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October 17, 2023

Early Stages of Capturing a Large Share of a $72bn Opportunity

Zscaler is a cyber security business which continues to grow strongly.

We had a strong close to our fiscal year. In Q4, we delivered 43pc revenue growth and 38pc billings growth, with balanced growth across all verticals, customer segments, and geographies. For the full year, our revenue grew 48pc to $1.6bn, and billings grew 37pc to over $2bn.

In addition to achieving record billings in the quarter, we also set records across several other measures. We added the highest number of $1m ARR [annual recurring revenue] customers, generated record new pipeline for Q4, and attained record operating profit margin. I’m proud of our team’s achievements and humbled by the trust our customers are placing in our platform. While the macro environment remains challenging, we are executing well.

We closed a record number of deals over $1m ACV [annual contract value]in Q4, driven by broad-based strength across our key industry verticals. In addition to our industry-leading top-line growth, we are generating record profitability. Due to our spending discipline, we achieved a record 19pc operating margin as we more than doubled our operating income on a year-over-year basis. These outstanding results reflect the strong unit economics of our business with best-in-class 80pc gross margins.

Our innovation and customer obsession drove our net promoter score to exceed 80, which is more than two times the average for SaaS companies and contributed to our high 90pc gross retention rate. I am very pleased to announce that we doubled our annual recurring revenue from $1bn to over $2bn in seven quarters, reaching a milestone only a select handful of SaaS companies have achieved. We secure over 7,700 customers and protect over 41m users. With every customer looking to adopt zero trust architecture in today’s world of cloud, AI, and mobility, we believe we are in the early stages of capturing a large share of our $72bn market opportunity.

We have our sights set on achieving our next goal of $5bn in ARR. We are on a mission to take zero trust everywhere to users, workloads, and OT systems and become the go-to platform for vendor consolidation, cost savings, increased business agility, and better cyber and data protection. To fully realize the business value enabled by our platform, customers are increasingly buying Zscaler for users, our complete zero trust solution for user protection, which includes ZIA, ZPA, ZDX, and data protection. In addition, we are gaining traction with workload protection powered by the same core ZIA and ZPA technology.

Jay Chaudhry, CEO, ZScaler, Q4 2023, 5 September 2023

It is blindingly obvious that this business is in incredible shape. As with Crowdstrike the valuation is rapidly becoming dramatically less demanding. Whereas in 2021 the shares valued the business at at around 50 times sales the could be less than 10 for the year to July 2025. In my way of thinking, assuming steady state profit margins of 20pc, a 10x ratio of MV to sales equates to a PE ratio of 50, which looks reasonable for a business with such outstanding long-term growth potential.

The business is on course to multiply sales 10-fold in seven years, which gives you an idea of what the company is capable. Could sales be $16bn 7 years from now? Nobody has any idea but looking at the history and the size and growth of the cyber security market that is not an entirely fanciful prospect.

Cyber Security is a Huge Problem

Cybersecurity remains the No. 1 IT priority, and having the right security architecture is fundamental to reducing cyber risk. According to our latest Zscaler ThreatLabZ VPN risk report, nearly half of enterprises reported they were targeted by cyberattackers who exploited a VPN vulnerability, and a third of enterprises fell victim to ransomware attacks within the past year. Growing cyberthreats, including ransomware, are driving IT leaders to transform security from legacy network security to zero trust architecture.

Jay Chaudhry, CEO, ZScaler, Q4 2023, 5 September 2023

Needless to say Generative AI is front of mind for ZScaler.

We have been investing in AI for quite a while, including our first AI acquisition in 2018, and we will continue to invest in fiscal ’24 for rapid AI innovations, cloud enhancements, and go-to market to take our AI solutions to the market. All investments will be made within the envelope of margin guidance that Remo will discuss. In closing, we are excited about the opportunities ahead. We have a track record of building and growing new innovations like ZDX data protection and zero trust for workloads, and we are now turning our attention to AI.

We believe these new products will contribute increasingly to our future growth. Our business value message is resonating in this challenging macro environment, and more customers are adopting our broader platform to consolidate multiple-point products. We believe customers trust Zscaler more than any other provider for securing their zero trust journey. We have grown our global team to nearly 6,000 employees with the mission to secure the hyperconnected world of cloud, AI, and mobility.

Jay Chaudhry, CEO, ZScaler, Q4 2023, 5 September 2023

Talking About Profit Margins

Due to our focus on spending discipline this year, we generated significant operating leverage in our model, with operating margin reaching 19pc, an increase of approximately 200 basis points year over year. Our free cash flow margin was 22pc, including data center capex of approximately 6pc of revenue. For the full year, our operating margin was 15pc, and free cash flow margin was 21pc. We ended the quarter with over $2bn in cash, cash equivalents, and short-term investments.

We are entering Q1 with a record pipeline, and our customer engagements remain strong. However, we are mindful that in this environment predicting close rates and ramps in any 90-day period remains challenging.

With a large market opportunity and customers increasingly adopting the broader platform, we’ll invest aggressively to position us for long-term growth and profitability.

