Zscaler $ZS Q2 2023 Earnings Call

Thank you, Bill. We delivered a solid Q2 despite economic challenges that have impacted the broader tech industry. For the quarter, our revenue grew 52% year-over-year and billings grew 34%. Billings were impacted by new customers being more deliberate about their large purchasing decisions at the start of the calendar year. These deals have not gone away and we have closed a few already in February. On the other hand, we had strong growth in our expansion business with existing customers increasing their deployments and adopting a broader platform. Once again, our dollar-based net retention rate was over 125%. We continue to delight our customers by accelerating their path to better security, business agility, and cost elimination, helping them solve some of their highest priorities. This drove our Net Promoter Score, or NPS, to a new high. Our NPS now exceeds 80, which is more than two times the average for SaaS companies. And today, more enterprises than ever before recognize Zscaler as the best choice to secure the digital transformation, strengthening my confidence in our $72 billion serviceable market opportunity. Our disciplined approach to growth is reflected in our strong operating profit and free cash flow, both of which doubled on a year-over-year basis. Our operating margin expanded by approximately four percentage points while our revenue also continues to grow at a very high rate. As the world's largest security cloud, we have outstanding unit economics with a stable high-90s gross retention rate and 80% gross margins. These best-in-class metrics are the results of our differentiated services, market leadership, and highly scalable multi-tenant cloud platform.

Let me share with you some of my observations about the environment and how we plan to manage our business for the remainder of 2023. With macro concerns weighing on business leaders, more organizations are being cautious and measured about their spending. In January, we saw a higher scrutiny on budgets compared to December, resulting in additional delays in large deals. These deals haven't gone away and customers are taking longer to make decisions and requiring additional approvals. In select instances where timing of budgets was a hurdle for new customers, we enabled them to ramp into larger subscription commitments. These strategic deals lowered our first-year billings but will grow into a higher annual run rate level in the second year. We typically have some ramp deals each quarter, but in Q2, the impact of ramp deals on our billings was higher. These ramp deals position us to expand the customer relationship over time to create long-term value. As we enter the second half of fiscal '23, we are expecting customer consciousness to continue. We have accounted for further lengthening of sales cycles and uncertain timing of large deals in our outlook. Even though our current pipeline has grown and has more mature deals, we are assuming a slight deterioration in close rates. While not immune to economic slowdowns, cybersecurity is relatively more resilient. In my conversations with hundreds of CIO executives, cybersecurity remains their organization's number one IT priority. Two weeks ago, we hosted a Zscaler Summit with CISOs from Global 2000 companies. They talked about the business need to innovate, become agile, and gain competitive advantage with security as the enabling foundation. They talked about the plans to shift to zero trust security to reduce attack surface and to adopt the direct-to-cloud architecture that Zscaler pioneered. Customers are excited by the new innovations being added to our platform and their engagement with us remains very strong. Given the large opportunity we see in front of us, we will keep on building and innovating while also increasing profitability across the board. After significantly growing our teams in recent years, we took a fresh look at our organization and found opportunities to streamline operations and to align people, roles, and projects to our strategic priorities. As a result of the review, we initiated our targeted cost optimization plan to drive additional operational efficiency that best positions us to deliver profitable growth. Remo will cover this in more detail.

