Varonis Systems, Inc. (VRNS) Earnings Call Transcript & Summary

Welcome, everybody. [indiscernible] from JPMorgan. I'm very happy to have the opportunity to host the discussion, albeit virtually. And unfortunately, we're having a problem with video. So we'll be doing this with audio. And people should still be able to see me. Today, we'll have virtually the management team of Varonis Systems, Yaki Faitelson, the company's CEO, President, co-Founder and Chairman of the Board; and Guy Melamed, the company's CFO and Chief Operating Officer. The company is headquartered in New York. Varonis is a pioneer in data security analytics, specializing in data protection, threat detection and response and compliance. For today's discussion, I have a list of topics that are top of mind for investors, but the audience can also submit questions by clicking the Q&A button in their browser, and we can cover them as well after I go through a few of my questions. Before we jump into Q&A, Yaki, I'd like to pass it over to you to give everyone an overview of the history of Varonis and what differentiates Varonis within the security landscape.

Hi, Brian. Good morning. Good morning, everyone. Varonis, as you said, it's an analytics company that really focuses on 3 use cases, data protection, threat detection and response and compliance in privacy. We've built a very vast platform on top of a very unique metadata technology. It started by us identifying a core problem that most of the data security breaches and the security breaches and the acute security events almost always related to data. And a lot of these data is unstructured and the problem is that nothing is growing faster than data. And you need to have a lot of collaboration in order to extract value from this data. And IT organizations can't answer basic questions. Who can access the data? Who is accessing it? What data is critical? And we remediate any problem. Throughout the year, we added a lot of streams in the platform. And we have thousands of customers, very strong overall customer lifetime value. Really the leaders in the space and owning this market. And what is very interesting that as time goes by, the market is more coming to us. And we benefit -- we're starting to benefit from a strong recognition of the marketplace. But this is a business problem that they need to solve. So these are very interesting times for Varonis. The other thing that I think that is worth mentioning is that Varonis moved to a subscription business from a perpetual business, and we were able to complete the transition from almost no subscription business to close to 100% within one year.

Excellent. Okay. Well, Guy, as always, Yaki's stealing some of your thunder and talking about some of the financial highlights. Well, let me dive in. You guys had a busy week last week between your first quarter results and your first capital raise since your 2014 IPO. Let's start with the earnings. Can you give us a quick recap of your results for Q1 and kind of what you saw within the quarter?

Yes. Brian, with your permission, I will start just with the dynamics of the business, and then Guy will talk about the numbers. So Q1 for us just started as a regular quarter, a healthy quarter, we had a healthy core, and celebrating the speed of the transition. And everything was business as usual. Then, obviously, the COVID crisis kicked off, which was very interesting for us. Because once it really started, we saw a tremendous uptick in our pipeline development. And remember, buying the pipeline for us is installed POC, is installed -- we call it risk assessment, proof-of-concept that we installed. We have very -- it's very hands-on with the customer. They are using the product. But we saw tremendous uptick in the -- and it was -- with the customer base, this was something that we never imagined that we can even experience. And the other thing, the other dimension of the pipeline funnel, we just saw enormous uptick in the website coming from just organic sales, people who are looking to solve these data protection problems. And this was the good news. But then what happened is that, like, most software companies, we are back-end loaded. And in the last 2 weeks of the quarter, customers just stopped buying. So we saw a big uptick in the usage of the platform, a lot of POC, but it was very hard to get deals. But after that, when April opened up, we started to see a healthy patterns in the buying patterns. And we had a successful April. And thankfully, this is also the trend here in early May. Remember, it's still a small sample, but, so far, we see that every deal has a lot of scrutiny, but, at the same time, customers are so far putting plenty of paper and they are buying. And we still have this very, very healthy trend with the pipeline.

