ZeroFox Holdings, Inc. (NASDAQ:ZFOX) Q3 2024 Earnings Call Transcript

ZeroFox Holdings, Inc. (NASDAQ:ZFOX) Q3 2024 Earnings Call Transcript December 5, 2023

ZeroFox Holdings, Inc. beats earnings expectations. Reported EPS is $-0.01, expectations were $-0.07.

Operator: Thank you for standing by, and welcome to the ZeroFox Fiscal Third Quarter 2024 Results Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. And as a reminder, today’s call is being recorded. I would like to turn the conference call over to Todd Weller, Vice President, Investor Relations for ZeroFox.

Todd Weller: Thanks, operator. Good morning, and thank you for joining us today to review ZeroFox’s fiscal third quarter 2024 financial results. With me on the call today is Foster, our Founder, Chief Executive Officer and Chairman; along with Tim Bender, our CFO. By now, everyone should have access to our earnings press release. This press release as well as supplemental financial information can be found on our Investor Relations website. During this call, we may make forward-looking statements, including statements related to our anticipated financial results, growth opportunities in external cybersecurity, our progress to achieving profitability and expected benefits from our acquisitions of IDX and LookingGlass. These statements are not guarantees of future performance, but rather are subject to a variety of risks and uncertainties.

Actual results could differ materially from expectations reflected in any forward-looking statements. Please review our earnings press release and recent SEC filings for a description of these material risks and uncertainties. Forward-looking statements made today speak only to our expectations as of today, and we undertake no obligation to publicly update or revise them. Additionally, non-GAAP financial measures will be discussed on this conference call. Please refer to the tables in our earnings release in the Investor Relations portion of our website for a reconciliation of these measures to their most directly comparable GAAP financial measure. With that, I’d like to turn the call over to Foster.

James Foster: Thanks, Todd. Good morning, everyone. Q3 was a record setting quarter for ZeroFox. We delivered another strong top line outperformance, while also generating positive free cash flow for the second consecutive quarter. We believe that our outperformance reflects the growing demand for external cybersecurity platform, demonstrates our team’s consistent execution and validates our balanced approach to growth and increased profitability. Today, I’m going to provide summaries on key areas of our results, share a few customer success stories and provide updates on our One Platform vision and discuss our plan to close out this year. As you may have seen in our press release this morning, we reported strong results. We reported core revenue of $44 million, an increase of 89% year-over-year, and we define core revenue as total revenue, less revenue from our one large government contract.

We ended the quarter with record ARR of $186 million, an increase of 21% year-over-year, and we accomplished this while also improving profitability and generating positive free cash flow quarter-over-quarter. Overall, I was very happy with our team’s performance in Q3. The ZeroFox platform is relied upon by enterprise customers to solve their external cybersecurity challenges, and we continue to see demand for our platform’s four strategic pillars, including protection, intelligence, disruption and response. Our continued success with enterprise customers was reflected in the 27% year-over-year growth in subscription customers with ARR greater than $100,000, and in general, our overall growth in large enterprise deals. Given the U.S. federal government’s fiscal year-end during the middle of our Q3, I thought it was relevant to highlight our public sector business this call, with a very strong performance with record bookings, new customers and public sector ARR.

In Q3, we signed an eight-figure renewal and expansion with strategic U.S. federal agency that is focused on cybersecurity. Through this contract and program, ZeroFox is supporting critical cyber threat intelligence, cyber defense and security operations across hundreds of federal, state and local government organizations. We also signed a multimillion dollar renewal and expansion with the U.S. cyber defense agency that is using ZeroFox to protect thousands of personnel from advanced digital attacks. Over the last three years, this customer has significantly increased their adoption of our platform, and specifically, over the last two years, has more than quadrupled their ARR with us. Our team all always takes great pride in supporting mission aligned organizations with critical capabilities.

We also added two additional six-figure customers that purchased six plus modules across our protection intelligence and disruption pillars. While public sector benefit — business benefited from the end of the government fiscal year and its seasonally strong spending, we believe there are underlying fundamental drivers that give us confidence in the future growth outlook and our One Platform approach. For example, the current geopolitical environment is amplifying the intensity and sophistication of the external threat environment and driving increasing awareness of the critical need for organizations to defend themselves against activity from nation state adversaries and organized cybercriminal groups. The days where insider threats were a top concern for CISOs are behind us.

Today, our customers are thoughtfully protecting themselves from a myriad of external threats that are beyond their perimeters and most frequently beyond their borders. Turning to our on-demand response services. We experienced another record quarter resulting in year-to-date revenue growth of nearly 100%. Our strong performance was driven by continued high levels of cybersecurity breach activity, including a significant increase in large scale breaches, and our continued success in capturing market share. We signed several six-figure deals as well as three seven-figure deals, including one with a large gaming and hospitality company. The market is recognizing our differentiated vision, brand and One Platform approach to helping customers navigate the increasingly complex emergency response and notification requirements, especially for regulated organizations.

