Earnings Call Transcript - ALLT Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Allot third quarter 2020 results conference call. All participants are in listen-only mode. Following management's formal presentation, instructions will be given for the question and answer session. As a reminder, this conference is being recorded. You should have received the company's press release. If you have not received it, please contact Allot's investor relations team at G.K Investor and Public Relations. I would now like to hand over the call to Mr. Ken Green of Investor Relations. Mr. Green, would you like to begin, please?

Kenny Green, Investor Relations

Thank you, operator. Welcome to the third quarter 2020 conference call. I would like to welcome all of you to this conference call and thank all of the management for hosting this call. With us on the line today, Mr. Ehud Helft, President and CEO and Mr. Ziv Leitman, CFO. I will begin and summarize the key highlights followed by a review of Allot's financial performance for the quarter, and then we will open the call for the question and answer session. Before we start, I'd like to point out that this conference call may contain projections or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions, and I cannot guarantee that they will, in fact, occur. Allot does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including as a result of the impact due to the COVID-19 pandemic, changing market trends, reduced demand, and the competitive nature of the security systems industry, as well as other risks identified in documents filed by the company with the Securities and Exchange Commission. And with that, I would like to hand over to Ehud. Please go ahead. Thank you, Kenny.

Erez Antebi, President and CEO

I'd like to welcome all of you to our conference call and thank you for joining us today. Our third quarter was another quarter of solid growth. Revenues grew 26 percent year over year for the third quarter and reached $34.8 million. This is our 11th straight quarter of double-digit revenue growth year over year, and I am very pleased with the results we achieved during the third quarter. I believe it shows we are on track and successfully executing on our plan. The number of opportunities we see continues to grow. We continue to close new deals, win against competition, bring in more business and grow our revenues. Our revenue growth in 2020 accelerated compared to our revenue growth rate in 2019, and we expect this to continue in the fourth quarter as well. As we see our opportunities grow, we increased our investments to capitalize on the significant number of opportunities that we see. Ziv will provide more details on our financials and forecast later. To allow better focus and faster response to market needs, we recently implemented an internal organizational change. Instead of having a single R&D group for all products and a single product management group for all products, we created two new product business groups, one for Allot Secure products and one for Allot Smart products. Each product business group will have its own R&D and its own product management. Sales and customer success will continue to be global and serve all product lines as today to lead the Allot Secure business group. We are joined by Ya'el, a cyber and data science expert. Among her previous roles, Ya'el was VP Security at Cisco and General Manager and CTO of RSA Israel and holds a Ph.D. in mathematics and statistics. Karen Romanenko, who served very successfully in the past couple of years as our Senior VP for Customer Success, will now lead the Smart Business Group. I believe this change, together with the new leadership, will create a stronger vision forward and will accelerate both product line success. I would like to take the opportunity to wish both Ya'el and Karen lots of success in their new roles. Like most others, our way of working has been significantly affected by the COVID-19 pandemic. I would like to update you on how we and our customers are adapting to the new situation. Most of our employees worldwide are continuing to work from home, while the numbers change from country to country as rules and conditions differ. In Israel, for example, approximately 25 percent of employees work from the office, and the rest work from home. Meetings, even for those in the office, are mostly held by videoconference to minimize physical contact. We continue to see high productivity across all departments. During the third quarter, R&D released several product releases in both Allot Smart and Allot Secure product lines. They were released on time with the required content and quality. Our Customer Success Group continues to deliver, install, and pass acceptance on new installations many times without being physically on site. Our global service organization is continuing to solve problems and lower the number of open customer trouble tickets. These achievements to sell, deliver, and service, according to plan, are a result of the spirit and dedication of all Allot employees worldwide. I want to take this opportunity to thank them for all their efforts and fantastic work. As I mentioned in the previous call, we do see that the current situation of working from home and lack of physical interaction is stressful for many of our employees. In an attempt to help, we maintain a policy where we fully adhere to all local rules and regulations but allow our employees the personal freedom of choice whether or not to come to the office where and when this is allowed. I would now like to turn our attention to our interactions with our customers worldwide and share with you a few broad observations. ISPs are continuing to provide services to their customers, even though many of their employees are working from home. Overall, operators are adjusting well to the situation and, for the most part, have managed to handle the changes in traffic patterns. These changes