Earnings Call Transcript - ZS Q1 2023

Operator, Operator

Thank you for standing by, and welcome to the Zscaler Fiscal Year 2023 First Quarter Results Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentations, there will be question-and-answer session. As a reminder, today's conference call is being recorded. I will now turn the conference to your host, Mr. Bill Choi, Senior Vice President, Investor Relations and Strategic Finance. Please, go ahead, sir.

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

Good afternoon, everyone, and welcome to the Zscaler first quarter fiscal year 2023 earnings conference call. On the call with me today are Jay Chaudhry, Chairman and CEO; and Remo Canessa, CFO. Please note that we have posted our earnings release and a supplemental financial schedule to our Investor Relations website. Unless otherwise noted, all numbers we talk about today will be on an adjusted non-GAAP basis. You will find a reconciliation of GAAP to the non-GAAP financial measures in our earnings release. I'd like to remind you that today's discussion will contain forward-looking statements, including, but not limited to, the company's anticipated future revenue, calculated billings, operating performance, gross margin, operating expenses, operating income, net income, free cash flow, dollar-based net retention rate, future hiring decisions, remaining performance obligations, income taxes, earnings per share, our objectives and outlook, our customer response to our products, and our market opportunity. These statements and other comments are not guarantees of future performance, but rather are subject to risks and uncertainties, some of which are beyond our control. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties, please see our filings with the SEC as well as in today's earnings release. I would also like to inform you that we'll be attending the following upcoming events in December, UBS Global TMT Conference in New York City on December 5. Nasdaq Investor Conference in London on December 6. Now, I'll turn the call over to Jay.

