Zscaler, Inc. Q1 FY2024 Earnings Call

Thank you for standing by, and welcome to Zscaler's First Quarter 2024 Earnings Conference Call. At this time, all participants are in listen-only mode. As a reminder, today's call is being recorded. I will now turn the call over to your host, Mr. Bill Choi, Senior Vice President of Investor Relations and Strategic Finance. Please go ahead.

Good afternoon, everyone, and welcome to the Zscaler first quarter fiscal year 2024 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 the 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. The 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. 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 also want to inform you that we'll be attending the UBS Global Technology Conference tomorrow. Now I'll turn the call over to Jay.

Thank you, Bill. I'm pleased to share our first-quarter results, which exceeded our guidance across all metrics. We delivered 40% revenue growth and 34% billings growth. Our operating profit and free cash flow more than doubled year-over-year, and free cash flow margin reached a record 45%. We exceeded the rule of 60 for the 13th consecutive quarter, at a significant scale of over $2 billion in ARR; we are delivering a unique combination of high growth and high profitability that only a few SaaS companies have accomplished. In Q1, we executed well in a challenging macro environment and what is typically a slower quarter for us. The elevated scrutiny of large deals remains mostly unchanged. The increased frequency of high-profile breaches, coupled with impending SEC disclosure requirements has propelled Zero Trust security more into focus at the management and the Board level. Against this backdrop, we achieved a Q1 record for the number of new logo customers with over $1 million in ARR. We also achieved a record for new pipeline generation in a quarter. More customers are adopting our broader platform to consolidate multiple point products, increasing our average deal size. As a result, we are actively working on more large, multiyear, multi-pillar opportunities than ever before. To meet this demand and to further scale our business, we're adding two key go-to-market leaders, one in sales and one in marketing. I will provide details about these new executives after reviewing our Q1 performance. Let me highlight three factors that drove our strong Q1 performance. First, large new logo wins were strong this quarter with a Q1 record of 14 new logos contributing over $1 million ARR. We ended with 468 such customers, up 34% year-over-year. These wins spanned across many verticals, proving that every vertical needs Zscaler. Second, customers are buying the broader Zscaler platform with multiple product pillars. I have said before, over time, I believe every one of our customers will buy ZIA, ZPA, and ZDX, for every user to deliver secure, fast, and reliable access to any application anywhere. This quarter, nearly half of our new logo customers purchased all three user pillars, ZIA, ZPA, and ZDX. In addition, strong platform upsells drove our 120% dollar-based net retention rate. Third, this was a record U.S. federal quarter with new business up over 90% year-over-year, including four deals that were greater than $1 million in ACV. We are starting to see larger awards as multiple U.S. federal agencies are standardizing on Zscaler to meet the President's executive order to adopt Zero Trust security. We are extremely proud of having landed 12 of the 15 cabinet-level agencies as our customers, where we have plenty of opportunity to expand. For example, at a cabinet-level agency, we expanded the ZIA and ZPA deployment from 25,000 users to 100,000 users while cross-selling ZDX for all 100,000 users. We also won a top defense integrator who purchased ZIA, ZPA, and ZDX for its employees. In parallel, they launched a go-to-market service to take Zscaler to their federal customers. As our SI partners are selling and deploying Zscaler for their customers, they are also adopting Zscaler to make their own business secure, agile, and competitive. From my conversations with hundreds of IT executives, it's clear that cybersecurity is the number one IT spending priority. Adopting Zero Trust architecture and protecting their enterprise from Gen AI risks are top priorities for CISOs in 2024. We have enhanced our data protection policies and AI/ML applications and tools to protect our customers' risk of data loss due to increasing use of Gen AI. Our AI-powered threat protection uses a diffusion model to detect complex exploits and to catch sophisticated phishing attacks that evade traditional security controls. These AI-driven features are included in our Advanced Plus bundles, which are often priced 20% higher than advanced bundles. We now secure, on average, over 2 billion AI transactions every month for our customers. Next, let me discuss some of our Q1 deals, which demonstrate our differentiation and business value. We are starting to see some wins where customers are coming to us after initially purchasing a firewall-based single vendor SASE solution that failed to deliver in the real world. For those who are not familiar, firewall-based single vendor SASE is the combination of SD-WAN and firewall and VPN deployed as VMs in the cloud. A leading software company made an architectural shift to our Zero Trust exchange platform after trying to deploy a leading firewall vendor SASE solutions across 50 office locations and multiple public cloud sites. It became clear to the customer that this solution expanded their attack surface to all locations and increased the risk of lateral threat movement. They decided to move to our Zero Trust security with the purchase of Zscaler for users, our complete bundle for ZIA, ZPA, and ZDX, for all 25,000 employees. Our Zero Trust Exchange connects users directly to apps, eliminating attack surface and lateral threat movement. For the unmanaged devices, the customer is deploying our browser isolation with ZPA to enable third parties to access their applications. Deals like this reinforce our conviction that firewall-based SaaS solutions are not the future of security that some analysts advocate. Customers are choosing Zscaler's purpose-built Zero Trust platform. Let me highlight one new logo win where our superior security helped the customer after a breach. Despite extensive investments in firewalls and VPNs, a hospitality and gaming company experienced a crippling ransomware breach. To restore their operations, they purchased the entire Zscaler for users bundle for 25,000 users. With Zscaler, the apps are now hidden from threat actors behind our Zero Trust Exchange and can't be discovered, exploited, or DDoS. This customer also purchased our new Risk 360 solution to understand the organization-wide risk and get actionable information to reduce it. We have shared with you that data protection is one of the fastest-growing solutions for us. For our customers, after