Zscaler, Inc. Q4 FY2022 Earnings Call

Welcome to the Zscaler Fourth Quarter and Fiscal Year-End Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentations, there will be a question-and-answer session. As a reminder, today's conference call is being recorded. I will now turn the conference over to your host, Mr. Bill Choi, Senior Vice President of Investor Relations and Strategic Finance. Sir, you may begin.

Good afternoon, everyone, and welcome to the Zscaler fiscal fourth quarter and full year 2022 earnings conference call. On the call with me today are Jay Chaudhry, Chairman and CEO; and Remo Canessa, CFO. Please note that we have posted our earnings release and a supplemental financial schedule to our Investor Relations website. Unless otherwise noted, all numbers we talk about today will be on an adjusted non-GAAP basis. You will find a reconciliation of GAAP to the non-GAAP financial measures in our earnings release. I'd like to remind you that today's discussion will contain forward-looking statements, including, but not limited to, the Company's anticipated future revenue, calculated billings, operating performance, gross margin, operating expenses, operating income, net income, free cash flow, dollar-based net retention rate, future hiring decisions, remaining performance obligations, income taxes, earnings per share, our objectives and outlook, our customer response to our products and our market share and market opportunity. These statements and other comments are not guarantees of future performance but rather are subject to risks and uncertainties, some of which are beyond our control. 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, please see our filings with the SEC as well as in today's earnings release. I would also like to inform you that we'll be attending the following upcoming events in September: Goldman Sachs Communacopia and Technology Conference on September 13th, Mizuho Software Summit on September 28th. Now, I'll turn the call over to Jay.