have, for the most part, stabilized. Most operators are continuing not only with their regular business, but with new projects as well, while delays in processes and decisions continue. We do see accelerated efforts by chief information officers to get back to business as usual despite not physically returning to their offices. Overall, I think demand, depending on the product, has either remained as it was or grown. I believe to a very large degree, we are all adjusting well to virtual meetings, replacing physical meetings and saving much travel time and expense in the process. We are, however, losing some of the informal relationship building that is important to establishing long-term trust. So far, the impact of this on the business is limited. As we discussed in the previous earnings call, the more challenging part is establishing new relationships and generating new leads with operators and people we are not familiar with. To this end, we modified our sales approach to increase lead generation by using targeted marketing campaigns. We started this with a security services campaign. As a result of this approach, our outlook is promising, as we have generated quite a few new leads interested in promoting security services to their customers. I will now briefly address each of the different market segments we are active in and provide a bit more granular color on what we see in the market. Allot Smart Traffic Management is used to provide operators visibility on their networks and manage their traffic. We are seeing growing interest from CSPs to gain better visibility on the network, as well as manage traffic surges and congestion on both mobile and fixed networks. I believe Allot Smart is well designed to address these needs, giving us an advantage. Many 4G and fixed networks already have a DPI system either from us or a competitor. Usually, stickiness with the DPI product is high, and operators do not tend to replace their current provider easily. During the third quarter, however, we were selected by a large tier one operator to replace our competitor's system. We are currently involved in several processes with other operators considering doing the same. While we cannot be assured of success in these processes, we view them as encouraging opportunities. In addition, there are also new RFPs for DPI systems from operators that do not have such systems in place. As I mentioned in the last earnings call, we are seeing a growing need for governments to protect their citizens from malicious or illegal activity. As a result, we are seeing growth in the number of opportunities for our digital enforcement use case. The growth we see in this use case worldwide is encouraging, and we are building a growing pipeline. In the enterprise market, larger enterprises, which are the focus of our business, seem to be less affected by the COVID-19 pandemic than smaller businesses. While we see some delays in projects, overall, our enterprise business is doing well, and we see it growing. As you may recall, during the first quarter, we signed an agreement with Broadcom to provide Allot products to enterprise customers currently using the packet cheaper product, which Broadcom chose to discontinue. Since signing that agreement, our enterprise pipeline has seen strong double-digit growth as a result. We have signed new distributors that previously worked with a competing product and have closed deals to replace that competitor's product. I am very optimistic about the growth our enterprise business may enjoy as a result of the Broadcom deal. While some deals take longer to materialize and it's a bit more challenging to bring new deals into the pipeline, several of our use cases are showing demand growth. Overall, I think the market demand for the Allot Smart product family is similar to or even larger than pre-COVID-19 demand. To summarize, I believe demand for the Smart product line, including congestion management, traffic management, analytics, regulatory compliance, and enterprise use cases will remain solid for Allot for the remainder of 2020 and in the years ahead. I would now like to turn our attention to the security markets. We continue to see an increase in cyberattacks, most notably phishing attacks on both consumers and small to medium businesses (SMBs). This is giving rise to a growing awareness on behalf of consumers and SMBs of the need for protection. It is also contributing to a growing awareness among operators that they should provide a secure broadband connection. One result of this is that our security business is seeing good traction. During the quarter, we signed an agreement with a major tier one operator in Asia-Pac to provide our home secure products to protect routers and Wi-Fi-connected devices in customers' homes. When deployed, Home Secure will protect millions of homes, making this the largest home secure deployment to date. In addition, since the previous conference call, we have been selected by several operators worldwide throughout Asia-Pac and Latin America to provide them with our security products and launch services to their consumer and SMB customers. We are currently in contract negotiations with these operators and believe we should be able to sign recurring revenue contracts with most of them before the end of the year. Additional operators we previously signed have decided to expand the use of Allot Secure to either additional products in the secure family or expand the service to an additional country in which they operate. Since the previous earnings call, a major telecommunications provider in Portugal and another European operator with whom we previously signed recurring security revenue deals launched the service to the public. While only a short time has passed since launch, the penetration rates we see are very encouraging and consistent with the high penetration rates we see in other security services that were launched. We consistently see that customers