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.

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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

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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.

And what we are seeing now is just the tip of the iceberg. We’re starting to have stability in the overall transition to a completely different usage, able to leverage the unique data that we have to have AI being the foundation for, really, the digital world to make sure that can be prepared and benefit AI in a secure way. And then we decided we are going to monetize this model, but at this point we want to make sure that we have so much to sell to our customer that it will be very easy for them to use it and to gain value.

Matt Hedberg: Thanks, Yaki.

Operator: Our next question comes from the line of Brian Essex with J.P. Morgan. Please proceed with your question.

Brian Essex: Hi, good afternoon. Thank you for taking the question and our thoughts are with you and your families in Israel as well. And just wanted to dig in a little bit towards, maybe for Yaki, what you’re seeing in the pipeline, particularly with regard to previous commentary reflecting elongated sales cycles and the impact of deals in flight as you or as those customers assess moving to SaaS instead of term. Maybe if you can help us understand the impact in the quarter? And then how much visibility into the pipeline, what was growth like and how much confidence that gives you into your ability to execute in the last quarter of the year here?

Yaki Faitelson: You see, they have seen pipeline across the board. And the other thing that we’re starting to see is that organizations understand that data protection is inevitable. It’s actually your first frontier and your last resort. If you don’t protect data, wherever you will be, it will never be protected. And if everything else that you are doing will fail, it’s the only thing that will save you. And I also think that many organizations didn’t attack it heads-on because it was hard to do. And with the robotic value proposition that we are building, they understand that they can do it. And if you look at really enterprise projects, they can gain immediate time to value and ongoing value in a completely automated way.

So, I just think that — I’m spending a lot of time with customers these days, and I definitely see that people understand that they need a sophisticated data security platform, and the only way that they can do it is automation. And we are very well-positioned to take this budget.

Brian Essex: Got it [technical difficulty]

Operator: Our next question comes from the line of Joel Fishbein with Truist. Please proceed with your question.

Joel Fishbein: Thanks for taking my question, and I’m also thoughts and prayers with all of you. I wanted to just follow up on the new SEC reporting rules, and if you are seeing it — your customers starting to ask questions about them? And also, is that there’s a potential driver to your pipeline and new business?

Yaki Faitelson: It’s definitely a potential driver. What position that we see all around is that people understand that they need to protect data. I think that, in the last few years, organizations spend a fortune on security, and a lot of them get not such great return on investment. You have a lot of security on the perimeter. And, at the end of the day, it will be set on most breaches all they are happening from an insider that is a user or someone stole a credential and acting like a user and really inflecting the damage on the data stores. Attacks can come from anywhere on any device, but only going in one direction, and it’s the data that essentially the most valuable assets that most organizations have, and the most vulnerable one. So, and the SEC regulation is another one, it’s just inevitable. You want to have cyber security, you need to protect data. So, this is really where we are. And what we see is definitely every regulation is helping.

Joel Fishbein: Thank you.

Operator: Our next question comes from the line of Roger Boyd with UBS. Please proceed with your question.

Roger Boyd: Great, thanks for taking the question, and congrats on another very strong quarter of SaaS adoption. I don’t think investors should be too surprised to see Varonis outperforming on a transition timeline. But just given the success you’re seeing in the SaaS and meaningful outperformance on mix expectations and conversions, any update to how you’re thinking about the timing of phase 2 of the transition? And why not lean further into a more active plan to covert existing customers? Thanks.

Guy Melamed: So, I think that question can be broken into two. One is the overall timeline and the second part is Phase 2. When we think about kind of the overall timeline, I think with a 5% SaaS increase versus last quarter, when you think about that math and kind of the way it extrapolates going forward, it definitely makes sense to reconsider our timeline. And that’s something that we talked about last quarter that we would revisit our guidance for that at year-end. And we plan to do that. I think overall, when you think about the transition, it’s moving very fast. We’re very happy to have 15% of our ARR coming from SaaS in just three quarters. It’s happening fast because our customers and our Salesforce are adopting it very, very positively.

