Zscaler, Inc. (ZS) Earnings Call Transcript & Summary

Let's get going here. I don't think we need much of an introduction for Zscaler. This is one of our favorite companies. We spotted a note out on it yesterday, reiterating our strong buy. We think the company is extremely well positioned in one of -- what should be a core holding in the cloud directed place. The company is presenting today for a few minutes and then we'll do a fair amount of Q&A, and then we'll open it up for questions. Jay Chaudhry, CEO, is presenting. My name is Alex Henderson.

Alex, thank you for the introduction. I'll take a few minutes to do, so to speak, a refresher. That will make it easier for some of the Q&A. So if you think about the whole digital transformation that's happening, it's driven by trying to make businesses more agile, competitive, and the technologies that are enabling us. Cloud is the biggest one, but mobility, Internet, IoT and all is all helping. The goal is different entities, workforce, customers, suppliers, they all should be able to talk to each other and access information and applications. And cloud and Internet are making it easier and easier to do so. But how do you do it securely is the big problem, all right? We -- you all know by now the hub-and-spoke network that every enterprise has built over the years, very expensive and slows things down. And the security is done by a model, what we like to call castle and moat. A drawbridge of boxes to go out of the castle, generally called outbound gateway, and a stack of boxes to come in from outside, called inbound gateway. Inside, you have trusted network; outside, everything is untrusted. It worked beautifully for 20-plus years when you essentially control the network, everything was sitting in your data center. What's happening now? As a part of the digital transformation, applications are moving to the cloud, either as SaaS or to public cloud. Once that does, this hub-and-spoke network no longer works well. Backhauling traffic from Phoenix to Chicago to go out doesn't really help. Like what's the last time you flew from San Fran to Chicago via Dallas. You don't like it. That's what's happened in this hub-and-spoke network. So what's the solution? You should be able to go direct from wherever you are, any branch office. But if you do that, the security becomes an issue because security is sitting in the data center. So you need to transform your security. Security was done by building perimeter. You can't build a perimeter around it. So the network security notion we have becomes irrelevant. When the network security means securing your network, you no longer control the network. How do you secure it? You don't. So fundamentally different approach is needed. So what's our solution? We don't secure the network at all. So we are not in the network security business, so to speak. We look at applications as destinations. We look at users as consumers of applications. We are sitting as a digital service exchange in the middle. A user connects with us, and we connect them with the right applications. Based on the type of applications and who the users are, the exchange service. So services exchange has to do different things, to access external applications, internet and SaaS, where you could be exposed to threats and whatnot or data leakage. We have a platform, a product line called ZIA, Zscaler Internet Access, to access the applications. To access internal applications, you're not worried about getting infected because you went to SAP. You worry about who can access it and how do you make sure the SAP is secure, it's not being DDoS-ed and the like. We have a product line called ZPA for that. A few months ago, we announced a new offering called Zscaler B2B. This is for your customers -- the customers of the enterprise being able to access business applications that they're building and hosting. And then lastly, Zscaler Digital Experience. When you go direct over the Internet, it's wonderful till something doesn't work. And when something doesn't work, where do you start looking at? Is the application slow, network slow, PC slow, Wi-Fi slow, something slow. Since we're sitting in the middle, we're seeing both sides of it. We are well positioned to be able to say, tell you what all is happening. End-user experience is becoming #1 priority for us. And all of this was designed as a distribute architecture being served from 150 data centers. This is probably the most important slide of blueprint, the way we look at the world. The blueprint gets a lot simpler. Applications shown on the top as destination. Data centers is nothing more than a destination just like Azure and AWS are. Users shown on the bottom, where we are sitting in line to enforce policy, just like an international airport. Identity, we complement identity, we feed lock the security operations, we work with endpoint vendors, and we work with all the branched networking vendors doing SD-WAN or routers or switches. So we have pretty well-defined road map. Anything that can be done by sitting in line for policy enforcement, [indiscernible] exchange as a switchboard with lots of intelligence, that's what we do. We changed the old world to new world. You can look at 4 fundamental things we do, that's meant for the new world: applications; data center versus anywhere; network hub-and-spoke versus direct to the Internet; direct to cloud over the Internet; castle-and-moat security versus connecting apps, devices and users with a policy engine; and last is probably the most important and the world is picking up on it, in the past, we had a trusted network, you trusted the network. In this world, there's no such thing as trusted network. That's why Gartners of the world are talking about Zero Trust Network. Don't put users on a device, so they can have movement left and right and cause damage to it. So that's really probably good amount of information about us. So with that, Alex, we can get into Q&A.

