Varonis Systems, Inc. (NASDAQ:VRNS) Q4 2022 Earnings Call Transcript

Varonis Systems, Inc. (NASDAQ:VRNS) Q4 2022 Earnings Call Transcript February 6, 2023

Operator: Welcome to the Varonis Systems, Inc. Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. And it is now my pleasure to introduce to you, Tim Perz with Investor Relations. Thank you, Tim. You may begin.

Tim Perz: Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis’ fourth quarter and full year 2022 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 would be considered forward-looking statements under federal securities laws, including projections of our future operating results for our first 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 captions, 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 of any — 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 fourth quarter 2022 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 website 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 to discuss our fourth quarter and full year 2022 performance. I would also like to provide an update on our new SaaS offering and updated outlook. We are at a very exciting time in our story as we introduce Varonis SaaS to the world nearly 100 days ago. Varonis SaaS is a big milestone for us is the first version of Data Advantage, the birth of our company. At the same time, there is a lot of uncertainty in the world, whether it is inflation, raising interest rates, growing layoff announcements or just general economic slowing. In the midst of all of this uncertainty, one thing is certain, whatever will happen in the world, people with eat, sleep and create data and that data needs to be protected.

Turning to our fourth quarter results. It is still very early, but the initial reception to our new SaaS platform was encouraging and that business performs better than we expected, though of a very small sample size. At the same time, the slowing macro environment continued to impact our customers. Our fourth quarter ARR came in above the high end of our guidance range we provided you last quarter. Although our reported growth remains below the goals we had at the start of the year. Guy will review the quarterly results and our outlook in more detail, but the initial performance of Varonis SaaS gives us additional confidence in our ability to weather this current economic environment and emerge from this transition with healthy growth and profitability on our path to achieving $1 billion in ARR.

Now I would like to take a step back and take a moment to remind you of the importance of what we do. Data is the most valuable assets for any company, second only to its people. If you have data, someone wants it. Everything depends on it, but data is completely out of control. Companies who don’t know what data they have or where it is, employees have too much access to weigh too much data on too many systems. This is a problem for every organization today, regardless of size, industry or geographic location. When we started, we needed to evangelize the problem. Today, everyone knows that data security is important, but without Varonis, the struggle to locate their sensitive data, see who has access to it and safely lock down without disrupting their business.

Securing data continue to get harder as massive on-prem and cloud repository growth. In the past few years of hybrid work, cloud and remote device usage exploded and together expanded their attack purpose by order of magnitude, whether it is APT, cyber criminals or home insider. There will always be a vulnerable system somewhere in this massive attack surface, and all it takes is one compromised user of machine to inflict significant amount damage, while the main attacker views will change, their end target, data, is always the same. You can replace an endpoint, you can rebuild an infrastructure, but once attacker gets to the data, it is all over. You can’t enrich data. This is why data protection is the most important security problem to solve.

With SaaS, we reduced the customer effort needed to solve this problem with significant automation that is built into the software. Although there are many benefits has to get from our SaaS platform, I would like to outline the top three. First and most important, customers are much better protected with much less effort. Varonis has much more automation to find and lock down exposures that come from over sharing, unneeded access and misconfiguration. We have more visibility into usage and behavior on all data stores that matter the most, which enhances our ability to detect and respond to attack. With our enhanced visibility, we now offer proactive incident response for SaaS customers, providing another layer of protection, again, reducing customer effort, continual automatic updates enable customers to stay in front of new and evolving threats and regulation and all of this is delivered faster.

Second, SaaS is easier to deploy and has significantly lower infrastructure costs and should result in quicker time to value. And third, SaaS is easier to maintain and upgrade, which saves our customers time and headcount, two of the scarce resources for any season. I would like to spend another moment diving deeper into our proactive incident response, which is a key differentiator for Varonis SaaS offering. As part of the growing SaaS subscriptions, customers get air cover from our world-class incident response team who proactively watch suspicious activity, investigate alerts and notify customers of potential incidents. This will reduce the pressure on customer security team and improve their ability to stop threats and the ability to provide this across our entire SaaS customer base make the service orders of magnitude more power.

On top of these critical benefits, we are making it easier to consume Varonis as we are doubling down on the bundling strategy we introduced at the beginning of last year. We have seen great reception from customers who received Varonis platform protection upfront and former sales force who benefit from a simpler pricing discussions, both in the initial deal and the revenues. The new strategy is a win-win for our customers and our company. Our customers receive more value from our platform in the initial deal. For our sales force, it is an easier story to tell our customers know that Varonis protect their largest and most important data store and application. They know the business outcomes that Varonis help them achieve, this is what matters to our customers and why we are doubling down on our platform selling approach.

