Abrupt start

financial results for the second quarter of fiscal 2019. With me on the call are Jay Chaudhry, Chairman and CEO; and Remo Canessa, CFO. By now, everyone should have access to our earnings announcement. This announcement may also be found on our website in the Investor Relations section. In addition, a supplemental financial schedule was posted to our website earlier today. Let me remind you that we’ll be making forward-looking statements during today’s discussion, including, but not limited to, the company’s anticipated future revenue, calculated billing, operating performance, gross margin, operating expenses, operating income, net income, free cash flow, dollar-based net retention rate, income taxes and earnings per share. These statements and other comments are not guarantees of future performance, but rather are subject to risk and uncertainty, some of which are beyond our control. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings with the Securities and Exchange Commission as well as in today’s earnings release. Unless otherwise noted, all numbers we talk about today will be on an adjusted non-GAAP basis. Please refer to our earnings release on the Investor Relations portion of our website for a reconciliation of GAAP to the non-GAAP financial measures. For historical periods, the GAAP to the non-GAAP reconciliations can be found in the supplemental financial information referenced a few moments ago. I would also like to inform you that we will be participating in the Piper Jaffray’s Security Symposium in Chicago on March 14th. Now, I’ll turn the call over to Jay.

Thank you, Bill and thank you everyone for joining us on our call today. I am pleased to share with you our record second quarter results. Our revenue grew 65% and calculated billings grew 74% year-over-year. In addition to our top line growth, we achieved another quarter of positive operating profit and free cash flow. Our operating margins improved 19 percentage points year-over-year to 13%. Our Q2 results demonstrate the leverage in our business model and our ability to drive growth and profitability. Having said that, we will continue to aggressively invest in our business to pursue our significant market opportunity. We are well positioned to capitalize on the megashifts in the data center and network architectures to support the secured adoption of cloud. In the cloud worlds, applications can be anywhere and devices and users can be anywhere. The notion of inside the network or outside the network is disappearing. It is no longer a simple matter of defending a network parameter which has effectively disappeared. Design for the wall which has no walls, the Zscaler clouds acts as a business policy engine deployed across more than 100 data centers to securely connect the right user to the right application; ZIA for Internet and SaaS applications and ZPA for internal applications in your data center, the public cloud or a hybrid cloud with the Zscaler security cloud there is no policy or trust assigned to the network level and therefore there is no need to maintain a complex expensive private network and stacks of appliances that is network security. Our comprehensive cloud security platform has been leveraged by our customers as they progress through various stages of their cloud adoption journey. Let me highlight several days in the quarter that illustrate the diverse used cases. A top global bank…

Thank you, Jay. As Jay mentioned, we had a very strong Q2. Revenue for the quarter was $74.3 million up 17% sequentially and 65% year-over-year. Q2 revenue was aided by $2.3 million and non-recurring revenue from the large public sector customer deploying our solution as a private cloud. This amount was mostly comprised of private cloud infrastructure as well as recognition of deferred subscription revenue from Q1 as we achieve a project milestone. From a geographic perspective for the quarter, Americas represented 53% of revenue, EMEA was 40% in APJ was 7%. Turning to calculated billings, which we define as the change in deferred revenue for the quarter, plus total revenue recognized in that quarter. Billings grew 74% year-over-year to $115 million. This quarter we benefited from a higher mix of upfront greater than one year billings including approximately $11 million from the public sector customer. As a reminder, our contract terms are typically one to three years when we primarily invoice our customers one year in advance. Excluding upfront greater than one year billings in both periods, billings would have grown over 50%. Total backlog, which represents remaining performance obligations was $461 million on January 31st, up 69% from $273 million one year ago. Our strong customer retention and ability to up sell have resulted in a consistently high dollar base net retention rate, which is 118% for the period ended January 31st. This compares to 122% a year ago, and 118% last quarter. Our increased success selling bigger deals upfront, which start with the transformation bundle and faster up sales within a year, while good for our business, can reduce our net dollar retention rate, which is calculated on a year-over-year ARR basis. Considering these factors, we feel 118% is outstanding and it will vary quarter-to-quarter. Total gross…

Thank you, Remo. We believe we’re the best choice for securing the cloud and the mobile-first world. The right architecture matters. On-prem, 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 cloud These imitators can scale, leave gap in security, are expensive and deliver a poor user experience. With multiple tailwinds such as SaaS adoption, SD-WAN and app migration to public clouds, we believe the market is coming to us. We thank you for your interest in Zscaler and look forward to reporting on our progress in the future. Operator, you may now open the call for questions.

Thank you. [Operator Instructions]. Our first question comes from Melissa Franchi with Morgan Stanley.

