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Why Zscaler Needs More Cloud Cybersecurity

By Herve Blandin – Updated Mar 5, 2020 at 4:02PM

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After better-than-expected fiscal second-quarter results, the company's stock price dropped by more than 10%, but its valuation remains high.

Zscaler (ZS -2.38%) continues to deliver strong performance. During the past quarter, the cloud cybersecurity specialist posted guidance-beating results, and management raised its full-year outlook. But revenue growth is decelerating and losses are increasing as the company ramps up its sales and marketing efforts. Zscaler needs more cloud cybersecurity products to boost its revenue growth and improve its profitability.

Strong revenue growth

Zscaler is taking advantage of the secular shift to cloud computing. Its two products leverage its cloud platform to provide cloud cybersecurity services. Zscaler Internet Access (ZIA) protects Internet users against malicious traffic, programs, and files, among other threats. Meanwhile, Zscaler Private Access (ZPA) allows access to remote applications in a secure way.

The adoption of software as a service, or SaaS, such as Microsoft's Office 365 represents a strong tailwind for ZIA, and the need to work in a secure way from untrusted networks boosts ZPA usage. In addition, Zscaler's solutions remain competitive. The research company Gartner positioned Zscaler as a leader for secure web gateways in terms of ability to execute and completeness of vision, far ahead of its competitors.

As a result, Zscaler grew its revenue at a compound annual growth rate (CAGR) of 55.6% between fiscal year 2016 and fiscal 2019, from $80.3 million to $302.8 million, respectively. With scale, the company's revenue growth is decelerating, but it remains strong. During the fiscal second quarter, revenue increased to $101.3 million, up 36% year over year. In addition, management raised its outlook, now expecting full-year revenue to land in the range of $414 million to $417 million, compared to the previous range of $405 million to $413 million.

However, the company is scaling up its sales teams to reach the symbolic threshold of $1 billion in revenue, which is pressuring its margins. Because of higher sales and marketing expenses that represented 60.8% of revenue during the last quarter (compared with 52.2% the year before), losses under generally accepted accounting principles (GAAP) increased to $29.2 million compared to $5.6 million a year ago.

Man touching cloud with padlock icon on network connection.

Image source: Getty Images.

More cloud cybersecurity products

With ZIA and ZPA, management estimates the company's total addressable market (TAM) amounts to $20 billion, which gives plenty of room to keep on growing. But Zscaler needs more products to sustain strong double-digit revenue growth over the long term and increase its profitability.

Selling additional products will expand the company's TAM and provide extra growth potential. An integrated and more comprehensive cloud cybersecurity portfolio will also trigger cross-selling opportunities and strengthen the company's competitiveness.

Cost savings should materialize, too. Zscaler can leverage its cloud platform to deploy more applications. And selling extra products to existing customers requires fewer sales and marketing efforts than acquiring new ones. 

Given these advantages, the company in a few months will be releasing two products that should leverage these opportunities. The first one, B2B, will provide enterprises with the possibility to grant private and secure access to some applications to partners and employees from anywhere, without exposing those applications to the Internet. And the second one, Zscaler Digital Experience (ZDX), will help technical support teams identify users' performance issues.

However, execution remains key for these new products to translate into profitable growth over the next several years. Despite the drop in the stock price after the publication of the fiscal second-quarter results, the company's valuation remains elevated. With Zscaler's enterprise-value-to-sales ratio of 22.3, the market already prices strong growth and improved profitability over the long term.

Thus, investors should keep in mind that management must provide flawless execution in expanding the company's portfolio over the next several years to justify a higher stock price.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft and Zscaler. The Motley Fool recommends Gartner and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Zscaler Stock Quote
Zscaler
ZS
$158.69 (-2.38%) $-3.87
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$237.92 (-1.27%) $-3.06
Gartner, Inc. Stock Quote
Gartner, Inc.
IT
$276.06 (-1.44%) $-4.04

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