Zscaler, Inc. — Call Transcript 2019

Speaker 12: Good day, welcome to the Zscaler third quarter 2019 earnings call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Bill Choi. Please go ahead, sir.

Speaker 3: Good afternoon, thank you for joining us to discuss Zscaler's financial results for the third quarter of fiscal 2019. With me on the call are Jay Chaudhry, Chairman and CEO, and Remo Canessa, CFO. By now, everyone should have access to our earnings announcement. This announcement may also be found on our website in the investor relations section. In addition, a supplemental financial schedule was posted to the investor relations section of our website earlier today. Let me remind you that we'll be making forward-looking statements during today's discussion, including, not limited to, the company's anticipated future revenue, calculated billings, operating performance, gross margin, operating expenses, operating income, net income, free cash flow, dollar-based net retention rate, income taxes, and earnings per share. These statements other comments are not guarantees of future performance, rather are subject to risks and uncertainties, some of which are beyond our control. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. These forward-looking statements apply as of today, you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings with the Securities and Exchange Commission, as well as in today's earnings release. Unless otherwise noted, all numbers we talk about today will be on an adjusted non-GAAP basis. Please refer to our earnings release on the investor relations portion of our website for a reconciliation of GAAP to the non-GAAP financial measures. For historical periods, the GAAP to the non-GAAP reconciliations can be found in the supplemental financial information referenced a few moments ago. I would also like to inform you that we will be participating in Bank of America Merrill Lynch's Global Technology Conference in San Francisco on June 5th. I will turn the call over to Jay.