As I mentioned before, I believe that periods of uncertainty can accelerate the adoption of disruptive technologies like ours. C-level leaders are telling me that technical debt of legacy network and security point products impedes progress and slows down business operations. By consolidating point products and embracing zero trust architecture with Zscaler, our customers are modernizing their security while reducing costs, giving them the competitive edge they need to succeed in today's rapidly evolving business environment. We have expanded our business value team to collaborate with customers to create CFO-ready business cases with clear ROI and payback periods that facilitate necessary deal approvals in today's environment. Customers can't afford to risk their mission-critical projects with immature offerings from unproven vendors. We are starting to see deal wins from customers who initially purchased a single-tenant SASE solution from the incumbent firewall vendor that failed to deliver in the real world. These customers were misguided by the flawed message: 'Keep on buying my boxes and use my so-called cloud service.' When your users are on the road or in a branch office, a single-tenant architecture, whether deployed as appliances or as virtual machines spun up in a public cloud, will not allow enterprises to fully realize the benefits of secure digital transformation. Every customer, large or small, has lots of firewalls in the data centers, but when it comes to zero trust security and digital transformation, they're choosing Zscaler because of our multi-tenant cloud architecture that scales and delivers business agility. Our Zero Trust Exchange is the largest inline security cloud in the world, processing over 280 billion transactions and preventing 9 billion security and policy violations per day. This massive amount of traffic provides us with more than 300 trillion signals per day to feed our machine learning and AI engines for better detection of user and application traffic anomalies, resulting in superior threat protection.

Our AI/ML capabilities are driving customer success at scale in the real world today. Let me share an example with you. In December, we helped a global 500 conglomerate experiencing a targeted cyber attack on one of its divisions. Our Threat Labs team worked closely with the customer to identify the root cause of the attack and act quickly to prevent any potential damage. Subsequently, this customer upgraded to our ZIA Transformation Bundle to prevent zero-day attacks and secure the entire ecosystem. This win highlights the value of our high-end product bundles and the benefits our Threat Labs research brings to our customers. I'm delighted to share that an increasing number of customers are purchasing our comprehensive platform capabilities, which not only accelerates the business value realization but also establishes us as a critical partner for their success. As I mentioned before, customers are increasingly buying Zscaler for Users, our complete platform for user protection which includes ZIA, ZPA, and ZDX bundled together. In addition, we're gaining traction with workload protection powered by the same core ZIA and ZPA technology. Thanks to new and existing customers purchasing these expanded bundles, we drove a 51% year-over-year growth in the number of customers with greater than $1 million in ARR, ending with nearly 380 of these customers. And over 30 of these customers have ARR greater than $5 million. Let me highlight three deals this quarter where the customers purchased all four product pillars. In a new logo win, our top 10 global identity software and services company purchased the Zscaler for Users bundle for 400,000 users, including our Advanced Data Protection suite, and our Zero Trust for Workloads for 3,000 workloads. This customer pursued a zero trust strategy due to their business growth resulting in a complex application and network environment and heightened risk from data sprawl. They selected Zscaler as the only scalable zero trust platform that reduces their attack surface and protects their sensitive data while bringing agility to their business. With an integrated platform, they will simplify their security operations by consolidating dozens of point products including firewalls, VPNs, VDIs, DLP, and CASB. By purchasing all four product pillars, the customer is making a platform bet on Zscaler to secure their users, workloads, and devices regardless of their location.

Next, in an exciting upsell win, a major auto manufacturer upgraded to Zscaler for Users bundle for 35,000 users and purchased Zero Trust for Workloads for 8,000 workloads. This platform purchase was driven by the customer's strategy to digitally transform their business operations, including management of their vast supply chain. In fact, we are helping them accelerate time to market for new EVs. Before purchasing ZPA, this customer experienced significant delays in commissioning new vehicles as third parties did not have fast and secure remote access for collaboration. By using ZPA and ZDX, they can now provision secure access to new third parties within a few days compared to over a month it used to take with legacy remote access technology. In addition, Zscaler for Users significantly reduced the risk of ransomware that the firewalls and VPNs allow. Finally, a global 500 pharmaceutical company upgraded from ZIA for 45,000 users to Zscaler for Users bundle for 85,000 users and purchased Zero Trust for Workloads for 2,000 workloads. They purchased all four product pillars to pursue a cloud-first strategy with zero trust security for all users and workloads. With this upsell, the annual spend of this existing million-dollar customer increased by 6x, with additional opportunity for workload protection as their public cloud usage grows.

