Varonis Systems, Inc. (NASDAQ:VRNS) Q4 2023 Earnings Call Transcript February 5, 2024
Varonis Systems, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Greetings and welcome to the Varonis Systems, Inc. Fourth Quarter 2023 Earnings Conference Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Tim Perz of Investor Relations. Thank you, Mr. Perz, you may begin.
Tim Perz: Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis’ fourth quarter and full year 2023 financial results. With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer of Varonis. After preliminary remarks, we will open the call to a question-and-answer session. During this call, we may make statements related to our business that would be considered forward-looking statements under federal securities laws, including projections of future operating results for our first quarter and full year ending December 31st, 2024. 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 captioned Forward-Looking Statements, and these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. These statements reflect our views only as of today and should not be relied upon as representing our views as of any subsequent date. Varonis expressly disclaims any application or undertaking to release publicly any updates or revisions to any forward-looking statements made herein. Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures is also available in our fourth quarter 2023 earnings press release and investor presentation, which can be found at www.varonis.com in the Investor Relations section.
Lastly, please note that a webcast of today’s call is available on our 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 2023 performance. Today, I would like to review our fast transition progress and discuss key drivers of our business in 2024 and how we are positioned to capitalize on them. One year ago, we discussed our initial excitement on Varonis SaaS. At the time, we talked about how we had invested heavily for years to build a world-class cloud-native SaaS offering, which allows our customers to secure their data automatically. We simplified our packaging to include automation that we know our customer needs. We had confidence in our product, our team and our plan, but it was early, and we had a lot to prove.
Despite on-going macro challenges, SaaS ARR grew from several million dollars in 2022 to approximately $125 million at the end of 2023. We are proud of the momentum we have achieved so far in how that set us up for 2024 and beyond. Our fourth quarter results reflect the sustained momentum of our SaaS platform, and I’m happy to announce that SaaS ARR represents approximately 23% of total company ARR at year end. This progress gives us the confidence to accelerate our transition’s time line, which we now expect to complete by the end of 2026, a year earlier than our initial outlook. Fourth quarter SaaS mix came at 66% versus our guidance of 60%. ARR grew 17% year-over-year to $543 million and we generated $54.3 million of free cash flow in 2023, up $0.5 million last year.
The macro environment remained stable during Q4, and we continue to see a high level of deal scrutiny with multiple levels of approval. Overall, we are excited by the progress of our SaaS transition against these headwinds. Guy will review our Q4 results and our 2024 guidance in more detail. We are still in the early innings with our transition to SaaS delivery model and the benefits we expect to realize are just getting started. But Q4 and 2023 overall marked a strong step in the right direction and I’m very grateful to the entire Varonis team for how we have executed so far. Turning now to our strategic priorities for 2024. Of course, continuing our transition to SaaS will be a primary focus. And to briefly remind you, there are three key benefits of SaaS platform provide to our customers.
Customers can achieve automated outcomes, which means we can ensure that data is protected with very little effort. SaaS is quicker to deploy and operationalize because of significantly lower infrastructure and personnel investments and SaaS is easier to maintain and upgrade. Additionally, there are three key benefits that we realized. They are shorter sales cycles, larger initial lands and margin benefits over time. We started to see evidence of these benefits in 2023 and expect them to continue in 2024. In addition to executing on our SaaS transition, the dangerous threat environment is creating increased awareness for data security, within that backdrop, we see three additional drivers. Our new managed data detection and response service, which we call MDDR, the adoption of enterprise generative AI like Copilot and Einstein and increasing compliance requirements such as the new SEC disclosure rule around cyber events.
With that, let’s tackle the overall environment and each of these drivers in more detail. Our foundation for innovation has been simple to follow the data and automate. With SaaS, we have been able to innovate much faster. We have gone wider with more coverage of enterprise data stores and we have gone deeper adding more automation so that our customers can achieve their business outcomes with very little effort, but this is just the beginning. One year ago, we introduced Proactive Incident Response, which provides our SaaS customers with a system from our world-class incident response team. Today, we are introducing the next evolution of this offering with the world’s first managed data detection and response service, which comes with an SLA and 24/7 coverage.
