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Zscaler, Inc. (NASDAQ:ZS)
Q1 2019 Earnings Conference Call
November 4, 2018, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the Zscaler first quarter 2019 earnings call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Bill Choi, VP of Investor Relations. Please go ahead, sir.

Bill Choi -- Vice President of Investor Relations

Good afternoon and thank you for joining us to discuss Zscaler's financial results for the fiscal first quarter, 2019. With me on the call are Jay Chaudhry, 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 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, net loss, pro forma net loss per share, free cash flow, and dollar-based net retention rate.

These statements and other comments are not guarantees of future performance, but rather are subject to risk and uncertainty, some of which are beyond our control. 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 filings with the Securities and Exchange Commission as well as in today's earnings release.

Unless otherwise noted, 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. For historical periods, the GAAP to the non-GAAP reconciliations can be found in the supplemental financial information referenced a few minutes ago.

I would also like to inform you that we will be participating in the Barclays Global TMT Conference in San Francisco tomorrow and the Needham's Growth Conference in New York on Tuesday, January 15th.

Now, I'd like to turn the call over to Jay.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Thank you, Bill and thank you, everyone for your interest in Zscaler. I am pleased to share with you our solid first quarter results. We posted strong revenue and calculated billings as we continued to experience robust growth in our business. Our revenue grew 59% year over year to $63.3 million and total billings grew 56% year over year to $64.6 million.

In addition to our topline growth, we achieved positive operating profit and free cash flow for the quarter. Our operating margins improved approximately 20 percentage points year over year to 2%. We are very pleased with reaching profitability this quarter. This demonstrates the leverage in our business model. Having said that, we will continue to aggressively invest in our business to pursue our significant market opportunity.

We believe the primary driver for our market success is the change in data center and network architecture to support the adoption of cloud. Cloud and mobility are breaking the traditional perimeter, where organizations build a hub and spoke network to back haul branch off traffic over private networks to the data center. Then they build a moat of security appliances to secure the network. That is why we call it network security.

In the cloud world, applications can be anywhere and devices and users can be anywhere. The notion of inside the network or outside the network is disappearing. We believe the corporate network is changing to a direct to internet architecture. This is commonly known as local internet breakout, which significantly improves user experience and lowers networking costs.

But when you go direct to the internet, what is the corporate network and where would you build a moat? How do you do network security in this world? Well, you can't. Network security is becoming irrelevant. Designed for the world which has no walls, Zscaler Security Cloud acts as a business policy enforcement engine, deployed across 100+ data centers to securely connect the right user to the right application -- ZIA for internet and SaaS applications and ZPA for internal application in your data center or the public cloud.

As organizations embrace the cloud, more and more deals start with a high-end transformation bundle, which includes cloud firewall, IPS, and sandboxing. I would like to highlight three new customer wins in the quarter that we believe illustrate the value we deliver for secure network transformation.

A Fortune 100 conglomerate purchased Transformation Bundle for all of its 100,000 employees. While we are replacing traditional networking appliances, such as secure web gateway, branch firewall, DNS, and a dozen data centers, it is mostly a greenfield opportunity. We are creating about 400 new secured local internet breakouts. Zscaler will be the only security check post for traffic headed to the internet from all branches and all the data centers, thus enabling a cloud-first approach to applications such as Office 365.

They also purchased ZPA for third-party contractors, who needed access to internal applications, replacing legacy VPN that provides them access to the entire corporate network, increasing their security risk.

In another deal, a Fortune 500 global food and beverage company purchased Transformation Bundle for 52,000 users to secure local internet breakouts for over 400 sites, including about 350 international locations. This customer had already realized the need for local breakouts but went about it the wrong way. They installed over 300 branch firewalls, which was complex and required substantial resources to manage.

Our system integrator partners saw an opportunity for the customer to do it the new way, using Zscaler's cloud platform. Our approach enhances security with coverage of all users, including mobile, with full SSL inspection. It also improves user experience, all this at a lower cost of ownership and greater operational simplicity, while eliminating on prem security appliances.

This customer also purchased DLP for all users. When customers do local internet breakout, data leakage becomes a major risk. They need a cloud-based DLP solution to secure sensitive information at any location.