Jay Chaudhry, Chairman and CEO

Thank you, Bill. I am pleased to share our Q1 results. For the quarter, our revenue grew 54% year-over-year and billings grew 37% against a difficult comparison. Normalized for higher billings duration a year ago, billings grew 42% as customers continue to embrace our Zero Trust Exchange platform to secure the digital transformation. Our disciplined approach to growth is enabling our operating profits to grow 76% year-over-year, with operating margins expanding by 150 basis points over the same period. Our free cash flow margin was 27%, which, once again, placed our performance above the Rule-of-80 for the quarter, a combination of growth and profitability that we believe only 1% of the public SaaS companies achieved. As the world's largest security cloud platform, we have outstanding unit economics in our business, reflecting a high 90% gross retention rate and over 80% gross margins. These industry-leading retention and margins are possible because of our differentiated service and highly scalable multi-tenant cloud platform. In September, Zscaler celebrated our 15th anniversary. When cloud and mobility were in their infancy, we founded the company with a bold idea to transform security and the corporate network. We started with a clean slate and created the Zscaler multi-tenant in-line cloud platform, establishing modern Zero Trust architecture. This approach is now recommended by NIST, one of the most respected standards bodies in the industry. Our Zero Trust Exchange is built on a unique architecture that securely connects users, devices and applications using business policies, regardless of their location. I could not be more proud of all our accomplishments to date, and I want to thank our employees, customers and partners for being a part of this journey. The vision we started Zscaler with is even more relevant today. Hybrid work and public cloud adoption are now mainstream as organizations, large and small, are racing to ensure their business operations are agile, resilient and secure. These generational tailwinds are durable and my conviction in our $72 billion serviceable market opportunity is greater than it has ever been. In my conversations with hundreds of IT executives, it is clear that cybersecurity remains their number one priority. Cyber threats, including ransomware and data exfiltration continue to grow exponentially as attackers exploit VPNs and firewalls. This is driving more organizations from firewall and VPN-based castle-and-moat security to Zscaler's Zero Trust architecture. To meet this need, we launched a new certification program that provides comprehensive knowledge of Zero Trust architecture and practical guidance for the planning, design and implementation of a Zero Trust architecture, enabling networking and security professionals to lead their organizations' secure digital transformation. In today's environment, ROI and cost optimization are becoming bigger priorities as business leaders are being asked to do more with less. Our Zero Trust Exchange eliminates the need for traditional security devices, either as on-prem appliances or virtual machines in the cloud that are difficult to maintain and require compromises between security, cost and user experience. Our business value message is resonating in this challenging macro environment and more customers are willing to adopt 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 align to the increasing deal sizes in each of our geo theaters, we reorganized our field level customer segmentation and expanded our enterprise segment efforts at the beginning of this fiscal year. When we started in the enterprise segment two years ago, it began with one global leader for all geos. As this business has grown, it made sense for us to align this segment under each geo leader for faster decision-making closer to the customer. These changes contributed to a late ramp in the seasonally tougher Q1, but we believe these changes position us to scale to reach our next milestone of $5 billion in ARR and beyond. In Q1, even as we saw additional deal scrutiny and longer reviews on most deals. We grew our base of customers with $1 million or more in ARR by 55% year-over-year, ending the quarter with over 340 of these customers. As I mentioned before, customers are increasingly buying Zscaler for users, our complete platform for user protection, which includes ZIA, ZPA and ZDX, bundled together. This accelerates our customers' transformation journey and makes us a critical partner for them. Now let me highlight several such deals. First, pursuing a strategic initiative to modernize the business, our top 10 global banks made a four-year $10 million per year commitment for Zscaler for users driven by cloud adoption, including Microsoft 365 and Zoom. This customer needed a proven and scalable SASE solution to secure thousands of branch offices and hundreds of thousands of employees operating in more than 100 countries. Importantly, we met the requirement to eliminate the risk of legacy VPNs and lateral threat movement, which was a board-level priority. Unlike a VPN in the cloud, Zscaler connects users to specific applications and not to the corporate network, which will significantly improve their security posture, as employees unwittingly bring infected laptops back to the office. Organizations need a true Zero Trust platform to eliminate the risk of lateral threat movement. Next, in an upsell deal, a Global 1000 financial services company in Asia after deploying ZIA for 110,000 users last year upgraded to Zscaler for users, our entire user protection platform for all 130,000 employees. As a growing company, they are using Zscaler to quickly and cost-effectively open new branch offices with secure Internet connectivity, reducing the branch opening costs by 50% compared to legacy firewall-based architecture. Also, ZPA replaces the extensive VDI infrastructure with Zero Trust access. This customer said, and I quote, 'ZPA provides a far more seamless user experience versus our existing VDI solution. And now we will have visibility to which user is accessing which applications, one of our key security requirements.' With this latest seven-figure purchase, this customer's total ARR more than tripled in just over one year. As these two wins illustrate, when these large financial services companies were ready to embrace the cloud, Zscaler was the only platform that met their needs. With security as a major requirement, these financial services companies chose a proxy architecture with the ability to inspect TLS traffic at scale and disqualified firewall-based SaaS solutions. We now have eight of the top 10 global banks and seven of the top 10 insurance companies outside of China as our customers. I'm also excited to see more $1 million ACV wins in our Enterprise segment. Let me share a new enterprise customer in the tech sector who bought all four product pillars, ZIA, ZPA and ZDX, for 4,000 users and posture control for workloads. Zscaler is enabling this secure digital transformation with direct and seamless access to SaaS and private applications regardless of their location. This supports the remote-first strategy, enabling them to close 12 offices and consolidate half a dozen point products. This deal was sourced by a VAR partner and speaks to the progress we are making with the channel. As this win shows, deal sizes in the smaller enterprise segment are growing, as customers adopt our broader platform. Next, we are also executing well on our federal government opportunity, which had a strong quarter. We remain the only cloud security service to have two products at the highest level of FedRAMP certification. These certifications are driving our federal business, as the US government pursues a Zero Trust strategy to enhance the nation's cybersecurity. We had four deals in the Fed vertical that were each over $1 million, all of which included ZIA and ZPA. Our highly differentiated architecture, which connects users to applications and not to the network, eliminating lateral threat movement, was critical to winning these deals. We have now landed 12 of the 15 cabinet-level agencies as customers with plenty of opportunity to upsell at these very large organizations. And as I mentioned, overall demand from customers to consolidate on our platform is growing. Our net retention rate has again exceeded 125%, now for eight consecutive quarters. Happy customers buy more, and our Net Promoter Score continues to exceed 70, which is more than two times the average NPS for SaaS companies. We have a 6x upsell opportunity with our existing customers, just for our core ZIA and ZPA product pillars. An important area of continued innovation, I'd like to highlight is data protection. Our comprehensive data protection offering has been gaining traction, as customers are concerned about data leakage with employees working from anywhere. In Q1, we delivered an industry-fast zero-configuration data and protection service, leveraging and building on our eight years of innovation in AI and ML. This DLP service provides auto-classification of unstructured data to expedite deployments with zero configuration. In addition, we completed the integration of recently acquired ShiftRight workflow automation technology with our data protection solution to enable organizations to manage hundreds of potential risks and incidents in a simple, yet very sophisticated way to significantly reduce case resolution time. Data protection is the first of many areas where we will broadly integrate ShiftRight workflow technology into the Zero Trust Exchange platform. These additional features, combined with previously released Exact Data Match and Indexed Data Match technology make us the leading data protection platform in the market. Beyond our core products, we are excited about the rapid adoption of our two emerging product pillars; ZDX to manage digital user experience and Zscaler for workloads to secure servers and workloads. New ACV from our workload communication product is growing nearly 100% year-over-year. And our newest deception and C-Net offerings are seeing strong customer interest. Let me highlight two upsell deals this quarter that were driven by our workload products. A Fortune 500 aerospace customer that is accelerating its AWS and SaaS adoption purchased the Zscaler for workloads to inspect one petabyte of PLS encrypted workload and IoT traffic per month, resulting in better security. This customer purchased our ZIA Transformation Bundle for 115,000 users two years ago as they've already committed to our Zero Trust architecture. It was seamless for them to add workload protection, which is built on the same core Zero Trust Exchange. This seven-figure ACV workload deal more than doubles the customer's annual spend with us. In another upsell win, a longtime customer upgraded and expanded their purchase to ZIA, ZPA and ZDX for 12,000 users and also added Zscaler for workloads to accelerate the application migration to Azure. Zscaler for workloads now represents one-third of this customer's $1 million-plus annual spend with us. As these customer wins illustrate our proven track record, running the world's largest in-line security cloud makes Zscaler the obvious and trusted partner of choice. Our Zero Trust Exchange processes over 270 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. Our demonstrated ability to scale our cloud platform becomes even more important as we address hundreds of millions of workloads and billions of OT and IoT devices. In closing, while there are broader macro challenges and economic uncertainties, we are seeing an increase in large multi-year commitments for multiple product pillars. As I mentioned earlier, as deal sizes have increased, we have adapted our field level customer segmentation to better serve our customers and to deliver more consistent execution. Our consultative sales process enables our account teams to quantify the business value of our platform to remain close to the customers, especially at the C level, and to get deals across the line. I believe periods of uncertainty can act as a catalyst for change. Customers are engaging with us to embrace zero trust architecture, consolidate point products, simplify IT and standardize on the Zscaler platform, all of which delivers better security and lower cost. CIOs are telling me that they are using this challenging environment to drive change and to eliminate the technical debt of legacy point products, which are expensive to buy and operate. Customers are increasingly turning to Zscaler in today's challenging environment, while overall IT budgets are tightening; we believe that security budgets remain more resilient. We are bringing more innovations to customers than ever before, while scaling our customer support and go-to-market organization. We believe we are still in the early innings of a significant market opportunity to enable secure digital transformation and achieve our $5 billion ARR goal. Now I'd like to turn over the call to Remo for our financial results.

