crossed the chasm is sustaining a high growth rate until reaching a dominant market position. Conversely, slowing revenue growth is a very straight-forward symptom for being stuck.

Luckily, there is some tangible research on the topic of the growth pace of high-tech companies. Consulting firm McKinsey&Company has even created a catchy phrase for the importance of growth in the high-tech space: Grow fast or die slow.

There are some very interesting insights from the McKinsey-research. For example, there are several leading indicators of a coming revenue growth stall:

  • slowing acquisition of customers due to market saturation,
  • the declining lifetime value of new customers,
  • decreasing participation of ecosystem partners (developers or channel resellers),
  • market disruption from new entrants, and
  • the loss of key talent from sales, presales, or engineering.

Unfortunately, in the concrete case, we cannot answer if any of the indicators above are applicable to Zscaler. Management is only sharing the number of customers adds at the end of the fiscal year, so there is no concrete information if or how much customer acquisition is stalling (although, it is easy to deduct from the information at hand – slowing revenue and billings growth and a focus on larger deals with longer sales cycles – that Zscaler is not adding record numbers of customers at the moment). The other indicators are also hard to pin down. It is worth mentioning, though, that there haven’t been any reports claiming that any of the indicators mentioned above are concerning Zscaler at the moment.

However, there is a further (a bit more troubling) finding from the McKinsey research, and I will quote this because it is so important: “Most interesting to us, companies whose growth rate fell off and then recovered created less than a quarter of the value of the companies that maintained growth — despite similar rates of growth at the $1 billion threshold. Taking their foot off the pedal for even a short stint had dramatic long-term consequences. Bankers call this the “humpty dumpty” problem: once growth is broken, it is impossible to put back together again.” (emphasis by the author)

Thus, even if Zscaler manages to stabilize (or even reaccelerate) revenue growth, there is empirical evidence that future stock returns are already damaged by the recent deceleration.

Furthermore, of the nearly 3,000 companies that McKinsey studied in 2014, only 28% reached $100 million in annual revenues; 3% got to $1 billion in annual sales, and just 0.6% (17 companies in total) grew beyond $4 billion. Will Zscaler be one of the lucky few?

What Management Had To Say

If you believe Zscaler’s management, they definitely are. As already mentioned they stated this very clearly in the conference call and tried to give investors confidence in their ability to turn sales execution around.

Since I have no experience in sales operation I must admit that most of the comments regarding sales execution in the conference call – which took up the majority of the call – sounded a bit jibberish to me. It is impossible for me to evaluate if the steps taken are the right steps to take in the current situation and what outcome these efforts will have. It is clear, though, that management has taken steps to address sales issues.

One tangible insight from the conference call was that sales cycles have not changed. Over time, Zscaler expects to see a shortening of sales cycles again, but currently, they are about the same: three to six months for smaller accounts and six to 12 months for larger accounts. Since the company is focusing more on larger deals, revenue recognition should be expected to be lumpy. Currently, Zscaler is seeing the negative effects of that lumpiness, as they haven’t been able to close enough deals to keep growth numbers up. On the other hand, if sales initiatives are fruitful, closing a higher amount of larger deals in later quarters could also lead to the reacceleration of revenue growth.

Since Zscaler sells transformational products it means that they have a top-down sales approach with the involvement of C level executives on the customers’ side. Zscaler has always understood this process but acknowledged that they did not have proper discipline and structure and enablement to take their sales process at a large scale level. Since the new CRO (Chief Revenue Officer) Dali Rajic took over, Zscaler increased their “sales enablement team” from 2 to 15 people to address this issue.

Zscaler’s management also mentioned that the sales pipeline quality has seen significant improvement in terms of both volume and quality. As a result, the company is quite optimistic about the second half of FY 2020.

It’s important to note, though, that the current company guidance (top of the range) calls for 35% revenue growth in Q3 2020, 34% in Q4 2020 and 38% for the full year 2020. Thus, this optimism is not really expressed in the guidance numbers provided. Whoever hopes that Zscaler will quickly turn around their recent sales woes and return to accelerating growth will probably be disappointed.

Also important to note is that the company only just beat revenue guidance this quarter by a narrow 1.3%. As a comparison, they beat revenue guidance by 4% in Q1 2020, 3.7% in Q4 2019, and 5.5% in Q3 2019. This is also a worrying trend to acknowledge. While in FY 2019 investors could happily ignore the very prudent guidance given by management, FY 2020 is painting a quite different picture.

What becomes clear is that the company wants investors to think they only have sales execution issues which can be – and actually already are – addressed. Management continues to insist that there are no competitive issues, that “the market is coming to us”, and that they have the right architecture for the cloud (as opposed to competitors who claim to have the right architecture but actually don’t have it).

Closing Thoughts

I’m not sure I’m buying that, though. Remember, Zscaler added $27 million of revenue year-over-year and $7.7 million sequentially in Q2 2020. Last year, they added $29.3 million year-over-year and $11 million sequentially. However, last year they had sales & marketing expenses of $38.8 million, while this year they spend $61.1 million. In other words, they spent 60% more to get worse results.

