Zscaler Q1 2024 Earnings Call Transcript

Quartr
Provided by Quartr
November 27, 2023

There are 15 speakers on the call.

Operator

You for standing by and welcome to Zscaler's First Quarter 20 24 Earnings Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. As a reminder, today's call is being recorded. I would now like to turn the call over to your host, Mr.

Operator

Bill Choi, Senior Vice President of Investor Relations and Strategic Finance. Please go ahead.

Speaker 1

Good afternoon, everyone, and welcome to the Zscaler First Quarter Fiscal Year 20 24 Earnings Conference Call. On the call with me today are Jay Choudhry, Chairman and CEO and Remo Canessa, CFO. Please note that we have posted our earnings release and a supplemental Financial scheduled to our Investor Relations website. Unless otherwise noted, all numbers we talk about today will be on an adjusted non GAAP basis. You will find the reconciliation of GAAP to the non GAAP financial measures in our earnings release.

Speaker 1

I'd like to remind you that today's discussion will contain forward looking statements, Including, but 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, future hiring decisions, Remaining performance obligations, income taxes, earnings per share, our objectives and outlook, our customer response to our products And our market share and market opportunity. The statements and other comments are not guarantees of future performance, but rather are subject to risk and uncertainty, some of which are beyond our control. These forward looking statements apply as of today, and 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, Please see our filings with the SEC as well as in today's earnings release.

Speaker 1

I also want to inform you that we'll be attending the UBS Global Technology Conference tomorrow. Now, I'll turn the call over to Jay.

Speaker 2

Thank you, Bill. I'm pleased to share our Q1 results, which exceeded our guidance across all metrics. We delivered 40% revenue growth and 34% billings growth. Our operating profit and free cash flow more than doubled Year over year and free cash flow margin reached a record 45%. We exceeded the rule of 60 for the 13th consecutive quarter At a significant scale of $2,000,000,000 plus in ARR, we are delivering a unique combination of high growth And high profitability that only a few SaaS companies have accomplished.

Speaker 2

In Q1, we executed well in a challenging macro environment And what is typically a slower quarter for us, the elevated scrutiny of large deals remains mostly unchanged. The increased frequency of high profile breaches, coupled with impending SEC disclosure requirements, Has propelled 0 Trust Security more into focus at the management and the Board level. Against this backdrop, We achieved a Q1 record for number of new logo customers with over $1,000,000 in ARR. We also achieved a record for new pipeline generation in a quarter. More customers are adopting our broader platform to consolidate multiple point products increasing our average deal size.

Speaker 2

As a result, we are actively working on more large multiyear, multi pillar opportunities than ever before. To meet this demand and to further scale our business, we're adding 2 key go to market leaders, 1 in sales and 1 in marketing. I will provide details about these new executives after reviewing our Q1 performance. Let me highlight 3 factors that drove our strong Q1 performance. 1st, large new logo wins were strong this quarter With a Q1 record of 14 new logos contributing over $1,000,000 ARR, we ended With 4 68 such customers, up 34% year over year.

Speaker 2

These wins spanned across many verticals, Proving that every vertical needs Zscaler. 2nd, customers are buying a broader Zscaler platform with multiple product pillars. I have said before, over time, I believe every one of our customers will buy ZIA ZPA and ZDx For every user to deliver secure, fast and reliable access to any application anywhere. This quarter, nearly half of our new logo customers purchased all 3 user pillars ZIA, ZPA and ZDx. In addition, strong platform upsells drove our 120 percent dollar based net retention rate.

Speaker 2

3rd, this was a record U. S. Federal quarter with new business up over 90% year over year, including 4 deals that are greater than $1,000,000 in ACV. We are starting to see larger awards As multiple U. S.

Speaker 2

Federal agencies are standardizing on Zscaler to meet the President's executive order to adopt 0 Trust security. We are extremely proud of having landed 12 of the 15 cabinet level agencies as our customers, where we have plenty of opportunity to expand. For example, at a cabinet level agency, we expanded the ZI and CPA deployment From 25,000 users to 100,000 users, while cross selling CDx for all 100,000 users. We also won a top defense integrator who purchased ZIA, ZPA and ZDx for its employees. In parallel, they launched a go to market service to take Zscaler to their federal customers.

Speaker 2

As our SI Partners are selling and deploying Zscaler for their customers. They are also adopting Zscaler to make their own business Secure, agile and competitive. From my conversations with hundreds of IT executives, It's clear that cybersecurity is the number one IT spending priority. Adopting 0 Trust architecture and protecting their enterprise GenAI risks are top priorities for CISOs in 2024. We have enhanced our data protection policies For AIML applications and tools to protect our customers' risk of data loss due to increasing use of GenAI, Our AI powered threat protection uses a diffusion model to detect complex exploits and to catch sophisticated phishing attacks That evade traditional security controls.

Speaker 2

These AI driven features are included in our Advanced Plus bundles, which are often priced 20% higher than advanced bundles. We now secure on average over 2,000,000,000 AI transactions Every month for our customers. Next, let me discuss some of our Q1 deals which demonstrate our differentiation and business value. We are starting to see some wins where customers are coming to us after initially purchasing a firewall based Single vendor SASE solution that failed to deliver in the real world. For those who are not familiar, Firewall based single vendor SASE is a combination of SD WAN and firewall and VPN deployed as VMs in the cloud.