implementing cyber protection, adopting data protection is the natural second phase of their Zero Trust journey. For example, a Fortune 500 travel and hospitality services provider more than doubled their annual spend with us, with data protection being a critical component of the upsell. The first purchase was ZIA for 22,000 users to inspect all traffic, including TLS encrypted traffic for cyber protection. As the next step, they are implementing real-time inline DLP for sensitive data. Our solution also enables this customer to enforce policies for secure use of AI applications. These deals highlight the breadth and depth of our Zero Trust security platform. We also help our customers achieve high ROI by eliminating tech debt and consolidating multiple point products. For example, a Fortune 200 financial services group turned to Zscaler to consolidate data centers and safely adopt cloud with the necessary security controls for regulatory compliance. They purchased Zscaler for users bundled for 10,000 employees and workload communication for 1,500 workloads. By leveraging our cloud platform, they will eliminate half of the data centers, reduce their MPLS spend, and consolidate security and networking client products. We are eliminating several point products, including secure web gateways, firewalls, IPS appliances, VPNs, CASB, and DLP from seven security vendors. This deal is expected to generate a remarkable 5x ROI for the customer. I'm also excited to share that ZDX, one of our emerging pillars, continues to gain significant customer adoption. It is an important part of every deal conversation due to its unique ability to eliminate IT blind spots. ZDX significantly reduces helpless hours spent on ticket resolutions and manual correlation of metrics. Let me highlight a new logo deal where ZDX played a pivotal role. A top-ranked U.S. hospital network purchased ZIA and ZDX advanced plus for 87,000 users and ZPA for 40,000 users. What initially began as a ZIA and ZPA project quickly evolved into a significant ZDX opportunity. The ZDX component alone is seven figures in ACV. Unlike the existing performance tools, ZDX provides comprehensive visibility and root cause analysis for users, devices, and applications. This deal is a great example of the leverage we gained from working with system integrators like Accenture, who was awarded this overall transformation project. We're also seeing strong customer interest in workload protection on another emerging product pillar. Our Zero Trust Exchange is designed for any to any secured communication. It may be users to apps, workload to workload, or IoT/OT devices. Thousands of enterprises already leverage the Zscaler platform for secure user-to-app communication. It is natural for them to extend our Zero Trust platform to secure their workload communication. To radically simplify multi-cloud connectivity and automated deployment of workload protection at scale, we recently released significant enhancements to our workload communications offering, including granular workload segmentation using AWS user-defined tags, the first Zero Trust security solution for workloads in the market. The only alternative is legacy virtual firewalls and real-time auto discovery of cloud resources. More than one-third of our customers have made initial purchases for workload protection. Workload communication often starts with small land deals, and we expect to rapidly expand to secure the growing number of workloads. Zscaler pioneered Zero Trust and SASE, both delivered by our cloud-native platform. We have established ourselves as a premier provider for user protection and are now making progress expanding into workload protection and IoT/OT protection. We continue to push the boundaries of what our platform can achieve, extending it for B2B and 5G use cases. As we are like a switchboard for all communications, we collect full transaction logs and trillions of signals daily. We are utilizing those signals and logs to deliver AI-powered insights and automation for our customers. Let me discuss a few of the high-value products in our AI cloud family. We recently launched Risk360, which is the industry's first holistic AI-powered risk quantification and mitigation solution. It delivers up-to-date risk posture and recommends corrective actions to mitigate risk in a timely fashion. We have already closed over 10 Risk360 deals and are in active evaluations with over 100 enterprises. For these deals, we are getting six-figure ACV on average, and we expect to grow this value over time. Risk360 provides critical insights to CISOs when reporting on cybersecurity risk strategy and governance, particularly in light of new SEC regulations. Another exciting new product, breach predictor, currently under development uses predictive and generative AI models to anticipate potential breach scenarios and eliminate those risks before they materialize. Early feedback from customers who have previewed breach predictor indicates the enormous potential value this solution can deliver. We are working with our technology partners to bring this world-class innovation to thousands of customers to proactively protect against potential breaches. While we have achieved tremendous success for user protection solutions, our platform's potential in other categories is just beginning. Our relentless innovations have paved the way for an ever-growing stream of opportunities. As our platform continues to scale and expand, our go-to-market efforts are continuing to evolve and scale as well. To enable the next stage of go-to-market scaling, I'm excited to share the appointments of two exceptional leaders, Mike Rich, CRO and President of Global Sales; and Joyce Kim as CMO. They bring a wealth of experience in driving revenue and pipeline growth. Mike joins from ServiceNow, where he was the President for Americas, establishing an efficient and scalable process to drive deeper engagements with large enterprises and scaling their business to over $8 billion in revenue; experience that's critical to the next phase of our growth journey. Joyce's previous experience includes CMO roles at Twilio, Genesis, and ARM, with expertise in building high-performance marketing teams and driving impactful marketing strategies and campaigns. With Mike assuming leadership of our sales organization, Dali, in his capacity as the COO, can focus on scaling our business operations. Dali has been instrumental in establishing the go-to-market process which has helped Zscaler achieve a milestone of $2 billion in ARR. With our expanded portfolio of products and experienced CRO and CMO on board, we will further scale our value-add sales process for larger platform deals, which will sustain our high growth. I'm thrilled to have strong go-to-market leaders who we believe will drive world-class execution to scale our business beyond $5 billion in ARR. Now I'd like to turn over the call to Remo for our financial results.

