ZSCALER, INC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and with our Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year endedJuly 31, 2019 , filed with theSEC . As discussed in the section titled "Special Note Regarding Forward-Looking Statements," the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such difference include, but are not limited to, those identified below and those discussed in the section titled "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. Our fiscal year end isJuly 31 , and our fiscal quarters end onOctober 31 ,January 31 ,April 30 andJuly 31 . Our fiscal year endedJuly 31, 2019 is referred to as fiscal 2019 and our fiscal year endingJuly 31, 2020 is referred to as fiscal 2020. OverviewZscaler was incorporated in 2007, during the early stages of cloud adoption and mobility, based on a vision that the internet would become the new corporate network as the cloud becomes the new data center. We predicted that with rapid cloud adoption and increasing workforce mobility, traditional perimeter security approaches would provide inadequate protection for users and data and an increasingly poor user experience. We pioneered a security cloud that represents a fundamental shift in the architectural design and approach to network security. We generate revenue primarily from sales of subscriptions to access our cloud platform, together with related support services. We also generate an immaterial amount of revenue from professional and other services, which consist primarily of fees associated with mapping, implementation, network design and training. Our subscription pricing is calculated on a per-user basis. We recognize subscription and support revenue ratably over the life of the contract, which is generally one to three years. As ofJuly 31, 2019 , we had expanded our operations to over 3,900 customers across major industries, with users in 185 countries. Government agencies and some of the largest enterprises in the world rely on us to help them transform to the cloud, including more than 400 of the Forbes Global 2000 as ofJuly 31, 2019 . We operate our business as one reportable segment. Our revenue has experienced significant growth in recent periods. For three months endedOctober 31, 2019 and 2018, our revenue was$93.6 million and$63.3 million , respectively. However, we have incurred net losses in all periods since our inception. For three months endedOctober 31, 2019 and 2018, our net loss was$17.1 million and$7.6 million , respectively. We expect we will continue to incur net losses for the foreseeable future, as we continue investing in our sales and marketing organization to take advantage of our market opportunity, to invest in research and development efforts to enhance the functionality of our cloud platform, to incur additional compliance and other related costs as we operate as a public company, and address ongoing legal matters and related accruals, certain of which are described in further detail in Note 8, Commitments and Contingencies, of our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Certain Factors Affecting Our Performance Increased Internet Traffic and Adoption ofCloud-Based Software and Security The adoption of cloud applications and infrastructure, explosion of internet traffic volumes and shift to mobile-first computing generally, and the pace at which enterprises adopt the internet as their corporate network in particular, impact our ability to drive market adoption of our cloud platform. We believe that most enterprises are in the early stages of a broad transformation to the cloud. Organizations are increasingly relying on the internet to operate their businesses, deploying new SaaS applications and migrating internally managed line-of-business applications to the cloud. However, the growing dependence on the internet has increased exposure to malicious or compromised websites, and sophisticated hackers are exploiting the gaps left by legacy network security appliances. To securely access the internet and transform their networks, 27 -------------------------------------------------------------------------------- Tabl e of Contents organizations must also make fundamental changes in their network and security architectures. We believe that most organizations have yet to fully make these investments. Since we enable organizations to securely transform to the cloud, we believe that the imperative for organizations to securely move to the cloud will increase demand for our cloud platform and broaden our customer base. New Customer Acquisition We believe that our ability to increase the number of customers on our cloud platform is an indicator of our market penetration and our future business opportunities. As ofJuly 31, 2019 and 2018, we had over 3,900 and over 3,250 customers, respectively, across all major geographies. As ofJuly 31, 2019 , we had over 400 of the Forbes Global 2000 as customers. Our ability to continue to grow this number will increase our future opportunities for renewals and follow-on sales. We believe that we have significant room to capture additional market share and intend to continue to invest significantly in sales and marketing to engage our prospective customers, increase brand awareness, further leverage our channel partnerships and drive adoption of our solution. Follow-On Sales We typically expand our relationship with our customers over time. While most of our new customers route all of their internet-bound web traffic through our cloud platform, some of our customers initially use our services for specific users or specific security functionality. We leverage our land-and-expand model with the goal of generating incremental revenue, often within the term of the initial subscription, by increasing sales to our existing customers in one of three ways: •expanding deployment of our cloud platform to cover additional users; •upgrading to a more advanced Business, Transformation or Secure Transformation suite; and •selling a ZPA subscription to a ZIA customer, a ZIA subscription to a ZPA customer, or other features on an a la carte basis. Investing in Business Growth Since our founding, we have invested significantly in growing our business. We