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

All right. Well, welcome back, everybody. I'm Walter Pritchard, software analyst here at Citi, and happy to keep going to our next session. We have Zscaler here, 3 representatives from the company. We have Jay Chaudhry, who's the Chairman and CEO and Founder; Remo Canessa, who's the CFO; and Bill Choi, who's the Senior Vice President of Investor Relations. I was going to turn the -- turn it over here to Jay for a few minutes to give some opening comments around some slides, and then we'll go through questions. [Operator Instructions] So Jay, with that, I'll turn it over to you.

Walter, thank you. I want to set the stage with a few slides, so I'm going to share my screen. And here you go. Walter, you can see my screen?

I can. Yes.

Wonderful. So we all talk about digital transformation quite a bit. So to decipher it, we look at digital transformation in 3 steps. Everything is driven by applications. So application transformation, application modernization, moving to the cloud becomes #1 step that every CIO is driving. But the infrastructure is hub-and-spoke network and castle-and-moat security. So once they start application transformation, the network must transform, otherwise it becomes an inhibitor, which means you should be able to go direct to wherever you need to go, for example, work from home or coffee shop or a branch office. That's where direct to net comes in with better performance, better cost. But it can't be done if security is transformed because security is currently sitting in the data center, it's sitting on-prem. That's where we come in. We actually enable security transformation, which is needed to do network transformation and which enables applications transformation. So what do we do? We look at applications as destinations, as shown on this slide, upper left, external applications. If you need to go there, rather than buying, deploying boxes, you simply direct the traffic from your PC, from you branch or wherever, to 1 of the 150 Zscaler data centers where we enforce policy and making sure we block the bad and we protect the good. So the employees become safe for Internet or SaaS communication. And then there's a second part to it, how are my applications sitting internally in my data center or in a public cloud? And for that, you need a different kind of policy because you're not worried about getting infected from going to SAP, you're worried about who gets there. So for that, we've built another policy engine that made sure you securely access applications without needing VPN and a whole load of other boxes you're typically buying and deploying a data center. So between these 2 services, your any employee can work from anywhere. That's why during this COVID shutdown, customers leaned on us to help them. We become the foundation for your application, for your network and security transformation. We are not just one more appliance and one more firewall to build the moat because there's no place to be building a moat around on. So as we have looked at the security approach, we're not about securing your network and building a moat, we are essentially a Zero Trust Exchange that's sitting between the user and the application or application-to-application who says, who should connect to who. Maybe in layman's terminology, we are a highly sophisticated switchboard to connect the right parties. We have started out earlier on with user to Internet access with Zscaler Internet Access, ZIA, service that has done extremely well, our flagship product. Then we added on Zscaler Private Access to access your private internal applications in the cloud or data center using zero trust approach. And you've seen from our recent numbers, ZPA has been going pretty rapid. Then our customers came to us and said, you are sitting in a strategic position between the application and the user. And now I have a problem figuring out user performance, user experience because all the old tools are irrelevant. They're designed for the branch and the data center. So we built Zscaler Digital Experience that can tell you exactly what's going on with a user and where some of the bottlenecks are. It's not a network performance tool, it's an end to end-user experience, including endpoint, network and application. The next big frontier for us is to apply our ZPA technology, our zero trust technology for app-to-app secure communication because thousands of workloads are being launched in a public cloud. Where is the security? You can't be building firewalls and network segments around it. So we came up with app segmentation with our network segmentation. And this is where actually we got some core IP, intellectual property, through the acquisition of Edgewise Networks. And all this is built on a purpose-built platform. We are not some old firewall, a proxy, we're trying to build upon. It is actually a platform that leverages machine learning, AI and some of the very real-time technologies others don't have. So with these 4 key solutions, in 4 key areas that are very synergistic, we help customers simply for IT reduce costs. We're doing consolidation, simplification. It's not a like-for-like product replacement. We think the security market is fundamentally changing, and you can't do security the old way. So the old school castle-and-moat security, hub-and-spoke network, the customers need to change. So what are legacy vendors saying? Well, I'll take my firewall and spin it in a public cloud. You go there and go through me, I'm a cloud. Well, not quite that fast. It's like trying to build Netflix streaming using DVD players. It doesn't work. So we built a zero trust architecture to connect a known entity to known entity without having to worry about the network and network security because Internet is becoming your network, cloud is becoming your data center. So there are 2 opposing architecture. The legacy vendors do network security by securing the network. We don't secure the network. We securely connect users to applications, and that's why our legacy just can't bolt on something and do it unless you fix the architecture. And last point, we have a very thought-through ecosystem of partners. We don't believe a single vendor can do all aspects of security. And we are not just security. We are sitting in line as a policy enforcement engine that can do security, that can do data protection, that can do user performance and that can do quality of service. All those things are done what can be done by sitting in line. We have 5 key areas of partnerships. We integrate tightly with all leading identity providers. We integrate tightly with leading endpoint protection and management vendors. We enter your routers and SD-WAN. We're not required to have SD-WAN, but SD-WAN integration makes it easy for you to do the next LAN networking. We can feed locks to security operations. And we integrate tightly with cloud providers as well as SaaS applications to provide you what we call the CASB functionality. With that, I hope you got clarity on our overall positioning. Walt, back over to you.

