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Stock Analyst Update

Zscaler Is Massively Overpriced

Its enterprise value/revenue multiple makes it more expensive on a fundamental basis than nearly every enterprise software firm in our coverage.

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 Zscaler (ZS) reported solid fourth-quarter results for its fiscal 2018 and we are raising our fair value estimate to $35 per share. Overall, we continue to believe Zscaler will grow very quickly, benefiting from underlying trends, such as its ability to upend the traditional VPN paradigm. However, we think on a valuation basis, with shares trading on an enterprise value/revenue multiple of approximately 22 times, Zscaler shares appear expensive and will need to experience accelerating revenue growth to justify that multiple. For context, Zscaler’s EV/revenue multiple makes it more expensive on a fundamental basis than nearly ever enterprise software firm in our coverage. We posit that part of that multiple may be due to a baked-in acquisition premium. Ultimately, even with aggressive revenue growth and margin expansion assumptions, our fair value is still modestly below where shares have traded since the IPO and we would recommend to investors to await a wider margin of safety before jumping into this name.

While we see Zscaler’s technology as potentially disruptive, our long-standing view is that it is difficult for cyber security businesses to establish economic moats as "innovative" technologies seem to be mimicked by peers over time. Zscaler’s tangential competitors on the endpoint and firewall side, almost exist in a Hobbesian state of nature, where new technologies and price wars make the environment fiercely competitive, which compels us to maintain our no-moat rating for Zscaler at this time, but we concede that Zscaler is not susceptible to the refresh cycle replacement risks of those peers.

The firm reported solid revenue of $56 million for the quarter and $190 for the year, with billings growth of 54%. Guidance for fiscal 2019 sat at $255 million at the midpoint and we track modestly above that range. Thus, we have raised our fair value estimate to $35 dollars per share, giving Zscaler greater credit for deferred revenue growth and margin expansion.

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William Fitzsimmons does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.