Great. Thank you so much for taking my question, and congrats on the quarter. So it sounds like obviously Zscaler is enabling a transformational scale particularly with ZIA, but also ZPA. Just given your result, it does seem like perhaps that transformational sale is becoming a little bit more mainstream. If that's correct, and it is becoming more mainstream What are you seeing in terms of the sales cycle or are you seeing a shortening of sales cycles as enterprises are getting more comfortable with this approach?

So thank you, Melissa. As we have said in the past, our sales cycles for smaller accounts is about three to six months, for larger is about six to 12 months. I would say, the number of deals are growing rapidly; hence our pipeline is going up. That's why we're closing more deals. But some of the transformations do take time. So it's probably moving to the lower end of the range we talked about. But I won't say it's been cut down until a few months. Yeah I would still say probably six or twelve months more on the lower side and upper side.

Our next question comes from Brad Zelnick with Credit Suisse.

Thank you so much and congrats once again, Jay, Remo and team on a phenomenal quarter. Jay, so much of a legacy approach and security is tied to infrastructure. Like you said in your prepared remarks, building moats and what we've protected things in the past like networks and endpoints, but now the world is hyper virtualized and dynamic which is really driving your success. But just in the last couple of days you've seen two major legacy security players rattling sabers as it relates to end point. And we're also seeing a battleground emerge around data analytics, and orchestration as the next platform plays. So, my question is in the past, you've talked about endpoint players being natural partners for Zscaler? Does that ever change, in and as well as for becoming the data orchestration layer, it would seem Zscaler has a natural advantage if you wanted to participate. How do you see the future shaping up in this regard, and what role might Zscaler play? And I've got a follow up for Remo.

Okay, it’s a good question. It is true that there are lots of security vendors out there and enterprises do want consolidation. But I believe real consolidation is done by building an extensible platform from a clean slate, and that's what we are doing about network security by sitting in the traffic path and consuming subsuming all that functionality. Now, having said that, I don't believe you see a God security vendor who consolidated all functionality from end point to analytics to identity and the like. So there needs to be a natural ecosystem of partners. Well you know where your strengths are. You talk about end point. Let's look at the end point. We think the core competencies and technology for end points are very different form in line traffic inspections. You've seen in the past many network security vendors have tried to sell Endpoint Protection for years. How much progress have they made? We believe in being partners with Endpoint pipe vendors. Now security analytics and orchestration, it is an interesting area. We actually partner in this area. You don't just need logs form in line traffic inspection, you need it from endpoints, identity, servers, applications like Office 365. I personally believe, that large non, network security vendors who have core competency of cloud scaling databases and machine learning will do a better job. So we are partnering with those vendors. I think we have talked to you in the past between ZIA, ZPA together eliminating entire in-line policy enforcement is about $18 billion Tam and it seems to be growing. So a long answer, but do we want to compete in the endpoint or security analytics? Not really. We have good partnerships there.

Our next question comes from Dan Ives with Wedbush Securities.

Yes. Hey hope all is well, and but just a phenomenal quarter. So my question is in terms of the transformation going on in terms of sales cycles, I mean are you are you seeing the transformation on a particular vertical or is kind of across the board in terms of this kind of acceleration that we're seeing in terms of the strategic deals.

Yes, Dan good question. So the transformation lies along the lines of which verticals are embracing cloud sooner than others. Our manufacturing sector actually embraced cloud before many others and they also needed to do local internal breakouts. So that's where we got GE and Siemens of the world out there. The companies that are a bit slow in embracing cloud, financial services were slower, but now they are picking up. Healthcare was slow, but they are picking up, so it's a bit along the vertical line, but it’s hard to meet a CIO who say’s I don’t embrace cloud. Once you embrace cloud you must transform your network and your legacy security. So we are seeing increased interest, but a little bit on the timing of the question, sorry the sales cycle. See transformation requires the CIOs, CTOs, CXOs, architects to come along together. So it does take some time. It’s not a matter of here is a cool new security box. It has better feeds and speeds and lesser place one with other. It is an architectural transformation that’s why it takes a bit longer time, and a different kind of technology.

Our next question comes from Andrew Nowinski with Piper Jaffray.

Great. Thank you, and congrats on a great quarter. So you talked about winning a deal against an on-premise Web proxy vendor and they were trying -- as customers trying to use that to support their Office 365 or a lot. I’d assume, that the scalability issues that you highlighted are likely not specific to that necessarily that customers environment meaning other potential customers deploying Office 365 would likely face similar issues. I was just wondering if you could give us your estimate of how far along we are with regard to the tailwind from the Migration Office 365?