Great. Thanks, Jay. So on -- I guess, let's follow-on on that because I think the 2 questions I get, one is a kind of a general question, but I think gets specific pretty quickly, which is around what -- you used the analogy DVD players in the cloud or DVD stacking -- DVD players to deliver Netflix. What is it from a customer perspective that they can't get from the other platforms that they could get from you? And I think one area that makes this debate tougher is you're obviously a decade or more into most of these product areas, some newer. But your product portfolio has a lot -- some customers are just looking to get started with a ZIA equivalent maybe, something that's simpler. What is it that they can get from your platform that they can't get from the others that sort of is dependent on the architectural difference?

So when a firewall company is protecting a network that's built around moat or a door, when they spin your virtual firewalls in a data center out there, they're extending your network all over. Imagine every branch office gets out and connected to the Internet. Just like VPN stretches your network over to each of the 50,000 employees you have, your attack surface becomes massive. Attack surface means those things can be seen, they can be exploited, they can be attacked. The market is moving towards zero trust architecture, which says, don't trust users being on the network because we don't control the network. So the fundamental flaw of the old school is this is my castle, this is my moat. I will extend the moat to every location and every user. Wrong approach. No wonder after spending billions of dollars on security, why are you hearing all these companies getting compromised? Because the security doesn't work. And then on top of that, you have operational issues. On top of that, you have user experience issues. That's why the biggest of the biggest company, whether it's DHL or Siemens or Shell or City of L.A., they all depend upon us. All these guys have tons of legacy firewalls and proxies out there. It'll be natural for them to add on, but they know that this just doesn't work. It's like people sort of trying to say, I can spin virtual machine in the cloud and I can be an HR system. See people trying to do what Salesforce did. It just doesn't work. History has told us that.

Got it. And then the other question I get that's architectural, I guess, and you mentioned it on -- you showed it on your second to last slide. I think we're seeing other players integrate SD-WAN with a security offering. And SD-WAN traditionally has been thought of as a networking technology and security on the security side. You've taken a different approach there. What is the -- what are the benefits that you see in terms of having the separated approach of SD-WAN and security versus this integrated approach that others are taking?

So if you think about the old approach, my network, it must be secure. If you believe in the old world, you should do both network and security because SD-WAN and security integration means the 2 together. If you come to the Zscaler world, which is a zero trust network access, which means you don't control the network because Internet has become your corporate network. You will have 5G on every device tomorrow. You'll never even connect to the corporate network. So should we depend upon the network? No. Network is an extremely important infrastructure piece. Network is the transport. Network doesn't need to be secured per se. So we love SD-WAN vendors. We have integrated with them. So they've become a mechanism to forward traffic to our cloud. But that doesn't mean that I need to own SD-WAN. We decouple application access for network access. That's the right way to do technology. If you look at Gartner's Zero Trust network access mechanism, integration on SASE is a good thing because customers' deployment becomes easy. Having the ownership, a real zero trust security company doesn't need to own SD-WAN.

Got it. Got it. Remo, just on your end, you obviously reported your Q4 results last night, and I think many tuned in to that. My virtual background died on me. Anyway, I wanted to, just on the quarter here, talk about a few things that we saw. I think we saw your overall new customer count was pretty healthy. You continue to see good up-sell. What were the sort of highlights to you, both for the quarter as well as for the year around what you reported last night?

