Varonis Systems, Inc. (NASDAQ:VRNS) Q3 2023 Earnings Call Transcript

Varonis Systems, Inc. (NASDAQ:VRNS) Q3 2023 Earnings Call Transcript October 30, 2023

Varonis Systems, Inc. beats earnings expectations. Reported EPS is $0.08, expectations were $0.03.

Operator: Greetings, and welcome to the Varonis Systems, Inc. Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Tim Perz, Investor Relations. Thank you. You may begin.

Tim Perz: Thank you, Operator. Good afternoon. Thank you for joining us today to review Varonis’ third quarter 2023 financial results. With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer of Varonis. After preliminary remarks, we will open the call to a question-and-answer session. During this call, we may make statements related to our business that will be considered forward-looking statements under federal securities laws, including projections of future operating results for our fourth quarter and full-year ending December 31, 2023. Due to a number of factors, actual results may differ materially from those set forth in such statements.

These factors are set forth in the earnings press release that we issued today, under the section captioned Forward-Looking Statements, and these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. These statements reflect our views only as of today and should not be relied upon as representing our views as of any subsequent date. Varonis expressly disclaims any application or undertaking to release publicly any updates or revisions to any forward-looking statements made herein. Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures is also available in our third quarter 2023 earnings press release and investor presentation, which can be found at www.varonis.com in the Investor Relations section.

Lastly, please note that a webcast of today’s call is available on our Web site in the Investor Relations section. With that, I’d like to turn the call over to our Chief Executive Officer, Yaki Faitelson. Yaki?

Yaki Faitelson: Thanks, Tim, and good afternoon, everyone. Thank you for joining us today. Let me start by saying our thoughts are with our employees, customers, partners, and all of those impacted by the recent events in Israel. We will continue to do whatever it takes to support our employees. Today, I would like to review our Q3 results and discuss how AI can serve as a meaningful tailwind to our business in the years to come. But first, I would like to remind you why Varonis exists and the problems we solve. Data is the prime target for bad actors because of its importance to a business. Data is also out of control. The explosion of the cloud and remote work have improved collaboration, but have also made securing data more difficult.

Varonis helps companies locate sensitive data, visualize who has access to it, and automatically lock it down. This allows companies to collaborate safely and get value from their data while managing risk, and AI will only make this an even greater priority. Our third quarter results reflect the continued healthy adoption of Varonis SaaS. We saw further evidence that our transition to a SaaS business model is working, and SaaS ARR now represent approximately 15% of total company ARR. Third quarter SaaS mix came in at 59%, comfortably ahead of our guidance of 45%. ARR grew 16% year-over-year to $517.5 million, and we have generated $46 million of free cash flow year-to-date, up from $800,000 through the same period last year. Guy will review our Q3 results and our updated guidance in more detail.

From a macro standpoint, we continue to see higher level of data scrutiny and longer sales cycle this quarter, but remain encouraged by the progress of our SaaS transition against these headwinds. Now, I would like to spend some time on how AI presents a meaningful opportunity for Varonis. In my conversations with customers and prospects, AI comes up more and more. And my key takeaway for Varonis is that the growth of AI has the potential to generate significantly more data, significantly more risk, and significantly increase the need for data security. Stepping back, generative AI presents both opportunity and risk for companies. It has an opportunity to boost productivity and efficiency, but in orderly to safely realize these benefits there are security risks that businesses must mitigate first.

These risks present opportunities for companies like Varonis. The first risk is related to what I call self-inflicted risk, which happens when businesses start using AI to suggest content to employees. Unless data is locked down, there is little to prevent AI from analyzing the company entire data estate and revealing critical business assets like customer lists, payroll files, or bank account information to the wrong people. Microsoft recommends mitigating this risk by securing sensitive data before deploying Copilot, which is the company’s AI assistant, and specifically recommend having [variety information] (ph) access controls and policies in place, which is precisely what Varonis does. Without Varonis, rightsizing access control is very challenging.