Speaker 2

A leading software company made an architectural shift to our 0 Trust Exchange platform After trying to deploy a leading firewall vendor SASE solution across 50 office locations and multiple public cloud sites, It became clear to the customer that this solution expanded their attack surface to all locations and increased the risk of lateral threat movement. They decided to move to our Zero Trust security with the purchase of Zscaler for users, our complete bundle for ZIA, ZPA and ZDx For all 25,000 employees, our Xero Plus Exchange connects users directly to apps, Eliminating attack surface and lateral attack movement. For unmanaged devices, the customer is deploying our browser isolation With ZPA to enable 3rd parties to access their applications. Deals like this reinforce our conviction that firewall based Sassy solutions are not a future of security that some analysts advocate. Customers are choosing Zscaler's purpose built 0 Trust platform.

Speaker 2

Let me highlight one new logo win where our superior security helped the customer after a breach. Despite extensive investments in firewalls and VPNs, a hospitality and gaming company experienced a crippling ransomware breach. To restore their operations, they purchased the entire Zscaler for users bundle for 25,000 users. With Zscaler, your apps are now hidden from threat actors behind our 0 trust exchange and can't be discovered, exploited Or DDoS. This customer also purchased our new Risk 360 solution to understand the organization wide risk And to get actionable information to reduce it.

Speaker 2

We have shared with you that data protection is one of the fastest growing solutions for us. For our customers, after implementing cyber protection, adopting data protection is the natural second phase of their 0 trust journey. For example, a Fortune 500 travel and hospitality services provider more than doubled their annual spend with us, With data protection being a critical component of the upsell. The first purchase was ZIA for 22,000 users To inspect all traffic, including TLS encrypted traffic for cyber protection. As the next step, They are implementing real time inline DLP for sensitive data.

Speaker 2

Our solution also enables this customer to enforce policies For secure use of AI applications. These deals highlight the breadth and depth of our Zero Trust security platform. We also help our customers achieve high ROI by eliminating tech debt and consolidating multiple point products. For example, a Fortune 200 Financial Services Group turned to Zscaler to consolidate data centers and safely adopt cloud With the necessary security controls for regulatory compliance, we purchased Zscaler for users bundle for 10,000 employees And workload communication for 1500 workloads. By leveraging our cloud platform, they will eliminate half of the data centers, Reducing MPLS spend and consolidates security and networking client products.

Speaker 2

We are eliminating several products including Secure Web Gateways, Firewalls, IPS Appliances, VPNs, CASB and DLP from 7 secondurity vendors. This deal is expected to generate a remarkable 5x ROI for the customer. I'm also excited to share that ZDx, One of our emerging pillars continues to gain significant customer adoption. It is an important part of every deal conversation Due to its unique ability to eliminate IT blind spots, CDX significantly reduces how this hours spent on ticket resolutions And manual correlation of metrics. Let me highlight a new logo deal with CDX played a pivotal role.

Speaker 2

A top ranked U. S. Hospital network purchased ZIA and ZDx Advanced Plus for 87,000 users And ZPA for 40,000 users. What initially began as a ZIA and ZPA project quickly evolved into a significant ZDx The CDX component alone is 7 figures in ACV. Unlike their existing performance tools, CDX provides comprehensive visibility and root cause analysis for users, devices and applications.

Speaker 2

This deal is a great example of the leverage we gained from working with system integrators like Accenture, Who was awarded this overall transformation project? We are also seeing strong customer interest in workload protection on other emerging product pillar. Our Zero Trust Exchange is designed for any to any secured communication. It may be users to apps, workload to workload or IoT OT device. Thousands of enterprises already leverage Zscaler platform for secure user to app communication.

Speaker 2

It is natural for them to extend our Zero Trust platform to secure their workload communication, to radically simplify Multi cloud connectivity and automated deployment of workload protection at scale, we recently released significant enhancements to our workload communications offering, including granular workload segmentation using AWS user defined tags, The first Zero Trust security solution for workloads in the market, the only alternative is legacy virtual firewalls and Real time auto discovery of cloud resources. More than a third of our customers have made initial purchases for workload protection. Workload communication often starts with small land deals and we expect to rapidly expand to secure a growing number of workloads. Zscaler pioneered 0 Trust and SASE, both delivered via our cloud data platform. We have established ourselves as the premier provider for user protection and are now making progress expanding into workload protection And IoT OT protection.

Speaker 2

We continue to push the boundaries of what our platform can achieve, extending it For B2B and 5 gs use cases, as we are like a switchboard for all communications, We collect full transaction logs and trillions of signals daily. We are utilizing those signals and logs to deliver AI powered insights And automation for our customers. Let me discuss a few of the high value products in our AI cloud family. We recently launched Risk360, which is the industry's 1st holistic AI powered risk quantification and mitigation solution. It delivers up to date risk posture and recommends corrective actions to mitigate risk in a timely fashion.

Speaker 2

We have already closed 10 plus Risk360 deals and are in active evaluations with over 100 enterprises. For these deals, we are getting 6 figure ACV on average and we expect to grow this value over time. RIS360 provides critical insights to CISOs while reporting on cybersecurity risk, strategy and governance, particularly in light of new SEC regulations. Another exciting new product Breach Predictor currently under development Uses predictive and generative AI models to anticipate potential breach scenarios and eliminate those risks before they materialize. Early feedback from customers who have previewed BreachPredator indicates the enormous potential value this solution can deliver.

Speaker 2

We are working with our technology partners to bring this world class innovation to thousands of customers to proactively protect against potential breaches. While we have achieved tremendous success for user protection solutions, our platform's potential in other categories is just beginning. Our relentless innovations have paved the way for an ever growing stream of opportunities. As our platform continues to scale and expand, our go to market efforts are continuing to evolve and scale as well. To enable the next stage of go to market scaling, I'm excited to share the appointments of 2 exceptional leaders, Mike Rich, as CRO and President of Global Sales and Joyce Kim, as CMO.

