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

Everyone, welcome to the Barclays TMT Conference. My name is Saket Kalia, software analyst here at Barclays. Very happy to have with us the team here from Varonis. We've got Guy Melamed, Chief Financial Officer and Chief Operating Officer; as well as Brian Vecci, Field CTO. We've also got Jamie Arestia, Head of Investor Relations on as well. We've got about 25 minutes together. Let's take the first 15 or 20 minutes or so to do some fireside chat with Guy and Brian, and then we'll leave the last 5 or 10 minutes or so for any questions from the audience. Feel free to e-mail me any questions I can ask them for you at [email protected]. So with that as sort of a framework, Guy, Brian, Jamie, thanks so much for being with here today.

Thanks for having us.

Thank you.

Absolutely. Absolutely. Guy, let's just start kind of high level on the overall demand environment post COVID. And maybe the question is, can you just talk about how that demand sort of evolved from, say, March, right, through maybe the most recently reported quarter? And qualitatively, what did you look at to sort of gauge that?

Absolutely. So if you go back to March, I think what initially happened is that companies were trying to understand how to deal with the shelter in place and the whole new environment. And the first reaction was to make sure that employees can work remotely, whether that means setting up laptops, antivirus, all the setups, VPNs that allow those employees to actually perform their jobs through that. And then we started seeing something very interesting happen. Companies actually realized that the risk of data being lost or breached or hacked has been elevated. And we started seeing much more interest from companies that wanted to make sure that they protect their data. And I think the risk, as we see it, is still very high, and it doesn't matter if tomorrow, everyone is going back to the office. This new norm of digital transformation where people are going to work on multiple platforms and this collaboration that companies are sharing and employees within companies are sharing files in a click of a mouse is really here to stay. And that's where we can help organizations. So when we look at kind of the evolution throughout the year, we saw in Q2, companies interest and demand kind of slowly trickling in our direction. Q3 was better than Q2. And I think that this -- we're not a type of company that benefits short-term from a hack. It's not that you see a hack and the next day we see a spike in revenue. We were never that type of company. I don't think we see that changing anytime soon. But what we do benefit from is from a thoughtful process that organizations go through, where they really try and understand how to protect their data. And I think that this digital transformation is here to stay. We can capitalize on it on the long term. Obviously, when you think about short term, there's obviously the challenges of COVID that are still here. But on the longer term, I think we have more confidence now than ever before on the opportunity that's ahead of us. And part of kind of our decisions throughout the year were to try and find the right balance between growth and profitability and cash flow from operations. And I think you called it very nicely throughout the year that we were talking more about the profitability and the fact that the flywheel effect of kind of being post transition is allowing us to show improved margins. And obviously, the cash flow is kind of a lagging indicator to the change of this transition. But I think that where we stand today, and it's part of the first acquisition we announced -- first acquisition ever that acquiring Polyrize, that we announced a couple of weeks ago, is very much fitting in that kind of framework of still being very committed to those 3 factors: top line growth, operating margin improvements and cash flow from operations. But at the same time, we just see the opportunity ahead. So we want to make sure that if we see the revenue growth being able to support our investments, we won't to be able to do that. So when you think about kind of year-over-year, there's -- we have this commitment to show non-GAAP operating margin improvements year-over-year. But at the same time, we want to make sure that we make the right investments now in order to show margins on a much higher revenue number. And I think that was part of the discussion that we had with Polyrize of build versus buy. And seeing the opportunity ahead, we just wanted to cut time to market, and that was part of the reason we made that investment. And if you think kind of about 2021, if we see that revenue comes in, in levels that we expect them to come or even higher, then it would make sense for us to make those investments again, being committed to that year-over-year margin improvement, but maybe kind of putting the foot on the gas in terms of the investments, just because we see this tremendous opportunity ahead of us.

Got it. Got it. Very helpful, Guy, as a framework, a lot to dig in there that I'd love to hit on. Brian, maybe to help frame us from the product perspective a little bit. If I think back to when we were talking last year and the year before that, right, kind of as we embarked on this transition to subscription, one of the things was just sort of having so many more licenses to offer. And so I guess, maybe just a follow-up on Guy sort of -- on the COVID question I asked to Guy, I guess, which products do you feel like or which licenses do you feel like saw maybe increased demand because of COVID and why?