Earlier I mentioned that in some instances we enable new customers to ramp to larger commitments. In one such new logo win, we are excited to partner with an innovative retail leader that's using facial recognition technology and cashless checkouts to redefine their future store experience. This is a significant win for us, and retail was a smaller vertical for us historically where we are now enabling new digital transformation possibilities. This retail company committed to an eight-figure total contract value for a multi-phase ramp to secure over 90,000 ZIA users, 20,000 ZPA users, and 400 petabytes per month of data from the 20,000 retail store operations. This customer had bought a firewall-based SASE solution which failed to scale as well as expanded their attack surface. Leveraging our highly scalable and reliable Zero Trust Exchange platform, they will use ZIA to create direct internet access for employee tablets and terminals while using ZPA to secure private access for store managers. Additionally, Zero Trust for Workloads will secure all traffic from cameras and controllers in the retail stores to the cloud. Workload protection accounts for approximately 40% of the total deal value. As these deals show, customers are embracing our expanded platform including our two emerging product pillars: ZDX for digital user experience management and Zscaler for Workloads for securing servers and workloads. These emerging products are on track to meet or exceed our full-year target of contributing high-teens percentage of new business. Our Zero Trust for Workload solution is roughly doubling year-over-year. In addition, our new CNAPP solution is generating significant customer interest. We made a call at CNCF Live in June. We launched our CNAPP solution called Zscaler Posture Control, which is an integrated solution that correlates vulnerabilities and risks across CSPM, CIEM, and infrastructure-as-code scanning. This quarter we had a Posture Control upsell win with a global 1000 engineering company for half a million dollar ACV to secure 5,000 workloads. Posture Control provided visibility across multi-cloud assets, remediated compliance violations, and revealed previously undetected high-risk vulnerabilities. We are proud that our Posture Control solution was recently recognized by research firm G2 in the leader quadrant based on independent peer reviews.

We are bringing more innovations to our customers than ever before. In our latest major cloud software release, we brought over 150 new features to market, including product innovations such as AI-powered phishing detection and dynamic risk-based access policy. We continue to drive both internal innovation and highly targeted acquisitions to expand our leadership in the SASE and zero trust security markets. As announced a few weeks ago, we acquired Canonic Security, an innovative startup in SaaS supply chain security which protects customer data in SaaS applications. For example, Google Suite could be sharing data with 30 other third-party connected SaaS apps that are posing significant risk of data breaches and data loss. Together with our inline DLP, browser isolation, auto-block CASB, and SSPM for SaaS posture management, Zscaler now provides unprecedented visibility and the most comprehensive data protection for SaaS applications and customer data. As we look ahead to the next few years, we are committed to driving broader adoption of our zero trust platform for users, workloads, and IoT/OT to maximize the value of our customers' secure digital transformation efforts. CIOs are telling me that they're using this challenging environment to drive change. ROI and cost optimization are becoming bigger priorities as they're being asked to do more with less. With our superior architecture and proven experience, we deliver measurable outcomes at the CxO level that are aligned with our customers' top priorities. Our business value proposition is resonating and more customers are consolidating multiple point products with our broader platform, which increases our wallet share with them. We believe that we are still in the early stages of a significant market opportunity to enable secure digital transformation and we are on track to achieve our $5 billion ARR goal. Now I'd like to turn over the call to Remo for our financial results.

All right, thank you. So if you look at the quarter, we found that our upsell was quite strong. Customers are loyal to us, they like our solution, so upselling becomes easier for us. In terms of challenging, new logos with large deals are more challenging as there was additional scrutiny and additional approvals needed. Other thing that worked well was the customers liked the fact that we're able to do consolidation with lots of point products, that clean architecture, and give them strong ROI. That thing has worked well for us. In terms of competitive positioning, we haven't really seen any change. In fact, I would say that on the higher end of the market, we actually feel like we are stronger than even before because we have established that we actually have the right architecture, right solutions with thousands of customers well deployed and very happy customers. We're beginning to see that some of the solutions that are sold by firewall vendors as SASE solutions, when customers can't deploy them, they are falling apart. You know, I have been asked many times in the past two years, 'Hey, are you replacing some of our firewall-based solutions?'