Furthermore, these requirements are becoming more stringent with the new SEC cybersecurity incident disclosure requirements for publicly traded companies. While we remain optimistic about our response services business, the go-to-market engine we are building and the trust we are creating with our customers, important to remember that the response business is largely reactive and macro driven. For example, major events and cyber cleanup campaigns like MoveIT, Log 4G or the [indiscernible] and SolarWinds are largely time bound and come in waves. And as you know, the great thing about things that come in waves is that there may be peaks and valleys, but it’s just a matter of time until that next great wave hit. With that, I’d like to change gears and spend a few minutes providing an update on our vision.

At ZeroFox, we believe that solving the external cybersecurity challenge and problem set requires a One Platform approach. This has been the driving force behind our strategy and the development of our comprehensive unified platform with four pillars of capabilities. We continue to see adoption of the modern security Triple Crown, where security organizations will standardize on internal platforms like Microsoft, CrowdStrike SentinelOne, edge platforms like Palo Alto Networks, or Zscaler and an external platform like ZeroFox. Customers have grown tired of the complexity and cost of managing multiple external cybersecurity point products for digital risk protection, threat intelligence, takedowns and even external attack service management, a dynamic that has intensified in the current economic environment.

We believe that our proven ability to provide an external cybersecurity platform that unifies protection, intelligence, adversary disruption and response is a critical component of the success of this organization and it provides us with key competitive advantages. We also believe that our technical EAS and capabilities from our acquisition of LookingGlass will provide immense value to our customers. Organizations need to understand their full external risk, their vulnerabilities in both digital and cyber scapes and have detailed information on threat actors that are attacking them. This and this alone stands for the robust capabilities required for organizations to defend themselves from these advanced external threats. Furthermore, our team is committed to protecting our customers.

It’s in the DNA of our company, and quite frankly, it’s what motivates us. It’s our passion. We’re not just AI data scientists, analysts and engineers, we are true cyber defenders for our customers, and it’s a responsibility that we cherish. Speaking of our customers. We had a six-figure new customer win with a large retail organization that is leveraging the power of nearly our entire platform. This customer purchased seven modules across protection, intelligence and disruption pillars to protect their external tech surface. We had another six-figure new customer win with a Fortune 500 financial services company that purchased four modules across protection and disruption pillars as well. This company selected ZeroFox based on our ability to protect multiple digital asset types, including brands, domains and a large number of credit card BIN numbers, given our ability and proven capability to do takedowns and disruption at Internet scale.

We were also able to showcase our full capabilities for a new health care customer. This organization initially purchased the ZeroFox platform for digital protection. However, during the sales process, they had an urgent need for on-demand response services and capabilities, and they selected ZeroFox for both incident and breach response capabilities. This resulted in a multimillion dollar deal in Q3. This customer experienced the full value of our One Platform vision in action as we’ve demonstrated our ability to disrupt and respond to aggressive external cyberattacks and furthermore protect them from those future attacks going forward. Another example was with an existing technology customer. This customer initially selected ZeroFox several years ago to protect its high-value digital assets.

In Q3, the customer significantly expanded the number of digital assets protected and added on on-demand response capabilities, resulting in a 6x increase in their recurring spend. In short, I’m very pleased with our team’s commitment to solving customer problems and the pace of innovation of our organization. As a cybersecurity company, the pace of innovation is critical to ensuring we stay ahead of our customers’ relentless adversaries. In Q3, we delivered significant advancements to our phishing and domain protection in global threat intelligence capabilities, specifically in the area of physical security intelligence. As we have always done, we will continue to leverage innovations in AI and machine learning to improve our ability to detect and disrupt threats.

Large language models, generative AI and various other types of computer vision, deep learning and machine learning capabilities are commonplace in the ZeroFox platform. For example, we are now using LLMs and generative AI to help us enhance our finished (ph) intelligence and alerted capabilities as well as evaluate risk for key alerts and attacks we identified. Shifting gears, I’d like to turn our focus to the goals for Q4, as we close out what has been a strong and transformative year for ZeroFox. We will continue to execute on our strategic plan to expand our platform capabilities in preparation for next year. We will grow our customer base and we will continue to increase adoption. We will also continue to prudently invest in our go-to-market engine, our services to support and enable customers and to optimize our business to improve efficiencies and profitability.