Thank you, Bill. I am very pleased to share our strong Q4 results to end another outstanding year. In the quarter, we delivered 61% revenue growth and 57% billings growth, as customers continued to embrace our Zero Trust Exchange platform to secure their digital transformation. We are delivering this strong growth while generating strong profitability. Our free cash flow margin was 24%, which was a record for Q4. While many Public SaaS companies are happy to get to Rule-of-40, we surpassed the Rule-of-80 for the quarter and for the full year. These outstanding results reflect the strong underlying unit economics of our business that has a high-90% gross retention rate and over 80% gross margins. This is possible because of our differentiated service and purpose-built, multi-tenant cloud platform that scales efficiently. For the full year, our revenue grew 62% to $1.1 billion and billings grew 59% to $1.5 billion. We are seeing revenue growth across all products, industry verticals, market segments, and geographies. Our platform is securing over 34 million users for over 6,700 customers, and we’re making great progress towards our goal of protecting 200 million users. To reach our goal, we will continue to invest aggressively in growing our business and driving innovation while focusing on operational efficiencies to drive the bottom line. Let me share with you some of my observations and how we plan to manage through the uncertain macro environment in fiscal ‘23. First, my conversations with hundreds of IT executives confirm that cybersecurity remains the number one IT priority and a top Board level issue. Independent CIO surveys confirm Zero Trust security and SASE will continue to be a top priority. Zscaler’s proxy-based cloud platform is the best solution for tackling sophisticated cybersecurity challenges. In addition, the rise of hybrid work and the need for secure digital transformation are driving the demand for Zscaler. We believe periods of macro uncertainty can accelerate adoption of disruptive technologies like ours, which offer better security and user experience while substantially reducing cost and IT complexity. As the pioneer and recognized leader in Security Service Edge, we are well positioned to capture this ongoing market shift towards Zero Trust. Second, we address a $72 billion market, with significant new customer and upsell opportunities. Our superior architecture and proven experience delivering measurable outcomes at the CXO level elevate us above the competitive noise. We drove 62% year-over-year growth in customers with greater than $1 million in ARR, ending with over 320 of these customers, including over 20 customers exceeding $5 million in ARR. We have a blueprint for delivering great value, which drives strong upsell for us. Approximately 60% of our new business comes from existing customers, and our net retention rate has again exceeded 125%, now for seven consecutive quarters. Happy customers buy more, and our net promoter score continues to exceed 70, which is more than twice the average NPS for SaaS companies. In addition, we expect our deep and wide platform together with our enviable customer base of large enterprises to continue to drive upsells. As we have indicated before, we have a sixfold upsell opportunity with our existing customers just for our core ZIA and ZPA product pillars. Lastly, our consultative sales process plays a major role in our success and enables us to maintain a high level of engagement with our customers, especially at the C-level. As part of this process, we produce CFO-ready business cases with ROI and payback periods calculated in collaboration with our customers. In Q4, as we saw more deals getting scrutinized, we delivered more of these business value assessments, which helped us close many large multi-year, multi-product pillar deals. We believe our adaptive sales process makes us resilient to the changing business environment and will continue to drive our business. Looking forward, I am excited about fiscal ‘23 as we continue to win opportunities with new and existing customers. Increasingly, customers are buying ZIA, ZPA, and ZDX together to deliver a complete Zero Trust solution for users. This accelerates our customers’ transformation journey and makes us a critical partner for them. Let me discuss two such deals in Q4. In a new logo win, a Fortune 50 pharmaceutical company purchased ZIA, ZPA, and ZDX for all 145,000 employees. This deal started with a regional need to improve security without compromising user experience in China. With multiple data centers in China covering various regions with premium connectivity options, Zscaler has superior zero trust access for multinationals out of China. Next, this customer engaged us for global M&A IT integration and hybrid work use cases. Impressed with these results, they accelerated their company-wide zero trust adoption with us. They disqualified their incumbent next-gen firewall vendor who had no referenceable customer at the required scale for its SASE cloud VPN product. This customer understands that a VPN, either as an appliance or hosted in the cloud under any name, is not zero trust and is the biggest security risk. This customer also purchased Zscaler for Workloads for 10,000 workloads to enable multi-cloud, app-to-app connectivity to support their M&A strategy. This was a three-year, eight-figure deal for all four pillars of our platform: ZIA, ZPA, ZDX, and Zscaler for Workloads, or what we used to call Cloud Protection. We closed this deal with AWS Marketplace, which is becoming a larger channel for us. Next, one of our largest deals in the quarter came from a delighted Fortune 500 tech customer who deployed the entire Zscaler for Users offering including ZIA, ZPA, and ZDX. This provided fast and direct access for users working from anywhere to applications in the data center or in the cloud. With dramatic improvements in user experience, employees were buzzing about the change. One employee stated, 'Every morning I log into my machine, I’m thankful for Zscaler!' This customer doubled their seats to 120,000 users and extended the commitment for another three years. Their journey with us started with a small M&A IT integration use case, which quickly expanded into a company-wide zero trust initiative. In less than two years, this customer’s annual spend with Zscaler grew 13x to well over $10 