Another new customer, a global pharma company, had a strategy to pursue a full transformation to the cloud for the network and for their applications. To realize the strategy, they bought our Transformation Bundle for ZIA and ZPA for over 15,000 users. They're deploying SD-WAN across 80 sites, with Zscaler securing all traffic from these locations.

With this new architecture, the customer is estimating a 50% reduction in the $35 million, four-year MPLS spend, plus lower CapEx and management cost for the network and security infrastructure. While ZIA provides secure and fast access to internet and SaaS, ZPA will do the same for the internal applications, some of which are in the data center, while others are moving to Azure and AWS.

The Zscaler platform enables a realization of their strategy -- a perimeterless enterprise with direct access to any service or application from anywhere on any device without backhauling traffic through the data center.

I also want to highlight two upsell deals with existing customers that are leveraging our platform for the next phase of the cloud journey. A customer in the food processing industry started with Zscaler one year ago with a security-led use case of protecting 50,000 mobile users with our business bundle. Last quarter, they purchased the transformation bundle and DLP for all 100,000 employees.

The value realized from the initial security use case helped us win over the networking team as they began to rearchitect the network for the cloud. This customer had recently deployed the leading next gen firewalls across 200 sales and manufacturing offices, but they realized that deploying security appliances and spinning virtual machines in a public cloud fails to deliver cloud security. The customer expects Zscaler to save them over $10 million per year on purchasing and managing firewall appliances.

Finally, let me highlight a customer headquartered in Europe that has been using Business Bundle and DLP for 32,000 users. Last quarter, they purchased additional 9,000 seats and added cloud sandbox for all users. Drivers of this deal were twofold -- one, M&A use case, the customer acquired a competitor in the US and wanted to implement a consistent policy and protection across the entire organization. Number two -- this initiative is part of a larger managed network services RFP. All five telecom services providers bid Zscaler for the security.

With over 40% of our sales in EMEA, we have been very successful in the European market because our cloud service is architected to meet stringent EU data privacy requirements. The only customer data that we store are customer logs and customers can choose to store these logs in our EU data centers or they can choose to store them in their own data center.

We believe these deals demonstrate the tremendous value we are delivering. A strategic advantage for us is the partnerships with large system integrators and global service providers, who implement cloud transformation projects. SI and SPs represent over 50% of our revenue and they are the fastest-growing channel for us. We will continue to invest in our partners to enable them to create leverage and accelerate our sales.

We are investing in our go to market capabilities, which enable us to sell top-down at the C-level. During the quarter, we hired a new CMO, Micheline Nijmeh, with deep experience in enterprise marketing and proven ability to grow revenue and pipeline. In addition, we hired Kavitha Mariappan as an SVP for a newly created role to drive customer experience and transformation.

With these two roles filled, our priority remains to find the right leader for our global sales organization. With strong sales leaders in place for Americas and international markets, I'm confident that our sales momentum will continue. We also continue to expand our global salesforce.

Overall, we're executing well on our vision. We believe we have a significant competitive advantage on the technology and architecture for cloud security. We have ten years of operational experience running our security cloud at scale. We process about 60 billion internet requests per day, which you can see on our website real time.

Each day, we detect and block about 100 million threats and perform more than 120,000 unique security updates. This network effect delivers superior security as compared to traditional appliances or a hybrid security cloud. Last week's report by Gartner named Zscaler a leader in its Secure Web Gateways Magic Quadrant for the eighth year in a row.

In October, we brought a Zenith Live Cloud Summit to London with hundreds of customers and partners attending from 19 countries. Zenith Live is where CIOs, CTOs, CSOs, security, and networking practitioners meet to discuss cloud transformation, with insights from leaders who have gone through this journey. We had an outstanding lineup of keynote speakers, including Microsoft, Siemens, Orange Business Services, Carlesberg Group, and others.

In summary, we are very pleased with our strong Q1 results and continued momentum in our business. We believe we are in 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.

Remo Canessa -- Chief Financial Officer

Thank you, Jay. As Jay mentioned, we had a very strong start to our fiscal year. Revenue for the quarter was $63.3 million, up 13% sequentially and 59% year over year. From a geographic perspective, for the quarter, Americas represented 49% of revenue, EMEA was 43%, and APJ was 8%.