So I'm going to start off with the easy one. I'm going to get up here, so the broadcast [indiscernible] system. Can you talk about the announcement this morning about the patent settlement?

Yes. A number of you probably know, Symantec filed a lawsuit against us in patent infringement 3-some years ago, I don't exactly recall the time. We always felt it was baseless. We always felt like typical in the Valley. When large companies get left behind on technology, they try to slow you down. So over the time, a lot of those claims had been invalidated by the courts and all. So we're sitting in a pretty good position to be able to do a settlement and get it behind us at a fairly low cost, a good thing. So we're happy with it.

So it says, when you read the patent press release with prejudice, so this is completely done with prejudice, meaningless in this context, would you have a license going forward?

That is correct. Right.

Just wanted to make sure people understood that. So the last couple of quarters, there's been some turbulence in the stock. It started off with Palo Alto making claim that they've won some customers from you. That was followed up with some turbulence in your earnings result as a result of you indicating you're seeing some pushouts. Can you talk through each of those? Let's start off with the competitive side of it. Have you lost any customers to Palo Alto? Are you seeing any change in competition with them? And how do you see your position relative to them? Is it an issue?

I think that the strange thing was for them to be blatant and talk about some large customer loss. We know our customers very well, so we can actually tell. That's why we strongly talk -- told you that was the wrong statement. Now to talk about prospects, something you don't know who, where, what. That were in a different thing altogether. In the large space and large enterprises, where our primary focus is, we lead with transformation. We rarely have break offs. So it is -- we win it on the architectural basis, we don't see any impact of Palo Alto or any other vendors. On the lower level, we do see vendors coming from time to time, and you will. It's a large market out there. But from competitive point of view, if we are engaged, we've been very well. So do I worry about the firewall guys giving us competition? I don't. Do we remain paranoid about making sure we keep on advancing? So the products that you're building, if you look at our portfolio, there's nothing to do with firewall. Out of the 4 product lines I talked to you about, where are they trying to compete? In the ZIA area. Okay. The rest of the stuff, it's very new and whatnot. So I think it's fine to make noise to -- because they feel threatened.

So have you seen any price pressure whatsoever from that?

Yes. We made our earnings. At announcement, we shared some numbers. Our discounts are down. Our average price is up. So we haven't really seen any pressure on pricing.

The second major issue, they made all these claims and then you had some pushouts in terms of timing, people complained and it was assumed that Palo Alto was causing that pressure, but there really wasn't any. If you look at those individual events, there wasn't any correlation between those 2, correct?

No. Absolutely not.

And so the new Chief Revenue Officer that's come in, can you talk a little bit about his background? Why this is so important? And how it's changing things?