million. Next, from a product perspective, we saw strong performance across all pillars of our platform. Our core pillars, ZIA and ZPA, have never been stronger, and we are excited about the rapid adoption of our emerging products: ZDX to manage digital user experience, and Zscaler for Workloads to secure servers and workloads. Emerging products contributed 14% of our new business in fiscal ‘22, and we expect continued growth in fiscal ‘23. We continue to innovate rapidly and expand our platform. At our Zenith Live conference in June, we launched Posture Control for public clouds as a fully integrated solution that correlates vulnerabilities and risks across CSPM, CIEM, and Infrastructure as Code scanning. In addition, we integrated our recently acquired deception technology into our platform and saw great adoption by our customers. This is an example of our highly targeted early-stage acquisition strategy shortening our time to market for new innovations and expanding our market opportunity. Let me highlight three deals that were driven by our emerging products: We won a seven-figure ACV with a government agency in Australia for ZIA, ZPA, and ZDX, where ZDX accounted for approximately $1 million of the total ACV value. ZDX pinpoints and resolves performance issues in real-time by monitoring the experience of every user, every network hop, and every application, regardless of their location. The customer said ZDX is a must-have, as it delivered immediate value by reducing troubleshooting time and improving employee productivity. In a seven-figure ACV upsell win, a Fortune 50 insurance company purchased the ZPA Transformation bundle for Zero Trust Access to implement user-to-app segmentation. This customer understands that if a user connects to the network with an on-prem or cloud VPN, that’s not zero trust. With this latest purchase, they plan to replace their legacy network security, including VPN, Network Access Control or NAC, network-based segmentation, and VDI infrastructure. They purchased Zscaler Deception to detect and intercept bad actors trying to infiltrate the network. Finally, a Global 500 financial services customer in APJ purchased Zscaler for Workloads for 36,000 workloads to complement their ZIA and ZPA services for users. With many apps running in AWS and Azure, they wanted to implement a Zero Trust architecture to prevent lateral threat movement and eliminate backhauling workload traffic through the data center for inspection. We reduced cost and complexity by eliminating the need for virtual firewalls and site-to-site VPN networks while improving security and operational efficiency. Next, let me discuss the progress we are making in the Federal vertical. We now have FedRAMP High authorization for ZIA, which together with ZPA, makes us the only cloud security service to have two products at the highest level of FedRAMP certification. In addition, ZPA is the only Zero Trust solution with DoD IL5 certification. These certifications are driving our federal business. In Q4, we added over 25 new Federal customers and over half of them purchased ZIA and ZPA together. Now, we have landed 10 of the 15 Cabinet-level agencies as customers, with plenty of opportunities for upsell at these large organizations. I want to highlight one federal deal that I’m particularly excited about: We were awarded a five-year, $46 million contract by a large cabinet agency with over 100,000 users. The value of this contract will be granted over time, based on deployment. Against this award, we received an initial low-seven-figure ACV task order for ZIA and ZPA. Next, let me comment on the increased leverage we’re driving with our channel programs. We saw over 50% year-over-year growth in channel-sourced deal registrations. Working closely with our cloud-centric VAR partners, we are building momentum down-market in the Enterprise and Commercial segments, which is providing higher contribution to our new business. At RSA Conference, you heard a key partner, Optiv, talk about their plans to grow with us and further invest in Zscaler certifications for their consultants. I’m also excited about the opportunities we can unlock together with the global SIs that are building large Zero Trust and SASE transformation practices. Moving to cloud marketplaces, this channel is growing very well for us. We have made strategic investments in our collaboration with AWS and Azure, including deep technology integrations, co-selling opportunities, and demand generation programs. In Q4, our new business through cloud marketplaces grew nearly fivefold year-over-year. For example, we signed five greater-than-$1 million deals through the AWS marketplace, including two of our top five new and upsell deals of the quarter. Our strengthening Azure and AWS partnerships also give us access to their customers’ sizable cloud budgets, which can streamline the deal close process. I want to highlight another important area for our customers, their ESG goals. Our highly efficient cloud eliminates the need for on-prem appliances, which significantly decreases IT waste, energy usage, and carbon emissions. We are also committed to our own ESG goals. Since achieving 100% renewable energy last year, we are proud to be Carbon Neutral for calendar ‘22, covering relevant Scope 1, 2, and 3 categories, including travel, customer use, public cloud use, and procurement. I am excited to announce our goal to be Net Zero by 2025, joining our customers in a collective effort to transition to a low carbon economy. In closing, even with uncertain macro conditions, we continue to see favorable demand for our Zero Trust Exchange platform, which makes businesses more agile and competitive, simplifies IT, consolidates point products, and reduces cost. We believe customers trust Zscaler more than any other provider for securing their cloud journey. We have grown our global team to approximately 5,000 employees who share a mission to secure the hyperconnected world of cloud and mobility. I am extremely proud of the strong growth and profitability we delivered in 2022. I want to thank our employees and our partners for their tireless efforts and commitment to our customers’ success. We will continue to invest aggressively to delight our customers and capture the large opportunity ahead of us, while delivering operational excellence. Now, I’d like to turn over the call to Remo for our financial results.

