Earnings Call Transcript - ZS Q2 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Zscaler Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Mr. Bill Choi, Senior Vice President of Investor Relations and Strategic Finance. Mr. Choi, the floor is yours.

Bill Choi, Senior Vice President of Investor Relations and Strategic Finance

Good afternoon, everyone, and welcome to the Zscaler Fiscal Second Quarter 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 market share, and market opportunity. These statements and other comments are not guarantees of future performance, but rather are subject to risk and uncertainty, some of which are beyond our control. 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. We will upload a copy of today's prepared remarks to the IR website when we move to the Q&A segment of the call. I would also like to inform you that we'll be attending the following upcoming events in March: Berenberg Thematics Software Conference on March 2; JMP Securities Technology Conference on March 7; and Wolf Research Virtual Software Conference on March 23. Now, I'll turn the call over to Jay.

Jay Chaudhry, Chairman and CEO

Thank you, Bill. I'm pleased to share our strong results for fiscal Q2. We continue to see strong demand for our Zero Trust Exchange platform, as our customers embrace the cloud. We delivered 63% year-over-year revenue growth and 59% billings growth, while also generating over 50% growth in operating profits and free cash flow. Public SaaS companies are happy to get to rule of 40, while we have been exceeding the rule of 70 for the last 12 months, validating our strong execution in pursuing our large market opportunity. Our continued investment in scaling our engineering and go-to-market machines is yielding the best revenue growth we have had in three years, even as we surpassed $1 billion in annualized revenue. We plan to keep making substantial investments across the company to continue our rapid pace of innovation and growth. What we deliver with our platform is critical to our customers' highest priorities. This is reflected in our deal sizes, which are increasing due to our success with large enterprises who are buying more of our expanding platform with a significant growth in the number of new logo and upsell customers for orders with over $1 million in annual value. We now have over 250 customers exceeding $1 million in ARR, an increase of 85% year-over-year. Business momentum for our Zero Trust Exchange is strong due to the market need for a modern security architecture in the world of cloud and mobility. Our flagship ZIA offering has been growing very well as we continue to expand our cyber and data protection services. ZPA has emerged as our second flagship offering, supporting millions of users and the majority of our Global 2000 customers. We are the clear market leader in zero trust application access with proven maturity and scalability. With ZIA and ZPA, we have demonstrated our success implementing zero trust for users. Our next immediate big opportunity is to bring zero trust to workloads in our ZCP pillar powered by the same core ZIA and ZPA technology. In addition, our ZDX pillar is enabling a highly productive workforce and it is seeing strong demand. In a single integrated cloud platform, our Zero Trust Exchange provides secure any-to-any connectivity for users, applications, workloads, and IoT and OT systems regardless of their location. While many vendors claim to offer a platform because they bought a bunch of point products that are very hard to integrate, no one comes close to the capabilities of our cloud-native extensible platform. We will continue to invest in engineering, customer support, marketing, and sales to accelerate the growth of new products while keeping the strong momentum on our flagship products. We believe we are in a sustained high-demand environment. We have a large and expanding market opportunity powered by our customers' digital transformation journeys, which continue at a pace never seen before. According to IDG's recent state of the CIO report, the top CEO mandate for IT in 2022 is to upgrade cybersecurity to reduce business risk. Whether it is supporting remote work or enabling new digital customer and employee experiences, IT leaders must ensure that business operations are agile, resilient, and secure. Given the explosion in ransomware and high-profile data breaches, IT leaders are looking to phase out castle and moat security to adopt zero trust architecture to unlock the full potential of digital transformation. It is clear from our growth in our large enterprise wins that architecture matters. Despite legacy vendors' marketing claims, true zero trust security cannot be built on legacy network security architecture. As I have highlighted before, there are two reasons why enterprises choose Zscaler. One, we are the only proven cloud security provider with a proxy architecture that inspects TLS encrypted traffic at scale to deliver superior security. We connect users to applications and not to the network, eliminating lateral movement. This is a core principle of zero trust architecture that can't be