intend to continue (i) investing in our research and development organization and our development efforts to offer new solutions on our platform and (ii) dedicating resources to update and upgrade our existing solutions. In addition, we expect our general and administrative expenses to increase in absolute dollars in the foreseeable future, as we continue to operate as a public company and deal with ongoing legal matters and related accruals, certain of which are described in further detail in Note 8, Commitments and Contingencies, of our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. We also intend to continue to invest significantly in sales and marketing to grow and train our sales force, broaden our brand awareness and expand and deepen our channel partner relationships. While these planned investments will increase our operating expenses in the short term, we believe that over the long term these investments will help us to expand our customer base and grow our business. We also are investing in programs to increase recognition of our brand and solutions, including joint marketing activities with our channel partners and strategic partners. While we expect our operating expenses to increase in absolute dollars in the foreseeable future, as a result of these activities, we intend to balance these investments in future growth with a continued focus on managing our results of operations and investing judiciously. In the long term we anticipate that these investments will positively impact our business and results of operations. 28 -------------------------------------------------------------------------------- Tabl e of Contents Key Business Metrics and Other Financial Measures We review a number of operating and financial metrics, including the following key metrics, to measure our performance, identify trends, formulate business plans and make strategic decisions. Dollar-Based Net Retention Rate We believe that dollar-based net retention rate is a key metric to measure the long-term value of our customer relationships because it is driven by our ability to retain and expand the recurring revenue generated from our existing customers. Our dollar-based net retention rate compares the recurring revenue from a set of customers against the same metric for the prior 12-month period on a trailing basis. Because our customers have repeat buying patterns and the average term of our contracts is more than 12 months, we measure this metric over a set of customers who were with us as of the last day of the same reporting period in the prior fiscal year. Our dollar-based net retention rate includes customer attrition. We have not experienced a material increase in customer attrition rates in recent periods. We calculate our dollar-based net retention rate as follows: Denominator: To calculate our dollar-based net retention rate as of the end of a reporting period, we first establish the ARR from all active subscriptions as of the last day of the same reporting period in the prior fiscal year. This effectively represents recurring dollars that we expect in the next 12-month period from the cohort of customers that existed on the last day of the same reporting period in the prior fiscal year. Numerator: We measure the ARR for that same cohort of customers representing all subscriptions based on confirmed customer orders booked by us as of the end of the reporting period. Dollar-based net retention rate is obtained by dividing the numerator by the denominator. Our dollar-based net retention rate may fluctuate due to a number of factors, including the performance of our cloud platform; our success in selling bigger deals for all employees with our Transformation bundle and faster upsells within a year can reduce our dollar-based net retention rate in future periods; the timing and the rate of ARR expansion of our existing customers; potential changes in our rate of renewals and other risk factors described in this Quarterly Report on Form 10-Q. Trailing 12
Months Trailing 12 Months
Ended October 31, Ended October 31,
2019 2018
Dollar-based net retention rate 120% 118%
Non-GAAP Financial Measures
In addition to our results determined in accordance with U.S. GAAP, we believe
the following non-GAAP measures are useful in evaluating our operating
performance. We use the following non-GAAP financial information to evaluate our
ongoing operations and for internal planning and forecasting purposes. We
believe that non-GAAP financial information, when taken collectively, may be
helpful to investors because it provides consistency and comparability with past
financial performance. However, non-GAAP financial information is presented for
supplemental informational purposes only, has limitations as an analytical tool
and should not be considered in isolation or as a substitute for financial
information presented in accordance with U.S. GAAP. In particular, free cash
flow is not a substitute for cash used in operating activities. Additionally,
the utility of free cash flow as a measure of our liquidity is further limited
as it does not represent the total increase or decrease in our cash balance for
a given period. In addition, other companies, including companies in our
industry, may calculate similarly-titled non-GAAP measures differently or may
use other measures to evaluate their performance, all of which could reduce the
usefulness of our non-GAAP financial measures as tools for comparison. A
reconciliation is provided below for each non-GAAP financial measure to the most
directly comparable financial measure stated in accordance with U.S. GAAP.
Investors are encouraged to review the related GAAP financial measures and the
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Tabl e of Contents
reconciliation of these non-GAAP financial measures to their most directly
comparable GAAP financial measures, and not to rely on any single financial
measure to evaluate our business.
Non-GAAP Gross Profit and Non-GAAP Gross Margin
We define non-GAAP gross profit as GAAP gross profit excluding stock-based
compensation expense and amortization of acquired intangible assets. We define
non-GAAP gross margin as non-GAAP gross profit as a percentage of revenue.
