Zscaler Inc (ZS) Q3 2019 Earnings Call Transcript
Zscaler Inc (NASDAQ: ZS)Q3 2019 Earnings CallMay 30, 2019, 4:30 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good day and welcome to the Zscaler's Third Quarter 2019 Earnings Call. Today's conference is being recorded. At this time like to turn the conference over to Mr. Bill Choi. Please go ahead sir.
Bill Choi -- Vice President, Investor Relations
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 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 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 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 financial measures. For historical periods, the GAAP to non-GAAP reconciliations can be found in the supplemental financial information referenced a few moments ago. I would also like to inform you that we'll be participating in Bank of America Merrill Lynch's Global Technology Conference in San Francisco on June 5th.
Now I will turn the call over to Jay.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 operating margins improved 14% points year-over-year to 8%. Our Q3 results demonstrate the leverage in our business model and our ability to drive growth and profitability. While we are pleased with our third consecutive quarter of profitability, we will continue to aggressively invest in our business for a significant market opportunity that is ahead of us. Based on our analysis of IDC's data, we believe we are going after a $20.3 billion 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, multi-tenant security platform to securely embrace the cloud. Unlike traditional network security, which builds a moat and own a castle, our cloud security platform acts as a business policy engine to securely connect the right user to write applications regardless of location. ZIA for access to SaaS or the Internet and ZPA for access to internal apps in a data center or a public cloud.
Our customers are leveraging increased functionality offer comprehensive cloud security platform as they progress through various stages of their cloud journey. We see this progression in product bundles purchased by our customers. A significant majority of revenue used to come from customers purchasing professional and business bundle. As expected, we are seeing continued strong adoption of a premium ZIA transmission bundle, which is growing as mix of our ARR. In addition, while we replace security appliances in existing Internet gateways, the majority of ZIA sales are coming from creating and securing new Internet breakouts. These are greenfield opportunities.
We are continuing to see significant interest in ZPA, which we introduce only a couple of years ago. It remains the fastest growing product in our history. ZPA delivers what Gartner calls zero trust network access, to provide application access to users without granting network access. This significantly reduces business risk. While ZPA has been and continues to be purchased as an up-sell by existing ZIA customers, we are seeing more upfront sales of both the ZIA and the ZPA. ZIA and ZPA together provide our customers a single platform for secure cloud transformation, which we believe no other vendor can match.
Let me highlight several new customer deals in the quarter. I will start with a deal that shows how large enterprises are buying the ZIA and ZPA platform. One of the world's largest pharmaceutical companies with its headquarters in Europe purchased our transformation bundle for 100,000 users aims the ZPA for over 17,000 users. Moving from a decentralized IT business units to a centralized IT model. This customer had a strategy to transform to the cloud, for their network and for their applications. To achieve this, the IT team identified two initiatives, one increase use of cloud including a move to Office365, Zoom and AWS.
And number two network and security transformation. They adopted a strategy to create secure local Internet breakouts for 200 offices around the globe. Our cloud security platform allowed them to realize the vision, a perimeter less enterprise with direct access to any service or application from anywhere, on any device without back hauling traffic through regional hubs. The results 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 zero trust network access approach.
Another deal involving both the ZIA and ZPA upfront was a Fortune 500 Financial Services Company that purchased our transformation bundle for 85,000 users and ZPA for 20,000 users. This customer was preparing to deploy Office365. The 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 web proxy. We offer the full security stack including next gen firewall, sandbox and SSL inspection. This customer decided to pursue a local Internet breakout strategy and use Zscaler to secure the SD-WAN initiative.
They purchased ZIA for all employees, which will also cover mobile users and improve the user experience. In addition they purchased ZPA for two use cases, one to integrate accusations of new businesses and two to replace remote access VPN for business units that were having poor user experience. I often receive personal notes from CIOs, CTOs and CSOs of Global 2000 Enterprises indicating how much they appreciate the quality of service of the Zscaler team and our commitment to their success.
