Good day, and welcome to the Zu Scalar Third Quarter 2019 Earnings Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Bill Choi. Please go ahead sir.
Good afternoon, and thank you for joining us to discuss Zscaler's financial results for the third quarter of fiscal 2019. With me on the call are Jay Chowdhry, Chairman and CEO and Remo Canessa, CFO. By now, everyone should have access to our earnings announcement. This announcement may also be found on our website in the Investor Relations section. In addition, A supplemental financial schedule was posted to the Investor Relations section of our website earlier today.
Let me remind you that we'll be making forward looking statements during today's discussion, including but not limited to the company's anticipated future revenue, calculated billings, operating performance gross margin, operating expenses, operating income, net income, free cash flow, dollar based net retention rate, income taxes and earnings per share. These statements and other comments are not guarantees of future performance, but rather are subject to risks and uncertainties, some of which are beyond our control. Our actual results may differ significantly from those projected or suggested in any forward looking statements. These forward looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call.
For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, Please see our All numbers we talk about today will be on an adjusted non GAAP basis. Please refer to our earnings release on the Investor Relations portion of our website for a reconciliation of GAAP to the non GAAP financial measures. For historical periods, the GAAP to the non GAAP reconciliations can be found in the supplemental financial information referenced a few moments ago. Global Technology Conference in San Francisco on June 5. Now, I'll turn the call over to Jay.
Thank you, Bill, and thank you everyone for joining us on our call today. I am pleased to share with you our strong third quarter results. Our revenue grew 61% and calculated billings grew 55% year over year. In addition to our top line growth, Our Q3 results demonstrate the leverage in our While we are pleased with our 3rd consecutive quarter of profitability, we will continue to aggressively invest in our business for a significant market opportunity that is we believe we are going after a $20,300,000,000 TAM in calendar 2019. Just as enterprises have adopted multi tenant SaaS applications like Salesforce and Workday to replace legacy on premise applications.
Enterprises are saying goodbye to security appliances and choosing Zscaler born in the cloud, multitenant security platform to securely embrace the cloud. Unlike traditional network security would build a moat and owned a castle. Our cloud security platform acts as a business policy engine, to securely connect the right user ZIA for access to SaaS or the Internet and ZPA for access to internal app in a data center or a public cloud. Our customers are leveraging increased functionality of our comprehensive cloud security platform, as they progress through various stages of their cloud journey. We see this progression in product bundles customers.
A significant majority of our revenue used to come from customers purchasing professional and business bundle. As a expected, we are seeing continued strong adoption of a premium ZIA transformation bundle, which is growing as a mix of our ARR, In addition, while we replace security appliances in existing internet gateways, the majority of ZIS sales are coming from creating and securing new internet breakouts. These are greenfield opportunity We are continuing to see significant interest in ZPA, which we introduced only a couple of years ago. It remains the fastest growing product in our history. ZPA delivers what Gartner calls 0 Trust network access to provide application access to users risk.
While ZPA has been and continues to be purchased customers. We are seeing more upfront sales of both ZIA and ZPA. ZIA and ZPA together provide our customers a single platform for secured cloud transformation, which we believe no other vendor can match Let me highlight several shows how large enterprises are buying the ZIA and ZPA platform. 1 of the world's largest pharmaceutical companies with a headquarters in Europe, purchased our transformation bundle for 100,000 users and ZPA for over 17,000 users. Moving from a decentralized IT and business units to a centralized IT model, This customer had a strategy to transform to the cloud for the network and for their application To achieve this, the IT team identified 2 initiatives: 1, increase use of cloud including a move formation.
They adopted a strategy to create secured local internet breakouts for 200 offices around the globe. Our cloud security platform allowed them to realize division, a perimeter less enterprise with directx to any service or application from anywhere on any device without backhauling traffic through regional hubs That result, reduced business risk, faster user experience, and significant cost savings. They will no longer need either a site to site VPN to AWS or remote access VPN. ZPA also enables the customer to rapidly integrate mergers and manage divestitures, while increasing the level of security with a 0 trust network access approach. Another deal involving both ZIA and ZPA upfront was a Fortune 500 Financial Services company that purchased our transmission bundle for 85,000 users and ZPA for 20,000 users.
This customer was preparing to deploy Office 365. They anticipated scaling issues with their own premise web proxy appliances, which would not keep up with the significant growth in internet bound traffic from 750 worldwide offices. The initial discussion of proxy replacement expanded significantly once the security team realized that Zscaler was much more than a traditional WAM proxy. We offer the full security stack including next gen firewalls, Sandbox, and SSL inspection. This customer decided to pursue a local internet breakout and use Zscaler to secure their SD WAN initiative.