Three Months Ended October 31,
2019 2018
(in thousands)
Gross profit $ 74,032 $ 51,199
Add:
Stock-based compensation expense 1,381 503
Amortization expense of acquired intangible assets 205 -
Non-GAAP gross profit $ 75,618 $ 51,702
Gross margin 79 % 81 %
Non-GAAP gross margin 81 % 82 %
Non-GAAP Income from Operations and Non-GAAP Operating Margin
We define non-GAAP income from operations as GAAP loss from operations excluding
stock-based compensation expense, certain litigation-related expenses and
amortization expense of acquired intangible assets. We define non-GAAP operating
margin as non-GAAP income from operations as a percentage of revenue. These
excluded litigation-related expenses are professional fees and related costs
incurred by us in defending against significant claims that we deem not to be in
the ordinary course of our business and, if applicable, accruals related to
estimated losses in connection with these claims. There are many uncertainties
and potential outcomes associated with any litigation, including the expense of
litigation, timing of such expenses, court rulings, unforeseen developments,
complications and delays, each of which may affect our results of operations
from period to period, as well as the unknown magnitude of the potential loss
relating to any lawsuit, all of which are inherently subject to change,
difficult to estimate and could adversely affect our results of operations.
Three Months Ended October 31,
2019 2018
(in thousands)
Loss from operations $ (18,275) $ (8,663)
Add:
Stock-based compensation expense 18,376 7,586
Litigation-related expenses 2,007 2,174
Amortization expense of acquired intangible assets 779 95
Non-GAAP income from operations $ 2,887 $ 1,192
Operating margin (20) % (14) %
Non-GAAP operating margin 3 % 2 %
Free Cash Flow and Free Cash Flow Margin
Free cash flow is a non-GAAP financial measure that we calculate as net cash
provided by (used in) operating activities less purchases of property, equipment
and other and capitalized internal-use software. Free cash flow margin is
calculated as free cash flow divided by revenue. We believe that free cash flow
and free cash flow margin are useful indicators of liquidity
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Tabl e of Contents
that provide information to management and investors about the amount of cash
generated from our operations that, after the investments in property, equipment
and other and capitalized internal-use software, can be used for strategic
initiatives, including investing in our business, and strengthening our
financial position.
Free cash flow includes the cyclical impact of inflows and outflows resulting
from contributions to our employee stock purchase plan for which the purchase
period of approximately six months ends in each of our second and fourth fiscal
quarter. As of October 31, 2019 , the employee contributions to our employee
stock purchase plan was $5.3 million , which will be reclassified to
stockholders' equity upon issuance of the shares during our second quarter of
fiscal 2020.
Three Months Ended October 31,
2019 2018
(in thousands)
Net cash provided by operating activities $ 21,429 $ 11,014
Less: Purchases of property and equipment (10,210) (5,414)
Less: Capitalized internal-use software (1,802)
(356)
Free cash flow$ 9,417 $ 5,244 As a percentage of revenue: Net cash provided by operating activities 23 % 17 % Less: Purchases of property and equipment (11) % (8) % Less: Capitalized internal-use software (2) % (1) % Free cash flow margin 10 % 8 % Calculated Billings Calculated billings is a non-GAAP financial measure that we believe is a key metric to measure our periodic performance. Calculated billings represents our total revenue plus the change in deferred revenue in a period. Calculated billings in any particular period aims to reflect amounts invoiced for subscriptions to access our cloud platform, together with related support services related to our new and existing customers. We typically invoice our customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance. Calculated billings increased$23.7 million , or 37%, for the three months endedOctober 31, 2019 over the three months endedOctober 31, 2018 . As calculated billings continues to grow in absolute terms, we expect our calculated billings growth rate to trend down over time. We also expect that calculated billings will be affected by seasonality in terms of when we enter into agreements with customers; and the mix of billings in each reporting period as we typically invoice customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance. Three Months Ended October 31, 2019 2018 (in thousands) Revenue$ 93,590 $ 63,298 Add: Total deferred revenue, end of period 245,869 165,279 Less: Total deferred revenue, beginning of period (251,202) (164,023) Calculated billings$ 88,257 $ 64,554 31
-------------------------------------------------------------------------------- Tabl e of Contents Components of Results of Operations Revenue We generate revenue primarily from sales of subscriptions to access our cloud platform, together with related support services. These subscription and related support services accounted for approximately 99% of our revenue for the three months endedOctober 31, 2019 and 2018. Our contracts with our customers do not at any time provide the customer with the right to take possession of the software that runs our cloud platform. Our customers may also purchase professional services, such as mapping, implementation, network design and training. Professional services account for an immaterial portion of our revenue. We generate revenue from contracts with typical durations ranging from one to three years. We typically invoice our customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance. We recognize revenue ratably over the life of the contract. Amounts that have been invoiced are recorded in deferred revenue, or they are recorded in revenue if the revenue recognition criteria have been met. Subscriptions that are invoiced annually in advance or multi-year in advance represent a significant portion of our short-term and long-term deferred revenue in comparison