achieved by next-gen firewalls or cloud VPNs. Let me discuss some of our Q2 deal wins that highlight the advantages of our Zero Trust Exchange. I will start with a big ZIA event. A Fortune 100 professional services customer initially purchased our ZIA transmission bundle plus CASB and DLP and ZDX for 125,000 employees working from anywhere. This quarter, they added 175,000 ZIA seats to secure all 300,000 employees. With a cloud-first strategy and mission-critical client-facing data at stake, they selected our proven scalable platform with a global footprint needed to support their business in over 150 countries, with 93% of their Internet traffic encrypted. TLS inspection was a major requirement, and the customer only considered a proxy architecture. Next is a new logo customer, which started with ZPA as part of a strategic initiative to transform their IT infrastructure. This global 50 manufacturer, headquartered in Europe, purchased ZPA for 200,000 users to implement zero trust securely. ZPA will eliminate their attack surface, protecting thousands of private applications behind our Zero Trust Exchange, hence their apps can't be discovered, exploited, or DDoS. We are replacing their firewall-based VPN that allowed lateral movement. A global systems integrator partner, who is implementing the overall transformation project, played a major role in driving the Zscaler win, an example of the channel leverage we are creating with our investments in our SI partners. As the shift to the cloud accelerates, customers are buying ZIA and ZPA together, enabling a true transformation with direct and seamless access to SaaS and private applications whether on-prem or in the public cloud. Let me highlight several such deals. In a new logo win, a Fortune 50 insurance customer signed a full-year commitment for ZIA, ZPA and ZDX to securely enable 65,000 employees working from anywhere for comprehensive cyber and data protection. They purchased the high-end transformation bundle plus CASB, advanced DLP and SSBM or SaaS security portal management, which is like CSPM for SaaS. Fast user experience and superior cybersecurity were the key factors in our win. In another new customer win, a Fortune 500 Fintech Company that has grown through acquisitions signed a nearly five-year commitment to up-level security and simplify IT. They purchased ZIA transformation plus CASB and DLP, as well as DPA and ZDX for 60,000 employees. This consolidated seven different security point products and accelerated the closure of 24 data centers. Moreover, ZPA also shortens new employee onboarding to a few days from 2.5 months. It also eliminates the need many employees had for two laptops to access two separate networks. I'm also excited about our success selling security transformation in new countries. A global 500 manufacturer headquartered in Mexico purchased ZIA and ZDX for over 18,000 users and ZPA for 14,000 users. This is our first seven-figure annual deal in Latin America, a region where we recently started making investments. Next, M&A is an elegant use case for the Zscaler platform. In an upsell deal, a diversified industrial conglomerate with over 20 operating companies that previously purchased ZIA Transformation Bundle added ZPA for 16,000 users to accelerate M&A integration and reduce business risk without having to connect two corporate networks with legacy firewalls, which could have taken 14 months or more. Our Zero Trust Exchange provided secure access to applications across both companies in weeks, saving time and money. This customer purchased a high-end ZPA bundle with integrated browser isolation to enhance data protection. They also bought our deception technology to intercept bad actors who may have infiltrated the network. This latest purchase more than doubled their annual spend with us. Next, let me highlight customers purchasing all four pillars of our platform. In a new logo win, a Global 2000 leader in technology products purchased ZIA transformation with DLP and CASB, ZPA and ZDX for 11,000 employees and ZCP workload posture for 6,000 workloads in a multi-cloud environment. As we accelerate the digital transformation, the CIO's core priority was to eliminate the risk of legacy VPNs and lateral movement while ensuring the best user experience. They put ZDX to the test by asking us to troubleshoot the poor Microsoft 365 experience of an executive traveling in Europe. ZDX mapped the entire network path over the Internet in real-time, isolating specific issues and allowing the customer to quickly resolve the problem and improve the user experience. This proof of value led to the quick ZDX purchase. I believe that over time every ZIA and ZPA customer will embrace ZDX as workforce productivity is one of the highest priorities for a CIO. Lastly, I'm happy with our early success in expanding our routes to market via cloud marketplaces, first with AWS and now with Azure. Let me highlight two Azure marketplace deals. First, an existing global 200 pharma customer with headquarters in Europe purchased ZPA for all 87,000 employees, enabling zero trust access to the private apps hosted in hybrid cloud environments. This