Zscaler Inc. (ZS, Financial) has one of the highest growth rates in its industry, based on my analysis of dominant peers. As such, I consider it a significant investment in artificieal intelligecne-integrated cybersecurity, with a particular moat in how it protects cloud operations. However, fast-changing digital landscapes, as they relate to the increased abilities of AI, could pose significant risks for shareholders. This needs to be monitored carefully.
Overview of operations
Founded in 2007, the company describes itself as “the world's largest any-to-any security cloud platform.” Its most valuable operational asset at this time is the Zscaler Zero Trust Exchange, which is a cybersecurity suite that operates under the fundamental tenet of trusting no one and verifying everything. This model treats all users and devices as potential threats, whether they are inside or outside of a network. The platform is cloud-native, meaning it is built and run on the cloud, which facilitates better scalability, performance and security.
I believe this technology is particularly important at a time when work environments are becoming increasingly hybridized, with some organizations opting for fully remote working conditions. Increased cybersecurity as a result of the high load of digital transactions of often sensitive data requires advanced systems of protection against data extraction, malware and other corruption of digital workflows.
Zscaler has countless technology partners, including Amazon's (AMZN, Financial) AWS, Microsoft (MSFT, Financial), SAP (SAP, Financial), Zoom (ZM, Financial), Alphabet's (GOOGL, Financial) Google, Salesforce (CRM, Financial), ServiceNow (NOW, Financial) and Slack (WORK, Financial). For example, with Microsoft, Szcaler is integrated into Azure Active Directory, Microsoft Sentinel and Microsoft 365 Defender. With Amazon Web Services, the integration of Zscaler improves the security of digital transformation, most significantly for organizations leveraging its cloud infrastructure.
Competition
Of Zscaler's competitors, and there are many, a few notable ones stand out to me as being potentially the biggest threats:
- Palo Alto Networks Inc. (PANW, Financial): I consider it to be the most significant competitor as the company has a wide range of security solutions, including advanced firewalls and cloud-based offerings.
- Cisco Systems Inc. (CSCO, Financial): The most well-financed peer, the company has an extensive range of security products, such as firewalls, VPNs and advanced malware protection.
- Fortinet Inc. (FTNT, Financial): The company covers everything from firewalls to secure SD-WAN, which manages traffic across wide area networks for higher efficiency.
It is useful for us to put these four peers into proper perspective based on some of the core financial metrics:
| Zscaler | Palo Alto Networks | Cisco | Fortinet | |
| IPO | 2018 | 2012 | 1990 | 2009 |
| Market Cap | $29.22 B | $92.71 B | $201.53 B | $52.1 B |
| Equity-to-Asset | 0.24 | 0.24 | 0.46 | -0.06 |
| Net Margin | -7.32% | 30.24% | 23.49% | 21.64% |
| 3Y Rev Growth Rate | 49.6% | 19.8% | 6.2% | 29.6% |
| FWD PE Ratio | 82 | 56 | 13.4 | 40 |
It is quite evident to me that Zscaler has particular appeal compared to some of the newer players, namely Palo Alto Networks and Fortinet, as it shows higher growth. I believe, as is the case with most excellent companies that last over the long term, it will manage to stabilize its profitability. This is already somewhat evident in that its median net margin over the past 10 years is -26.69%, but, over time, it has reined this in to -7.32%.
While Palo Alto Networks looks like a compelling alternative investment, Zscaler is more attractive by and large, in my opinion. Palo Alto Networks has a strong acquisition strategy, including CloudGenix in 2020 and Twistlock in 2019, and a diverse product portfolio, including its Prisma cloud and Cortex AI security platform. But Zscaler's portfolio looks stronger and it has also made multiple high-status acquisitions, bolstering its five key areas of operation that act as a simple framework for enterprise partnerships. Among these are:
- Zscaler Internet Access: Efficient in secure internet and SaaS application access, replacing traditional VPN and firewall technology.
- Zscaler Private Access: Access to private applications securely, without a VPN, without bringing users onto the internet.
- Zscaler Cloud Protection: Provides security for public cloud environments.