They purchased ZIA for all employee which will also cover mobile users they purchased ZPA for 2 use cases: 1, to integrate acquisitions of new businesses and 2, to replace remote access VPN for business units that were having poor user experience. I often receive personal notes from CIOs, CTOs, and CISOs of Global 2000 Enterprises. Indicating how much they appreciate quality of service A number of them have broad Zscaler into the new organizations after making a career move. I'm excited transformation bundle for 17,000 users and ZPA for 6500 users. The new CTO came from a large Healthcare company, where he had deployed Zscaler 1 year ago.
In another case, a financial services company purchased our transformation bundle for 10,000 users. Their new CIO moved from another Financial Services company which had rolled out Zscaler 3 years ago. These wins demonstrate the strong loyalty of our customers and value our platform. We also had a number of notable upsell wins in Q3. A U.
S. Base conglomerate has been a Zscaler customer since 2015 using our business bundle. What is 2 dozen portfolio companies to protect 70,000 employees around the world. This customer purchased ZPA for 40,000 to replace multiple remote access VPN solutions and made ZPA the standard solution across multiple portfolio companies. The driver, customer is moving its applications to SaaS and public cloud and needed a future proof solution that provides secure and fast access to their applications.
In addition, as this conglomerate actively acquires new businesses. ZIA and ZPA will enable them to quickly integrate the acquired companies. This latest purchase resulted in doubling off the total customer annual spend with Zscaler. A Fortune 500 bank with headquarters in Asia that purchased our business bundle for 38,000 users 2 years completed the addition of 12,000 users and upgraded all 50,000 users to the transformation bundle. The driver of this deal was the need to upgrade security posture for all employees at any location on any device using a cloud based integrated platform.
They also required granular policies to control access to certain applications for defined roles such as restricting webmail and chat access for traders during the trading winter In addition, they purchased our data loss prevention solution to help meet stringent regulatory requirements. Let me say a few words traditional firewall and VPN vendors are finally acknowledging that the legacy security appliances can secure the new digital enterprise and are attempting to build a security cloud using single tenant software designed for on premise appliances. Just like you can't create a Netflix service by stacking thousands of DVD players in the cloud, you can't offer cloud. This is a defensive strategy of cloud imitators, which, in our view, serves the self preservation of the vendor not the needs of the customers. We believe we have a significant competitive advantage as a result of the technology architecture and maturity of our cloud security platform, including: 1, we were born in the cloud for the cloud just like Salesforce and Workday.
2, we have a purpose built globally distributed multi tenant cloud for fast user experience. Unlike imitation clouds, Zscaler requires no back hauling from front doors to a central compute 4, we delivered 0 Trust network that provides application access without network access, reducing business risk unlike firewalls and VPNs. And lastly, we have over 10 years of experience running a mission critical in line cloud for Global 2000 customers, processing 65,000,000,000 transactions a day. As someone said, there is really no compression algorithm for experience. We continue to innovate and invest in maintaining our significant technology lead, our latest 4th generation large data centers provide multiple 100 positions.
Our previously announced TrustBot acquisition is already well integrated into the Zscaler platform and their machine learning and AI technology is helping us deliver better threat detection. Just this week, we acquired Appsulate, a pre revenue browser isolation company with a talented group of developers, This technology is highly effective for use cases where the internet or application content should not be downloaded to the endpoint. Due to security or data protection concerns. Instead, it should be rendered as pixels in the browser. We plan to incorporate the technology into capabilities.
We are welcoming a new VP and General Manager in EMEA with substantial experience in selling to large enterprise to help us scale EMEA to the next level. We will be holding our annual Zenith Live cloud summit in Las Vegas on September 16 through 18th and Zenithlide Europe in Lisbon Portugal on September 30 through October 2nd. We will have an inspiring lineup of keynote speakers to talk about cloud transformation. In summary, we are very pleased with the strong Q3 results, and continued growth in our business. We believe we are in the early innings of a significant market opportunity to disrupt traditional network security.
I'd like to now turn over the call to Remo to walk through our financial results.
Thank you, Jay. As Jay mentioned, we had a very strong Q3. Revenue for the quarter was $79,100,000, up 6% sequentially and 61% year over year. For the sequential comparison, recall that Q2 revenue was aided by $2,300,000 in nonrecurring revenue from a large public sector customer deploying our solution to Helly Private Cloud. From a geographic perspective, for the quarter, Americas represented 51 percent of revenue and EMEA was 41% and APJ was 8%.
Turning to calculated billings, which we define as the change in deferred revenue for the quarter, plus total revenue recognized in that quarter. Billings grew 55 percent year over year to $85,000,000. As a reminder, our contract terms are typically 1 to 3 years, and we primarily invoice our is 1 year in advance. Excluding upfront greater than 1 year billings, in both periods, billings growth was over 60%. Total backlog, which represents remaining performance obligations, was $497,000,000 on April 30, up 63% from $305,000,000 1 year ago.