purchase was done with just a couple of mouse clicks and it doubled their annual spend with us. Second, a new Fortune 500 customer in the energy industry made a three-year eight-figure commitment for ZIA, ZPA and ZDX for all 23,000 employees. We will continue to invest in cloud marketplaces as a new channel to revenue. Enterprises trust Zscaler over cold imitators and new entrants because we have a true Zero Trust architecture and have over 10 years of operational experience, running the largest security cloud in the world. Our Zero Trust Exchange processes over 210 billion transactions in line and prevents more than seven billion security and policy violations per day, providing our customers an unmatched network effect for superior security to flawlessly run the world's largest security cloud with five 9s of availability requires more than security expertise. It requires networking expertise and the ability to control the traffic path. As Zscaler was born as a cloud company and has been operating an in-line cloud since 2008, we have gained this expertise over time. There's no compression algorithm for years of experience. This expertise will become even more important as we address hundreds of millions of workloads and billions of OT IoT devices. Let me share an example of our cloud operations differentiation. Microsoft extended direct fiber connectivity from the major data centers to ours because of the volume of traffic that flows between Zscaler and Microsoft. This direct connectivity enables us to deliver higher reliability and performance compared to the traditional Internet exchange peering approach. This is a validation of our scale and the criticality of our services to our mutual customers. Another example of delivering great availability and high performance is our integrations with Microsoft and Zoom. With API-based integration for Teams and Zoom, we proactively identify and resolve performance issues for these latency-sensitive apps. Without this, user collaboration is disrupted and business productivity is lost. Our proven track record running the world's largest in-line security cloud makes Zscaler the obvious and trusted partner of choice, as enterprises need to securely access mission-critical applications. Let me also talk about our recognized market and innovation leadership. Zscaler pioneered the zero trust architecture, and over time, our platform subsumed functionality of multiple point products into our secure web gateway foundation as the market evolves and customers migrate towards a platform approach such as Zscaler. Gartner expanded the scope of the Secure Web Gateway MQ to include functionalities such as CASB, ZTNA, Digital Experience Monitoring, and Browser Isolation, and renamed it SSE or Security Service Edge. After 10 consecutive years of being named a leader in Gartner's MQ for secure web gateway, we were again named a market leader for SSE. Many of you are aware of SASE. So how are SASE and SSE related? SASE framework is the combination of SSE and WAN Edge. SSE has all the security capabilities built on zero trust architecture and is independent of the type of network. WAN Edge, which is generally SD-WAN, provides connectivity to an SSE cloud. Importantly, zero trust security is implemented in the SSE cloud, not in the WAN Edge. As the category leader in SSE with the widest and deepest offerings, Zscaler is the go-to platform for vendor consolidation, cost savings, increased user productivity, and better cyber protection. As our market opportunities expand, we are promoting two strong leaders to continue scaling Zscaler. We're expanding Amit Sinha's role to President of the company. Amit will continue to lead our engineering and cloud operations teams while also assuming broad responsibilities for expansion of our platform into new areas. We are also promoting Dali Rajic to Chief Operating Officer. Dali will continue to lead our global sales organization while also assuming broader responsibilities for interlocking among sales, marketing, business development, and transformation teams to further enhance the customer lifecycle journey. In their new roles, Amit and Dali will be responsive to driving further growth, operational excellence, and collaboration across the scale, as we continue the path towards our next milestone of $5 billion in ARR. To enable our customers' ever-growing digital transformation aspirations and extend our market leadership, our entire organization is focused on attracting and developing talent and creating a culture that rewards innovation at all levels. We added approximately 1,000 employees globally in the last six months and have over 4,000 employees who are energized by our shared mission to create a hyperconnected digital world in which the exchange of information is always secure and seamless. In today's competitive hiring market, Zscaler is a destination for top talent. We are proud of our Glassdoor rating, which is among the highest in the industry. Zscaler has never been stronger, and I believe we have a large and growing opportunity in front of us. Now I would like to turn over the call to Remo for our financial results.