So, we definitely look forward to providing more color on that part in our next earning call. In terms of Phase 2, when you think about kind of the conversion of the installed base and that’s how we define Phase 2, it hasn’t begun yet. But we are increasing the number that we expect in terms of conversion in Q4 to $12 million. And that’s gone up from $10 million that we guided last quarter. And when you think about the Q3 number, we actually came in at $10 million, which is a really high number as you think about it. And it’s very positive, but still a very small percentage of our existing customer base. So, as much as we’re seeing very strong adoption that’s happening in a natural way, we haven’t prioritized it yet, but we plan to do that next year.

So, I think overall, as we look at the progression of the transition, it’s been really positive. And we hope to continue to move in that pace going forward.

Roger Boyd: Thanks, Guy.

Operator: Our next question comes from the line of Andrew Nowinski with Wells Fargo. Please proceed with your question.

Andrew Nowinski: Okay. Thank you for taking the question. I think last quarter, your guidance was for SaaS to account for about 45% of that new and upsell business because of the expected contribution from the U.S. Federal deals. So, I guess given how much higher SaaS was relative to your guidance this quarter, is it fair to assume that the Fed demand was not as strong as you expected? And if so, what happened to those deals? Thanks.

Guy Melamed: So, the growth driver this quarter was overall the enterprise business. And when you look at the 59%, it was driven by the enterprise business. It’s a strong reflection of how customers in the enterprise business are adopting SaaS. When you look at the federal industry as a whole, we definitely see the opportunity there. But it’s still small, mid-single-digit percentages out of ARR. But when we look at the opportunity, we feel very confident about our ability to grow there.

Operator: Our next question comes from the line of Fatima Boolani with Citi. Please proceed with your questions.

Fatima Boolani: Hi, thanks for taking my questions, and our prayers are with you and the entire employee base in the conflict zone. Yaki, a question for you a bigger picture one actually, we’ve been hearing a lot about data protection, data security posture management and sort of all the new monikers that are coming up as well as more traditional backup and recovery vendors on the infrastructure side, talk a lot about the importance of data protection and data recovery. I wanted to get your perspective on how you are interfacing with buyers as buying psychology changes around data protection? I wanted to get your sense of how those conversations are changing for you, if at all and if these sort of “Changes in the competitive landscape” are benefiting you in a way in providing a spotlight to what you’ve been saying all along with respect to the importance of data protection?

Yaki Faitelson: I think that we just don’t see the backup and business continuity in data protection. We are much more on data security. But it’s just people understand that they need to protect valuable data. Regarding posture management and all of this stuff, I think the organization understands very well that this is the first time that we are benefiting from other people doing marketing. And in order to solve the problem, you really need these three use cases and need the Metadata and something that is very hard to do. And everything really eventually in order to solve the problem need to be under one umbrella of the data security platform. You think it’s most breaches people are doing this lateral movement between a data store and you need to enrich the data.

So, definitely see that the marketplace understand that they need one big platform. You need to be able to classify in one place and then in all repository to do it at scale, to have the profile of how people and identities are using data and to be able to do remediation in a very reliable automated way. So, we definitely see that everything that is happening in the ecosystem benefiting us. And we are very excited to have a tailwind from the marketing that other vendors do.

Operator: Our next question comes from the line of Chad Bennett with Craig-Hallum. Please proceed with your question.

Chad Bennett: Great. Thanks for taking my question. So, just on, I know it’s early, but just in terms of kind of the type of customer converting from on-prem subscription to SaaS, I think you’ve talked before about that 25% to 30% uplift, and I think you gave a couple examples on the call already. But is there any commonality in terms of where the on-prem subscription customer is in their license journey when they’re converting? And is there — are you seeing significant cross-sell up-sell on that conversion from a license standpoint? Or is the hope, obviously, like a lot of conversion stories, that once you get them to SaaS like-for-like product, that whole cross-sell up-sell just becomes easier and kind of accelerated?