to invoices issued quarterly in advance or monthly in advance. Accordingly, we cannot predict the mix of invoicing schedules in any given period. We generally experience seasonality in terms of when we enter into agreements with our customers. We typically enter into a higher percentage of agreements with new customers, as well as renewal agreements with existing customers, in our second and fourth fiscal quarters. However, because we recognize revenue ratably over the terms of our subscription contracts, a substantial portion of the revenue that we report in each period is attributable to the recognition of deferred revenue relating to agreements that we entered into during previous periods. Consequently, increases or decreases in new sales or renewals in any one period may not be immediately reflected as revenue for that period. Accordingly, the effect of downturns in sales and market acceptance of our platform, and potential changes in our rate of renewals, may not be fully reflected in our results of operations until future periods. Cost of Revenue Cost of revenue includes expenses related to operating our cloud platform in data centers, depreciation of our data center equipment, related overhead costs and the amortization of our capitalized internal-use software. Cost of revenue also includes employee-related costs, including salaries, bonuses, stock-based compensation expense and employee benefit costs associated with our customer support and cloud operations organizations. Cost of revenue also includes overhead costs for facilities, IT, and amortization and depreciation expense. As our customers expand and increase the use of our cloud platform driven by additional applications and connected devices, our cost of revenue will increase due to higher bandwidth and data center expenses. However, we expect to continue to benefit from economies of scale as our customers increase the use of our cloud platform. We intend to continue to invest additional resources in our cloud platform and our customer support organizations as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future. Gross Profit and Gross Margin Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, have been and will continue to be affected by various factors, including the timing of our acquisition of new customers and our renewals of and follow-on sales to existing customers, the average sales price of our services, mix of services offered in our solutions, the data center and bandwidth costs associated with operating our cloud platform, the extent to which we expand our customer support and cloud operations organizations and the extent to which we can increase the efficiency of our technology, infrastructure and data centers through technological improvements. We expect our gross profit to increase in 32 -------------------------------------------------------------------------------- Tabl e of Contents absolute dollars and gross margin to remain relatively unchanged over the long-term, although our gross profit and gross margin could fluctuate from period to period depending on the interplay of all of the above factors. Operating Expenses Our operating expenses consist of sales and marketing, research and development and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, stock-based compensation expense and, with respect to sales and marketing expenses, sales commissions that are recognized as expenses. Operating expenses also include overhead costs for facilities, IT, depreciation expense and amortization expense. Sales and Marketing Sales and marketing expenses consist primarily of employee compensation and related expenses, including salaries, bonuses and benefits for our sales and marketing employees, sales commissions that are recognized as expenses over the period of benefit, stock-based compensation expense, marketing programs, travel and entertainment expenses, expenses for conferences and events and allocated overhead costs. We capitalize our sales commissions and associated payroll taxes and recognize them as expenses over the estimated period of benefit. The amount recognized in our sales and marketing expenses reflects the amortization of cost previously deferred as attributable to each period presented in this Quarterly Report on Form 10-Q, as described below under "Critical Accounting Policies and Estimates." We intend to continue to make significant investments in our sales and marketing organization to drive additional revenue, further penetrate the market and expand our global customer base. As a result, we expect our sales and marketing expenses to continue to increase in absolute dollars and to be our largest operating expense category for the foreseeable future. In particular, we will continue to invest in growing and training our sales force, broadening our brand awareness and expanding and deepening our channel partner relationships. However, we expect our sales and marketing expenses to decrease as a percentage of our revenue over the long term, although our sales and marketing expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Research and Development Our research and development expenses support our efforts to add new features to our existing offerings and to ensure the reliability, availability and scalability of our solutions. Our cloud platform is software-driven, and our research and development teams employ software engineers in the design, and the related development, testing, certification and support, of these solutions. Accordingly, a majority of our research and development expenses result from employee-related costs, including salaries, bonuses and benefits, stock-based compensation expense and costs associated with technology tools used by our engineers. We expect our research and development expenses to continue to increase in absolute dollars for the foreseeable future, as we continue to invest in research and development efforts to enhance the functionality of our cloud platform, improve the reliability, availability and scalability of our platform and access new customer markets. However, we expect our research and development expenses to decrease as a percentage of our revenue