Remo Canessa, CFO

Thank you, Jay. As Jay mentioned, we are pleased with the results for the second quarter of fiscal 2022. Revenue for the quarter was $256 million, up 11% sequentially and 63% year-over-year. On a year-over-year basis, revenue growth accelerated in the quarter, driven by strong business activity. ZPA product revenue was 17% of total revenue. From a geographic perspective, we had broad strength across our three major regions. Americas represented 51% of revenue, EMEA was 35% and APJ was 14%. APJ continues to be our fastest-growing region, with revenue growth of 16%. Our total calculated billings grew 59% year-over-year to $368 million, with billings duration near the midpoint of our 10 to 14 months range. We are also pleased to report 61% year-over-year growth in short-term billings. Remaining performance obligations, or RPO, were $1.95 billion as of January 31, growing 90% from one year ago. The current RPO is 50% of the total RPO. 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%. We had 251 customers paying us more than $1 million annually, up 85% from 136 in the prior year. The continued strength in this metric speaks to the role we play in our customers' digital transformation initiatives. We added over 560 customers in the past 12 months paying us more than $100,000 annually, ending the quarter at 1,751 such customers. Turning to the rest of our Q2 financial performance, total gross margin of 80.4% was approximately flat quarter-over-quarter and down 90 basis points year-over-year. Our total operating expenses increased 13% sequentially and 62% year-over-year to $183 million. Operating expenses as a percentage of revenue were up at 72%, similar to a year ago, even as we made ongoing investments in smokescreen and trust-owned businesses we acquired in the second half of last year and the partial return of T&E. Operating margin was 9% and free cash flow margin was 12%. We continue to expect CapEx as a percentage of revenue to be in the high single digits for the full year. We ended the quarter with over $1.61 billion in cash, cash equivalents, and short-term investments. Now moving on to guidance and modeling points. As a reminder, these numbers are all non-GAAP, which excludes stock-based compensation expenses and related payroll taxes, amortization of debt discount, and amortization of intangible assets. For the third quarter of fiscal 2022, we expect revenue in the range of $270 million to $272 million reflecting year-over-year growth of 53% to 54%, gross margins of 79%. I would like to remind investors that a number of our emerging products, including ZDX, workload segmentation, and CSPM, will initially have lower gross margins within our core products because we are more focused on time to market and growth rather than optimizing them for gross margins. Operating profit in the range of $19 million to $20 million. As noted before, we have more interest events starting this quarter, including customer events, conferences, our internal mid-year sales events, net loss and other income of $100,000, income taxes of $4 million, earnings per share of $0.10 to $0.11 assuming 149 million to 150 million fully diluted shares. For the full year fiscal 2022, we are increasing our revenue guidance to a range of $1.045 billion to $1.05 billion or year-over-year growth of 55% to 56%, increasing calculated billings to a range of $1.365 billion to $1.37 billion or year-over-year growth of 46% to 47%, increasing our operating profit to a range of $95 million to $98 million, increasing our earnings per share to a range of $0.54 to $0.56 assuming approximately 149 million to 150 million fully diluted shares. Please note that our share count guidance includes dilution from our convertible debentures based on the existing treasury method of accounting. With a large market opportunity and customers increasingly adopting the broader platform, we're committed to investing aggressively in our company. We see a window of opportunity to extend our first-mover advantage in this fast-growing market, which will have positive long-term impacts. We will balance growth and profitability based on how our business is growing, but we'll continue to prioritize growth, which we believe is in the best interest of our shareholders, employees, and customers. Operator, you may now open the call for questions.

Operator, Operator

Thank you. We also ask that you please limit yourself to one question at a time. Now, stand by as we compile the Q&A roster. Our first question comes from Andrew Nowinski of Wells Fargo. Your line is open.

Andrew Nowinski, Analyst

Great. Congrats on a nice quarter, gentlemen. I'd like to start off with a question on the impact from the Russia-Ukraine conflict. So at the start of the COVID pandemic, you clearly saw some new momentum with ZPA, as more employees were forced to work remotely. I'm wondering if the Russia-Ukraine conflict has had a similar effect, creating any new demand for your solutions and whether it's from companies in the region or even outside of Ukraine that might be concerned with the ensuing cyberattacks that could be launched?

Jay Chaudhry, Chairman and CEO

Andrew, it's a little bit early to tell the impact, but our customers are concerned. There's higher cyber sensitivity. I was talking to a CXO from Germany earlier today and he actually opened the call I had with him with this topic. Customers want to make sure they're secure. One of the things we think will help us directly is ZPA, which can hide our attack surface. If you can't see something, you can't attack it. ZIA becomes more important for all the in-line protection. Our research team is seeing signals of increased reconnaissance activity that has been increasing for the past few weeks. We have a 100% research team, and we're making them available as a resource to our customers.

Andrew Nowinski, Analyst

Got it. Thank you.

Operator, Operator

Thank you. Our next question comes from the line of Matt Hedberg of RBC Capital Markets. Your line is open.

Matt Swanson, Analyst

Yes. Thank you. This is Matt Swanson on for Matt Hedberg. Jay, first of all, incredibly impressive to be able to find and hire 1,000 people over the last six months in this environment. But when you think about one of every four Zscaler employees being new to the company, could you just talk about how you're managing that growth? And also, given the expanded draft of the products and the more multi-polar sales, how should we think about the ramp time for adding new sales headcount?

Jay Chaudhry, Chairman and CEO

Well, thank you for the multi-part question. Let me start by saying that we are very pleased that we have been able to do good hiring in this tough hiring environment because we are a top destination for top talent. So hiring is obviously the starting point. Beyond that, we are doing a number of things that need to be done to make sure these people can be easily incorporated into the company. In the past, we talked about a very strong enablement team, a number of boot camps for training we do, and buddy systems. We've implemented a number of strategies to help these individuals become part of the team. The data we've shown over the past two years proves that in this COVID environment, we have been able to get them productive.

Remo Canessa, CFO

From a headcount perspective, we called out last quarter, we had an outstanding quarter for a few quota pass. We had an equally great quarter also in Q2. Our plans are to really push growth. We see this as a huge market opportunity. We're going to continue to do that and we're going to continue to hire across the company.