Thanks, Walter. The key thing is we saw a significant acceleration in the second half of our year. If you take a look at our billings growth that we had in Q3 and Q4, they're both 55% each quarter. The traction that we received from our sales organization was significant. Our goal of hiring net 60% hire field quota sales reps, we met. Putting in place the leadership structure and the structure in the sales organization at an incredibly fast pace. Hiring new CRO, Dali, a year ago, basically, it is in place. Everything is in place. The foundation, everything in place, sales enablement, sales operations, systems and all those things. Acceleration of new customers. We had the highest quarter increase in new customer adds in Q4. It was 30%, 35% higher than any quarter we've had in the last 3 years. The business, all internal metrics that we're seeing, the pipeline growth, the new customer meetings, it's just the leadership, the employees. Employees are -- our sales guys getting to productivity. It's just -- it's moving quickly. And it was spurred by the COVID-19. The COVID-19 started, the question was really are we a one-trick pony related to what happened in Q3 with COVID-19, and we'd fall off. On a dollar basis, it was comparable for ZPA in Q3, Q4. It just -- all indications, we've got the product for the market, and we've got the team. We're just in a really good position. So it was a great year for Zscaler and a really strong second half and that momentum is carrying into fiscal '21. In addition, one thing we didn't really talk about, our federal business. I mean that could be -- we've made a significant investment in federal with FedRAMP certifications high for ZPA, and we're looking -- working on that for ZIA. It just puts us in a unique position that no one else has that. So we're hoping that federal is going to be a good contributor for us going forward.

Great. I guess, tieing that to some of the things you said there, Remo, to you, Jay. On the go-to-market side, I mean, I think you were very forward about -- you took your time on the CRO hire. You were without a CRO for a period of time, maybe that posed some challenges then. What is it that you've seen happen with the new CRO hire? And I guess from your perspective, how far through are sort of the evolution and changes that Dali has been putting in place around the sales organization at this point in time?

Yes. Walter, thank you. We have been pretty transparent as we went through kind of, call it, the transformation of our sales to make sure we can go from $300 million and $400 million to $1 billion and beyond. We knew exactly how to sell. We needed a proper, scalable process enablement systems in place and with a focus on top-down selling with value creation. Those are the things Dali brought to the table to scale our business. We're going to share with you our progress. We're seeing leading indication. We are putting them to the field level. So -- and in hiring great leadership team across the board in sales was important for us. I think we have made all the changes that we needed to make. And now we are at a level, we are focused on execution because you can't count on execution forever. So scaling, execution but with a proper framework in place. So that's why we're very bullish on what we've done. And the biggest thing I'm proud of is these changes set us for the next big phase of our journey, and I'm excited about it. So are there any changes left to be done? Not really. Is there ongoing refinement? Yes. Do we need to add a lot more salespeople, SEs, architects to the team? Of course, that's an ongoing work in progress.

Got it. And then another question, maybe widening out the aperture and talking longer term, Jay. I mean you have -- your customer counts are kind of in the mid-thousands. You're going to be a $700-ish million billings company in the next 12 months based on your guidance. And we think about some of these markets that you're addressing and just the -- like the network security appliance market is $7 billion, $8 billion, $10 billion, and there's markets adjacent to that. How do you think about sort of the playbook that goes beyond how many reps you hire in the next 12 months and so forth to bring quota capacity online in order to drive this to be something like the firewall companies have 100,000-plus customers? How does it get to that level from a sales and marketing perspective?

