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

All right. We will kick it off. Good morning, and thanks for joining us at the Zscaler session at the Goldman Sachs conference today. I'm Gabriela Borges, I cover security here at Goldman. Delighted to have on stage with me, Jay Chaudhry, CEO and Co-founder; and Remo Canessa, CFO. Thank you for your time. Good morning.

Thank you.

Thank you.

Remo and Jay, I wanted to start a little bit on the medium-term outlook. And I figured I'd ask the question to first start with, how does your planning process go this year for FY '25? What was some of the debates that were top of mind for the leadership team? And then we can slide into some of the more detailed questions on guidance.

Yes. That's a great question. Regarding basically FY '25, what you need to consider is that our billings, there's really 3 parts to them. It's the new and upsell, it's the renewals and also the contracted scheduled billings. If you listened to our earnings call, what we indicated is that the first half growth in billings was going to be 13% and acceleration in the back half of 23%. Then the question comes down to, well, that seems like it's back half loaded and what created that. So the scheduled billings is a significant piece of our billings. And when you think about it, what we do is we do 3-year contracts and then we bill annually. So in fiscal '23 and fiscal '24, primarily fiscal '23, with the global macro economic impacts, we were challenged. And with those challenging years, in first half of fiscal '23 and '24, the residual impact is those scheduled billings, which are contracted coming through in fiscal -- first half of fiscal '25, the growth rate was 7%. That increases to 23% in the second half. So that's what's creating the primary difference basically in the billings growth of the first half, which I mentioned, 13% in the back half of 23%. When you take a look at the underlying business, it's strong. So the underlying business related to the growth that we're seeing in new and upsell and renewals is growing in the high-teens percent-type range, maybe 20% in the first half and above 20% in the second half. In addition, we hired a new Chief Revenue Officer, and we talked about higher attrition in Q3 '24. So we called that out and we expect it. In the fourth quarter also, we indicated that our attrition would stabilize, which it did, but it's still high. So what -- it takes a year for new sales reps to get to full quota. So that impact also is coming through in the first half. And in the second half, as these sales reps become more productive, then that's also helping basically the second half growth. But really, the primary reason is the scheduled billings. So from my perspective, when I take a look at where we are today versus where we were a year ago with the leadership changes that we've made in our go-to-market, both the CRO and CMO, we're in a very, very much, much better place, in a strong position to really grow our company and to basically do very well.

Remo, the way that you were describing the year 2 and year 3 of the contracted billings sounds very mechanical.

Yes.

Where do you think the swing factors or the risk factors are when you look at the new logos piece of the business and the upsell piece of business?

Yes. I mean, from -- one of the things that we're seeing is we're seeing basically that the sales productivity is increase -- will increase next year with the type of salesperson that we're getting. From my view, is that we're just in a great, great position to do well.

I think they've taken into account all the, what you call, risk factors. What's our risk? First of all, we have a leadership team that has scaled the business to billions of dollars. So when you have someone proven who comes to say, I take Zscaler to the next level, the account-based sales-led, mush, mush, it's a wonderful thing. These are proven leaders. In fact, our pipeline is strong, our close rate is good, and we have been prudent on guidance. If you look at our guidance for fiscal '25, it factors some of that sales ramp timing. And I think we're well positioned. Beyond '25, '26, '27, the positioning is good. Our product portfolio is very strong, and we are one of the very few companies that can do actual cost takeout by removing a bunch of products, firewalls, VPN and the like to show real savings. So I'm pretty pleased with where we're headed.

So Jay and Remo, together what you're alluding to is the secular growth drivers of the business. Remo, you also mentioned the weakness in 1H '23 that's impacting some of the unique seasonality of this year. How much are you still seeing a potential downdraft from contracts that were signed in the 2020, '21 time frame where our customers were expecting perhaps to increase head count, when in reality perhaps it comes to be on the pressure? Talk about how that's impacting NRR? And if that has any factor on how you've been [ turning ] your renewal business.