Jay Chaudhry, Chairman and CEO

The only comment I'll add next to it is, it's not just ASMs that matter for us. Our top-down strategic sales process requires solution architects. We have a transmission team of CIOs, CSOs, and CTOs. They all play an important role, and we're doing well across the board in hiring.

Matt Swanson, Analyst

Thank you.

Jay Chaudhry, Chairman and CEO

Thank you.

Operator, Operator

Thank you. Next, we have the line of Alex Henderson of Needham. Your line is open.

Alex Henderson, Analyst

Great. Thanks. Let me also extend my compliments for an outstanding quarter. You guys really, against a very tough comp, delivered superb results. I was hoping you could talk a little bit more in terms of hiring around the capacity expansion within your sales organization, to what extent you've delivered on the prior hiring, say, a year ago getting to quota and where we are on the current hiring getting to when you think they'll get to quota and what your expectations are for CY 2022 for staffing increases in sales capacity. Is it reasonable to think that it could be another year of 50% capacity growth? Thanks.

Remo Canessa, CFO

Yes. I'll take it. So from a quota perspective, we are seeing people ramped quicker, but they're on full quota after one year. So that hasn't changed at all. Regarding sales capacity, I don't want to give percentages out. What I'd like to say is that it's a huge market opportunity, and we see it. We'll continue to build sales capacity in our model.

Jay Chaudhry, Chairman and CEO

The only comment I'll add is that our top-down strategic sales process requires solution architects. We need to have all of our teams engaged from the CIO, CSO, and CTO level, and we are successfully hiring across the board.

Matt Swanson, Analyst

Thank you.

Operator, Operator

Thank you. And next, we have the line of Hamza Fodderwala of Morgan Stanley. Your line is open.

Hamza Fodderwala, Analyst

Hey, guys. Thanks for taking my question. Remo, if I could direct my question to you first. I mean, Jay mentioned a lot of great things about the demand environment, about some of the secular tailwinds that you guys are seeing with larger deal sizes. If I look at the billings growth and 59% growth at this scale is obviously very impressive. It was a little bit below sort of the usual seasonality and the 70% type billings growth that you guys were doing over the last four quarters. So I'm just curious, when we think about billings at this scale, is there anything we should be mindful of in terms of seasonality going forward, or anything that was perhaps one-time in the last quarter when we think about billings growth in relation to revenue growth over the next four quarters?

Remo Canessa, CFO

Yeah. I mean, a lot of questions there. Let me try to answer it. So 59% billings growth, as you mentioned, is absolutely outstanding. If I take a look at Q2, if there's one area that didn't perform at the level that we wanted, it was federal. Federal was low single digits of our new and upsell business. Now why is that? It's just the budget constraints. So our feeling is that federal will be a big portion or a substantial portion of our business. We've got the FedRAMP certification. Also, we've built up a strong team with relationships. To call out one thing in the quarter that I would say didn't meet our expectations, it would be federal. It was low single digits. Regarding billings and revenue going forward, it's hard to say. It all depends on our really top-level growth. Like I mentioned before, with Alex, it's a huge market opportunity. We feel we're well positioned. We're seeing traction with our customers. I believe we had 251 customers greater than the $1 million ARR, which is a growth rate of 85% over the prior year. Our customers paying more than $100,000 ARR was like $1,750. Substantial growth year-over-year.

Hamza Fodderwala, Analyst

Got it. Really helpful.

Operator, Operator

Thank you. And next we have Joel Fishbein of Truist. Your line is open.

Joel Fishbein, Analyst

Thank you and congrats on the great execution. I guess this is for Jay and Remo. You've been pretty successful in terms of cross-selling a lot of the different products, and obviously, deal sizes are going up pretty dramatically. I'd love to get your take on how ARPU per seat has been trending. And then the second part of that is, how is it being able to sell into different parts of an organization since the products affect obviously different parts of an organization? That would be helpful as well. Thank you.

Jay Chaudhry, Chairman and CEO

Let me start. In my prepared remarks, I covered many deals where ZIA, ZPA, and ZDX worked together and a number of deals with all four product pillars being acquired. So we're actually very happy with the traction we're seeing. You've seen over the past couple of years that ZIA and ZPA coming together has become a fairly common thing. On ZDX for the last year, it has become more and more integrated. We've seen lots and lots of customers buying ZDX because without this, you can't troubleshoot if something goes wrong. ZCP is also becoming an interesting seat opportunity for us because that's an early market for workloads. We're positioning ourselves well to grow it. We feel very good about the cross-sell potential.

Remo Canessa, CFO

Yeah. I mean, the ARPU is definitely increasing, and we'll be giving information on that on an annual basis. New versus upsell in the quarter was 45% new and 55% upsell. So a good balance between new and upsell for us.