over the long term, although our research and development expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. General and Administrative General and administrative expenses consist primarily of employee-related costs, including salaries and bonuses, stock-based compensation expense and employee benefit costs for our finance, legal, human resources and administrative personnel, as well as professional fees for external legal services (including certain litigation-related expenses), accounting and other related consulting services. These litigation-related expenses include professional fees and related costs incurred by us in defending significant claims that we deem not to be in the ordinary course of our business and, if applicable, accruals 33 -------------------------------------------------------------------------------- Tabl e of Contents related to estimated losses in connection with these claims. We expect our general and administrative expenses to increase in absolute dollars for the foreseeable future, as we continue to incur compliance costs, and other related costs necessary to operate as a public company, and due to ongoing legal matters and related accruals, certain of which are described in further detail in Note 8, Commitments and Contingencies to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. However, we expect our general and administrative expenses to decrease as a percentage of our revenue over the long term, although our general and administrative expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. In particular, litigation-related expenses related to significant litigation claims may result in significant fluctuations from period to period as they are inherently subject to change and difficult to estimate. Interest Income, net Interest income consist primarily of income earned on our cash equivalents and short-term investments and interest earned on outstanding notes receivable extended to certain current and former employees who early exercised their stock options. During the three months endedOctober 31, 2018 , the principal amount and accrued interest of the outstanding notes receivable were fully repaid. For more information on these notes receivable, refer to Note 9, Stock-Based Compensation, of our consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Other expense, net Other expense, net consists primarily of foreign currency transaction gains and losses. Provision for Income Taxes Our provision for income taxes consists primarily of income and withholding taxes in the foreign jurisdictions in which we conduct business and partially offset by the nonU.S. tax benefit for excess stock-based compensation deduction. We have not recorded anyU.S. federal income tax expense. In theU.S. we have recorded deferred tax assets for which we provide a full valuation allowance, which includes net operating loss carryforwards and tax credits. We expect to maintain this full valuation allowance for the foreseeable future as it is more likely than not that some or all of those deferred tax assets may not be realized based on our history of losses. Additionally, in theU.K. , we have recorded deferred tax assets for which we provide a full valuation allowance, which includes net operating loss carryforwards. We expect to maintain this full valuation allowance for the foreseeable future as it is more likely than not that some or all of those deferred tax assets may not be realized based on our history of losses. 34 -------------------------------------------------------------------------------- Tabl e of Contents Results of Operations The following tables set forth our results of operations for the periods presented in dollars and as a percentage of our revenue: Three Months Ended October 31, 2019 2018 (in thousands) Revenue$ 93,590 $ 63,298 Cost of revenue(1)(2) 19,558 12,099 Gross profit 74,032 51,199 Operating expenses: Sales and marketing(1)(2) 59,411 36,545 Research and development(1)(2) 20,271
13,186
General and administrative(1)(3) 12,625 10,131 Total operating expenses 92,307 59,862 Loss from operations (18,275) (8,663) Interest income, net 2,022 1,590 Other expense, net (29) (188) Loss before income taxes (16,282) (7,261) Provision for income taxes 794 327 Net loss$ (17,076) $ (7,588)
(1) Includes stock-based compensation expense as follows:
Three Months Ended October 31,
2019 2018
(in thousands)
Cost of revenue $ 1,381 $ 503
Sales and marketing 10,039 2,801
Research and development 4,874 2,795
General and administrative 2,082 1,487
Total $ 18,376 $ 7,586 (2) Includes amortization expense of acquired intangible assets as follows:
Three Months Ended October 31,
2019 2018
(in thousands)
Cost of revenue $ 205 $ -
Sales and marketing 8 -
Research and development 566 95
Total $ 779 $ 95 (3) Includes certain litigation-related expenses as follows:
Three Months Ended October 31,
2019 2018
(in thousands)
Litigation-related expenses $ 2,007 $ 2,174
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Tabl e of Contents
Three Months Ended October 31,
2019 2018
Revenue 100% 100%
Cost of revenue 21 19
Gross margin 79 81
Operating expenses
Sales and marketing 63 58
Research and development 22 21
General and administrative 13 16
Total operating expenses 98 95
Operating margin (19) (14)
Interest income, net 2 3
Other expense, net - -
Loss before income taxes (17) (11)
Provision for income taxes 1 1
Net loss (18)% (12)%
Comparison of the Three Months Ended October 31, 2019 and 2018
Revenue
Three Months Ended October 31, Change
2019 2018 $ %
(in thousands)
Revenue $ 93,590 $ 63,298 $ 30,292 48 %
Revenue increased by $30.3 million , or 48% for the three months ended October
31, 2019 , compared to the three months ended October 31, 2018 . The increase was
driven by an increase in users and sales of additional subscriptions to existing
customers as reflected by our dollar-based net retention rate of 120% for the
trailing 12 months ended October 31, 2019 . The remainder of the increase in
revenue was attributable to the addition of new customers, which contributed
$11.7 million in revenue, as we increased our customer base by 17% from October
31, 2018 to October 31, 2019 .