Our updated packaging ensure that customers receive an autonomous data security platform that will help them achieve their business outcomes on day one. Now that I have provided you with an update of how we are making it easier for customers to see value on the Varonis platform, let me review some of the benefits that we should realize through our SaaS offering. First, we expect SaaS will result in a shorter sales cycle, risk assessments, the core of our go-to-market motion are expected to be quicker and easier to deploy because customer infrastructure requirements are greatly reduced. Along this, our updated product packaging should help simplify the pricing discussion, which we also think will result in shorter sales cycles. Second, our new customer launch be largely driven by platform selling approach and a 25% to 30% pricing uplift, which is justified by the product’s lower total cost of ownership as compared to our on-premise subscription offering.

We expect that quicker time to value and improved customer satisfaction will lead to greater customer lifetime value and even better renewal rates in these larger initiatives. And SaaS help us to innovate faster and support our customers more easily, which we expect to benefit our margin profile as we scale. It is still very early in the transition, but we are beginning to see initial proof of this benefit. Before I turn the call to Guy, I want to briefly discuss the capital of key customer wins from Q4 with illustration. A global packaging company over 4,000 employees became a Varonis customer this quarter. This organization wanted to improve its ability to detect and respond to threats on sensitive data and intellectual property and comply with GDPR and CCPA privacy requirements.

This deal was originally an OPS deal that was switched to a SaaS deal during the fourth quarter because of infrastructure and resource cost savings we could realize. The purchase packages to protect Windows, Microsoft 365 and Active Directory and we’re already in discussions to supplement the fretting capabilities with edge and to protect the exchange online and Box environment. At the same time, our existing customer base continue to serve as a key growth driver. A couple of weeks ago, a health care organization, originally a customer will purchase a double-digit number of perpetual and OPS licenses upgraded to our SaaS platforms and will protect its hybrid window environment is the power of Varonis SaaS. This renewal was a win-win for the customer and Varonis.

The customer with benefits from greater automation and will reduce its total cost of ownership due to lower infrastructure costs. We will recognize an uplift in ARR as a result of the conversion. We are excited by the initial reception of the Varonis SaaS and look forward to sharing how we see this driving our doable growth in the coming years at our Investor Day on March 14. Finally, I would like to thank our team for their tireless efforts this past year, and we are excited to make this transition a success in 2023. With that, let me turn the call over to Guy. Guy?

Guy Melamed: Thanks, Yaki. Good afternoon, everyone. In addition to providing more color on our fourth quarter performance and updating our 2023 full year outlook, I plan to focus my time today on the initial progress of our SaaS transition, and update to our views of how the macro environment is affecting our customers. Let’s start with the early signs we’re seeing from our new SaaS rollout. As Yaki mentioned, while it’s still very early in the transition, the behavior we’re seeing from our customers and our sales force during the fourth quarter gives us increased confidence in our anticipated trajectory of this transition as compared to when we first made the announcement nearly 100 days ago. Regarding the macro environment, we did see a deterioration, but it was slightly more benign than what we assumed in our guidance.

Despite the softening of the macro environment, our fourth quarter results came in above the top end of the guidance on both ARR and the bottom line. We ended the year with ARR of $465.1 million, up 20% year-over-year or 24% adjusting for FX and Russia. In the fourth quarter, we were approximately free cash flow breakeven, which was up from negative $6 million last year, reflecting the inherent operating leverage in the business model and the measures we took to manage our expenses. In the fourth quarter, SaaS as a whole performed better than we expected and represented approximately 10% of new business and upsell ARR. For the year, we sold approximately $3.5 million of DA Cloud, which was slightly below our expectations, but we believe the number was impacted by the announcement of our new SaaS product as reps gravitated towards selling Varonis SaaS once we introduce the product.

Photo by Fotis Fotopoulos on Unsplash

It’s still very early stages, but we are very pleased with the behavior seen in the fourth quarter which leaves us cautiously optimistic about our 2023 outlook. Now I’d like to elaborate on what we saw in the fourth quarter from a macro perspective. As we assumed in our Q4 guidance, economic cost, continued to negatively impact our European business and worsening of the macro environment began to impact our North America business as well. Across the board, we saw additional deal scrutiny and longer sales cycles. Some of the deals that slipped in Q4 have since closed, but we expect deal cycles to continue to lengthen as a result of the ongoing additional budgetary scrutiny. Despite this, our pipeline continues to build as the deals that have slipped were not lost to competition and remain in the pipeline.

In spite of the uncertainty in the economy and widely publicized focus on optimizing cloud spend, we continue to see healthy new customer interest and engagement from our existing customers. As of December 31, 2022, 78% of our customers with 500 or more employees purchased four or more licenses, up from 73% a year ago and 63% two years ago. 50% of those customers purchased six or more licenses, up from 41% last year and 30% two years ago. Due to the SaaS packaging changes that Yaki discussed earlier, this will be the last quarter that we provide these metrics. We plan to introduce new KPIs to help you better understand the trends in our business at our Investor Day next month. Lastly, our dollar-based net retention rate for subscription customers was 115% ABM this 2022 or 117% adjusting for FX and Russia.

