May 28, 2020 - 9:29am EST by
2020 2021
Price: 74.53 EPS 0 0
Shares Out. (in M): 129 P/E 0 0
Market Cap (in $M): 9,600 P/FCF 0 0
Net Debt (in $M): -385 EBIT 16 -15
TEV ($): 9,215 TEV/EBIT 0 0
Borrow Cost: General Collateral

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I am recommending a SHORT on Zscaler (Ticker: ZS) with a price target of $49/share, providing a 35% gain in a base case scenario.


Zscaler is an overvalued cloud-based cybersecurity company (trading at 18X 2021 Sales), that I expect will show low billings growth and provide disappointing guidance when it reports earnings after the close on Thursday May 28 (for the three months ending April 30, 2020). IT spending across industries is generally decreasing, and many of Zscaler's competitors have indicated that cybersecurity spending is a low priority amongst enterprise customers, even as businesses seek to extend work-from-home policies. Additionally, as businesses become cash-strapped, Zscaler's premium-priced solution is unlikely to appeal to customers across industries and sizes, with many cheaper alternatives of comparable quality available. Even in a scenario where Zscaler performs well in its upcoming earnings report, there are a number of headwinds that will leave them unable to live up to their growth story going forward. Zscaler's previous earnings report, released on February 20th, showed evidence of these headwinds impacting financial performance and sent the stock price tumbling the following day. The pandemic has since led to over-excitement about the future of remote work and Zscaler being a beneficiary of increased cybersecurity spending to provide remote employees with secure access to enterprise applications. However, there are a number of competitive and economic reasons for why Zscaler will see limited benefit from this trend, detailed further in the "Investment Merits" section below.


My 2021 Billings forecast of $573M (+18% YoY) is 12% below the street estimate of $648M, assuming continuing pressure on growth. In similar growth slowdown scenarios, Zscaler has traded as low as 10X forward Sales as the market tempers its future expectations, yet still well above its peer average of 6X EV/Sales (4.5X median). Applying a more modest 12X EV/Sales multiple on my 2021 Sales forecast of $498M, in a base case scenario, gives us a $49 price target with a potential 36% gain on a short position.


Business Overview:

Zscaler is a disruptive vendor of network cybersecurity services, geared toward large enterprise customers. As one of the few pure cloud vendors in network security – specifically the secure web gateway (“SWG”) market – Zscaler’s core product is a software solution that allows a company’s employees to securely connect to externally managed SaaS applications (e.g., Dropbox, Salesforce, Workday, Office 365). Zscaler’s value proposition is that it provides this secure access without the need for physical appliances within an on-premise (“on-prem”) datacenter. This is becoming more relevant as businesses shift to the cloud and a greater number of employees are working remotely. The company was founded in 2008 and is headquartered in San Jose, California.


Zscaler’s two primary products are Zscaler Internet Access (“ZIA”) and Zscaler Private Access (“ZPA”):

1) Zscaler Internet Access (est. 92% of Revenue) is Zscaler’s core product that filters web traffic to enable a company’s employees to securely access externally managed SaaS applications or the internet.

2) Zscaler Private Access (est. 8% of Revenue) is a zero-trust network access solution that Zscaler positions as a VPN replacement, allowing users to securely access internally managed applications hosted internally in a company’s data centers, as well as public or private clouds.


Zscaler primarily focuses on midsize and large enterprise customers across a wide range of industries, and primarily competes against traditional network security appliance vendors Symantec (Blue Coat), Cisco (Umbrella), Palo Alto (Prisma Access), and McAfee.


Zscaler’s regional split is approximately 51% Americas, 40% EMEA, and 9% Asia-Pacific.