Thank you, Jay. Our Q1 results exceeded our guidance on growth and profitability, even with ongoing customer scrutiny of large deals. Revenue was $497 million, up 40% year-over-year and up 9% sequentially. From a geographic perspective, Americas represented 53% of revenue, EMEA was 32%, and APJ was 15%. As Jay highlighted, from a new business perspective, Federal had its best new ACV quarter ever, growing over 90% year-over-year. Our new ACV outside of the Fed also grew year-over-year. Our total calculated billings in Q1 grew 34% year-over-year to $457 million. On a sequential basis, total billings declined 37% quarter-over-quarter with a difficult comparison to Q4, which had a $20 million upfront billing on a multiyear deal. As a reminder, our contract terms are typically one to three years, and we primarily invoice our customers one year in advance. Our calculated current billings grew 33% year-over-year, a seasonal decline of 32% quarter-over-quarter. Our remaining performance obligations, or RPO, grew 30% from a year ago to $3.49 billion. The current RPO is approximately 51% of the total RPO. We ended Q1 with 468 customers with greater than $1 million in ARR, adding 19 such customers in the quarter. 14 of the 19 $1 million ARR customer adds were new logos, which was a record for Q1. The continued strength of this large customer metric speaks to the strategic role we play in our customers' digital transformation initiatives. We also entered the quarter with 2,708 customers with greater than $100,000 in ARR. Our 12-month trailing dollar-based net retention rate was 120%. Turning to the rest of our Q1 financial performance, total gross margin of 80.7% compares to 80.7% in the prior quarter and 81.4% in the year-ago quarter. Higher public cloud usage for emerging products drove the year-over-year change in the gross margin, partially offset by approximately 60 basis points of benefit from a change in accounting attributed to the longer useful life of our cloud infrastructure. As mentioned last quarter, as a result of advances in technology and efficiencies in how we operate our server and network equipment, starting this quarter, we extended the depreciable useful life of these assets in our cloud infrastructure from four to five years. Moving on, our total operating expenses increased 11% sequentially and 26% year-over-year to $311 million. We continue to generate significant leverage in our financial model with operating margin reaching 18%, an increase of approximately 620 basis points year-over-year. Our free cash flow margin was 45%, including data center CapEx of approximately 6% of revenue. Free cash flow benefited from strong collections for Q4 billings, including the $20 million upfront billings I mentioned. We ended the quarter with over $2.3 billion in cash, cash equivalents, and short-term investments. Next, let me share some observations about the macro environment and our framework for guidance for the rest of the fiscal year. While the global macro environment remains challenging, and customers continue to scrutinize large deals, from our perspective, customer sentiment seems to be stabilizing. Our customer engagements remain strong, and we have a large and growing pipeline. However, we want to be prudent in our assumptions given the sales leadership change. In our outlook for fiscal '24, we're balancing our business optimism and continued sales execution with ongoing macroeconomic uncertainties. With that in mind, let me provide our guidance for Q2 and full year fiscal 2024. As a reminder, these numbers are all non-GAAP. For the second quarter, we expect revenue in the range of $505 million to $507 million, reflecting a year-over-year growth of 30% to 31%, gross margins of 80%, including the change in accounting for useful life of server equipment. I would also like to remind investors that a number of our emerging products, including newer products like ZDX and Zscaler for workloads will initially have lower gross margins than our core products. We are currently managing the emerging products for time to market and growth, not optimizing them for gross margins. Operating profit in the range of $84 million to $86 million. Net other income of $15 million, income taxes of $8 million, earnings per share in the range of $0.57 to $0.58, assuming $160 million fully diluted shares. For the full year fiscal 2024, we're updating our guidance as follows: increased revenue in the range of $2.09 billion to $2.1 billion or year-over-year growth of 29% to 30%; calculated billings in the range of $2.52 billion to $2.56 billion or year-over-year growth of 24% to 26%. We still expect our first half mix to be approximately 42% of our full year billings guide; increased operating profit in the range of $360 million to $365 million, which reflects up to 250 basis points of operating margin improvement compared to last year; income taxes of $35 million; increased earnings per share in the range of $2.45 to $2.48 assuming approximately 161 million fully diluted shares. We expect our free cash flow margin to be up year-over-year and in the low 20% range. We continue to expect our data center CapEx to be high single-digit percentage of revenue for the full year, reflecting a three to four percentage points of headwind to free cash flow margins. We expect the timing of CapEx spend to be more towards the second half of the year as we invest in upgrades to our cloud and AI infrastructure. Our guidance reflects our plans to invest aggressively in our business to pursue our significant market opportunity. With our new CRO and CMO coming on board, we expect to step up our sales and marketing investments in the coming quarters. In addition, we'll increase investments in our technology platform and cloud infrastructure. With a large market opportunity and customers increasingly adopting the broader platform, we plan to invest aggressively to position us for long-term growth while increasing profitability.