are willing to pay a premium of five percent to ten percent over the access charge to get security services, and we see the take-up rates are high. Another European operator who launched the service to customers physically entering stores recently saw the number of customers signing up for the services grow to a majority of those to whom it is offered. Yet another operator, who is offering the service to SMBs, reached over 30 percent penetration in a year, and the penetration is continuing to grow month by month. These numbers are very encouraging and I believe they validate the value security services bring to customers and their willingness to pay for them. We continue to see more projects initiated, and the interest by CSPs to deliver secure broadband connectivity to their customers looks to be growing worldwide. We continue to see new opportunities worldwide, and our pipeline for recurring security revenue deals is expanding, which is encouraging. It is worth noting that we see large growth specifically in the number of opportunities we have to provide security as a service to SMBs. While motivations vary, I think this is a result of operators viewing SMBs as part of the enterprise customers that see both growing cyberattacks and are willing to pay more. While our pipeline is growing nicely, we are seeing some projects getting delayed as operators are more focused on delivering existing services rather than new services. I remind everyone again that working with CSPs takes time, with sales cycles typically exceeding 12 months and the time from signature to launch of the service around nine months. The COVID-19 pandemic may delay some sales cycles by even a few months more and may also delay the launch for some of the deals we already signed. As discussed in the past, Allot is endeavoring to sign security deals under a recurring security revenue deal model. While not all operators will accept this model, we are encouraged to see that more operators are becoming receptive to it. Our goal, therefore, is to build a substantial base of CSPs who accept the recurring security services model, which will allow us to work with them to help a large number of end-users sign up for the security services. These are the type of deals that will ensure the long-term growth and success of Allot. I would like to address briefly 5G networks and where we fit in. An increasing number of operators are moving ahead with their 5G plans and are rolling out 5G services. We expect this trend to continue and we see a very large opportunity for Allot here. 5G networks have significantly higher bandwidth and will have a very large number of IoT devices on them, as well as many breakout points connecting to the Internet. This results in higher vulnerability of the network itself to cyberattacks, as I discussed in our previous call. Allot has a unique position to play in securing the user plane and 5G networks. Our combination of being able to analyze in real-time the full traffic flow, mitigate DOS attacks inline very quickly, and protect the network from rogue IoT devices puts us in a unique position to help operators secure their 5G networks. Allot comes to the 5G world with strong technology products that scale easily to the 5G bandwidth requirements and full multi-tenancy support to enable differentiated services. These abilities are key differentiators for us in future 5G deployments. As I mentioned earlier, we are currently active in several major opportunities, including with several tier one carriers, and some of them we passed initial evaluations successfully and are advancing to commercial discussions. Overall, we view 5G as a potentially significant growth engine for Allot, as we mentioned today. We see significant opportunities in the market across multiple products and use cases. We believe there's a market opportunity here we should take advantage of, given the strong opportunities we see even in the current environment. We remain committed to leveraging our strong cash position to invest for future growth as we work with more Tier one operators worldwide. We are temporarily increasing our R&D investments this year by using subcontractors to help us close product gaps quickly. In 2021, we expect R&D expenses to be lower than those in 2020. I would now like to summarize the overall picture and the key messages. We are proceeding according to our plan and continuing to grow the business, despite seeing delays in several different projects. In the Smart product line, we see a strong pipeline. Some use cases such as digital enforcement, congestion management, and the enterprise business are growing. Overall, we see solid demand for Allot Smart at similar or even higher levels compared to pre-COVID-19. In the security area, we see long-term growth. We are encouraged by the pipeline growth we see and by the consumer and SMB take-up rates as they sign up for the service. We signed a significant deal for our Home Secure product and were selected by several other operators for recurring security revenue deals. While these deals always take time to close, COVID-19 has pushed the closure of several deals a bit more. It is also postponing the commercial launch of some of the deals that were already signed. Overall, the pipeline is robust, and I am confident we will meet our goal for recurring security revenue deals this year. Looking at our backlog, the market demand as we see it now, and the pipeline of deals that we are working on, I would like to reiterate our revenue guidance for 2020 to be between $135 million to $140 million. I would also like to reiterate our guidance for 2020 of new recurring security revenue contracts signed in 2020 to exceed an MLR of $140 million. This will be, of course, in addition to the $85 million MSR deals we signed in 2019. In addition, we expect to be profitable during the last quarter of this year. And now I would like to hand the call over to Ziv Leitman, our CFO.