Thank you, Jay. We are pleased with the results for the fourth quarter and full year. Revenue for the quarter was $318 million, up 61% year-over-year and up 11% sequentially. ZPA product revenue was approximately 19% of total revenue, growing 80% year-over-year. From a geographic perspective, we had broad strength across our three major regions: Americas represented 52% of revenue, EMEA was 33%, and APJ was 15%. APJ continues to be our fastest growing region with revenue growth of 88% year-over-year. For the full year, revenue was $1.09 billion, up 62% year-over-year. This is an acceleration from the 56% growth we delivered in fiscal 2021. Our total calculated billings in Q4 grew 57% year-over-year to $520 million, with billing duration comparable to a year ago and slightly above the midpoint of our normal 10 to 14 months range. We saw strong growth in our top five verticals: Finance, Manufacturing, Healthcare, Technology, and Services. Our remaining performance obligations, or RPO, grew 68% from one year ago to $2.607 billion. The current RPO is 49% of the total RPO. As a point of clarification, the total contract value of the five-year, $46 million award from a U.S. Federal government agency that Jay mentioned is not included in our RPO. RPO for this contract will be recognized as the individual task orders are received, which are 12-month terms as is typical for our federal customers. Moving on to our product pillars, for the full year, emerging products, which include ZDX and Zscaler for Workloads, or what we used to call Cloud Protection, met our targets and contributed 14% to our total new business. Including our new CNAPP and deception offerings in the Zscaler for Workloads pillar, we expect emerging products to contribute high-teens percentage of our total new business in fiscal 2023. ZPA was 27% of our total new business in fiscal 2022, and grew as a mix between the two core ZIA and ZPA pillars. We have a large opportunity with all our pillars, and we will continue to innovate and expand our portfolio to strengthen our leadership position in the Zero Trust security market. Our strong customer retention rate and our ability to upsell the broader platform have resulted in a high dollar-based net retention rate, which was again above 125% for the last seven quarters. We have a strong base of large enterprise customers, which provides us with a significant opportunity to upsell our broader platform. We had 327 customers paying us more than $1 million annually, up 62% from 202 in the prior year. The continued strength in this metric speaks to our large enterprise focus and the strategic role we play in our customers’ digital transformation initiatives. We added 198 customers in the quarter paying us more than $100,000 annually, ending the year at 2,089 such customers. Expanding our field engagement with smaller enterprises with 2,000 to 6,000 employees and the increased investments in our Summit Partner program are contributing to overall customer growth. Turning to the rest of our Q4 financial performance, total gross margin of 81.6% was up nearly 1 percentage point quarter-over-quarter and year-over-year. Our total operating expenses increased 8% sequentially and 60% year-over-year to $221 million. Operating margin was 12%, and free cash flow margin was 24%. We continue to expect data center CapEx to be around high-single-digit percent of revenue for the full year. We ended the quarter with over $1.73 billion in cash, cash equivalents, and short-term investments. Before providing our guidance, I would like to share a few thoughts about the framework for our business outlook in the current environment. Zscaler is operating from a position of strength. We are entering this fiscal year with a record pipeline and a large set of customer opportunities. We have confidence in the durability of our business model, with very high contribution margins after the initial land, and proven ability to retain and upsell to our enterprise customer base. With customers increasingly adopting the broader platform with long-term commitments, we plan to continue to invest in capturing our large market opportunity. As Jay mentioned, there was more deal scrutiny at the end of Q4, which resulted in business being more back-end loaded. We think it's prudent to expect this higher level of review and scrutiny by our customers to continue given the uncertain macroeconomic outlook. While demand for the Zscaler platform remains very strong, if the business environment changes, our business model allows us to adapt quickly and to deliver on our operating profit and margin goals. In fiscal ‘23, in our guidance, we intend to deliver operating margin expansion of approximately 150 basis points. Now, moving on to guidance and modeling points. As a reminder, these numbers are all non-GAAP excluding stock-based compensation expenses and related payroll taxes, and amortization of intangible assets. For the first quarter of fiscal 2023, we expect revenue in the range of $339 million to $341 million, reflecting a year-over-year growth of 47% to 48%; gross margins of approximately 80%. I would like to remind investors that a number of our emerging products will initially have lower gross margins than our core products, as we are more focused on time-to-market and growth rather than optimizing them for gross margins. Operating profit in the range of $37 million to $38 million. Net other income of $5 million. Income taxes of $2.5 million. Earnings per share of approximately $0.26, assuming 155 million fully-diluted shares. Please note that starting in fiscal 2023, we adopted the new accounting standard which requires the use of the if-converted method for calculating EPS. To account for our convertible notes, you will need to add back $360,000 in quarterly interest expense and include 7.63 million shares to the fully-diluted share count. For the full-year fiscal 2023 we expect revenue in the range of $1.49 billion to $1.5 billion or year-over-year growth of approximately 37%; calculated billings in the range of $1.92 billion to $1.94 billion or year-over-year growth of 30% to 31%. While we don’t normally guide to quarterly billings, I want to remind you that we will have a difficult year-over-year comparison in Q1. In the year-ago quarter, we had a one-off deal and multi-year invoices that resulted in billings duration at the high end of our normal 10 to 14-month range. With that in mind, we expect Q1 ‘23 billings to grow approximately mid-30% year-over-year. We also expect our first-half mix to be approximately 42% to 43% of our full-year billings guide, which is higher than the first-half mix in the last few years. Operating profit in the range of $173 million to $176 million. Income taxes of $14 million. Earnings per share in the range of $1.16 to $1.18, assuming approximately 157 million fully diluted shares. As noted earlier, to account for our convertible notes in EPS, you will need to add back $1.44 million in annual interest expense and include 7.63 million shares to the fully-diluted share count. Let me conclude with comments on our investment framework. We will balance growth and profitability based on how our business is growing. If we continue to have high growth, we will prioritize investing in the business. As we have discussed, if we are growing revenue faster than 30%, you can expect less than 300 basis points of margin expansion in the year. We remain confident of reaching 20% to 22% operating margins in the long term. With a huge market opportunity and customers increasingly adopting the broader platform, we’re committed to investing aggressively in our company while balancing this with our operating profit goals. However, if we see a deteriorating global economic environment, we have the flexibility to place a higher priority on operating profitability.