Yes. So we have said all along, when you are really transforming security, it's a fundamental change. It has to be done differently. So we figured out several years ago, 5, 6 years ago, that our sale had to be different, had to be top-down, and that's partly because who drives transformation. Technical people don't. Security is typically bought by techies. Even CISO is not the primary driver of transformation. CISOs are risk-averse. Who drives your cloud transformation? It starts with a CIO. And when you saw the application, then who's the next party. The response time of Office 365 is slow. Network needs to be fixed. Your CTO, your head of infrastructure, head of network becomes second-party, and CISO plays the role. All 3 parties play an important role. So when you're driving it, it's driven top-down and it's really not based on technology. It's really based on how you are transforming them to cloud-enabled business. Dali comes from a similar background at his previous company, AppDynamics. If you followed it, these guys actually drove application performance monitoring not as a tool. If you contrast the 2 companies in this space, New Relic actually sold it as a tool, AppDynamics really sold it from business side of it. When he and I met, I saw someone who had a strong conviction, unlike lots and lots of sales leaders especially in that security and networking space who come from box-selling background. So we saw the right fit. He's come in. We haven't changed the core sales process that we learned and evolved over the past 5, 6 years. What we needed to do was to make sure we can scale it as we go from 100 sales reps to 300, 400 sales reps, as we go from a dozen sales leaders to several dozen sales leaders. So the biggest changes we've put in place, a very strong enablement team with this good leader there, that's number one. Number two, we have actually tightened the process -- sales process, made it more repeatable so it can be easily followed. Three, put in a lot of tools in place, whereby in the past, at the headquarters level, at the geo level, we had all the inspection available. Now we've pushed it down to every sales manager level, the first-line management. So they can run their business, their forecast and all those things in a much better way. So these changes he is putting in place are to scale the business to $1 billion and beyond.

So have you seen a response from the people in the enterprise in your company that these are going to be successfully taken up? Have we seen a change in the behavior? How is it manifesting inside the company?

So I can tell you that customer engagement is improving quite a bit. I got a call from this 1 CIO that I stay in touch with. He said, one of your salesperson called because there was a quarterly business review scheduled. He called me to say, hey, I want to have a prep call to make sure the QBR gets done right. The level of prep to do the right job, these are small incremental steps. A lot of that is happening with a lot more discipline than we did before and all that adds up to make a difference. So look, I mean, we -- with the change in CRO, we didn't really try to say we are slowing things down, we obviously had given you projections and numbers based on what we feel good about, but we remain bullish.

So is there a friction that's going to start as a result of some change in processes or alternatively fast uptake and the sales teams are excited about what they're hearing and feel like there's more support for them? Which -- is there's something that's slowing the process down initially and then it will ramp up? What's the shape of the curve?

So overall, okay, the things we're doing are benefiting the sales team and sales leadership. There always will be some number of people who don't like change. And if thing aren't a good fit, it's good to make a change there. So have there been some changes? Yes. But our turnover is in line with what has been previously. So has it really spiked it? Not really. But are the changes out there? There are people who don't like to change. I'm part of it. And that -- for them to move out is a good thing for them and good thing for us.

Can you talk a little bit about your hiring plans to fill out additional roles that might be created? Should we expect an overspend on sales and marketing to build out these capabilities?

If you look at various areas -- area of expenditure, we have a pretty well-run, well-oiled machine when it comes to development and cloud operation and the like. I tell Dali and Remo just go and spend aggressively in go-to-market because it's a big opportunity. But we are prudent. So there's only so much you can spend without kind of trying to run $2 million ads in Wall Street Journal. That's the easy way to lose -- spend money. So we have aggressive plans on sales side of it, and we're doing quite well on hiring. The hiring process, the steps and all this has improved quite a bit. We have tightened it. We have come at [ glow ] speed step-by-step process. We rolled out actually training. We trained about 110 leaders in sales in the past quarter or so on various management aspect, including a first-time how do you recruit good salespeople. When we start, we all kind of know-how to hire and all, but to bring the consistency, bring the quality up, we've gone through, we rolled out a -- it's about a 48-page booklet on a recruiting playbook for our sales leader. That's one example of the things we are doing to scale and to do a good job.

So a lot of networking companies changing the service a little bit here. A lot of network companies or as such security companies have seen a pretty big pop in their stock as a result of the recent world events. Have you seen any change in activity in terms of attacks or other challenges in the marketplace as a result of the events over the last couple of weeks?

So if you look at the number -- amount of traffic going through our cloud, about 80 billion transactions a day, we are probably the most reliable barometer for enterprise and what we're seeing -- what you see in the enterprise space, right? We typically see somewhere between 90 to 110 million, 120 million threats that we detect and block every day. Have we seen some spikes? Some. Have we seen some spikes that are totally outstanding -- kind of standing out big time? Not really.