Varonis MDDR is a paid service that takes responsibility of managing Varonis out of our customer’s hands and places it with us. Customers will no longer have to monitor the Varonis alerts. Instead, our teams will leverage behavioural analysis, machine learning automation, and our unique metadata telemetry to protect them. We introduced this service because no security teams or such team in MDDR builds upon automation enabled by the SaaS platform and maximizes the return on investment. Another driver for us in the year ahead will be the impact of generative AI and large language models. We spend sometime last quarter discussing what this tailwind means for Varonis. But to briefly review, generative AI represents both opportunity and risks for companies.
The growth of AI has the potential to generate significantly more data and also significantly more risk, which in turn increases the need for automated data security. Without robust data security strategy, AI will reveal sensitive data to the wrong machines and people, most generative AI tools utilize existing access control, which leaves organizations overexposed to this strength. Companies will also need to ensure that sensitive data is not being used when training LLMs and hackers will leverage these tools to craft better phishing e-mail, create malware or even search for data once inside an organization. Simply put, generative AI is forcing organizations to take a hard look at their data and they are realizing that access control must be correct to ensure sensitive data can be exposed.
These are core use cases for Varonis. In support of this, two weeks ago, we announced a strategic partnership with Microsoft to help companies safely harness the power of Microsoft Copilot. This integration helps customer improve the Microsoft 365 data security posture before, during and after deploying Copilot. As a result of increasing risks and regulation, we are seeing data security become more of a priority. Varonis is in a unique position to capitalize on this as we help organizations protect their data like a bank watches its money. Bank spots financial crime by analyzing financial transaction. Varonis spots cybercrimes by analyzing data transactions. Our customers have Varonis watching the data and the infrastructure close to it, which limits the likelihood of damage.
In addition to watching data usage, we locate sensitive data, visualize access to it and automatically lock them. This allows companies to realize more value from their data, leverage it safely and keep it protected. The world has never been more reliant on data than it is today. And if you dissect every major breach, the one common threat is that nobody was watching the data. Take for example what happened at a large ride-sharing company with a very sophisticated security stack, but no data security platform. A group of teenagers was able to bypass the multifactor authentication, access file shares and steal critical data. It wasn’t until the hacker posted messages in Slack that they knew they were breached. The biggest threats can come from insiders.
Think about WikiLeaks, Snowden and the Pentagon Breach. These breaches highlight the damage that can happen when insiders have access to far too much data. When the perimeter fails and you have a rogue insider, we are best positioned to catch it. Data breaches and the danger of ransomware used to be something we had to explain. And today, every organization knows that they are at risk. The increasingly dangerous threat environment has led governments to enact regulation. For example, the Securities and Exchange Commission rule which took effective in December required public companies to disclose cyber-security breaches in a Form 8-K within four business days after determining it has a material impact on the business. It also puts more structure into how they disclose their cyber-security risk management strategy and governance will also be telling management in the board of roles and expertise in handling these risks.
This increased scrutiny on US listed public companies has raised awareness for cyber-security and we believe Varonis is well positioned to help companies comply with these regulations. With that, we’d like to briefly discuss a couple of key customer wins from Q4. A real estate company with 5,000 employees became a new customer this quarter. Our organization had an executive mandate to find sensitive data across its hybrid environment. During the risk assessment, our team discovered over 250,000 records containing PII and thousands of employment contracts and mortgage documents that were open to everyone in the organization. Our incident response team even stopped multiple data breaches attempts. This customer evaluated Varonis and two other vendors.
But ultimately, Varonis was the only one who could automatically ensure their data was protected. As a result, they purchased Varonis SaaS package for Windows, Microsoft 365, Edge, AWS and S3. We continue to see strong interest from customers wishing to convert to Varonis SaaS. One example is a large municipal government that became a Varonis on-prem subscription customers in 2018. We are leveraging our software to find and protect sensitive data and to monitor abnormal user behaviour in a single department. The success this organization had protecting their on-prem environment enabled our team to meet the mandate for the broader municipal organization. This quarter, they converted to Varonis SaaS and expanded from just 500 users to 25,000 users.
