Zscaler, my take on their results

My take on the Zscaler results:

Sept 2019 – July Quarter and Fiscal Year results

Quarter Highlights

Our strong fiscal 2019 results demonstrate our ability to drive growth and profitability while investing in our business, as we continue to see enterprises transforming their network and security to realize the benefits of the cloud. I am also excited to welcome Dali Rajic as our new President of Go-to-Market and Chief Revenue Officer and look forward to working together to scale our business.

• Revenue up 53% $86 million
• Billings up 32% to $126 million (Weak, but they warned of tough comparison)
• Deferred revenue up 53% to $251 million
• Adj net income of $9.1 million up from a LOSS of $1.4 million
• Adj Op Income was $7.9 million, or 9% of revenue, up from a LOSS of $2.4 million, or 4% of revenue, a yr ago…
• Adj EPS was 7 cents, up from a LOSS of 1 cent a year ago.
• Op Cash Flow was $17.8 million, or 21% of revenue, compared to $14.7 million, or 26% of revenue, a year ago. Free cash flow was $7.6 million, or 9% of revenue, compared to $11.9 million, or 21% of revenue, a year ago. [They fell back on Cash Flow but remained positive]
• Deferred revenue: $251 million, up 53%
• Cash of $365 million , up $66 million yoy.

Full Year Fiscal 2019

• Revenue: $303 million, up 59% .
• Op Income was $25 million, or 8% of revenue, improved from a LOSS of $15 million, or 8% of revenue, last year.
• Adj net income was $30 million, improved from a LOSS of $14 million a year ago.
• Adj EPS was +22 cents, up from a loss of 13 cents.
• Op cash flow was $58 million, or 19% of revenue, up from $17 million, or 9% of revenue, a year ago.
• Free cash flow was $29 million, or 10% of revenue, up from $2 million, or 1% of revenue, a year ago.

Saul: My Take: The numbers were great except for the quarterly billings, but people were really worried about guidance and the stock sold off a lot.

Austin pointed out that they guided low a year ago too:

I was a bit worried about the 32% guidance for FY 2020… this is really no different than what they did in a year ago. I think ZS’ future is very bright with a lot of disrupting legacy providers ahead. It seems like PANW is very scared and worst-case scenario, I think someone like MSFT would acquire ZS in a heartbeat (hope that doesn’t happen)

They just guided for revenue of $400 million for the fiscal year, up 32%, BUT :

A year ago, guidance was for revenue this past year of $255 million, up 34%. This year they actually brought in revenue of $303 million, which was up 59%.

I (Saul) responded :
Austin, The numbers aren’t different but the talk is. They sound like they have a problem. They are clear that the problem is not competition, and I believe it, but the legacy players have now become aware of them and are fighting back as best as they can. But ZS is talking about an execution problem: They say that to scale up they need an expanded, better, and revised, sales and marketing system. They hired a bunch of people in the quarter. They also make too many excuses about last years big sale causing tough comparisons (so why didn’t they make another big sale this year?) It’s my second biggest position so I reduced it a little, but it’s still second biggest by far. (Maybe about 15% of my portfolio). I think they do have all the tailwinds and inevitability they talk about, but they still have to go out and do it! I didn’t want to sell other companies that aren’t having the same hiccups in order to add to ZS, but I doubt I will reduce it further.

Now, after looking further at this year’s results (which I admit is looking backward instead of forward), I see that they had a beyond great year! I see that the last four year’s revenue increases were 50%, 57%, 51%, and now 59%, so this was their highest revenue growth of all of them.

Operating income was $25 million, up from a LOSS of $15 million.

Adj net income was $30 million, up from a LOSS of $14 million a year ago.

Adj EPS was +22 cents, up from a LOSS of 13 cents.

Op cash flow was $58 million, or 19% of revenue, up from $17 million, or 9% of revenue, a year ago.

Free cash flow was $29 million, or 10% of revenue, up from $2 million, or 1% of revenue, a year ago.

Saul again: And with results like that they are down 50% from their highs???