So just to add on Yaki's commentary, I think really the shelter-in-place couldn't have happened at a worse time for us, around March 15. And like Yaki mentioned, we are, similar to other enterprise software companies, back-end loaded. And during that time, during the last 2 weeks of the quarter, companies were very focused on the work from home. But we saw that disconnect between atypical purchasing patterns during those 2 weeks and how the pipeline was increasing. And as we ended the quarter, it ended in a very atypical way, but the ARR still grew close to 60%. Now it grew 59% compared to Q1 2019. And what was also very interesting is that our subscription mix was 98% for the quarter, which meant that in Q1 revenues, we had more than 95% recurring revenues compared to less than 40% when we ended 2018, which means that we are in a much stronger position to weather this storm. And then during April, we started seeing things coming back in terms of customers started to sign POS. We closed some of the slip deals from Q1. And we were very encouraged. Just like Yaki mentioned, April is still a small part of the quarter. But this was very encouraging, especially the fact that the business was up month-over-month when you compare April 2020 compared to April 2019.

Yaki, Guy, a question. Why is your technology -- why are your products -- it sounds like based upon the activity, just the proof-of-concepts and the website track, why do you think this technology is more relevant today than what we're seeing? I would imagine it's the work from home. And how do you -- what have you found with customers in terms of what they're telling you about their risk environment or the threat environment, given the massive shift in dynamics with workforces that are working from home?

Yes. I think that we really benefit from the work-from-home dynamics and the understanding of the problem that we solved because what you see is it was a rush to set up this environment to a different way of working. And so a lot of the employees are accessing the on-premises, data systems from VPN and allot it from unsecured networks and sometimes unsecured machines. We saw tremendous uptick in 365, primarily with Teams. And a lot of workloads that customers configured fast in AWS and in Azure that was open to everybody. So without being too technical, you can look at the remote desktop protocol, so much of it was just exposed to the world with connectivity to the local system. So it's very easy for Azure to get in with what we call human-operated attack. And also a lot of anxiety around COVID that people are very -- there is a lot of tension -- people have a high level of anxiety and they are clicking on links they shouldn't and their machines get compromised. Once you are compromised, at the end of the day, it's almost all about getting your data. And getting your data, getting your unstructured data, I'm sure that everybody that listen to this call, most of the data that is critical for you is in forms of files and emails. And even a data that comes from application you usually extract into files. So I think that what happened is that we saw enormous uptick in attacks. So Varonis is also combining data from VPN, proxy and DNS. So we were able to see attacks on VPN, brute force, access from compromised machines. And then you're trying to infect the organization, but whenever you're trying to access data and exploit really [ data ]. The other thing is there is also an uncertain environment. And unfortunately, there is the risk of people being fired. And when people are being fired, they are trying to take a lot of data or access data they shouldn't access. This is the frontier. So I think that organizations understand, okay, we set up, so we can access the cloud. And we can use Teams, and we can use Azure and AWS and increase their VPN capacity and constantly everybody asking from VPN, but they don't have visibility for what is going on. And my data is at risk, so I must make sure that I find the critical data and close it without stopping business. And you need a lot of automation because there is scarcity of talent, and everybody needs to do less with more. And when you look at it, when you really quantify where is the risk, it's the data that's gone it's protecting. So in the short term, it's hard to really evaluate how we are going to monetize it. But in terms of the long term, I think that there is a very strong market realization, that this is the problem. And we need a lot of analytics to visualize the problem, to remediate, to find the critical data. And this is the battle that we have. We need to protect the data and the critical systems, and I think that we are doing it very well. So there are some things that happen in terms of market awareness and the understanding of I need to evaluate where my digital assets are and what I need to protect. And in these kind of dynamics, Varonis is really benefiting.

So that's helpful from a product and technology standpoint. Curious, and just a reminder, because I'm getting a few questions. So if people have questions, you can submit questions on the Q&A, and I'll turn to those in a few minutes. Focusing on the selling motion, you, obviously, as an organization, have the same pressures that a lot of your customers have with work from home. How has the selling motion changed given COVID? And is that impacting sales cycles? And your sales force, do you still have the same efficiency and efficacy with the sales force given these constraints?