Remo Canessa, CFO

Thank you, Jay. Our Q1 results exceeded our guidance on growth and profitability even as we manage through additional deal scrutiny and longer reviews. Revenue was $356 million, up 54% year-over-year, and up 12% sequentially. ZPA product revenue was approximately 19% of total revenue, growing 78% year-over-year. From a geographic perspective, Americas represented 52% of revenue, EMEA was 33% and APJ was 15%. Our total calculated billings in Q1 grew 37% year-over-year to $340 million against a difficult comparison. As we expected, billings duration was a headwind to growth this quarter. Our Q1 billings duration was above the midpoint of our normal 10 to 14 months range, but was below last year's higher levels. We estimate that duration negatively impacted our billings growth by approximately 5 percentage points. Normalized for this higher duration, our billings grew 42% year-over-year. Our remaining performance obligations, or RPO, grew 57% from one year ago to $2.682 billion. 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 is once again above 125%. We have a strong base of large enterprise customers, which provides us with a significant opportunity to upsell our broader platform. At the end of Q1, we had 348 customers paying us more than $1 million annually, up 55% from 224 in the prior year. The continued strength of this metric speaks to our large enterprise focus and the strategic role we play in our customers' digital transformation initiatives. We added 128 customers in the quarter, paying us more than $100,000 annually, ending the quarter at 2,217 such customers. Turning to the rest of our Q1 financial performance. Total gross margin of 81.4% was up nearly 85 basis points year-over-year. Our total operating expenses increased 12% sequentially and 53% year-over-year to $247 million, primarily due to higher compensation expenses from a very successful hiring quarter. Operating margin was 12% and free cash flow margin was 27%. We continue to expect data center CapEx to be around the high single-digit percentage of revenue for the full year. We ended the quarter with over $1.82 billion in cash, cash equivalents and short-term investments. Before providing our guidance, I'd like to share a few observations about the current business environment. Demand for the Zscaler platform remains strong. Across our key customer segments, we're seeing deals getting larger as customers are trying to consolidate more and accelerate their security transformation around our Zero Trust exchange. Customers are expanding their commitments with us, from a targeted use case to a much broader platform-centric approach. In our opportunity pipeline, we're actively working on more multi-year and multi-pillar opportunities than we historically have. While good for our business, larger deals take longer to close, as customers introduce more checks and reviews. In this environment, we think it's prudent to expect a higher level of review and scrutiny by our customers to continue. We'll continue to balance growth and profitability, based on how our business is growing. In our outlook for fiscal 2023, we intend to deliver operating margin expansion of more than 150 basis points, which is an increase from our prior guidance. Now moving to guidance and modeling points. As a reminder, these numbers are all non-GAAP, which excludes stock-based compensation expenses and related payroll taxes and amortization of intangible assets. For the second quarter of fiscal 2023, we expect revenue in the range of $364 million to $366 million, reflecting a year-over-year growth of 42% to 43%. Gross margins of approximately 80%, operating profit in the range of $42 million to $43 million, net other income of $8 million, income taxes of $4.5 million. Earnings per share of $0.29 to $0.30, assuming 156 million fully diluted shares. Please note that starting in fiscal 2023, we adopted the new accounting standard which requires the use of the if-converted method for calculating EPS. To account for our convertible notes, you will need to add back $360,000 in quarterly interest expense and includes 7.6 million shares to the fully diluted share count. For the full year fiscal 2023, we expect revenue in the range of $1.525 billion to $1.53 billion or year-over-year growth of approximately 40%, calculated billings in the range of $1.93 billion to $1.94 billion or year-over-year growth of approximately 30% to 31%. We expect our first half mix of billings to be approximately 43% of our full year billings guide. Operating profit in the range of $179 million to $183 million. Our guidance reflects 150 to 180 basis points of operating margin improvement compared to last year, while growing revenue at 40%; income taxes of $19 million, earnings per share in the range of $1.23 to $1.25, assuming approximately 157 million fully diluted shares. As noted earlier, to account for our convertible notes in EPS, you'll need to add back $1.4 million in annual interest expense and include 7.6 million shares to the fully diluted share count. Let me conclude with comments on our investment framework. We remain confident in our ability to deliver on our tremendous growth opportunity, while increasing profitability. We continue to see a robust pipeline and are prioritizing our investments in innovation and selling capacity while also being thoughtful and prudent in managing our overall cost structure. The recurring nature of our business model gives us good visibility on top line revenue and allows us to adapt quickly to changes in the market conditions while delivering on our operating profit and margin goals. As we have discussed, if we're growing revenue faster than 30%, you can expect less than 300 basis points of margin expansion in the year. We remain confident of reaching 20% to 22% operating margins in the long term with a huge market opportunity and customers increasingly adopting the broader platform, we'll continue our disciplined approach to managing our business to maximize value for our shareholders.