Speaker 8: Thank you, Bill, and thank you everyone for joining us on our call today. I am pleased to share with you our strong third quarter results. Our revenue grew 61%, and calculated billings grew 55% year-over-year. In addition to our top-line growth, our operating margins improved 14 percentage points year-over-year to 8%. Our Q3 results demonstrate the leverage in our business model and our ability to drive growth and profitability. While we are pleased with our third consecutive quarter of profitability, we will continue to aggressively invest in our business for the significant market opportunity that is ahead of us. Based on our analysis of IDC's data, we believe we are going after a $20.3 billion TAM in calendar 2019. Just as enterprises have adopted multi-tenant SaaS applications like Salesforce and Workday to replace legacy on-premise applications, enterprises are saying goodbye to security appliances and choosing Zscaler's born in the cloud, multi-tenant security platform to securely embrace the cloud. Unlike traditional network security, which builds a moat around a castle, our cloud security platform acts as a business policy engine to securely connect the right user to right applications regardless of location. ZIA for access to SaaS or the internet, and ZPA for access to internal apps in a data center or a public cloud. Our customers are leveraging increased functionality of a comprehensive cloud security platform as they progress through various stages of their cloud journey. We see this progression in product bundles purchased by our customers. A significant majority of our revenue used to come from customers purchasing professional and business bundle. As expected, we are seeing continued strong adoption of our premium ZIA transformation bundle, which is growing as a mix of our ARR. In addition, while we replace security appliances in existing internet gateways, the majority of ZIA sales are coming from creating and securing new internet breakouts. These are greenfield opportunities. We are continuing to see significant interest in ZPA, which we introduced only a couple of years ago. It remains the fastest-growing product in our history. ZPA delivers what Gartner calls Zero Trust Network Access to provide application access to users without granting network access. This significantly reduces business risk. While ZPA has been and continues to be purchased as an upsell by existing ZIA customers, we are seeing more upfront sales of both ZIA and ZPA. ZIA and ZPA together provide our customers a single platform for secure cloud transformation, which we believe no other vendor can match. Let me highlight several new customer deals in the quarter. I will start with a deal that shows how large enterprises are buying the ZIA and ZPA platform. One of the world's largest pharmaceutical companies, with its headquarters in Europe, purchased our transformation bundle for 100,000 users and ZPA for over 17,000 users. Moving from a decentralized IT in business units to a centralized IT model, this customer had a strategy to transform to the cloud for their network and for their applications. To achieve this, the IT team identified two initiatives. One, increased use of cloud, including a move to Office 365, Zoom, and AWS. Number two, network and security transformation. They adopted a strategy to create secure local internet breakouts for 200 offices around the globe. Our cloud security platform allowed them to realize their vision of perimeterless enterprise with direct access to any service or application from anywhere on any device without backhauling traffic through regional hubs. The result, reduced business risk, faster user experience, and significant cost savings. They will no longer need either a site-to-site VPN to AWS or remote access VPN. ZPA also enables the customer to rapidly integrate mergers and manage divestitures while increasing the level of security with a Zero Trust Network Access approach. Another deal involving both ZIA and ZPA upfront was a Fortune 500 financial services company that purchased our transformation bundle for 85,000 users and ZPA for 20,000 users. This customer was preparing to deploy Office 365. They anticipated scaling issues with their on-premises web proxy appliances, which would not keep up with the significant growth in internet-bound traffic from 750 worldwide offices. The initial discussion of proxy replacement expanded significantly once the security team realized that Zscaler was much more than a traditional web proxy. We offer the full security stack, including next-gen firewall, sandbox, and SSL inspection. This customer decided to pursue a local internet breakout strategy and use Zscaler to secure their SD-WAN initiative. They purchased ZIA for all employees, which will also cover mobile users and improve their user experience. In addition, they purchased ZPA for two use cases. One, to integrate acquisitions of new businesses, and two, to replace remote access VPN for business units that were having poor user experience. I often receive personal notes from CIOs, CTOs, and CSOs of Global 2000 enterprises indicating how much they appreciate the quality of service of the Zscaler team and our commitment to their success. A number of them have brought Zscaler into the new organizations after making a career move. I'm excited to share with you two recent examples. A travel and leisure company purchased our transformation bundle for 17,000 users and ZPA for 6,500 users. The new CTO came from a large healthcare company where he had deployed Zscaler one year ago. In another case, a financial services company purchased our transformation bundle for 10,000 users. Their new CIO moved from another financial services company, which had rolled out Zscaler three years ago. These wins demonstrate the strong loyalty of our customers and the value of our platform. We also had a number of notable upsell wins in Q3. A U.S.-based conglomerate has been a Zscaler customer since 2015, using our business bundle for its two dozen portfolio companies to protect 70,000 employees around the world. This customer purchased ZPA for 40,000 users to replace multiple remote access VPN solutions and made ZPA the standard solution across multiple portfolio companies. The driver? Customer is moving its applications to SaaS and public cloud and needed a future-proof solution that provides secure and fast access to their applications. In addition, as this conglomerate actively acquires new businesses, ZIA and ZPA will enable them to quickly integrate the acquired companies. This latest purchase resulted in doubling of the total customer annual spend with Zscaler. A Fortune 500 bank with headquarters in Asia that purchased our business bundle for 38,000 users two years ago completed the addition of 12,000 users and upgraded all 50,000 users to the transformation bundle. The driver of this deal was the need to upgrade security posture for all employees at any location on any device using a cloud-based integrated platform. They also required granular policies to control access to certain applications for defined roles, such as restricting webmail and chat access for traders during the trading window. In addition, they purchase our data loss prevention solution to help meet stringent regulatory requirements. Let me say a few words about the competitive landscape. As organizations increasingly make the shift to the cloud, traditional firewall and VPN vendors are finally acknowledging that their legacy security appliances can't secure the new digital enterprise, and are attempting to build a security cloud using single-tenant software designed for on-premise appliances. Just like you can't create a Netflix service by stacking thousands of DVD players in the cloud, you can't offer an inline high-performance security cloud by spinning up a bunch of virtual machines in a public cloud. This is a defensive strategy of cloud imitators, which, in our view, serves the self-preservation of the vendor, not the needs of the customers. We believe we have a significant competitive advantage as a result of the technology, architecture, and maturity of our cloud security platform, including, one, we were born in the cloud for the cloud, just like Salesforce and Workday. Two, we have a purpose-built, globally distributed multi-tenant cloud for fast user experience. Unlike imitation clouds, Zscaler requires no backhauling from front doors to a central compute data center of a public cloud. Three, we perform SSL inspection at scale as a purpose-built proxy for better security. Four, we deliver Zero Trust Network Access that provides application access without network access, reducing business risk unlike firewalls and VPNs. Lastly, we have over 10 years of experience running a mission-critical inline cloud for Global 2000 customers, processing 65 billion transactions a day. As someone said, there is really no compression algorithm for experience. We continue to innovate and invest in maintaining our significant technology lead. Our latest fourth generation large data centers provide multiple 100 Gbps links. We continue our strategy of targeted tuck-in acquisitions. Our previously announced TrustPath acquisition is already well integrated into the Zscaler platform, and their machine learning and AI technology is helping us deliver better threat detection. Just this week, we acquired Appsulate, a pre-revenue browser isolation company with a talented group of developers. This technology is highly effective for use cases where the internet or application content should not be downloaded to the endpoint due to security or data protection concerns. Instead, it should be rendered as pixels in the browser. We plan to incorporate this technology into our extensible cloud platform. We remain focused on execution and on investing in our go-to-market capabilities. We are welcoming a new VP and General Manager in EMEA with substantial experience in selling to large enterprises to help us scale EMEA to the next level. We will be holding our annual Zenith Live Cloud Summit in Las Vegas on September 16th through 18th, and Zenith Live Europe in Lisbon, Portugal, on September 30th through October 2nd. We will have an inspiring lineup of keynote speakers to talk about cloud transformation. In summary, we are very pleased with the strong Q3 results and continued growth in our business. We believe we are in the early innings of a significant market opportunity to disrupt traditional network security. I'd like to now turn over the call to Remo to walk through our financial results.