Investment Thesis:

For years, Zscaler has effectively had no competition as it disrupted the SWG segment of the network security market, rapidly gaining share as it enables businesses to effectively and securely transition to cloud-based architectures. Investors have witnessed Zscaler’s 50%+ annual revenue growth (until the most recent two quarters), the large TAM communicated by management, the lack of cloud-based competitors, and have valued the company accordingly with lofty growth expectations through 2023. However, legacy vendors including security giants Cisco and Palo Alto have not stood still and have recently developed their own cloud-based alternative solutions to Zscaler. Additionally, new entrants to the network security market also present new challenges to Zscaler’s growth prospects. iboss and Menlo Security are smaller, rising competitors with cloud-native solutions, and we even see large CDNs like Akamai and Cloudflare incorporating competing services within their bundled cybersecurity solutions. We are likely seeing the beginning of these competitive forces slowing Zscaler’s growth, as their most recent two quarters showed the company’s slowest year-over-year growth in revenue, accompanied by a slowdown in billings and recurring revenue growth. Exacerbating these competitive forces, Zscaler is going through an intense period of management and sales force turnover with a newly appointed CRO, and has historically had a poor relationship with its channel partners, many of whom now seem happy to have alternatives to Zscaler.


The recent hype around remote work and cloud-based services due to Covid-19 has only complicated these issues. I expect the net Covid-19 impact on Zscaler to be neutral at best, and this short-term run-up in price improves the entry point for a short position.


Given these factors, there is significant share price depreciation ahead for investors to benefit from a short position in Zscaler shares as the market begins to price in a dramatic slowdown in the company’s growth over the next 6-18 months.



Investment Merits (Bear Points):

Zscaler management has expressed the company’s ability to reaccelerate revenue growth and sales force productivity, and my short thesis is predicated on the company’s inability to achieve these stated revenue growth goals and margins for reasons outlined below:


1) Increasing competitive intensity.


Previously the only cloud-based SWG vendor, Zscaler is now facing competition from a number of viable alternatives to its core products.


Zscaler has grown by selling their cloud-based products to customers of the dominant on-prem network security vendors Cisco, Palo Alto, and Check Point whose hardware still sits within these customers’ datacenters. Each of these on-prem vendors now offers their own cloud solution that competes directly with Zscaler, bundled within a broader cybersecurity platform at a significant discount to Zscaler. Enterprise customers are generally looking to consolidate their number of cybersecurity vendors and tend to prefer the platform approach, particularly if there is a cost advantage to doing so. With Zscaler contract terms around 12 months, we are likely to see a significant number of these existing customers fail to renew over the next few quarters. 


CDNs like Akamai, Cloudflare, and Fastly have integrated SWG products that compete directly with Zscaler, on cloud-native infrastructures that generally offer higher performance and lower latency.


Previously seen as partners and complimentary to Zscaler, SD-WAN vendors like Fortinet and Cisco have developed their own competing SWG products, and will challenge Zscaler’s growth.


Office 365 adoption has been the primary driver of Zscaler wins, and Microsoft’s new partnership with iboss – a direct competitor to Zscaler, winning market share – will put greater limitations on this growth driver going forward. iboss offers a cheaper solution and customers have indicated that iboss is closing the gap with Zscaler in terms of execution and functionality.


2) Zscaler’s technical superiority is disappearing.


With recent acquisitions and product development, competitors are closing the gap with Zscaler functionality. 


For example, Palo Alto’s competing product, Prisma Access, is reportedly able to deliver 70-80% of the functionality that Zscaler can deliver, with significantly lower latency. Zscaler is also priced at a significant premium to Prisma Access, because Palo Alto typically bundles the pricing with its other products and services, resulting in 20-30% of the price of Zscaler.


Zscaler is known for its performance issues with customers over 2,500 seats – typically latency issues and downtime. These performance issues, along with implementation delays, have left many enterprise customers actively looking to transition to an alternative technology. Gartner customer reviews show that technical issues with Zscaler’s implementation and technology result in a lower perception of value versus competing vendors.


3) Sales force and management issues are likely to weigh on growth and margins.


Disruptions in Zscaler’s sales org have slowed its growth and have generally been viewed negatively, with channel partners now leaning more to Zscaler’s competitors.


Zscaler hired its new Chief Revenue Officer, Dali Rijac, from AppDynamics in September 2019 and aims to grow more aggressively into the network security market, challenging traditional security vendors. Management and partners have described the degree of turnover in Zscaler’s sales force since Dali’s arrival as intense, as he “cleans house” and brings in his own sales managers – many from AppDynamics.


Increased Sales & Marketing expenditures are not translating to proportionate increases in billings and revenue. Management will ramp up spending over the next 6-12 months as they build and train their sales force. New sales reps are expected to be at full capacity after 12 months, and are therefore not expected to have a positive impact on billings, revenue, and margins until late 2021.