Operator, Operator

You may now open the call for questions. Thank you. Our first question comes from Matthew Hedberg of RBC Capital. Your line is open.

Matthew Hedberg, Analyst

Great. Thanks for taking the question, guys. Maybe just a question on the sales segment reorg. It seems like a really good thing to achieve these longer-term goals. Maybe just a little bit deeper understanding of what that looks like. And also, I think, Jay, you may have mentioned that there was maybe a slight impact to Q1 billings as a result of that. Wondering if that was the case and if there's any way to quantify that?

Jay Chaudhry, Chairman and CEO

Of course, Matt. As you know, we start to pursue the smaller enterprise segment a couple of years ago. At that time, we put the enterprise sales team under a global leader who directly reported to our CRO. As this segment has nicely grown, it was the right time for us to move it into geo teams under geo leaders. So that was one change. The second, we made changes where accounts got redistributed among our four market segments at the field level, as you know, we've got major, large Enterprise, and Commercial. And this contributed to a late ramp in a seasonally tougher Q1, but these changes are done, and we're already seeing better results, better pipeline, and we think this is the right thing for us to do to grow to our big target of $5 billion ARR.

Operator, Operator

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

Alex Henderson, Analyst

Great. Thank you very much. First off, I'd like to compliment your outstanding execution in what is obviously a toughening environment. I was hoping you could give us a little bit of context of what's going on in the lower end of the marketplace for you. I know you don't do much in the SMB space, but that's obviously been an area that a lot of other companies have seen challenges. I was wondering if you were seeing any issues in what you call your smaller business segments. Thanks.

Remo Canessa, CFO

Yes. Alex, overall, I mean I think all segments were impacted in the quarter. I think the macro environment, as you mentioned is that all companies are basically feeling the macro impact. The enterprise segment change that we made also impacted basically results in the quarter. On the lower end, we're doing okay, but it did impact all segments. I think it's more driven by macro than anything else.

Jay Chaudhry, Chairman and CEO

But Remo, the low end wasn't more impacted than others, so.

Remo Canessa, CFO

Yes. No, low ended a little bit better than the upper end.

Operator, Operator

Thank you. One moment please. Our next question comes from Andrew Nowinski of Wells Fargo. Your line is open.

Andrew Nowinski, Analyst

Great. Thank you very much for the question and congrats on another nice quarter. I guess, I just want to ask a question on the billings guidance. Maybe a little bit less of a raise than you've done historically. I'm wondering, number one, did you factor in a change in duration, or what kind of duration assumptions do you make with regard to your billings? And then did you add any extra levels of conservatism into that guide given the macro backdrop? Thank you.

Remo Canessa, CFO

Yes. The billing guide for Q2, the duration is similar to last year. It's slightly above the midpoint. One thing to call out for fiscal 2023, Q3 is going to have headwinds, because in Q3 of last year, the duration was longer. Related to the conservatism, related to our billing guide, it's really related to what we saw happening in Q1. So what we saw happening in Q1, we're taking forward into Q2 and for the rest of the year. What we're seeing basically is elongation of sales cycles. As we talked about and Jay mentioned on the prepared remarks, our deal size is getting bigger. Customers are buying more of our platform. It's more of a platform sale, all good. Our pipeline is increasing. Our pipeline is increasing five regions. Each region pipeline is increasing. But whereas before for the larger deals, we talked about, it was nine to 12-month sales cycle. It was trending down into more than nine months, now it's trending up more into the 12-month type range. So, all those things basically were taken into consideration with our guidance.