So I look at a few things. One, is the market ready and coming to us. Of course, it is. If the market isn't ready, it's hard. Number two, do you have the product portfolio to address? Are you a one-trick pony? You're seeing our portfolio expand significantly. And it's not just adding things to compete with people. We are actually disrupting thing. We're doing it in a new way. In fact, I kind of joke with my sales team and say, we have far more products than we know how to sell. But it is -- we need to learn and refine some of these things. Number three, do you have a great sales and marketing engine that makes it happen? So with all those 3 things in place, your question to customers, other vendors claiming 100,000 users, look, I look at ServiceNow and say how many customers do they have. Sitting over $4 billion in sales with a few thousand customers, resolving some real problems. We are not saying we're going to stay only on the high end. But the largest and most complex problems are with Global 2000, Global 5000, Global 10000 type of companies. That's our primary focus. I've never turned on appeal coming from a 2,000-user company or a 1,000-user company. But our biggest differentiation value-add is upstream and that's our focus. And if I only had a narrow product offering, I would be looking a lot more customers because they're only so much I can sell. But if you look at even just about 450 some of the Global 2000 companies who have bought it, I mean, 1/3 of them have bought ZPA, 2/3 still needs ZPA. None of them have bought the 2 new portfolios. We talked about user experience and some of the cloud-based workload protection. We think we got a great portfolio that's integrated, working well together. That will disrupt the market. I see -- I look at it as a pipeline, with a strong sales team that's growing rapidly, a portfolio in the pipeline. ZIA doing great and growing. ZPA is getting to a level which is becoming significant. User experience are early stage market, but ready to go market. And cloud workload in a nascent market right now but it's growing rapidly. So we see tons of revenue growth opportunities with the portfolio we have without trying to jumping into SMB market.

Got it. Great. And then, Remo, on the other end of it for you around sales and marketing investments and some of the things Jay talked about. I think -- I don't know if he mentioned it there, but I think you mentioned last night on the call that 60% increase in quota-carrying reps coming out of the year in July. And I think you've guided to something like 30% billings growth. And just help us understand sort of how you're connecting the investments that have been made in sales and marketing to the forecasting that you've put forth for the next 12 months.

Yes. Basically, we just see a huge market opportunity and everything is coming our way. So from my perspective, and when Jay and I talk, we're going to keep our foot on the gas related to investments in the company, not just sales and marketing, but R&D. We're making -- this will be a significant year of investments in our R&D organization and cloud operations. Last year, significant in sales and marking. It will still be significant in sales and marketing, but also in other areas. The comment that I made related to the 60% growth, and the question came up, what is the growth in our field quota sales reps in fiscal '21? The comment I made is the number is going to be more in fiscal '21. This is a kind of a -- let's just call it a moving target for a better analogy, and we've put the goalposts. And the goal post are basically our guidance for fiscal '21. And we're going to get to a 20%, 22% operating profitability model, which we say we're going to get into -- get to for our full year fiscal '24. Those are the goalposts. A SaaS model is most people are aware or maybe you're not, you can get to profitability very quickly, very, very quickly and positive free cash flow. And from our perspective, that's a disservice to the -- our shareholders. Is it a service to our employees. And to ourselves because of what we see as our market opportunity. So we're going to continue to put our foot on the gas. Those are the goalposts. We'll stay within those goalposts. And we're just going to -- we're going to run it as well as we possibly can. And I can tell you that everybody is aligned, the company is aligned. It is a company that I've never been associated with -- if you look at our Glassdoor ratings, goes through the roof. It is a completely aligned company. And one of the reasons for that is these slides that you see, this basically communication that Jay is doing, everybody in the company gets it. And basically, they -- we understand the significance that we have in front of us. So growth, we're going to prioritize goalpost that we have. We're going to stay within, and we're going to run it as best as we possibly can.

How do you think about, I guess, just sort of the puts and takes? You've given that metric around the quota-carrying reps. You've talked about -- you saw improving productivity in fiscal '20, given especially as you exited the year, how -- are there -- what sort of offsets are there, though, to -- if I got 60% growth in reps, I have much less than that in terms of billings. How would you explain to folks the -- what sort of keeps that billings growth at the level that you've guided and not higher given the investments you made and the capacity that it seems like you're building?

That's an interesting question. What's interesting is that if you take a look at our acceleration in the second half? Remember -- one of the comments we made, when we had the change in leadership and brought Dali on board, we had significant -- we talked about it, we had significant turnover in the RSM ranks. In that first half also, we basically restructured the entire leadership team completely and related to people who are on board that we promoted as well as people we brought in from the outside. We've put the sales enablement and sales operations teams in place very, very quickly. So now what you've got basically, you've got your basically tenured sales reps was low in the second half because you made all those changes in the first half. And even with the tenured sales reps low in the second half, we grew our billings and reaccelerated, so 55% growth each quarter. That's another metric that we looked at related to what is the -- what are our tenured sales reps doing? And it's all positive. And so from our perspective, also looking into fiscal '21, it's the model that we put in place, certainly seems like it's working. And so we're going to keep investing. The outlook for us going into '21, again, based on all these metrics, they're very, very positive. That's what makes us bullish about what we're doing with our investments. And again, it all comes down to basically getting market share. It all comes down to building that ARR. And it all comes down to selling the value proposition on a platform basis and the communication of what we have. And the best way to do that is really for your sales and marketing efforts as well as building the product portfolios, as Jay described.