A number of them have brought Zscaler into the new organizations after making a career move. I am excited to share with you two recent examples. A travel and leisure company purchased our transformation bundle for 17,000 users and ZPA for 6,500 users. Their CTO came from a large healthcare company, where he had deployed Zscaler one 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 three years ago.
These wins demonstrate the strong loyalty of our customers and the value of our platform. We also had a number of notable up-sell wins in Q3. A US based conglomerate has been a Zscaler customer since 2015, using our business bundle, for it's two dozen portfolio companies to protect 70,000 employees around the world. This customer purchased ZPA for 40,000 users to replace multiple remote access VPN solutions and made ZPA the standard solution across multiple portfolio companies, that driver customer is moving its applications to SaaS and public cloud and needed a future proof solution that provides secure and fast access to the applications. In addition, as this conglomerate actively acquires new businesses ZIA and ZPA will enable them to quickly integrate (ph) 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 two years ago, 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 web mail, and chat access for traders during the trading window. In addition they purchased are data loss prevention solutions to help meet stringent regulatory requirements.
Let me say a few words about the competitive landscape. As organizations increasingly make the shift to the cloud, 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 an inline high performance security cloud by spinning up a bunch of virtual machines in a public 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 cloud security platform including one, we were born in the cloud, for the cloud just like Salesforce and Workday. Two, we have a purpose built globally distributed multi-tenant cloud for fast user experience, unlike imitation cloud, Zscaler requires no back hauling from front doors to a central compute data center of a public cloud. Three, we perform SSL inspection at scale as a purpose built proxy for better security. Four, we deliver zero trust network access that provides application access without network access reducing business risk unlike firewalls and VPN's.
And lastly we have over 10 years of experience running a mission critical inline cloud for Global 2000 customers, processing 65 billion transactions a day. As someone said, it is really no compression algorithm for experience. We continue to innovate and invest in maintaining our significant technology lead. Our latest fourth generation large data centers provide multiple 100 gigabits per second links. We continue our strategy of targeted tuck-in acquisitions. Our previously announced trust path 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 with Internet or application content should not be downloaded to the end point due to security or data protection concerns, instead it should be rendered as pixels in the browser. We plan to incorporate this technology into our extensible cloud platform. We remain focused on execution and are investing in our go to market capabilities. We are welcoming a new VP and general manager in EMEA with substantial experience in selling to large enterprises to help us scale EMEA to the next level.
We will be holding our annual Zenith Live Cloud Summit in Las Vegas on September 16th to 18th and Zenith Live Europe in Lisbon, Portugal, on September 30th through October 2nd. We will have an inspiring lineup of keynote speakers to talk about cloud transformation. In summary, we are very pleased with a strong Q3 results and continue 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.
Remo E. Canessa -- Chief Financial Officer`
Thank you, Jay. As Jay mentioned we had a very strong Q3. Revenue for the quarter was $79.1 million, up 6% sequentially and 61% year-over-year. For the sequential comparison recall the Q2 revenue was aided by $2.3 million and non-recurring revenue from a large public sector customer deploying our solution as a private cloud. From a geographic perspective for the quarter Americas represented 51% of revenue, EMEA was 41% and APJ was 8%.
Turning to calculated billings which we define as a change in deferred revenue for the quarter plus total revenue recognized in that quarter. Billings grew 55% year-over-year to $85 million. As a reminder our contract terms are typically one to three years, and we primarily invoice our customers one year in advance. Excluding upfront greater than one year billings in both periods, billings growth was over 60%. Total backlog which represents remaining performance obligations was $497 million on April 30th, up 63% from (inaudible) one year ago.
Please keep in mind that next quarter we'll have a difficult comparison with a large public sector deal that closed in Q4, 2018. This deal added $16.5 million to billings and $26 million the backlog in the July quarter, which will pose a difficult year-over-year comparison in Q4. Our strong customer retention and the ability to up-sell have resulted in a consistently high dollar based net retention rate, which was 118% for the period ended April 30th. This compares to 120% a year ago and 118% last quarter. Our increased success selling bigger deals upfront, which start with the transformation bundle and faster up sales 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. Considering these factors, we feel 118% is outstanding and 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-medium term, as it is important to 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 $58.9 million, 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% more in sales and marketing. Sales and marketing increased 17% sequentially and 37% year-over-year to $38.8 million. The increase is primarily due to headcount increases, compensation related expenses and marketing expenses. R&D was up 15% sequentially and a 30% year-over-year to $12.3 million .