Managing access control only gets harder over time which with data store and AI will surely contribute farther to this problem. Without the right controls in place, AI doesn’t know who should see what, and surface everything for everyone. This becomes a huge risk for organizations, and bad actors won’t even need to search for content they want to steal, AI will help them to find it automatically. AI will also increase the risk that companies face from external attackers. A few examples of this include helping bad actors curate and translate phishing emails so they can use them in many languages, creating fake datasets in order to trick companies into paying ransoms and creating [malwares] (ph). Unfortunately, the use of AI will continue to lower the barriers to entry for hacking.

Varonis helps organizations mitigate this risk by ensuring that only the right people have access to information that they need to do their job. Varonis can help organizations ensure that employees only see content suggestions that are relevant to their job function. If a bad actor bypass critical control, Varonis can lockout the compromised users or machine, preventing damage from happening. Although it is early and we are still quantifying timing and sizing, we see AI becoming a growth staying to our business as it gains momentum, and have a detailed plan to execute on it. Apart from demand opportunity that we arising from security risk related to AI, we are also leveraging this technology in new ways to improve our customer experience. Varonis has been using machine learning and AI for many years in our analysis engine and threat model, for example.

And today, we are announcing two exciting generative AI capabilities in our SaaS Data Security Platform, AI system security operations center, or what we call SOC, and natural language search. Although we do not plan to sell AI as a separate SKU, our AI assistant SOC will provide security analysts with an intelligent AI assistant specialized in performing investigations, [remediating] (ph) threats, and proactively hardening environments. Our SaaS platform can analyze the risks and provide context and next steps to help analysts more efficiently resolve security incidents. With natural language search, AI makes every Varonis user a power user. Anyone, from the helpdesk to CSO, can use natural language to get fast and accurate answers to questions such as do we have any files containing passwords that are exposed to everyone on the internet or what users has been accessing our payroll file.

Today, nearly introduced generative AI features build upon the Varonis SaaS benefits that we have discussed with you over the past year, and will further reduce the time to value for our customers and improve their experience with Varonis. I would like to spend a moment to remind of the three key benefits our SaaS platform provides our customers. First, customers are much better protected with much less effort with the automated remediation and Proactive Incident Response. Second, SaaS is quicker to deploy and have significantly lower infrastructure costs. And third, SaaS is easier to maintain and upgrade. Few of the key benefits that we realized are, one, shorter sales cycles; two, larger initial lands; and three, margin benefits over time.

This quarter, we continue to see additional proof points of these benefits. A large state government organization became a Varonis SaaS customer this quarter. We first gained a department of this state as a customer in 2022. Over the past year, we had a very successful deployment in that department that allowed us to build credibility, and ultimately win the broader state government mandate. For this organization, SaaS was a masthead because their security team is spread thin. Now, they will benefit from quicker time to value, faster deployment, and most importantly they will be better protected with our Proactive Incident Response team and automated remediation for Windows on-prem and Microsoft 365. We also continue to see healthy interest from existing self-hosted customers who converted to SaaS this quarter.

One example was a multinational financial institution that first became a customer in 2020. Given their large volume of sensitive customer data, they needed to make sure that information was locked down. They originally purchased four on-prem subscription licenses to protect their on-prem Windows environment. This organization’s success protecting on-prem Windows [indiscernible] designs to consumer all of the platform by going both and wider and deeper. Varonis SaaS will now help them shrink their [blast radius] (ph) in the cloud, just as they did on prem. Proactive Incident Response will supplement their threat detection capabilities, and Varonis SaaS eliminates the need for this customer to manage their [on-hauling] (ph), which will improve their scalability.

They converted their on-prem Windows licenses to a SaaS-equivalent package, and they purchased an additional SaaS package for Microsoft 365, widening their coverage. The sustained momentum that we saw from our SaaS transition this quarter coupled with our faster pace of innovation gets us closer to achieving our $1 billion ARR target and delivering meaningful stakeholder value. With that, let met turn the call over to Guy. Guy?