SaaS is the ideal fit for them because for automated remediation, improved scalability and infrastructure savings. They purchased SaaS package for Windows, Microsoft 365, Active Directory and Exchange Online, which will allow them to protect their data without training their security teams. Finally, about a month ago, we had our sales kick-off event here in New York with the amount of changes and magnitude of innovation we had in 2023, it was important for us to bring our team together, and I cannot speak enough about the level of energy and enthusiasm during the event. I would like to thank our team for their tireless effort as none of this would be possible without them. We are excited about the reception of our SaaS platform and the momentum of our business leaves me optimistic as I look ahead.
Not only to 2024, but also beyond, as we approach our $1 billion ARR target. With that, let me turn the call over to Guy. Guy?
Guy Melamed: Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. We are pleased with our fourth quarter results, which reflect the strong adoption trends of Varonis SaaS against the challenging but stable macro backdrop. Our SaaS transition continues to gain momentum and after just one year in the transition, SaaS now represents approximately 23% of our total company ARR. As a result of this momentum, we now expect to complete our SaaS transition in 2026 which is one year earlier than previously outlined. As a reminder, our transition will be considered complete when 70% to 90% of total company’s ARR is coming from SaaS. In the past, we’ve described the transition is occurring in two phases. Phase 1 began when we introduced the product and is the phase where we focus on selling SaaS to our new customers.
Phase 2 of the transition, which is converting our installed base of on-prem subscription customers to our SaaS platform is planned to begin in earnest during the second half of this year. We expect that the ramp-up of this phase will not be linear and anticipate growing momentum in each quarter of 2024 and further accelerating in 2025 and 2026. We ended the year with ARR of $543 million, which increased 17% year-over-year, and we generated $54.3 million of free cash flow in 2023 up from $0.5 million last year. These metrics illustrate our ability to drive top line growth, margin leverage and cash flow generation even in the first year of transition. Our fourth quarter SaaS mix represent 66% of new business and net new upsell ARR versus our guidance of 60%, which led to a full year SaaS mix of 57% versus our guidance of 55%.
We again saw more of our existing customers converting to our SaaS offering. In the fourth quarter, we had approximately $15 million in conversions of existing customers impacting our Q4 revenue. To be clear, this $15 million represents the renewal amount that was previously booked as on-prem subscription, but which converted to SaaS during the quarter. Because SaaS revenues are recognized ratably when the $15 million worth of customer renewals convert from on-prem subscription to SaaS, it causes a headwind to our reported revenue and operating margin. The $15 million revenue impact from this quarter does not include the uplift that we realized from these conversions, which is accretive to ARR and free cash flow. We ended the year with approximately 4,950 subscription customers, which was up 14% year-over-year.
Our dollar-based net retention rate for subscription customers was 107% at the end of 2023 adjusting for FX. Turning now to our fourth quarter results in more detail. As a reminder, ARR, free cash flow and ARR contribution margin are the leading indicators for this transition. The shift from on-prem subscription licenses where approximately 8% of the deal’s value is recognized upfront to a SaaS delivery model with fully ratable revenue recognition will cause initial headwinds on the traditional income statement metrics. As we said previously, the faster we progress through the transition, the more headwinds we will experience to our traditional income statement metrics. We view these headwinds in a positive light. In the fourth quarter, we continue to see deal scrutiny with multiple levels of approval which are still impacting our results.
But if I had to describe the environment in one word, I would use the same word I used last quarter, which is stabilization. Q4 total revenues were $154.1 million, up 8% year-over-year. During the quarter, as compared to the same quarter last year, we had approximately a 16% headwind to our year-over-year revenue growth rate as a result of having increased SaaS sales in our bookings mix, which are recognized ratably versus the upfront recognition of our on-prem subscription products. Subscription revenues were $129.2 million, and maintenance and services revenues were $24.9 million as our renewal rates were again over 90%. Moving down the income statement, I’ll be discussing non-GAAP results going forward. Gross profit for the fourth quarter was $136.4 million representing a gross margin of 88.5% compared to 89.9% in the fourth quarter of 2022 despite significant revenue headwinds, which were largely offset by SaaS platform efficiency.