Turning to calculated billings, which we define as change in deferred revenue for the quarter plus total revenue recognized in that quarter -- billings grew 56% year over year to $64.6 million. As a reminder, historically, Q2 and Q4 have been our strongest billings quarters with sequential declines in Q1 and Q3 quarters, respectively. The sequential decline is higher than prior years due to a difficult comparison from a large upfront deal we had in Q4.

Excluding the $16.5 million upfront deal from Q4, billings would have declined sequentially about 18%, which is an improvement over the 25% declines seen in the prior two years. Also, as a reminder, we primarily invoice our customers one year in advance and our contract terms are typically one to three years. The upfront greater than one-year billings year over year were fairly small in both periods. Total backlog, which represents remaining performance obligations, was $411 million on October 31st, up 77% from $232 million one year ago.

Our strong customer retention and ability to upsell have resulted in a consistently high dollar-based net retention rate, which is a 118% for the period ended October 31st. This compares to 116% a year ago and 117% last quarter.

Our increased success selling bigger deals, which start with the transformation bundle, while faster upsells within a year, while good for our business can reduce our net dollar retention rate, which is calculated on a year over year AAR basis. Considering these factors, we feel 118% is outstanding and will very quarter to quarter. Total gross margin was 82%, up 2 points sequentially and 2 points, year over year.

The year over year increase was driven primarily by an increased mix of higher-priced bundles and more functionality as well as operational efficiencies. While we are pleased with our gross margins, our focus is not to maximize our gross margins at this stage. We feel 80% continues to be a good target range in the near to medium term. It is important to continue to invest in our platform and to drive customer satisfaction to drive topline revenue growth.

Turning to our operating expenses, our total operating expenses grew 7% sequentially and 29% year over year to $50.5 million, the decrease as a percentage of sales to 80%. As we continue to invest to grow our business, we increased our headcount by over 80 employees in Q1 and approximately half were in sales and marketing.

Sales and marketing increased 10% sequentially and 29% year over year to $33.7 million. We have been building our sales and marketing teams and investing in marketing programs to drive growth and awareness, including the Zenith Live Conference held in Europe during the quarter.

R&D was flat sequentially and up 22% year over year to $10.3 million. As we continue to invest to enhance product functionality and to offer new products. G&A increased 1% sequentially and 42% year over year to $6.5 million. The year over year growth in G&A includes investments in building our teams, consulting, and other expenses that we've made as we became a public company. These expenses exclude $2.2 million in litigation-related expenses.

Our first quarter operating margin was a positive 2%, which compares to a negative 19% in the same quarter last year. Net income in the quarter was $2 million or non-GAAP earnings per share of $0.01. Given the positive earnings in the quarter, our EPS was calculated on a fully diluted basis of approximately 134 million shares. We ended the quarter with $314 million in cash, cash equivalents, and short-term investments. Free cash flow was positive $5.2 million in the quarter compared to negative $8.9 million for the same quarter a year ago.

Our ESPP program contributed approximately $3 million to our free cash flow in the quarter. The first stock engagements under the ESPP program will be in December, which will reduce our free cash flow by approximately $8 million in Q2 but will have no impact on 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 second quarter, we expect revenues within the range of $65 million to $67 million, operating loss in the range of $1 million to $3 million, income taxes of $600,000.00, net loss per share in the range of $0.00 to $0.02, assuming approximately 122 million to 123 million common shares.

While we are pleased with our profitability head of schedule, we will continue to aggressively invest for growth. We believe we have a unique opportunity to disrupt and to capture a large market opportunity. As I have mentioned in the past, we plan to achieve sustained profitability and positive free cash flow sometime in Fiscal 2020.

For the full year 2019, we expect revenue in the range of $268 million to $272 million or year over year growth of 41% to 43%. Operating loss in the range of $4 million to $6 million, income taxes of $2.4 million and net loss per share in the range of $0.01 to $0.03, assuming approximately 124 million common shares outstanding.

As you model billings for Fiscal 2019, I want to remind you that in Q4 2018, we had a large upfront billing of $16.5 million from one customer. This will produce a difficult year over year comparison in Q4 2019. If we exclude this large upfront billing of $16.5 million from Fiscal 2018 results, we believe total billings growth in Fiscal 2019 would be comparable to our guided revenue growth, which would imply a billings range of $340 million to $345 million for the year.