Joel Fishbein, Analyst

Thanks.

Operator, Operator

Thank you. And next we have Gray Powell of BTIG. Your line is open.

Gray Powell, Analyst

Great. Thanks for taking the question. Congratulations on a strong quarter. I know a lot of people are focused on billings as the primary metric. But if I'm doing my math correctly, it looks like current RPO grew about 80% this quarter, pretty close to 83% last quarter and well above your 63% revenue growth rate. So just curious what you think we should be looking at as the best leading indicator for future revenue growth? And should it converge to RPO trends over time?

Remo Canessa, CFO

Yeah, that's a great question. If you take a look at our RPO growth year-over-year, it was about 90%. CRPO growth was 79%. What we've always pointed out when the RPO growth rates and CRPO growth rates are going in the triple digits, we brought back investors and said billings are the best way to look at our business. Both in the quarter, our duration was right in the middle of the range of 10 to 14 months. One thing I'll also call out that investors probably look at is short-term billings growth. Our short-term billings growth was 61%. So I would look at everything as an investor, but from a Zscaler perspective, it's really billings. And if we're in that range of 10 to 14 months, it kind of bounces, and short-term billings growth is the key metric.

Gray Powell, Analyst

Understood. That’s really helpful. Thank you very much.

Operator, Operator

Thank you. Our next question comes from the line of Jonathan Ruykhaver of Baird. Your line is open.

Jonathan Ruykhaver, Analyst

Yes, hey guys. So, you announced last quarter general availability of workload communication. So, just kind of curious to hear commentary on adoption trends expectations around that ramp. And how would you view long-term adoption over time? Will it be somewhat limited to larger organizations similar to what you've commented on workload segmentation, or is it a bigger opportunity?

Jay Chaudhry, Chairman and CEO

It's a very good question. Workload segmentation is only one piece of our offering. The core, the basic offering is what we call zero trust for workloads. Workloads are a mirror image of users. Like users, they talk to the Internet and like users talk to workloads, workloads also talk to other workloads. So, we've taken our disruptive zero trust for users, ZIA, ZPA, and applied it to workloads. Today, what is typically done to secure workloads in the cloud? It's largely the traditional firewall approach. We believe we will disrupt workload-based security the same way we did for users with the ZIA, ZPA. So, it's an asset opportunity. I highlighted a number of deals where actually multiple products got bought together, including ZCP. Some of these deals included a Fortune 500 semiconductor company, a Fortune 500 financial services company, and a global logistics company. Now, I would say that customers do start small in the cloud workload area and then they grow with us.

Jonathan Ruykhaver, Analyst

Helpful. Thanks. Jay.

Operator, Operator

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

Fatima Boolani, Analyst

Hey good afternoon. Thank you for taking my question. Remo this is a question for you on cash flow. We saw the relationship between operating margins and the cash flow margins diverge pretty materially over the course of the pandemic, and we are starting to see that consolidate a little bit. So, I'm curious if you can shed some light on how we should think about the free cash flow trajectory from here, particularly in the context of the multi-year commitments and large deals that Jay alluded to in his prepared remarks and as you start to do a lot more enterprise and large deal in seven, eight-figure business?

Remo Canessa, CFO

Yes. Let me first say we would like to be prudent with our projections. So, keep that in mind. If you take a look at our free cash flow margins in Q1, it was like in the 35% to 36% range of revenue. In fiscal Q2, our free cash flow margins were 12% with operating profitability at 9%. From my perspective, I just think it's prudent to think about free cash flow being slightly higher, by three, four, five percentage points higher than operating profitability. It is going to fluctuate on a quarter-on-quarter basis. Our Q1 to Q3 are typically our highest quarters for free cash flow. The reason for that is that our Q2 to Q4 is our biggest billing quarters. As we get bigger, we build typically annually. When we talk about billings, that is what we discuss. Certainly, we could increase free cash flow by doing multi-year billings, but that's not our model. What we try to do is get multi-year commitment contracts, which we have seen increase. But for free cash flow or billings, we typically state that on one year.

Fatima Boolani, Analyst

Very helpful. Thank you.

Operator, Operator

Thank you. Next, we have Tal Liani of Bank of America. Your line is open.

Tal Liani, Analyst

Hi. I want to ask about billing growth because the stock is going down on lower billing growth than buy-side expectations. So you grew billing around 71% pretty stable in the previous four quarters. This quarter it was much better than guidance, but it was lower than what we've seen in the previous four quarters. So that's 59%. And then the guidance for the year is 46% more or less. So the question is, how should we think about billing growth? What can you say about this quarter? Why is it lower than previous four quarters? And what's the explanation or what are the puts and takes for the following few quarters? Thanks.