Jay Chaudhry, Chairman and CEO

Remo, if I may add. The strong pipeline in Q2 is what we feel pretty good about. But we do know that there's a closing time factor we are factoring in.

Operator, Operator

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

Joel Fishbein, Analyst

Thanks for taking my question. Jay, just wanted to follow up on your comments about the Fed space. Obviously, being the only one that has FedRAMP high. I'd love to understand how you are positioned there competitively, how long the tail is on some of those deals as the government undergoes some of these security transformation projects. Just a lot more color around that. Thank you.

Jay Chaudhry, Chairman and CEO

The Fed business was quite good for us. We have been building on it. We are investing in it. That's where it has taken us to all these certifications. The impact of macro is less on the federal business. It has its own budget cycle goes through its own process. We now have landed 12 of the 15 cabinet-level agencies and we're helping them, and they all start actually at a fairly small level and they have been growing at a pretty decent pace. And so it's an early stage. Though last quarter, we did have a sizable $46 million project, which actually gets billed on a periodic basis. So feel very good and strong about the Federal business, but Federal takes its own time in closing some of these deals.

Operator, Operator

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

Hamza Fodderwala, Analyst

Hi, guys. Good evening and thank you for taking my question. Maybe for Jay or Remo, feel free to chime in. So, obviously, macro is impacting every company. So that's clear. I think on the other hand, Zscaler did have the chance to, kind of, give a full year guide back in September. And it seemed like at that point, a lot of your outlook seemed derisked for what we're growing macro concerns at that time. So is it really these sales force changes that's driving that perhaps somewhat incremental headwind that you're talking about? And are we talking about a full-on sales reorg, or is it just some tweaks that are being made to help you align better to your long-term growth opportunities? Thank you.

Remo Canessa, CFO

Sure. I'll begin. I believe it's a combination of the macroeconomic conditions we're experiencing. For our full year forecast that we provided at the start of the year, we initially projected $1.92 billion to $1.94 billion in billings growth. We've now adjusted that to $1.93 billion to $1.94 billion. So, the midpoint has gone up. The macroeconomic factors are influencing this. We've indicated that due to uncertainties in the macro environment, we aimed to take a cautious approach with our guidance. It involves both aspects; primarily the macro and to some extent the changes we've experienced. However, as Jay pointed out, the changes are largely in the past, and overall, the outlook is very encouraging.

Jay Chaudhry, Chairman and CEO

Yes, I want to clarify that this was not a complete reorganization. We have four segments, and as our deals have grown in size, some that were previously in lower segments are now being managed by the upper segment. Realigning the segments has been beneficial for optimizing deal sizes and determining the appropriate teams to work on them. Additionally, the lower enterprise team, which used to report directly to the Chief Revenue Officer, is now linked to specific geographic areas. While these changes are more significant than usual, they are not drastic. Importantly, none of our deals are being lost; we are positioned well and are already winning some deals while working on additional ones. As a result of these changes, our pipeline is expanding, and I am quite confident about it.

Remo Canessa, CFO

Yes. One other point. Really, when you take a look at the amount of accounts that shifted, it was a pretty substantial amount of accounts that shifted into the various segments. So, again, as we mentioned, as Jay mentioned before, we feel largely that is taken care of. Could there be some impact going forward? There is. But again, from our perspective, it's largely macro.

Operator, Operator

Thank you. One moment, please. Our next question comes from Tal Liani of Bank of America. Your line is open. Please, make sure your phone is on unmute.

Tal Liani, Analyst

Here you go. Can you hear me now?

Operator, Operator

Loud and clear.

Tal Liani, Analyst

Thank you. I have two related questions. The first is about Palo Alto Prisma, which had much better-than-expected results on a like-for-like basis. Do you see any changes in the competitive landscape or in the pricing dynamics and aggressiveness of other players that could be influencing the changes we're observing? The second question is about understanding the bigger picture. A year ago, I would have said that the impact of an economic slowdown on your area would be minimal because you're transitioning from CapEx to OpEx, allowing customers to adapt without substantial upfront CapEx. If there are budget constraints, they should still proceed. So why are we seeing this area affected despite its potential to help companies reduce spending if necessary?

Jay Chaudhry, Chairman and CEO

Yeah. So okay, I'll start. Your first question about competition and pricing dynamics, I'll tell you on the higher end of the large enterprise segment, we haven't really seen much competitive changes at all. These large enterprises aren't savvy. They look for the right architecture. They take this thing very seriously. And almost all these large deals, when firewall companies have tried to come in and compete, they're often excluded. I mentioned some of them during the call. So I do wonder where do those deals come from, because if you ask me some of my largest deals, if you took top x-deals, we aren't really competing with the firewall companies out there. Price dynamics will matter if you really are competing. That's number one. But also number two, the service we're selling is very mission critical. In fact, it's probably more mission critical than Office 365. That's what I hear from CIOs, because we are on the switchboard. We are connecting everything to everything. So we have not seen pricing pressure from the competitive side of it. We have been told a few times that the customer said, yes, this vendor came and offered us a third, the core price, but we decided we are not serious about it because it doesn't meet the requirements. Your second part of the question was about the impact of economic slowdown. It is very true that the area we are playing in really does two things for customers. One, it's important cyber area. Number two, with consolidation, simplification and standardization, customers do save money. So those are the two things that are helping us a lot more than many other market segments. But when the broader macro is tough, there is obviously some impact but I would say, relatively speaking, it is far less than other areas. As I had talked to many CIOs and CXOs, they don't see securely budget getting reduced much. As compared to IT budgets, we are in a much better shape, but there is impact. And sorry, and one part of the impact is these large deals are going more and more through CFOs and CEOs for approval.