Speaker 2

They bring a wealth of experience in driving revenue and pipeline growth. Mike joins from ServiceNow where as the President for Americas, We established an efficient and scalable process to drive deeper engagements to large enterprises and to Scale the business to over $8,000,000,000 in revenue, an experience that's critical to the next phase of our growth journey. George's previous experience includes CMO roles at Twilio, Genasys and Arm with expertise in building high performance marketing teams And driving impactful marketing strategies and campaigns. With Mike assuming leadership of our sales organization, Dali in his capacity as the COO can focus on scaling our business operations. Dali has been instrumental in establishing the go to market process, which has helped Zscaler achieve a milestone of $2,000,000,000 in ARR.

Speaker 2

With our expanded portfolio of products An experienced CRO and CMO on board, we will further scale our value led sales process for larger platform deals, which will sustain our high growth. I'm thrilled to have strong go to market leaders who we believe We'll drive world class execution to scale our business beyond $5,000,000,000 in ARR. Now, I'd like To turn over the call to Remo for our financial results.

Speaker 3

Thank you, Jay. Our Q1 results exceeded our guidance on growth and profitability, Even with ongoing customer scrutiny of large deals, revenue was $497,000,000 up 40% year over year And up 9% sequentially. From a geographic perspective, Americas represented 53% of revenue, EMEA was 32% And APJ was 15%. As Jay highlighted, from a new business perspective, Federal had its best new ACV quarter ever, Growing over 90% year over year. Our new ACV outside of the Fed also grew year over year.

Speaker 3

Our total calculated billings in Q1 grew 34% year over year to $457,000,000 On a sequential basis, total billings declined 37% quarter over quarter with a difficult comparison to Q4, We should have a $20,000,000 upfront billing on a multiyear deal. As a reminder, our contract terms are typically 1 to 3 years. We primarily invoice our customers 1 year in advance. Our calculated current billings grew 33% year over year At a seasonal decline of 32% quarter over quarter, our remaining performance obligations or RPO grew 30% From a year ago to $3,490,000,000 the current RPO is approximately 51% of the total RPO. We ended Q1 with 468 customers with greater than $1,000,000 in ARR, adding 19 such customers in the quarter.

Speaker 3

14 of the $191,000,000 ARR customer adds were new logos, which is a record for Q1. The continued strength of this large customer metric speaks to the strategic role we play in our customers' digital transformation initiatives. We also ended the quarter with 2,708 customers with greater than $100,000 in ARR. Our 12 months trailing dollar based net retention rate was 120%. Turning to the rest of our Q1 financial performance, Total gross margin of 80.7% compares to 80.7% in the prior quarter and 81.4% in the year ago quarter.

Speaker 3

Higher public cloud usage for emerging products drove the year over year change in the gross margin, partially offset by approximately 60 basis points of benefit for a change in accounting attributed to the longer useful life of our cloud infrastructure. As mentioned last quarter, As a result of advances in technology and efficiencies in how we operate our server and network equipment, starting this quarter, We extended the depreciable useful life of these assets in our cloud infrastructure from 4 to 5 years. Moving on, our total operating expenses Increased 11% sequentially and 26% year over year to $311,000,000 We continue to generate significant leverage in our financial model with operating margin reaching 18%, an increase of approximately 6 20 basis points year over year. Our free cash flow margin was 45%, including data center CapEx of approximately 6% of revenue. Free cash flow benefited from strong collections from Q4 billings, including the $20,000,000 upfront billings I mentioned.

Speaker 3

We ended the quarter with over $2,300,000,000 in cash, cash equivalents and short term investments. Next, let me share some observations about the macro environment and our framework for guidance for the rest of the fiscal year. While the global macro environment remains challenging And customers continue to scrutinize large deals. From our perspective, customer sentiment seems to be stabilizing. Our customer engagements remain strong and we have a large and growing pipeline.

Speaker 3

However, we want to be prudent in our assumptions given the sales leadership change. In our outlook for fiscal 'twenty four, we're balancing our business optimism and continued sales execution With ongoing macroeconomic uncertainties. With that in mind, let me provide our guidance for Q2 and full year fiscal 2024. As a reminder, these numbers are all non GAAP. For the Q2, we expect revenue in the range of $505,000,000 The $507,000,000 reflecting a year over year growth of 30% to 31%, gross margins of 80%, including the change in accounting for useful life of server equipment.

Speaker 3

I would also like to remind investors that a number of our emerging products, Including newer products like ZDX and Zscaler for workloads will initially add lower gross margins than our core products. We are currently managing the emerging products for time to market and growth, not optimizing them for gross margins. Operating profit in the range of $84,000,000 to $86,000,000 net other income of $15,000,000 Income taxes of $8,000,000 earnings per share in the range of $0.57 to $0.58 Assuming 160,000,000 fully diluted shares. For the full year fiscal 2024, we are updating our guidance as follows: Increased revenue in the range of $2,090,000,000 to $2,100,000,000 were year over year growth of 29% to 30%. Calculated billings in the range of $2,520,000,000 to $2,560,000,000 or year over year growth of 24% to 26%.