Granted that they guided low, the way they did last year, and quarterly billings growth came in low at up 32%, but quarterly billings weren’t low! At $126 million they were the highest billings they’ve ever had by $11 million, and were up by $41 million sequentially, or up 48% sequentially!!! The problem is that they were compared to the extraordinary $95 million that they had in the July quarter a year ago, so it looked like they were weak at 32% growth, but last year. That $95 million really was extraordinary! That $95 million was surrounded by billings of $55 million and $65 million in the quarters before and after. I’d say that was extraordinary, and an unfair comparison, but that’s just me.

This company is not dead AT ALL.

Saul

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Saul,
I have similar take…they had a great year, tons of upside, but that dreaded “execution” item came up. But I believe the execution concerns to be overblown, and here is what I mean:

As noted elsewhere, ZS sells top-down, as their approach is a dramatic shift from legacy infrastructure usually owned by the network or security teams. It is a C-focused sale, because you can be potentially eliminating jobs (expense) or at the very least you are threatening the status quo of the folks that were making the decisions and were responsible for maintaining the legacy on-prem firewall-type of security solutions.

Using hyper-converged as an example: when you sell HCI, you can’t go to the storage admin, because normally they have expertise and a comfort level with the storage arrays they already have (netapp, emc, pure, etc) and HCI sort of eliminates the need for a storage admin in some cases. So you have to go ABOVE the storage admin.

Same thing here with security…have to go above the teams that have expertise and comfort level with legacy solutions. In some cases there are new cloud-roles in larger Orgs…or the CISO has a big-picture mentality. Either way, you need to speak with decision-makers that will have an open mind to the ROI associated with doing things very differently.

ZS, like any smaller company, can only scale so much, in terms of the actual touches they can get with clients. So they need to leverage partners. ZS refers to SI’s and service providers as the normal IT reseller channel isn’t ideal for them…those resellers often focus on on-prem and their contacts are the same ones that ZS is trying to go above. So those Accentures and Deloittes of the world that will help companies “transform” are the type of partners that help ZS. Microsoft touting ZS for O365 is huge. I do not know if MSFT sales reps actually ever mention ZS…probably not, as they are focused on their own sales of msft products, but just the fact that ZS and their partners can point to MSFT web showing ZS as a preferred security provider for O365 is additional help.

After the first waves of momentum fade, you need to ramp up Sales, which they are doing. Their reps made the company what it is, then the IPO brought tons of attention, and now PANW and others are helping their cause by calling out that ZS is the one to beat. But in order to scale and win more of those big accounts in a top-down manner, you need someone connected.

I don’t put stock in any one sales leader, but I do agree they appear to have been selective and got a good one in Dali Rajic. He headed sales for App Dynamics, which Cisco bought.
Here is glassdoor talking about their sales culture, with mostly positive reviews
https://www.glassdoor.com/Reviews/AppDynamics-sales-process-…
More on their sales culture here: https://www.youtube.com/watch?v=aCxr51JYYe4

Here is interesting article by one of AppDynamics founders on evolution of App Dynamics as a younger company until being acquired by Cisco, and talks about the hire of Rajic:

https://www.linkedin.com/pulse/science-enterprise-software-s…
In 2011, we were interviewing for VP of Sales for the Eastern US. We had just filled the position, but we had one last candidate, Dali Rajic, who had flown in from Chicago to interview so we didn’t want to cancel. I asked him, “How would you deliver targets consistently and never miss?” He said, “I manage to sales capacity, not to deals. When you manage to deals, you miss. If you have enough productive sales capacity and the right sales process, you can never miss.”

“Even though we’d already filled that Eastern U.S. sales position, I was blown away by Dali’s structured approach and confidence so I asked to create a special position for him. And it turned out to be a great decision; today, Dali is our Chief Revenue Officer and runs worldwide sales for all of AppDynamics.”

Yet another article on the sales process success at AppDynamics from Medium:
https://medium.com/lightspeed-venture-partners/building-a-3-…

Yet another article…this one actually written by current MDB CEO, via Forbes:
https://www.forbes.com/sites/ciocentral/2017/02/01/what-ever…

Again…one leader is just one guy, but this seems like a great hire, and his processes should take root about 3 Q’s from now, giving ZS a great 2H of their coming fiscal year. In the meantime, the secular tailwinds of O365 and SD-WAN and existing customer base spending more, should lead to a good 1H.