Ziv Leitman, CFO

Please go ahead. Thank you. Before I begin reviewing the financial results for this quarter, unless otherwise noted, I would refer entirely to the non-GAAP financial measurements when discussing the operational results, which is what we use internally to judge the ongoing performance of our business. The financial differences in respect from the generally accepted accounting principles exclude stock-based compensation expenses, expenses related to M&A activity, amortization of intangible assets, and defensive changes in deferred tax and tax-related items. The revenue for the third quarter of 2020 was $34.8 million, growing by 26 percent compared with those of the third quarter of 2019. I would like to give you some more color regarding the revenue breakdown and diversification. The geographic breakdown for the third quarter was as follows: Americas with $1.9 million, 6 percent of revenues; EMEA $28 million, or 80 percent of revenue; and Asia-Pac was $4.9 million, around 14 percent of revenues. The breakdown between products and services in the third quarter of 2020 versus the comparable quarter last year was as follows: Product revenues were $24.4 million compared to $16.6 million last year. Professional services revenues were $2.9 million compared to $2.4 million last year. Support and maintenance revenues were $7.5 million compared to $8.7 million total last year. The revenues from Communication Service Providers out of the total revenue in the third quarter were 86 percent, compared to 82 percent in the comparable quarter last year. I note that the revenue breakdown may fluctuate from quarter to quarter depending on specific revenues and deals we recognize. In the third quarter, our top 10 customers made up 76 percent of our revenues, compared with 64 percent in the second quarter last year. Gross margin for the quarter was 69 percent compared to 70.2 percent in the second quarter of 2019. I would like to mention the gross margin expected for the fourth quarter is around 70 percent. However, I remind you that the variation reflects the product mix and deal mix sold in that particular quarter and is not indicative of any specific trend. Operating expenses for the quarter were $25 million compared to $21.7 million overall in the third quarter of 2019. In particular, I want to highlight that our expenses increased to $11.3 million, totaling 33 percent of revenues versus $7.5 million, 27 percent of revenues in the fourth quarter last year. The increase is in line with self-torture. If you remember, last quarter we discussed that given the margin opportunities we see in our target market, we had intended to accelerate our development plans and increase our R&D at a faster rate than originally planned at the start of this year. We are fortunate in that our strong cash position, especially in the current market environment, enables us to pursue growth further, enhancing our competitiveness and taking advantage of opportunities. The total number of full-time employees worldwide as of the end of the quarter was 684. This is an increase of 10 full-time employees compared with the end of the previous quarter and an increase of 90 since the end of 2019. The non-GAAP operating loss for the quarter was reduced to $1 million, compared with $2.2 million in the third quarter of 2019. The net loss for the quarter was $1.2 million, or three cents per share, versus $1.9 million, or five cents a share in the first quarter of 2019. For the three months ended September 30, 2020, the weighted average number of basic shares was 35.2 million, an increase of 815,000 compared with the same period last year. The weighted average number of fully diluted shares was 137.5 million. Turning to the balance sheet, our cash reserves comprised of cash, cash equivalents, and investments as of September 30, 2020 was $107.2 million, compared to $109.2 million on June 30, 2020. The restricted cash balance was reduced to only $1.7 million versus $24 million in the previous quarter. The countercyclical cash is due to margin required for foreign currency hedging activities and other collateral inventory. In the third quarter, total inventory was $15.5 million, which is a reduction of $1.7 million from the previous quarter but still $4.9 million above the level as of the end of 2019. This is primarily due to equipment waiting at customer sites for revenue recognition terms to be fulfilled. In terms of guidance, we maintain our full year 2020 revenue guidance to be between $135 million and $140 million. We continue to maintain our expectation to be profitable in the fourth quarter of the year. Finally, our focus remains to close additional recurring security revenue deals while the ongoing pandemic has delayed the closure of some of these deals. We believe that by the end of the year, we will achieve our target of closing a total of at least $140 million, in addition to the $85 million signed in 2019. I know the new deals we've signed do not expect to produce recurring revenues in 2020, but will build a strong foundation for revenue growth in the coming years. Despite a much more challenging environment than when we started the year, we remain pleased with our overall financial performance. That concludes my remarks. We would be happy to take your questions now.