Yes. When you take a look at the amount of users that we have, it's increasing. It increased double-digit year-over-year. So even with downdraft related to overall economy with -- basically with head count reductions and so forth, we're not seeing it. So for us, basically, I think we indicated we have 47 million users on our platform. That is a double-digit growth on a year-over-year basis. Regarding going forward, I would expect the comps to get easier related to the contracted billings. Our gross retention rate is in the high 90% range. So you take all these factors into consideration basically -- like Jay mentioned, if you look at our history, we've been prudent, basically, with our projections. And we're prudent also going forward, taking into account, like I said, the leadership changes, sales productivity, close rates, the emerging products, existing products, all those factors come into play. But again, the underlying point that I want to make is that the business is strong. The underlying point I want to make is that basically, it's a huge opportunity. But the market size that we've basically looked at, it's a $96 billion market SAM. I believe it's much bigger than that. And if you take a look at Zscaler, this past year, we're about $2.1 billion basically in revenue, going up to our projections for fiscal '25. There is no other company better positioned than Zscaler. We are seeing -- going through 500 billion transactions per day. That is an order of magnitude of -- any other security vendor can see that amount basically of traffic. When we went public back in -- I believe it was fiscal '20...

'18.

'18. '18, yes, 30 billion transactions. We're now 500 billion transactions. Our gross margin, which talks -- if you take a look at the strength of the platform, our gross margins were 80% 7 years ago. They're still 80% currently.

Yes. We can scale and keep slow margins at that level. I mean, just to highlight that point, if you don't mind. For a provider like Zscaler, that takes so much traffic and still do it at 80% gross margin is something very, very remarkable. In fact, anyone who comes from behind try to do this kind of stuff, I bet they'll struggle to get to 60% or 70% gross margins, okay, because this is the power of the architecture we've built. Some of the vendors who claim to do lots of revenue in this area, have they ever talked about number of transactions they do? Why haven't? Is the traffic actually flowing? Or is it shelved here? All those things need to be kept in mind. The other, I think, thing you probably implied in your question we should answer is, some of the deals got done during COVID. That's the question I'd add into. So we don't like Zoom and say, hey, this is needed and after COVID, it goes away. You need to have secure access to applications, whether you're sitting at home or in the office or wherever they are. So the notion that some of the deals got done will go away because people are back to the office, not true. As part of that would have been a question about VPN versus APA. APA has not been bought for all users all the time, but with Zero Trust for office as well, that number is becoming the same. We are seeing that every customer on Zscaler, it's a matter of time we'll have ZIS, ZPA and ZDX for all users. And our number one selling bundled these days is Zscaler for Users, which sells all 3 of those things. So I think we're pretty well positioned. The issue that COVID contracts will go will have an impact, not really. There's a second factor that you may be thinking about as some of the companies have gone on reduction of workforce. How is that impacting us? If our business was really heavily focused on Silicon Valley high-tech start-up companies who went through a lot of blood bath, then you'll see that impact. Most of our business is in the Fortune 500 global [ tools and land ]. There have been some reductions there, but they're not massive. And if there's some, our platform is so big, we're able to say, okay, if you moved 3,000 people out, I can apply that cost to give you product A or product B. That stuff has worked. And also, we have been doing a lot of upsell. In Q4, Remo, was -- our fiscal '24, what was upsell?

It was 68%.

68%. There's so much to sell. We're actually not just making up for any loss because of people but able to add more and more products that help eliminate lots of point products. The question -- the point I want to emphasize in this talk is, in today's world, when macro is still tight, deal scrutiny is still tight. Cyber has budgets. It's rare to say cyber initiative doesn't have a budget. Now they need to prioritize with cyber. And zero trust architecture ends up being very high because it's number one thing that reduces the risk of [ ransomware ] attacks because [ ransomware ] attacks takes advantage of lateral type moment. We eliminate lateral movement, which is enabled by firewalls and VPN. Then the second part ends up being, okay, how do you close the deal? There is scrutiny out there. We are able to show that. I can -- you're paying $20 million for firewalls and VPNs and stuff. In 2 years, I can bring it down to $8 million to $10 million. Okay. Tangible savings because firewalls need to go away, they're going away. So we can play that angle very well. That's what helps us do the deal. People who talk about my platform and all that bundling, these are firewall vendors who need to protect legacy firewall. How can you save money when your core product is at risk? Disruptors can do that, incumbents can't. Did I make sense?