Our first question comes from Andrew Nowinski of Wells Fargo.

A lot of interesting data points, I guess, but I'll start with the big Fed deal. It doesn't sound like it contributed maybe any revenue in Q4 given that it's not in RPO yet, but wanted to clarify that. And I'd imagine a deal that size was likely competitive. So just wondering if you could discuss which vendors you beat in that deal. And then finally, given the upcoming fiscal year end with the Fed, how does the remaining pipeline in the Fed look this quarter given the strong results you just put up? Thanks.

I'll take the first part, Andy. You're absolutely right. There's not much revenue in the quarter from that large deal. But your mention that it's not in the RPO is also important, which is what we've been discussing regarding RPO growth. It's more advantageous for Zscaler to focus on billings growth because nearly the entire $46 million is not included in RPO. Now, I'll turn it over to Jay.

Good. So, regarding the deal, the nature and competitiveness, you can imagine that almost all federal deals need to go through a very competitive offer process. And all the obvious names you would expect were all competing, all legacy vendors, network security firewalls and the like. They all competed for it. But it was the architecture that won at the end of the day. So, we are excited about it. But as you know, some of these federal deals take time. We do have 10 of the 15 Cabinet-level agencies as our customers, and there's a lot of opportunity for us in the federal market.

Our next question comes from Brad Zelnick of Deutsche Bank.

On a fantastic end and impressive execution in a tough environment, which leads to my question. Jay, it's clear that security and connectivity are essential budget items for customers. However, in challenging times, it seems more difficult to acquire new customers. Is this true for Zscaler, and how do you address this? Additionally, are you noticing any changes in how customers are allocating their budgets for their network and IT transformation initiatives? Thank you.

Thanks, Brad. It does take more time and effort to attract new customers, especially when our existing clients are very satisfied. Our business growth is coming from account expansions as well as new customers. To attract new clients in the current market, I want to highlight an interesting trend. We've noticed that CXOs who frequently transition from one company to another often reach out to us. I've personally witnessed over a hundred such instances. When they contact us, conversations progress significantly faster. We are also implementing various demand generation programs to support our channel partners, mainly focusing on acquiring new customers while also upselling existing ones, both of which are crucial for us. Regarding your question about budget sources, CIOs and CFOs are currently looking for ways to reduce costs by eliminating numerous point solutions. They want assistance in saving money, and our platform is designed to streamline operations by consolidating many products, demonstrating a strong return on investment and leading to larger budget approvals. Additionally, some of our significant contracts are coming from hyperscaler budgets, which have already been allocated. Customers are indeed seeking better business value, and we are addressing that need through a robust business value process, which has contributed to our success despite increasing challenges.

Fantastic. Thank you so much. And congrats again, guys.

Thank you.

Thank you.

Thank you. Our next question comes from Alex Henderson.

I think back at your Zenith Live event, you talked about conditions such that, yes, there may be some stretching of duration. But that, in turn, is resulting in a higher adoption rate, mainly because you're able to help them lower cost and lower the amount of employees they need to run their operations as well as eliminating the point products. So as the conditions have tightened further over the last 1.5 months, have you seen an increased win rates and some larger deal sizes as a result of that ability to help companies significantly diminish their staffing and cost requirements?

We have many customers who have publicly stated at our conferences that the resources required to operate Zscaler's service are significantly reduced. Typically, it simplifies what it takes to manage appliance companies, firewall companies, and similar services, contributing to the operational costs you mentioned. Customers generally consider four cost factors when evaluating savings from Zscaler. Operational costs are one aspect. Cost savings from eliminating point products is another key area, as numerous security products are found in large enterprises. One Chief Information Security Officer referred to it as appliance overkill. The third area is enhanced business productivity, which relates to user experience. This is notable as users access critical information from various locations in the cloud; they are quite intolerant of any delays or poor experiences. The fourth factor is risk reduction. While quantifying risk can be challenging, our customers are concerned about the cost of breaches and downtime. We have consistently implemented a solid business value assessment process that is succinct. When we engage with C-level executives who sponsor this process, it aids us in demonstrating savings and helps us successfully close deals.

The question, just to be clear, was, has there been a change in that environment that has then amplified the benefit of those four factors?

Yes. Probably the direct answer would be, it is more and more need to do a strong assessment, quantification and commitment to delivering those results. Absolutely, yes.

Our next question comes from Joel Fishbein of Truist.

Congratulations on the excellent execution. Remo, I have a question with two parts. You showed great performance in the gross margin aspect of the business, and I’d like to understand what the drivers of leverage will be moving forward. I know you provided some insights on fiscal year 2023. Additionally, with $1.7 billion in cash, what do you believe is the best use of that cash at this stage of development?

I mean, good questions. So, the outperformance in gross margins in Q4, we did 81.6%. Basically, it's the efficiency that we've created with our software authorization and just overall lower cost, bandwidth cost, colo cost, depreciation as well as the outperformance on the top line. Those are the primary reasons. Key thing to recognize with our gross margin, we have the ability to come out with applications faster by putting basically applications in public cloud. We will continue to do that. Again, from our perspective, we are going to deliver the best products as quickly as we can to our customers. In our gross margin, we expect in fiscal '23 and also the midterm is 80%. From a long-term perspective, we expect gross margins between 78% and 82%. So, as long as we're within that bound, it just gives tremendous flexibility from a modeling perspective for Zscaler because we have such high gross margins with high growth to invest in the business. From a perspective of the $1.7 billion in cash, really no plans for that. It will be used for strategic purposes. We clearly don't need it for working capital as our free cash flow last year was significant. And also from a free cash flow perspective in fiscal '23, I'd expect free cash flow margin to be 20% or above. So really just for strategic purposes is that cash.