Yes. It's a good question. So for us, nothing is changing in terms of the -- technically how we do it. So all of our risk assessments and support and professional services, it's all being done remotely. So we're demoing the product remotely. So a lot of the -- our engagement with our customer is as it is being set up that way. Enterprise software, there is always benefit to meeting customers and -- face-to-face. But in terms of our ability to engage with customers, to support them, to demonstrate the value of the platform, it's exactly the same. So for us, in that terms, it's business as usual. And obviously, the company is working remotely, and a lot of the sales force was set up like that before. So in terms of just the mechanics of how we sell and the overall sales motion, demonstrating the value, it's the same. The only thing that you see that there is definitely more scrutiny on every day.

And Brian, I want to add from a Q2 guidance perspective just to provide some color on stuff from what Yaki just mentioned. The way we thought about guidance, we did bake in sales cycles kind of being increased slightly more just because we are seeing this scrutiny on every single deal. So we baked that in our Q2 guidance. I think that one important thing to mention is that the low end of our -- top of our guidance kind of assumes shelter-in-place is still in effect at the end of Q2. And overall, the way we thought about it for the quarter was very much kind of a reflection of a continuation of the end of March. We wanted to make sure that we are -- I think we're very responsible always in the way we guide, but we just added an extra layer of scrutiny in our thought process with our Q2 guidance.

Okay. That's helpful. Staying on the topic of Q2 results, you -- you disclosed a few new metrics this quarter, specifically the net retention rate and that your net retention rate of more than 105% as well as the number of customers with 500 employees or more purchased more than 4 and 6 licenses. Can you talk a little bit about these metrics, why you think they are an important read on the business to help investors understand Varonis?

Yes, absolutely. I'll start with the NRR. First of all, I think just trying to reemphasize the definition of NRR and the way it's calculated, this is not a regular NRR for SaaS companies that have a large denominator and have sold subscription for many, many years. And kind of you can see the expansion. The way we've calculated NRR is really using the denominator of ARR from subscription customers from Q1 2019, which is still a very, very small sample. We sold in Q1 2019 roughly about $7 million in revenue in subscription. So the sample size is still very, very small. It takes into consideration some of the pilots that we had in H2 of 2018. But the number, the denominator there is still a small sample, and we wanted to see what was the ARR from that sample. And the number that we provided in the earnings call was it was higher than 105%. If you take some of the late renewals that came in during April and May, that number is actually 110%. So we did have some timing issues that impacted that number and the number is higher. And it's actually higher, even higher than that, on the larger customers. So the reason we wanted to provide that metric and that KPI is basically to provide some color with all that was going on with COVID. It's much more reflective and it would have much more meaning at the end of the year. And in some of the discussions that we had with investors throughout 2019, we kind of mentioned that the first time it would be truly meaningful on a larger sample size, that would be at the end of December 2020, when it will include the full year -- full 2019 subscription sales and kind of see how that's expanded. But we did want to provide that slightly earlier just because of all the uncertainties that was going on with COVID. The other thing to point out is that through this transition from perpetual to subscription, we've been able to sell significantly more licenses to our new customers. And we gave commentary throughout 2019 and also in Q1 2020 where the number of new licenses went from 2 to 3 selling perpetual deals to new customers to about 4 to 5 under the subscription method. So the ability to sell more to our new customers has increased. We've really truly unleash the potential of the platform through this transition. And some of the feedback that we got from investors throughout 2019 was, will you be able to sell more licenses to those customers? And by providing this NRR, being at 110%, and we do believe that, that number can actually increase on a larger sample size, but looking at how we're still able to sell to -- even when that initial sale went from 2 to 3 licenses to 4 to 5 licenses, we feel that's a very good start. In terms of the additional -- the other KPI that we provided, the number of licenses, customers with more than 500 employees, who have 4 or more licenses or 6 or more licenses, I think that there's 2 takes -- 2 things to take from that data. One is that with this subscription transition, we have truly been able to sell more of the platform to our customers, going from 45% last year on the 4-plus licenses to 55% and going from 14% to 21% on the 6-plus licenses is a very nice increase. But it also demonstrates one significant thing, how underpenetrated we are within our existing customer base. How much more we can sell to them. And I think the color that we were trying to provide there with all of kind of the uncertainty with COVID was that we are entering this kind of unchartered territories with all that's going on and the macro and COVID as a whole, with a lot of opportunities, with a high ARR, with recurring revenue that's north of 95%, but with a tremendous opportunity to continue to sell within our existing customers.