Speaker 14: Thank you, Jay. As Jay mentioned, we had a very strong Q3. Revenue for the quarter was $79.1 million, up 6% sequentially and 61% year-over-year. For the sequential comparison, recall that Q2 revenue was aided by $2.3 million in non-recurring revenue from a large public sector customer deploying our solution as a private cloud. From a geographic perspective, for the quarter, Americas represented 51% of revenue, EMEA was 41%, APJ was 8%. Turning to calculated billings, which we define as the change in deferred revenue for the quarter, plus total revenue recognized in that quarter. Billings grew 55% year-over-year to $85 million. As a reminder, our contract terms are typically one to three years, we primarily invoice our customers one year in advance. Excluding upfront greater than one-year billings in both periods, billings growth was over 60%. Total backlog, which represents remaining performance obligations, was $497 million on April 30th, up 63% from $305 million one year ago. Please keep in mind that next quarter will have a difficult comparison with the large public sector deal that closed in Q4 2018. This deal added $16.5 million to billings and $26 million to backlog in the July quarter, which will pose a difficult year-over-year comparison in Q4. Our strong customer retention and ability to upsell have resulted in a consistently high dollar-based net retention rate, which was 118% for the period ended April 30th. This compares to 120% a year ago and 118% last quarter. Our increased success selling bigger deals upfront, which start with the transformation bundle, and faster upsells within a year, while good for our business, can reduce our net dollar retention rate, which is calculated on a year-over-year ARR basis. Considering these factors, we feel 118% is outstanding, it will vary quarter-to-quarter. Total gross margin was 82%, up 2% sequentially and 1% year-over-year. We feel that 80% continues to be a good target in the near to medium term, as it is important to continue to invest in our platform to drive top-line revenue growth. Turning to operating expenses. Our total operating expenses increased 18% sequentially and 38% year-over-year to $58.9 million, decreased on a year-over-year basis to 74% of revenue. The sequential increase in operating expenses is primarily due to increased headcount, compensation related expenses, marketing expenses, and professional fees. We increased our headcount in Q3 by over 110 employees, approximately 40% were in sales and marketing. Sales and marketing increased 17% sequentially and 37% year-over-year to $38.8 million. The increase is primarily due to headcount increases, compensation related expenses, and marketing expenses. R&D was up 15% sequentially and up 30% year-over-year to $12.3 million, as we continue to invest to enhance product functionality and to offer new products. G&A increased 32% sequentially and increased 43% year-over-year to $7.8 million. The growth in G&A includes investments in building our teams, compensation related expenses, and professional fees, including acquisition related expenses. G&A expenses exclude $6.2 million in litigation related expenses, including the settlement of the Finjan lawsuit. Our third quarter operating margin was a + 8%, which compares to a - 6% in the same quarter last year. Net income for the quarter was $7.4 million, or non-GAAP earnings per share of $0.05. We ended the quarter with $353 million in cash equivalents, and short-term investments. Free cash flow was positive $4.6 million in the quarter compared to positive $3.7 million for the same quarter a year ago. Please keep in mind in the quarter, we made a payment of $7.3 million to settle the Finjan lawsuit. We had a positive impact from our ESPP program, which contributed $4 million to our free cash flow. The ESPP program does not impact our overall cash balance. Now moving on to guidance. As a reminder, these numbers are all non-GAAP, which excludes stock-based compensation expenses, amortization of intangible assets, certain litigation related expenses, and any associated tax effects. For the fourth quarter, we expect revenue in the range of $81 million-$83 million, reflecting year-over-year growth of 44%-48%. Operating profit in the range of $0-$2 million, income taxes of $700,000, and earnings per share of approximately $0.01-$0.02, assuming 138 million common shares outstanding. For the full year 2019, we expect revenue in the range of $298 million-$300 million, or year-over-year growth of 57%-58%. Billings in the range of $379 million-$381 million, or year-over-year growth of 47%-48%. Operating profit in the range of $17 million-$19 million, income taxes of $2.2 million, and earnings per share in the range of $0.16-$0.18, assuming approximately 136 million common shares outstanding. The acquisition of Appsulate is expected to have little to no impact on revenue either in Q4 or fiscal 2020, as we are primarily acquiring technology and the development team. Our plan is to further develop this technology and incorporate it into our platform. The deal is all cash with a purchase price of approximately $13 million. We expect to incur approximately $7 million-$9 million in additional operating expenses in fiscal 2020 related to the acquisition and to build out new services. As reflected in our guidance, I would emphasize that our plans are not to maximize profitability or generate additional operating leverage in the near term, but to invest aggressively in our business to pursue our significant market opportunity. We plan to continue to invest in our sales organization and marketing programs, as well as increase investments in our technology platform and cloud infrastructure. We are very proud of what we have achieved and look forward to building on our opportunity. Now, I will hand the call back over to Jay.

Speaker 8: Thank you, Remo. We believe we are the best choice to secure cloud transformation. The right architecture for a security cloud matters. On-premise, single-tenant architecture, whether deployed as appliances or as virtual machines in a public cloud, will not allow enterprises to fully realize the benefits of cloud. These imitators cannot scale, leave gaps in security, are expensive, and deliver a poor user experience. With multiple tailwinds such as fast adoption, SD-WAN, and application migration to public clouds, we believe the market is coming to us. We thank you for your interest in Zscaler and look forward to reporting on our progress in the future. Operator, you may now open the call for questions.

Speaker 12: Thank you. If you'd like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again, that is star one if you'd like to ask a question. We'll take our first question from Brad Zelnick with Credit Suisse. Please go ahead.

Speaker 4: Great. Thank you so much. Jay, Remo, and Bill, congrats to you and the team on another great quarter. I mean, 55% billings growth, over 60% excluding upfront deals is truly impressive. My question, Jay, at the risk of getting too deep into the technology, and you talked about this briefly in your prepared remarks, but I'm hoping you can help us understand your differentiation versus some of the competitors that are leveraging public cloud partnerships to compete with Zscaler. Why might this make sense or not make sense, and what are you seeing when you go head-to-head in proof of concept with these types of solutions? Are they able to perform and deliver on all the capabilities that you are? Thanks.

