Zscaler, Inc. annual report, FY2018

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Zscaler, Inc. — FY2018 Form 10-K

Reporting period: Fiscal year ended July 31, 2018. The filing also reports fourth-quarter results for the three months ended July 31, 2018. Zscaler sells cloud security subscriptions and related support, primarily under one-to-three-year contracts, with subscription revenue recognized over the contract term.

Business context and performance

Zscaler’s cloud platform provides internet and private-application security services. At year-end, it served more than 3,250 customers in 185 countries, including more than 300 Forbes Global 2000 companies. Approximately 55% of FY2018 revenue came from outside the United States; no single customer represented 10% or more of revenue.

  • FY2018 revenue: $190.2 million, up 51% from $125.7 million in FY2017. Management attributed growth to new customers and increased users and services among existing customers.
  • Gross profit and margin: $152.3 million and 80%, compared with $98.2 million and 78% in FY2017.
  • Operating expenses: $186.9 million, up from $133.3 million. Sales and marketing was $116.4 million; research and development $39.4 million; general and administrative $31.1 million.
  • Operating loss: $34.6 million, versus $35.1 million in FY2017. Net loss: $33.6 million, versus $35.5 million. GAAP diluted loss per share attributable to common stockholders was $0.63, compared with $1.54; the FY2018 figure includes preferred-stock accretion in the common-stockholder loss calculation.
  • FY2018 fourth quarter: Revenue was $56.2 million and net loss was $7.0 million. Revenue rose from $49.2 million in the prior quarter; quarterly results can vary and are not necessarily indicative of future periods.
  • Retention and billings: Dollar-based net retention was 117%, versus 115% in FY2017. Calculated billings were $257.6 million, up 65% year over year; management cautioned that its growth rate is expected to trend down over time.

Cash flow, liquidity and obligations

  • Operating cash flow: $17.3 million provided in FY2018, compared with $6.0 million used in FY2017. The improvement included a $67.4 million increase in deferred revenue from advance customer billings.
  • Free cash flow: $2.1 million, versus negative $14.2 million in FY2017; FY2018 capital spending included $13.4 million of property and equipment purchases and $1.8 million of capitalized internal-use software.
  • Cash and investments: $298.5 million at July 31, 2018, consisting of cash, cash equivalents and short-term investments. Working capital was $204.3 million. The company said these resources should fund operating and capital needs for at least 12 months.
  • Debt and commitments: The presented balance sheet does not show funded debt. Contractual obligations totaled $28.8 million, including operating leases, data-center contracts and non-cancelable purchase obligations.
  • Deferred revenue: $164.0 million, of which $140.7 million was current. Remaining performance obligations were $397.9 million; management expected to recognize 53% within 12 months and 96% within three years.

Material changes and unusual items

  • Revenue growth slowed to 51% in FY2018 from 57% in FY2017, while gross margin improved to 80% from 78%.
  • Sales and marketing expense rose 47%, and general and administrative expense rose 52%, reflecting growth investments, public-company costs and legal matters. FY2018 litigation-related expenses were $8.0 million; stock-based compensation was $11.2 million.
  • The March 2018 IPO raised $205.3 million after underwriting discounts and commissions; the offering also involved $6.5 million in costs. Preferred stock converted into common stock upon the IPO.
  • FY2018 operating cash flow turned positive, but free cash flow remained slightly positive after capital investment. Investing cash outflow was $178.1 million, primarily because of purchases of short-term investments.
  • After year-end, in August 2018, Zscaler acquired TrustPath technology and its development team; consideration was described as not material.

Outlook, risks and contingencies

Management provided no specific numerical financial guidance in the supplied filing. It expects continued net losses for the foreseeable future and higher absolute operating expenses as it invests in sales and marketing, research and development, infrastructure, international expansion and public-company compliance. Management expects gross margin to remain relatively unchanged over the long term, while noting that margins and expenses may fluctuate.

  • Key business risks include intense competition, uncertain adoption of cloud security, customer renewal and expansion risk, dependence on channel partners, and the ability to scale sales, support and platform infrastructure.
  • Channel partners generated 92% of FY2018 revenue; the five largest partners and affiliates represented 42%. Service outages, cyberattacks, security failures or failure to meet service-level commitments could harm customer retention and reputation.
  • Zscaler was defending patent litigation brought by Symantec and Finjan. It recorded a $3.2 million liability related to past negotiations with Finjan; it had not recorded a liability for the Symantec cases because it did not consider a loss probable. Litigation outcomes and potential losses remain uncertain.
  • Other risks include privacy and data-protection requirements, international regulation and currency exposure, tax uncertainty, and possible restrictions on the use of tax attributes. The company maintained a full valuation allowance against U.S. federal and state deferred tax assets.
  • Management concluded that disclosure controls and procedures were effective at the reasonable-assurance level. The filing did not include management’s assessment or auditor attestation of internal control over financial reporting because of the transition period for newly public companies.

Investor verification checklist

  • Verify the FY2018 revenue growth drivers, 117% dollar-based net retention rate and the sustainability of calculated billings growth.
  • Track whether cash generation improves beyond the $2.1 million of FY2018 free cash flow, particularly as deferred contract acquisition costs and infrastructure spending grow.
  • Monitor channel-partner concentration and the company’s ability to expand direct and partner-led customer relationships.
  • Review developments, accruals and potential exposure in the Symantec and Finjan patent cases.
  • Assess the pace of operating-expense growth against revenue growth and progress toward profitability, for which the filing provides no specific timeline.
  • Confirm subsequent disclosures on TrustPath integration and the final accounting and tax effects of the Tax Cuts and Jobs Act.