As we continue to invest to enhance product functionality and to offer new products, G&A increased 32% sequentially and increased 43% year-over-year to $7.8 million. The growth in G&A includes investments in building our teams, compensation-related expenses, professional fees including acquisition related expenses. G&A expenses include $6.2 million in litigation related expenses including the settlement of the pension losses. Our third 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 $7.4 million or non-GAAP earnings per share $0.05.
We ended the quarter with $353 million in cash, cash equivalents and short-term investments. Free cash flow was positive $4.6 million in the quarter, compared to positive $3.7 million for the same quarter a year ago. Please keep in mind in the quarter, we made a payment of $7.3 million to settle the pension lawsuit. We got a positive impact from our ESPP program, which contributed $4 million to our free cash flow. 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 million to $83 million, reflecting year-over-year growth of 44% to 48%; operating profit in the range of zero to $2 million; income taxes of $700,000, earnings per share of approximately $0.01 to $0.02, assuming $138 million common shares outstanding.
For the full-year 2019, we expect revenue in the range of $298 million to $300 million or year-over-year growth of 57% to 58%; billings in the range of $379 million to $381 million or year-over-year growth of 47% to 48%; operating profit in the range of $17 million to $19 million; income taxes of $2.2 million; and earnings per share in the range of $0.16 to $0.18, assuming approximately 136 million common shares outstanding. The acquisition of Appsulate is expected to have little to low impact on revenue, either in Q4 or fiscal '20 as we are primarily acquiring technology in the development team. Our plan is to further develop this technology and incorporate it into our platform. The deal is all cash with the purchase price of approximate $13 million . We expect to incur approximately $7 million to $9 million in additional operating expenses in fiscal '20 related to the acquisition and to build up new services.
As reflected in our guidance, I would emphasize that our plans are not to maximize 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 increased 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.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you Remo. We believe we are the best choice to secure cloud transformation. The right architecture for the 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 SaaS adoption, 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 for questions.
Questions and Answers:
Operator
Thank you. (Operator Instruction) We'll take our first question from Brad Zelnick with Credit Suisse. Please go ahead.
Brad Zelnick -- Credit Suisse -- Analyst
Great. Thank you so much. 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 and 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 makes sense and what are you seeing when you go head-to-head and proof of concept with these types of solutions or are they able to perform and deliver on all the capabilities that you want? Thanks
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Brad thank you. Very good questions. Appliance vendors are having to compete for the cloud using technology that it wasn't meant from 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 points of presence, others call them natural 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 is 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 POC's . We are driving top down cloud transformation through the CIOs. So none of this is impacting us from POC's point of view.
Bill Choi -- Vice President, Investor Relations
Yeah, Brad just want to clarify that Jay meant to say that two compute of these hyperscale are done on centralized data centers that really number around 20 in the 100 plus are really what they call point of presence or network edge locations and there where content is either pushed or in an inspection service like this back hauled, so it's a back hauling collection points.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you, Bill.
Brad Zelnick -- Credit Suisse -- Analyst
Thanks 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 but on cash flow I think you might have come in a little bit later than some had been expecting. But you did settle the Finjan lawsuit and then there's also I think the offset from 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.
Remo E. Canessa -- Chief Financial Officer`
Yeah. Thank you Brad. So we did pay the Finjan settlement in April for $7.2 million, which had a negative impact on free cash flow. As we've talked about the ESPP program once we hold funds from employees for the ESPP program that's a positive impact and that was about $4 million during the quarter. As we go forward, when you think about Q4 on a free cash flow basis. If you look at the seasonality that we have our Q2 and Q4 is our largest quarters from a business in billings perspective, where Q1s and Q3s are smaller. So the cash flow -- free cash flow impact for Q4 will be impacted by that. In addition with the Appsulate acquisition, overall cash flow will decline based on the payments we'll make and we have made in the last few days.