So a couple of things to keep in mind. It's a really good question. But a couple of things to keep in mind is that Varonis is a single platform. All of these licenses, we can talk about them in terms of being separate products. But when we say -- we talk about them as licenses because everything is a single code base and a single platform. The Polyrize acquisition aside, which I'll touch on. What that means is that these licenses aren't just additive, they are cumulative. So they all -- -- everything is tightly integrated together. So as the customer adds on one or more licenses, they all enrich and inform each other. They're not separate products that you use separately. And that's part of why the subscription transition has been so beneficial for our customers, and that it's made it so that they can consume more licenses upfront and make it easier to add on more licenses over time, which gives them an exponential amount of value. 1 plus 1 doesn't equal 2, it equals 5 or 10. As far as the transition to remote work or work from anywhere, we've seen that in addition to our core licenses of monitoring and classifying and protecting data on-premises within the data center, the ability to connect that activity in data protection and threat detection to OneDrive for Business, SharePoint Online, Exchange Online, Azure Active Directory as well as the perimeter of the network, which includes connectivity through the VPN, reconnaissance and potential exfiltration through web proxy and through DNS, our edge products and our 365 products have become even more critical than they were before. One of the things that -- and Guy really hit on this, but I want to make sure that we emphasize, is that COVID and this transition to work from home is really just an acceleration of a transformation or really a process that we've seen the company has been going through for the last few years or really up to a decade. COVID just accelerated that. Varonis and these licenses are an increased adoption of Edge and 365, increased automation to lock things down. That's not a response to COVID. COVID has just highlighted the need for it. My 3-year Microsoft teams rollout plan became a 3-week plan in March. Suddenly, I really need to know what data is sensitive, who has access to what and really ensure that people only have access to the right things. I hope that makes some sense.

Yes, that does. That does maybe to say it differently. There was no -- there wasn't a benefit here in 2020, and Guy, feel free to comment on this. But if I'm hearing the message correctly, there was no benefit here in 2020 that, that will potentially become a headwind here in 2021. It was an accelerant to maybe some of the other licenses. Is that sort of the right way to think about it?

I think that's -- go ahead, Guy.

So 2020 was -- we didn't benefit from COVID in terms of -- COVID happened and we saw a spike in revenue. That's not the way we work. And I know there are other companies that benefit from that immediately. We're not that type of company. But we are benefiting from the digital transformation that's here to stay and from the fact that companies have this elevated risks. That won't go away even if they all go back to the office tomorrow. This collaboration and the fact that companies -- that employees are going to work partially from home or at least log into their e-mails from home even if they go back to the office is going to happen. And the setup is there where the VPNs are ready for those employees to work from home, no one's going to go and take the laptops away from employees. And I think the collaboration and the fact that the ability to hack into organizations with this multiple platform use is going to benefit us on the longer term. And I think we're seeing the opportunity. That's part of the reason that we made the investment and the acquisition with Polyrize because we want to kind of speed our time to market on additional platforms. And just like Brian said, Polyrize is not instead of existing licenses that Varonis has to offer today, it's in addition to. And we talked about the fact that we don't expect revenue to come from that acquisition in Q4 or in 2021, but we definitely see kind of the path where this is increasing our TAM and is showing -- increasing our market and our ability to address with new customers, and even go back to our existing customers and offer them additional licenses. So the way we look at the opportunities that are ahead, we see multiple ways that can be growth drivers in the years ahead.

Got it. Got it. Guy, maybe I'll skip ahead to maybe some of the financial questions here. And I want to talk about ARR, which was such a useful metric to this transition. And I think you've been very consistent in sort of saying that ARR growth here would be impacted as we lapped quarters where the subscription mix was high, right? And so the question is, can you just explain the dynamics of that a little bit? And perhaps what you think ARR could kind of grow longer term, assuming a more consistent mix?