Cost of Revenue and Gross Margin
Three Months Ended October 31, Change
2019 2018 $ %
(in thousands)
Cost of revenue $ 19,558 $ 12,099 $ 7,459 62 %
Gross margin 79 % 81 %
36-------------------------------------------------------------------------------- Tabl e of Contents Cost of revenue increased by$7.5 million , or 62%, for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 . The overall increase in cost of revenue was driven primarily by the expanded use of our cloud platform by existing and new customers, which led to an increase of$4.1 million for data center and equipment related costs for hosting and operating of our cloud platform for our expanded customer base. Additionally, our employee-related expenses increased by$2.5 million , inclusive of an increase of$0.9 million in stock-based compensation expense, driven primarily by a 46% increase in headcount in our customer support and cloud operations organizations fromOctober 31, 2018 toOctober 31, 2019 and by the shift from granting stock options to restricted stock units subsequent to our IPO. The remainder of the increase was primarily attributable to increased expenses of$0.5 million for professional fees. Gross margin decreased from 81% during the three months endedOctober 31, 2018 to 79% during the three months endedOctober 31, 2019 . The decrease in gross margin was primarily due to increased stock-based compensation expense and, to a lesser extent, from increased amortization expense of acquired intangible assets. Operating Expenses Sales and Marketing Expenses Three Months Ended October 31, Change 2019 2018 $ % (in thousands) Sales and marketing$ 59,411 $ 36,545 $ 22,866 63 % Sales and marketing expenses increased by$22.9 million , or 63%, for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 . The increase was primarily due to an increase of$14.2 million in employee-related expenses, inclusive of an increase of$7.2 million in stock-based compensation expense, driven by a 35% increase in headcount fromOctober 31, 2018 toOctober 31, 2019 and by the shift from granting stock options to restricted stock units subsequent to our IPO. Additionally, our sales and marketing expenses increased by$4.6 million primarily due to growth of certain major sales and marketing events held during our current fiscal quarter, including ourZenith Live events. The remainder of the increase was primarily attributable to increased expenses of$2.0 million in sales commissions expense and$1.8 million in travel expenses. Research and Development Expenses Three Months Ended October 31, Change 2019 2018 $ % (in thousands) Research and development$ 20,271 $ 13,186 $ 7,085 54 % Research and development expenses increased by$7.1 million , or 54%, for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 as we continued to develop and enhance the functionality of our cloud platform. The increase was primarily driven by an increase of$7.5 million in employee-related expenses, inclusive of an increase of$2.1 million in stock-based compensation expense, driven by a 38% increase in headcount fromOctober 31, 2018 toOctober 31, 2019 and by the shift from granting stock options to restricted stock units subsequent to our IPO. The remainder of the increase was primarily attributable to increased expenses of$1.6 million for facility, IT and professional services. These increases in expense were partially offset by decreased expenses of$2.3 million , as a result of higher capitalized internal-use software development costs. 37 -------------------------------------------------------------------------------- Tabl e of Contents General and Administrative Expenses Three Months Ended October 31, Change 2019 2018 $ % (in thousands) General and administrative$ 12,625 $ 10,131 $ 2,494 25 % General and administrative expenses increased by$2.5 million , or 25%, for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 . The overall increase was primarily driven by$1.7 million in employee-related costs, inclusive of an increase of$0.6 million in stock-based compensation expense, driven by a 33% increase in headcount fromOctober 31, 2018 toOctober 31, 2019 and due to shift from granting stock options to restricted stock units subsequent to our IPO. The remainder of the increase was primarily attributable to$0.6 million in professional fees. Interest Income, Net Three Months Ended October 31, Change 2019 2018 $ % (in thousands) Interest income, net$ 2,022 $ 1,590 $ 432 27 % Interest income, net increased by$0.4 million for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 . The increase was primarily driven by our increased holdings of cash equivalents and short-term investments as compared to the three months endedOctober 31, 2018 . Other Expense, net Three Months Ended October 31, Change 2019 2018 $ % (in thousands) Other expense, net $ (29)$ (188) $ 159 (85) % Other expense, net decreased by$0.2 million for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 . The decrease was primarily driven by fluctuations in foreign currency transaction gains and losses for the three months endedOctober 31, 2019 as compared to the three months endedOctober 31, 2018 . Provision for Income Taxes Three Months Ended October 31, Change 2019 2018 $ % (in thousands) Provision for income taxes $ 794$ 327 $ 467 143 % Our provision for income taxes increased by$0.5 million for the three months endedOctober 31, 2019 , compared to the three months endedOctober 31, 2018 , primarily related to income taxes in the foreign jurisdictions in which we operate. Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, we update our estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, we make a cumulative adjustment in such period. 