We've drastically increased the overall customer lifetime value, the ability for our customers to consume the platform. And once they have more licensees, the value of the product is going literally down. So this is a -- we are well positioned to do very well in the base.

Good. Okay. I've got -- so I'm getting questions. So people -- encourage people to continue to submit. I'm going to turn to a question from the audience on the topic of financials. Could you talk about what the prospects are for OpEx leverage, if any, and what category of spending?

So I'll address that. When you look at kind of our behavior and the way we've been thinking about profitability and revenue, we've paid a lot of attention to both. And I think we've done a very good job. If you look at kind of the evolution of the company, both from a cash flow perspective, generating cash for 4 straight years prior to the IPO and showing operating margin improvement as we progress towards kind of the year of transition, if you look at up to 2018, we showed year-over-year improvement of operating margins. And sometimes, in some years, it was more than 800 basis points. In 2018, it was flat, but we had -- it was just -- when you take in the FX headwind, we showed more than 300 basis points improvement. So we were very focused on the bottom line. And most of the operating margin leverage comes from the sales and marketing. The -- when we kind of do the risk assessments, and the way we've seen the market evolve, we have seen over the last couple of years where the market is coming to us more. There's way more understanding to the risk of having sensitive files that are open to everyone in the company. And the risk of critical data that is exposed and can be taken either from a hacker, taking over the account and the credentials of an insider or whether an insider decides to take that data and give it to a competitor. So with that market coming to us, we've been able to see leverage mainly coming from our sales and marketing department. And I would say that looking forward, that's kind of the category that we expect to continue to see leverage going forward for a couple of reasons. One is that the market is continuing to come to us. And if we can show the high-level executive how vulnerable they are, they understand the risk now way better than they did 4 or 5 years ago. And they don't brush it off. And I'd say that on top of that, we have a large base and the cost, obviously, of revenue coming from existing customer is much -- is lower than acquiring from new customers. So with that increased base that we have, we can continue to show that leverage.

Okay. Good. I'm continuing to get questions. I have one comment that noted that I get out of my chair, and I'm still streaming. That was a risk assessment of work from home with the family coming down for breakfast. So apologies for that. I'm going to turn to another question here. Turning to the customer side. Given the new environment, I'm curious to hear which verticals and business lines you markedly increased opportunity in during this environment, for example, education, finance, health care, any new industries that you historically -- you haven't historically been and where you're seeing new activity.

So I'll say that, first of all, we are very diversified. And our verticals very much mimic kind of the IT spend breakdown when you think about it, financial services being kind of in the 20%, 25%, and kind of then very much diversified within -- when you think about all the other verticals that are out there. I think what's very clear to see with this new environment is how the first kind of initial thought was the setup for work from home, make sure that your employees are ready to work and are able to work with the new setting. And I think that when we look at the pipeline right now, it's really, when you look at the industries, there's a lot of understanding on the elevated risk of your employees working from home and how vulnerable the organization is with employees that have laptops that all family members are using. And you don't know who's clicking on what link and who has a phishing attack, and the fact that this is not from a secured office network, but it's connected through VPN. So when we're looking at the industry, the diversification has kind of continued as we see it right now. But I think that's just the understanding of how the risk is has been elevated, and we see that through the pipeline.

Okay. That's good. I want to touch briefly upon, can you talk about the competitive environment? Are you seeing anyone new? And who do you typically -- who are your typical customers -- I'm sorry, who are your typical competitors?