Guy Melamed: Chad, I think that’s a very good question. And when you — well, I’ll start by saying that the SaaS offering is so much better for our customers, but it’s a no-brainer for them, and we’re seeing that with the amount of conversions that are happening in a natural way. When conversions happen, we can get an uplift in the number of licenses that they buy because we’re selling the platform. They don’t have the opportunity to buy individual licenses. We can get an uplift in the fact that the number of users goes up, and we can get an uplift in their ability to consume more of the product. It really depends on the situation of the customer, where they are in terms of the renewal, whether they want to speed it up and/or wait for the actual renewal date to come to place.

So, it’s very individual, but at the end of the day, once we get them to the SaaS offering, their ability to see value and the simplicity of the usage of the product gives us a tremendous opportunity to continue to sell them more and more licenses. So, I would say there’s no one straight answer on how it happens, but at the end of the day, it just works in our favor to get them to SaaS with good confidence in our pricing methodology as we see it so far.

Operator: Our next question comes from the line of Rob Owens with Piper Sandler. Please proceed with your question.

Rob Owens: Great. Thank you for taking my question. I was curious if you could comment on just what the channel response has been regarding the move to SaaS, and are you getting the breadth of channel participation that you would hope in new transactions? Thanks.

Yaki Faitelson: Yes. The channel reaction is usually just in direct correlation to the customer reaction. So, definitely they understand it’s much easier to sell, and it requires significantly less professional services, and this is something that they will need to adapt to. The whole thing of this platform is tremendous automation, but we’re definitely getting a lot of help with the channel to take this platform to market.

Operator: Our next question comes from the line of Jason Ader with William Blair. Please proceed with your question.

Jason Ader: Yes. Hi, guys. I wanted to ask you on first the clarification. You said a 12% headwind to revenue growth in Q3, I believe. That’s 12 percentage points, correct?

Guy Melamed: Correct.

Jason Ader: Okay. And then, just on the kind of following up on the channel question, can you remind us how you go to market, how much is direct, how much is indirect, and then where are you seeing the most success right now in terms of finding new customers?

Guy Melamed: So, we sell 100% through channel, but our outside sales force really does all of the heavy lifting of doing the risk assessment, talking to the customers, explaining where the risks are. So, the channel helps us in getting the meeting and they help us in closing the deal, but all the hard work in between is done by our outside sales force. When we look at the opportunity with our SaaS offering, it opens up new markets, it opens up new territories, it opens up new industries to basically new customer opportunities that we didn’t have before. And all of the reception that we have to-date received on the SaaS offering has been positive. And we expect that to continue as we kind of really went through the toughest part of the transition, kind of clearing through the pipeline, and now introducing every new customer with a quote that is SaaS only, and not really on-prem subscription as we had in the past.

So, I think overall, we’re very well positioned to take advantage of that opportunity going forward.

Operator: Our next question comes from the line of Joseph Gallo with Jefferies. Please proceed with your question.

Joseph Gallo: Hey guys, thanks for the question. And I appreciate the AI commentary. You guys have a large M365 footprint. Can you just give us an updated size and growth profile of that business? And then maybe just to be clear, given the rollout of copilot this week, does your existing solution capture that opportunity now, or is it more just that you guys are perfectly positioned to capture that opportunity long-term? Thanks.

Yaki Faitelson: Regarding the product, in terms of preparing an organization for AI, it’s already here. So, it’s just the basic value proposition. Understand what data is critical. Make sure that only the right people can access the right data. Alert and stop any abnormal behavior. It’s the basics. Without it, you can’t use it in a secure way. And this is 100% us.

Guy Melamed: Just to touch on the first part of the question, when we look at the Office 365 contribution, it’s definitely become a significant tailwind for us going forward. But if you go back to our Investor Day in March, we actually showed in one of the slides there that our penetration within the overall 365 opportunity was, at the time in March, it was 1%; hasn’t grown too much since then. So, when you think about the opportunity going forward, there’s so much for us to capitalize on. And we see the reception of our customers very positive when we sell that license.