38 -------------------------------------------------------------------------------- Tabl e of Contents Our quarterly tax provision, and estimate of our annual effective tax rate, is subject to variation due to several factors, including variability in pre-tax income or loss, the mix of jurisdictions to which such income relates, changes in how we do business, and tax law developments. Our estimated annual effective tax rate for the year differs from theU.S. statutory rate of 21% primarily due to the benefit of a portion of our earnings being taxed at rates lower than theU.S. statutory rate. The realization of deferred tax assets is dependent upon the generation of sufficient taxable income of the appropriate character in future periods. We assess our ability to realize our deferred tax assets on a quarterly basis and we establish a valuation allowance if it is more-likely-than-not that some portion of the deferred tax assets will not be realized. We weigh all available positive and negative evidence, including our earnings history and results of recent operations, scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies. Due to the weight of objectively verifiable negative evidence, including our history of losses in certain jurisdictions, we believe that it is more likely than not that ourU.S. federal, state, andU.K. deferred tax assets will not be realized. Accordingly, we have maintained a valuation allowance on ourU.S. federal, state, andU.K. deferred tax assets. Liquidity and Capital Resources As ofOctober 31, 2019 , our principal sources of liquidity were cash, cash equivalents and short-term investments totaling$377.6 million which were held for working capital and general corporate purposes. Our cash equivalents and investments consist of highly liquid investments in money market funds,U.S. treasury securities,U.S. government agency securities and corporate debt securities. InMarch 2018 , upon completion of our IPO, we received net proceeds of$205.3 million , net of underwriters' discounts and commissions of$15.5 million . In connection with the IPO, we incurred offering costs of$6.2 million which were recorded in stockholders' equity as a reduction of the net proceeds received from the IPO. Previously, we have financed our operations principally through private placements of our equity securities, as well as payments received from customers using our cloud platform and services. We have generated significant operating losses from operations, as reflected in our accumulated deficit of$241.5 million as ofOctober 31, 2019 . We expect to continue to incur operating losses and have in the past and may in the future generate negative cash flows from operations in future periods due to expected investments to grow our business. We believe that our existing cash, cash equivalents and short-term investments will be sufficient to fund our operating and capital needs for at least the next 12 months from the issuance of our financial statements. Our assessment of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties. Our actual results could vary as a result of, and our future capital requirements, both near-term and long-term, will depend on, many factors, including our growth rate, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing and international operating activities, the timing of new introductions of solutions or features, and the continuing market acceptance of our services. We have and may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We have based this estimate on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, or if we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, our business, operating results and financial condition would be adversely affected. We typically invoice our customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance. Therefore, a substantial source of our cash is from such prepayments, which are included on our consolidated balance sheets as a contract liability. Deferred revenue consists of the unearned portion of billed fees for 39 -------------------------------------------------------------------------------- Tabl e of Contents our subscriptions, which is subsequently recognized as revenue in accordance with our revenue recognition policy. As ofOctober 31, 2019 , we had deferred revenue of$245.9 million , of which$218.2 million was recorded as a current liability and is expected to be recorded as revenue in the next 12 months, provided all other revenue recognition criteria have been met. Subscriptions that are invoiced annually in advance or multi-year in advance contribute significantly to our short-term and long-term deferred revenue in comparison to our invoices issued quarterly in advance or monthly in advance. Accordingly, we cannot predict the mix of invoicing schedules in any given period. The following table summarizes our cash flows for the periods presented: Three Months Ended October 31, 2019 2018 (in thousands) Net cash provided by operating activities$ 21,429 $ 11,014 Net cash used in investing activities$ (33,626) $ (115,346) Net cash provided by financing activities$ 3,059