So we barely have any competition. So we are the dominant force in this market. We saw historically a bit of Symantec and Quest, but they almost vanished here and there. Sometimes, there are small startups, but it's -- they are not holding up. At this point, we are almost alone, and we are measuring in every one of our risk assessment. So, so far, this is the situation. So, so far, when we are doing a assessment, usually, in most use case sales, we are uncontested.

Okay. That's helpful. I do want to touch -- at the start, we talked about your busy week last week with Q1 earnings. You also executed your first capital raise since the company went public. The company's been very capital-efficient in its history. You raised $250 million on a convertible. Can you talk about the thinking around the capital raise? And in particular, what are your thoughts around use of proceeds?

So we're using -- have written a prospectus that the proceeds are for general corporate purposes. I think we were opportunistic in the way we were thinking about this raise. We also -- also important to mention that we -- some of the proceeds we used for a cap call with 100% -- with using the 100% from a stock price that was at $70.86 or somewhere around that number so we definitely believe in our ability to continue to grow over the next couple of years. We felt that this was the right thing to do for us as an organization. And we're happy with the way that this was received.

Excellent. Okay. And can we talk -- you talked about kind of investing, can you talk a little bit about how you are thinking about investing to acquire for customers. So we talked a lot about the activity, we'll call it, at the top of the funnel. How would you think about investing given the opportunity in this market environment?

So one of the things that we talked about in the earnings call was some of the measures we took in the beginning of April. We did some cost cutting. We reduced some of the salaries for employees. But what we have also kind of kept front and center for us is our ability to reaccelerate in terms of the investments, in terms of the growth. We understand the opportunities out there. We understand that we could benefit from it in the long term, and this new environment can help in the understanding of the risks. And we want to be able to capitalize on that, but we felt that with this ending to Q1 and the atypical purchasing patterns that we saw in the last 2 weeks of the quarter, that we always have to make the adjustments on the expense side to align them with the revenue that we expect. And I will tell you that if we see conversion rates of this elevated pipeline at historical levels or even if they're slightly below historical levels, we -- that would be a great indication for us that we can reaccelerate. I think we've positioned it the right way. We're still hiring opportunistically. Mainly if we see the opportunity for quota-carrying reps, we will do that. And at the same time, if we see that the end of Q1 was atypical in Q2, kind of mimics more of April, we're ready to reaccelerate.

And how do you think this -- I know we've got just a couple of minutes here. How do you think that activity and some of what Yaki talked about at the start, top-of-the-funnel activity, some of the investment, how do you think that positions you for 2021? You talked a lot about 2020. How do you think this positions you for 2021?

You know, Brian, we are not economists, and we don't know how the COVID will play out. Historically, when we have POCs, they're translating very well into actual revenues. So I think that what we can say we see a very strong pipeline, very strong demand, very strong use of the platform and the adoption of all the licenses. So far, the quarter started healthy, but, again, this is still a small sample. We never know how we end up before the last few days of the quarter. But so far, it's healthy. Historically, when we have a good pipeline, we're usually doing well. And we definitely see that our ability to expand the platform within a customer base and the overall customer lifetime value just increased drastically. And we also believe that what the COVID situation is doing is letting people to assess everything. And I think that many times, in security, you will need to think long and hard, what are the problems that they have? What are the risks that I can take? Where do I need to protect my -- how I need to protect my data and infrastructure, and how I'm going to really balance collaboration with protecting my digital assets and the infrastructure? And I believe that from this thought process, we're really going to benefit. So now we have the COVID. That's clearly helping us with the thought process. And we had a lot of regulation that help customers think about data. So I really believe that we built a very unique valuable technology. And the marketplace is -- just because of everything that is happening in the world, slowly but surely coming to a realization that this is a massive spend. And once they are starting to buy, they are buying more and more.

Excellent. Well, I am -- Yaki, Guy, thank you for taking time to join us on this virtual presentation. You've got a great story, and we very much appreciate you sharing the details today. Thank you, guys.

Thank you, Brian.

Thank you.