Our first question comes from Brad Zelnick of Deutsche Bank. Your line is open.

Great. Thanks so much. And congrats on a strong start to the year and nice to see the leverage in these results. Jay, your distinction of SASE has always been clear, and it's perhaps no more obvious than right now at a time when traditional network security providers are having a tough time selling more and more boxes. And it seems they're paying you a nice compliment as they all double down on their focus on the cloud and SASE. So as this all plays out competitively and you're increasingly subject to the law of large numbers, how should we think about your ability to sustain high growth and specifically the rate at which you can scale your emerging product portfolio? Thanks.

Brad, very good question. It is flattering to see all kinds of vendors becoming SASE vendors overnight. But the challenge for them would be that it's a different architecture. It's not an incremental change and feature you can add on to it. That's where we spent a dozen-plus years building a true Zero Trust architecture, which is an advantage. That's why we became the market leader. We pioneered this market. We evangelized the fact that this is what's needed for better cybersecurity and ransomware protection and cost reduction. The way I look at sustaining high growth is the following. One, is there a market demand? The market is growing and expanding at a pace much faster than I even thought. Two, do you have the right platform with the right architecture and the right functionality? You've seen us build this platform on a true Zero Trust architecture and expanded over the years. I think of what we had at the time of IPO versus what we have today. And the third area is go-to-market execution. We've done a great job starting with IPO, crossing $2 billion in ARR, and now we've got our sights set on crossing $5 billion. And we have been growing and adapting go-to-market also along with the platform. That's why I'm very excited about bringing two key leaders: Mike as CRO; and Joyce as CMO, who can help us take this to the next level. Great market execution, great platform. I think with that, I'm very excited about the opportunity in front of us.

Thanks. Appreciate it.

Thank you. One moment, please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Okay. Great. Hi guys, thanks for taking my question here. Jay, maybe for you, just building off of that last question on some of the slowness that we've seen with the traditional network security guys and the challenges with appliances. The question for you is do you feel like customers are more willing now to replace their appliance firewalls, at least at the branch, with SASE architecture like what Zscaler provides so well?

You know what I said many times, firewalls won't go away, but they will become like mainframes. We have been replacing firewalls at the branches for the last several years. Now that trend is accelerated. One of the things done to help accelerate the demise of firewalls in branches is our branch connector technology, which we now package to make it available. You can become a Starbucks-like office in a matter of minutes rather than trying to wait for a long, long time. So we've seen a campus environment becoming just like that. The only place where firewalls have been playing a significant role for a while is the data center, the east-west traffic and the like. You know that traffic is going away from the data center, and that demand has to go away. So a big thing for someone to do it right had to really offer a Starbucks-like branch and zero-trust architecture. Market has made progress with traditional SD-WAN. We think traditional SD-WAN is a transitory technology. And once we have entered the market with Branch Connector, we think it is the next big phase to make it simple. I'm very excited about the opportunity to make the world free of firewalls.

Makes sense. Thanks, guys.

Thank you.

Thank you. One moment please. Our next question comes from the line of Alex Henderson of Needham & Company. Your line is open.

I'm torn on what to ask, but I think I'll go with the question around the channels. So you guys have been doing a lot of work on expanding your VAR channels, expanding reach into federal, expanding reach into MSPs, and expanding into the cloud arena as much as possible. Can you give us some sense of how you think the mix of your sales leads will be driven by those different channel opportunities as we move through the current fiscal year, please?