Please keep in mind that q44 2018. This deal added $16,500,000 to billings and $26,000,000 to backlog in the July quarter, which will pose a difficult year over year comparison in Q4. Our strong customer retention and ability to upsell have resulted in a consistently high dollar based net retention rate, which was 118 percent for the period ended April 30th. This compares to 120 percent a year ago and 118% last quarter. Our increased success selling bigger deals upfront, which start with the transformation bundle and faster up sells within a year, while good for our business can reduce our net dollar retention rate, which is calculated on a year over year ARR basis.
During these factors, we feel 118 percent is outstanding and it will vary quarter to quarter. Total gross margin was 82% up 2% sequentially and 1% year over year. We feel that 80% continues to be a good target in the near to meeting term, as it is important continue to invest in our platform to drive top line revenue growth. Turning to operating expenses. Our total operating expenses increased 18% sequentially, and 38% year over year to $58,900,000, but decreased on a year over year basis to 74% of revenue.
The sequential increase in operating expenses is primarily due to increased headcount, compensation related expenses, marketing expenses and professional fees. We increased our headcount in Q3 by over 110 employees and approximately 40% were in sales and marketing. Sales and marketing increased 17% sequentially, and 37% year over year to $38,800,000. The increase was primarily due to headcount increases, compensation related expenses and marketing expenses. R and D was up 15% sequentially and up 30% year over year to $12,300,000, as we continue to invest percent sequentially and increased 43 percent year over year to $7,800,000.
The growth in G And A includes investments in building our teams, compensation related expenses, and professional fees, including acquisition related expenses. G and A expenses exclude $6,200,000 in litigation related expenses, including the settlement of the Finjan lawsuit. Our 3rd quarter operating margin was a positive 8%, which compares to a negative 6% in the same quarter last year. Net income for the quarter was $7,400,000 or non GAAP earnings per share of 0 point 0 $5. We ended the quarter with $353,000,000 in cash, cash equivalents and short term investments.
Free cash flow was positive $4,600,000 in the quarter, compared to positive $3,700,000 for the same quarter a year ago. Please keep in mind in the quarter we made a payment of $7,300,000 to settle defension lawsuit, and we had a positive impact from our ESPP program, which contributed $4,000,000 to our free cash flow. The ESPP program does not impact our overall cash balance. Now moving on to guidance. As a reminder, these numbers are all non GAAP, which excludes stock based compensation expenses, amortization of intangible assets, certain litigation related expenses, and any associated tax effects.
For the fourth quarter, we expect revenue in the range of $81,000,000 to $83,000,000, reflecting year over year growth of 44 to 48%. Operating profit in the range of 0 to $2,000,000, income taxes of $700,000 and earnings per share of approximately 0 point 0 $1 to 0 point 0 $2, assuming 138,000,000 common shares outstanding. For the full year 2019, we expect revenue in the range 8%. Billings in the range of $379,000,000 to $381,000,000 or year over year growth of 47% to 48%. Operating profit in the range of $17,000,000 to $19,000,000, income taxes of $2,200,000 and earnings per share in the range of $0.16 to $0.18.
The fiscal 'twenty as we are primarily acquiring technology and the development team. Our plan is to further develop this technology and incorporate it into our platform. The deal is all cash, with a purchase price of approximately $13,000,000. We expect to incur approximately $7,000,000 to $9,000,000 in additional operating expenses in fiscal 2020, related to the acquisition and to build out new services. As reflected in our guidance, I would emphasize that our as profitability or generate additional operating leverage in the near term, but to invest aggressively in our business to pursue our significant market opportunity.
We plan to continue to invest in our sales organization and marketing programs, as well as increase investments in our technology platform and cloud infrastructure. We're very proud of what we've achieved and look forward to building on our opportunity. Now, I will hand the call back over to Jay.
Thank you, Ramon. We believe we are the best choice to secure cloud transformation. The right architecture for security cloud matters, on premise single tenant architecture, whether deployed as appliances or as virtual machines, in a public cloud will not allow enterprises to fully realize the benefits of cloud. These imitators cannot scale leave gaps in security are expensive and deliver a poor user experience, with multiple tailwinds, such as SAS adopt SD WAN and application migration to public clouds, we believe the market is coming to us. We thank you for your interest in Zscaler and look forward to reporting on our progress in the future.
Operator, you may now open the call questions.
You.
We'll take our first question from Brad Zelnick with Credit Suisse. Please go ahead.
Jay, Remo, and Bill, congrats to you and the team on another great quarter. I mean, 55% billings growth over 60% excluding upfront deals is truly impressive. My question, Jay, at the risk of getting too deep into the technology, you talked about this briefly in your prepared remarks, but I'm hoping you can help us understand your differentiation versus some of the competitors that are leveraging public cloud partnerships to compete with Zscaler. Why might this make sense or not make sense? And what are you seeing when you go head to head in proof of concept with these types of solutions?
Are they able to perform and deliver on all the capabilities that you are? Thanks.