Speaker 8: Brad, thank you. Very good questions. Appliance vendors are having to compete for the cloud using technology that wasn't meant for the cloud. When they are spinning these virtual machines on public cloud and claiming to have presence in 100 locations or more is totally misleading. Let me walk through a little bit on how these public clouds work. Google, AWS, they're very large, centralized data centers in about 100 locations around the world. They call them regions. That's where applications run. That's where storage and compute actually runs. Now, in addition, they have 100 some locations. Some of them call them points of presence, others call them network edge locations. These are front doors that collect information so that the thing can be sent to the regions, which are about 20 or so. These clouds are built to run applications as the destinations, not an in-transit cloud. For example, take AWS data center in Ohio. It is kind of staying away from Chicago. The traffic goes there and comes back. Speed of light is speed of light. The performance can't be good unless you build a cloud that's distributed to handle security, do enforcement, hence the response time architecturally can't be good. The second part of your question was about POCs. We actually don't really do our business through POCs. We are driving top-down cloud transformation through the CIOs. None of this is impacting us from POC's point of view.

Speaker 3: Yeah, Brad.

Speaker 4: Thanks, Jay. If I could-

Speaker 3: Just want to clarify that Jay meant to say the true compute of these hyperscale are done on centralized data centers that really number around 20, and the 100 plus are really what they call point of presence or network edge locations. They're where content is either pushed or in a inspection service like this, backhauled. It's a backhauling collection points.

Speaker 8: Thank you, Bill.

Speaker 4: Thanks for clarifying, Bill. If I could just follow up one for Remo. Remo, I believe you went through this in your prepared remarks, but on cash flow, I think you might have come in a little bit lighter than some had been expecting, but you did settle the Finjan lawsuit. Then there's also, I think, the offset from the ESPP. Can you just walk us through that clearly one more time? Also, as we go out to Q4, how should we think about cash flow seasonality? Thanks.

Speaker 14: Thank you, Brad. We did pay the Finjan settlement, in April for $7.2 million, which had a negative impact on free cash flow. As we've talked about the ESPP program, once we hold funds from employees for the ESPP program, that's a positive impact, and that was about $4 million during the quarter. As we go forward, you think about Q4 on a free cash flow basis, if you look at seasonality that we have, our Q2s and our Q4s are our largest quarters, from a business and billings perspective. Our Q1s and Q3s are smaller. The cash flow, free cash flow impact for Q4 will be impacted by that. In addition, with the Appsulate acquisition, overall cash flow will decline based on the payments we'll make, and we have made in the last few days.

Speaker 4: Thanks for clarifying, guys.

Speaker 14: Great. Thank you.

Speaker 12: Thank you. We'll take our next question from Patrick Colville with Arete Research.

Speaker 13: Thanks for taking my question, congrats on an awesome quarter. Can I ask you about one of your competitors is having a lot of internal issues, and just how Zscaler kind of react to that. Does it change your planning? Do you become more aggressive? Does it change the dialogue with customers? How are you guys reacting to your chief competitor being extremely weak at the moment?

Speaker 8: Thank you for the question. If we were selling a security box or a proxy box through the same channel looking for refresh opportunities, this will be a big impact. We've always said we have been selling top-down transformation. Our need is driven by applications like Office 365, projects like SD-WAN. Our core business comes from securing new local breakouts, which is a greenfield opportunity. In almost all cases when Zscaler is deployed, we end up replacing secure web gateway or web proxy that's generally sitting in centralized locations. We competitors, does it help us? Generally, yes. Does it change our sales process? Not really.

Speaker 13: Got it. Can I ask about ZPA, if possible? That's a product that clearly has a ton of potential, and I would assume it's going to be one of the major growth drivers from here. We didn't talk about it that much in the quarter. Is that just because the business is being driven by ZIA right now, that's where the focus is? Just any color on ZPA would be awesome.

Speaker 8: Yeah. While ZIA platform is growing fast, ZPA is growing much faster. It's hard for ZPA to catch up with ZIA. If you think about the deals we talked about, a number of our large deals, ZIA, ZPA, they both came together. We are seeing more and more attach rate of ZPAs, and we are very bullish for the opportunity, it's a relatively new technology in a relatively new market. We're seeing very good traction and bullish about the opportunity.

Speaker 13: Great. Thank you. Keep up the good work.

Speaker 8: Great. Thank you.

Speaker 12: Thank you. We'll now move on to our next question from Alex Henderson with Needham & Company.

Speaker 1: Great. Thank you very much. I was hoping you guys could talk a little bit about the degree to which you have any challenges in hiring of salespeople, what the environment looks like, and how much of the spending is going into new hires to drive future growth. It seems like given the tense, the difficult market out there, that may be a challenge to continue to scale at that rate. Is that an issue that we should be concerned about? Thanks.