Sure. Alex, you rightly said, we don't have a simple straight VAR channel that traditionally firewall and network security vendors had. We have VARs who play a role. We have system integrators, and we have service providers. Then there's a separate set of SIs for federal business as well. Let's look at each of these areas. VARs were slow to adopt Zscaler, but now as the market has moved, more and more of them are embracing us, and our leader has launched a number of programs where we're seeing good progress, with new source pipeline coming from our channel. The area we see as a very rapidly growing opportunity is global systems integrators. My experience at ServiceNow, where many partnerships with global SIs have played a big role, leads me to expect that area to accelerate. In this next level of fulfillment versus transformation, we like partners who work with us and our customers to drive that transformation. We have been selective. You're not going to find us with 5,000 or 10,000 channel partners. Our partners number in the hundreds, and we are doing targeted programs. We're working with some of the large global SIs and high-value deals to drive transformation. I mentioned one of these deals in my prepared remarks and another SI that actually brought Zscaler internal along with launching the service to go out there. Remo, do you want to add any more color?

No, I think that's good, Jay.

Okay. Thank you, Alex.

No comment on internal sales? Which is obviously a piece of it?

So yes. So we've increased our capacity in the quarter for our sales reps. Our plan is to increase capacity through the year. The one comment I'd make on Q1 is that we did hit our expectations internally, but we expect to hit basically our sales targets for the year. The current sales capacity that we have supports our guidance. And as Jay mentioned, with the new leadership with Mike on board, we'll be looking to accelerate our hiring as we go through fiscal '24.

Great. Thank you so much.

Thank you. One moment please. Our next question comes from the line of Joel Fishbein of Truist. Your line is open.

Thanks. And thanks for taking my questions. Great execution here. Jay, one for you, and then I'll jump back in queue. On these new advanced plus bundles, obviously very exciting. Just can you share with - you said AI is included - some of the new AI included in that. Can you talk about adoption rates and whether or not you're getting any pushback on pricing as it relates to some of those bundles?

Yes. So we have had advanced bundles that include a bunch of functionality of ZIA or ZPA type of stuff. Now we have added functionality where some of the data protection can be done with AI advanced techniques, along with some of the cyber threat protection. So we clear these bundles, we call them advanced plus. So we're getting very good traction. These advanced plus bundles are about 20% or so higher than the non-plus bundles. This is a good area. In fact, this is a good way for us to reach our customers as they're looking at buying these bundles with additional functionality. It's helping them and helping us. In addition, we're also creating some standalone SKUs. We talked about Risk360, a very popular recently introduced product. When I talked about having closed 10-plus deals in a significant manner where the average ACV is sitting in six figures. Then you'll see more SKUs coming down the road as you'll really be - as AI cloud is one of the big focus areas. The reason we're making this focus is because we have better logs, better data to train AI/ML models. The starting point for good AI/ML is the data that we have, better than anybody else.

Great. Thank you.

Thank you. One moment please. Our next question comes from the line of Rob Owens of Piper Stanley. Your line is open.

Great. Thanks for taking my question. Maybe building a little bit on Joel's question. You mentioned in your prepared remarks with an example around data protection as kind of one of the faster-growing solutions and how it doubled spend at an existing customer. Just curious about the potential for that and what you're seeing relative to typical uplift when you're able to attach that solution? Thanks.

You know, when Zscaler customers started working with us several years ago, the number one focus for them was cyber protection, so they don't get compromised. Data protection was slower in adoption; it also takes a little bit of work, as there's more contributions and customization needed. In large enterprises where our large customers have been, they've used Symantec among others as one of the primary data protection products. Over the past five or six years, we have expanded our data protection platform significantly, not just inline, but also endpoint DLP and cloud data protection, all those things, including EDM IDM technology are there. So with all that technology, we're in a great position to replace some of those complicated data protection products out there. And it's natural. If we are sitting in traffic path, if we are doing access and inspection, it makes sense for the customers to use our cloud because the traffic is coming to a cloud from all kinds of positions. That's really driving our growth. That's why we talked about this data protection DRR approaching $0.25 billion and it grew 60% year-over-year for us, and we see a lot of growth for quite a long time in this area. Did I answer your question?

Yes. Thanks.

The one comment I'll make is, we have a more complete platform for data protection. Customers want one set of policies, whether they want to secure data at rest or data in motion. That's why it's picking up quite fast.

Thank you. One moment please. Our next question comes from the line of Joseph Gallo of Jefferies. Your line is open.

Hi, guys. Appreciate the question. Remo, I appreciate the rationale on the full-year billings guide. But just on methodology, is there any changes there? I mean you saw a strong Q1 driven by Fed stream; why not pass along some of that beat? Is that solely due to the market or the go-to-market change conservatism? Or is there anything else you're seeing there with large customer calendar '24 budgets? And then maybe just to simplistically ask, is fiscal '24 billings more or less conservative now than it was 90 days ago?

Great question. So the guide that we gave is solely related to basically the go-to-market with our new sales leadership on board. We feel it's prudent to do that. When you take a look at close rates for Q2 this year versus last year, we're being a little more conservative with our close rates this Q2. From a market perspective, the overall market remains challenging, but we feel that there's more acceptance of Zero Trust; there's more understanding of our platform. So we feel good. Regarding guidance, whether it's more conservative now or not, I'd like to say we like being prudent. And again, it's all related to go-to-market with our new CRO, and I don't want to comment any further than that.