Our next question comes from John DiFucci of Guggenheim.

My question is somewhat broad and relates to what Brad mentioned earlier. It concerns the macro environment that affects everyone. It's reassuring to see you recognize it, even if it's not reflected in your financial results. According to our calculations, your new ACV has accelerated despite a challenging comparison, and your guidance suggests you have some confidence in the future. However, you addressed the impact of macro weakness and why it isn't influencing your business at the moment. I believe this is more relevant for Remo. How do you view this situation, and how does it factor into your annual guidance, if at all, particularly regarding any potential softness or deterioration? You mentioned that businesses are becoming more backend loaded, which was somewhat anticipated, yet you managed to close deals regardless. Is there any further insight you could provide on this?

No, I think it's a great question, and I appreciate you asking it. We observed increased deal scrutiny in the fourth quarter, which influenced our guidance. This increased scrutiny primarily affected large, multiyear, multi-product deals. As you pointed out, John, it hasn't had a significant impact on our business. When we reviewed our guidance, we noticed that many customers have not finalized their budgets for calendar 2023, which will occur in the next few months or quarters. This introduces a certain level of uncertainty for the second half of our fiscal year 2023. We considered all these factors when formulating our guidance, which is why we are anticipating a higher contribution to our billings in the first half compared to the first half mix in previous years. We believe this approach is prudent. Additionally, we recognize that our visibility for the second half of the fiscal year is not as strong, which is why we have greater confidence in the first half.

And if I may add on two things. I may ask two things we've done to make sure we do a good job. One is we are working more closely with our customers to identify what needs to go, what needs to change from a savings point of view. We are a lot more focused on helping customers save money because CIO is asking us, what can you do to save money? I have a lot of legacy debt products, please help. So, our sales process is focused more on that than it used to be before. That's one point. And the second, we alluded to it, but the business value assessment needs to be much sharper now than it used to be.

Our next question comes from Roger Boyd of UBS.

Just to touch on the cloud marketplaces, it seems for a couple of quarters now you've highlighted the momentum with AWS and Azure, but 5x growth really stuck up this quarter. Any sense for how big of a channel that is for Zscaler today and how big that could get given it seems like a win-win for customers, VARs, and ISVs like yourself? Thanks.

Yes. I'll start then I'll have Jay. It's still relatively early. It's still relatively a small part of our business. But the cloud marketplace is increasing, and we do see it as a very important and strategic channel for us. So with that, I'll turn it over to Jay.

Yes. It has become a new source of revenue for us. Over the past three years, it has grown dramatically from nothing to a significant amount. This is why, starting from a small base, the numbers appear large. However, major providers are now collaborating with us and jointly selling, which is creating a valuable new pipeline for us. Additionally, some budgets for hyperscalers are committed on an annual basis, and our solutions qualify for those budgets. This adds another layer of justification for easier budget approvals, creating further opportunities for us. We are allocating resources and investing in this channel to help it grow.

Our next question comes from Mike Walkley of CGF.

Thank you very much. And congratulations on the strong results. Jay, I just wanted to get your thoughts, just given the economic uncertainty and increased deal scrutiny, given Zscaler's value proposition, why wouldn't this year be a year you even accelerate share gains in the market? Or alternatively, are you just seeing customers, given the uncertainty, just tighten budgets and sticking with what they currently have?

I mean, that's what I tell Remo. Come on, let's be more aggressive. Remo, go ahead.

That's a good question. We'll have to wait and see. We have provided our guidance, and we aim to be cautious with it. However, from my perspective, Zscaler was specifically designed for this environment. We offer the highest level of security, including proxy-based solutions and support for SSL traffic. As Jay mentioned, we also simplify complexity. There is a significant demand for security professionals, which is likely to increase, along with the need for lower costs. We prefer to provide our guidance carefully and will observe how the situation develops. But I believe we are in a strong position as a company.

Yes. That's what I would say. I mean certain hard times obviously require a lot of extra effort to make things happen. I would say with all the great things that are positioning us well, I expect us to do far better than first to the vendors out there.

Our next question comes from Hamza Fodderwala of Morgan Stanley.

