Beyond the Firewall of Hype
Two Overlooked Compounding Machines vs. Silicon Valley's Story Stocks
Model Portfolio Positioning
We initiate a 4% capital-neutral long/short basket with the following weights:
+1% Long Digital Arts (2326 JT) – Japan’s high-margin security filter vendor with accelerating growth and a defensible domestic franchise
+1% Long Gen Digital (GEN) – A capital-efficient, cash-flow generative U.S. security incumbent overlooked for its stability
−1% Short Zscaler (ZS) – A cloud-native proxy firm priced for flawless execution amid slowing billings
−1% Short Cloudflare (NET) – A darling of developer security and CDN now trading at ~30x sales on narratives
This is not a factor-neutral trade. It’s a trade on valuation realism, margin discipline, and business model durability in cybersecurity.
The Thesis in Brief
Digital Arts and Gen Digital represent opposite ends of the security spectrum, one a Japanese public sector stronghold, the other a U.S. consumer SMB staple, but both share three traits our shorts do not: real earnings, real margins, and capital returns.
Cloudflare and Zscaler, meanwhile, are still chasing scale, issuing stock heavily, and priced for 25–30% growth in perpetuity. In a market where fundamentals are returning to focus, we see significant upside for the longs and multiple compression risk on the shorts.
Digital Arts (2326 JT): Japan’s Quiet Security Compounder
FY2025 looked soft on paper but beneath the surface core revenue, bookings, and operating margin are all growing. The decline stemmed from divesting a low-margin consulting arm. Stripping that out, Digital Arts’ subscription-first content filtering business (web/email/DLP) is scaling cleanly.
FY2026 guidance implies +26% sales and +35% EBIT growth, backed by record GIGA School contracts and strong public-sector demand. Free cash flow is positive, strong cash position, and it returns capital via dividends and buybacks.
It trades at ~7.6x EV/sales. Compare that to Cloudflare at ~30x sales and Zscaler at ~16x, neither profitable on a GAAP basis.
Gen Digital (GEN): The Free Cash Flow Giant
Born from the NortonLifeLock and Avast merger, GEN is a stable cash cow in the consumer/corporate endpoint space. It generates over $1.2B in annual FCF, has an 80%+ gross margin, and trades at just 11x forward earnings.
The market yawns because growth is slow. We lean in because earnings are real, durable, and unappreciated. GEN returns the majority of FCF to shareholders via buybacks and dividends. This is the inverse of our shorts: high-quality cash flows, strong customer retention, and valuation compression already priced in. If there’s a market multiple rotation, GEN rerates.
Zscaler (ZS): Growth Decelerating, Valuation Still Elevated
Zscaler’s core offering is excellent. But execution now matters more than promise. Q2 FY2025 revenue was +23% YoY; calculated billings +18%. That’s a downshift from prior 40%+ growth. Free cash flow was $143M (22% margin), but stock comp remains high and GAAP profitability elusive.
It trades at ~16x sales. There’s no dividend, no buyback, and the company continues to raise convertible debt. As comps like Palo Alto pivot toward platform bundling, Zscaler must spend heavily just to sustain its sales force. The bar is high. A single miss resets the narrative. This short hedges tech beta and capital-intensive growth.
Cloudflare (NET): Too Much Narrative, Not Enough Net Income
Cloudflare deserves credit for innovation. But we believe it's priced beyond perfection. Q1 2025 revenue was +27% YoY. GAAP operating margin: −11%. Free cash flow finally positive, but barely (11% margin).
It trades at ~30x sales. The market is discounting a security/AI/cloud convergence that may play out, but not soon enough to justify current multiples. Cloudflare’s $100M+ contract win this quarter was impressive. But unless it strings together many more like it, the valuation requires every pillar to hit. History suggests sentiment can snap fast.
Conclusion
We’re long real margins and capital return (Digital Arts, GEN), short valuation hype with thin FCF and high SBC (ZS, NET).
The trade will work if:
Earnings matter again
High-multiple names miss even modestly
Digital Arts’ FY2026 guidance is confirmed
GEN rerates
Model Portfolio Weights:
+1% Digital Arts / +1% Gen Digital vs. −1% Zscaler / −1% Cloudflare
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ZScaler promises a lot and is then not fun to use.
Churning is hard to do but with a compelling offer I can see a lot of people moving.