Remo Canessa, CFO

Yes. I mean great question. Four quarters in a row at 70% plus annual growth is outstanding; sustaining that as we get to our size is tough. 59% billings growth is outstanding. If you take a look at some of our prior quarters, duration plays into that top-line billing growth. If you look at short-term billings growth, it was 61%. Looking forward, we see this as a huge market opportunity, and we're going to continue to invest in our business. We don’t see any reason to slow down our growth. Our focus continues to be on top-line growth as we see the tremendous leverage in a SaaS model with the contribution margin in that 60% range for years two and three. It doesn't take long to get to operating profitability. Our focus is on building up our ARR.

Tal Liani, Analyst

Got it. Thank you.

Operator, Operator

Thank you. Our next question comes from Mike Walkley of Canaccord Genuity. Your line is open.

Daniel Park, Analyst

Hi, guys. Good afternoon. It's Daniel on for Mike. Thanks for taking my question. So over recent periods, you've been working on really improving your sales motion within the enterprise segment. Could you give us some color on how this part of your business trended this quarter? And I guess, if you're recognizing some additional wins given the investments you've made so far?

Jay Chaudhry, Chairman and CEO

Hi, this is Jay. The enterprise segment, which we define as 2,000 to 6,000 employees per company, is progressing very well and we continue to make significant investments in growing the team. Moving to small enterprises is a natural step for us. It's an attractive market, and it's also a market where channel can play a bigger role, and some of our channel programs have been helping us quite a bit. So we plan to continue to invest and grow the same.

Remo Canessa, CFO

Yes. I mean in the quarter, all segments grew well. Given our strength in large deals during the quarter, the large enterprise did better.

Daniel Park, Analyst

Okay. Great. Thank you so much for the color.

Operator, Operator

Thank you. Our next question comes from Patrick Colville of Deutsche Bank. Your line is open.

Patrick Colville, Analyst

Hey, thank you so much for taking my question. Can I just double-click on the point you made earlier in the call around federal. You called out that federal was only low single digits of new and upsell. Can you just give us a framework to compare what that was like last quarter or last year so we can get a frame of reference? And can I also just ask were there any deals that were pushed out that have subsequently closed after January 31 that you hope that we should be aware of?

Remo Canessa, CFO

I'll answer the first part and Jay can answer the second part about the deals. But typically, federal has been mid-single digits. Sometimes even high single digits. But I don't recall what it was last year. You can think of federal typically being mid-single digits on average contribution of our quarterly new and upsell business, whereas this quarter was low single digits.

Jay Chaudhry, Chairman and CEO

In terms of pipeline, deals are growing. We are well engaged. We're seeing more momentum coming from some of the new memos and initiatives being put in place. We have the architecture, we have certain certifications. One thing remains a little unpredictable is some of the federal budgets and the timings.

Patrick Colville, Analyst

Thank you so much.

Operator, Operator

Thank you. Our next question comes from Keith Bachman of Bank of Montreal. Your line is open.

Keith Bachman, Analyst

Hi, thank you. Just a clarification on the question, Remo. You mentioned duration. If you look at short-term billing, you grew at 61%. It's a little bit of a degradation call it seven points from the previous quarter but the compare was six points higher. So your short-term billings have been pretty steady. If I look at the last January through July quarters of last year, you grew 70-plus percent. Can you just remind me how much that was enhanced by duration so we can normalize for the compare? And if I’m allowed to sneak one in, I just wanted to see if you could talk about NRR trends as you see going through the year. Does it stay steady, or do you think, as you're rolling out new products like ZCP, those trends may improve to facilitate growth? Thanks very much.

Remo Canessa, CFO

I'll just call out one quarter that I'm aware of, which is Q3 of last year. Q3 of last year, in that 10- to 14-month range, it was close to that 14-month range. So that's the duration impact in Q3 of last year which I can recall. Regarding NRR, new products, the comment that we made last quarter is that if it's over 125%, we're not going to give out specifically what the NRR is. It was over 125% in the quarter, but our new products are doing well. I mean, our new products are doing well as well as ZPA. Those are very big contributors related to that NRR. I believe we expect NRR to do well. But having said that, it's one of those things we see the bigger bundles we sell upfront, the lower NRR. If we do the first deal today and in two quarters we do the second upsell deal, that doesn't get picked up in NRR. So, happy with NRR. In the past we've said that we don't focus too much on NRR, which is why we provided 125% or higher as a good indicator.

Keith Bachman, Analyst

Great. Thanks, Jay.