The other thing I like, is that, imo, this is the bottom in the sense that full fiscal year guidance (sandbagged as usual) was given. For the next 3 Q’s, we get to benefit from beat-and-raise.

I did think ZS was running too hot, and like ESTC, they were expensive from the IPO start. I think the dip today was a great place to add or start a position in ZS, if you hadn’t already had a large allocation.

Dreamer

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“Even though we’d already filled that Eastern U.S. sales position, I was blown away by Dali’s structured approach and confidence so I asked to create a special position for him. And it turned out to be a great decision; today, Dali is our Chief Revenue Officer and runs worldwide sales for all of AppDynamics.”

Thanks Dreamer for that inspiring story about Zscaler’s new hire’s previous job at AppDynamics. That really inspires confidence. That Zscaler was able to capture a guy like that not only says great things about their new hire, but says great things about Zscaler, and its reputation in the industry.

Thanks again,

Saul

23 Likes

Thanks Saul and Dreamer for your perspective, it’s very much appreciated.

I just wanted to add a couple of observations that felt important to me:

1.) Forget about their guidance! It reminds me a lot of last year. To remind you, in Q4 2018 they were guiding for $260 mil 2019 full year revenue (+36.6%). At the time they had a total backlog (or RPO) of 398 mil and current RPO (CRPO, for the next twelve months) of $211 mil. That means they already had 81% of their 2019 guidance booked – done deal. Of course, they came in at $303 mil which means they made $92 mil additional revenue in 2019. Now, they guided for $405 mil in 2020 full year revenue (+33.7% – very similar to last year albeit a tad slower). At the same time, they have a total backlog of $554 mil at the moment and $305 mil (CRPO) will be recognized in the next twelve months. So very similarly to last year, 75% of 2020 guidance is already in the bank!!! That’s 6% lower than last year, but still you can see the power of the SaaS model here. They already took care of most of their guidance for 2020 in 2019. That’s amazing. Currently, the company “expects” to make $100 mil incremental revenue in 2020, that’s only $8 mil (or 8.6%) more than the $92 mil incremental revenue they made this year. I’m confident that with their growing sales force they will be able to increase their incremental revenue gains by more than roughly 9% in 2020. When an analyst pointed this out in the cc, the CEO had this one liner in response: “We like to be prudent with our guidance and our guidance we feel is prudent.” Clearly, he is aware that their guidance is quite ridiculous.

2.) I would also like to point out that management was very clear to debunk Palo Alto’s recent trash talk. Although we already knew these comments from Palo were not based on facts, it was important to me to hear management call it out as BS. Check mark here.

3.) Generally I had the feeling that management was very positive regarding the competitive environment. My take away is that the competitive field hasn’t really changed much. The paradigm change story is still very much intact. The only thing that changed is investor’s perception.

4.) Yellow flags in terms of Billings growth deceleration and the dreaded talk of elongating sales cycles have already been mentioned. There is no way to sugarcoat this – it’s not a good sign to hear these things. But at the same time revenue grew 53% and they guided for 42% for Q1 2020, which they will surely beat. It’s not like growth is falling off a cliff. My perception is that they are changing gears a bit to set themselves up already to reach $1 billion in revenue and beyond, which seems sensible to me(although I don’t want to pretend to have any knowledge in selling/scaling SaaS products).

Anyways, I liked the quarter (not a blow-out but solid nonetheless) and will continue to hold my shares and am thinking about adding. I will sleep over it, look at the numbers again and hope to read some more insights here.

Best,
Niki

48 Likes

Hi Niki,

Unfortunately you didn’t read to the end of my post. You write:

Yellow flags in terms of Billings growth deceleration and… have already been mentioned. There is no way to sugarcoat this – it’s not a good sign to hear these things.