Operator, Operator

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

John DiFucci, Analyst

Thank you. So guys, this macro slowdown is much different than the last one we saw due to COVID, where Zscaler benefited from more distributed access. So as we look out into fiscal 2023 and beyond, as we layer in the soft and perhaps softening, further softening macro backdrop, how should we expect the appetite for new customers to undergo a transformation of their security paradigms?

Jay Chaudhry, Chairman and CEO

Yes. That's a good question. You're basically saying, will new customers start transformation projects? It depends upon what kind of projects you're looking at. CIOs are prioritizing projects must do versus projects that can wait. That's one part. But if you look at what we do, where we fit, okay. Cyber is not going away. The risk of cyber is still there. It is a Board-level discussion. It's happening. Number two, there is pressure on cost consolidation and simplification. Yes, while customers won't start big new projects, but projects that can be done without big investments, and they are being done. If you look at the total IT budget of a CIO, and the security is a fairly small part of it. By engaging at the CIO level, we are actually able to get a fair share of the budget. So I think we feel pretty good about fiscal 2023. Having said that, will there be a bigger hurdle to cross to close those deals? Absolutely, yes. But to do so, you need two things: one, you need CIO, CXO level engagement, which we have traditionally done; two, you need better business justification to make a strong case to the CFO that it makes sense. And we have been doing that for quite a while, and now the number of assessments, value assessments we're doing is actually much higher than it used to be.

Remo Canessa, CFO

Yes. A couple of comments, John. Our split between new sales and upsells in Q1 was approximately 50-50. This quarter was driven by large Federal deals and strong performance in the financial sector with new accounts. Looking ahead for fiscal 2023, I believe a mix of 40% new and 60% upsell is a more accurate projection. However, we must not forget the size of this market, which we estimated to be $72 billion two years ago and is clearly larger now. It is on an upward trajectory, and considering our penetration in this market and others, we are still in the early stages. As we navigate the current global economic climate, it will get better, and we believe it will improve. Zscaler has a competitive edge from a cost, security, and user experience standpoint, and we feel it is one of the leading platforms globally for networking and security. Therefore, we need to manage through this macro environment while continuing to execute, and we are confident that things will fall into place.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Roger Boyd of UBS. Your line is open.

Roger Boyd, Analyst

Great. Thanks for taking the questions. I think you gave the contribution of emerging products to new business, and forgive me if you did, but it sounded like you did have some nice wins in the quarter there with ZDX and Zscaler for workloads. So I'm wondering if you can just update us on how you're thinking about upselling these solutions in the current environment relative to your guide last quarter for, call it, high teens percent of the new business. Thanks.

Remo Canessa, CFO

Yes. Hey, Roger, they're tracking still to the high teens. So they're doing well. ZDX and our cloud protection products are tracking in the high teens for the year.

Jay Chaudhry, Chairman and CEO

Yes. If I may add, ZDX has been our fastest-growing service. It has grown faster than ZPA, if you look at a similar time line or similar stages. And the cloud protection has two main areas. One is what we call CNAPP, its API-based security, that's a posture control product. And second is, Zero Trust in workloads for in-line security, and we are the only vendor who has done tight integration between the two. And our actually customer interest has been pretty strong. Our new ACV nearly doubled year-over-year for our Zero Trust for workloads. I talked about a couple of deals, large deals during the earnings thing. One was a seven-figure ACV workload deal. It more than doubled customers' annual spend with us. That's significant. Another deal I mentioned, workloads now represent one-third of this customer's $1 million annual cost spend with us. So these things, which used to be fairly small three, four quarters ago, are beginning to get pretty significant.

Operator, Operator

Thank you. One moment, please. Our next question comes from…

Unidentified Speaker, Analyst

Nice conversation. Is it fair to assume that in the first part, can you hear me?

Jay Chaudhry, Chairman and CEO

Yes.

Unidentified Speaker, Analyst

Hey. So just a quick question. You talked about the pipeline growing. Just wondering, is the coverage ratio growing at a significant enough level to offset the elongation in sales cycles? Thank you.

Remo Canessa, CFO

We take all of that into consideration in our guidance. Everything has been included in our guidance, and yes, it has been accounted for.