Brad, thank you. Very good questions. Science vendors are having to compete for the cloud using technology that wasn't meant for the cloud. So when they are spinning these virtual machines on public cloud and claiming to have presence in 100 locations or more, is totally misleading. Let me walk through a little bit on how these public clouds work.
Google, AWS, they're very large centralized data centers in about 100 locations around the world. They call them regions. That's where applications run. That's where storage and compute actually runs. Now in addition, they have 100 some locations Some of them call them point surprises, others than others call them network edge locations.
And these are front doors that collect information so that the thing can be sent to the regions, which are about 20 or so. So these clouds are built to run applications as the destinations, not an in transit cloud. For example, take AWS data center in Ohio. It is kind of staying away from Chicago. So the traffic goes there and comes back.
Speed of light to speed of light. So the performance can't be good unless you build a cloud that's distributed to handle security, to enforcement, hence the response time, architecturally can't be good. The second part of your question was about POCs. We actually don't really do business through POCs, we are driving top down cloud transformation through the CIOs. So none of this is impacting us.
From POC's point of view.
Yes, Brett.
I just
want to clarify that, Jay meant to say the true compute of these hyperscale are done on centralized data centers that really number around 20. And the 100 plus are really what they call point of presence or network edge locations. And there were where content is either pushed or in, in, inspection service like this, backhauled, so it's a backhauling collection points.
For clarifying, Bill. And if I could just follow-up one for Remo. Remo, I believe you went through this in your prepared remarks, but on cash flow, I think you might have come in a little bit lighter than some have been expecting, but you did settle the Finjan lawsuit. And then there's also, I think, the offset from the ESPP. Can you just walk us through that clearly one more time?
And also as we go out to Q4, how should we think about cash flow seasonality? Thanks.
Yes, thank you, Brad. So we did pay the Finjan settlement in April, for $7,200,000, which had a negative impact on free cash flow. As we've talked about BSP program, once we hold funds from employees for the SPP program, that's a positive impact, and that was about $4,000,000 during the quarter. As we go forward, and you think about, Q4 on a free cash flow basis, if you look at the seasonality that we have, our Q2s and our Q3 4s are our largest quarters from a business and billings perspective, or Q1s and Q3s are smaller. So, the cash flow free cash flow impact for Q4 will be impacted by that.
In addition, with the absolute acquisition, overall cash flow will decline based on the payments we'll make in what we have made in the last few days.
Thank you. We'll take our next question from Patrick Colville with RT Research.
Thanks for taking my question and congrats on the awesome quarter. Can I ask you about when your competitors is having a lot of internal issues? And just how Zscaler kind of react to that does it change your planning? Did you become more aggressive? Does it change the dialogue with customers?
How are you guys reacting to your chief competitor being extremely weak at the moment.
Thank you for the question. If we were selling a security box or a proxy box, the same channel looking for, refresh opportunities this will be a big impact. We've always said we have been selling top down transformation. Our need is driven by applications like Office 365, projects like SD WAN. So our core business comes from securing new local breakouts, which is a greenfield opportunity.
But in almost all cases when Zscaler is deployed, we end up replacing secure web gateway or web proxy that's generally sitting in centralized locations. So, weak competitors, does it help us? Generally, yes, does it change our sales process? Not really.
Got it. Got it. And can I ask about ZPA if possible? I mean, that's a product that clearly has a ton of potential and I would assume it's going to be one of the major growth drivers from here. I mean, we didn't talk about the dampers in the quarter.
Is that just because the business is being driven by ZIA right now. And so that's where the kind of focus is or just any color on ZPA would be awesome.
Yes. So while ZIA platform is growing fast, ZPA is growing much faster. But it's hard for ZPA to catch up with ZIA. So if you think about the deals we talked about, a number of our large deals, GIS DPA, they both came together. So we are seeing more and more a attach rate of ZPA.
And we are very bullish about the opportunity, but it's a relatively new technology in a relatively new market. But we're seeing very, very good traction and bullish about the opportunity.
Thank you. We'll now move on to our next question from Alex Henderson with Needham And Company.
Great. Thank you very much. I was hoping you guys could talk a little bit about the degree to which you have any challenges in hiring of salespeople. What the environment looks like and how much of the spending is going into new hires to drive future growth. It seems like given the tense, the difficult market out there that that may be a challenge to continue to scale at that rate.
Is that an issue that we should be concerned about? Thanks.
It is a competitive environment, Alex, this is Remo. However, I think we're making, you're doing well on a hiring front. It's something that we are investing in significantly. We're not giving out what our RSM count is. However, when you take a look at sales and marketing, headcount, it remains in the 40%, forty five percent range of our total company headcount.
This last quarter, We added over 110 employees, approximately 40 were in sales and marketing. In some of the regions, it's easier than others. And I had a conversation with one of our VPs this morning, who's a bullish related to hiring. So I think that Zscaler being a public company for about a year now, as well as the momentum that we're having. As well as the market continuing to come to us with our performance.
