Zscaler: 3 Important Takeaways From Q3 Results


  • Zscaler’s strong progress continued in its recently concluded quarter, with the business accelerating quarterly revenue growth yet again.
  • Strong RPO growth suggests revenue growth may continue to accelerate.
  • The business is seeing signs of very good success in the mid-market segment, which is an important development for Zscaler to execute its full opportunity.
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Zscaler (ZS) reported an impressive set of earnings results in its most recent quarter. The business has been a core holding of the Sustainable Growth Service since early 2020, added at $48 a share. The results indicate 3 very important takeaways about Zscaler and its long-term positioning for me.

#1 Zscaler is not just a work from home play

Zscaler was unfairly categorized as just a work from home beneficiary during the pandemic, along with other beneficiaries of digital transformation. This categorization largely stems from the fact that the business was used to help large enterprises manage the security threats they face from distributed access to corporate data by their employees during the work from home phase of the pandemic.

Such corporate data access included that within an enterprise environment as well as that which was distributed via other cloud-based applications.

Zscaler’s ability to provide a secure path to access such a corporate data meant that enterprises were falling over themselves during the pandemic to deploy Zscaler systems. The fact that it was the first “cloud native” security solution meant it delivered meaningful efficiency and performance improvements compared to legacy, on premise systems. That has led the business to experience consecutively accelerating quarterly revenue growth since January 2020.

Source: Q3 2021 Earnings Call Presentation

However concerns increased that with enterprises now starting to shift back to a more normalized working environment, with less of their employees staying remote, Zscaler would start to feel the effects of this and return to more normalized levels of growth.

My view on this has always been that Zscaler has been riding a secular trend of enterprises seeking to provide distributed access in a VPN freeway and that the increasing use of cloud-based applications containing sensitive corporate data would mean that Zscaler‘s cloud native solution would continue to be preferred by corporations in preference to bulky, legacy systems deployed on premise.

There was evidence in Zscaler’s results that this appears to be playing out. Zscaler saw impressive revenue strength, with yet another quarter of accelerating quarterly growth, increasing 60% year-over-year.

Yet revenue growth for some cloud security companies like Zscaler is a legacy measure. It reflects the results of past contracted deals largely being recognized in current quarters as Zscaler deliver services to its customers.

More indicative of current sentiment are customer wins and billings growth. Zscaler increased its customer numbers by over 20% year over year. With a current total of over 5,000 customers, that implies that nearly 800 customers that were added by the business in the last year.

Billings growth is an even more current indication of customer intention and near-term product demand. If anything, this shows that the attractiveness of the Zscaler solution is increasing.

Zscaler saw billings growth of 71% year-over-year, a number which is meaningfully higher than the current quarter’s revenue growth. This reflects products that are invoiced in the quarter, which will show up in revenue in future quarters. The interesting takeaway here is that billings growth has been accelerating in recent quarters and the rise in quarterly volume of billings suggests that demand is increasing, not weakening and is certainly higher than the pre-pandemic.

Source: Q3 2021 Earnings Call Presentation

#2 Zscaler’s Revenue Growth Should Accelerate

One of the more understated parts of Zscaler’s earnings was the increase in Remaining Performance Obligations (“RPO”) that the business recorded in the quarter. RPO increased nearly 83% year-over-year during the most recent quarter. RPO reflects non-cancelable commitments that Zscaler has received for future project revenue which are still to be implemented.

Zscaler has shown a trend these last few quarters of delivering increasing RPO and deferred revenue. This has generally been correlated with revenue growth that has steadily ticked higher quarter on quarter. In Q1 2021, RPO was up 56% year-over-year to $864M. The growth in RPO was 68% year-over-year in Q2 to $1.02B and was most recently 83% year-over-year in Q3 to $1.2B. In a little over 6 months, Zscaler has nearly $330M of future revenue.

Approximately 51% of total RPO is current RPO, or revenue expected to be recognized in the next 12 months and is nearly $600M. Said another way, Zscaler already has expected revenue for the next 12 months equivalent to what it delivered over the last 12.

It’s no surprise that as RPO growth has accelerated, Zscaler’s revenue growth over the last few quarters has accelerated as well, with more of the higher backlog being recognized in year. Given yet another quarter of accelerating RPO, I expect revenue growth to top the 60% delivered last quarter.

#3 Zscaler is showing good signs of market expansion

Zscaler continues to dominate the Global 2K market for secure enterprise networking with a nearly 25% market share of the global 2000 companies as customers. One of the keys to success here has been the strong partnerships that it has with large systems integrators and service providers who have hooks in large enterprises. These partnerships contribute almost 40% of Zscaler’s revenue.

Source: Q3 2021 Earnings Call Presentation

Zscaler’s solution so dominates the SI and SP channels that the company recently referenced a deal where 6 out of 6 SI & SP RFP respondents to an enterprise security project bid the Zscaler solution.

For SI’s it just so happens that the Zscaler system is significantly complex that its implementation yields a large services revenue stream. Large enterprises also prefer to have certainty of an SI to deploy and manage an implementation, which suggests that Zscaler will continue to have success leveraging this channel.

There is significantly more penetration to be obtained in Global 2000 and a long runway still to go.

However, Zscaler is now more aggressively attacking the mid-market enterprise segment which consists of organizations of between 2000 and 6000 employees. On its Q3 earnings call, Z Scaler referenced that it is seeing a higher mix of new business from the segment. In fact, it is the fastest growing segment that the company is currently seeing , representing a couple of percentage points of quarter on quarter growth.

The business has been actively adding to its direct salesforce, which now represents nearly 10% of total revenue, to address this market. It has also formed partnerships with value added resellers. The much faster sales cycles in this segment has meant Zscaler has seen rapid rewards from these efforts.

It will be interesting to see how the competitive dynamics evolve here. Cloudflare (NET) has introduced Cloudflare for Teams, a competitive offering which on its surface appears to be easier to integrate and set up. It’s ideally tailored for a mid-market customer type. Zscaler‘s current traction here suggests that it’s seeing good success from going down the market and aggressively attacking the space.

Concluding Thoughts

Q3 has been a blockbuster quarter for Zscaler. The quarter shows that the business has maintained its momentum in the large enterprise space and is adding new deals at an increasingly more aggressive rate. Comments from management about mid-market success also reflect a desire to acquire as much of this market as possible, something which it seems to be successfully doing at present. The market reacted positively to Zscaler’s results and sent the stock price up nearly 12%.

Zscaler’s current valuation isn’t cheap. The company currently trades at just under 40x sales. However, with accelerating momentum and revenue growth likely to top 60% for the next couple of quarters, I believe the business continues to be one to hold at current prices and to potentially enter or add to on pullbacks.

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