Absolutely. The one medium-term question I want to ask here, do you want to follow up on competition and some of the other points you're making. So as analysts, most of us will run multiyear models 2 to 3 years out. We have the fiscal year '25 guidance. Remo, I believe you've commented that FY '26 comps will be there. You've also got a go-to-market push towards cross-sell into the enterprise, which makes your business more seasonally back-half weighted. So Remo, what advice would you give us as we think about the 3-year profile of the company? How do we reconcile the structural element here, which is more enterprise with some of the unique idiosyncrasies of '25?

Yes. Well, definitely for fiscal '25, clearly more back-end loaded -- or back-end weighted. Going forward, it's hard to say I would say slightly, it's not going to be significant, but slightly more back-half weighted would be my general direction.

Absolutely. Jay, let's come back to the comments on competition. And you made a comment last week on how one of the bigger disconnects between the investor community and the conversations that you have internally with customers is the level of competition. So help us understand from the outside in, what are some of the questions we should be pushing your competitors on [ to throw ] out? What's real? And how do you think about where there could be risk in the competitive environment over the medium term?

Yes. I think about it quite often. There's so many questions that keep on coming on competition. Why is that? Because I don't see that when I talk to customers. That's because perhaps you guys are talking to all the vendors is all you talk to. If you talk to more customers, you will have a very different perspective on it, okay? Now when hasn't been there competition for us? During the IPO time frame, Blue Coat/Symantec was dominant player. Just to remind you, about 6, 7 years ago, Blue Coat had 85% of Fortune 500 companies as their customer, okay? They're dominant. McAfee, Websense, Cisco, they all competed with us for the ZIA business, okay? And then for ZPA, all these VPN vendors, Juniper, Citrix, Cisco, AnyConnect, they're all there. They're all kind of gone by the wayside now lately. And they used to be a lot of CASB vendors trying to come in, recompete with Zscaler, it's all gone, it's sold out. One of them is still trying to figure out who to get sold to. The final vendors are going to say, hey, I need to do something. Why? Because firewalls are going away. They will go, it's a matter of time. All of you could say, well, they're still around. They are. I think inertia is powerful. It takes some time. But the world is moving to a level where every branch office is becoming like Starbucks. They're just an island, just like your home, there's no firewall that will be needed. And even the SD-WAN thing is bound to go over, it's a matter of time. Just like we have done innovations, you'll see more or more stuff happening in that space. So the move by firewall guys is largely a defensive move, trying to build -- claim Zero Trust on top of firewalls. Zero Trust was created because firewalls, VPNs created the issue. Unless you rebuild it as a clean slate, you can't really do Zero Trust. But obviously, vendors who are finding themselves at risk, trying to make all those kind of claims out there. And the large end of the market, customers understand it very well. That's why we are in a very good position. We don't really get into a lot of head-on-head competition. We go in, we show the case. We do have an architectural win. Yes, some of these firewall vendors have been talking about this story for 5, 6 years. The large customer all heard the story. They understand it. From my point of view, in the large end of the market, the competition has become easier because it's clarity. Zscaler has a big brand now. It's understood. It's almost every CIO, CISO understand what Zscaler has done. We have a good reputation out there. In fact, I was sharing recently that 1 week and a few months ago, I was looking at my travel and my meetings, who I met. And I said, "huh, I met this person, oh, here, here." Then I found that 280 CXO-type from Fortune 1000 companies had bought Zscaler twice. That's my own data, my meetings based on people I know. About 84 had bought Zscaler 3 times and 45 had bought Zscaler 4 times, okay? And I'm sure this number is growing. I mean, last year, the number of Global 2000 logos we added was twice as compared to '23. So I think we are in a wonderful position. If you forgot the mechanical part of contractor billing, and if you factor that, when you go through proactive change, you need to give some room for the new leadership to come. But these changes should be done proactively from time to time. At the time of IPO, I knew I needed to move to the next level of leadership and changes. When -- where we are doing our $300 million, $350 million or so at that time, and we proactively brought on new leadership to make our sales process from unstructured to more structured, more methodical, more cadence. It gave us a good run, took us to past $2 billion. Now this new plan is to take it from $2 billion to $5 billion to $10 billion. It's a more meaningful plan. So '25, transition, I'm personally here to grow at a much faster pace because that's what Mike is here for. That's why we are here for. The opportunity is there, platform is there. and we're going through the right set of changes and transitions.