Speaker 3

We still expect our first half mix to be approximately 42% of our full year billings guide. Increased operating profit in the range of 360 To $365,000,000 which reflects up to 2 50 basis points of operating margin improvement compared to last year. Income taxes of $35,000,000 increased earnings per share in the range of $2.45 to 2 point 48 dollars assuming approximately 161,000,000 fully diluted shares. We expect our free cash flow margin to be up year over year and in low 20% range. We continue to expect our data center CapEx to be high single digit percentage of revenue for the full year, reflecting a 3 to 4 percentage points of headwind to free cash flow margins.

Speaker 3

We expect the timing of CapEx spend to be more towards the second half of the year As we invest in upgrades to our cloud and AI infrastructure, our guidance reflects our plans to invest aggressively in our business to pursue our significant market opportunity. With our new CRO and CMO coming on board, we expect to step up our sales and marketing investments in the coming quarters. In addition, we'll increase investments in our technology platform and cloud infrastructure. With a large market opportunity and customers increasingly adopting The broader platform we plan to invest aggressively position us for long term growth while increasing profitability. Operator, you may now open the call for questions.

Operator

Thank you. One moment for our first question. Our first question comes from the line of Brad Zelnick Deutsche Bank, your line is open.

Speaker 4

Great. Thanks so much and congrats on a strong start to the year And nice to see the leverage in these results. Jay, your distinction at SASE has always been clear and it's perhaps no more obvious than right now at a time when Traditional network security providers are having a tough time selling more and more boxes. And it seems they're paying you a nice complement As they all double down their focus on the cloud and SaaS, so as this all plays out competitively and you're increasingly subject to the law of large numbers, How should we think about your ability to sustain high growth and specifically the rate at which you can scale your emerging product portfolio? Thanks.

Speaker 5

Very good question. It is flattering to see all kind of vendors becoming SaaS fee vendors overnight. But the challenge for them would be, it's a different architecture. It's not an incremental change and feature you can add on to it. That's where we spent a dozen plus years building a true Zetadoclass architecture, which is our advantage.

Speaker 5

That's why we became the market leader. We Pioneer, this is Mark. We evangelize to the fact that this is what's needed for better cybersecurity and ransomware protection and cost reduction. The way I look at to sustain high growth is the following. 1, is there a market Demand came out.

Speaker 5

The market is growing and expanding at much faster pace than I even thought. 2, do you have the right platform with the right architecture, the right functionality. You've seen us build this platform on a true 0 Trust architecture and expand it over the years. Think of what we had at the time of IPO versus what we have today. And the 3rd area is go to market execution.

Speaker 5

We've done a great job starting with IPO crossing $2,000,000,000 in ARR and now we got our sights set on crossing 5,000,000,000 And we have been growing and adapting go to market also along with the platform. That's why I'm very excited about bringing 2 key leaders, Mike, a CRO and Joyce, a CMO, who can help us take us to the next level. Great market execution, great platform. I think we're set. I'm very excited about the opportunity in front of us.

Speaker 5

Thanks. Appreciate it.

Operator

Thank you. One moment please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Speaker 4

Okay, great. Hey, guys. Thanks for taking my question here. Jay, maybe for you just building off of that last question On some of the slowness that we've seen with the traditional network security guys and the challenges with appliances, The question to you is maybe, do you feel like customers are more willing now to replace their appliance firewalls, at least at the branch, With SaaSy architecture like what Zscaler provides so well?

Speaker 5

I have said many times, firewalls won't go away, but they will become like mainframes. We have been replacing firewalls at the branches for the last several years. Now that trend is So, Renee, and from one of the new things we've done to help accelerate the demise of firewalls and branches It's our branch connector technology, which now we have packaged to make it available. So you can become a Starbucks like office In a matter of minutes rather than trying to wait for a long, long time. So we've seen in campus environment becoming just like that.

Speaker 5

The only place where firewalls have been playing a significant role for a while is the data center, the east west traffic and the like. You know that traffic is going away from the data center and that demand has to go away. So The big thing for someone to do it right had to really offer a Starbucks like Brant with 0 Trust architecture. Market has made progress with traditional SD WAN. We think traditional SD WAN is a transitory technology And what we have brought to the market with branch connector actually is the next big phase to make it simple.

Speaker 5

Very excited with the opportunity to Make the world free of firewalls. Makes sense. Thanks, guys. Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Alex Henderson of Needham and Company. Your line is open.

Speaker 6

I'm torn on what to ask, but I think I'll go with The question around the channels. So you guys have been doing a lot of work on expanding your VAR channels, Expanding reach into federal, expanding reach into MSPs, expanding into the cloud arena as much as possible. Can you give us some sense of How do you think the mix of your sales leads will be driven by those different channel opportunities As we move through the current fiscal year, please.

Speaker 5

[SPEAKER SIVASANKARAN SOMASUNDARAM:] Sure. Alex, you rightly said, We don't have a simple straight VAR channel that traditionally firewall and network security vendors had. We have VARs who play a role. We have System integrators and with service providers and then there are separate set of SIs for federal business as well. Let's look at each of these areas.

Speaker 5

VARs were slow to adopt CSCR, but now as the market has moved, more and more of them are Jingas and our leader Carl has launched a number of programs where we're seeing very good progress, A new source pipeline coming from our channel. The area we see Probably a very rapidly growing opportunity is Global Systems Incubators. Actually money coming from ServiceNow, we have a lot of partnership with global SIs that played a big role. I expect that area to accelerate. And in this next level of fulfillment versus transformation, we'd like partners who work with us and work with partners, Sorry, our customers do transformation and we have been selected.