Operator: Our next question comes from the line of Rudy Kessinger with D.A. Davidson. Please proceed with your questions.

Rudy Kessinger: Hey, great. Thanks for taking my question. Guy, what was SaaS as a percentage of the mix if you exclude federal in Q3? And then just how much higher is federal as a percentage of new and upsell ARR in Q3 relative to Q4 in the other quarters?

Guy Melamed: So, like I said before, the actual driver this quarter was the enterprise business. And that’s really what drove the 59%. To remind you, we’re not FedRAMP certified yet. So, we didn’t have SaaS sales that were sold under the federal business, but we do expect to have FedRAMP for next year’s cycle, which can become a significant opportunity for us. And when you think at the overall opportunity from a new business and an upsell in that market, we fit like a glove to that type of use case. The amount of malicious actors that have happened only the last couple of months has been tremendous and our product fits their very, very nicely. And we feel that we can capitalize on that opportunity and grow our ARR coming from that industry going forward.

Operator: Our next question comes from the line of Joshua Tilton with Wolfe Research. Please proceed with your question.

Joshua Tilton: Hey guys, thanks for sneaking me in and I’ll just say my thoughts and prayers with your employees and just all the people of Israel. I’m actually going to sneak in two-and-a-half questions really quickly. My first question is just how should we think about the implied Q4 net new ARR seasonality and are the macro impacts baked into 4Q worse than they were a quarter ago? And on the AI front, which is my second question, why won’t Microsoft offer these capabilities? And if so, do you expect this to bring you into more competition with them going forward?

Yaki Faitelson: So, in terms of Microsoft, we are the only duly company in the world today that taking three streams of Metadata, the permissions, the content, and the activity to build this robot for tri-size access. So, we need to build completely different type of solutions in order to do that. So, I just think that we can for a long time leverage our mode and maintain a tremendous competitive advantage in this space.

Guy Melamed: And when we kind of think about the guidance, our philosophy hasn’t changed. So, we’re definitely thinking about the guidance in the same way that we’ve talked about it throughout the year. I think in terms of where we are in Q3, we definitely saw things stabilize compared to previous quarters. And that’s a good sign for us. But our assumptions in terms of guidance have stayed the same. And we think that we are set up well for having our large Q4 in terms of seasonality. We don’t see any change compared to the on-prem subscription. So, SaaS should be the largest quarter. Q4 should continue to be the largest quarter of the year as it has been in previous years. Obviously, from a revenue recognition perspective, it does change because it’s ratable.

But you’ve heard me talk millions of times about the fact that ARR, free cash flow and ARR contribution margins are the right metrics for this transition. And especially in Q4, they should be viewed as the leading indicators of the business.

Operator: Our next question comes from the line of Shelby Seyrafi with FBN Securities. Please proceed with your question.

Shelby Seyrafi: Yes, thank you. So, your headcount really was flattish in terms of growth in Q1 and Q2 and looks like it grew around 50, which is a decent pace for the first time in like a year. So, my question is, is this a sign that the environment is better for you. You talked about deal scrutiny, et cetera. But at least is it better and therefore you’re hiring more and relate to this, talk about your headcount growth expectations going forward?

Yaki Faitelson: We know how to do this transition and it was very important for us when we did it just to be focused on just the right moving parts to make sure that it will work. We definitely see just more stability in the transition than despite of the economic headwinds, we definitely see that there is just inevitable demand for data security. This is something that organizations need and we have a lot of pipeline in what we can do in terms of a roadmap of features and products in massive total available market. So, we need to cover it with a [self-pose] (ph) and make sure that our customers succeed and keep building the organization. So, the business is performing and we are investing against the massive opportunity.

Guy Melamed: And if you go back to our last quarter’s earning call, you could hear in the commentary that we talked about the fact that we’re hiring. So, obviously, the fact that we grew the headcount was part of our planning. We want to continue to increase the headcount, but we obviously want to do it in the right way, and we want to make sure that we generate increased productivity, and I think we can do that going forward. So, it’s a balancing act of increasing headcount at the right pace, in the right positions, in the right location, but also improving our leverage as we have done when you look at kind of the fact that the ARR contribution margin is now 11.1%, an increase of 750 basis points year-over-year, which is pretty significant.