So despite all of the publicity around Iranian attacks, it hasn't really manifested in the traffic?

There's no massive consistent stuff that's heightened up. We're seeing some spikes, but not to say it's really changing a whole lot.

Let's shift gears a little bit, talk about digital transformation. What's the rate that you're seeing at enterprises? Has there been any acceleration in that over the last 6 to 12 months? Do you expect 2020 that there will be an uptick in that activity, which typically drives your business?

Yes. So the amount of evangelism we had to do has been coming down consistently over the past 3, 4 years. Where 3, 4 years ago, we still had to convince people that you need to do local Internet breakout. That really is a lot less and less that needs to be done, okay? So now it's becoming a bigger and bigger priority for CIO. The message is getting out. So we are seeing digital transformation kind of becoming more and more mainstream, and that's helping us, and with a large customer base now, they all talk to each other. One of the things that's helping us in lead gen that I didn't expect is CXOs move very frequently. I didn't quite think -- it literally -- my numbers, my own guesstimates, typical CIO, CISO averages now 18, 20 months, say, at a given place. I personally know probably about 60, 70 C-level who have moved in the past 3, 4 years and called back and say, you guys need to help me here. So when you start doing that at the Fortune 1000 or Global 2000 level, it starts helping you quite a bit, and we are seeing a lot of traction from that area. That's an important one when you sell to large enterprises. So we are not trying to get 50,000, 60,000 customers. That's a philosophy some companies attribute to. And sometimes we ask, why isn't your customer count going up so fast? Okay? That's not our primary focus. I was talking to the CRO at Dave Schneider, good friend, kind of I use them as a sounding board to -- just because they build such an amazing business. Look at ServiceNow having done so well and I was talking with him about the customer count and he said, look, I know less than 3,000 customers, $103 billion ARR. If you have the product line, you don't need to run after 10,000, 15,000 customers. So with focus on large enterprises with such a big product portfolio to sell, I think we remain focused on the larger enterprises and also larger enterprises understand and appreciate security, the lower end don't. So in that area, we think we'll do very well. Now having said that, we will expand lower down, but primary strength is staying in the higher end, and then we'll come down naturally because that's an opportunity.

So I guess taking that to be -- we are seeing an acceleration in activity around digital transformations, and it's becoming more of an imperative.

Absolutely. Absolutely.

Let's shift a little bit. 2 areas that kind of get a lot of attention. MPLS traffic costs for Fortune -- large accounts and the concerns or the deployment of SD-WAN. We've seen significant changes in the SD-WAN market. Initially, it was a networking layer application. It's moved up to the application layer. It seems like there's some newer players that are really growing quite rapidly like us. For instance, Silver Peak are growing at 80% plus clip, whereas some of the larger players, VMwares and the Ciscos, seemed to have slowed quite sharply in that space. Can you talk about how you interface with SD-WAN? And whether that's a driver for you or a competitive to -- part of your product line?

Yes. When you want to do local Internet breakout, you need to be able to take traffic from routers in a branch and say, Internet traffic here, internal traffic here. We have been doing this transformation for 10 years. You don't have to have SD-WAN to do network transformation, 90% of customers today are actually using typical Cisco and Juniper routers. But SD-WAN, think of it, the branch tool [ out of a ] box that cloud managed that makes it easy to deploy, manage and run. So it's actually helping. The only other vendors who are preaching network transformation besides us are SD-WAN vendors. So we look at them as a good thing for us because there's someone else creating market demand out there. Now building -- so the next question ends up being, what happens of security for SD-WAN? Do you put in the box? How do you really do it in the cloud? You should look at a research note that Gartner published a few months ago. The title is, the future of network security is in the cloud. And the main story behind is a new term that Cowen call SASE, S-A-S-E, which stands for secure access service edge. It basically says that as the world evolves, there'll be local breakouts, but the branch will be thin. That means you don't put a lot of stuff in every branch. You've got hundreds of branches. How do you manage? How do you update? So the role of SD-WAN ends up being global breakout path selections and the like and cloud management. We see as very complementary stuff. Now having said that, some vendors will try to say, can I do security as well? It's a natural thing for to think about. Cisco has been trying to do umbrella and all for their Viptela and all that stuff. Most of my large customers are Cisco customers. I would -- I believe, number one, SD-WAN deployment vendor we have with Zscaler is Viptela because they are quite out there. VMware is a great partner for us with VeloCloud. Silver Peak is a pure play company. They are a great partner. We do a lot of go-to-market together. So we think it's accelerating us. There will be some vendors who will try to do security in the SD-WAN box. We think there'll be probably some of the low end. They have some room, but in the large enterprises, lots of branches, trying to do security in that little box in the branch office for X hundred dollars is not pragmatic.