I think we're getting more visibility And we're hopeful that we're going to do a good job in hiring our sales and marketing people as we continue to go forward. As Jay mentioned, our focus is sales and marketing, But in addition, we're a technology company. So we're looking to continue to do development through tuck in type acquisitions. As well as growing our R And D organization.
So when you think about the sales expansion Are you starting to see any leverage as a result of increased recognition or other variables that would allow your productivity of your sales teams to start to see higher deliverables on a per capita basis?
Yes. So for our tenured salespeople, we're certainly seeing that, they're doing well on a quota basis. Overall, when I look at year over year and I take a look at the sales productivity in Q3 of 2018 versus Q3 of 2019, absent anything related to the one time large deal, the sales productivity flattish to up which is what we planned for for the year. The reason for that is that, we're trying to hire, aggressively hire We see this as a large market opportunity. We understand, but it comes down to execution.
From our perspective, we have the product the market's there and the needs there. Really from our perspective, we just need to continue to hire salespeople, solution architects, CXOs, and also to build our support organization, support the product, both from a personnel perspective, but support people, professional services, as well as building our cloud operations.
Great. Thank you very much.
Thank you.
Thank you. We'll move on to our next question from Saket Kalia with Barclays.
Hey guys, thanks for taking my questions here. Maybe first for you Remo, First of all, thanks a lot for the updated billings guidance. You spoke about in your prepared remarks, last Q3 for, we had a large multi year upfront deal that swayed the sequential growth. Can you just talk about what sort of typical Q4 billing seasonality looks like if you exclude those maybe historically? And the corollary to that is, can you just talk about overall pipeline for multi year upfront deals in general?
Yes, good questions. When you take out that public sector deal out of Q4, you look at the guidance that we are giving for this Q4, It implies a billings guidance of 46% to 48%, which is consistent to our revenue guidance of 44% to 48%. So typically Q4, as you mentioned, is our strongest seasonality quarter or season quarter in Q2 and Q4, our top two quarters, From a pipeline perspective, we don't comment what our pipeline is. We take a look at things related to what we feel may be multiyear type deals. Our methodology related to the guidance that we have given has not changed.
So we feel that the guidance that we have, when you take out that large upfront deal from last year at 46% to 48% on a year over basis is very good.
Got it. Got it. Maybe for you Jay, just to learn a little bit more about the ZPA offering, I guess the question is, do the number of subscribers for ZPA differ versus ZIA? I mean, clearly ZIA in a typical deal that is. ZIA clearly has broad use cases for local internet breakout, But do those same customers typically subscribe to a similar seat count for ZPA for VPN?
Is it typically lower? I'm just thinking about some of the examples that you gave in your prepared remarks. It felt like there were some differences in seat counts. Can you talk a little bit to that?
Yes, Saket, good observation. As we have always said, for ZIA, when customers buy the platform, they want to protect every employee in the company who goes to internet or SaaS applications. So hence, it's almost always all employees. When you look at ZPA, it is about access to certain type of applications. So the number of ZPS subscribers is generally lower than ZIA.
If I have to give you a broad range, it ranges somewhere from 10% to 15% of the ZIA users so far. In some cases, if it's VPN replacement, that may be 30%, 40% of the total users. In other cases, if it's M and A integration, it may be the number of employees they need to integrate from the company being acquired. So in the short term, the number will be a subset. Probably 20%, 30%, forty percent, fifty percent would be the range.
But I think over time as everyone moves to the cloud, and you don't have a notion of I must be in the office to access applications. Eventually, everyone will need to use ZPA. So ZPA starts with smaller number of users and grows over time.
Very helpful. Thanks very much guys.
Thank you.
Thank you. We'll hear now from Andrew Nowinski with Piper Jaffray.
All right, thank you. Congratulations on another great quarter. I guess, I just wanted to follow-up on the billings guidance for Q4 just to make sure you understand this. I know if you did have a tough comp, that $16,000,000 deal, if you pull it out, it is in line with your normal seasonality, but you just put up 50 5 percent of growth off of another very similar difficult comp in your backlog continues to grow well above your billings growth rate. So I'm just wondering, is there any other factors in there other than just some conservatism that we should consider for the Q4 guidance on billings?
We like to be prudent with our guidance and that's historically what we've done and we continue to do that.
Okay. I got it. And then, as it relates to your large deals, can you give us any color on the duration of the large deals that you cited in your prepared and whether that duration of your large deals may be different than some of your other deals, are they longer or shorter in duration?
So historically for the for the look on a 4 quarter average for new customers, the duration of those deals it's been in the 70% range, which are 3 years or greater. So that's remained relatively consistent since our public offering. So really no change
in the
duration. Related to the billing timing, from our perspective, we bill annually And if customers pay upfront for the full 3 years, it's not something we compensate for. It's something done by the customer.