Turning now to our fourth quarter results in more detail. Before I get into the numbers, I’d like to take a moment to remind you of the importance of ARR. You’ve heard me talk about ARR as the leading metric for the past six quarters. We talked about this because we saw this with the direction that the company was moving. And going forward, this metric will only become even more important. During the transition period, the shift of our business from term licenses where approximately 80% of the deal value is recognized upfront to a SaaS model with fully ratable revenue will make our income statement metric less indicative of the health of the business than they have been in the past. Throughout this transition period, ARR and free cash flow will be our and your north stars because they are not impacted by the speed of the transition.

To help you better understand the differences in accounting treatment for SaaS versus on-prem subscription deals, we’ve included a slide in our investor presentation. Now on to the numbers. Q4 total revenues were $142.6 million, up 13% year-over-year or 17% adjusting for FX and Russia. During the quarter, as compared to the same quarter last year, we had approximately a 2% headwind to our year-over-year revenue growth rate 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 products. Subscription revenues were $116.7 million, and maintenance and services revenues were $25.9 million, as our renewal rates, again, were over 90%. When looking at our reported maintenance and services growth rate on a year-over-year basis, I’d like to call out three headwinds, which impact the comparability: a, FX was a 200 basis point headwind; b, the exit of our Russia business was another 200 basis points in headwind; and c, the conversion of perpetual maintenance to on-prem subscription was 100 basis points, for a total of approximately 500 basis points.

In North America, revenues grew 17% to $104.3 million or 73% of total revenue, reflecting a slowdown in the economy in the region and a headwind from the SaaS mix, too. In EMEA, revenues grew 1% to $34.4 million or 24% of total revenue. Adjusting for FX and Russia, growth was 16%. The rest of world revenues grew 19% to $3.9 million or 3% of total revenue. Moving down the income statement. I’ll be discussing non-GAAP results going forward. Gross profit for the fourth quarter was $128.3 million, representing a gross margin of 89.9% compared to 89.6% in the fourth quarter of 2021. Operating expenses in the fourth quarter totaled $102.3 million. As a result, fourth quarter operating income was $26 million or an operating margin of 18.2%, this compares to operating income of $22.4 million or an operating margin of 17.7% in the same period last year.

After accounting for the 50 basis points headwind in related to our shekel hedging program, the expansion was 100 basis points. During the quarter, as compared to the same quarter last year, we had approximately a 1.5% 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 products. During the quarter, we had financial income of approximately $5.2 million, driven by interest income on our cash and short term investments. Net income for the fourth quarter of 2022 was $26.1 million or income of $0.21 per diluted share compared to net income of $18.5 million or income of $0.16 per diluted share for the fourth quarter of 2021.

This is based on 126 million and 118.6 million diluted shares outstanding for Q4 2022 and Q4 2021, respectively. As of December 31, 2022, we had $732.5 million in cash, cash equivalents, marketable securities and short-term deposits. For the 12 months ended December 31, 2022, we generated $11.9 million of cash from operations compared to $7.2 million generated in the same period last year. CapEx for 2022 was $11.4 million compared to $10.5 million last year. Free cash flow improved from negative $3.3 million in 2021 to $0.5 million in 2022, despite an approximate $4 million headwind from the Tax Cuts and Jobs Act capitalization of R&D provisions. During the fourth quarter, we repurchased 2.9 million shares at an average purchase price of $19.37, and we have $43.6 million remaining on our share repurchase authorization.

We ended the year with approximately 2,150 employees, a decrease from the third quarter, which reflects the 5% headcount reduction measures taken, which were completed in the fourth quarter. I will now briefly recap our full year 2022 results. Total revenues grew 21% to $473.6 million or 25% adjusting for FX and Russia. Our full year operating margin was 6.2% compared to 6.5% for 2021. After adjusting for the 200 basis points headwind on from our Shekel hedging program, the expansion was 170 basis points. Turning to our guidance in more detail. From a macro perspective, we are factoring in a continued worsening of the economic conditions across the board, which assumes four quarters of softness in both EMEA and North America — versus 2 to 2.5 and one quarter, respectively, in 2022.

This also continues to factor in additional budgetary scrutiny, longer sales cycles and an increase in unemployment expectations among a worsening of other economic conditions. From a SaaS transition standpoint, we are factoring in a six-month ramp-up period, which began in early January when the new sales comp plan was introduced. Our guidance also assumes increased sales force turnover in the first half of the year, lower sales productivity as our sales force gains comfort in selling the new product as well as longer sales cycles as on-prem subscription deals in the pipeline may convert to SaaS. These assumptions will primarily impact the first and second quarters and are based on learnings from our last transition. While all of these factors create a level of uncertainty, this is already contemplated in our guidance.