So one of the other buckets that are spending -- that enterprises are dealing with is the impact of hair-pinning traffic from their branch offices, their users, their home office to their data -- private cloud data centers spending significant amounts of money on MPLS. That's a spend that most companies don't want to have to keep doing. Can you talk about the magnitude of that bucket of spending? And to what extent that funds your business?

Yes. I'll give you my stats. I use lot of my stats because I don't even know some of these third-party stats, how reliable they are. Because if I'm meeting hundreds of customers, I got data from them. It's my data, and so I believe it. In the past 3 years, the largest customer of MPLS spend I found is about $270 million per year, okay? In a Fortune 500 space, that's small.

Just for people who may not know what MPLS is, can you define that for them?

Yes. So in the old world, every branch office had to connect to the data center because your application sat in the data center. So they could come and access applications from branch office in Raleigh from Dallas from wherever. Okay? So the private network is called MPLS network, and you paid a lot of money for that because the cost was high and the service providers provided you that, okay? Now -- so how big is that cost? I found the smallest Fortune 500 Company that spent about $20 million on the high end $275 million per year. It's a lot of money. Network is the second largest spend after data center and applications.

I just thought it's in there, so how does the growth of that spend look like over time for companies that don't do a direct-to-cloud breakout? It seems like the traffic growth should be accelerating back and forth?

Exactly. Once you roll out Office 365, where all the traffic that used to sit in the data server exchange has to go in and out. So -- also, the traffic of the Internet itself is growing a lot because Internet is rich media. So if you don't do anything, you're probably going to spend 30% to 35% more money on the network because of traffic growth and more boxes. If your traffic goes up by 1/3, if you had 9 boxes for some security, now you need to buy 3 more and so on and so forth. It's an expensive process.

So when I turn on Office 365, the data I heard was that the traffic literally doubled going in and out of the data center. Is that the ballpark?

At least, actually, in some cases, more. But double is a good number.

So if I had an IT stack of Palo Alto gear and F5 gear and intrusion detection, IPS and all kinds of other good gear in that IT stack that you show in your diagram, I'm going to need to significantly increase that IT stack.

Yes. That's correct.

So if [indiscernible] going cloud direct all of that money on the $200 million worth of MPLS costs.

Exactly. Yes.

And the traffic drives up into the data center, which then means they don't spend on that increases and inefficient.

Exactly, and that becomes a big driver for Zscaler. Not only -- so user experience is one, cost saving is two, the security is three, and fourth is simplification of whole network, while convoluting the stuff, the network and everything gets complicated. So the business case for us is pretty impressive, pretty compelling, but the key is for us to -- our biggest, if I may say, challenge to growth is getting in front of the C-level and telling a story. It's not a competitive stuff that often gets asked about. And our focus is to hire the right people, train them right way to be able to have an engagement at the C-level.

So about 8 to 10 minutes left. Do we have some questions from the audience? Something you guys want to get out on the table?

Competitively, can you talk a little bit about CDNs? And how they might address some of the payment application?