Right. So if I may add and clarify, we had never incented our sales force to go and do multiyear deals for upfront payment. All prior deals generally are annual payments with some exceptions that we call out.
Okay. That makes sense. Thanks. Just actually a quick clarification. When you said you're going to generate additional or you're not expecting to generate additional operating leverage presumably in the near term, does that mean, on a margin basis or those absolute dollar basis in terms of the operating expectations?
Yes, it's on a margin basis and we'll be giving guidance on the next call. Both for the quarter and the full year for revenue billings and operating profitability. So we'll give more clarity on that. However, we wanted to make that comment, and this is the comment we're staying consistent with since our public offering. We understand that we have a model that is highly leveraged.
We know we have the ability to increase operating profitability significantly with 80% gross margins. We know that we can increase free cash flow significantly. That is not our intent. Our intent is to grow this mark to continue to grow the market and have the market come to us. We strongly feel And that cost is spending money.
We're spending funds for R And D, sales and marketing, for branding, and continue to build the infrastructure of Zscaler. Jay and myself both have significant experience related to running companies over the last 34 years We have a finger on the pulse, and we're trying to maximize the value of the company for our shareholders to build the presence of Zscaler and to increase our market share. The comment related to offering profitability free cash flow is that I know it's important from a Wall Street perspective, but from a company perspective, important for us to grow the market and become
Thank you.
We'll take our next question from Gray Powell with Deutsche Bank.
Thanks for taking the questions. So, maybe just a high level. So we've seen some fairly volatile results from the securities space this quarter, particularly from more of the on prem focus tenders. Obviously, you guys had some good just curious, have you seen any change in customer behavior or buying patterns? And then just how do you feel about the demand environment the rest of 2019 versus last year.
Great. Thank you. Good question. Our solution delivers great ROI and lots of savings, which actually makes it very attractive, even when the market spend slows down. And secondly, we are driven for helping customers do their cloud transformation.
And transformation is a very high priority for CIOs. And our sales process is driven by that we are not driven by here's another security product that need to be sold or need to replace or need to refresh. So we aren't really seeing the impact of that slowdown. Is there anyone you want to add anything?
No, that's fine. Thank you. Thank you. We'll take our next question from Daniel Ives with Wedbush.
Yeah, thanks. My question more Shutizrically, MNJ, as you're talking to customers, maybe talk about how things are changing today versus even 6 to 9 months ago. In terms of deals, maybe uphill versus downhill? Are you getting more inbounds? Obviously, deal size continue to increase.
Maybe you can just give some anecdotal commentary there to start off.
Yes. So a couple of comments I'll make in that area. Year or 2 years ago when I met the CIO, a number of them would say we're ready for the cloud, but still a good number of them will say we're still thinking, not quite sure. Today, it's hard to find a CIO or a CTO who doesn't want to embrace cloud but they're worried about how to do it securely and how to do it without messing things up. So clear interest, the market movement is happening faster.
And when they realize that, they we have good solution. Things move faster than they would move otherwise. That's why we've seen a larger deal flow than we were seeing before. 2, as the number of customers we have in the Global 2000 segment growth. These are large credible companies.
These CTOs, CIOs are willing to speak publicly about the benefit that they are deriving for security, for user performance and cost savings. That's helping us quite a bit. 3, I shared with you a couple of examples where our C XOs from our customers move to new customers. They're able to actually go in and say, I would like to bring Zscaler back in. So pleased with the environment, but as Remo said, we are just heads down focus on execution but market feels good.
Great. And I mean, maybe you can just talk, when you think about just overall deal sizes and sales cycles, obviously, just given the nature of some of these larger deals, but Are sales cycles changing or, obviously, are they shortening overall? In terms of just getting deals closed. Are there any discernible changes that maybe Remo or Bill or Jay comment there?
Yes. Good question, Dan. Not really. I mean, for smaller deals, it's still 3 to 6 months, larger deals, 6 to 12 months, after a customer has made the decision to go to the cloud and do transformation. From a average deal size perspective, we look at it for customers are greater than 3000 users.
We're in the mid-three 100,000 range. It's increased every quarter and it did increase in Q3 versus Q2. So we are seeing from an average deal size increases every quarter as we did this past Q3.
Yes, if I may add, the number of engagements and awareness have gone up. So that's obviously needed for us to deliver big numbers.
Keep crushing it. Thanks.
Thank you.
Thank you. We'll now move on to our next question from Nick Yako with Cowen and Company.
Hey, thanks for taking my questions. Jay, maybe one for you. There's certainly a growing awareness that legacy networks security models don't really work in a cloud and mobile first world. But do you have any sense of where we are in the adoption curve of local internet breakouts today? And then along those same lines, any color you can provide around the percent of your own customers that have moved to local breakouts?