Operating Activities Net cash provided by operating activities during the three months endedOctober 31, 2019 was$21.4 million , which resulted from a net loss of$17.1 million , adjusted for non-cash charges of$30.7 million and net cash inflows of$7.8 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of$18.4 million for stock-based compensation expense,$5.5 million for amortization of deferred contract acquisition costs,$3.6 million for depreciation and amortization expense,$2.6 million for amortization of operating lease right-of-use assets and$0.8 million for amortization expense of acquired intangible assets. Net cash inflows from changes in operating assets and liabilities were primarily the result of a decrease of$22.9 million in accounts receivable primarily due to timing of billings and collections and an increase of$1.4 million in accrued compensation. Net cash inflows were partially offset by cash outflows resulting from an increase of$6.2 million in deferred contract acquisition costs, as our sales commission payments increased due to addition of new customers and expansion of our existing customer subscriptions, decrease of$5.3 million in deferred revenue due to billing seasonality, an increase of$2.5 million in prepaid expenses, other current and noncurrent assets to balance our working capital requirements, a decrease of$2.0 million in operating lease liabilities, and a decrease of$0.5 million in accrued expenses, other current and noncurrent liabilities. Net cash provided by operating activities during the three months endedOctober 31, 2018 was$11.0 million , which resulted from a net loss of$7.6 million , adjusted for non-cash charges of$13.9 million and net cash inflows of$4.7 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of$7.6 million for stock-based compensation expense,$4.3 million of amortization of deferred contract acquisition costs and$2.2 million of depreciation and amortization expense. Net cash inflows from changes in operating assets and liabilities were primarily the result of a decrease of$12.4 million in accounts receivable primarily due to timing of billings and collections, an increase of$2.1 million in accrued expenses, other current and noncurrent liabilities, an increase of$1.3 million in deferred revenue from advanced invoicing in accordance with our subscription contracts, offset by a decrease of$4.7 million in accrued compensation, an increase of$4.4 million in deferred contract acquisition costs as our sales commission payments increased due to addition of new customers and expansion of our existing customer subscriptions, an increase of$1.1 million in prepaid expenses, other current and noncurrent assets, and a decrease of$0.8 million in accounts payable. Investing Activities Net cash used in investing activities during the three months endedOctober 31, 2019 of$33.6 million was primarily attributable to the purchases of short-term investments of$88.4 million and capital expenditures of$12.0 million to support 40 -------------------------------------------------------------------------------- Tabl e of Contents the growth of our cloud platform and investments in leasehold improvements associated with our new corporate headquarters. These transactions were partially offset by proceeds from the maturities of short-term investments of$66.8 million . Net cash used in investing activities during the three months endedOctober 31, 2018 of$115.3 million was primarily attributable to the purchase of short-term investments of$137.4 million , investments in capital expenditures of$5.8 million to support our cloud platform and headcount and payments for acquired intangible assets of$1.5 million . These activities were partially offset by proceeds from the maturities of short-term investments of$29.3 million . Financing Activities Net cash provided by financing activities of$3.1 million during the three months endedOctober 31, 2019 was due to proceeds from the exercise of stock options. Net cash provided by financing activities of$11.4 million during the three months endedOctober 31, 2018 was primarily due to$9.8 million in proceeds from the exercise of stock options, primarily as a result of the termination of our initial public offering lock-up period ending inSeptember 2018 , and$1.9 million in proceeds from repayments of notes receivable for early exercised stock options. Proceeds were partially offset by$0.2 million in payments of offering costs related to our IPO. Contractual Obligations and Commitments During the three months endedOctober 31, 2019 , there have been no material changes outside the ordinary course of business to our contractual obligations and commitments from those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, or our Annual Report on Form 10-K for the fiscal year endedJuly 31, 2019 filed with theSEC onSeptember 18, 2019 . See Note 7, Operating Leases to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for a table of our contractual obligations and commitments as ofOctober 31, 2019 . Off-Balance Sheet Arrangements As ofOctober 31, 2019 , we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As ofOctober 31, 2019 , we had outstanding irrevocable standby unsecured letters of credits for an aggregate value of$3.1 million with a bank, which serve as security under certain real estate leases included in Note 7, Operating Leases to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance withU.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, as well as related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss below. Our significant accounting policies are discussed in Note 1, Business and Summary of Significant Accounting Policies to our consolidated financial statements included in the Company's Form 10-K filed with theSEC onSeptember 18, 2019 . 41 -------------------------------------------------------------------------------- Tabl e of Contents There have been no significant changes to these policies for the three months endedOctober 31, 2019 , except as described in Note 1, Business and Summary of Significant Accounting Policies to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Recently Issued Accounting Pronouncements Refer to Note 1, Business and Summary of Significant Accounting Policies to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for more information regarding recently issued accounting pronouncements. 42
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