Operating expenses in the fourth quarter totaled $109.2 million. As a result, fourth quarter operating income was $27.2 million or an operating margin of 17.7%. This compares to operating income of $26 million or an operating margin of 18.2% in the same period last year. During the quarter, as compared to the same quarter last year, we had approximately a 10% headwind to all operating margin as a result of having increased SaaS sales in our bookings mix, which are recognized fully ratable versus the upfront recognition of our on-prem subscription products. Fourth quarter ARR contribution margin was 13.4%, up from 4.5% last year. The significant leverage improvement even during the early stages of the transition, reflects our ability to drive strong incremental margin while growing ARR and transitioning to SaaS.
During the quarter, we had financial income of approximately $8.1 million, driven primarily by interest income on our cash, deposits and investments in marketable securities. Net income for the fourth quarter of 2023 was $34.3 million or $0.27 per diluted share compared to net income of $26.1 million or net income of $0.21 per diluted share for the fourth quarter of 2022. This is based on $126.1 million and $126 million diluted shares outstanding for Q4 2023 and Q4 2022, respectively. As of December 31st, 2023, we had $744.8 million in cash, cash equivalents, short-term deposits and marketable securities. For the 12 months ended December 31st, 2023, we generated $59.4 million of cash from operations compared to $11.9 million generated in the same period last year and CapEx was $5.1 million compared to $11.4 million last year.
I will now briefly recap our full year 2023 results. Total revenues grew 5% to $499.2 million. In 2023, as compared to 2022, we had approximately a 12% headwind to our year-over-year revenue growth rate as a result of having increased SaaS sales in our booking mix, which are recognized ratably versus the upfront recognition of our on-prem subscription products. Our full year operating margin was 5.8% compared to 6.2% for 2022. In 2023, as compared to 2022, we had approximately a 10% 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. Turning now to our 2024 guidance. We continue to take a responsible approach to our guidance philosophy, which includes factoring in the continuation of long deal cycles and multiple layers of deal scrutiny throughout 2024.
Our commitment to balancing top line growth, margin leverage and cash flow generation has not changed. While at the same time, we also see an opportunity to invest in order to capture the longer-term opportunity that we see and capitalize on the secular tailwinds that Yaki discussed. These investments are already baked into our guidance, which shows our ability to invest in the business while generating improvements in our North Star metric. When we launched this transition, we committed to being transparent and also to providing metrics that accurately measure the health of the business. As we turn our attention towards the final phase of this transition, our main focus is now completing this transition, which means SaaS is 70% to 90% of total ARR.
In an effort to provide metrics that help you monitor our progress throughout the next phase, we will be providing SaaS revenue and also SaaS as a percentage of total ARR on a quarterly basis. At the same time, this will be the final time that we provide SaaS mix as that metric measures the progress of Phase 1 of the transition. Going forward, we expect the vast majority of new customers to purchase our SaaS offering. For the first quarter of 2024, we expect total revenues of $111 million to $115 million, representing growth of 3% to 7%. Non-GAAP operating loss of negative $15 million to negative $13 million and non-GAAP net loss per basic and diluted share in the range of negative $0.10 to negative $0.09. This assumes 110.1 million basic and diluted shares outstanding.
For the full year 2024, we expect ARR of $617 million to $625 million, representing growth of 14% to 15%. Free cash flow of $70 million to $75 million. Total Revenue of $536 million to $546 million, representing growth of 7% to 9%. Non-GAAP operating income of $7.5 million to $12.5 million. Non-GAAP net income per diluted share in the range of $0.11 to $0.13. This assumes 127.7 million diluted shares outstanding. In summary, we are excited by the progress of our SaaS transition, which is benefiting our three North Star metrics. ARR, free cash flow, and ARR contribution margin. The momentum of our transition, coupled with the tailwinds of MDDR, the adoption of generative AI and increased data-centric regulation gives us the confidence as we finish the initial stage of the transition and look to grow new customers and convert existing ones to our SaaS platform in 2024 and beyond.
With that, we will be happy to take questions. Operator?
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