Speaker 14: It is a competitive environment, Alex. This is Remo. I think we're doing well on a hiring front. It's something that we are investing in significantly. We're not giving out what our RSM count is. When you take a look at sales and marketing headcount, it remains in the 40%-45% range of our total company headcount. This last quarter, we added over 110 employees. Approximately 40 were in sales and marketing. In some of the regions, it's easier than others. I had a conversation with one of our VPs this morning, who's bullish related to hiring. I think that Zscaler being a public company for about a year now, as well as the momentum that we're having, as well as the market continuing to come to us with our performance, I think we're getting more visibility, and we're hopeful that we're going to do a good job in hiring our sales and marketing people as we continue to go forward. As Jay mentioned, our focus is sales and marketing. In addition, we're a technology company. We're looking to continue to do development through tuck-in type acquisitions, as well as growing our R&D organization.

Speaker 1: When you think about the sales expansion, are you starting to see any leverage as a result of increased recognition or other variables that would allow your productivity of your sales teams to start to see higher deliverables on a per capita basis?

Speaker 14: Yeah. For our tenured salespeople, we're certainly seeing that they're doing well on a quota basis. Overall, when I look at year-over-year, and I take a look at the sales productivity in Q3 of 2018 versus Q3 of 2019, absent anything related to the one-time large deal, the sales productivity, it's flattish to up, which is what we planned for the year. The reason for that is that we're trying to aggressively hire. We see this as a large market opportunity. We understand that it comes down to execution. From our perspective, we have the product, the market's there, and the need's there. From our perspective, we just need to continue to hire salespeople, solution architects, CXOs, and also to build our support organization to support the product, both from a personnel perspective with support people, professional services, as well as building our cloud operations.

Speaker 1: Great. Thank you very much.

Speaker 14: Thank you.

Speaker 12: Thank you. We'll move on to our next question from Saket Kalia with Barclays.

Speaker 15: Hey, guys. Thanks for taking my questions here. Maybe first for you, Remo. First of all, thanks a lot for the updated billings guidance. You spoke about in your prepared remarks, last Q4, we had a large multi-year upfront deal that swayed the sequential growth. Can you just talk about what sort of typical Q4 billing seasonality looks like if you exclude those, maybe historically? The corollary to that is, can you just talk about the overall pipeline for multi-year upfront deals in general?

Speaker 14: Yeah, good questions. When you take out that public sector deal out of Q4, you look at the guidance that we are giving for this Q4, it implies a billings guidance of 46%-48%. Which is consistent to our revenue guidance, 44%-48%. Typically Q4, as you mentioned, is our strongest seasonality quarter or quarter in Q2 and Q4 are our top two quarters. From a pipeline perspective, we don't comment what our pipeline is. We take a look at things related to what we feel may be multi-year type deals. Our methodology related to the guidance that we have given has not changed. We feel that the guidance that we have, when you take out that large upfront deal from last year at 46%-48% on a year-over basis is very good.

Speaker 15: Got it. Maybe for you, Jay, just to learn a little bit more about the ZPA offering. I guess the question is, do the number of subscribers for ZPA differ versus ZIA? In a typical deal, that is. ZIA clearly has broad use cases for local internet breakout, but do those same customers typically subscribe to a similar seat count for ZPA for VPN, or is it typically lower? I'm just thinking about some of the examples that you gave in your prepared remarks. It felt like there were some differences in seat counts. Can you talk a little bit to that?

Speaker 8: Yeah. Good observation. As we have always said, for ZIA, when customers buy the platform, they want to protect every employee in the company who goes to internet or SaaS applications. Hence, it's almost always all employees. When you look at ZPA, it is about access to certain type of applications. The number of ZPA subscribers is generally lower than ZIA. If I were to give you a broad range, it ranges somewhere from 10%-15% of the ZIA users so far. In some cases, if it's a VPN replacement, that may be 30%-40% of the total users. In other cases, if it's M&A integration, it may be the number of employees they need to integrate from the company being acquired. In the short term, the number will be a subset. Probably 20%, 30%, 40%, 50% would be the range. I think over time, as everyone moves to the cloud and you don't have a notion of I must be in the office to access applications, eventually everyone will need to use ZPA. ZPA starts with smaller number of users and grows over time.

Speaker 15: Very helpful. Thanks very much, guys.

Speaker 14: Thank you.

Speaker 12: Thank you. We'll hear now from Andrew Nowinski with Piper Jaffray.

Speaker 2: All right. Thank you. Congratulations on another great quarter. I guess I just wanted to follow up on the billings guidance for Q4, just to make sure I understand this. I know you did have a tough comp on that $16 million deal. Once you pull it out, it is in line with your normal seasonality. You just put up 55% growth off of another very similar difficult comp, and your backlog continues to grow well above your billings growth rate. I'm just wondering, is there any other factors in there other than just some conservatism that we should consider for the Q4 guidance on billings?

Speaker 14: We like to be prudent with our guidance, and that's historically what we've done, and we continue to do that.

Speaker 2: Okay, I got it. As it relates to your large deals, can you give us any color on the duration of the large deals that you cited in your prepared remarks, and whether that duration of your large deals may be different than some of your other deals? Are they longer or shorter in duration?

Speaker 14: Historically, looking at a four quarter average for new customers, the duration of those deals has been in the 70% range, which are three years or greater. That's remained relatively consistent since our public offering. Really no change in the duration. Related to the billing timing, from our perspective, we bill annually, and if customers pay upfront for the full three years, it's not something we compensate for. It's something done by the customer.