Jay, one of the comments you made there is competition, in your opinion, has actually gone down at the large enterprise. And I think you've continually been saying for some quarters now that your focus is on cross-sell at the large enterprise rather than competing at the low end. How do you think from a go-to-market perspective about the demarcation between large and medium and small, where it makes sense for you to compete versus where it doesn't?

Right. So we do, if you sell, yes, our biggest focus majors, then we've got large enterprises, the low end of the market. We don't want to say no to any purchase orders, okay? We do have some coverage on the lower end, but there's so many accounts on the lower end, our coverage is limited. It is contributing meaningful numbers to us. But if you look at -- we are -- it's 80-20 rule. 80% of that ARR comes from 20% of the customers, which is kind of a typical part of life. So we do have coverage in the lower end. On the lower end, we do see a whole range of people out there. Often, I've been seeing Cisco bundling network and security at the low end for a long time. Every viral vendor is trying to do the same thing as well. Once we engage, we show that the savings simplification, we do win. Our win rate on the low end is pretty good as well. But our coverage in the low end is not very good. Our coverage in the high end is very good. If you look at Global 2,000 or even Global 5,000 or 6,000 companies, we have very good coverage.

You've consistently talked in the last few minutes about the upgraded go-to-market. Tell us a little bit about the signals that you were looking at in the business that said to you, okay, now is the time to focus on Mike Rich and the upgraded talent and the go-to-market. And maybe share with us some of the highlights from the sales kickoff this year as you think about priority for FY '25.

Yes. So the -- sorry, the first part was signal for what?

I had signals on why now to upgrade the market?

Sales organization. Yes. So this was a thought-through plan. In fact, about 18, 20 months ago, I'm sitting, presenting the Board and telling them to look, we're doing all these great deals. And my presentation was about 20%, 25% of my people know how to do these big account-focused deals. A lot of them are more opportunity-centric, a little bit less experienced salespeople. And to a discussion that maybe it's time for us to proactively look for how do we take to the model. You can try to do it incrementally or you bring someone who's been there, who has done it, who has a proven track record. And there's so much similarity between us and ServiceNow, both our platforms both sell at CIO, CISO level. And both are account-focused upsell kind of stuff. So that's where the decision was. We need to bring a good leader like Mike from ServiceNow. It took me many months to convince him to leave ServiceNow and come to us. We say, you could build a new legacy and far more impactful. So we knew this change. I needed to take rather than 20%, 25% people doing account-focused large accounts, how do we have 80%, 90% people being able to do that. So a process had -- it wasn't a new thing. It worked in Zscaler, we need to scale it. So bringing someone who had brought in here is a good thing. These changes, I call them step-function changes. You don't do them every year. Every year, you tweak things. And every 5, 6 years, you look and say, I've gone x-fold more. Now how do I fundamentally look at the next level of changes? So it is fairly obvious to us the change that we made. The good thing is we're able to move through it fairly quickly because Mike's leaders, his leaders and his next leaders are all in place. I was surprised how quickly sales rep got hired. Yes, we had high attrition. A bunch of it made it easier for us because we needed to move some of them out because everyone wasn't accounts focus-centric stuff. And I thought we'll take x months to do it with lots of recruiters. But our leaders were so good. All these -- most of these leaders -- salespeople got handpicked. So we've done very strong hiring in the past 4, 5, 6 months. We'll still keep on hiring at a good pace. But we are giving some time for people to get ready. What are the signals that results we are seeing? Okay. In fact, even the short amount of time, Remo, you talked about the quality of our pipeline, as we called it has gone well. The close rate overall has gone well, I call it conversion, so to speak. So these are good indicators. I think we know what to look for. I'm very comfortable about the progress we're making, I would rather say. The things are moved ahead of the pace, I thought it will move. And SKO, sorry, [indiscernible] 3,000 people in Vegas. Our customers sharing some of the fascinating stories of how they had done transformation, save money, improve cyber posture and simply for all the stuff. It's very exciting. We have channel partners who joined us there as well. So my team is excited. We are excited, and we're focused on execution.