You missed what I wrote:

Granted that they guided low, the way they did last year, and quarterly billings growth came in low at up 32%, but quarterly billings were NOT low! At $126 million they were the highest billings they’ve ever had by $11 million, and were up by $41 million sequentially, or up 48% sequentially!!! The problem is that they were compared to the extraordinary $95 million that they had in the July quarter a year ago, so it looked like they were weak at 32% growth, but last year. That $95 million really was way out of the ordinary! The quarters before it and after it had billings of $55 million and $65 million. I’d say that $95 million was not an ordinary quarter, and an unfair comparison, but that’s just me.

That sugar coats it pretty well, don’t you think. Can you still find “billings growth deceleration” ???

Best,

Saul

23 Likes

Saul,

I agree with you mostly. As I said I liked the quarter and also think they had tough comps from last year (which management clearly communicated so it shouldn’t be a huge surprise). But then again, Q4 (and Q2) are the strong sequential growth quarters for Zscaler. Just as comparison: In Q4 2018 they grew Billings by 74% sequentially, in Q4 2017 they grew 75%. 48% is great, no doubt, but much lower than the last two years.

Here are my notes on sequential Billings growth for the last 12 quarters:


      Q1      Q2      Q3       Q4  
2017 -24,78 % 75,40 % -28,51 % 75,32 %
2018 -25,09 % 59,04 % -17,12 % 74,41 %
2019 -32,39 % 78,29 % -26,35 % 48,52 %

Don’t you think this looks like deceleration?

Best,
Niki

9 Likes

First, Dreamer - great post.

But, I’m trying to understand why Dali Rajic’s interview answer: I manage to sales capacity, not to deals. … If you have enough productive sales capacity and the right sales process, you can never miss [targets].” was so great. This isn’t a dig on Rajic or AppDynamics, I’m just trying to both see how I would respond and trying to understand the sales world, which I am most definitely not in.

I’ve filled engineering manager roles quite a bit. I do ask candidates how they develop projects on time, and I would not look at a similar answer to Rajic’s - that you scope the project according to the engineering team capacity you have - as knocking my socks off. It would actually be an obvious answer, and frankly I’d be a tad frustrated that the candidate was wasting time not getting to the real issues of why project goals are missed.

In my engineering world, there are VPs of Marketing, C-suiters, etc. all asking for X features in Y time. No engineering/project manager worth his salt would ever try to manage to such targets without understanding what team capacity would need to be in place to be successful. The same should be true of sales, no?

The real issues in this regard are:
• How well you can estimate what your team’s future capacity is? (I ask candidates how they do estimates)
• How can you improve the productivity of the team you have, or do you need to shift towards different skill sets?
• Given a limited budget (and every company’s budget is limited, not just startups), how do you go about negotiating which should be the company’s priorities, and which can be deferred for later? (I ask candidates about how they structure such discussions)
• How well can you convince the C-suite/business unit owner to allocate more money towards your team? How do you show your team’s contribution to the company’s past success as indication of what more your team could do with more investment?

If I had gotten Rajic’s answer from a candidate, my follow-up question might have been: “OK, but what do you do when the company’s targets are greater than the existing sales capacity, and being a small company, we have a limited budget?”

Because, that’s where success or failure lies. If a Sales Leader wants to manage towards his team’s capacity and not the company’s target, he may be personally successful in that, but the company may fail because it didn’t grow sales as much as was needed. And Saul seeing that sales didn’t grow enough would sell the stock instantly. ;^)

I can guarantee that at every company we look at here on this board, there’s a constant negotiation of dollars available to fund sales as well as engineering. And there are sales managers complaining that the targets they’re given are too high for the team they have, while the C-suite is responding with that there’s no more money, and even if there were more, you can’t hire and train sales reps quickly enough. Just as I know there are engineering managers saying that marketing is asking for too many features too quickly for the team they have while the C-suite is saying there’s no more money, and even if there were more, you can’t hire and train engineers quickly enough.

The real question is how the leaders at the company prioritize what’s important, do cost/benefit analysis on each feature or sales approach, and what creativity can be employed - like whether a different feature not yet thought of would be more valuable, or whether a different, currently untapped market is worth attention.