Absolutely. So I want to clear one question that we kind of still get from investors, and I want to be very clear with that. We don't go back to our existing customers and try and convert the perpetual license that they own into subscription license. We said all along that our customers that own perpetual license and are paying maintenance, we are so underpenetrated within our offering. And there is so many more additional licenses that we can offer to them, that we simply go to them and offer them the additional platform licenses under the subscription model. So they pay the maintenance of perpetual. And on top of that, they're paying the subscription licenses. And for them, it's one line item, as an OpEx line item, so it really doesn't matter. So I just want to kind of state that because we do get those questions and the impact on ARR, and we don't see an impact on ARR from conversion. So that's kind of the method we talked about all along. But when we announced the transition in 2019, we talked about the fact that the right way to look at the company and kind of the fundamental strength of the company with the headwind that will come from revenue and the non-GAAP operating margin is ARR. Because obviously, the quicker you go through this transition, the stronger you are fundamentally as a company. And from a financial perspective, there's a flywheel effect, but yet you'll have a stronger headwind. And I think that was part of the reason that we kind of provided that KPI and wanted to make sure that investors understand the strength of the business. What's going to be very interesting going forward is that when you think about Q1 2021 and compare that to Q1 2020, we had 99% subscription mix in Q1 2020. So on the comparable, it really is apples to apples. And when we went through this transition, obviously, the higher the subscription mix year-over-year, obviously, the ARR was impacted positively. And when you get to this apples to apples comparison, it truly starts becoming much more of a reflection of what the underlying revenue growth would be. So when we think about ARR in 2021 and even in Q4, it would decelerate quarter-over-quarter or from -- if you compare Q3 2020 to Q4 2020, but that doesn't mean anything negative about the business. On the contrary, we're seeing the demand actually improve, and we're seeing our ability to sell and cater to our customers actually on the positive side. So that's just the semantics of pure mathematical mechanics. And when you think about 2021, it's going to be a pure apples to apples comparison.

Got it. Got it. That's helpful. Brian, I guess, related to that growth, right, and that demand, I mean, I think one of the questions that I sometimes get is just about competition, right? And so I'd love if we could talk a little bit about competition in the current environment. The question is, who are you running into competitively? And who are you replacing, if anything, in most of your customers? Do we still have Brian?

Brian, I think you're muted.

I muted up. Sorry about that. So it's a really smart question, and it's one that we get every day. And the answer is broadly, we don't really compete with anybody. We're not really replacing anything. And I know that might sound easy to say, but let me explain why. 15 years ago, the ability to understand where sensitive data was on file systems and really understand who had access to what, where it was exposed, how it was being used, who it belonged to and to clean up thing -- clean things up, so that you could both measure and reduce risk and make sure that the right people have access to what they're supposed to simply didn't exist. Varonis as a company and a technology platform was created to solve those problems. And we certainly expanded over time into other behavior streams and data stores. We've added on more automation, more intelligence, alerting and behavior analytics have all been added as the platform has grown. What that means though is that there's nobody that does what we do the way that we do it. Nobody built this kind of thing before. When we compete and we track competition very closely, we're a data-driven company. We look at everything. And we look at every single deal. And so we know when and if there's any kind of competition. And we see competition in 1 out of every 20 deals, or about 5%. And those 5% of deals are scattered amongst a galaxy of different tools and manual methods. There is no single competitor that we run into at all really. What we're really competing against are, I am trying to solve one specific use case like, I believe my problem is I need to, and I'm saying I as a potential customer. I believe my problem is I need to classify data on file systems. And when we're in that scenario, it's like, all right, there are other tools that you can use to go and find sensitive data potentially, but none of them are going to tell you where that data is at risk, open to too many people. None of them are going to monitor how that data is being used. None of them are going to help you make sure that you can safely reduce access and that only the right people have access to it. And none of them are going to alert you when something goes wrong, using that data classification. So nobody does what we do, the way that we do it, and we've got such a head start, and it's not just the technology. In order to make software like this work, you not only have to build it, which of course takes huge investments in R&D, you also have to go have people use it. It's not hardware that you rack and stack. It's not a commodity technology where we are replacing something like another firewall, like checkpoint or an endpoint protection, where there's lots of different vendors that are competing in the same space. Varonis sits at the intersection of lots of different technologies. There is nobody that does what we do in the way that we do it and solve the same problems or get to the same outcomes like we do. And we've got such a technical mote around us that again, it's software. If you wanted to build it, you could, but we've got thousands of customers over a decade-and-a-half of experience. So we don't just have the technology, we've got the people that know how to use it and help our customers be successful. We've got a plan to do it in a methodology, and now we're, of course, expanding into other use cases and data stores. We're increasing usability. We're increasing automation. And especially now with Polyrize, we're really going to accelerate our ability to combine behaviors from lots of different places in unique ways. So I hope that gives you some color about why we don't really see any competition.

Yes, absolutely. Very helpful.

And Saket, I'll add on that, if I may. One of the...

Please.