Remo Vanessa, CEO, Zscaler, Q4 2023, 5 September 2023

Strategy – Buy Stocks with Outstanding Fundamentals

As can be seen from this chart severe downturns for US stocks are rare events and are invariably followed by buy signals. There was a downturn between 2000 and 2003 (the bursting of the Internet bubble and the attack on the World Trade Centre). There was another in 2007-8 (the banking crisis when many of the world’s banks became insolvent, property values nosedived and investors feared a global depression). The latest one, only the third in in nearly 40 years, was triggered by the sharpest rise in bond yields ever experienced, albeit from very low levels. This hit fast growing technology shares many of which using the newly fashionable market value divided by sales technique (often used in the absence of profits because the companies were investing so heavily for growth) were on extremely demanding valuations.

After a strong rally recently shares have reacted as bond yields have moved even higher and seem likely to stay at high levels for longer. The good news is the surprise resilience of the US economy and the prospects of Generative AI and the associated requirement for dramatically enhanced computing power to drive the technology onwards and upwards in an endlessly accelerating process of dramatic chain.

The Battle of the SuperComputers

We could almost say the world and some of its greatest corporations are in the battle of the super computers.

Tesla’s version is the Dojo super computer which engineer, Andrej Karpathy, claims will be the fifth most powerful super computer in the world. This is what a third party commentator said about it.

Moving away from raw compute performance, Dojo and its jaw-dropping engineering puts all supercomputers to shame in almost every other way imaginable.

Clean Technica, 22 August 2021

Another observer made the following points.

As of July, Tesla has sold 4,527,916 cars during its history, and every one of these vehicles is transmitting data back to Tesla to power the company’s efforts to develop full self-driving capabilities. Meshing a huge mobile sensor and camera network with powerful edge computing capabilities to a backend supercomputer designed in-house to learn from that data is a paradigm we haven’t seen before and elevates Tesla beyond purely a vehicle manufacturer.

Tesla’s Dojo promises to revolutionize the AI processing landscape by focusing solely on improving the company’s FSD capabilities. With this vertical integration, Tesla aims to construct an ecosystem that encompasses hardware, data, and practical application—a trifecta that could usher in a new era of supercomputing, explicitly designed for real-world data processing.

Details are hard to come by but various commentators have put Tesla’s hoard of NVIDIA A100 GPUs at over 10,000 units, which by any stretch puts Tesla as having one of the largest training systems globally, and the company has been at this for at least 2 years now.

The architectural uniqueness of Dojo is evident in its building block, the D1 chip, manufactured by TSMC using 7 nm semiconductor nodes, with a large die size of 645 mm² and 50bn transistors and leveraging a RISC-V approach and custom instructions. The system scales by deploying multiple ExaPODs, housing up to 1,062,000 cores and reaching 20 exaflops. This kind of scalability has never been more necessary, especially when one considers the gargantuan volume of data that Tesla’s fleet generates. Furthermore, Dojo uses the software language PyTorch and introduces novel floating-point formats—CFloat8 and CFloat16—enabling more efficient vector processing and storage requirements.

While some industry experts consider Dojo to be an incremental rather than a revolutionary change, and others downplay everything Musk is associated with as bluster, it’s important to contextualize Dojo within Tesla’s broader FSD [full self driving] ambitions and the future of AI applications. Being developed entirely in-house, Dojo provides Tesla with the kind of control that can lead to accelerated development cycles, thereby fast-tracking innovations in autonomous vehicles and possibly other domains of AI including the computer vision-powered robots Tesla is working on.

In summary, Dojo’s advent signals a shift in the supercomputing paradigm, one that leans toward edge-driven, vertical integration, specialization, and scalable architecture. Time will tell whether it transforms supercomputing, but what is unequivocal is its potential to provide Tesla with a technical moat that other more traditional auto manufacturers will never be able to catch up to.

By focusing on specific real-world applications and demonstrating an architecture fundamentally different from conventional designs, Tesla’s Dojo emerges not merely as a tool for the company’s FSD aspirations but as a landmark development in the ever-converging worlds of AI and supercomputing.

Forbes, 11 September 2023

I have been reading Walter Isaacson’s biography of Elon Musk. It is an electrifying read and reveals Musk as an even more amazing and ruthless guy than I ever imagined. He is unstoppable in pursuit of his goals and requires insane levels of commitment and delivery in his employees, which has made him the richest man in the world at the age of 52 and a serious game changer on a planetary and maybe ultimately interplanetary scale. This guy is Alexander the Great reborn as an entrepreneur who thinks bigger than anyone else on the planet.

Winners & Losers

As always with technology there will be winners and losers. Pick the winners and bear markets and macro-inspired overall stock market setbacks becoming buying opportunities. Nevertheless it is much easier to make money in the bull phases.

If it is a bull phase at the moment it is a patchy one with more shares falling to new lows than reaching new 52 week highs, poor market breadth generally with declining shares outpacing rising shares and great volatility even when shares are doing well, two steps forward and one step back is a typical pattern.

One day we will be off to the races but not yet. Meanwhile Zscaler looks a good candidate for your portfolio. Tesla is what it always was, a bet on the driving (pun intended) ambition of an extraordinary man.

My simple idea for this market, now at a mature stage of an extended bear phase which has decimated share values and seen bond yields rise to heights not seen for decades, is that it is a good time to begin accumulating, or adding to, a portfolio of great, well chosen, world beating growth stocks.

Share Recommendations

Zscaler ZS Buy @ $172

Tesla. TSLA. Buy @ $252

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