Do, yeah, apparently Dali Rajic is a great Sales Leader, but I wouldn’t cite that interview answer as predictive of that. Unless somehow Sales doesn’t do the kind of analysis that Engineering almost always does.

14 Likes

Yesterday, I looked at some of the supplementary info available on ZS’s website and came across a presentation that was entitled “Securing your IT Transformation to the Cloud” (link below). The presentation was dated September 2019 and included q4 financials.

https://ir.zscaler.com/static-files/f2f4c074-8bce-4b71-b7a6-…

What caught my eye was that on P. 20, it stated:
“Estimated $20.3 Billion spent annually on disparate security appliances”

I went back to the S-1 that was filed on 2/16/18 and on page 109 it stated the following:
Based on our analysis using IDC data, $17.7 billion annually is spent on disparate security appliances to perform the functions we offer in our platform.

It appears that ZS’s TAM has increased by $2.6 Billion. This would seem like a significant difference and I’m a little surprised that ZS hasn’t mentioned this.

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But, I’m trying to understand why Dali Rajic’s interview answer: I manage to sales capacity, not to deals. … If you have enough productive sales capacity and the right sales process, you can never miss [targets].” was so great. This isn’t a dig on Rajic or AppDynamics, I’m just trying to both see how I would respond and trying to understand the sales world, which I am most definitely not in.

I’ve filled engineering manager roles quite a bit. I do ask candidates how they develop projects on time, and I would not look at a similar answer to Rajic’s - that you scope the project according to the engineering team capacity you have - as knocking my socks off. It would actually be an obvious answer, and frankly I’d be a tad frustrated that the candidate was wasting time not getting to the real issues of why project goals are missed.

Have limited time, so probably can’t do this question justice in short reply, but here goes:

https://www.engageselling.com/blog/what-is-your-sales-capaci…

"your sales capacity is the answer you obtain from the following equation: the number of sales reps you have on the team, multiplied by the number of weekly hours that your team works per year, multiplied by the percentage of time spent selling and finally multiplied by the closing ratio of your team (typically about 30%).

The number is just a benchmark that you should aim to improve WITHOUT ADDING to the number of weeks worked in a year or number of hours worked in a day."

"Test your own organization and see where you place. The key thing is to note your current score and work to improve it over time – this will translate directly into the number of deals you close. "

Basically, I took his answer to be that an efficient and scalable process, once put in place, will optimize the amount of deals you can go after and increase your close %. Think of it like an engineer sizing an array or something…it isn’t enough to just give your client a new array…it needs to be sized to fit their needs today, yet scale for their expected growth. The CRO is looking at how to best size the sales force…just the right amount and type of training and ramp-up, the right person (solution in engineer’s terms) in the first place, and then maximizing the selling time (time on phone, sending emails, traveling onsite to clients) by reducing the noise for sales. Some companies allow way too much in way of distraction…allowing other vendors/partners way too much access and time and pulling sales away from client-facing motions. Some companies don’t have good sales processes in terms of CRM or basic things like order entry, inside support, and other supply-chain related items. Some companies don’t have the correct ratio of engineers or architects or specialists to sales people, etc…

Either way…I wouldn’t read too much in his quote…it is just something the guy said, and in isolation it is worth as much as anything Tony Robbins or a random NY hotdog vendor says. Actions count, and my point of all those links is that it is apparent, in retrospect, that this new CRO had done a really good job executing as a sales leader at his previous employer and that employer was known for having an excellent sales force and great sales process. That should bode well for Zscaler. Plus, odds are the sales leaders brings (poaches) some key talent over to Zscaler that he has worked with previously. Those reps come with client relationships, etc etc…

Ever met a bored engineer? He probably is tied to poor sales reps. Good engineers ensure the deal closes in many cases, I have seen. The sales rep provides the at-bats. The more quality at-bats, the more hits and homeruns. I am sure I can come up with another lame sports analogy, but I think you get the idea.

Dreamer

22 Likes

Dreamer,

Thanks again for the post. So PANW smacks down ZS but they have to. They sell to the Security / IT team and they have to defend their clients.