Speaker 5

You aren't going to find us with 5,000 or 10,000 channel partners. Our partners are 100 and we are doing targeted provenance. We're working with some of the very large global SIs and very large deals To do transformation, I mentioned one of these deals in my prepared remarks and I mentioned another SI We actually brought Seasquita internal along with actually launching the service to go out there. Remo, you want to add any more color?

Speaker 3

No, I think that's good, Jay. Okay.

Speaker 6

Thank you, Alex. No comment on internal sales, which is obviously a piece of it.

Speaker 5

Tom Shipps, Rick Shipps.

Speaker 3

So yes, so we've increased our capacity in the quarter for our sales reps. Our plan is to increase capacity through the year. The one comment I'd make on Q1 is that We were we did hit our expectations internally, but we expect to hit basically our sales targets for the year. The current sales capacity that we have supports our guidance. And as Jay mentioned, with the new leadership with Mike onboard, We'll be looking to accelerate our hiring as we go through fiscal 2024.

Speaker 5

Great. Thank you so much. Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Joel Fishbein of Truist, your line is open.

Speaker 7

Thanks and thanks for taking my questions. Great execution here. Jay, one for you And then I'll jump back in queue. On these new Advanced Plus bundles, obviously very exciting. Just can you share with you that you said AI has included some of the new AI apps or included in that.

Speaker 7

Can you talk about adoption rates and Whether or not you're getting any pushback on pricing as it relates to some of those bundles?

Speaker 5

Yes. So we have advanced bundles that include a bunch of functionality of ZIA or ZPA type of stuff. Now we have added functionality where some of the data protection can be done with AI advanced techniques, some of those cyber threat Protection can be done using that. So we clear these bundles, we call them Advance Plus. So we're getting very good And these Advanced Plus bundles are about 20% or so higher than the non Plus bundles.

Speaker 5

So this is a good area. In fact, this is a good way for us to reach our customers as they're looking at buying these bundles with additional functionality. It's helping them. It's helping us. Now in addition, we are also creating some standalone SKUs.

Speaker 5

We talked about RISC 360, A very popular recently introduced product, when I talked about having closed 10 plus deals in a pretty significant manner Where the average ACV is sitting in 6 figures. And then you'll see some more SKUs coming down the road as you really beat AI in Cloud is one of the big focus areas and the reason we're making focus is because we have better logs, better data to train AIML models, the starting point of good AIML is the data that we have better than anybody else.

Speaker 7

Great. Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Rob Owens of Piper Sandler. Your line is open.

Speaker 4

Great. Thanks for taking my question. Maybe building a little bit on Joel's question. You mentioned in your prepared remarks

Speaker 5

with an example around data

Speaker 4

protection as kind of as kind of one of the faster growing solutions and how it doubled spend in an existing customer. Just curious the potential for that and what you're Being relative to typical uplift when you're able to attach that solution? Thanks.

Speaker 5

When Ceesco customers started working with us several years ago, the number one focus for them was cyber protection, so they don't get compromised. Data protection was slower in adoptions. Data protection also takes a little bit work, There's more configurations and customization needed. And in large enterprises where our large customers have been, We have used Symantec 12 as one of the primary data protection products. Over the past 5, 6 years ago, we have Expanded our data protection platform significantly, not just in line, but CASB, actually endpoint DLP, Cloud data protection, all those things including EDM, IDM technologies are there.

Speaker 5

So with all that technology, We are in a great position to replace some of those complicated data protection products out there. And this is natural. If we are setting in traffic path, if we are doing assets and inspections, it's natural for the customers To use our cloud because the traffic is coming to our cloud from all kind of locations, that's really driving our growth that's why We talked about this data protection ARR is approaching about quarter of $1,000,000,000 and it grew 60% year over year for us And we see a lot of growth for quite a long time in this area. Did I answer your question? Yes.

Speaker 5

Thanks.

Operator

Thank you.

Speaker 5

Yes. One comment I'll make is, we have more complete platform for data protection and customers want one set of policies Well, if they want to secure data address or data in motion. That's why it's picking up quite fast.

Operator

Thank you. One moment please.

Speaker 5

Thanks.

Operator

Our next question comes from the line of Joseph Gallo of Jefferies. Your line is open.

Speaker 4

Hey, guys. Appreciate the question. Remo, I appreciate the rationale on the full year billings guide. But just on methodology, Is there any changes there? I mean, you saw a strong 1Q driven by Fed strength.

Speaker 4

Why not pass along some of that beat? Is that solely due to the market or the go to market change conservatism? Or is there anything else you're seeing there with large customer calendar 2024 budgets? And then maybe just to simplistically ask, is fiscal 2024 billings more or less conservative now than it was 90 days ago?

Speaker 3

Great questions. So I mean the guide that we gave is solely related to basically the go to market with our new Sales leadership on board. We feel it's prudent to do that. When you take a look at close rates For Q2 this year versus last year, we're being a little more conservative with our close rates this Q2. From a market overall market perspective, the macro still remains challenging, but we feel that things There's more of an acceptance to 0 Trust.

Speaker 3

There's more of an understanding of our platform. So we feel good. Regarding Guidance, whether it's more conservative now or not, I'd like to say, we like being prudent. And Again, it's all related to go to market with our new CRO and I don't want to comment any further than that.

Speaker 8

Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Gabriela Borges of Goldman Sachs. Your line is open.

Speaker 9

Good afternoon. Thank you. Raimo, I wanted to ask you about some of the idiosyncratic drivers in your federal business. And more specifically, as we think about all the momentum that you're seeing now, how should we think about the durability of growth in the federal vertical? Meaning, is this like a 3 to 5 year product cycle where we'll see a ramp and then we should be cognizant of a slowdown?

