Zscaler, Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 5/5

Zscaler is a cloud security company that provides a zero trust exchange platform, enabling secure internet and application access. It serves customers in various sectors, including the financial, telecommunications, and industrial sectors.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Zscaler operates within the cybersecurity industry, a sector characterized by high growth, rapid technological change, and fierce competition.

Business Overview

Zscaler’s core offering is its Zero Trust Exchange platform, designed to secure internet and application access. Unlike traditional security models that rely on perimeter defenses, Zscaler’s approach is based on zero trust principles, assuming that no user or device is inherently trustworthy. The platform sits between users and applications, regardless of where they are located, inspecting all traffic and enforcing security policies.

Here are some key elements to consider about its business:

  • Revenue Model: Zscaler primarily generates revenue through subscriptions to its cloud platform. It offers various subscription tiers tailored to different customer needs, including specific features or levels of support. Subscription contracts vary in length, but a portion are multi-year.
  • Customer Base: Zscaler’s clients come from a diverse range of industries, with a strong emphasis on the technology industry, which has the largest share of subscription revenues. The government and financial sectors represent other key areas of its business. It reports having nearly 8,000 customers worldwide, spread between North America, Europe, and APAC.
  • Industry Trends: The cybersecurity market is rapidly evolving due to an increase in remote work trends. This has greatly improved the demand for more secure connection platforms such as Zscaler. Companies have to make sure they have secure access while on public and personal networks. With the rise of edge computing and IoT devices, cloud-based security has become crucial.
  • Competitive Landscape: The cybersecurity market is highly competitive, with both established players and emerging companies vying for market share. Competitors include traditional cybersecurity firms that have adapted to the cloud such as Palo Alto Networks (PANW) and Fortinet (FTNT), as well as other cloud security firms. Zscaler’s competitive edge lies in its pure-play cloud approach, its Zero Trust Exchange architecture, and the integration of a broad range of security features into a single, unified platform, all of which should lead to higher margins.
  • What makes Zscaler Different?: Zscaler is a “pure-play” cloud security provider, meaning that unlike others, its focus is entirely on cloud-based security. The company’s Zero Trust Exchange architecture allows it to inspect traffic anywhere it exists and enforce granular access control policies. This gives Zscaler an advantage over competitors in the security industry that are trying to adapt from on-premise solutions. The company is growing and expanding with over 47% year over year growth in the first quarter of 2024.

Zscaler faces the challenge of continuously innovating and updating its security platform to stay ahead of evolving cyber threats.

Financial Analysis

  • Revenue Growth: Zscaler has demonstrated strong revenue growth, driven by increased adoption of its Zero Trust Exchange platform. Revenue has continued to increase in 2023, with a 47.3% year-over-year growth in the first quarter.
  • Profitability: While Zscaler generates high revenue, profitability has been an ongoing focus for the company. The company is not currently profitable and is reinvesting a large portion of gross profit back into the company.
  • Margins: Zscaler has high gross margins, which indicates the value it brings to its subscribers, and room for future profit growth.
  • Cash Flow: While the company is not yet profitable, Zscaler has a very good free cash flow of 389 million dollars in 2023 and is generally cash flow positive and expects this trend to continue.
  • Balance Sheet: Zscaler has a strong and conservative balance sheet. It has 1.8 billion dollars in cash and investments with only 1 billion in liabilities (debt plus other non-current liabilities).

Zscaler is investing a lot of capital into its business. As it gains scale and market share, the company’s strong free cash flow should enable it to be even more profitable.

Moat Analysis: 3/5

Zscaler possesses a moderate, but not impenetrable, economic moat. Here’s a breakdown:

  • Network Effects: As a cloud-based security company, Zscaler benefits from the network effect; the more users and data they have, the more valuable their security services become and hence, the better they can secure their networks. This is a strong competitive advantage. However, this advantage is not unique to Zscaler, other competitors have this too.
  • Switching Costs: Once a company has integrated its network into the Zscaler platform, switching costs are relatively high. This makes it more difficult for customers to switch over to competitors, increasing customer retention. However, competitors provide the same services, which means the switching costs are not extremely high.
  • Scale: Zscaler is gaining substantial scale, especially in the US and western Europe. The advantage here is that the largest competitor in the sector is quite fractured. If the company continues to grow at its current pace, it may be able to capture more and more of the market share. However, they aren’t completely unique, and other companies in the space do have some market share.
  • Intangible Assets: Zscaler’s brand and technology, while important, are not insurmountable. Competitors can replicate or compete with their technology or branding.

The moat is growing stronger as the company’s scale increases. However, it is easily threatened, making it a decent but not outstanding moat.

Risks to the Moat and Business Resilience

  • Competition: The cybersecurity market is very competitive, with multiple players trying to capture market share. The company is facing increased competition, and has no lock-in. Therefore, competition can directly erode their returns, hence, erode the moat.
  • Technological Change: Cybersecurity is heavily reliant on the latest technology. If a company lags behind new and innovative technology, they will lose market share, and may lead to loss of revenues. A slow response to changing market conditions is a huge risk to the company.
  • Execution Risk: Zscaler needs to maintain its strong rate of revenue growth while successfully managing costs, in the face of significant competition. It must continue to make smart acquisitions that add value. The company is still a loss-making venture, which means that management must continue to focus on profitability.
  • Management Issues: As Zscaler grows in size, the impact of management decisions will have greater impact. If the management underperform, or makes bad decisions, the stock will go down. However, currently, management has displayed solid execution.
  • Economic Downturn: An economic downturn could lead to lower spending on cybersecurity, especially in the small businesses sector. Companies might favor more cheaper solutions instead of expensive solutions such as that offered by Zscaler.
  • Customer Concentration: While Zscaler has a wide customer base, a significant portion of its revenue comes from a handful of clients. The loss of a significant client will impact the company significantly.

Understandability: 3/5

While the core concepts of cloud-based security and the zero-trust model are not difficult to grasp, the intricacies of Zscaler’s platform and its technical differentiators may be challenging for the average investor to fully understand.

Understanding the company’s financials requires paying careful attention to the difference between GAAP and Non-GAAP, as well as its large equity-based compensation and various expenses involved.

Balance Sheet Health: 5/5

Zscaler’s balance sheet is very strong. It has a huge amount of cash and short-term investments on hand, and very little debt.

Overall, Zscaler has a very strong and solid balance sheet, that will allow it to stay afloat and capitalize on any new opportunities.

Recent Concerns / Controversies and Management’s Response

  • Competition: Zscaler continues to face increasing competition in the cybersecurity space. Management acknowledges this and is working hard to differentiate itself by offering a complete Zero Trust Exchange solution.
  • Profitability: Management has repeatedly emphasized its focus on continued revenue growth while maintaining profitability, however the profitability hasn’t yet been fully achieved. The management has stated that it intends to focus on “disciplined spending”. Management believes that the recent rise in margins is due to its greater size and scale.
  • Unpredictable Guidance: Zscaler provided a weak guidance in the first quarter of 2024, despite beating the earning’s estimate for that quarter. In the 10-Q report, it was noted that they expect revenue to be roughly similar as in the last quarter and a decrease in the full year forecast. Management said “macroeconomic and geopolitical uncertainty” is affecting its ability to generate growth. Management said that, if the global environment remains unstable, the full-year forecast will probably be the final results. They had also made cuts in their workforce to curb expenses.