Operator, Operator

And next we have Brian Essex of Goldman Sachs. Your line is open.

Brian Essex, Analyst

Hi. Good afternoon and thank you for taking the question and congrats on the results. I guess Jay, maybe if you could address this one. I know when Dali came on board, the focus was on increasing deal velocity and also hiring. Now that you're getting larger deals, you have a more mature sales force, so there are some puts and takes there. Maybe any commentary you can provide on sales cycles? And now that you're larger growing larger numbers with bigger deals but now with a more mature sales force, how you're managing that dynamic and what those sales cycles look like? Thank you.

Jay Chaudhry, Chairman and CEO

Yes. It's a good question. The sales force with all the processes and enablement we've put in place has helped us grow exceptionally well over these past 2.5, three years since we implemented this new motion. That being said, we are expanding further down to the enterprise segment, which is doing quite well. As you would expect, some cycles are lower towards the lower end of the market; it remains fairly long on the high end of the market. It is a transformation sale that involves multiple parties, but as we engage, we end up winning back. We are so sticky that we keep upselling and growing. I feel very confident and comfortable. As these numbers grow, we need to keep executing. The market is there, the product portfolio is there, and we have no competitive pressure. We just need to keep doing our job well.

Brian Essex, Analyst

Great. Any way to quantify what sales cycles are and how they've trended?

Jay Chaudhry, Chairman and CEO

I would say we haven't quantified the exact percentage reduction, but it has been within the range we have always stated. Smaller deals were typically three to six months, while larger deals extend from six to twelve months. As we scale, we're beginning to see some compression on the lower end of the spectrum, but deals come in many shapes and sizes. I’m confident in our growing pipeline and our close rates.

Brian Essex, Analyst

Very helpful. Thank you.

Operator, Operator

Thank you. Next, we have Roger Boyd of UBS. Please, your line is open.

Roger Boyd, Analyst

Hi, thanks for taking my questions. Wondering if you could talk about so first of all, a really strong performance out of the $1 million plus ARR cohort. I wonder if you could talk about what you're seeing in that smaller enterprise cohort in terms of competition and then also what's the recognition of Gartner on their new secure service edge Magic Quadrant means as you go to market with that smaller 2,000 to 6,000 cohort?

Jay Chaudhry, Chairman and CEO

It's a good question. The MQ is not just the lower market; it's across the board. The MQ is probably more relevant in the larger markets to some degree because larger companies tend to be Gartner customers. I was surprised to see the twin CASB vendors listed in the leaders quadrant because we don't see them in the real world out there. If I were to quibble with the criteria that Gartner used, I believe it was overweight on CASB, which is much easier to build. Our platform has expanded significantly with ZIA, ZPA, ZDX, ZCP, and more. As for smaller enterprises, we do see more vendors at the low end compared to the high end, where higher end customers are more discerning. They rule out vendors that don’t have the right architecture. Yesterday I had a call with the CIO of a large financial services company who wanted to discuss one thing: so many vendors keep coming and talking about all kinds of features and functionality, and when I talked to their operational experience running the cloud, they didn’t have much to say. In the lower end, we do see firewall vendors and new entrants, but once we engage and win, we are able to help them move forward effectively.

Roger Boyd, Analyst

Great. Helpful. Thanks, Jay.

Operator, Operator

And next we have Joshua Tilton of Wolfe Research. Your line is open.

Joshua Tilton, Analyst

Hey guys, thanks for squeezing me in. I kind of just wanted to follow up on the previous competition question, but just a little bit more broadly. Could you possibly comment on how your number of opportunities has been trending? And how would you characterize your overall win rates across the entire market relative to maybe previous quarters?

Jay Chaudhry, Chairman and CEO

Yes, so driven by transformation deals, there aren’t too many cases where we have active back-off in the security space. Our main source of back-off would be delays in closing rather than competitive pressure. We're gaining market presence, and we look to actively pursue and win. We're seeing more platforms emerge in our business and taking a larger stance than even two or three years ago, where ZIA was a relatively small piece.

Joshua Tilton, Analyst

Thank you. That's very helpful.

Jay Chaudhry, Chairman and CEO

Thank you.

Operator, Operator

Thank you. That concludes the Q&A portion of the call. I will hand the conference back over to Jay Chaudhry for final comments.

Jay Chaudhry, Chairman and CEO

Thank you everybody for joining us and your continued interest in Zscaler. I also want to thank our customers, partners, and employees who are helping us deliver strong results. We look forward to seeing you at upcoming investor events or updating you next quarter on our continued progress. Thank you, again.

Bill Choi, Senior Vice President of Investor Relations and Strategic Finance

Goodbye.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect. Have a pleasant day.