Guy Melamed: Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. It goes without saying that the health and safety of our employees is of paramount importance to us, and we will continue to do whatever it takes to support them. Before I discuss results, I want to briefly comment on the impact of the war in Israel on our operation. From a top line perspective, Israel has historically represented less than 1% of our business. We have approximately a third of our employees located in Israel, which includes our principal research and development facility as well as a portion of our support and general and administrative team. At this time, a low single-digit percentage of our global team members have been called up to active duty.

We have executed business contingency plans to minimize the impact on our business. And at this time, we don’t expect a material impact on our global operation. With that, I’d like to turn to Q3 result. We are pleased with the continued strong adoption of Varonis SaaS against continued macro headwind. Our SaaS transition continues to gain momentum, and this quarter provided additional proof of the numerous benefits to our customers as well as the tailwind to our ARR and cash flow performance. As a reminder, ARR, free cash flow, and ARR contribution margin are the leading indicators for our business during this transition. The shift from on-prem subscription licenses, where approximately 80% of the deal’s value is recognized upfront to a SaaS model with fully ratable revenue recognition will cause initial headwinds on the traditional income statement metrics as the SaaS mix and conversions of existing customers to SaaS increase.

And this quarter’s impact was meaningful as the number of existing customers converting to SaaS again increased. However, these headwinds are a function of accounting treatment and are not indicative of the health of our business. In fact, the greater these accounting-related headwinds are the better it is for our business as it means the transition is progressing at a faster pace. Our third quarter’s SaaS mix represented 59% of new business and net new upsell ARR versus our guidance of 45%. And after only three quarters into the transition, SaaS now represent approximately 15% of the company’s total ARR. The average deal sizes realized in Q3 continue to provide us with confidence in the 25% to 30% pricing uplift and margin structure that we previously provided.

In the third quarter, a significant amount of SaaS deals were sold to new customers. So, we again saw an increase in existing customers converting to our SaaS offering. In the third quarter, we had approximately $10 million in conversions of existing customer, impacting our Q3 revenue. To be clear, this is the renewal amount that was previously booked as an on-prem subscription that is now SaaS, which causes a headwind to our reported revenue and operating margin, but does not impact ARR or free cash flow. The $10 million from this quarter does not include the uplift that we realize from these conversions, which is accretive to ARR and free cash flow. As we look to our revenue guidance for the fourth quarter, we’re now assuming that approximately $12 million of existing customers’ renewals will convert to SaaS in Q4, which is up from $10 million previously.

In the third quarter, ARR grew 16% year-over-year to $517.5 million. Year-to-date, we generated $46 million of free cash flow, which was up from $0.8 million over the same period last year, reflecting the inherent leverage in our model, as well as our commitment to balancing top-line growth with improving cash flow generation. In Q3, we continue to see a macro environment that was similar to the first-half of the year. We’re still seeing deal scrutiny and longer sales cycles across the board, which is impacting customer purchasing patterns and is constraining our near-term results. We expect these longer deal cycles to continue, along with the associated budgetary scrutiny, and our updated guidance takes this into consideration. Turning now to our third quarter results in more detail, before I get into the numbers let me remind you of what we’ve said for a while now.

ARR, free cash flow, and ARR contribution margins are the leading indicators for this transition. We take our commitments to the Street seriously, and our revenue guidance is based on a combination of our expected SaaS mix and existing customer conversion. As we said previously, the faster we progress throughout the transition, the more headwinds we will experience to our traditional income statement metric. We view these headwinds in a positive light, as they show our customers are adopting our SaaS solution more rapidly. Q3 total revenues were $122.3 million, down 1% year-over-year. During the quarter, as compared to the same quarter last year, we had approximately a 12% headwind to our year-over-year revenue growth rate, as a result of having increased SaaS sales in our booking mix, which are recognized readily versus the upfront recognition of our on-prem subscription products.