Thank you.

Thank you. One moment please. Our next question comes from the line of Gabriela Borges of Goldman Sachs. Your line is open.

Good afternoon. Thank you. Remo, I wanted to ask you about some of the idiosyncratic drivers in your federal business. More specifically, as we think about all the momentum that you're seeing now, how should we think about the durability of growth in the federal vertical? Meaning, is this like a three to five-year product cycle where we'll see a ramp then we should be cognizant of a slowdown? Is it an 18-month to 36-month product cycle? How do we think about some of the visibility you have in federal and how it's going to impact your growth over the medium term? Thanks.

It's another great question, Gabriela. I'll start, and then maybe Jay can come in also. We've invested significantly in federal. This is not an overnight occurrence. This has been happening over the last five, six years with significant investments both from a platform technology and from people within the federal organization that works for us. We're in 12 of the 15 cabinet agencies. As Jay talked about in the script, our growth rate in federal in Q1 was 90% year-over-year. I feel that we are very well positioned in federal. What we talked about is that we've got an incredibly strong federal team. I feel that going forward, federal should be a good driver, and potentially a significant driver for Zscaler. We're doing well in federal. I'll turn it over to Jay.

Yes. So this is how I think about it. First of all, the number of users in the federal commerce DoD, non-DoD. Yes, we do have 12 of the 15 cabinet agencies, but they are in various stages. There's a big, big upsell opportunity there itself. Then DoD is just scratching the surface out there. So if you look at the number of users, it's a massive market in front of us because we count the number of users. Then there are workloads for federal. There's a whole range of IoT and OT devices in federal business that need to be taken care of. So massive opportunities, but then on top of that, it's a platform. Our platform has expanded, and it keeps expanding. I think this is a significant growth opportunity for a long, long time. And then DoD takes us to other federal-friendly countries out there. They all want to follow what the U.S. has done here. That's an opportunity for us. The state governments are getting worried about adopting Zero Trust. That's another big opportunity for us. So I am very bullish. We've made some big investments, and that's why we have some of the best certifications for the Zscaler platform than any other company out there.

Thank you for the color. And congrats on the quarter.

Thank you. One moment please. Our next question comes from the line of Jonathan Ruykhaver of Cantor Fitzgerald. Your line is open.

Yes. Thank you. So Jay, we are seeing this convergence between cloud workload protection platforms, CSPM, CIM, a lot of other acronyms being thrown into this bucket. We're also seeing a number of next-gen vendors that seem to have more of a product-led sales motion aimed at the developer, which contrasts with your approach, which is more a high-touch AB to C level. So as a product that fits between build and runtime environment, you could argue maybe that portfolio is shifting further left. How do you balance those dynamics when you look to go to market with your CNAPP offering?

It's a very good question. All those four-letter acronyms you provided, we're trying to track them. There have been 100-plus vendors in that space over the past two years. So about a year ago, I used to see a new vendor show up every other day. For the last year or so, it has slowed down and actually they're shrinking. But there's adjacent technology to it. That is cloud workload communication. Cloud workload communication is about workloads talking to each other. That's where our core strength comes in the Zero Trust architecture. We are the only vendor I know out there that has workloads talking to each other through Zero Trust architecture without being on the network; that's our starting point. Then we look at CNAPP as an extension. To me, CNAPP is almost like cases in many ways. You make API calls, leading logs, and you lead configurations to figure out risk and whatnot; and that is shifting more to the left. We believe that a combination of cloud workload detection, along with CNAPP, puts us in a better position. Regarding product net growth, I think there's an interesting opportunity for some companies. Obviously, we don't come from that side. I haven't seen many security companies growing to hundreds of millions of dollars doing product-led growth. But we are watching and monitoring the space, and we will be going from where our strengths are. Our large customers love Zscaler's user solutions; now they're embracing Zscaler for workloads and communication, and that allows us to extend it to the CNAPP space as well. That's how we look at it.

Yes. That's helpful. Thank you.

Thank you. One moment please. Our next question comes from the line of Patrick Colville of Scotiabank. Your line is open.

Hi, there. Thank you for taking my question. I mean, really impressive set of results, guys. So congrats on the strong start in the new fiscal year; it’s great to see your momentum. I guess I wanted to touch on the leadership change, these two new executive-level hires. How has Dali's role changed? Is he still at the firm? Or has he moved on? And if so, how can we expect his decisions to change going forward?

Dali has an active role as the COO of the company. He has played a phenomenal role in Zscaler's growth you've seen over the past four years. He built a great go-to-market machine that has helped us go past $2 billion in ARR. So Mike's goal is to take us from here to $5 billion and beyond. This frees up Dali to focus more on his capacity as COO to really help scale our business operations capabilities. Now, what do you mean by that? As we are growing at a rapid pace, we have many things to improve on the scaling side, especially in operational areas like streamlining our post-sale customer engagements. Ranging from support to TAM to deployment and success, we have to bring these functions together to enhance productivity and ensure better value realization for customers. Second, we need to improve cash process systems and overall productivity. If we can do a better job in these areas as a company, we will become much more productive, and Dali's experience across the company will help us achieve key improvements.