Yes. My comment also looking around, I'm probably the oldest person in this room. So -- and from my perspective, when you've got a great product and you've got a huge market opportunity, it really comes down to the people that you hire, which are really going to take the company to that next level. What are the things that I see. And one of the comments I made at the very beginning, is we're in a much better place now than we were last year. Why am I making that comment? So when Mike came on board within his basically first 3 or 4 months, maybe 5 months, he had his entire leadership, direct reports in place. Also, he had the next line in place also. When you take a look at when you want your company to transition from a $2 billion company to a $5 billion and $10 billion company, you need to go to a place where someone's been successful at another company at that size. ServiceNow, it's in that $10 billion type range. Mike ran Americas, 70% of their business came from Americas. And then what you look at also, when you look at the leadership, where are they coming from? Are they coming through recruiters. I can tell you if you go through recruiters, best case, 25% chance it's going to work. Maybe 50% between -- it's just not because you don't know. But when you basically put your leadership in place and people are following you, that speaks volumes basically related to the foundation that we're creating. And it's just -- it feels good. That's what I'm trying to say. It feels good. So now what it comes down to, it's execution. It's execution on our part as a management team to take the company to the next level. From a product platform perspective, no comparison to any company out there. People will tell you that Zscaler is the top -- well, maybe won't tell you. Our competition won't tell you, but we are. We're the top cloud security company in the world with all the transactions going deep into the packets with basically encrypted traffic, proxy-based firewall, it just doesn't exist. So really, people make the difference. And with our go-to-market changes we made, I think we're in a great position.

There's a number of pieces to the platform that you've touched on. Remo, you just touched on cloud, DLP certainly and the VPN replacement cycle as well. Jay, you mentioned just now having relationships at the top of the organization with your customers. And certainly, there's so much of the network transformation motion that happens with Zscaler. You have to have [ a guy in ] at the top of the house. Do you feel like you need to expand the number of senior sponsors that you have with the customers in order to successfully cross-sell? And when you look at the deals that you talked about on the earnings call, where you have expanded the platform, what do those customers have in common? And what does that cohort have in common such that you can move -- everyone else to look more like the customers that buy more?

Right. When you say sponsor, you mean from the customer side?

Correct.

There are 3 primary leaders we deal with. CIO, who is looking at overall application transformation. When you do application transformation or cloud, you need to change the network because the old network doesn't work. So you end up dealing with that -- he or she, the CR ends up bringing Head of Network and Infrastructure to the table. Then security also changes because you're no longer having all this castle and moat security. So Head of Security comes. Those are the 3 primary parties we deal with. Our deal could start from CISO network or CIO side. We generally end up creating 1 champion and the 2 other end up coming along with that. But that -- it's not a long-winded shop. When you -- there may be many security products underneath, but they're all under the CISO. Now CISO may say, I have one leader for data protection. I have a second leader for cyber protection. But one should at the CISO level, the job gets a lot easier.

That makes sense. And particularly on some of the newer products like cloud and DLP, so many upgrades have come down the road map with DLP just in the last 9 months. Do you still have to fight the same architectural fights that you have to fight back in the network security side with cloud and DLP? Or are those conversations getting easier because customers are already bought into process architecture and DLP superiority?