Subscription revenues were $97.7 million, and maintenance and services revenues were $24.6 million, as our renewal rates were again over 90%. Moving down the income statement, I’ll be discussing non-GAAP results going forward. Gross profit for the third quarter was $106.7 million, representing a gross margin of 87.3% compared to 88.3% in the third quarter of 2022, despite significant revenue headwinds, which were largely offset by greater efficiency on our SaaS platform than we initially expected. Operating expenses in the third quarter totaled $101.9 million. As a result, third quarter operating income was $4.9 million, or an operating margin of 4%. This compares to operating income of $9.8 million, or an operating margin of 7.9% in the same period last year.

During the quarter, as compared to the same quarter last year, we had approximately an 11% headwind to our operating margin, as a result of having increased SaaS sales in our booking mix, which are recognized fully ratable versus the upfront recognition of our on-prem subscription product. Third quarter ARR contribution margin was 11.1%, up from 3.6% last year. The significant leverage improvement, even during the early stages of the transition, reflects our ability to drive strong incremental margins while growing ARR and transitioning to SaaS. During the quarter, we had financial income of approximately $8 million, driven primarily by interest income on our cash, deposits, and investments in marketable security. Net income for the third quarter of 2023 was $10.4 million, or $0.08 per diluted share, compared to a net income of $6.7 million, or net income of $0.05 per diluted share for the third quarter of 2022.

This is based on $126.7 million diluted shares outstanding, and $126.9 million diluted shares outstanding for Q3 2023 and Q3 2022 respectively. As of September 30, 2023, we had $731.5 million in cash, cash equivalents, short-term deposits, and marketable securities. For the nine months ended September 30, 2023, we generated $49 million of cash from operation compared to $8.4 million generated in the same period last year and CapEx was $2.9 million compared to $7.6 million last year. During the third quarter, we repurchased 1.2 million shares at an average purchase price of $30.10 which completed our intended share repurchases. Over the course of the program, we repurchased approximately 4.4 million shares at an average purchase price of $22.64 for a total consideration of approximately $100 million.

Turning to our guidance in more detail, we’re raising our full-year SaaS mix of new business and upsell ARR guidance, the 55% up from 50% previously and we expect Q4’s SaaS mix to be 60%. We continue to take a prudent approach in building our SaaS mix outlook as the dollar value of deals we expect to close in the fourth quarter is the largest of the year which is in line with historical trends. In Q4, we’re assuming that $12 million of renewals will convert to SaaS which will serve as a headwind to revenue. Convergence to SaaS before considering any uplifted deal sizes do not impact ARR. Our guidance continues to factor in the same level of macro headwinds that we’ve discussed at length in the past. Now, turning to our guidance, for the fourth quarter of 2023, we expect total revenues of $115 million to $154 million, representing growth of 5% to 8%; non-GAAP operating income of $25 million to $27 million and non-GAAP net income per diluted share in the range of $0.22 to $0.24.

This assumes 126.1 million diluted shares outstanding. For the full-year 2023, we now expect ARR of $535 million to $539 million, representing growth of 15% to 16%. Free cash flow of $40 million to $45 million, which includes $8 million to $10 million of headwinds related to the TCJA capitalization of R&D provision; total revenues of $495 million to $499 million, representing growth of 5%; non-GAAP operating income of $26.5 million to $28.5 million; non-GAAP net income per diluted share in the range of $0.31 to $0.33. This assumes 126.6 million diluted shares outstanding. In summary, we continue to see solid demand for both new and existing customers who wish to consume Varonis through our SaaS platform. As a result, our transition continues to move quickly, and approximately 15% of our total ARR is now coming from SaaS.

This is benefiting our ARR performance and cash flow generation, which positions us for a strong fourth quarter. With that, we will be happy to take questions. Operator?

