Zscaler (ZS, Financial), a technology company that belongs to the application software industry, develops and provides cloud security solutions for enterprises, calling itself a pioneer in cloud-deployed security gateways with more than 2,800 customers across the globe.
Although Zscaler operates in a an industry that is set to witness high-double digit growth in coming years, slowing sequential growth, a high valuation and the risk of prospective competition make it a risky bet for investment.
Revenue insights
Source: SEC filings, Q2 2016 to Q1 2019; the last two quarters are forecasted from the growth trend.
Zscaler is growing its billings – i.e., the invoiced amount to clients – at a sequential rate of 25-29%, as evidenced from the quarterly results of the last two years. Revenue, as a result, continues to grow at a CAGR of 11% per quarter.
It’s worth mentioning that if the company manages to follow the growth trend from the recent past, it is expected to report revenue of $189 million in 2018 and $286 million in 2019. Wall Street is looking for revenue of $184 million in 2018 and 236 million in 2019. Therefore, revenue beats in upcoming quarters can catalyze Zscaler’s stock price.
Industry prospects
The cloud security market is hot at this time. Corporations are transitioning from legacy security to cloud security, and the estimated total addressable market is $17.7 billion. According to Gartner, the cloud-based security market is set to reach $8.9 billion by 2020, a CAGR of 15% during 2017 to 2020. Gartner argues that small- and medium-sized businesses are driving the growth of cloud-based security amid cost benefits “especially for powering and cooling hardware-based security equipment” and data center floor space.Â
Another research firm, Forrester, expects the spending on cloud security to grow at a CAGR of 28% during 2016 to 2021.Ă‚
In short, cloud-based security – or SaaS security – is expected to witness high double-digit growth in coming years. Naturally, the security solution providers are garnering attention from investors, and Zscaler aligns with thet growth prospects of the industry.
How does Zscaler measure up against competition?
“We have the opportunity to dramatically change the legacy security market and to significantly reduce the costs of networking and security infrastructure," said Zscaler CEO Jay Chaudhry in first earnings press release after the initial public offering.
Zscaler is doing well in its niche. Gartner named it a leader in the magic quadrant for secure web gateways in June 2017. Gartner further noted that Zscaler has around 55% of the total market share in cloud-based security web gateway services. The only other leader in the niche is Symantec, according to Gartner.
Per Forrester’s assessment of Software-as-a-Service (SaaS) web content security, Zscaler is a leader in terms of strategy and current offerings; the closest competitor is Symantec’s Blue Coat. Only IDC assesses that Blue Coat is ahead of Zscaler in worldwide web security.
Overall, Zscaler is among the leaders in cloud-based security web gateways with few direct competitors. It seems that the company is set to benefit from the growth of cloud security alongside Symantec going forward.
There are several red flags though
1. Slowing sequential growth
Sequential growth is not showing much promise. Zscaler is eyeing midpoint revenue of $50.5 million for the fourth fiscal quarter of 2018, an increase of only 2% sequentially. As historical sequential growth was, on average, above 10%, such a decline doesn’t bode well for the growth expectations of the market.
The charts clearly depicts that sequential revenue growth is slowing down. The cloud security provider reported 12% sequential growth in revenue during the third quarter of 2017, which fell down to 9.3% during the third quarter of 2018. The situation is expected to worsen during the fourth quarter of 2018 as the company is expected to report a mere 2.7% growth in sequential revenue as compared to 10.9% growth in the same quarter last year. The bottom line is that revenue growth seems to be slowing down for Zscaler. Given that the company trades at a very rich multiple, it can’t afford a persistent slowdown in growth in order to maintain its stock price.
2. High market expectations
Another important consideration from a valuation standpoint is the price-sales ratio of Zscaler. The company would trade at a price-sales ratio of 18 if it manages to meet the 50% per-year revenue growth expectation during 2019. For price-sales to fall below 5, Zscaler has to grow its revenue 50% per year consistently until 2023. In effect, the market has attached strong growth expectations with Zscaler; a slightest of slipup in growth could prove devastating for the stock price.
3. Risk of rising competition
Although big players have not yet transitioned towards the cloud-based deployments of security solutions, the prospective growth in the industry will certainly attract seasoned players from on-premise security to cloud security. Given Zscaler’s lack of resources, the company might face problems in competing against resourceful players like Cisco (CSCO) and McAfee’s Skyhigh Networks.
Disclosure: I have no position in any stocks mentioned and no plans to initiate any positions in the next 72 hours.