So, very good question. You are correct, that this issue wasn't specific to this customer and the Web proxy. This is what happens when you move your exchange server to the cloud 80% of e-mail traffic and calendar traffic that used to stay within your company, only a 20% used to go out. Now all traffic, every e-mail, every calendar entry has to go out to the cloud and come back. So the amount of traffic with all the file attachments and everything grows significantly. What we are finding is once you go to [Technical difficulty] simply increase your total Internet traffic to double or triple. Now that not only creates problems for web proxies, it creates problems for firewalls and because each outlook client creates 15 to 20 persistent connections. You run out of connections, you have to operate the security equipment out there and then there are bandwidth costs and MPLS. So Office 365 doesn't just work through simple proxies in a firewall. It has a lot of IP address management issues. There's some bandwidth quantity or service issues. We have worked Microsoft over the past three years, with single click deployment and handling quality of service and the like. So we are well positioned to handle Office 365. Now, the second part of the question is how much deployment? What's going on with Office 365? Office 365 has actually been bought by probably a majority of the enterprises we deal with, and those who haven't bought, they are probably in the early stage of piloting and the like. So to give you a perspective, today about 22% of the traffic that goes through these colored cloud is Office 365 traffic. Three years ago, that number was about 2%. Okay, as it goes up, the number will keep on going up. I believe, we have probably about 25% of the Office 365 customers, off our customers on the cloud, but there's plenty of headroom for us where office becomes a catalyst for us to drive transformation.

That's great. Thanks Jay. And then one question with regard to the marquee public sector customer you referenced on the call. Do you think that when established that Zscaler somewhat the vendor of choice in the public sector that you can leverage that win across other agencies perhaps?

So it definitely does. The interesting point is, when the customer put all the requirements, we were the only vendor who could really meet the requirements. I think, the [Indiscernible] position, but still you have to go and engage in and win the deal, but very well positioned for others.

That’s great. Keep up the good work, guys.

Thank you.

The next question comes from Gray Powell with Deutsche Bank.

Great. Thanks for taking the questions and congratulations on the good results. I'm curious, I know that you're selling a much broader platform, but I love to hear what your what your view is on the overall growth of the secure web gateway market? And then, within that do you think or how fast do you think that cloud form factors are growing versus appliance form factors?

So we don't track the growth of appliance form factor. I'm not even sure there is a growth in appliance form factor. But having said that, every deal Zscaler wins, actually has some kind of web proxy out there, because it's hard to find an enterprise that doesn't have web proxy for outbound traffic. Web proxy has been the standard for user traffic going to the Internet. But as you saw in most of our deals something may start with web proxy, but it evolves to the next and the next level. Are Web proxy equal and bundle is actually our professional bundle, which is a very small number of probably 3% about 5% of the business comes from essentially a proxy placement. The remaining from business bundle which has a lot of advance functionality, including bandwidth controls type of stuff needed and transformation bundle, which obviously includes firewall and cloud -- sandbox and the like. The point I'll make is, I don't think our business is driven by replacement of a Web proxy or a firewall. Our business is driven by a CIO saying, I am embracing cloud which is driving to do network transformation which essentially requires local Internet breakouts and they must be secured and we are the purposeful solution for securing the local breakouts.

Got it. That's that's really helpful. And then one for Remo, if I may. Just kind of looking at sequential trends, if I back out the onetime item from revenue, you grew revenue by about 14% in the January quarter from the October quarter. Any expect -- and reason we should expect growth to be more like 3% to 4% sequentially in April?

Well, I mean, let's you've got our guidance. So you know we're comfortable with our guidance. And again we feel prudent with the guidance that we've given.

Okay. Thank you very much.

Great. Thank you.

Our next question comes from Gabriela Borges with Goldman Sachs.

Good evening. This is Dan Church on for Gabriela Borges. Thanks for taking my question. Yes just a start. It certainly sounds like customers are coming onto the platform at higher AOV. Maybe just, if you can walk me through some of the puts and takes of me you know what they're like what AOVs look like relative to a year ago when you IPO and what that puts and takes to upscale opportunity from there and how that's been trending?

What is an AOV?

Average Order Value, sorry or Initial Order Value.

Got it. So yes, the average sales price. Yes. It's been increasing on a quarter-over-quarter basis. It currently you know for customers of and we look at the larger customers that are greater than 3000 users. It's in the mid-300,000 range. It has gone up year-over-year and it has gone up consistently quarter-over-quarter.

Probably at the IPO time it is less than 300 KL, the same type of customer.

That's correct. At the IPO time was below 300.

Right. Thank you. I guess just as a follow up there's a handful of appliance vendors out there talking about SD-WAN maybe, how have your conversations with customers been changing and how our customers thinking about the transformative switch to Zscaler versus going with another appliance vendors and maybe some of the puts and takes? And if you think – given the ROI and lower MPLS costs, customers are willing to invest in these transformations irrespective of a more challenging macro environment.