Speaker 8: Right. If I may add and clarify, we never incented our sales force to go and do multi-year deals for upfront payment. Multi-year deals generally are annual payments with some exceptions that we call out.

Speaker 2: Okay, that makes sense. Thanks. Just actually a quick clarification. When you said you're not expecting to generate additional operating leverage, presumably in the near term, does that mean on a margin basis, or are those absolute dollar basis in terms of the operating expectations?

Speaker 14: Yeah. It's on a margin basis, we'll be giving guidance on the next call both for the quarter and the full year for revenue billings and operating profitability. We'll give more clarity on that. However, we want to make that comment, and this is a comment we're staying consistent with since our public offering. We understand that we have a model that is highly leveraged. We know we have the ability to increase operating profitability significantly with 80% gross margin. We know that we can increase free cash flow significantly. That is not our intent. Our intent is to continue to grow the market and have the market come to us. We strongly feel that we have the best solution in the market. What we need to do is execute. Part of that execution is going to come at a cost, and that cost is spending money. We're spending funds for R&D, sales and marketing, for branding, and to continue to build the infrastructure of Zscaler. Jay and myself both have significant experience related to running companies over the last 34 years. We have a finger on the pulse, and we're trying to maximize the value of the company for our shareholders to build the presence of Zscaler and to increase our market share. The comment related to operating profitability, free cash flow, is that I know it's important from a Wall Street perspective, but from a company perspective, it's important for us to grow the market and become the market leader as quickly as we can. That's our focus.

Speaker 2: That's great. Keep up the good work, guys.

Speaker 14: Thank you.

Speaker 12: Thank you. We'll take our next question from Gray Powell with Deutsche Bank.

Speaker 7: Great. Thanks for taking the questions. Maybe just a high level. We've seen some fairly volatile results from the security space this quarter, particularly from more of the on-prem focused vendors. Obviously, you guys had some good numbers. Just curious, have you seen any change in customer behavior or buying patterns? Just how do you feel about the demand environment for the rest of 2019 versus last year?

Speaker 8: Okay. Great. Thank you. Good question. Our solution delivers great ROI and lots of savings, which actually makes it very attractive even when the market spend slows down. Secondly, we are driven for helping customers do their cloud transformation, and transformation is a very high priority for CIOs, and our sales process is driven by that. We are not driven by, here's another security product that need to be sold or need to replace or need to refresh. We aren't really seeing the impact of that slowdown. Remo, you want to add anything?

Speaker 14: No, that's fine. Thank you.

Speaker 7: That's great. Thank you very much.

Speaker 12: Thank you. We'll take our next question from Daniel Ives with Wedbush.

Speaker 5: Yeah, thanks. My question more strategically, I mean, Jay, as you're talking to customers, maybe talk about how things are changing today versus even six to nine months ago in terms of deals, maybe uphill versus downhill. Are you getting more inbounds? Obviously, deal size continue to increase. Maybe you can just give some anecdotal commentary there to start off.

Speaker 8: Yes. A couple of comments I'll make in that area. A year or two years ago, when I met a CIO, a number of them would say, "We're ready for the cloud," but still a good number of them will say, "We're still thinking, not quite sure." Today, it's hard to find a CIO or a CTO who doesn't want to embrace cloud, but they're worried about how to do it securely and how to do it without messing things up. Clear interest. The market movement is happening faster. When they realize that we have good solution, things move faster than they would move otherwise. That's why we're seeing a larger deal flow than we were seeing before. Two, as the number of customers we have in the Global 2000 segment grow, these are large, credible companies. These CTOs, CIOs are willing to speak publicly about the benefit that they are deriving for security, for user performance, and cost savings. That's helping us quite a bit. Three, I shared with you a couple of examples where our CXOs from our customers move to new customers. They're able to actually go in and say, "I would like to bring Zscaler back in." Pleased with the environment, but as Remo said, we are just heads down focused on execution. Market feels good.

Speaker 5: Great. Maybe you can just talk, when you think about just overall deal sizes and sales cycles, obviously, just given the nature of some of these larger deals, but are sales cycles changing or obviously, are they shortening overall, in terms of just getting deals closed? Are there any discernible changes there? Maybe Remo or Bill or Jay, comment there. Thanks.

Speaker 14: Yeah. Good question, Daniel. Not really. For smaller deals, it's still three-six months. Larger deals, 6-12 months, after a customer's made the decision to go to the cloud and do transformation. From a average deal size perspective, we look at it for customers with greater than 3,000 users. We're in the mid $300,000 range. It's increased every quarter, and it did increase in Q3 versus Q2. We are seeing, from an average deal size, increases every quarter as we did this past Q3.

Speaker 8: Yeah. If I may add, the number of engagements and awareness have gone up. That's obviously needed for us to deliver big numbers.

Speaker 5: Okay. Keep crushing it. Thanks.

Speaker 8: Thank you.

Speaker 14: Thank you.

Speaker 12: Thank you. We'll now move on to our next question from Nick Yakob with Cowen and Company.

Speaker 11: Hey, thanks for taking my questions. Jay, maybe one for you. Do you have any sense of where we are in the adoption curve of local internet breakouts today? And along those same lines, any color you can provide around the % of your own customers that have moved to local breakouts?

