Zscaler: Sales Resilience In A Challenging Market

It's been a rollercoaster for Zscaler's (NASDAQ:ZS) stock over the spring season, but it proved to be very opportunistic for bulls. After its FQ2 earnings report in March, the stock began an aggressive slide over the following weeks. Much, if not all, was triggered by the company's tepid outlook on its Billings metric. Because of the macro environment and the elongating sales cycle due to it, the company expected elevated seasonality for billings. However, just two months later, the company preannounced earnings for the April 30th (FQ3) quarter, saying seasonality would swing from unseasonably higher to unseasonably lower (muted). Moreover, at official report time, full-year guidance was further increased above even the raised preannouncement guidance from a few weeks earlier.

But macro environment! But poor visibility! But customer scrutiny!

Yet, Zscaler seems to be selling into a different world, one without concern for spending money on cybersecurity software.

And that's the investment case in a nutshell.

I'll present how sales scrutiny has not impacted the company's sales and products to a point where competitors can crack the door or, with time in the sales cycle, customers realize they no longer need what Zscaler is selling. My analysis shows neither situation is happening. Instead, the company is being asked to increase deal sizes during this supposedly challenging environment.

Scrutiny Is A Way Of Life

Let me start by defining scrutiny in the IT world.

Having dealt with dozens of purchases, contracts, and vendors in my career, I'm familiar with the chain of approval to implement a new project or software. Every dollar is tracked, and once you get above $50,000, the "eyes" are placed on approving and releasing those dollars. Above $100,000 adds another layer of approvals with more eyes, and so on and so forth as it scales higher.

Of course, these dollar levels vary from shop to shop, but these are the most common levels I've seen. Much as checks require two signatures over a certain amount, IT budgets require more debate, meetings, requirement checks, goal-setting initiatives, POC (proof of concept) rigor, planning, and approvals as the price of the product/project increases. So when Zscaler sells products in the hundreds of thousands and sometimes $1M+ category, you can bet the highest in command will see the requisition come across their desk, leading to a diatribe of questions needing answers before the approved stamp comes out.

But we hear more about scrutiny lately due to the low visibility macro environment. In turn, it means only the most needed projects and purchases will be approved. Those nice-to-haves and lower-priority software purchases will get back-burner'd until the company knows it can make it through the challenging economic times.

Spend only what you need, and spend it on things with a clear ROI (return on investment).

How Zscaler Makes It Through The Process

Because cybersecurity is a top priority, the company's deals continue to get approved, especially if they have an immediate return against legacy security systems and policies. And because Zscaler focuses so intently on ROI, it makes its wins more certain.

We are partnering earlier with CXOs to jointly create compelling CFO ready business cases, that have clear ROI and payback periods.

- Jay Chaudhry, CEO, FQ3 '23 Earnings Call

Don't gloss over this. Any company I ever worked for and any customer I ever worked with wanted to know the ROI of software purchases I'm implementing. Sometimes it's more straightforward than other times to present the ROI case. Sometimes it's more opaque and nuanced because certain aspects aren't easily calculable or are intangible.

Cybersecurity isn't a tough sell for ROI because the consequences of having just one missed breach or data exposure can send a company's business and reputation spiraling out of control. Therefore, the natural laws of IT are already on your side as a cybersecurity company.

In my conversation with hundreds of IT executives, cybersecurity remains their number-one IT priority. Traditional network security based on firewalls and VPNs cannot handle the complexity of safeguarding enterprises, in what has become a work from anywhere world.

- Jay Chaudhry, CEO, FQ3 '23 Earnings Call

But if you can further the case in front of CIOs, CFOs, and CEOs with concrete figures, the decision will be swayed in the seller's favor, especially when those figures are in the hundreds of percent range.

ZPA was an area of strong growth [in the quarter] and we saw large new logo deals that landed with ZPA...A Fortune 100 logistics company made a four year multi-million dollar ACV purchase of ZPA and ZDX for 100,000 users. ZPA will provide Zero Trust application access architecture for their employees, partners and suppliers as it consolidates multiple point products, including multiple VPNs, load balancers, VDIs and dedicated private network services.

As a result, ZPA is expected to generate over 300% ROI for this customer.

- Jay Chaudhry, CEO, FQ3 '23 Earnings Call

These kinds of wins aren't found in tough economic times with heightened scrutiny. These wins are to be expected during decent and great times. Yet, Zscaler continues to wrangle money from the checkbook of CIOs and secure wins during very uncertain times. That only happens with convincing sales pitches for a working, scalable product with a defined ROI.

The Proof Is In The Numbers

Coming into the FQ3 report, the company was expecting a seasonally elevated 9% decline in sequential Billings. However, the report showed a 2% decline in Billings, well ahead of initial guidance and ahead of the negative 4%-6% historical seasonal trend.

Management's foresight to get in front of its customers' executives with the incredible ROI outline places it in the best position to get the thumbs-up approval.

But since the macro environment is keeping customers cautious and spending limited, it requires moving through extra steps, careful validation of the proposed ROI, and additional rigor in the POC. As long as the numbers line up at the end, CIOs and CFOs are giving the go-ahead to purchase Zscaler's security products.

This extended timeline results in more conservative guidance from company management, but it's not resulting in lost sales. The product and need for cybersecurity in the work-from-anywhere world does all the talking.

But even with conservative guidance, management said it expects a repeat of the 2% decline in sequential Billings for FQ4. That's not a show of "pull-forward" demand into FQ3. It also means management has left room for improvement in sequential Billings for FQ4.

I would consider the same [for Billings], quarter-over quarter. Just remember it is a tough compare last year, our billings growth was approximately, basically I think it was close to 60% billings growth.

- Remo Canessa, CFO, FQ3 Earnings Call Q&A

In Q4, also, we had a strong Q3, so basically a tough compare.

- Jay Chaudhry, CEO, FQ3 '23 Earnings Call Q&A

Combine a tough compare and continued scrutiny, and you have a very conservative guide for Billings with a buffer to be exceeded.

Slower And Bigger, Not Less

But here's the interesting piece. This macro environment might be slowing down the sales process, but it's not just because of the scrutiny of ensuring only the most necessary purchases are made. It's also because customers are turning the initial sale into a bigger overall deal.

...the global macro environment remains uncertain and customers continue to scrutinize large deals. We are seeing deals getting larger as customers are trying to consolidate more and accelerate their security transformation around our Zero Trust Exchange.

- Remo Canessa, CFO, FQ3 Earnings Call

CIOs are seeing the opportunity to get a one-and-done approval for significant ROI. But remember what I said earlier. The higher the cost, the more eyes and scrutiny focused on the project and purchase. So it's not the macro environment scrutiny directly causing a longer sales cycle; it's the bigger purchase at the customer's request pushing it to the next level of approvals and oversight needed. This desire to expand the deal may indirectly be due to the macro environment, but this turns it into a net benefit situation.

So the longer sales cycle might seem like a bad omen to closing sales, but considering customers are packaging more into one sale, the sales cycle isn't longer due to outside forces alone. Instead, the sales process is following the standard approval procedure for a high-value purchase I outlined at the beginning of this article.

Continued Winning, Continued Holding

As far as I'm concerned, scrutiny smootiny; bring on the larger sales with massive return for its customers. So what if it takes a little longer?

With management executing very well during this lower visibility, trying macro environment, I'm apt to continue holding my position. It's the best cybersecurity company in the best sector with the best sales execution right now. Longer sales cycles aren't a concern when the wins continue and get bigger. This sets the company up to continue to increase guidance in a conservative manner, leading to the stock tracking higher.

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