Thank you so much.

Thank you. One moment please. Our next question comes from the line of John DiFucci of Guggenheim Securities. Your line is open.

Thank you. Jay and Remo both spoke about the challenging macro backdrop. And I think Remo, if I - correct me if I’m wrong, but I think you said that you did not hit your internal targets for 1Q. I guess, what do you think the reasons for that were? I mean, you have new go-to-market people; you explained that with the guide with Joe's question. Sometimes that means the previous people were an issue, but your COO is really good at it, to say the least. I know Remo said customer sentiment is stabilizing, but I'm not quite sure how that sort of fits in. Has the macro gotten a little worse? Or is there something else that I'm not thinking about?

Yes. The macro has not gotten worse. The comment, John, was related to quota-carrying reps. So we didn't hit our internal projections for internal reps. We do expect to catch up. We've talked about this before on earlier calls; we are in a huge market opportunity, and we're going to invest significantly in our company. You can see in the second half, we're going to increase our sales and marketing spend based on our guidance. That's related to overall; we have new CMO on board, and Mike is coming on board. That was the gist of the comment. It's related to quota-carrying reps. We did increase capacity, but not to the levels we wanted. From my perspective, John, it's really execution on our part. We need to execute better in that area.

Got it. Thank you, everyone.

Thank you. One moment please. Our next question comes from the line of Tal Liani of Bank of America. Your line is open.

I'm sorry, I pressed the mute button. Can you hear me now?

Yes.

Perfect. Okay. RPO growth was slower. Also, the billing guidance was a tad below. Although you hit the quarter, you're above the quarter expectations. So I wanted to ask about the discount level and contract duration. Was there any change in the pricing environment or contract duration this quarter that is driving the lower RPOs? And also, how do I think about - I know you don't provide kind of quarterly guidance, but how do I think about first half versus second half in terms of billings and RPOs? Thanks.

Yes. I mean a lot of questions in there, but I appreciate you bringing it up. RPO decline is primarily related to federal. Federal is a big piece of our business. When you look at federal contracts, even though they're multiyear contracts, we really take federal in for one year in our CRPO. That was a big driver for that. When you take federal out of the contract duration, really, contract durations are comparable year-over-year and also quarter-over-quarter. Discount levels? No, not really seeing anything on a discount level perspective. I'd say it's the same and has been the same for a while. First half, second half, you can expect billings to be in the 42% range in the first half and the rest in the second half. The RPO basically primarily relates to the federal business, which is recognized on a one-year basis.

Got it. Thank you.

Thank you. One moment please. Our next question comes from the line of Fatima Boolani of Citi. Your line is open.

Good afternoon. Thank you for taking my questions. Jay, this one's for you. You were very explicit about the success in the federal business coming from strong wins and partnerships with federal SIs. So I wanted to better understand what the moat and differentiation is, and if you can help explain to us why this wouldn't necessarily cannibalize your direct business, which you're executing just fantastically in?

So our direct business versus channel business, almost all of our business is through the channel. A few customers insist that they must do a deal directly with us. So the channel is supposed to bring leverage. The more channel partners working closely with us, the more heavy lifting they do, better productivity, and better sales acceleration happens. So it's important for us. Now, in a transformation sale like ours, the channel wasn't quite ready there to say, 'Hey, tell me the latest box. I'm ready to sell.' We had to work with them to show them transformation. The federal government is driving big transformation at all levels. The President's Executive order is asking for Zero Trust architecture, and a large number of systems integrators in the federal market actually need technology like ours to make it happen. In federal, it becomes more interesting as you must have certification up to certain levels, and there are FedRAMP certifications at different levels. We've achieved most of them. So with certifications leveraging those system integrators, we are able to drive transformation. I think we are in very good shape sitting there with a big market, working side by side with our partners. So there's no cannibalization. Did I make it clear? Or did I miss something?

No, that’s super clear. Thank you.

Thank you. One moment please. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Your line is open.

Hi, good evening. Thanks for taking my question. Remo, regarding your comment on the sales changes and the impact of the full-year billings guide. Just curious, are you anticipating the leadership change will drive a broader restructuring in the sales org? Like you saw a few years ago when Dali came on board? Or is it going to be more incremental? Thank you.

Yes. The leadership we have in our sales organization is very strong, and what Dali has created is a solid structure. I don't see significant changes. Maybe Jay can speak to it, but I don't see significant changes. The structure that we've built under Dali's leadership was a strong one.