We were very pleased with our Q3 cash flow performance and believe this trend reflects our commitment to balancing growth and profitability. And before I turn the call over to Tim for a detailed review of our Q3 financial performance, I would like to share one more customer story with you. I’ve always enjoyed meeting with customers and hearing their goals and challenges. It’s personally been rewarding. In Q3, I had an opportunity to meet with one of our top 10 customers who is also on the Fortune 10 list. During our discussion, this customer described our offering as unbeatable in the marketplace, and highlighted the significant ROI they are generating, using the ZeroFox platform each and every day. They even went up so far to say that ZeroFox was saving them hundreds of millions of dollars per year.

We aid up agreeing to expand our scope for the third consecutive year, and ZeroFox also agreed to help automate and streamline another key external challenge with our platform with them. To me, there is nothing more powerful than the validation of this kind of direct customer feedback, particularly from a customer of the size and sophistication. It feels really good to know that a platform works, a team is committed and that what we’re doing is really helping people and organizations around the world. In short, I love this industry. And with that, I want to thank all of our Foxes for their energy, passion and commitment throughout Q3 and certainly before that. And now, I’d like to turn the call over to our CFO, Tim Bender.

Timothy Bender: Thanks, Foster. As Foster mentioned, ZeroFox generated strong Q3 results across both top and bottom line metrics. With the exception of revenue and unless otherwise stated, all financial results we will discuss today are non-GAAP financial measures. Reconciliations between our GAAP and non-GAAP results can be found in our earnings release. This is the first quarter where we can truly present comparative year-over-year financial information, although, the year ago quarter excluded three days as our de-SPAC transaction closed on August 3, 2022. For Q3, ZeroFox reported revenue of $65 million, an increase of 45% year-over-year. Subscription revenue was $23.7 million, an increase of 51% year-over-year, and services revenue was $41.3 million, an increase of 42% year-over-year.

Services revenue consisted of $20.7 million of recurring revenue from our strategic government customer and $20.6 million from our on-demand response services. The significant outperformance in services revenue was driven by another record quarter of on-demand response bookings as we benefited from continued high levels of cyber breach activity and continued success winning enterprise deals. As you’ve heard from Foster, we feel well positioned to continue winning enterprise service opportunities. However, given our significant performance in Q3, we currently anticipate a sequential decline in 4Q services revenue. Our services revenue continues to be less predictable when compared to our subscription revenue. Because of the unforeseen nature of response services, we would encourage investors to look at the performance of our services business on an annualized basis to assess our performance and growth potential.

As of October 31, annual recurring revenue was $186 million, an increase of 21% year-over-year. ARR consists of platform subscriptions, a small amount of recurring on-demand services and $83 million from our strategic government contract. We ended the quarter with a record high 1,330 subscription customers. As Foster mentioned, in Q3, we saw continued success winning larger deals. We ended Q3 with 182 customers with ARR greater than $100,000, which represented an increase of 27% year-over-year. Turning to gross margin. For the third quarter, subscription gross margin was 73%, up from 72% in Q2. For Q4, we expect subscription gross margin to be consistent with Q3 levels. As expected, services gross margin of 18% was consistent with Q2. Services gross margin continues to be impacted by a higher mix of notification services, driven by the mix of large deals.

Given the continued impact from large deals in Q4, we would expect Services gross margin to be relatively consistent with Q3 levels before returning to more normalized historical levels over the course of fiscal year ’25. Total gross margin was 38%, consistent with Q2. As we look to Q4, we would expect gross margin to increase slightly from Q3 levels, driven by a higher mix of subscription revenue. We continue to see opportunities to improve our overall gross margin as we scale our business and we expect our higher margin subscription revenue to become a greater portion of our overall revenue mix. Turning to operating expenses. Total operating expenses were $27 million in the quarter. The sequential decrease in operating expenses was driven by lower R&D and G&A expenses resulting from acquisition cost synergies.

Our loss from operations was $2.5 million, a significant improvement from $4.8 million in Q2. Looking at the balance sheet and cash flow. We ended the quarter with $30 million in cash, $38 million in accounts receivable, $88 million in total deferred revenue and $194 million in total outstanding debt. In Q3, we generated cash flow from operations of approximately $1.8 million and free cash flow of approximately $1.6 million. Our Q3 cash flow performance was positively impacted by the timing of collections from our enterprise customers, and also reflects our focus on improving profitability. We are committed to enhancing our financial position and are considering various options to strengthen our balance sheet, manage our convertible debt and optimize our capital structure.

We will continue to focus on sustaining our strong business fundamentals and improving profitability. Now to our outlook. Our outlook assumes no material changes in the macro environment. Demand for our external cybersecurity platform remains consistent and assumes that no incremental outsized response deals closed within the quarter. For Q4 fiscal year ’24, we currently expect revenue to be in the range of $56 million to $58 million and non-GAAP loss from operations to be in the range of $5.8 million to $4.8 million. For fiscal year ’24, we currently expect revenue to be in the range of $228.7 million to $230.7 million and non-GAAP loss from operations to be in the range of $21.4 million to $20.4 million. We continue to focus on profitability.