Got it. Yes. It makes sense. Jay, on -- sort of high level on the demand picture, what do you see in terms of customer budget coming to you that might have been allocated somewhere else in the past, appliance budget, remote access budget versus budget that's more tied to transformational initiatives and it would be harder to tie back to displacement of a prior technology? And especially, what's been the trend here as we've been in this COVID environment for the last several months?

So pre COVID, our growth was driven by digital transformation. Customers wanted to move away from the typical old school hub-and-spoke and all that castle-moat security. COVID simply accelerated it because people had to work from wherever. So there are 2 approaches. One is that let's go with an approach like Zscaler. Obviously, our customer base of ZIA took advantage of that quite a bit and we got a bunch of new customers as well. But a large number of customers who did not know Zscaler, we're still a small company, relatively speaking. They still bought a lots of legacy boxes over the short term. But what the customers, what the CIOs learned was that in this new world, they actually don't need to spend a lot of time on the legacy network. In fact, there's an interesting discussion with a CIO of 100,000-person company. And once he moved to this new company, he called me because he worked with Zscaler before, he rolled out Zscaler before. And he said, I need to get Zscaler rolled out pretty quickly. Now we are working that account for several months and a little bogged down with service provider network, managed network, this and that. And I asked him, so how are you going to change that because things are kind of sitting slowly moving. The network transformation takes time. He said that if there's a good thing about COVID, he said, "My employees are working at home. I don't need to touch the network. I don't need the network anymore." They're going to download your lightweight agent to 100,000 users, deploy it, roll it out, it's done. Guess what? The deal happened in weeks. Our rollout happened in a few weeks. This is what can be done without the network. And CIOs are learning and finding that, wow, I am not overly dependent for the network the way I used to think. Now they're becoming a more forward thinker in making a change. So it is accelerating transformation and combined with a zero trust momentum that's picking up, customer getting educated on it. So we are getting budget for actually consolidation, simplification, transformation and cost savings at the same time. Our value proposition is so compelling that if you really invested $1 million per year on Zscaler, you could be saving literally $8 million, $10 million, $15 million per year. We just -- our challenge has been getting to the C-level and telling the story. And now as the brand has gotten bigger, as more and more C-level people are out there moving around because CIOs, CTOs, CISOs change are frequent, right? What's the average job span? About a couple of years. And they go out there, they really call us and that customer satisfaction with our Net Promoter Score being 76 is helping us quite a bit. But net-net, the budget is driven by saving lots of money that's being spent on legacy technologies that's not really helping the post-cloud and post-mobile world.

Got it. Got it. And on -- I think you mentioned, Jay, in your answer to the prior question on the Global 2000, about a 1/3 of them have ZPA and 2/3 don't have it. It would seem the solution for -- the substitute for ZPA is still very legacy technology, and yet many of these companies have moved forward with you buying a ZIA. Can you talk about what the -- are there additional barriers to customers adopting ZPA once they've adopted ZIA? Is it just a matter of time? How do you think about -- not necessarily where that percentage goes and what time frame, but what's holding it back at this point?

It's just a matter of time. They know really, there's nothing holding them from a technology point of view. It's essentially telling the story. Sometimes large company, there are different decision-makers. Of course, everything comes under the CIO level. Sometimes ZIA is -- if ZIA is bought by the security team and ZPA has to be bought with the networking team, we just need to reach out to them and tell the story. But the message of integrated ZIA, ZPA together, where you can work anywhere without turning on VPN, which most users dislike, without the security risks of ZPA because it is an attack surface, we think almost all of our customers will embrace ZPA. It's a matter of time.

Got it. And how do you think about, I guess, more aggressively bundling ZPA versus sort of letting it sell at a higher price on its own value and that as a go-to-market? And just generally, I mean, you have a lot of products now. And so you have this transformational bundle, which, to some degree, has seen good demand. But generally, how do you think about like putting this all together into a bundle?