The cybersecurity market was valued at $173.5 billion in 2022. This is forecasted to grow at a solid 8.9% compound annual rate, reaching a value of $266.2 billion by 2027, according to Markets and Markets research. Zscaler Inc. (ZS, Financial) is poised to benefit from this trend as a leader in the Security Service Edge, according to Gartner. The company has continued to produce strong financial results and reported a beat for both revenue and earnings growth in the third quarter of 2023. In this analysis, I will break down its business model, financials and valuation. Let’s dive in.
Innovative business model
Zscaler has pioneered what is called the “zero trust” network methodology. In a standard information technology network, users are “trusted” by default to access all applications and tools once they are logged into the computer or system. The danger with this is hackers can access a system through a low-risk application before moving laterally to a high-risk application like finance. The zero trust methodology solves this issue through a concept called least privileged access. This means users are only given access to the applications they need. For example, a human resources employee is given access to HR applications. While a finance employee is giving access to the finance applications. This is even more vital with external contractors working in an organization who may be doing a menial task but have access to the entire company’s data.
The mechanics of how Zscaler solves this issue is via security policies and a zero trust exchange. This acts as an “intelligence switchboard” via a private network in order to keep data secure via encryption. Many organizations use virtual private networks to solve this challenge currently. However, many of these can be slow and do not actually stop the lateral movement performed by hackers.
Its products are sold via bundles, which offer major upsell opportunities to existing customers. Its products include the Secure Internet Access (ZIA), Secure Private Access (ZPA), Digital Experience (ZDX) and Posture Control.
AI improvements
Zscaler has introduced a number of artificial intelligence tools and features to enhance its existing platform. This includes using AI to improve threat detection and response, via giving its AI models access to the huge amount of threat signature data. The company has also introduced data loss prevention for generative AI queries and outputs, which is vital for auditing. The key with this is it also keeps the users' data private and confidential, which has been a concern for many organizations whose employees use ChatGPT.
Its AITotal platform includes a risk scoring system to automatically evaluate the risk of various AI applications, while its AI access control monitors in-app usage, enabling granular access to specific apps and employees.
Zscaler has also launched a security autopilot solution, which helps AI models automatically perform analysis and recommend policies.
Further, its Zscaler Navigator includes a natural language interface to enable users to interact with its product.
Growing financials
Zscaler reported strong financial results for the fiscal third quarter of 2023. Its revenue of $418.8 million beat analyst forecasts by $7.24 million and rose by 46% year over year.
Billings rose by 40% year over year to $482 million, while its remaining performance obligations grew 36% year over year to $3 billion. This is a positive sign for future revenue consistency.
Its dollar-based retention was a staggering 125%, which was driven by an increased number of upsells.
In one upsell opportunity, a bank in the Asia Pacific region upgraded to Zscaler for 150,000 users. This reduced the wait time to open new branches by 50%, eliminating the need for firewalls and other external network services. Financial services has been a strong area of adoption for Zscaler, as the company serves eight of the 10 largest financial services companies in the world.
Zscaler now has 400 customers with a staggering $1 million in annual recurring revenue or more. This includes 35 customers with over $5 million in ARR each. Such high ticket prices is an indication of the platform's value and its curated sales process.
The company takes a consultative sales approach with an organization as it becomes a strategic partner with them. The business has created “CFO ready” business cases to show the return on investment and payback period for the solution. This high-touch method is vital, especially given the current climate where deals are being scrutinized to a greater degree.
Margins and balance sheet
Moving on to profitability, Zscaler operates with a strong gross margin of 80.2%, which is down slightly from 80.6% in the prior year, driven by higher public cloud usage, although this is still solid overall.
The company reported a 33% spike in its operating expenses to $272 million. This would be a worrying sign for most companies, but approximately $30 million of this increase was driven by higher research and development expenses. In addition, higher compensation costs contributed a large portion, which I do not believe is all bad as Zscaler aims to secure the best talent.
Despite higher expenses, its operating margin of 15.3% rose by 600 basis points year over year. Its free cash flow margin was 18%.
Data center capital expenditure is expected to be around a high single-digit percentage of revenue for the full year.
Zscaler has a strong balance sheet with $1.97 billion in cash, cash equivalents and short-term investments. Its total debt is $1.2 billion, but this looks to be manageable given the vast majority is long term.
Valuation
Zscaler trades with a price-sales ratio of 14.32, which is lower than its five-year average.
Based on historical ratios, past financial performance and analysts' future earnings estimates, the GF Value Line indicates a fair value of $422 per share. Thus, the stock is significantly undervalued at the time of writing.
Guru interest
Guru investors Ron Baron (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) were all buying shares in the second quarter of 2023. The stock traded for an average price of $122 per share during the quarter, which is slightly cheaper than where the stock trades at the time of writing.
Final thoughts
Zscaler is a great company that is poised to benefit from the growth in the cybersecurity industry. The AI market offers many huge opportunities, but also creates increased risks for organizations. Therefore, I believe this will be a net benefit to Zscaler’s security business. The company has continued to produce solid financial results. As such, it looks to be a potentially great long-term investment.