Speaker 9

Is it an 18 month to 36 month product cycle? How do we think about some of the visibility you have in federal and how it's going to impact our growth over the medium term? Thanks.

Speaker 3

It's another great question, Gabrielle. I'll start and then maybe Jay can come in also. We've invested significantly in federal. This is not an overnight basically This is occurring over the last 5, 6 years of significant investments, both from a platform, Technology as well as people within the federal organization that works for us. We're in 12 of the 15 agencies, Capital agencies.

Speaker 3

As Jay talked about in the script, our growth rate in federal In Q1 was 90% year over year. I feel that we are Very well positioned in federal, it's what we've talked about. We've got incredibly strong federal team Ian, I feel that going forward, federal should be a good driver, potentially significant driver for Zscaler. And we're doing well. In federal, I'll turn it over to Jay.

Speaker 7

Yes. So this is how

Speaker 5

I think about it. First of all, number of users in the federal government, DoD, non DoD. Yes, we do have 12 to 15 cabinet lab agencies, but they are in various stages. There's a big, big upsell opportunities there itself. In DoD, we're just scratching the surface So if you look at from number of users point of view, it's a massive market in front of us because we count number of users.

Speaker 5

Then there are workloads For federal, there's a whole range of IoT, OT devices in federal business that need to be taken care of. So massive stuff, but then on top of that, it's a platform. Our platform has expanded. It keeps on expanding. So I think this is a significant growth opportunity for a long, long time.

Speaker 5

And then DoD takes us to next sorry, Federal takes to other federal friendly countries out there. They all want to follow. The NATO friendly countries want to adopt what U. S. Has done here.

Speaker 5

That's an opportunity for us. The state governments are getting very, very worried about adopting 0 Trust. That's another big opportunity for us. So very bullish. We've done some big investments and that's why we have some of the best certifications for Please go back from than any other company out there.

Speaker 9

Thank you for the call and congrats on the quarter.

Operator

Thank you. One moment please. One moment please. Our next question comes from the line of Jonathan Ruckenhaver of Cantor Fitzgerald, your line is open.

Speaker 7

Yes. Thank you. So Jay, we are seeing This convergence between Cloud Workload Protection Platform, CSPM, CIM, A lot of other acronyms that are being thrown into this seed app kind of bucket. And we're also seeing a number of next gen vendors that seem to have more of a product led growth sales motion You're aimed at the developer, which contrasts with your approach, which is more a high touch aimed at the sea level. So as a product that fits between build and run time environments and you could argue maybe that portfolio is shifting either Even further left, how do you balance those dynamics when you look to go to market with your CNAB offering?

Speaker 5

It's a very good question. So all those four letter acronyms you gave us, okay, and we tried to track them. And there have been 100 plus vendors in that space over the past 2 years though. About a year ago, I used to New vendors show up every other day. For the last year or so, it has slowed down and actually they're shrinking.

Speaker 5

But there's adjacent time next to it. That is Cloud workload communication. Cloud workload communication is about workloads talking to Internet workloads talking to each other. That's where our core strength comes in the 0 Trust architecture. We are the only vendor I know of out there.

Speaker 5

We have workloads talk to each other through 0 Trust architecture without being on the network. That's our starting point. Then we look at CNAP as an extension. To me CNAP is almost like Caspin's many ways. You read, you make API Calls, reading logs, reading configurations to figure out the risk and whatnot.

Speaker 5

And that is towards shifting more to the left. We believe that combination of Cloud Workload Protection along with ZNAP puts us in a better position. Regarding product net growth,

Speaker 2

I think there's an interesting opportunity

Speaker 5

for some of the companies. Obviously, we don't come from that side. I haven't seen many, many QD companies have grown to 100 of 1,000,000 of dollars during product net growth, but we are watching and monitoring the space, but we will be going from where our strength is. Large customers love CSCR for users, now they're embracing CSCR for workloads, for communication and that allows us to extend it to CNM space as well. That's how we look at it.

Speaker 8

Yes. That's helpful.

Speaker 5

Thank you. Thank you.

Operator

One moment please. Our next question comes from the line of Patrick Colville Scatosia Bank, your line is open.

Speaker 8

Hey there. Thank you for taking my question. I mean really impressive set of results guys. So congrats on starting the new fiscal year as you have with you guys shown Very impressive momentum. I guess I wanted to touch on the leadership change.

Speaker 8

These 2 new executive level hires, How has Dali's role changed? Is he still at the firm? Or has he moved on? And if so, how Can we expect his decision to change going forward?

Speaker 5

Yes, Tony has an active role as the COO of the company. He has played a phenomenal role in Zscaler's growth you've seen over the past 4 years. We've built great go to market machine that has helped us Go past $2,000,000,000 in ARR. So Mike's goal is to take us from here to $5,000,000,000 and beyond. This frees Abdali to focus more in his capacity as a COO to really help Scale our business operations capabilities.

Speaker 5

Now what do you mean by that? As we are growing at a rapid pace, We have many things to improve on scaling side up in the operational side. Streamlining up wholesale customer engagements, Ranging from support to TAM to deployment to success, how do you bring them together to make it More productive and better streamlined for better value realization of the customers. 2nd example, We do cash process, systems, productivity improvements, streamlining. If we do a better job in these areas, As a company, we'll become a lot more productive.

Speaker 5

And the earnings experience across the company will help us achieve some of those key things that are needed.

Operator

Thank you.