Jay, we've seen a lot of changes in the nature of work and IT over the past couple of years. However, it seems that security architectures haven't fully adapted, and there is still a significant amount of technical debt. I'm interested to know if, when Zscaler engages in transformational deals, there is increased pressure for CIOs and CISOs to replace existing solutions. Additionally, what technologies are you currently replacing more frequently as we move into a more hybrid world?

That's a great question. When considering our extensive product portfolio with ZIA and ZPA, we are essentially replacing traditional branch devices and firewall proxies, marking the first wave of this transformation. Secondly, with ZPA, we are starting to replace traditional VPNs, as well as handling the entire inbound DMZ that many customers need to deploy. This is just the beginning. So, we're focusing on replacing branch firewalls and proxies first. Regarding cloud workloads, we've introduced new solutions with Zscaler for Workloads that bring zero trust to the cloud, which is relatively new over the past eight or nine months. We've seen a growing number of customers operating without firewalls in the cloud. Typically, they would purchase multiple virtual firewalls, but we believe our customers can be firewall-free in the cloud. The third aspect is the data center, which moves at a slower pace. The data center and DMZ environments are complex, and we prefer not to compete heavily in that area as it is somewhat cluttered, and data centers are shrinking over time. My preference is to focus on future trends rather than past ones. Currently, we see some customers still purchasing firewalls for their data centers due to a bit of demand from the corporate side. Overall, we are replacing nearly all branch solutions out there, while the public cloud is in its early stages but shows promising potential. As for the data center, we plan to step back for a while. Did that answer your question?

That's helpful. Thank you.

Thank you. Our next question comes from Josh Tilton of Wolfe Research.

I'll echo my congratulations on the quarter. You guys obviously gave operating margin guidance for next year. Are there any guardrails you can provide us and how we should think about maybe the delta between the operating margin and the free cash flow margin for the full year?

Yes. Over the past two years, our free cash flow has consistently remained above 20%. For fiscal year '23, our guidance reflects the same expectation, which should align with what we've achieved in the past two years being over 20%. Zscaler is a highly efficient company. When we consider our cloud capital expenditures, these typically range in the high single digits per quarter, which is quite low. We maintain high gross margins and strong overall operating profitability. A notable aspect of our cash flow is our annual billing cycle, with billing periods ranging from 10 to 14 months. This places us in a solid position with an efficient model. Looking at the last two years, I do not anticipate any significant changes in our free cash flow margin and expect it to remain above 20%.

Our next question comes from Gregg Moskowitz of Mizuho Group.

Congrats on ZIA's FedRAMP authorization. Given that you're clearly already seeing a lot of momentum in your federal business, Jay, maybe you could expand on what having dual FedRAMP high authority will add to Zscaler incrementally. And then for Remo, it's interesting to me that your headcount growth actually accelerated in fiscal '22 to 58%, especially since you grew a robust mid-50s in the prior year. Given the macro uncertainty, how are you thinking about hiring growth over the next 6, 12 months? Thank you.

I will start. We had strong results in Q4 and are anticipating positive and healthy outcomes for our federal business in Q1. However, we recognize that federal business requires time to develop. It has taken us years to achieve the high-level certifications, which have been more challenging than any others I've encountered, but they are beneficial. They are positioning us favorably. The responsibility for certification still falls on us with smaller deals, and there are numerous opportunities to expand. For instance, out of the 15 Cabinet-level agencies we discussed, most have initially started small, which gives us a chance to grow. We are investing in these resources, our pipeline is expanding, and we have high expectations for our federal business.

From a headcount perspective, you're absolutely right. It was a great year for us, marking expansion in fiscal '22. We are excited about the opportunity ahead. We believe it’s important for everyone to continue focusing on growth while being mindful of operating profitability. We plan to maintain our focus on growth moving forward. Due to the leverage in our model, we are preparing to deliver 150 basis points of margin expansion. We can achieve this because of our SaaS model, which provides predictable revenue with a strong ARR balance, offering good visibility as we enter the year. Coupled with high gross margins above 80%, this makes our model very appealing for managing our business. Currently, we believe we have the right product at the right time, addressing significant needs for our customers. We intend to invest across the board in the company, including in go-to-market strategies, R&D, and our cloud services, to help customers navigate this challenging period by lowering costs, increasing security, and simplifying their operations. Therefore, we will continue to prioritize growth and will keep hiring as part of our plan for fiscal '23.

Remo, I just want to add a comment. We performed well last year. We are facing some challenges this year. We have established ourselves as the top destination in our field. In terms of research and development and sales, we are likely the best organization to choose. Six to nine months ago, many well-funded start-ups were trying to hire people while also laying off employees, and we are making significant investments in this area. In line with that, we have hired Brendan Castle as our new Chief People Officer. He has extensive experience in talent acquisition and development from his time at Google. I am very excited and optimistic about the business opportunities ahead.