We're very proud of what we have achieved and look forward to building on our opportunity. Now, I will hand the call back over to Jay.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Thank you, Remo. We believe we're the best choice for securing the cloud in the mobile-first world. The right architecture matters. On prem senior tenant architecture, whether deployed as appliances or as virtual machines spun up in the public cloud will not all enterprises to fully realize the benefit of cloud. They can't scale, leave gap insecurity, are expensive, and deliver a poor user experience.

With multiple tailwinds such as SaaS adoption, SD-WAN, and app migration to public clouds, we believe the market is coming to us. We're making solid progress in the global 2000 accounts as these large enterprises embrace cloud transformation. We are executing on our vision. We are scaling our cloud to meet the growth in customer base, driving greater adoption of our high-end transformation bundle and ZPA. We are delivering high ROI for customers that leverage our platform for transformation.

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 for questions.

Questions and Answers:

Operator

Ladies and gentlemen, at this time, we will open the floor for questions. If you would like to ask a question, please signal by pressing *1 on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach out equipment. Again, press *1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions.

We'll take our first question from Brad Zelnick with Credit Suisse.

Brad Zelnick -- Credit Suisse -- Managing Director

Excellent. Thank you so much and congratulations on another phenomenal quarter, guys. I've got two questions. My first is for Jay -- Jay, your primary competitor has experienced disruption of late with leadership turnover and various company-specific distractions. Is this perceptible to you in the field? Can you maybe just give us an update more generally on the competitive environment?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Brad, thank you. We are having tremendous success in the field. I think our number one reason for the success is our innovative multi-tenant architecture, which scales and works well. Whether the success is due to our competitors' issues or not, I'm not sure I can tell, but we are winning. We're seeing market growing rapidly. I don't see a significant shift in the competitive landscape.

Brad Zelnick -- Credit Suisse -- Managing Director

I appreciate the commentary. Remo, just for you -- thanks for calling out and reminding us the $16.5 million upfront billing in Q4, which if you remove that, you've actually done better than the seasonality we've seen in Q1 the last couple years. Also, appreciate the guidance that you've given us on billings for the full year. But as we think about the seasonality from here, anything we should take into account as we model the quarter billings given the strong start that you've had here in Q1?

Remo Canessa -- Chief Financial Officer

Brad, just what we've said before -- you mentioned that we've called out both Q2 and Q4 as strong quarters. Q4 year-end and Q2 straddles 12/31 and also our prior year-end as a company was 12/31. So, we have a lot of renewals to come through. I would expect the same type of seasonality. It was a great quarter for us. I would expect the same type of seasonality going forward.

Brad Zelnick -- Credit Suisse -- Managing Director

All right. Thanks again and congrats.

Operator

Thank you. Once again, ladies and gentlemen, if you would like to ask a question, please press *1 now. We'll take our next question from Daniel Ives with Wedbush.

Daniel Ives -- Wedbush Securities -- Managing Director

Thank you. Jay, you alluded to it a little, but maybe you could elaborate. How are conversations changing in regard to more enterprises looking to really expand with Zscaler? Maybe customers 6 to 12 months from now have small deployments, now the pipeline is expanding significantly. What do you think the drivers are there? Thanks.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Right. The biggest change in the past one to two years versus now is almost every CIO wants to do cloud transformation with security in mind. That was two years ago. Where it's directly impacting us in a couple of ways. One is with transformation, they're all looking at local internet breakout is one of the key drivers, which really drives our Transformation Bundle, which includes Cloud Firewall, Cloud Sandbox, and the like. That's number one.

Two, we used to have a lot more deals, starting with Business Bundle, which really got full security breakout, but did not have all protocols, all functionality. So, moving to a bigger bundle is one and having a bigger pipeline, more momentum is two. That's why we are posting strong growth in sales.

Daniel Ives -- Wedbush Securities -- Managing Director

Could you just quick comment about talking M&A and how you're thinking about that just as we go through 2019? Thanks again.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

We are always open to M&A opportunities. We aren't looking to volume companies for revenues. If we look at something, it will be largely driven by a strategic fit to expand our platform in a meaningful way. We did a small acquisition last quarter or so. It was in the machine learning and AI area. It's already delivering results. So, as opportunities present themselves and the strategic area, we will be open to those and be looking to those.

Operator

Thank you. We'll take our next question from Alex Henderson with Needham.