Contract duration is down year-over-year to the minimum 12 months, while the sales cycle remains unchanged, indicating that customers are not willing to lock themselves into long-term contracts with Zscaler products.


4) Weak distribution channels.


Zscaler’s channel partners are not incentivized to sell their products over competing solutions.


Zscaler typically sells directly to the C-suite, leading deals with their channel partners (i.e., system integrators, VARs, telcos) playing a reduced role versus typical deals. Channel partners generally find Zscaler difficult to work with and prefer competitors like Palo Alto. Zscaler’s limited support organization also makes it difficult to compete with larger new competitors.


Zscaler relies on non-exclusive relationships with big telcos (e.g., BT and Verizon) to distribute their products. Verizon’s partnership with iboss calls the strength of these relationships into question.


5) Interest in hybrid solutions will continue in the short term.


Zscaler competitors offer much more compelling solutions for customers who will continue to have servers on-prem, even as they transition parts of their business to cloud. 


Whereas Zscaler is cloud-only, competitors like Palo Alto are able to offer cloud, on-prem, and hybrid services. On-prem security is still necessary for enterprises who need quick response times to any cybersecurity event, particularly financial services companies. Some enterprise customers have said they will never be fully on the cloud, as it takes away too much control and puts its fate in the cloud vendor's servers, with the liability to customers still being held by the enterprise. Palo Alto, Cisco, and other traditional security vendors offer hybrid solutions that are much more cost-effective than Zscaler and allow customers to gradually transition from on-prem to the cloud.



Investment Risks (Bull Points):

The top risk factors include the following:


1) Zscaler still maintains its reputation as a leader in the SWG market: Zscaler is still ranked highly by industry experts and this may support its growth going forward.


Mitigants – Latency issues, implementation delays, and a high price point have all pushed Zscaler customers off the platform in the past, and their low customer reviews relative to competitors contrasts sharply with what industry rankings seem to show. With a new range of competitors, Zscaler’s strength as a point solution will not compete well with enterprise customers who are looking for a platform solution to cybersecurity.


2) Covid-19 may lead to a rapid shift to remote work and SaaS applications that benefit Zscaler: In response to the virus, many businesses may increase their use of SaaS applications, and will require Zscaler products to secure user access to these applications.


Mitigants – IT and security budgets across Zscaler’s existing and target customers are likely to be impacted by Covid-19 as well. This is especially relevant as half of Zscaler’s revenue comes from EMEA and APAC and is billed in U.S. dollars, which could exacerbate any weakness internationally. With a larger number of significantly cheaper, effective alternatives to securing cloud-based apps, Zscaler is unlikely to benefit from any short-term, accelerated adoption.


3) Potential M&A: Zscaler is still a rapidly growing and prominent player within its niche industry, and the cybersecurity industry is very active in M&A. If Zscaler does begin to see its valuation decline, it is possible that a larger competitor will seek to acquire the business.


Mitigants – Zscaler is majority (~46%) owned by insiders including the CEO, Founder, President, and Chairman who owns 37% of the company, making it a less feasible target for an acquirer. As many of the large network security vendors invest in their own competing products, the number of potential buyers is also becoming more limited. Additionally, most public acquisitions in the cybersecurity space have occurred around ~6X Sales, which is far below Zscaler’s current valuation.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


1) Continued decline in billings and revenue growth: The market is pricing in a reacceleration of growth in H2 2020, as this is what has been communicated by management. Any divergence from these expectations is likely to negatively impact Zscaler’s share price.


2) Greater difficulties with sales force hiring and retention: Zscaler’s reacceleration story is predicated on their ability to hire and ramp up their newly onboarded sales force to full capacity over the next 12 months. If the high sales force turnover continues over the next couple quarters, this timeline will be pushed out and we will likely continue to see sales productivity, billings and revenue growth deteriorate.


3) Continued M&A and product development in the SWG network security market: There are still many smaller and private businesses developing cloud-based products that compete with Zscaler, and any acquisition of these businesses by larger network security vendors will give greater credence to the mounting competitive threat. This would also hold true if we continue to see competing products being announced by networking vendors who have not historically competed with Zscaler.


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