Yes. If you think about CDN, vendors like Akamai, so they are kind of server-facing. Think of 2 things. There's something called sitting in front of users and other thing called sitting in front of applications, right? So with Zscaler Internet Access, we take users to their destinations, CDN kind of doesn't -- is not relevant for that. When United Airlines is protecting its 80,000 employees, they all go through Zscaler, whether they go to united.com or wherever, whatever. But when a consumer from France or wherever comes to united.com, not are you only -- they don't go through us. And they probably hit Akamai first. I'm guessing, CDN -- and then from there, they actually go and access -- the continents continuous cached and made available. We don't really -- the area we don't play in is consumer website. Okay? So that's a totally different market. We do play in when you want to access applications that are probably sitting in public cloud or your data center and you want to go and access them. ZPA is a Zero Trust Network Access mechanism, whereby you don't have users on the network. But CDN, a different space. We don't really intend to be in that space. Not really. Also, if you look out in future, the big cloud guys will give you more and more CDN capabilities without you buying CDN because they offer Office 365, Microsoft wants to make sure your e-mails are available in Chicago and Singapore, wherever, wherever you're sitting close to what needs to be done. So overall, these big guys will automatically make their applications available. So I see a trend shifting in the CDN market. Yes, please?

Jay, you mentioned that the pushback in some of the deals may be natural or may be people taking longer in terms of what extra merits of qualification what is protecting us. In the past, have you seen any change in terms of any [indiscernible] or classification of what was going on there? And then have the other companies or customers [indiscernible] the one that they can't push back or you have done a longer period of [indiscernible].

I'm going to repeat the question for anybody out in the audience. So the question is asked and from the audience. You had some pushouts. Have you seen any reduction in that? Have you seen that extend?

Yes. I think it's -- the fourth quarter, we mentioned to be totally transparent, the statement I made was, we -- there are always deals in the pipeline, everything doesn't close. And my comment was, we had more deals that didn't close that we expected to close and they kind of pushed out. So it was kind of that point in time we are tracking. That's a data point we shared with you, are we seeing consistence in getting pushed or we haven't. When we announced the Q1 numbers, we talked about it. We delivered what we expected. So things are tracking pretty much the way we have planned.

Which is back to the store kind of -- back to the store sales cycles? Or are you planning now [indiscernible] extension?

The sales cycle hasn't fundamentally changed. In some of the larger deals, it has been 6 or 12 months. On the smaller deal, it has been 3 to 6 months. It's been similar. Obviously, the pipeline has to grow and is growing to deliver bigger and bigger numbers. And our focus is to make sure we keep on building growing the pipeline and some of the secular market trends are helping that. And obviously, having a larger and better trained sales organization is helping that.

Another question? Let me open up another issue. The Microsoft guys put you on as a finalist. Can you talk a little bit about what it is you've done for Microsoft? Why they love you so much? And what they're saying about how close the enterprise user needs to be to Office 365 to get good user experience?

Yes. If you look at the core story, we had talked about, you've -- the traffic from every branch used to come to the data center. We used the center of gravity. Life was wonderful. Now Office has moved to the cloud. Rerouting, hair pinning slows things down. The biggest thing done for Microsoft is, when Zscaler gets deployed, users can start going direct, experience of Office 365 goes up significantly. Microsoft is laser-focused on user experience. And since we are instrumental in fixing it, we have done it for some of the largest companies of the globe, so we get their attention. And we're working very closely to do the next level and the next level of things, better integration, for example, to deploy Office 365. We got one click configuration that we built with Microsoft, whereby all the configuration changes can be done very easily. We got some other optimizations with Microsoft. So it's a good win-win partnership.

So you're a finalist in their top tiers...

We are the...

What -- can you give us a little bit on that?

Yes. So what's my -- Microsoft had a number of partnership program. Here, this was a thing to really select the best partners that are adding the most value to them. I mean if you think of it, this is not just office area, this is overall Microsoft. So it's exciting to be really selected and the word they used was the top 2 finalists in the area. We also have done a lot of work in the security space. So lots of good engagements with Microsoft for many areas that helps us. It also helps on the field too because if we are complementary with them, their salespeople are open to work with our salespeople. When sales starts working in the field with each other, it becomes a mutually win-win proposition.

We should probably break there since we're running into the next.

Thank you for your time. I hope the discussion was worthwhile.

Next up in this room is Limelight.