A very good question, Nick. So till SD WAN initiatives came into market, the only vendor that was pushing for local breakout was Zscaler. So if you want to look at the size of the market of local breakout, our own market share is a good indication of that. We are we announced, I guess, last year about 300 of the largest global 2000 companies were our clients. Now what percentage of Zscaler customers are doing local breakout was the second question.
Actually, the number one reason we have bought is to do local breakout. Now the customers who haven't done breakout with Zscaler, it's only because they haven't gotten around it. Okay. But I would say almost all of our customers have bought us for local breakout. And if you look at the SD WAN market, where one of the big reasons to deploy is local breakout, we are the predominant vendor.
Who secures the SD WAN market. So if I were to give you my guesstimated answer in large enterprises, that number of customer with down local breakout is sitting in the mid teens.
Okay. That's really helpful. And then maybe just a quick follow-up I was just wondering if there were any metrics you guys could provide around ZPA, whether it's customer uptake or percent of revenue or new deals. And if not, then just maybe some of the common use cases you see gaining traction?
Yes, from a metric perspective, we'll give that on our next call. All I can say is that, ZPA is our fastest growing product and we're happy with the growth. And we're looking forward to talking about it on our next
Premo, the metrics you gave last year was 10% of the new and upsell business we got. And I think at the end of this quarter, end of Q4, we'll update on an annual basis where the numbers are. But your second question was about use cases. Lots of very interesting use cases, on a simple tactical front, replacing VPN, remote access VPN is a very popular use case because customers don't like VPN. They're slow.
But more importantly, VPNs are a big security risk because they put users on the network. Imagine 5000 people in Fythons Cities, including some sitting in Moscow or Croatia, they're on your network. VPN needs to be eliminated to make are enterprises in our country safe. But second use case, big one. Access to applications sitting in public cloud like AWS and Azure.
Without a solution like ZPA, your users need to go back to your data center, which is a choke point, and then here, pin back to a public cloud, a silly thing to do. But that's what most customers do because that's all they know of. A third interesting use case, which I used to think will be only a very small number of cases, M and A integration or divestitures. I'm so price to follow how many companies are being merged and divested. And that's helping.
Those are the use cases.
Okay, great. Thank you guys.
Thank you. Thank you. We'll move on to our next question from Melissa Franchi with Morgan Stanley.
Thank you and congrats on the quarter. Jay, I wanted to follow-up on the Appsolete acquisition interesting that you're adding browser isolation technology. Can you maybe add some more color on how that tech is complimentary to what you're already doing from a web proxy perspective? And then what should we expect in terms of the timeline of getting that integrated?
Okay. Good. The browser isolation is a relatively new market, and it's evolving. And it has special use case in certain verticals where security is a very important financial services, health care, maybe defense kind of area. This, call it feature, call it, a module is very relevant for C Scalar because we're sitting in the traffic path.
And simple example could be traffic going to certain known type of sites. It could go direct using the technology Zscaler is using today. But there may be some unknown and fairly suspicious sites. You don't want all that traffic coming to the user endpoint and those hyper destinations are funneled through our browser isolation technology. So it becomes very, very complementary and very good fit So that's the use case.
In terms of integration, what we bought is a young developers team, a very sharp team, and a very, very innovative core engine. And that engine will be integrated into our platform and made sure it scales in the cloud. And that's the work we are doing in coming a few quarters. And once we're comfortable with that, we make it available as an offering to our customers. We're not planning for any revenue
or very little revenue in Q4 or in our fiscal 2020. I think one of the key points is that, you know, when the strength of Zscaler is we have 1 code base and we're putting this on our platform, we're going to integrate it into our platform. Which I believe will give us a competitive advantage.
Yes, I have seen so many companies who go on a buying spree end up products never integrate. They may put a little UI in front of it, but customers complain about that type of stuff. So our focus by good core technology and properly integrate them. So it's like one product, a single pane of glass, not just the facade of us.
Okay, that's helpful. And then one quick follow-up. Jay, it's been about a year since the COO role went vacant with the departure of Bill Welch. Just wondering if that role is still open and how you're feeling from a sales leadership perspective?
Yes, that is correct. We have retained search. We have lots of good candidates with lots of good interest. It's a very important role for us, and we're being very selective, but we will be filling that role. We're making progress on it.
Great. Thank you very much.
Thank you. We'll take our next question from Jonathan Rupaver with Baird.
Yes, good afternoon. I'm kind of curious if you could talk about the SPSI contribution to ARR. I have in my notes that it was around 45% around the time of the IPO. So I'm just kind of curious how those channels have contributed to ARR since then?
Yes. On a revenue basis, it's a little bit higher. It's in the low 50% range. Currently, the traditional VARs distributors in the low to mid-forty percent range and 2% or 3% direct. All our new business though is through SPs and SIs and VARs.