Alex Henderson -- Needham & Company -- Analyst

Thank you very much. I would also extend that congrats. That's a spectacular quarter. The question I wanted to address, there are two pieces of it. Could you talk about in terms of new orders what the mix looks like between ZIA and ZPA? Are you seeing an accelerated uptake or any metrics around the rate of uptake on ZPA, which obviously is a small part of revenues, currently, but is a key piece.

Second, could you give us any metrics around the display move up the stack from professional to business to transformational bundles? Where are we on that. Have we seen a meaningful change in the rate of uptake of transformational bundles versus the other two? Thank you.

Remo Canessa -- Chief Financial Officer

I'll take that, Alex. From a new business perspective, which is new or upsell, we talk about when there are meaningful changes in our business, what we called out last quarter is for a new and upsell business for ZPA that represented approximately 10%. What I can say about ZPA on a year over year basis is it's close to doubled, so good traction with ZPA. Similarly, for Transformation, what we called out last quarter is that Transformation has increased to 35% of our total ARR for ZIA. What I can say is that it is going up. So, it is increasing. We'll make updates when we feel it's meaningful.

Alex Henderson -- Needham & Company -- Analyst

Great. When you look at that mix, is there any change in the sell cycle associated with the time it takes for either of those upscale purchase orders or is the sell cycle fairly similar despite the fact that you're selling a lot more product?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

This is Jay. Alex, thank you. We are selling more higher bundles, though the sell cycle hasn't changed. I would say a years ago, if the sales cycle was X-months to sell Business Bundle, we are able to sell the Transformation Bundle in the same kind of sales cycle. So, it's helping -- similar sell cycle but being able to sell bigger bundles. That's partly because market is moving faster in our direction.

Alex Henderson -- Needham & Company -- Analyst

Sounds good. Thank you very much.

Operator

Thank you. We'll take our next question from Gary Powell with Deutsche Bank.

Gray Powell -- Deutsche Bank -- Managing Director

Thank you very much. Congratulations on the strong results. So, just one on my side -- over the last few weeks, we've heard a lot of questions around the macro environment and the sustainability of the improved IT spending we've seen in 2018 extending into 2019. How do you feel about things going into calendar 2019 and then how do you think Zscaler is positioned if the overall macro next year is not as strong as it was in 2018? Thanks.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Good question. I'll answer it in two parts. Number one, Zscaler not only helps you drive cloud transformation, it actually helps you drive tremendous ROI. So, in many ways, when spending is tight, we become a more attractive solution. That's one. Number two, we are still such a small piece of the overall IT environment or budget that I don't think we will see much of a change because of some of the environment tightening.

I'll tell you an interesting dialogue I had with a CIO of a Global 2000 company. I said, "Thank you for making time for me. I know I'm a very tiny fraction of your overall IT budget." He interrupted me and said, "Stop, you may be a small piece of my IT budget but I don't have a cloud strategy without you. So, I want you to come and see me every six months." So, with that kind of strategic positioning for transformation with such a small piece of budget, I don't think we'll see a negative impact.

Gray Powell -- Deutsche Bank -- Managing Director

Got it. That's very helpful. Thank you very much.

Operator

Thank you. We'll take our next question from Melissa Franchi with Morgan Stanley. Melissa, your line is open.

Melissa Franchi -- Morgan Stanley -- Analyst

Congrats on the quarter. Jay, you noted how adoption of the Transformation Bundle is being driven by the need to enable secure local internet breakout. Can you maybe elaborate what functionality explicitly within the Transformation Bundle enables those local breakouts? Since the cloud firewall is part of the Transformation Bundle and that's incremental relative to the prior bundle, that says to me that you're displacing firewalls either at the branch or in the data center.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

That's a good question. First of all, to give you the difference, Business Bundle has lots of good functionality and local breakout for the web traffic. The two big modules in Transformation Bundle that's new outside the Business bundle -- one is cloud firewall, the second is cloud sandboxing.

So, people are buying Transformation Bundle, not because they're displacing branch firewalls. People are buying it because they are creating new local internet breakouts and when they see the option with the cloud firewall where they can handle all protocols rather than just web traffic at a relatively smaller cost, it becomes attractive for them to buy Transformation Bundle.