- Zscaler Digital Experience: A comprehensive monitoring solution that ensures optimal user experience of Zscaler tools while also optimizing security.
In short, Zscaler offers a one-point solution with some of the most advanced technology on the market, which I think outperforms Palo Alto Networks, Cisco and Fortinet operationally in many areas, specifically as it relates to cloud security and simplicity in these operations.
Market drivers
Zscaler's growth is hinged on the widely anticipated expansion of the broader digital services market, particularly the managed services market, which includes managed data centers, security, network and infrastructure services. Mordor Intelligence estimates this will grow at a compound annual rate of 7.90% from 2024 to 2029. It attributes factors such as an increasing shift to hybrid IT, improved cost and operational efficiency demand and rising IT complexity as core drivers of this market growth. My own opinion is that the market as it relates to Zscaler will grow faster than this, even more so than Mordor's estimate of an 11.44% CAGR for the cybersecurity market from 2024 to 2029. My own estimate is around a 15% CAGR over the next decade, as my belief is the adoption of cloud services, hybrid and remote working and demand for advanced digital services and associated security will increase exponentially as AI proliferates the mainstream more readily, driving new business models that are more operationally digital due to cost-effectiveness, a higher amount of self-employed and independent contractors and a lower reliance on human labor in general as functions become more reliably automated.
This is a very interesting time to be in the job market, as I believe we are going to see faster change than we ever have in history, and people will have to be quick to react to shifting labor demands. That being said, one constant seems to ring true, which is that most, if not all, of these labor demands will be significantly dependent on digital workflows and associated data protection and security, which will be highly beneficial for companies like Zscaler.
Valuation
Successfully valuing Zscaler based on earnings is difficult because of how early on it is in its development. As this is the case, I have opted to analyzes its price-to-free cash flow ratio relative to peers instead. I have also looked at the company's price-to-operating cash flow ratio against peers for the same reason. First of all, consider each of the four peers compared based on the two valuation metrics:
| Zscaler | Palo Alto Networks | Cisco | Fortinet | |
| P/FCF | 57 | 34.5 | 15 | 31 |
| P/OCF | 44 | 33 | 14 | 28 |
Zscaler is quite clearly the highest valued of the four, but investors should consider that its valuation has come down considerably in the last few years. Its median price-to-free cash flow ratio over the past 10 years is 221.75, indicating a 74.10% discount from the historical valuation. Additionally, its price-to-operating cash flow median over the past 10 years is 132.90, indicating a 66.60% discount from the historical valuation.
Considering analysts expect, on consensus, an earnings per share without non-recurring items CAGR of 31.17% over the next three years, I believe the present valuation shows a significantly strong price and an attractive entry point despite trading at a premium to the three peers. We must remember that Palo Alto Networks has a much lower forecasted CAGR over the next three years of 17.05%, hence the lower premium in the valuation attributed by the market.
Risks
There is evidently a risk that Zscaler will be outcompeted by other cybersecurity companies that develop, and it appears that there is not a concentrated monopoly in cybersecurity at this time. As such, there is, in some sense, an arms race toward that monopoly in AI-led cybersecurity, similar to how Microsoft and Apple (AAPL, Financial) have a duopoly in software and hardware. Zscaler investors should watch the market carefully, as there may come a time in the not-too-distant future when it makes sense to sell the stake for another provider if it becomes clear the balance of power has begun to shift.
Additionally, along similar lines, as AI becomes more powerful and we reach unprecedented capabilities, it is quite possible the cybersecurity and digital landscapes shift considerably. What is now cutting-edge, the cloud, could in the future become outdated and Zscaler has an enormous task at hand in keeping up to date with the rapid shifts that are likely to happen in the AI and associated cybersecurity industries. The company has a large ecosystem with partners and connections in the industry that provide it with some moat in this regard in terms of operational collaboration and financing capabilities, but investors must be aware of the risk of rapid change.
Conclusion
From my research, I believe Zscaler to be one of the best investments in cybersecurity currently, but the markets are shifting quickly. Nonetheless, I believe now is a prudent time to consider the stock due to the favorable valuation and high growth expected by analysts. My research into market drivers bodes very well for the company's long-term future.