And I used to give is I haven't seen very many out there and I'll be a big need to see some of them. A large retailer I mentioned on my call with 20,000 stores tried for about 18 months to deploy the firewall-based SASE solution, so to speak, and eventually gave up, and we are really taking care of it. The other thing I would mention is Remo has often said we can adjust our business model as needed. As the environment is getting tighter, we are adjusting our model by slowing down hiring. Our unit economic cost is very high, so you're seeing expansion in gross margins and operating margins, sorry, operating margins, which investors do like to see. Lastly, my confidence is coming from hundreds of customer calls I made. We had 80 CSOs with us for two days doing an exchange. All of these guys I have deployed have done a great job. They understand the architecture. The more the word spreads out there, a better understanding of the architecture, the more they're able to fend off the FUD being spread by competitors. So I'm very comfortable in our ability to stay far ahead of the competition.

Thank you.

As you know, every company has some kind of legacy solution for internet gateway or even VPN access. Those are the two starting points for us. The idea is to replace some kind of firewall or VPN. We started replacing some kind of VPN, then expands from there. So almost all business we do starts by replacing something, except for add-on upsells. So if you look at add-on upsells, that means we may have ZIA, some pieces deployed, we may be upselling to replace another vendor or some other stuff. So almost all business is replacement for us. You will call some of the stuff expansion. For example, when customers want to have direct access to applications sitting in Azure and AWS without going through the data center, we're still replacing some of the stuff sitting in the data center and some of the direct connects they may have bought. So it's replacement of a bunch of products into a few superior offerings. That's really where the savings come from. That's where the simplicity and operational ease comes from.

If I may add, I mean, you look at it as a strategic investment on our part to help customers get started and manage their cash flow investments in year one by deferring some of that stuff through ramps.

Yeah, so we are still selectively going to hire, adding sales reps as well as core engineering team members, and we expect our year-end headcount to be higher than the headcount today.

Patrick, as we made changes to our Enterprise segment, the lower end of the mid-market segment at the start of the year, and we have new geo leaders, those changes are behind us. They're done. If you want to know bearing on Q2 numbers, okay. So the main thing we're seeing at the highest level is some of the macro conditions that are impacting from the higher and larger deals. The low end of the market segments, Enterprise and Commercial, they actually have done quite well. There's no impact there.

Yeah, I would start on the pricing pressure or discount you talked about. That's an important part of it. So due to a hyper macro environment, there is increasing scrutiny and pressure on CIOs. Now customers are negotiating harder on payment and renewals. But customers view us as one of the most mission-critical services, and they want to make sure they buy the service that works, the service they can depend upon. So they're not looking for the cheapest solution. So from that point of view, I would say we aren't seeing tremendous pressure on discounting. There's some focus on it, and to help that, that's where some of the ramps come in to help lower the first-year cost for the customer and manage the spend. But being strategic, being at the right level, and actually delivering a lot of ROI value reduces pressure on us from a pricing point of view.

Thank you. Our overall adoption of cloud workload product is pretty good as planned. And as customers are launching more and more workloads, they have two options: either they extend their corporate network, just like a branch network, to every cloud region and put virtual firewalls there, or they do zero trust architecture with Zscaler. So these products are primarily sold to our customers. Customers understand the value of it, and that's where they're embracing it. Now, the initial deals are smaller. Customers are growing, and there are some large deals, but a majority of the deals start small and customers start buying into it. They largely end up doing the same thing, just like the ZIA for users, the ZPA for users, and this is the ZIA for workloads, the ZPA for workloads. That's where we believe the opportunity for us is significant. In terms of go-to-market, all reps are equipped to sell it, but we also understand that there are a bunch of nuanced discussions in this area. So we do have product specialists, this is an overlay sales team, these product specialists in this area, and they do help in the sales process.