So, to the driver for Transformation Bundle, cloud firewall to handle all kinds of traffic, and especially Office 365 traffic, Skype and all, which works beautifully through our cloud firewall and which won't work very well through a traditional web proxy. And sandboxing -- everyone has bought Sandbox in the data center. They all buy into it because of security threats. When they find that with Zscaler or not, this functionality is available everywhere on every branch office, even for Road Warrior, it becomes easy for an add-on of Cloud Sandbox. Those are the two drivers that are in there.

One key module that's not in the Transformation Module is DLP, data loss prevention and that's still bought a la cart. Did I answer your question?

Melissa Franchi -- Morgan Stanley -- Analyst

Yes, that's great. Thank you. Remo, in terms of operating margin, particularly related to sales and marketing leverage, I'm wondering if you can maybe just elaborate what's enabling that magnitude of sales and marketing leverage. I'm wondering if you can comment on hiring plans and how that came in relative to your expectations in the quarter and if you see them engaging in sales attrition.

Remo Canessa -- Chief Financial Officer

Good question. We had very good sales and marketing leverage. The productivity on a quarter over quarter basis from Q1 of last year versus this year. From a hiring perspective, what we called out is that we hired over 80 employees, net employees in Zscaler and about half of those were in sales and marketing and most of those were in sales.

So, what we plan to do as we go forward, we're very proud of achieving profitability, but we see this as such a large marketing opportunity that we're going to continue to invest. So, from our perspective, there's no change. In that, we expect to be sustained, profitability and free cash flow positive, sometime in Fiscal 20, which I think what we've demonstrated over the last three quarters, being positive free cash flow and reaching operating profitability, we've got the model in order to really show significant expansion in profitability.

But because of the large market opportunity, we're going to do investment and we're going to try to capture this market opportunity as best we can.

Operator

We'll take our next question from Gabriela Borges from Goldman Sachs.

Gabriela Borges -- Goldman Sachs -- Analyst

Jay, I would love to understand a little bit better for your new CMO and your new SVP for Customer Engagement and Customer Success, what are the priorities for those two roles and what are some of the key initiatives that the ladies will be working on over the next 12 months or so.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

So, the two new roles, the CMO, Micheline Nijmeh, her number one priority is overall, help us do more demand generation as our goals are getting bigger and bigger, targets bigger and bigger, so is the need for higher demand gen. Along with that, we are going to focus on building up brand and awareness overall. IPO has helped us in this area quite a bit, a lot of visibility, but we think a lot more can be done in that area. So, those are two big objectives in addition to many others.

Regarding our SVP of Customer Experience and Transformation, we are a very customer-focused company. It starts from me. This customer experience is really starting with the products experience, the sales experience, to once the sale is made, deployment in ongoing traction. So, Kavitha is able to really pull together all these things in a holistic fashion across multiple functions to make sure our customers have the best experience.

The second part, the transformation is actually not only the customer side of it, but it's our own transformation as a company. We have been going through changes and transformation in the way we deal with customers and the way we go to market. You have seen some of the innovations done in go to market at Zscaler, which is not traditional sales through VARS.

We figure out the go to market top-down, CXO, CTO-level. We figure out how the new transformation sales need to be done with some of the architects and the like. So, this is more to focus on making sure Zscaler as a company is transforming and changing itself as the world is moving fast. So, we're very happy to have these two very capable executives join my team.

Gabriela Borges -- Goldman Sachs -- Analyst

That's helpful. Thank you. The follow up is on the status of some of the telecom service provider partnerships that you have. I think you mentioned in the prepared remarks where five separate telecom partners bid it to offer Zscaler services. Are there large telecom providers that you can still bring online? Do you feel like you have good penetration in the partnerships you already have? Is there more willingness to embrace the Zscaler platform as a counter to what otherwise may be a headwind in MPLS? Thank you.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Yeah. We all know that the world is moving from hub and spoke network to local breakout. It is true that up to three or four years ago, many telcos were wondering between how fast to move in that direction and how much they could do to slow it down, but everyone realized the market is moving in that direction.

If I would say the top ten largest telcos in the world, they all do business with us. Some of them, a lot more than others. So, our goal is to make sure we work more closely with them. They see it as a joint opportunity. They want to see the customer moving to a new network that's still managed by them.

So, they are managing the network. They're managing Zscaler security service for the customer. So, it's a good win-win proposition and we are seeing more leverage, more traction coming from SPs, partly because of two reasons -- one, the market is taking them there. That's number one. Number two, they're seeing increased revenue opportunity with Zscaler along with able to keep account control. Did that make sense?