Our next question comes from Shaul Eyal of Cowen.

Guys, congrats on the ongoing strong performance and guidance. A question for either Remo or Jay. So clearly, Jay, as you've indicated, you're showing great ROI for your customers. I want to actually focus on your ARPU trends. Maybe can you provide us with some color on recent ARPU trends? Are they on par with recent quarters? Have they been moving up in recent months? Have you instituted any pricing increases over the course of the past few months? Thanks for that.

Yes. I'll take that. ARPU has been increasing on a year-over-year basis. Our ARPU has increased 20%. Related to price increases, we typically do it on an annual basis. And really, it's related to additional applications and bundling. And with that, prices do go up, but they go up probably in the mid-single-digit-type range, nothing really significant, but it relates to additional applications and bundling. But that's typically done on an annual basis.

Yes. We haven't implemented any pricing changes like some of the hardware vendors mentioned recently, who discussed deadlines for orders. We have no deadlines in place, so none of that pricing affected our business in the third quarter.

Our next question comes from Keith Bachman of BMO.

The question is, how are you thinking about mix in particular? And what I mean by that is, I think, Jay, you said about 60% of your new business is from existing customers. Do you see that changing as perhaps new logos get more challenging? And/or do you see a different composition associated with the solution set, meaning VPN replacement has been a really strong business for the last couple of years. Is there any saturation there? Just any comments on how we should be thinking about mix. And finally, within the guidance, I also wanted to ask, Remo, you mentioned visibility is lower in the second half of the year, which I think is completely understandable. But did you take a heavier cut, so to speak, or a more prudent approach, shall we say, versus what you're seeing in the current macro environment as you thought about the second half of that guidance?

I'll start, Keith. By the way, regarding the mix, I think the 60% I mentioned is upsell and 40% is new. It's not the other way around. So with that, we are experiencing some technical difficulties. Historically, we've grown our enterprise business very well. The large enterprise segment will come from there. As our business expands, our customer base is growing larger, leading to increased upsell opportunities. With a bigger platform and more customers, our upsell percentage of the total business is naturally increasing. You'll see both upside and new large customers. When it comes to the lower end of the market, which is relatively newer for us, we are primarily focused on acquiring new logos there. Our demand generation programs are supporting our efforts to gain more logos in that market, and our channel partners are also assisting us. So, I think you'll see a combination of both. Remo, you can provide some normal guidance, but I expect our upsell to increase over time as our customer base continues to grow.

Absolutely, Jay. I believe the upsell will exceed 60%, which was the case last year, for the reasons you mentioned. We currently have 6,700 customers. Additionally, we discussed a sixfold opportunity to sell just the ZIA and ZPA at our last Analyst Day, and this does not account for workloads, which represents another area of our business. Therefore, there is a significant opportunity to upsell to customers. Regarding considerations for the second half of the year, that's why we projected the first half contribution of our total billings to be at the midpoint of 42.5% compared to last year's 41.5%. In our overall guidance of 30% to 31% billings growth year-over-year, we anticipate that 42% will occur in the first half of this year, compared to last year's 41.5%. That's how we factored it in.

Our next question comes from Phil Winslow of Credit Suisse.

Congrats on another great quarter. I mean, obviously, the sales productivity metrics that we can follow from the outside looking remain super strong. I wonder if you could give us just more color on sort of what you're seeing there, particularly in terms of the time to ramp new reps, their productivity metrics. And as you think about just the forward guidance, obviously, you're talking about continuing to lean in on the go-to-market in terms of headcount. But when you think about what's implied in terms of guidance, what sort of productivity levels relative to what we have been seeing are baked in there?

The time to ramp is faster, there's no doubt about that. The market is more mature along with our sales operation and sales enablement group. Our sales enablement group is exceptional and trains our sales representatives quickly. Additionally, as Jay mentioned, the contribution from the channels and the cloud marketplace is also helping these sales reps ramp up quickly. In terms of the guidance for fiscal '23 regarding sales rep productivity, we expect it to be flat or slightly down. This is because we are continuing to prioritize growth over operating profitability. However, even with flat or declining sales productivity, we anticipate about 150 basis points of operating margin expansion year-over-year, which is our guidance. Our model, with high gross margins and significant top-line growth, provides us the flexibility to make the right decisions to effectively capture this market.

Yes. And if I may add, I think I understand the importance of operating profitability, especially in today's market. We'll definitely be mindful of that. Remo said more balanced growth and profitability.

Thank you. This does conclude our conference. I'd like to turn the call back over to Jay Chaudhry for any closing remarks.

Thank you for your continued interest in period. I hope to see many of you at the upcoming sell-side events. Goodbye.

Thank you.

Ladies and gentlemen that does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.