Speaker 5

Thank you so much.

Operator

Thank you. One moment please.

Speaker 5

Thank you.

Operator

Our next question comes from the line of John DiFucci of Guggenheim Securities. Your line is open.

Speaker 10

Thank you. Jay and Remo both spoke about the challenging macro backdrop. And I think Remo, Correct

Speaker 5

me if I'm wrong, but

Speaker 10

I think you said that you did not hit your internal targets for 1Q. I guess, what do you think the reasons for that were? I mean, you have new go to market people and you explained that with the guide with Joe's question. And sometimes that means the previous people were an issue, but Daniel, your COO is really good at it, to say the least. I know Remo said customer sentiment is stabilizing, but I'm not quite sure how that Sort of fits in.

Speaker 10

Has the macro gotten a little worse or is there something else that I'm not thinking about?

Speaker 3

Yes. The macro has not gotten worse. And the comment, John, was related to quota carrying reps. So we didn't hit our internal projections for internal reps. We do expect to catch up.

Speaker 3

We've talked about Before on earlier calls, we're in a huge market opportunity. We're going to invest significantly in our company. You can see in the second half, we're going to increase our sales and marketing spend based on our guidance. That's related to just overall. We've gotten to do CMO on board with Mike on board.

Speaker 3

That was the gist of the comment. It's related basically purely to quota carrying reps. We did increase capacity,

Speaker 5

but not to

Speaker 3

the levels we wanted. And from my perspective, John, it's really execution on our part. We need to execute better on that.

Speaker 10

Got it. Thank you very much.

Operator

Thank you. One moment please. Our next question comes from the line of Ty Liani of Bank of America. Your line is open.

Speaker 11

Yes. Perfect. Okay. RPO growth was slower. Also the billing guidance was a tad below, although You hit the quarter.

Speaker 11

You're above the quarter expectations. So I wanted to ask about the discount level contract duration. Was there any Change in the pricing environment or contract duration this quarter that is driving the lower RPOs? And also how do I think about I know you don't provide kind of quarterly, but how do I think about First half versus second half in terms of billings and RPOs? Thanks.

Speaker 3

Yes. I mean, a lot of questions in there. And I appreciate you bringing it up. RPO decline, it's primarily related to federal. Federal is a big piece of our business.

Speaker 3

And when you look at federal, federal contracts Even though they're multi year contracts, we only take federal for 1 year in our CRPO. So that was a big driver for that. When you take out basically federal out of the contract duration, Really contract durations are comparable year over year and also quarter over quarter. Discount levels, No, not really seeing anything on a discount level perspective. I'd say it's the same and has been the same for a while.

Speaker 3

First half, second half, you can expect billings to be in the 42% range in the first half And the rest basically in the second half. But the RPO basically relates Primarily relates to federal business, which is 1 year of recognized.

Speaker 4

Got it. Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Fatima Boolani Citi, your line is open.

Speaker 12

Good afternoon. Thank you for taking my questions. Jay, this one's for you. You were very about the success in the federal business coming from very strong wins and partnerships with federal SIs. So I wanted to better understand what the moat and differentiation is.

Speaker 12

And if you can help explain to us why this wouldn't necessarily cannibalize your direct Business, which you're executing just fantastically in?

Speaker 5

So our direct business versus channel business, almost all of our business is supposed to be channel. A few customers insist that they must do a deal directly with us. So the channel is supposed to bring leverage. The more channel partners are working closely with us. The more heavy lifting to do, better our productivity, better our sales acceleration happens.

Speaker 5

So it's important for us. Now in a transformation sale like ours, the channel wasn't quite ready there to say, hey, tell me the latest box I'm ready to sell. We had to work with them to show them transformation. Federal government is driving the transformation at all levels. President's executive order is asking for 0 Trust Architecture and there are large number of Systems integrators in the federal market who actually need technology like ours to make it happen.

Speaker 5

And in federal, it becomes more interesting as you must have certification up to certain levels. There are FedRAMP certification at the medium level, at high level and whatnot and IL5, we have done most of them. So with certifications, Leveraging those system integrators, we are able to drive transformation. And I think we are in very good shape sitting there with the big market, Working side by side with our partners. So there's no cannibalization.

Speaker 5

Did I make it clear or did I miss some?

Speaker 12

No, that's super clear. Thank you.

Speaker 5

Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Hazma Baudiwala Morgan Stanley, your line is open.

Speaker 6

Hi, good evening. Thanks for taking my question. Remo, regarding your comments on the sales changes And the impact of the full year billings guide, just curious is it are you anticipating the leadership change will Drive a broader restructuring in the sales org like you saw a few years ago when DALL E came on board or is it going to be more incremental? Thank you.

Speaker 3

Yes. So the leadership we have in our sales organization is very strong with what Gauley has created. I don't see significant changes. Maybe Jay can speak to it, but I don't see significant changes. And again, the structure that we've built Under Dolly's leadership was a very strong basic play structure.

Speaker 3

Yes.

Speaker 5

In many ways, our sales process at Seesquita is very similar to Service, no. Sales cost, it's concentrated, it is top down selling, it's enterprise focused. Really, so we expect the same kind of stuff Carry on. There needs to be. There will be ongoing refinements, but don't expect any big changes.

Speaker 5

Some of the things As I talked to Mike earlier, as he is understanding the organization, you'll see probably more focus on top account program. We have a big opportunity to take our large customers and double, triple and quadrupled ARR with us because our platform supports You're going to see more focus on verticals. We already have some level of verticals. Public sector is a vertical for us. Healthcare, you'll see more focus there.