Operator, Operator

Thank you. One moment please. 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 questions. Either for Jay or Remo, please chime in. I appreciate a lot of the commentary you shared around the opportunity that you have with large multi-year, multi-pillar deals, the pipeline composition for those types of transactions is increasing, but against a much, much tougher environment. So there's a little bit of a dichotomy there, and I wanted to peel that back a little bit, because if your business and execution and pipeline is that much more reliant on some of these larger deals and the environment is admittedly harder to execute in. What are some of the things that you are doing and that you have under your control to make sure that we don't see the type of slippage that could cause some more variability into your building performance? And just as a related matter, are you changing incentives to ensure you're driving that type of behavior and successful close rates on those large transactions, which, it seems like you're becoming more dependent on? Thank you.

Jay Chaudhry, Chairman and CEO

Right. Fatima, yes, the pipelines for multi-year, multi-pillar deals are growing. We're experiencing a tougher environment with increased scrutiny and approval levels. We have identified two significant trends that are helping us close these deals. First, customers are seeking better business justification. This includes CFO-ready business cases and business value assessments that help us quantify the potential returns. For instance, if you exclude these eight-point security and networking products, this is the ROI you can achieve, and we are demonstrating more than 200% ROI in most cases, which is quite strong. We are improving in this area. The second important factor for closing deals in this challenging environment is strong C-level engagements. Making a compelling case at that level is crucial, and if you are included in the CIO's budget instead of just the security budget, your chances of success improve significantly. Both of these strategies are contributing to our progress, and we are considering them as we provide our forecast.

Remo Canessa, CFO

Yeah. And from an incentive perspective, I wouldn't say we're doing anything out of the ordinary that we've done in any quarter. So no real changes from an incentive perspective.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Mike Walkley of Canaccord. Your line is open.

Mike Walkley, Analyst

Great. Thanks for taking my question. Just maybe following up on that last answer. As you work with closing these larger deals, are these larger customers maybe slowing their pace of deployment to help their own OpEx in terms of how they're ramping deals, or once you close them, they're ramping similar to prior experiences?

Jay Chaudhry, Chairman and CEO

Yes, the market presents an interesting dynamic. It is challenging, but when Chief Information Officers assess their needs, they seek consolidation and simplification, which is leading to larger deals for us. Larger deals come with increased scrutiny. However, we are assisting our customers in gradually making larger commitments to implement our platform. This is a phased approach we have been executing for several quarters, and it continues to progress.

Remo Canessa, CFO

Yeah. So we're not seeing any increased ramping. It's always been part of our business. We've called it out. I mean, you look at the type of deployments we have with hundreds of thousands of users, you can't do that overnight. So again, we're not seeing any increased ramping, and it's been part of our business for a long time.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Joshua Tilton of Wolfe Research. Your line is open.

Joshua Tilton, Analyst

Hey, thanks guys for squeezing me in here. I just have two quick ones. First one goes back to Andrew's question. I just want to ask it a little differently. If 2Q has normal duration comps, is there any reason we shouldn't expect that billings growth should return to this 40-plus range that you saw in Q1 after adjusting for the duration? And my second question is, if you look at the deferred revenue, it did decline sequentially from 4Q to 1Q for the first time in a while? So just anything unusual to call out there.

Remo Canessa, CFO

Yeah. I mean, you've got our guidance. So we feel comfortable with it and how we're going to come in. We'll see at the end of the quarter. Related to the decline in deferred revenue Q4 to Q1, again, there's seasonality to our business. So the growth rates from Q4 to Q1 have been very small. It declined slightly this quarter. Nothing really to call out other than seasonality and our performance in the quarter.

Operator, Operator

Thank you. One moment, please. Our next question comes from the line of Peter Levine of Evercore. Your line is open.

Peter Levine, Analyst

Thank you for including me. To follow up on an earlier question from John, could you discuss what you’re observing at the top of the sales funnel? Considering we're nearing the end of the COVID work-from-home deal phase, is there a possibility of a decline in the pipelines or a negative impact on new billings, especially given the current circumstances? It seems like the pipeline for the second quarter is solid, but any additional insights would be appreciated.

Jay Chaudhry, Chairman and CEO

Yes, the Q2 pipeline is robust and set a record. We experienced some benefits from COVID starting in March 2020, but most CIOs had to take action within a quarter or two, so the significant impact of COVID had ended by mid-2020. Since then, our business growth has been driven by the demand for security and digital transformation. We've been successfully building our pipeline. It's true that certain changes we implemented at the beginning of Q1 caused a temporary slowdown, but we have moved past that. The pipeline looks good, and the key challenge now is how effectively we navigate the increased scrutiny and additional approvals required to secure the deals we aim for. That's our focus, and we have a strong pipeline. Remo, do you want to add anything? Okay.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Keith Bachman of BMO. Your line is open.