I'm sorry, can you expand the last part?

Yeah, our customers are not looking for best-of-breed point products. They're looking for best-of-platform with the right architecture. To continue, if you talk with the low end of the market, they can kind of live with some of the solutions that are kind of half-baked. So when you talk about Global 2000, these customers are generally pretty savvy. The requirements are complicated, and we believe the best architecture will win in the long term. I gave you an example this time with a large retailer that had gone a different way, thinking that a firewall-based architectural approach tried, failed, and came back. I expect to see a lot more customers do the same thing. I think we have ample opportunity in the Global 2000 to take our current penetration to a much, much higher level.

So we aren't really making any special changes to upsell versus new logos. This has been asked to us many times over the years. Do we have a special incentive for new logos? Not really. Our platform is very broad and big, so we really want new logos, we want expansion. And expansion, we know that expansion means upsell is a little bit easier than new logos. That's why you're seeing some of the upsell numbers going up this quarter compared to new logos. Now, we keep on making the refinements to our go-to-market structure and model from time to time, but there's nothing significant we're doing now to make any changes. I think that one of the best things we have, a very good sales organization, our architecture is very good, our deployments are very good. That's why customers come back and rave about us. I mean, talking to so many customers, they believe we have the best service, best architecture, and best security. That's why we've been, and I think we'll keep on, these two from driving it. But in today's market, we expect upsell numbers to stay high because it's a bit easier as compared to a new logo.

Oh, sorry, big product, yes. So if you look at, almost every Zscaler customer has the ZIA. Okay, ZPA can be a starting point, but that's not common. But more and more, customers are starting with ZIA and ZPA. But there's still a sizable install base that has the ZIA. Now, ZIA and ZPA together in the higher end will be close to 60%. That's right. That means so many customers have the ZIA, there's upsell opportunities on ZPA. There's an upsell opportunity within bundles. A lot of these customers, about business, they moved to transformation, from transformation, there's a big opportunity for us to sell data protection. Data protection, especially advanced data protection, is very much in the mind of large corporations. And there's a lot of old stuff spinning from Symantec, McAfee, and some of the macro stuff. And when you deploy these architectures, you can't really sit with the old school DLP technology. Data protection is a big opportunity for us. If there's one other product I would highlight, it is ZDX. Digital experience is one of the favorite services of CIOs and heads of networking because when someone is coming from some home, some coffee shop, some hotel, when things are slow, customers struggle to figure out. ZDX has become very sophisticated to help them pinpoint issues and take care of them. User experience is becoming more and more important, and it's this highly, highly differentiated service that we offer.

I'll start and then we'll connect things to it. This quarter, EMEA had less dependency on large deals. Okay, and as you know, a lot of students are getting more school. And U.S. was rather to be speaking weaker because they had higher dependency on large deals.

Okay, and this is another color I could give you on the market vertical kind of stuff. You know, there are certain verticals that did better than others, as you would expect. The tech vertical was weak in today's market.

That's correct, that's correct.

Had a hard time hearing you, so you might... I think we've caught something about maybe hyperscaler and perhaps if you could repeat that.

Yeah, so let me share with you lots of conversations I have. Customers are embracing cloud. Okay, there's nobody saying I want to come back or not embrace at all. That's point number one. Point number two, the speed at which these guys are moving forward is slowing down. I even expect because some of these large software development projects are slowing down for cost reasons. Number three, that's actually creating an interesting phenomenon whereby customers aren't able to use all the spend that's committed. Okay, that's actually giving us an opportunity where we are actually partnering more closely with some of these hyperscalers where our platform can be part of that customer commit because we are an approved partner for some of the cloud spend. So those are some of the things we are seeing. But overall, we do see it's rare to find a CIO that says I don't like cloud anymore. Are there complaints about cost in the clouds? Yes. Do they see an alternate to go back to the data center? No.

Thank you for your continued interest in Zscaler. We look forward to seeing you at some of the upcoming conferences. Thank you again.