Gabriela Borges -- Goldman Sachs -- Analyst

Yes, thank you for the color.

Operator

We'll take our next question from Saket Kalia with Barclays Capital.

Saket Kalia -- Barclays -- Analyst

Hey, guys. Thanks for taking my questions here. Jay, just to pick up on an earlier line of questioning on the transformation bundle and the traction there, do you track any stats on which of those modules are being used particularly heavily. So, you mentioned cloud firewall and cloud sandboxing are the biggest additions versus the Business Bundle. Are you seeing one module used more heavily than the other?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

It's a good question. If we were in the appliance world, then you would say, "Well, this module got turned on. This did not." When you buy a cloud sandbox in the traditional world, there are a bunch of steps to integrate how to take traffic, how to authentic users, how to set up SSL sandboxing. All those things are essentially in place when the traffic comes to Zscaler.

So, turning on firewall or turning on sandboxing is very simple. So, I would say once the customer has bought Zscaler modules, they are essentially turned on almost all the time. It's very rare when those modules are not used. Now, it is possible that a customer may have only 20 local internet breakouts early on and it would take them nine months to go from 20 to 200.

Now, they still turn on our sandboxing and firewall on those 20 local breakouts. As additional 180 get added, they still remained turned on and now, they're making more benefit of the benefits. It's rare to have something where customers bought a module from Zscaler and they're not using it because turning on is simple. It's simple a single click in our configuration. In fact, we in our sales show the customer, what we call a single-click deployment of Cloud Firewall and Cloud Sandbox from our console.

Saket Kalia -- Barclays -- Analyst

Just a follow-up for you, Jay -- you mentioned DLP is sold a la cart outside of the bundling strategy. Can you talk about why a la cart pricing is the best avenue and could we see DLP as part of a bundle in the future?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Yes. Bundling is an interesting exercise with no simple answers. If you bundle too much, you can increase the price too much. If you don't bundle enough, you're not selling additional modules. It's one of those art and science things. I think when a module becomes widely accepted and more and more customers start buying it a la cart, it tells us it's really time to bundle it.

So, if you asked me two years ago, I wasn't ready to bundle Cloud Firewall and Cloud Sandbox, so Transformation Bundle is relatively new. I think, Remo, it's about a 15-month old bundle. We didn't have this bundle before. We sold Cloud Firewall and Cloud Sandbox separately. DLP is an interesting area.

So, we have been selling a decent amount of DLP before. There's one critical module we needed to add to make it the richest DLP functionality in the world. That's called exact data match, where we can match exact field from a customer's record about Social Security number or data of birth and the like. That module became available.

Also, what's happening is as customers are opening hundreds of local breakouts and they may have DLP deployed in three or five data centers, now the DLP is no good because lots of your locations don't really go through a DLP system, so to speak. So, we are seeing an increased demand of DLP. We're selling more of it as we highlight. A few customers during our call earlier, we do see potentially DLP becoming a part of a bundle in the future, but not exactly sure what timing is. It's a natural course for us to move to.

Saket Kalia -- Barclays -- Analyst

Got it. Thank you.

Operator

We'll take our next question from Fatima Boolani with UBS.

Fatima Boolani -- UBS -- Analyst

Jay, in your prepared remarks around the customer examples, you gave a lot of instances of customers who went in with you at the point of land with both of the ZIA and ZPA. So, broadly speaking in terms of the pipeline, are you starting to see a greater incidence of landing with both your product portfolios and just as an extension, what sort of impact is this having on your land ARRs?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

If I give you some idea, probably approximately half of ZPA are coming as brand new customers who have never bought from Zscaler before and the other are coming with ZIA as an upsell. That's a broad trend. It is true that a number of deals are picking up ZPA along with ZIA upfront, but I would say that in a majority of those cases, ZPA is bought for a subset of users, not for all users. As we have said before, when ZIA is bought, it is bought to protect all users from all locations, essentially every employee in the company.

When ZPA is bought, it's largely driven by business application needs. Typically, in an enterprise, the number of ZPA users may be somewhere from 40% to 80% of the total users. So, if I were to simplify it, wherever ZPA is bought, a majority of the cases, it's a subset of users and people are still moving applications to Azure and AWS. They're still in early phases. As that market matures more and more, the number of ZPA users will go up significantly.