Speaker 5

You're also going to see more persona focus in our sales stuff. And I mentioned early on too, you'll probably see more focus on global system integrators as they drive some of the large transformations, But no significant changes.

Speaker 6

Helpful. Thank you.

Speaker 8

Yes.

Operator

Thank you. One moment please. Our next question comes from the line of Matthew Hedberg of RBC, your line is open.

Speaker 13

Great. Thanks for taking my question. Raimo, question for you on the macro. There's been a couple of questions on billings and RPO and obviously the federal strength. But I guess maybe I'm just a little confused because when I look back at your Q4 script, When you talked about the macros, you said you noted global uncertainty, but it seemed to me like there was a change in tone from your comments here.

Speaker 13

I think you said you noted customer sentiment is Smuruth sentiment is starting to stabilize. So I guess, I'm just sort of curious, what drove that comment that things are starting to stabilize versus last quarter when you noted uncertainty? And was this something that happened During the quarter or anything that kind of prompt you to maybe change the script a bit from 4Q?

Speaker 3

I'll let Jay comment too. Yes.

Speaker 5

I think what I commented last time was there's a slight reduction in scrutiny of the deals. So the term I exactly used. I think what we're seeing, we're seeing there's no change in macro the way we have been seeing. So macro is not Playing a role at this stage to say the forecast needs to be assuming macro is not getting any worse than it has been.

Speaker 2

Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Srinik Kothari Baird, your line is open.

Speaker 14

Yes. Thanks for taking my question and congrats on the great quarter, Jay Remo. It's great to see your focus on large transformative deals in top accounts as you just highlighted, Jay. The ongoing traction with bundled offerings Across your emerging new products contributing to the new business. So all of that speaks to great in house kind of innovation model that you have talked about.

Speaker 14

Jay, how do you see the role of strategic M and A play in expansion plans as we are starting to see with some others, Especially around cloud and data security and what if any potential areas to focus? And Remo, can you provide the new versus upsell split in the quarter And how it compares with the expected the forty-sixty mix? Thanks.

Speaker 5

Yes. A very good question. So with tighter funding and lots of security companies out there, we're seeing lots of attractive opportunities coming out of We are looking at a number of innovative technologies and strong development teams. It's an option. We've done a number of Small ones in the past some time.

Speaker 5

Yes, there are some areas, interesting technologies, especially in the new world of data and AI kind of stuff. It's an option we're keeping. I think you will not see us trying to buy revenue through an M and A. You're going to see us buying innovative disruptive technologies that can help us get to market sooner, faster is important And that integrates with our platform. I hate to see acquisition being done where you have Standalone product, they don't work together with each other.

Speaker 5

But we are actively exploring the various apps. There's no reason why we should not. Hey, Mohan. Yes.

Speaker 3

And the new and upsell was 45% new, 55% upsell. On our year end call, we said we expect Upsell to be above 60%. That's still our expectation for the year, but for the quarters, it was 55% upsell.

Speaker 10

Got it.

Speaker 14

Thanks a lot, Jay and Remo. Appreciate it.

Operator

Thank you. One moment, please. Our next question comes from the line of Brian Essex of JPMorgan. Your line is open.

Speaker 5

Hi, good afternoon and thank

Speaker 8

you for taking the question.

Speaker 13

I guess Rema, I want Dig into margins

Speaker 8

and specifically maybe gross margins. I mean, you guys are about 3 times the size you were 2.5 years ago, You've hovered kind of in the segment just below 81% gross margins, give or take 50 basis points or so. And I appreciate the comments you had that emerging products will initially have lower gross margins. I think that's been the case for some time. But how do we think as you continue to Grow at an accelerated pace and scale, how can we expect that to impact your margins?

Speaker 8

How are you managing your Structure and then maybe just an adjacent comment on sales and marketing. It seems as though that was quite a bit lower than billings. Did you hold back on sales and marketing spend ahead of The arrival of Mike and Joyce. Thank you.

Speaker 3

Yes, a few questions. Did we hold back sales and marketing spend? No problem. With do we hold back sales and marketing spend? Not really.

Speaker 3

It's just the way things worked out. Maybe a little bit on the marketing side, but that's about it, but not really. From a gross margin perspective, our stated gross margin Has been between 78% 82%. And you're right, Brian, we've been in the 80% range for a long time. The beauty of Zscaler quite frankly is the platform and technology that's been created.

Speaker 3

When I started here, We're doing 30,000,000,000 transactions per day. We are doing 360,000,000,000 transactions per day right now and we still have 80% gross margin. The benefit that we have is we can make decisions related to maximize gross margin or to get Applications are get applications are increased the strength of our product by going through public cloud. So we balance that. I would expect gross margins to be in that 78%, 82% long term.

Speaker 3

Short term, mid term, I'd expect the 80% gross margin range. If we need to shift our focus with more increase in our margins, we will. But we do manage it. We do look at it. The emerging products do carry lower gross margins and we'll keep on innovating and on the slowdown building more products.

Speaker 8

That's helpful. Thank you.

Operator

Thank you. Okay. Thank you. And that is all the time we have for questions Today, I would like to turn the call back over to Jay Chaudhry, CEO for any closing remarks.

Speaker 5

My sincere thanks to our employees, our Customers and partners are delivering a strong quarter. Thank you for your interest in Zscaler. We look forward to seeing you at Some are at the investor conferences. Thanks. Great.

Speaker 5

Thank you.

Operator

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.

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Earnings Conference Call
Zscaler Q1 2024
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