For data protection, conversation is getting a lot easier. Think of it this way. Everything bad comes from the Internet, everything good leads to the Internet. When ZI is deployed, first thing customer did was cyber protection. They want to make sure they don't get compromised. And DLP is a little bit more complex to deploy. So a lot of ZIA deployments happen without data DLP or lightweight DLP. Now with ransomware, data protection is becoming a big issue. When traffic is already going through us, we are opening it inspecting for malware. We can also inspect it for data loss. So it's natural for every Zscaler customer to buy Zscaler data protection. There's no really fight to say, let's do an RFP for DLP again somewhere else. In our customer base, we have a natural party to get there. So it's a big upsell opportunity now. There's in-line DLP, but now DLP is expanding a lot. There's so much data sitting in SaaS applications. That's where data and protection needs to be in cloud, on the endpoint, e-mail. All of the stuff is being done. So our portfolio has become very strong. We -- it's one of the fastest-growing solution for us. And we have a very, very good team driving it.

And Remo, the associated pricing and margin question for you, is how do you think about making it easy for customers to buy more, whether that's bundling, discounting, enterprise license agreements? What strategies work best with the Zscaler platform? And then the margin part of the story is -- part of the question is, what does incremental margins look like on the cross-sell?

Yes. I mean -- so again, we're at 80% gross margin. So -- and the ROI that we give to our customers is significant. When you take a look at the security landscape, I'm not sure how many companies are out there but thousands of companies. What you're going to see over time, is you're going to see more of a consolidation. Security is not getting any simpler. It is getting more complex. So the advantage of Zscaler is that we take basically a lot of these point-type products, put them into our portfolio and platform, which gives significant ROI to our customers. And from my perspective, long range you can think of Zscaler. Again, we target about -- we target 80% gross margin. I don't think you're going to really see anything different from that going forward. From my perspective also, if you take a look at our bottom line operating profitability, I mean, we were -- we indicated that our operating profitability target at the time of our public offering was 20% to 22%. This past year, we're at 20.4%. In Q4, we're at 21.5%. I'm not concerned basically about operating profitability. If you have 80% gross margin, the flexibility that you have in your model to make the right decisions for the company to grow, my view is, as I talked about, it's a $96 billion SAM, serviceable addressable market. We're at the early stages. I feel we have an unfair advantage with Zscaler with our platform. We will continue to invest in growth of the company. We'll be mindful, basically, of our bottom line operating profitability. Our free cash flow margin this past year was 27%. We indicated our free cash flow margin for fiscal '25 being 23.5% to 24%. We're in a unique position. So we're going to keep on investing. We're going to give ourselves the best opportunity to dominate this market. And I think there's no other company better positioned than Zscaler to do that.

And any comments on the packaging of new products to make it easier for customer spend?

So we are. We run -- we do keep on refining packaging, but we have created new bundles. For example, data protection has 6 products. So here is the data protection bundle, you have multiple products for buying multiple together this pricing incentive but ability to switch within data protection to product A, B or C, all those things are being built in. Risk management is packaged on its own. Zero-Trust cloud branch and all is packaged on its own. So it's evolving. It's getting -- platform is getting bigger, but we are packaging it across solutions. We have 4 main solutions, just to refresh your memory, cyber protection, data protection, Zero Trust branch and cloud, and risk management. And these 4 solutions apply to 4 entities, the most important point. Our so-called competitors are trying to do this protection for employees that we've done for a long time. In addition to Zscaler for Users, for employees, now we have Zscaler for workloads, full protection, a brand-new area Zscaler for ITOT, securing IoT OT, number three. And number four, Zscaler for your customer suppliers and partners becoming more and more important, everyone is connected with everything else. And the risk of third-party supply side is becoming big.

Excellent. We'll leave it there. Please join me in thanking Jay and Remo for their time. Thank you, gentleman.

Thank you, Gabriela.

Thank you.