Speaker 8: Very good question, Nick. Till SD-WAN initiatives came into market, the only vendor that was pushing for local breakout was Zscaler. If you want to look at the size of the market of local breakout. Our own market share is a good indication of that. We announced, I guess, last year, about 300 of the largest Global 2000 companies were our clients. What percentage of Zscaler customers are doing local breakout was the second question. Actually, the number one reason we are bought is to do local breakout. The customers who haven't done breakout with Zscaler, it's only because they haven't gotten around it, okay? I would say almost all of our customers have bought us for local breakout. If you look at the SD-WAN market, where one of the big reasons to deploy is local breakout, we are the predominant vendor who secures the SD-WAN market. If I were to give you my guesstimated answer, in large enterprises, that number of customers who have done local breakout is sitting in the mid-teens.

Speaker 11: Okay. That's really helpful. Maybe just a quick follow-up. I was just wondering if there were any metrics you guys could provide around ZPA, whether it's customer uptake or % of revenue or new deals. If not, then just maybe some of the common use cases you see gaining traction.

Speaker 14: From a metric perspective, we'll give that on our next call. All I can say is that ZPA is our fastest-growing product, and we're happy with the growth, and we're looking forward to talking about it on our next call.

Speaker 8: Remo, the metrics you gave last year was 10% of the

Speaker 14: That's correct

Speaker 8: new and upsell

Speaker 14: Business

Speaker 8: business we got. I think at the end of this quarter, end of Q4, we'll update on an annual basis where the numbers are. Your second question was about use cases. Lots of very interesting use cases. On a simple tactical front, replacing VPN, remote access VPN, is a very popular use case because customers don't like VPNs. They're slow. More importantly, VPNs are a big security risk because they put users on the network. Imagine 5,000 people in 5,000 cities, including some sitting in Moscow or Croatia. They're on your network. VPN needs to be eliminated to make our enterprises and our country safe. Second use case, big one, access to applications sitting in public cloud like AWS and Azure. Without a solution like ZPA, your users need to go back to your data center, which is a choke point, and then hairpin back to a public cloud. A silly thing to do, but that's what most customers do because that's all they know of. A third interesting use case, which I used to think will be only a very small number of cases, M&A, integration or divestitures. I'm surprised to follow how many companies are being merged and divested. That's helping. Those are the use cases.

Speaker 11: Okay, great. Thank you, guys.

Speaker 14: Thank you.

Speaker 12: Thank you. We'll move on to our next question from Meta Marshall with Morgan Stanley.

Speaker 10: Thank you, and congrats on the quarter. Jay, I wanted to follow up on the Appsulate acquisition. It's interesting that you're adding browser isolation technology. Can you maybe add some more color on how that tech is complementary to what you're already doing from a web proxy perspective? What should we expect in terms of the timeline of getting that integrated?

Speaker 8: Okay. Good. The browser isolation is a relatively new market, and it's evolving, and it has special use case in certain verticals where security is a very important financial services, healthcare, maybe defense kind of areas. This, call it feature, call it a module, is very relevant for Zscaler because we're sitting in the traffic path. Simple example could be traffic going to certain known type of sites. It could go direct using the technology Zscaler is using today. There may be some unknown and fairly suspicious sites. You don't want all that traffic coming to the user endpoint, and those type of destinations are funneled through our browser isolation technology. It becomes very, very complementary and very good fit. That's the use case. In terms of integration, what we bought is a young developers team, a very sharp team, and a very innovative core engine, and that engine will be integrated into our platform and made sure it scales in the cloud, and that's the work we are doing in coming a few quarters. Once we're comfortable with that, we make it available as an offering to our customers.

Speaker 14: We're not planning for any revenue or very little revenue in Q4 or in our fiscal 2020. I think one of the key points is that, one of the strengths of Zscaler is we have one code base, and we're putting this on our platform. We're going to integrate it into our platform, which I believe will give us a competitive advantage.

Speaker 8: Yeah. I have seen so many companies who go on a buying spree and the products never integrate. They may put a little UI in front of it, but customers complain about that type of stuff. Our focus, buy good core technology and properly integrate them so it's like one product, a single pane of glass, not just a facade of pane of glass.

Speaker 10: Okay, that's helpful. One quick follow-up. Jay, it's been about a year since the COO role went vacant with the departure of Bill Welch. Just wondering if that role is still open and how you're feeling from a sales leadership perspective.

Speaker 8: Yes, that is correct. We have retained search. We have lots of good candidates with lots of good interest. It's a very important role for us, and we're being very selective, but we will be filling that role. We are making progress on it.

Speaker 10: Great. Thank you very much.

Speaker 8: Thank you.

Speaker 12: Thank you. We'll take our next question from Jonathan Ruykhaver with Baird.

Speaker 9: Yes, good afternoon. I'm kind of curious if you could talk about the SP/SI contribution to ARR. I have in my notes that it was around 45% around the time of the IPO, so I'm just kind of curious how those channels have contributed to ARR since then.