Just in terms of the usability of the product and the number of licenses. I think we talked a lot about the fact that the -- the move to subscription was driven from customers. The desire for customers to actually consume the platform and the fact that when we went public in 2014, we had 10 licenses and it made a lot of sense under the perpetual model where they bought between 2 to 3 licenses in the first initial purchase and then they would come back and buy more. But when we came out with so many additional licenses, as so many of them were geared towards automation, we started hearing from the field in 2018 on this desire for the customers to consume more of those licenses. And I think the numbers, as you look at them throughout 2020, have been numbers we're very proud of. When you look at new customers buying under the subscription model, more than 5 licenses compared to the between 2 to 3 licenses that they bought under the perpetual model, that really means that they're using the platform, and they want to be better protected from the get-go. But it also means that the potential and the path that we see to get to double-digit licenses on average per customer has never been clear. I think we -- one of the pushbacks that we got in 2018 was, you're talking about the fact that customers are buying more licenses. Does it mean you're cannibalizing your growth? And we said, we don't see that, that way on the contrary, the fact that they're buying more licenses actually means that they're seeing more value in the product. They would want to be better protected on additional platforms. And with the offering that we have, there's just so much more room for us to grow within our base. And I think the numbers that we've provided, when you think about the KPI that we introduced this year, companies with more than 500 employees that have 4 or more licenses and 6 or more licenses, the number went from 50% last year on the 4 or more to 60% this year. And on the 6 or more licenses, it went from 17% to 26%. So great increase and great improvement that kind of fits with the story that we've been providing. But at the same time, having only 26% of our customers, 500-plus that have 6 or more licenses, and the path that we see the double-digit licenses means that there's so much more room to grow within our base. And the fact that they consume more of the licenses just makes us stronger as an organization.

Very helpful. Maybe this will be the last question given the time that we've got. But Guy, I really want to double-click on what you said earlier and just kind of talk about expenses, margins vis-à-vis sort of revenue growth. I think you've been very clear in saying that Varonis is going to invest for growth, but of course will think about balance. I think you've been consistent with that through the year in your opening commentary today. I guess maybe if you could dig a little deeper, what does that mean to you? And what I mean by that question is, is there a relationship between expense growth and revenue growth or perhaps points of margin expansion? Just any level deeper you can go into us for how you think about that balance, if you will?

Absolutely. So kind of summarying kind of our philosophy, the 3 most important components that we look are at top line growth, non-GAAP operating margin and cash flow from operations. We obviously are focused on driving each one of them in the benefit of the company and our shareholders. When you think about the non-GAAP operating margin improvements, I think when you look at the progression pre-transition, pre the announcement of the transition, there were some years where we showed 300 basis points improvement year-over-year. Other years, we showed 800 basis points improvements and there were some years that we showed less than that. We are committed to trying to show year-over-year margin improvements. But I think the level of improvement really depends on the revenue growth and what we see can show us kind of the path to investment. So if we see that the revenue is actually happening better than we expect, we can put some of it -- even put more of it back to the business because we see the path to growing and improving our top line and showing the margins when the revenue number is actually higher. So when you look at the flywheel effect and you look at the fact that we have set up the company where we're starting to get the renewals back in, we're seeing kind of the renewals kick in and obviously, we only had 1 year of renewals now. And next year, you get the 2 years, and then you start building with the subscription companies that have been as such since inception and they have years of subscriptions that are coming back, we just started. But when we look at 2021, the top line growth that we see, and we talked about this when we started the transition, we feel very good with our ability to grow 20-plus percent for the next couple of years. That hasn't changed, we believe and where we sit today, and we'll obviously give more color about 2021 in the next earning call, but we still stand behind that 20-plus percent. And when I think about the margin improvements, we're going to stand behind margin improvements year-over-year, but we might actually put our foot on the gas slightly more in terms of the investments, just because the top line number can support it. So we're very, very responsible in the way we invest, but we definitely tie the expense level to the top line number. Does that makes any sense?

That does. That does. That's Super helpful. Guy, Brian, Jamie. I've got so many more questions for you, but just limited time. So unfortunately, we have to end it there. Guys, thank you so much for the time. This was really valuable. I hope your investors dig into some of the stuff in your one-on-ones today. But look forward to when we can meet in person again and do this in San Francisco like we usually do. But until then, thanks for taking the time here, guys.

Thank you very much.

Thank you.

Thanks, Saket.

See you. Have a good month. Bye now. See you.