Brad Zelnick -- Credit Suisse -- Analyst
Thanks for clarifying guys.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
All right. Thank you.
Operator
Thank you. Take our next question from Patrick Covell (ph) with RT Research.
Patrick Covell -- Analyst
Thanks for taking my question and congrats on the quarter. Can I ask you about when your competitors is having a lot of internal issues and just how Zscalar kind of react to that? Does it change your planning and 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?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you for the question. You know if we were selling a security box or a proxy box with the same channel looking for refresh opportunities, this will be a big impact. We have always said we have been selling top down transformation. Our need is driven by applications like Office365, projects like SD-WAN. So our whole business comes from securing new local breakouts, which is a greenfield opportunity. But in almost all cases where Zscaler is deployed we end up replacing secure web gateway or web proxy, just generally sitting in centralized locations. Weak competitors does it help us generally? Yes. Does it change our sales process? Not really.
Patrick Covell -- Analyst
Got it. Can I ask about the ZPA if possible. I mean that's a product that clearly has a ton of potential. And I would assume it's one of the major growth drivers from here. I mean we didn't talk about assumption in the quarter, is that just because this has been driven by the ZIA right now and that's where the kind of focus is or just the any color on ZPA, would be awesome?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes, so while the 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 deal ZIA and ZPA, they both came together. So we are seeing more and more attached rate of ZPAs and we are very bullish for the opportunity, but it's a relatively new technology in relatively new market, but we're seeing very very good traction and bullish about the opportunity.
Patrick Covell -- Analyst
Great. Thank you. Keep up the good work.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Great. Thank you.
Operator
Thank you. And then move on to another question from Alex Henderson with Needham and Company.
Alex Henderson -- Needham and Company -- Analyst
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 sales people, what the environment looks like and how 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 may be a challenge to continue to scale at that rate. Is that an issue that we should be concerned about? Thanks.
Remo E. Canessa -- Chief Financial Officer`
It is a competitive environment, Alex. This is Remo. However, I think we're making -- we're doing well on a hiring front. That's something that we are investing insignificantly. We're not giving out what our RSM (ph) headcount is. However when you take a look at sales and marketing headcount, it remains in the 40% 45% range of our total company headcount. This last quarter we added over a 110 employees, approximately 44 in sales and marketing. In some of the regions it's easier than others and I had a conversation with one of our VP's this morning who's a bullish relative 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&D organization.
Alex Henderson -- Needham and Company -- Analyst
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.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes, for our tenures (ph) in the salespeople, where it certainly seems that they're doing well on a quarter 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 is flattish to up, which is what we planned 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 that it comes down to execution. From our perspective, we have the product, the markets there and the needs there. Really from our perspective we just need to continue to hire salespeople, solution architects, CXO and also to build our support organization, support the product both from a personnel perspective, but support people, professional services as well as being our cloud operations.
Alex Henderson -- Needham and Company -- Analyst
Great. Thank you very much.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you.
Operator
Thank you. Move on to our next question from Saket Kalia with Barclays.
Saket Kalia -- Barclays -- Analyst
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 in your prepared remarks last Q4 we had a large multi-year upfront deal that swayed the sequential growth. Can you just talk about what sort of typical Q4 billings seasonality looks like if you exclude those maybe historically and the correlate to that is, can you just talk about the overall pipeline from multi-year upfront deals in general?
Remo E. Canessa -- Chief Financial Officer`
Yes, good questions. So, when you take a pick up at public sector deals out of Q4, and 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 and quarter Q2 and Q4 are 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 maybe multi-year type deals. Our methodology related to the guidance that we have given does not change. So, you know 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.
Saket Kalia -- Barclays -- Analyst
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 or is a 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 and in seat counts, can talk a little bit about that?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 ZPA subscribers is generally lower than ZIA. If I were to give you a broad range and its ranges somewhere from 10% to 15% of the ZIA users so far, in some cases if it's a VPN replacement that maybe 30%, 40% of the total users. In other cases if it's M&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%, 40% 50% would be the range. But I think over time as everyone moves to cloud and who don't have a (inaudible) he must be in the office to access applications. Eventually everyone will need to use the ZPA. So ZPA starts with smaller number of users and grows over time.