Consistent with what we said last quarter, we expect free cash flow for Q4 to be at or near breakeven. And as we begin to look at fiscal year ’25, we now expect that we will achieve free cash flow on an annual basis. To conclude, we are pleased with our 3Q results, for which we again exceeded top and bottom line expectations and are raising guidance for Q4. With that, we’d like to take your questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Joseph Gallo with Jefferies. Your line is open.

Joseph Gallo: Hey, guys. Thanks for the question. You said that you’re assuming macro stays the same in your guidance, but you raised full year revenue by more than the beat in the quarter, which is really impressive. So maybe just talk through where some of the incremental positivity is coming for 4Q? And then, just on macro, how are your customers thinking about their calendar ’24 budgets?

James Foster: Yeah. Good morning, Joe. Thanks for the question. I think we’ll tag team this one here. So on the macro, I think you’ve got to see us execute here now. We had a really strong Q3. And so timing of subscription as well as some of those large services deals will help us, not only with the foundation for Q4, but we see some opportunity. As you saw, we raised guidance above beat for Q4. So I think that’s exactly what we did. In general, with the macro environment that we’re seeing right now, we haven’t really seen a slowdown in large deals and we’ve seen some of the pressures maybe in other parts of the world that were there in previous quarters improved in the last quarter or so. So I think we’re pretty bullish about Q4 and decided to kind of finish out the year strong.

Timothy Bender: And Joe, this is Tim. I missed your second half of the question on the — I think you’re asking about calendar ’20 or next year’s budgets?

Joseph Gallo: Yeah. Just as far as like the macro conversation, like when you’re talking to your biggest customers, right, you said you’re assuming macro stays the same, but how are they feeling? How are they thinking about calendar ’24 budgets? Is that fresh P&L that you can attack?

Timothy Bender: Was that — again, I think it’s similar just — again, our platform is strong and we’ll compete at that level. And I think from that standpoint, customers see the value in our platform and we’re going to continue to win customers. So I don’t think there’s any real material change as it relates to how customers are thinking about spending on external next year.

Joseph Gallo: Okay. Thanks. And just on…

James Foster: And I double click on that for you Joe too is we, as an organization, continue to try to strike this healthy balance between growth and profitability. And so going into Q4, profitability is still a top area that we’re continuing to optimize the business around. We had nice growth in free cash flow quarter-over-quarter and we’re going to continue to refine and improve the business there. We’re not done growing profitability year. That’s for sure.

Joseph Gallo: You must have a crystal ball because that kind of leads into my second question, which is just great to see the second straight quarter of free cash flow positive and strong margin performance. You mentioned synergies being a large driver of the margins. How do we think about incremental synergies or leverage as we enter calendar ’24? That’s all from me. Thanks.

James Foster: Yeah. Thanks. We did have nice outperformance in the quarter, right? I mean, our subscription gross margin ticked up 1 point quarter-over-quarter between Q2 and Q3, a little earlier than we had in our plan, which was nice to see. We think that we’ll have the ability to continue to kind of continue to run that ahead of plan or maybe even tick up a little bit in the next couple of quarters. Our long-term plan for this organization continues to tick up our subscription gross margin in a meaningful fashion in the coming years. We think we’ve been able to improve margin by 1 point to 2 points roughly every year, 1.5 years for the last half a decade and we can continue that same cadence for the next half a decade. So that’s kind of like point number one.

And I think it was — in terms of profitability, right, the market has said and the market is rewarding those organizations that continue to find optimizations, we acquired LookingGlass two quarters ago. I mean, when you think about acquisition synergies, we’ve done a really nice job with that organization. We’ve got really strong talent we brought into the fold. But our acquisition synergies and the tail around some of those things are going to take quarters still to play out. They had some leases and some other long-tail contracts that we’ve synergized our platforms, but we’ve just got to let those things run out. So you will see improvements and overall operating expenses, G&A and other areas of the business continue to play out in the coming quarters, which will result in higher chance of profitability.

Joseph Gallo: Thanks.

Operator: Thank you. Our next question comes from Brad Reback with Stifel. Your line is open.

Brad Reback: Great. Thanks very much. Deferred revenue contribution was very strong in the quarter. I think it was a positive $21 million. Can you guys talk to where those payments came from? Thanks.

Timothy Bender: Sure. Thanks, Brad. I’d say they are driven by two certainly enterprise quality deals. As Foster mentioned in the talking points earlier, we had that large eight-figure public sector deal. That was a nice renewal that came in kind of towards the middle end of the quarter. And then we mentioned the large breach response with a large gaming company and that as well came in late in the quarter. So those two alone were the significant contributors to the increase in deferred revenue.