Before I get into the numbers, our first quarter and full year guidance now assumes a 15% SaaS mix of new business and upsell ARR, up from 5% previously. This reflects the encouraging initial reception from our customers and our sales force to our new SaaS product in the fourth quarter. We have a two-phase approach to the transition. In Phase 1, which we just initiated, we are focused on selling SaaS to new customers, and this metric will help you gauge the success of this initiative. Phase 2, which is converting our base of existing customers to SaaS will come later on. But if an existing customer wants the benefit of our SaaS earlier, we will, of course, work with them as we always do. To be clear, the SaaS mix calculation is SaaS new business and upsell ARR divided by total new business and upsell ARR.

For example, if we had a renewal of $100,000 that converts to SaaS at $150,000, then we would only include the incremental $50,000 of upsell in the numerator and the nominator of the SaaS mix calculation. Now turning to our guidance. For the first quarter of 2023, we expect total revenues of $106 million to $108 million, representing growth of 10% to 12%, non-GAAP operating loss of negative $7 million to negative $6 million and non-GAAP net loss per basic and diluted share in the range of negative $0.05 to negative $0.04. This assumes 108.5 million basic and diluted shares outstanding. For the full year of 2023, we expect ARR of $513 million to $523 million, representing year-over-year growth of 10% to 12%. Free cash flow of $20 million to $25 million, which includes the $6 million to $8 million headwind related to the TCJA capitalization of R&D provisions.

Total revenues of $519 million to $529 million, representing growth of 10% to 12%. Non-GAAP operating income of $36 million to $41 million and non-GAAP net income per diluted share in the range of $0.33 to $0.35. This assumes 127.3 million diluted shares outstanding and CapEx is expected to be $8 million to $10 million. In summary, we remain laser-focused on execution on our SaaS transition and thoughtfully managing our business for long-term growth under any economic condition which, in turn, will unlock significant value for all Varonis stakeholders. Thanks for joining us today. I look forward to seeing you all in person at our Investor Day on March 14 in New York. With that, we will be happy to take questions. Operator?

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. And our first question comes from the line of Matt Hedberg with RBC Capital Markets. Please proceed with your question.

Unidentified Analyst: Yeah. Thank you. This is Matt Johnson on for Matt. And congratulations, guys, on the quarter in this macro, especially on that fast transition. I guess, Guy, you made a comment about your guidance that you’re using some of the insights you learned from your subscription transition. And I think just given the rapid pace and success of that subscription transition, it might be helpful for us to hear a little more about what you’re seeing that’s the same and maybe what’s different in these early stages in the SaaS transition based on your conversations with customers and with your sales force?

Guy Melamed : That’s a great question. I think when we look at the introduction of the SaaS offering that we really only introduced 100 days ago, the feedback that we’re receiving from both our customers and our sales team is very positive. With that said, it’s very, very early in the transition. So there’s a lot of lessons that we’ve taken from the previous transition. And that’s why when we build the guidance, we factored in some deterioration in the macroeconomic environment, and we factored a lot of kind of longer sales cycles and more deal scrutiny. But from the SaaS perspective, we factored in a six-month ramp-up period. And that really just started in January when we introduced the new comp plan. But on top of that, we also kind of assumed increased sales force turnover in the first half of the year, lower sales productivity as our sales force gains comfort in selling the new product.

And on top of that, we also assume that our sales teams are going to try and convert some of the deals that are in the pipe as on-prem subscription and try and convert them to SaaS. All of these assumptions are baked into our guidance, and the expectation is that they will impact us mostly in the first six months of the year. But I can tell you that overall, the feedback that we’ve received has been extremely positive.

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

Hamza Fodderwala: Hi, guys. Good evening. Thanks for taking my question. Just a couple of quick clarifying questions. It seems like EMEA, the growth rate there on a constant currency basis was pretty consistent with what you saw in Q3. Is it fair to say that region came in a little bit better than you expected? And then Guy, you talked about doubling down on the bundle strategy. Can you talk a little bit about how you’re thinking about discounting into ’23 to drive that SaaS adoption? Are we thinking about those maybe going up a bit to get that SaaS adoption upfront — or are they more or less staying the same versus a year ago? Thank you.

Yaki Faitelson : Overall, the adoption in Europe was what we expected. And regarding the bundles, it’s just all about the value. With the bundles customers get just a lot of automation, which just works extremely well with our SaaS strategy. The SaaS is still in the early innings. And we need to see how it will evolve. But so far, the initial reaction is very, very encouraging.