Operator: Our next question comes from the line of Shrenik Kothari with Robert W. Baird. Please proceed with your question.

Shrenik Kothari: Hey, thanks for taking my question, again, thoughts and prayers to our entire team out there. Just to follow-up to the previous Microsoft question, Yaki you mentioned the tailwinds and the growth runway in implementing the access controls and governing policies. And there was a previous question on the competitive advantage versus Microsoft as well. Just trying to understand, of course, as the significance of data security rises, as you just pointed out and especially in the realm of Generative AI, where you’re anticipating kind of more traction, particularly for data access governance, is it the right way to think that Varonis is kind of focusing on a comprehensive data protection platform, including data security, access control governance, versus what Microsoft is offering, just kind of more narrow kind of DLP.

And this urgency around data security and of course with respect to the data protection tailwinds, like is this the competitive advantage that you guys have and is that the right way to think about the competitive dynamic from your perspective? I have a quick follow-up there as well.

Yaki Faitelson: Yes, it’s essentially completely different. What we just giving you automated outcomes regarding access control classification and fare detection. We have very little pictures that overlap and a lot of very good strategy to work with the way that they can label for DLP. As you mentioned and other stuff, but it’s different. We actually work very well with them and we have a very good partnership regarding Generative AI, which is the foundation, the building blocks. If you want to use Generative AI the right way and not to introduce a lot of risk and can end up in disaster, you need to use our solution to make sure that you are ready. So, this is set of all the AI features that we can deliver using technologies with large language models. We are the foundation to make sure that businesses can use it in order to extract value from the data.

Operator: Our next question comes from the line of Hugh Cunningham with TD Cowen. Please proceed with your question.

Hugh Cunningham: Hey guys, thank you for taking my call, and I’ll echo that, everyone here in our team, our thoughts and prayers are with you and your families, your friends and your co-workers for Varonis.

Yaki Faitelson: Thank you.

Hugh Cunningham: I do have two quick ones. The first one is the 25% to 30% uplift that we’re talking about that’s just on pricing of subscription versus SaaS. That doesn’t include any assumptions that you mentioned before, more licenses, users go up anything like that.

Guy Melamed: Apples to apples only, so yes.

Hugh Cunningham: Okay. And then, these conversions of existing customers, are these taking place at the end of their existing contracts? What I’m trying to figure out here is if when you quote a number, 10 million or 12 million, that number includes a sort of accelerated recognition or the initial period in that subscription. Is that right?

Guy Melamed: No, that relates only to the deals within the quarter.

Hugh Cunningham: Quarter, okay.

Operator: Our next question comes from the line of Brian Colley with Stephens. Please proceed with your question.

Brian Colley: Hi guys, thanks for taking my question here. Can you talk about how the SaaS platform has impacted the pipeline for new logos, as well as sales cycles for those new customers? I’m just curious if you’re seeing an acceleration in new logo ads or sales cycles?

Guy Melamed: So, I can tell you when we look at the new customer ads, we’ve definitely seen positive signs this quarter. And I think that as we look at our ability to sell SaaS to new customers, as I said in one of my previous answers before, it opens up opportunities that we didn’t have before with the on-prem subscription. So, I think overall, the signs that we’re seeing are healthy and positive, and it definitely gives us the ability to show value. I said before, we’re kind of past the challenging part of the transition where we have to “Clean” through the pipeline where some of the quotes were introduced to customers in the past as on-prem subscription. Now, we’re just starting with the SaaS as part of the quote, and it’s been very well received by customers because the value of our SaaS product is much greater than the on-prem subscription.

Operator: That’s the end of our Q&A session. I’d like to hand it back to management for closing remarks.

Yaki Faitelson: Thanks for your interest in Varonis. I look forward to meeting you all at our conferences this quarter.

Operator: Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

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