Alex Henderson -- Needham and Company -- Analyst
Very helpful. Thanks very much guys.
Operator
Thank you. We'll hear now from Andrew Nowinski with Piper Jaffray.
Andrew Nowinski -- Piper Jaffray Companies` -- Analyst
AlAll right, thank you. Congratulations on another great quarter. I guess I just want to follow up on the billings guidance for Q4, just to make sure you understand this. I know you did it have a tough comp of that $60 million deal as you pull it out, it is in line with your normal seasonality, but you just put up 55% growth off another very similar difficult comp and 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 and billings?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
We like to be prudent with our guidance and that's historically what we've done and we continue to do that.
Andrew Nowinski -- Piper Jaffray Companies` -- Analyst
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 remarks and whether that duration of your large deals may be different than some of your other deals? Are they longer or shorter in duration?
Remo E. Canessa -- Chief Financial Officer`
Historically for that further look at the fourth quarter average for new customers the duration of those deals it's been in the 70% range, which are three 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 three years, it's not something we compensate for, it's something done by the customer.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Right, say if I may add and clarify, we've never incented our sales force to go and do multi-year deals for upfront payment. Multi-year deals generally are annual payments with some exceptions that we call out.
Andrew Nowinski -- Piper Jaffray Companies` -- Analyst
Okay that makes sense. Thanks a lot. Just a quick clarification, when you said you're going to generate additional, 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?
Remo E. Canessa -- Chief Financial Officer`
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 margin. We know that we can increase free cash flow significantly. That is not our intent. Our intent is to grow this market, continue to grow the market and have the market come to us.
We strongly feel that we have the best solution in the market, but we need to do is execute, part of that execution is going to come at a cost and that cost is spending money. We're spending funds for our R&D, sales and marketing, for branding and to continue to build infrastructure of Zscaler. Jay and myself both have significant experience related to running companies over the last 34 (ph) 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 operating profitability free cash flow is that I know it's important from a Wall Street perspective, but from a Company perspective it's important for us to grow the market and become the market leader as quickly as we can. That's our focus.
Andrew Nowinski -- Piper Jaffray Companies` -- Analyst
Great, keep up the good work guys.
Remo E. Canessa -- Chief Financial Officer`
Thank you.
Operator
Thank you. We'll take our next question from Gray Powell with Deutsche Bank.
Gray Powell -- Deutsche Bank -- Analyst
Great, thanks for taking the questions. So maybe the high level, so we've seen some fairly volatile results from the security space this quarter, particularly from more via the on-prem focused centers. Obviously, you guys had some good numbers, but just curious have you seen any change in customer behavior or buying patterns? And then just how did you feel about the demand environment for the rest of 2019 versus last year?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
It's 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 the cloud transformation, and transformation is 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, that need to replace, that need to refresh. So we aren't really seeing the impact of that slowdown. Remo you want to add anything.
Remo E. Canessa -- Chief Financial Officer`
No, that's fine, thank you.
Gray Powell -- Deutsche Bank -- Analyst
That's great. Thank you very much.
Operator
Thank you we'll take our next question from Daniel Ives with Wedbush.
Daniel Ives -- Wedbush -- Analyst
Yes, thanks, My question is more strategically. I mean Jay, as you're talking to customers -- maybe talk about how things are changing today versus even six to nine months ago in terms of deals maybe uphill versus downhill, you get more inbounds. Obviously deal size continues to increase. Maybe you can just give some anecdotal (inaudible) to start off.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes, so a couple of comments I'll make in that area. Two years ago when I met a CIO, a number of them would say we're ready for the cloud, but still a good number 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 there we have a good solution. Things move faster than they would move otherwise. That's why we're seeing larger deal flow than we were seeing before.
Two, as the number of customers we have in the Global 2000 segment grow, these are large credible companies. These CTO's and CIO's 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. Three, I shared with you a couple of examples where our CXO's from our customers move to new customers that are able to actually go in and say I would like to bring these back in, so pleased with their environment, but as Remo said we are just heads down focus on execution, but market feel is good.