Speaker 14: Yeah, on a revenue basis, it's a little bit higher. It's in the low 50% range. Currently, the traditional VARs distributors in the low to mid 40% range and 2% or 3% direct. All our new business, though, is through SPs and SIs and VARs. We feel that SPs and SIs are very strategic for Zscaler. A lot of our emphasis is being put in that channel. However, we understand the importance of the VAR distributor channel. We plan to continue to invest in that channel to go forward.

Speaker 9: Can you talk about the impact that SP might be having a transformation in ZIA in the same thing, with SI in ZPA?

Speaker 8: Yes. SPs, service providers are the folks who provide network and internet connectivity to enterprises. They are our natural partners for the sale of ZIA, and ZIA is a mature offering from Zscaler, and SP channel is fairly mature. Systems integrators have a better fit for ZPA because they are the folks who move internal applications to public clouds. Along with that, we are working with them to bundle our ZPA offerings. They not only do migrational applications, they also provide a secure and fast access to the customers. That's in an early stage since ZPA is young, so is the SI relationship. We are pleased with the progress we're making in that area.

Speaker 9: Right. Okay. My final question, secure SD-WAN is an alternative architecture to securing local internet breakout. Some of the larger networking companies talk about that as a successful use case. Jay, could you just compare, contrast, how you view secure SD-WAN versus ZIA?

Speaker 8: Absolutely. SD-WAN's core thing starts being a sophisticated cloud-managed branch 2.0 box that integrates routing and switching that gives you connectivity back to the data center over traditional MPLS or over the internet. That's one use case. We don't play into that use case. The second part of the SD-WAN, along with that, is to be able to peel off internet and SaaS-bound traffic at the source at each branch, so it can go direct over a broadband or whatever the connection may be. That location, that local breakout must be secure. Either you build a local gateway with traditional network security appliances such as firewall proxies, DLP, and the like, or you point that traffic to Zscaler ZIA. You can imagine hundreds of branches, which solution is better, simply pointing the traffic to us. Some SD-WAN vendors may say that we will build the functionality in each box. If you got 1,000 branches, we'll put that functionality in 1,000 branches. At least doesn't seem to make sense. The customers want the lightest footprint in each branch. Simply they do the network functionality, point the traffic to the cloud, and security can be done in the cloud. That's why most of the SD-WAN deployments we know of, we are the default platform that secures SD-WAN. Could we see a few cases where SD-WAN vendor may be trying to add security in the box? In rare cases, but most of the time it will be done in the cloud, and we are the biggest beneficiary of that.

Speaker 12: Thank you. We'll now take our final question from Fatima Boolani with UBS.

Speaker 6: Good afternoon. Thank you for taking the questions. I have one for Jay, and I have one for Remo. Jay, in your prepared remarks, I did notice the coincidence of ZPA and ZIA deals has certainly increased, over the last four quarters. I'm wondering as, I guess the de facto head of sales, if you have put in place any specific incentives or quota retirement targets from a go-to-market perspective to really drive that inflection in ZPA adoption that you were talking about.

Speaker 8: Yeah, very good question, Fatima. First of all, ZPA is maturing. We announced it. We made it available a little over a year, two years ago, obviously there's more awareness. It'll be natural for us to expect ZPA in more deals. Internally, we do give financial incentives for ZPA sales. It's a combination of maturity, awareness, well-trained sales team, and some financial incentives.

Speaker 6: That's very clear. Remo, for you, just on the COGS front, you've been very efficient on your delivery costs. Just from a COGS perspective, you've held the line to show the strong gross margin performance. I'm wondering if there's any other dynamics that are really enabling you to outperform on gross margins, whether it be pricing leverage or pricing increases within the base or anything beyond the cost front that you're doing that's helping gross margins. That's it for me. Thank you.

Speaker 14: Thank you, Fatima. I think we just have a very efficient platform, to be honest with you. When you're driving 80+% gross margin with the amount of traffic that we have going through and the amount of security applications that we run, it's got to start with the software. It's got to start with the strength of the platform that we've created. In addition to that, we do look at pricing. We periodically increase pricing, but that's related to increased usage on the part of our customers, increased bandwidth that they're using. Our cloud operations group is outstanding. We have a very strong cloud operations group, which is very efficient, that's created basically automated tools to help us basically manage our cloud. From a professional services, technical account manager, professional services perspective, depreciation of capital equipment, those are all things that we manage on a literally weekly, monthly basis. We stay on top of it. It really starts with the strength of the platform, with the ability to scale our cloud to the level it is at these types of gross margins. We're very proud of it.

Speaker 8: Excellent, Remo. If I may add, what Remo talked about platform, I would say it's a purpose-built architecture that we built that gives us the biggest advantage. Two, since we had to optimize software, we have highly optimized software we developed on our own without having to pay any royalties to third parties. Third, another new point I'll mention is we have no money to pay to public cloud vendors to run our stuff in those public clouds.

Speaker 12: Thank you. That does conclude today's question- and- answer session. I would now like to turn the conference back over to Mr. Chaudhry for any additional or closing remarks.

Speaker 8: Thank you. Thank you for your interest and time. We'll see some of you at the Bank of America Merrill Lynch conference next week. Otherwise, we'll speak with you at our next earnings call.

Speaker 14: Great.

Speaker 8: Great.

Speaker 14: Thank you very much. Bye-bye.

Speaker 12: Thank you. That does conclude today's conference. Thank you all for your participation. You may now disconnect.