Keith Bachman, Analyst

Hi. Thank you very much. I wanted to ask Remo a question, which has two parts. Remo mentioned that the billings beat this quarter was one of the smallest in many years and that you're raising the midpoint, but the top end of the billings guidance remains the same. The macro environment has gotten tougher. Last quarter, many of us noted that it seemed like Zscaler had derisked the numbers. Given that context, it appears there’s been some additional risk introduced to the billings, and I wondered if you could provide your perspective on that. The second part of my question is regarding the increase in operating income by about $6 million from the previous guidance. It seems like if growth isn't accelerating and you keep the billing range as it is, why not raise it more on the operating income side? That's all from me. Thank you.

Remo Canessa, CFO

Yes, those are great questions, Keith. The macro environment has changed, and we discussed the uncertainty heading into 2023. We're observing similar trends in most earnings reports, primarily due to the macro backdrop. The changes in our enterprise segment play a smaller role in this. It's crucial to acknowledge that the macro environment has shifted. Regarding our operating profitability, with the contribution margin in years two and three exceeding 60%, achieving operating profitability is relatively straightforward. However, I believe prioritizing this may shortchange our company and shareholders. Our free cash flow margin and overall profitability show we're enhancing our operating profitability, and we will maintain a prudent and disciplined approach in managing the business. The key point is the market size and its early-stage development. Our main focus is on growth. While we've observed a slight increase in operating profitability, our emphasis on it is greater than before, but we will adopt a measured approach to find the right balance for our business.

Operator, Operator

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

Shrenik Kothari, Analyst

Hey, guys. Thanks for taking my question. Either for Jay or Remo, just chime in. You spoke about Federal vertical, call our friends in financial services vertical clearly, our top 10 global banks for your $10 million commitment. So, broadly, we'll be hearing, thinking in some verticals, to tech or CPG retail kind of getting impacted more than others, including public sector to science, utilities, more solid. Is that something that you guys are observing in terms of bifurcation or divergence in sectors there? Is there a guidance now building into itself a potential accelerator of macro into so far less of factored verticals, yes?

Remo Canessa, CFO

I'll speak specifically about the verticals. Jay, if you'd like to add more comments, please do. In Q1, the verticals that we saw do well for us were financial, federal services, and healthcare. Those are the strong verticals for us. Have we taken into account the impact of verticals going forward? The answer is yes, not specifically per vertical, but current customer and where that deal is, in the deal cycle. So it is being taken into account. But speaking to other verticals, maybe, Jay would like to comment more on that.

Jay Chaudhry, Chairman and CEO

Yes. I think, even though we did well in some of the verticals Remo pointed out, I'm not sure overall vertical is a big, big factor. Macro is impacting broadly, but there are certain verticals that have less, for example, in oil and gas, doing differently than many of others. But I won't say it's a big factor for us. It is a factor, but not a major effect.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open. Please, make sure your phone is on unmute.

Saket Kalia, Analyst

Sorry. I'm so sorry. I was on mute there. Hey, guys. Thanks for taking my question here. A lot of my questions have been asked. Jay, maybe for you, just a little bit of a broader one. Clearly, the fiscal year for Zscaler is very different than a calendar year. But a lot of your customers operate on December fiscal years. Maybe the question for you is, what have you heard anecdotally, just on the prospect of budget flush this year from your customers? Is that something that you think is going to be more muted for security this year, or is it more related to timing? Any perspective that you have there would be helpful.

Jay Chaudhry, Chairman and CEO

Look, as you have seen in the past few quarters, deals are getting more and more back-end loaded. We saw that a few quarters ago. We saw it in Q1. We think we will have a linearity thing, similar to Q1, maybe a little bit better than Q1. But I don't think that December will significantly change everything out there. Remo?

Remo Canessa, CFO

Yes, there could be a positive impact related to December 31, but from a linearity perspective, I expect something similar to what we experienced in Q4 and Q1, which tends to be more back-end loaded. It is possible, but I anticipate a similar type of linearity.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Adam Borg of Stifel. Your line is open.

Adam Borg, Analyst

Awesome. Thanks so much for taking the question. Just two quick ones just on the Federal space. Not sure if I missed it, but what was the mix that the Fed business represented in the quarter? And when you think about the opportunity, it's great to hear those wins, is it really just on ZIA and ZPA, or what's the opportunity for ZDX and Zscaler for workloads in the Federal space? Thanks.

Jay Chaudhry, Chairman and CEO

I'll start at the broad level for a month, and you can get into specifics. Yes. Federal is most of the stuff in place is ZIA and ZPA, but it's building strong interest on ZDX and some of the newer products. But currently, it's a strong mix of ZIA and ZPA.

Remo Canessa, CFO

Yes, as Jay mentioned, 12 of the 15 cabinet agencies secured four deals exceeding $1 million. This has clearly been a positive quarter for us in the Federal sector. We are starting to assess Federal's performance on an annual basis, focusing on new opportunities and upselling. Overall, Federal had a strong quarter in Q1.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude our conference. I'd like to turn the call back over to Jay Chaudhry for any closing remarks.

Jay Chaudhry, Chairman and CEO

Thank you for your interest in Zscaler. We look forward to seeing you at upcoming investor events. Thank you, and goodbye.

Remo Canessa, CFO

Thank you.

Operator, Operator

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