Daniel Ives -- Wedbush -- Analyst
Great. And I mean maybe you can just talk, when you see overall deal sizes in 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 closer, are there any discernible changes that maybe Remo or Bill or Jay comment there? Thanks.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes, good question Dan. Not really, I mean for smaller deals it's still three to six months,larger deals six to 12 months, after customers made the decision to go to the cloud and into transformation. From a average deal size perspective, we look at it for customers of greater than 3,000 users. We're in the mid-300,000 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.
Remo E. Canessa -- Chief Financial Officer`
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.
Daniel Ives -- Wedbush -- Analyst
(Inaudible) it. Thanks.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you.
Operator
Thank you and then move on to the next question from Nick Yako with Cowen and Company.
Nicholas Yako -- Cowen and Company -- Analyst
Hey, thanks for taking my questions. Jay maybe one for you. There's certainly a growing awareness that legacy networks and 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 the same lines any color you can provide around the percent of your own customers that have moved to local breakouts?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 off local breakout, on owns market share is a good indication of that. We are -- we announced, I guess last year there were 300 of the largest Global 2000 companies were are our clients. Now, 1% of Zscaler customers are doing local breakout was the second question. Actually the number one reason we bought is to do local breakout. Now customers who haven't done breakout with Zscaler, it's only because they haven't gotten around it. But, I would say almost all of our customers have bought us a local breakout and if you look at the SD-WAN market, were one of the big reasons to deploy local breakout. We are the predominant vendor, who secures to SD-WAN market. So if I give you my estimated answer in large enterprises that number of customers with down local breakout is fitting in the mid-teens.
Nicholas Yako -- Cowen and Company -- Analyst
Okay. That's really helpful. And 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?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 call.
Bill Choi -- Vice President, Investor Relations
Remo the metrics you gave last year was 10% off the new and up-sell business regard, and I think at the end of this quarter, end of Q4 will update on an annual basis where the numbers are. But your second question was about use cases, a lots of very interesting use cases. On a simple tactical front, replacing VPN -- remote access VPN is very popular use case because customers don't like VPN, they're slow, but more importantly VPN's are big security risk because they put users on the network. Imagine 5,000 people in Python (ph) series including some sitting in a Moscow or Croatia, they are on your network. VPN needs to be eliminated to make our enterprises, our country safe.
But second use case big one, access to applications fitting in public cloud like AWS and Azure. Without a solution like the ZPA, your users need to go back to your data center, which is a choke point and then (inaudible) back to a public cloud, a silly thing to do. But that's what most customers do because that's all they know if. Third interesting use case, which I used to think will be only a very small number of cases, M&A integration or divestitures. I'm surprised to follow how many companies are being merged and divested and that's helping. Those are the used cases.
Nicholas Yako -- Cowen and Company -- Analyst
Okay great. Thank you guys.
Operator
Thank you. Move on to our next question from Melissa Franchi with Morgan Stanley.
Melissa Franchi -- Morgan Stanley -- Analyst
Thank you and congrats on the quarter. Jay, I wanted to follow up on the Appsulate acquisition. It's interesting that you're adding browser isolation technology. Can you maybe add some more color on how that tech is complementary 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?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 very important, financial services, healthcare maybe defense kind of areas. This call it -- feature call it a module is very relevant for Zscaler because we're sitting in the traffic. Simple example could be traffic going to certain known type of sites. It could go direct using the technologies 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 end point and those type of destinations are funneled through our browser isolation technology, so it becomes 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 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 have comfortable with that, we make it available as an offering to our customers. But we're not planning for any revenue or very little revenue in Q4 or our fiscal '20. I think one of the key point is that when the strength of Zscaler is we have one 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. I have seen so many companies who go on a buying spree and the 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 a good core technology and properly integrate them, so it's like one product -- a single pane of glass not just a facade pane of glass.
Melissa Franchi -- Morgan Stanley -- Analyst
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 self-leadership perspective?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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 the role. We are making progress on it.