Yes. In many ways, our sales process at Zscaler is very similar to the ServiceNow sales process. It's consultative; it is top-down selling, and it's enterprise-focused. So we expect the same kind of structure to carry on; there will be ongoing refinements, but don't expect any big changes. Some of the things, as I talked to Mike early on, as he's understanding the organization, you'll see a probably more focus on a top account program. We have a significant opportunity to take our large customers and double, triple, or quadruple the ARR with us because our platform supports it. You are going to see more emphasis on verticals. We already have some focus on verticals, public sector as a vertical for us, healthcare; you'll see it expanding further. You're also going to see more persona focus in our sales staff. And I mentioned earlier too, you'll probably see more focus on global system integrators as they drive some of the large transformations, but no significant changes.

Helpful. Thank you.

Thank you. One moment please. Our next question comes from the line of Matthew Hedberg of RBC. Your line is open.

Great. Thanks for taking my question. Remo, a question for you on the macro. There's been a couple of questions on billings and RPO, and obviously, the federal strength. But I guess, maybe I'm just a little confused because when I look back at your Q4 script, when you talked about the macros, you said you noted global uncertainty, but it seems to me like there was a change in tone from your comments here. I think you said you noted that customer sentiment is starting to stabilize, so I guess I'm just sort of curious what drove that comment that things are starting to stabilize versus last quarter when you noted uncertainty? And is this something that happened during the quarter, or anything that prompted you to maybe change the script a bit from 4Q?

Yes. I'll let Jay comment to this.

I think what I commented last time was that there's a slight reduction in scrutiny of deals, that's the tone I used. I think what we're seeing though, there’s no change in macro; the forecast needs to be assumed as macros not getting any worse than it has been.

Thank you.

Thank you. One moment please. Our next question comes from the line of Shrenik Kothari of Baird. Your line is open.

Yes. Thanks for taking the question, and congrats on the great quarter, Jay and Remo. It's great to see your focus on large transformative deals in top accounts as you've just highlighted, Jay. The ongoing traction with bundled offerings across your emerging new products contributing to the new business. So all of that speaks to creating an in-house kind of innovation model that you have talked about. Jay, how do you see the role of strategic M&A play in expansion plans as we are starting to see with some others, especially around cloud and data security? And what, if any, potential areas to focus? And Remo, can you provide the new versus upsell split in the quarter and how it compares to the expected 40-60 mix? Thanks.

Yes. Very good question. With tighter funding and lots of security companies out there, we're seeing lots of attractive opportunities coming our way. We are looking at a number of innovative technologies and strong development teams. It's an option we've done a number of small acquisitions in the past, and yes, there are some areas—interesting technologies, especially in the new world of data and AI. It's an option we're keeping. I think you will not see us trying to buy revenue through an M&A. We're looking for innovative, disruptive technologies that can help us get to market sooner, faster. It's important that those technologies integrate with our platform. I despise acquisitions where standalone products do not work together. But we are actively exploring those areas; there’s no reason why we should not be. Remo?

Yes. The new and upsell was 45% new, 55% upsell. On our year-end call, we said we expect upsell to be above 60%. That's still our expectation for the year. But for the quarter, it was around 55%.

Okay. Thanks a lot, Jay and Remo. Appreciate it.

Thank you. One moment please. Our next question comes from the line of Brian Essex of JPMorgan. Your line is open.

Hi. Good afternoon, and thank you for taking the question. I guess, Remo, I wanted to dig into margins, specifically maybe gross margins. I mean, you guys are about three times the size you were 2.5 years ago, but you've hovered kind of in this just below 81% gross margins, give or take, 50 basis points or so. I appreciate the comments you had that emerging products will initially have lower gross margins. I think that's been the case for some time. But how do we think as you continue to grow at an accelerated pace and scale; how can we expect that to impact your margins? How are you managing your infrastructure? And then maybe just an adjacent comment on sales and marketing; it seems as though that was quite a bit lower than billings. Did you hold back on sales and marketing spend ahead of the arrival of Mike and Joyce? Thank you.

Yes, a few questions there. Did we hold back the sales and marketing spend? Not really. We held back sales and marketing spend, but not significantly. From a gross margin perspective, our stated gross margin has been between 78% and 82% for some time now. You're right, Brian. We've been in the 80% range for a long time. The beauty of Zscaler is the platform technology we've created. When I started here, we were doing 30 billion transactions per day. We are doing 360 billion transactions per day right now, and we still have 80% gross margin. The benefit that we have is that we can make decisions really to maximize gross margin or to get applications or increase the strength of our product by going through public cloud. We balance that. I'd expect gross margins to be in that 78% to 82% range long-term; short-term, midterm, I'd expect them to be in the 80% gross margin range. If we need to shift our focus to maximize our margins, we will, but we are committed to keep innovating. We won’t slow down on building more products.

That’s helpful. Thank you.

Thank you. And that is all the time we have for questions today. I'd like to turn the call back over to Jay Chaudhry, CEO, for any closing remarks.

My sincere thanks to our employees, our customers, and partners for delivering a strong quarter. Thank you for your interest in Zscaler. We look forward to seeing you at some of the investor conferences. Thank you.

Thank you.

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