Fatima Boolani -- UBS -- Analyst

Remo, just a follow-up for you on the profitability trends in the quarter, if I think about some of the commentary you gave us during the IPO around unit economics being fairly weak in the first year of the customer acquisition process but then seeing a significant improvement in year two, as I think about you doing larger deals up front, more transformed bundle deals out the outset, you've got better awareness as a public company and better awareness overall, can you give us a sense of how those unit economics have changed from a customer acquisition perspective?

Remo Canessa -- Chief Financial Officer

So, you're talking about the contribution margin. Our contribution, as we talked about at the public offering is that in years two and three was in the high 60% range. What I'd like for you to keep in mind is we see this as a very large market opportunity. Our plans are to go to the company as quickly as we can. As we talked about on the road show and it hasn't changed, it relates to our long-term model of 22% operating profitability once we reach $800 million to $1 billion in revenue, that's still our plan.

So, we've not deviated at all related to our short-term goals or expectations of hitting break even and positive free cash flow profitability on a sustained basis in Fiscal 2020 and also the 2022 percent. So, when you think about contribution margin, yes, if we stopped everything and just went with renewals, it goes incredibly high. With this large market opportunity, we're going to keep investing in business to maximize what we feel is the biggest shareholder value.

Operator

We'll take our next question from Jonathan Ruykhaver with Robert. W. Baird.

Jonathan Ruykhaver -- Robert W. Baird -- Analyst

You've commented in the past that high-volume transaction business into the mid-market through channel was tracking at about 40% of total business. I'm just wondering is that still consistent with what you're seeing today?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Jonathan, thank you for the question. What we talked about in the past is the business coming through the VAR channel in the 40% range. It's not really the midmarket business. It's the total business coming through the VAR channel. That's still sitting broadly in the same range. If you look at the two broad channel buckets, SPSI is one bucket and VAR is the second bucket. Yes, we are seeing some VARs so are successfully able to pivot to the cloud and they are driving more business for us. Overall growth from our channel is coming faster from the SPSI side of it.

Jonathan Ruykhaver -- Robert W. Baird -- Analyst

It's safe to assume that when you look at the channel investments you're making, the greater allocation is going to SPSI?

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Yes, but we are also investing in VAR channel as well to make sure we're working on all channels. We are picking up a new kind of channel called born in the cloud VARs. These guys are built for the new world who are not really married to pushing boxes. They are pretty good channel for us, small, growing.

Jonathan Ruykhaver -- Robert W. Baird -- Analyst

Remo, I just wanted to get some clarification -- the large deal activity you saw in 3Q and 4Q of Fiscal 18, you've suggested the impact of those large initial upfront deals is very positive on retention rates when they occur, but as they get anniversaried, should be expect to see a dampening effect?

Remo Canessa -- Chief Financial Officer

It depends related to those deals. If we get these large upfront deals for multi-year -- customers are making the investment and also having Zscaler as their security and networking company they're going to use. These upfront deals where what we'd look at is more on our contract basis. On a contract basis over the last four or five quarters, for new business it's been over 70% for three-year type deals, that's our focus. Related to dollars, if customers would like to pay more to Zscaler because of budgetary reasons, then we will accept that.

Operator

Thank you. At this time, there are no further questions in the queue, I would like to turn the call back over to CEO Jay Chaudhry for closing remarks.

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Thank you for your time to join us. We look forward to talking to you during the next quarter's earnings call. Thank you again.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.

Duration: 59 minutes

Call participants:

Bill Choi -- Vice President of Investor Relations

Jay Chaudhry -- Founder, Chairman and Chief Executive Officer

Remo Canessa -- Chief Financial Officer

Brad Zelnick -- Credit Suisse -- Managing Director

Daniel Ives -- Wedbush Securities -- Managing Director

Alex Henderson -- Needham & Company -- Analyst

Gray Powell -- Deutsche Bank -- Managing Director

Melissa Franchi -- Morgan Stanley -- Analyst

Gabriela Borges -- Goldman Sachs -- Analyst

Saket Kalia -- Barclays -- Analyst

Fatima Boolani -- UBS -- Analyst

Jonathan Ruykhaver -- Robert W. Baird -- Analyst

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