Melissa Franchi -- Morgan Stanley -- Analyst
Great. Thank you very much.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Thank you too.
Operator
Thank you. We'll take our next question from onathan Ruykhaver with Baird.
Jonathan Ruykhaver -- Baird -- Analyst
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?
Remo E. Canessa -- Chief Financial Officer`
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 40% 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 that 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.
Jonathan Ruykhaver -- Baird -- Analyst
Can you talk about the impact that SP might be having on transformation in ZIA and the same thing with SI in ZPA?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes. SPs, service providers, are the folks who provide network and 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 an early stage, since ZPA young, so is the SI relationship, but me we are pleased with the progress we are making in that area.
Jonathan Ruykhaver -- Baird -- Analyst
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, can you just compare and contrast how you view Secure SD-WAN versus ZIA?
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Absolutely, SD-WANs, core things starts being sophisticated, cloud-managed, branch 2.0 box that integrates routing and switching, that gives you connectivity back to the datacenter over traditional MPLS or over the Internet. And that's one use case. We don't play into that use case.
The second part of the SD-WAN along with that is to be able to peel off the Internet and SaaS bound traffic at the source at each branch, so it can go direct over to a broadband or whatever connection maybe. 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 hundreds of branches with solution is better, simply pointing the traffic to us. Now, some SD-WAN vendor may say that, we will build the functionality in each box. So if you got 1,000 branches, we'll put that functionality in 1,000 branches and this 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 off, 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, but most of the time it will be done in the cloud and we are the biggest beneficiary of that.
Operator
Thank you and I'll take our final question from Fatima Boolani with UBS.
Fatima Boolani -- UBS -- Analyst
Good afternoon. Thank you for taking the question. I have one for Jay, and I have one for Remo. Jay, in your prepared remarks, I did notice the coincident of ZPA and ZIA deals have certainly increased over the last four quarters. So I'm wondering, I guess, de facto head of sales, if you have put in place any specific incentives or quota retirement target from a go-to-market perspective to really drive that inflection in ZPA adoption that you were talking about.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Yes, very good question, Fatima. So, first of all, ZPA is maturing. We announced it to be made it available a little over a year -- two 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.
Fatima Boolani -- UBS -- Analyst
That's very clear. And Remo 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.
Remo E. Canessa -- Chief Financial Officer`
Thank you, Fatima. I think we just have a very efficient platform, to be honest with you. When you're driving 80% plus 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 increase pricing and that's related to increase usage on the part of our customers, increase 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, technical account manager, professional services perspective, depreciation, 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.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Excellent, Remo, if I may add. What Remo talked about platform, I would say, it's a purpose-built architecture that they built that gives us the biggest advantage. Two, since we had to optimize software, we have highly optimized software we developed on our own without having to pay any of royalties to third parties. And third, the new point I'll mention is, we had no money to pay to public cloud vendors to run our stuff in those public clouds.
Operator
Thank you and that does conclude today's question-and-answer session. I would now like to turn the conference back over to Mr. Chaudry for any additional or closing remarks.
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
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.
Remo E. Canessa -- Chief Financial Officer`
Great. Thank you very much. Bye bye.
Operator
Thank you. That does conclude today's conference. Thank you all for your participation. You may now disconnect.
Duration: 64 minutes
Call participants:
Bill Choi -- Vice President, Investor Relations
Jay Chaudhry -- President, Chief Executive Officer and Chairman of the Board
Remo E. Canessa -- Chief Financial Officer`
Brad Zelnick -- Credit Suisse -- Analyst
Patrick Covell -- Analyst
Alex Henderson -- Needham and Company -- Analyst
Saket Kalia -- Barclays -- Analyst
Andrew Nowinski -- Piper Jaffray Companies` -- Analyst
Gray Powell -- Deutsche Bank -- Analyst
Daniel Ives -- Wedbush -- Analyst
Nicholas Yako -- Cowen and Company -- Analyst
Melissa Franchi -- Morgan Stanley -- Analyst
Jonathan Ruykhaver -- Baird -- Analyst
Fatima Boolani -- UBS -- Analyst
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