Of course, some of that additional spending is related to the sales ramp up that will only show effects later. Also, the marketing expenses of a quarter are not directly contributing to revenue growth in the same quarter – there is always a certain lag, especially if sales cycles are longer. Still, it is a worrying fact to look at.

One reason for my excitement about a Zscaler-investment when they came public was that they saw extremely high and accelerating top-line growth while showing a very clear path towards profitability. Currently, they are showing quickly decelerating top-line growth while profitability and cash flows are waning.

The real investment story, however, was a story of disruption. Rethinking network security and providing a cheaper and better new paradigm of cybersecurity that supports increasing mobility of the global work-force. Current growth numbers tarnish the overall picture of that disruption story.

Maybe Palo Alto was right when they claimed a couple of quarters ago that they are seeing competitive wins against Zscaler. At the time I interpreted that comment from Palo Alto as weakness and confirmation of the disruptive nature of Zscalers product. Maybe I was wrong.

A few days ago, Palo Alto (PANW) reported rather disappointing earnings numbers. However, they also mentioned that “billings for our Next-Generation Security offerings continued to perform very well. As customers progress on their journey to the cloud and elevate cybersecurity as an integral part of network transformations, Palo Alto Networks remains a trusted partner to organizations worldwide.” Next-Gen Security billings are expected to be in the range of $810 million to $820 million, representing year-over-year growth of 79% to 82%. So, Palo Alto is growing these offerings at a much higher pace at more than double the scale of Zscaler. Of course, you cannot compare Palo Alto’s “Next-Gen Security” to Zscalers’ products apples to apples. We don’t know what these “Next-Gen Security” products comprise of concretely and how this growth is related to the cannibalization of other product lines within existing customers.

But there are other companies like Cloudflare (NET), which seem to have a lot of potential to compete with Zscaler. In the article I already linked above, it is stated that Cloudflare “wants to replace corporate VPNs and firewalls with its own networks“. Sounds awfully similar to Zscaler, right? Well, it is. Netskope is another cloud-first cybersecurity company, which even got a mention in the conference call.

This is not an attempt to analyze the competitive landscape of Zscaler in any detail or to suggest that these competitors are “better” than Zscaler. It’s simply a recognition of the fact that while Zscaler might have a competitive advantage against legacy cybersecurity vendors like Palo Alto through their disruptive approach, their competitive advantage against other competitors with similar products – like Cloudflare and Netskope – is not as clear. For example, I thought that Zscaler had a competitive advantage through its 100 data centers around the globe – a clear scale advantage in my view that seemed hard to replicate. Well, it turns out Cloudflare has 200 of these data centers.

Finally, there is valuation: As of this writing, the company has a TTM EV/S of around 18. Using a 35% growth rate for the next twelve months, the forward EV/S comes to 13.5. That is neither incredibly expensive nor particularly cheap.

As a comparison, when I first wrote about Zscaler they were trading at a forward EV/S just below 18. However, I wouldn’t jump to the conclusion that shares are a bargain because of this. Back then, the company was firing on all cylinders. Comparatively, I would even argue that the shares are more expensive now than a year ago – despite the lower EV/S multiple. One simply has to consider the current business outlook, especially the (justified) uncertainty about future growth.

ChartData by YCharts

Also, compared to other software companies with similar 30%-40% revenue growth rates Zscaler doesn’t look particularly cheap. Among the companies shown in the graph Zscaler is also the one with by far the lowest TTM revenue (the second largest among the group, HubSpot, has almost double the TTM revenue as Zscaler) and the steepest decline in quarterly revenue growth over the last quarters. Thus, it could be argued that, while shares of Zscaler have already fallen a long way from the top, they are still relatively overvalued because investors have been reluctant to adjust to the new fundamentals.

Then again, it is not unreasonable to put a little faith in the companies management and believe that the current fundamental weakness is only temporary. Until now, management hasn’t given investors any reason to distrust them, so you might as well give them some slack. Also, if you take the time to read some of the customer stories of Zscaler, and the kind of companies they were already able to onboard, it seems difficult to argue that they are currently “stuck in the chasm” – it appears that they have already jumped that gap some time ago. It also doesn’t hurt that IT investing expert Bert Hochfeld seems to believe firmly in Zscaler’s prospects.

I still think there is a good chance that Zscaler’s disruptive story is intact and that they can reaccelerate growth. However, there are problems in Zscaler’s growth that simply cannot be ignored. At the least, they have to be monitored closely.

I haven’t decided yet if I will trim my position in Zscaler but it is likely; I’m probably going to hold some of the shares to keep them on my radar. I’m definitely not going to add shares because I generally try to avoid buying into company weakness. As I said in the introduction, holding and buying shares of Zscaler requires a bit of a leap of faith at the moment.

If you enjoyed this article and wish to receive updates on my latest research, click “Follow” next to my name at the top of this article.

Disclosure: I am/we are long ZS, AYX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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