Our focus is to, I mean, we feel SPs and SIs are very strategic for Zscaler. A lot of our emphasis is being put in that channel. However, we understand the importance of the VAR distributor channel. We plan to continue to invest in that channel to go forward.
Can you talk about the impact that SP might be having a transformation in ZIA and the same thing with SI and ZPA?
Yes, so SP's service providers are the folks to provide network and net internet connectivity to enterprises. So they are our natural partners for the sale of ZIA, and ZIA is a mature market. Sorry, a mature offering from Zscaler and SP channel is fairly mature. Systems integrators have a better fit for ZPA because they are the folks who move internal applications to public clouds. And along with that, we are working with them to bundle our ZPA offerings.
So they not only do migration of applications. They also provide a secure and fast access to the customers. And that's in a early stage. ZPA Young, so is the SI relationship. But we are pleased with the progress we're making in that area.
Right. Okay. My final question, secure SD WAN is an alternative architecture to securing local internet breakout. Some of the larger networking companies talk about that as a successful use case. Jay, could you just compare, contrast how you view Secure SD WAN versus ZIA?
Absolutely. SD bands, core things starts being a sophisticated cloud managed branch 2.0 box that integrates routing and switching that gives you connectivity back to the data center over traditional MPLS or over the internet. And that's one use case. We don't play into that use is the second part of the SD WAN, along with that, is to be able to peel off internet and SaaS bound traffic. At the source at each branch.
So it can go direct over a broadband or whatever the connection may be. Now that location that local breakout must be secure. Either you build a local gateway with traditional network security appliances such as firewall, proxies, DLP and the like, or you point that traffic to Zscaler, ZIA. You can imagine 100 of branches, which solution is better, simply pointing the traffic to us. Now some SD WAN vendors may say that we will build the functionality in each box.
So if you've got 1000 branches, will put that functionality in thousand branches. At least doesn't seem to make sense. The customers want the lightest footprint in each branch. So simply they do the network functionality, point the traffic to the cloud and security can be done in the cloud. That's why most of the SD WAN deployments we know of, we are the default part default platform that secures SD WAN.
So could we see a few cases where SD WAN vendor may be trying to add security in the box in rare cases. Most of the time, it will be done in the cloud and we are the biggest beneficiary of that.
We'll now take our final question from Fatima Boolani with UBS.
Good afternoon. Thank you for taking the questions. I have one for Jay and I have one for Remo. Jay, in your prepared remarks, I did notice the co incidence of ZPA and ZIA deals has certainly increased over the last four quarters. So I'm wondering as I guess the de facto head of sales, if you have put in place any specific incentives or quarter retirement targets from a go to market perspective to really drive that inflection in ZPA adoption that you were talking about?
Yes, very good question for Timas. So first of all, ZPA is maturing. We announced that we made it available a little over a year 2 years ago. So obviously, there's more awareness. So it'll be natural for us to expect ZPA in more deals.
Internally, we do give financial incentives, for ZPA sales. So it's a combination of maturity, awareness, well trained sales team, and some financial incentives.
That's very clear. And Nuremo, for you, just on the gross margin front, you've been very efficient on your delivery costs. So just from a COGS perspective, you've held the line to show the gross margin strong gross margin performance. But I'm wondering if there's any other dynamics that are really enabling you to outperform on gross margins, whether it be pricing leverage, or pricing increases within the base or anything beyond the cost front that you're able to that you're doing that's helping gross margins. And that's it for me.
Thank you.
Yes, thank you Fatima. I think we just have a very efficient platform, to be honest with you. When you're driving 80 plus percent gross margin with the amount of traffic that we have going through and the amount of application, security applications that we run, it's got to start with the software. It's got to start with the strength of the platform that we've created. In addition to that, we do look at pricing.
We periodically increased pricing. And but that's related to increased usage on the part of our customers, increased bandwidth that they're using. Our cloud operations group is outstanding. We have a very strong cloud operations group, which is very efficient, that's created basically automated tools to help us basically manage our cloud. From a professional services, a technical account manager, professional services perspective, depreciation of capital equipment.
Those are all things that we manage on a literally weekly monthly basis. And we stay on top of it. But it really starts with the strength of the platform, with the ability to scale our cloud to a level it is at these types of gross margins. We're very proud of it. Excellent, Emil.
If I may add what Remo talked about platform I would say it's a purpose built architecture that we built that gives us the biggest advantage. 2, since we had to optimize software We have highly optimized software we developed on our own without having to pay any royalties to third parties. And third, another new point I'll mention is we have no money to pay to public cloud vendors to run our stuff in those public clouds.
Thank you. And that does conclude today's question and answer session. Would now like to turn the conference back over to Mr. Shadra for any additional or closing remarks.
Thank you. Thank you for your interest and time We'll see some of you at the Bank of America Merrill Lynch Conference next week. Otherwise, We'll speak with you at our next earnings call.
You. That does conclude today's conference. Thank you all for your participation. You may now disconnect.