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Q&A Session

Operator: Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Saket Kalia with Barclays. Please proceed with your question.

Saket Kalia: Okay, great. Hey guys, thanks for taking my question here and just want to send our thoughts to the Varonis team and their families in Israel.

Guy Melamed: Thank you.

Yaki Faitelson: Thank you.

Saket Kalia: Absolutely. If I stick to one question, maybe I’ll make it for you here, Yaki. You know, it just seems like great traction on SaaS. For those customers that are moving to your SaaS tools, what are you seeing on usage of the different modules, are you seeing any change in usage now that the tools are arguably easier to deploy and use?

Yaki Faitelson: No, we see just a dramatic change. We see what we call robotic value proposition. And it’s — the North Star was always what we call 10% of the effort, overall magnitude more value, and this works according to plan, we can measure everything from installation, to update, to remediation, our ability to reduce threats. And the other thing, we also build the ability of our people [by our] (ph) professional services to support the customer with much more ease. We can provide a lot of the value of the platform with the customer almost doing nothing, just very, very little in helping in terms of configuration, so just completely different value proposition. We’re literally unleashing robots to solve the problem.

Saket Kalia: Got it, very helpful. I’ll get back in queue. Thank you.

Operator: Our next question comes from the line of Hamza Fodderwala with Morgan Stanley. Please proceed with your question.

Hamza Fodderwala: Hey, good evening. Thank you for taking my question. Yaki, I wanted to dig in a little bit more about your commentary around generative AI. I think a lot of the CIOs and CSOs that we’re talking to more recently are talking about our data security and governances is a big hurdle to deploying these large language models. And I’m curious to what extent are you starting to have conversations with customers on how they can [display] (ph) these generating AI models in a way that can prevent things like data leakage or poisoning from occurring?

Yaki Faitelson: I think that is going to be completely a game-changer. The other thing is that, we still haven’t seen it completely, but just the initial release of stuff like Copilot for business, this is essentially what it does. It’s mining all the data that people can access. And this is not me saying, Microsoft are saying that 90% of the access control are excessive, you don’t need them. So, you have these — a tool leverages large language models that going and mining massive amount of data creating tremendous rate high-value information products that are completely out of policy. So, when I was thinking about it, if I take your credentials, and 90% of the data you can access is not relevant for you, and you have these AI tools that are extremely sophisticated that’s creating this highly valuable data, I just think that, very soon, what you will see is that organizations understand that they need to make sure that they have access controlled data auditing and classification in place in order to make sure they can realize productivity gains and avoid disaster.

So, this is something that we’re starting to see that the customers are talking about it, that all the customers are talking about it. And I really believe that Varonis is the foundation to make sure that you will be able to use these AI-based data.

Hamza Fodderwala: Thank you.

Operator: Our next question comes from the line of Matt Hedberg with RBC Capital. Please proceed with your question.

Matt Hedberg: Well, thanks, guys. Congrats on the results, and we send our thoughts and prayers to all the Varonis employees around the globe and out in Israel. Yaki, maybe as a follow-up to Hamza’s question, I think in the prepared remarks you said you don’t expect to sell a separate gen AI SKU at this point. I’m curious, could that change in the future? And then maybe secondarily, as you’re having these initial conversations with customers, how do you think it could impact deal sizes longer-term?

Yaki Faitelson: So, where it’s — definitely it can change. If you think what we are doing with our AI, one thing is that it can use the product with just natural language, which means that you don’t need to learn syntax, which is tremendous. The second thing, really if you look at the metadata you are collecting, we are the only company in the world that has this metadata, which we call it a data-oriented threat detection and response. And it will take a regular IT person, and he has now had the assistant to be world-class threat detection person. But, with time, maybe we will monetize it. But it’s, for us, the best way to monetize it is to sell the platform. And this is really answering the other part of your question. Initial deals is great, but I really think that the way we can grow ARR within those customer base, I think that it’s significant.