Yes. Good question. We actually are the natural choice for the SD-WAN securing the SD-WAN. As I said in some of the earlier comments, that natural transformation is driving local Internet breakouts, and those breakouts need to be secured. SD-WAN vendors are consolidating that functionality at branch level, switching, routing functionality, but they really don't have security built in and some of them are trying and they will try to do so. But it's very hard to do top notch security. So the way I look at it, as SD-WAN market accelerates, it becomes a stronger and stronger tailwind for us. Now ZIA sales does not require SD-WAN. Traffic can be sent to Zscaler from any router. But SD-WAN makes deployment and management of the branch network easier, by doing local breakcode, it can save money but it still needs security and that's where we play in. So we believe the SD-WAN wave will keep on helping us, and also, we were working with all of them. In fact we've done integration where literally with a single click on the console configuration the traffic can be sent to us through APIs and monitoring can be done very excited and comfortable with that opportunity.

Our next question comes from Tal Liani with Bank of America.

Hey guys. This is Dan Bartlettson [ph] for Tal. Thanks for taking my questions. Kind of follow up to the last one, but I wanted to focus on pricing. And so you guys have obviously discussed a lot of the tactical advantages, but when we look at your competitors that can bundle SD-WAN meaning mainly Cisco umbrella [ph] and Ford and SD-WAN and knowing those architecture differences, do you think Zscaler would still potentially be a lower cost option there?

Do you think Zscaler will be a lower cost option there? So, first of all, even before SD-WAN in fact I was talking to you one of the Cisco executive a couple of years ago, 70% of the traffic that came to Zscaler came from Cisco devices, 70%. In fact, he smiled and said, oh, that's in line with my market share of 70% that I would present in the market are my routers. Okay. So what you are really seeing is, we have been all the customers we have out there from these big network vendors. The traffic is still coming to us. And the reason is the following; the Zscaler security is not bought as a part of the network stuff. Zscaler truly transformation sales top down driven. It creates kind of a need for securing the local breakout and when the customer selects SD-WAN and all we become a natural player. So the other point I'll mention is, in all these large enterprises, security becomes functionality, the richness, ability for policy to move around, ability for logs to come back, GDP compliance. The requirements of so high that some of the solution that are not designed for the cloud world, they just they just don't work very well. So do those things concern us? Not really.

Okay, great. Make sense. And then, really quick if we get any metrics on the breakout of percent of sales that are direct or through the channel or manage through service providers? Just trying to get a feel for where the momentum is shifting in the go-to-market strategy as well? Thanks.

Yes. So, direct is under 5%, [Indiscernible] or legacy deals we’ve got – everything is going to the channel currently for new business, and its pretty close split 50-50 between SPs and SI with 50% and 50% for the VAR channel.

If I may add, I mean, having done appliance companies before, typical appliance vendor but 85%, 90%, 95% business go through traditional VARs and SPs and SI is very small percentage because those are -- they don't like to resell boxes. In our case to have over 50% revenue comes from SP and SI is a good differentiation because those drive transformation.

And our next question comes from Alex Henderson with Needham.

Hey, guys. So price for perfection and you delivered it. Nice job.

Okay.

Again, just the housekeeping things I'd love to take care of. Can you give us some sense of what the uptake around the ZPA was in the quarter? What the mix and bundles was? And what was the increase in sales staffing percentage-wise sequentially? I think 15%, am I doing the math right?

The increase related to transformation and ZPA. What we said is that, we give metrics out on that when we had meaningful changes. All I can say is that ZPA is doing very well and business has been increasing on a quarter over quarter basis. Transformation also as companies are recognizing the need to adopt a transformational strategy, our transformation sales are also increasing. We’ll give you an update certainly at the end of our fiscal year for that. Related to the sales increase and sales mix and so forth, we increased our headcount overall in the company by approximately 100 employees in Q2, and about half of those were in sales and marketing. So we see the large market opportunity that we have in front of us and we are aggressively hiring.

I got this.

But let me add on ZPA, Alex. It’s a fastest growing product for us and very bullish on it.

I got the 50 higher, just trying to figure out what the base was compared to that 15% to 20% increase sequentially in staffing on account?

We haven’t given those metrics out related to what the increase is.

Okay, great. Thanks.

That concludes today's question-and-answer session. CEO, Jay Chaudhry at this time, I will turn the conference over back for your closing remarks.

Well, thank you all for your interest and time. Hope to see many of you at the Odyssey Conference. Otherwise we’ll talk to you at the next quarter's earnings call. Thank you again. Bye-bye.

This concludes today's call. Thank you for your participation. You may now disconnect.