Getting to the top decisions makers and by-passing the current mid-management is not easy. The Customer has to have confident (or desperate) executives to entertain this. However, events that expose top-level leaders to compatriots, in similar circumstances, can break down resistance, thus Dali.

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I just look at it as expanding the sales channel. The more sakes management you have, the more sales reps you can have. The more sales reps you have, the more they can field customer inquiries. The more customer inquiries fielded, the more sales.

DOCU said the same thing last quarter. Sales cycle was becoming elongated due to the new systems of agreement product they just released. They said this was the reason for the falloff in billings. Then this quarter they had the best revenue growth in a long time and Billings shot up.

I know docu is not zs but there is a precedent for elongated sales cycles and lower billings suddenly reversing course for the better.

ZPA is now 14% of sales, up from 10% last year. The more ZPA is part of negotiations the longer the sales cycle. And the more time each sales rep needs to spend on one sale.

I may be a sucker for the story and ignoring those brush fires, but I don’t see ZS as being a broken thesis stock. I am holding.

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I came to the same conclusions as Saul this morning after sitting down to the actual numbers and added another 1/3 on top of the 100% (already full size) ZS holding today. I had cash I’d wanted to deploy for a few months anyway and couldn’t gut myself into doing so due to the valuations of all my high-flyers (AYX, OKTA, SHOP and the many others we’ve done well with over the last few years). I wish I’d been able to run the analysis a little quicker so I could buy shares a few $ cheaper, but it is what it is.

I don’t see a ZS dumpster fire or a brush fire, but any sales issue can certainly become that if not addressed quickly and thoroughly. However, this reduces my cost basis significantly (as would any huge drop), so I’m in the “nothing ventured, nothing gained” camp until next earnings and beyond.

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The numbers aren’t different but the talk is. They sound like they have a problem. They are clear that the problem is not competition, and I believe it, but the legacy players have now become aware of them and are fighting back as best as they can. But ZS is talking about an execution problem: They say that to scale up they need an expanded, better, and revised, sales and marketing system. They hired a bunch of people in the quarter. They also make too many excuses about last years big sale causing tough comparisons (so why didn’t they make another big sale this year?) It’s my second biggest position so I reduced it a little, but it’s still second biggest by far. (Maybe about 15% of my portfolio). I think they do have all the tailwinds and inevitability they talk about, but they still have to go out and do it!

As I read the discussions around ZScaler’s execution problems (whether real or predicted), I’m reminded of prior dicussions around Nutanix. As Saul points out, the numbers for ZScaler may not yet show it, but does anyone think that maybe Zscaler management knows something we haven’t yet seen in the results?

Many people here bailed out of NTNX quickly at first sign of their problems, but it seems that many here are not just sticking with ZS, but adding. If you’re one of those, how short a leash are you keeping on the company, and what specific aspects will you be looking at - and can you see that data before the next earnings announcement?

I own ZS, but have always been cautious about their sales model, because great as the product may be, adopting Zscaler is a lot of work, and typically wide-ranging. The competition can often swoop in with an incremental improvement that’s cheaper and more narrowly applied and therefore less risky.

10 Likes

That is exactly my fear. Better product not always wins in marketplace. Crowdstrike seems to have a better sales model with less friction.

“incremental improvement” may be all most companies are willing to risk if they think a recession is coming within the next year or so. And that seems to be the consensus among most economists. And despite evidence to the contrary ,many people still take these predictions seriously. Watch longer term bond yields to get a hint abut degree of “risk off” thinking.
I agree about the "execution problem and that worries me. Zscaler may be hitting some sort of sales chasm, where they will have to switch from tech enthusiasts and early adapters, people who are pre sold to a large extent, to main street users who have to be sold hard, and who buy based more on what peers do than anything else. That is not an easy transition, made harder by the fact that it has to be sold to upper management, people who are usually older and got where they are by not making many big mistakes and by seeking consensus. Consensus is made harder when people inside the company who install and maintain security hardware become redundant when it is all done by ZS software.

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