Operator, Operator

Thank you. Ladies and gentlemen, this time we will begin the question and answer session. If you have a question, please press star one. If you wish to cancel your request, please press star two. If you are using speaker equipment, kindly lift the headset before pressing the numbers. Your questions will be pulled in the order they are received. Please stand by while we poll for your questions.

Michelle Waller, Analyst

Thanks. Hi, guys, thanks for taking the question. Quick one for you guys – are expenses declining in 2021? Just wondering if you expect that to be offset by other factors such as travel expenses and whatnot coming back into the model that we may have had taken out due to COVID. Also, can you give us an update on your hedging strategy and how it impacted the quarter?

Erez Antebi, President and CEO

I'll take this first question. We don't yet have a budget for 2021, so honestly, I don't think we can address exactly what the various elements of expenses we expect to have or not have. I believe we'll have that by the end of the year in the next conference call or provide guidance on where we see Twenty twenty one numbers go. But I think that's about all we can say right now.

Ziv Leitman, CFO

Regarding the exchange differences, we didn't have a significant effect on the quarterly results. Each one percent change in the Israeli currency affects our results by less than one million dollars, so it's not a significant risk for the full year.

Michelle Waller, Analyst

Thanks, that's helpful. And as a follow-up, you guys had good traction in announcing deals this past quarter. Can you talk a bit about your pipeline and how that looks with you guys continuing to win new deals, despite some delayed launches? It seems like your pipeline is building strongly as you kind of mentioned in your prepared remarks. Are there any areas where you see headwinds, such as prolonged project launches or areas where you're not seeing as much activity as you expected?

Erez Antebi, President and CEO

I think I try to help to address it during the call. When we look at each market segment separately, we're seeing mostly growing demand across the various segments. Yes, COVID-19 does create some delays in closing and launching deals, but overall, I think the net effect is that we are seeing more business. The pipeline we have today looks very robust, particularly for the security product line, and that's also true for the Allot Smart product line. Overall, we see a very healthy pipeline, and that looks promising.

Michelle Waller, Analyst

That's helpful. And congrats on the quarter again. Thank you.

Eric Martinuzzi, Analyst

Thanks, and congrats on the quarter as well. I see consensus at $39.2 million for Q4. If I back off the nine months from the full year revenue guidance, I would be talking about $38 million to $43 million. Is that correct? Is it $38 million to $43 million?

Erez Antebi, President and CEO

Yes, you subtracted correctly.

Eric Martinuzzi, Analyst

I've got an MBA, so I just want to clarify. When I look at the backlog exiting 2019, you mentioned a $138 million backlog, and that's $70 percent of that would translate into revenue in 2020. Is that still a correct assumption, roughly?

Erez Antebi, President and CEO

Roughly speaking, that's a correct assumption.

Eric Martinuzzi, Analyst

Your expectation of the $140 million mark is winding up with a logjam in Q4 because of COVID. To hit the $140 million mark, we need to sign a bunch of business. Are there transactions maybe that you haven’t announced yet that translate into that $140 million mark?

Erez Antebi, President and CEO

A significant portion of that $140 million should be signed in Q4.

Eric Martinuzzi, Analyst

Will you be able to announce them, or is it due to operators' preferences that you won’t be able to do that?

Erez Antebi, President and CEO

Hopefully, we will announce them. If we face pushback from the customer, we may not be able to announce it. Maybe we will announce it without mentioning the name. Typically, by the beginning of February when we finalize, we will announce the deal. Announcing the deal can be tricky because operators typically prefer to agree to make announcements only when they launch the commercial service for their own reasons. They don't want to notify the market about their plans.

Eric Martinuzzi, Analyst

Yeah, I understand. Lastly, I’d like to dive deeper into the organizational announcement that you opened the call with. You brought on a skilled executive there. What should we be looking for given this bifurcation of R&D into two groups?

Erez Antebi, President and CEO

The rationale behind that is simple. The R&D in the product and the product management were previously somewhat segregated. The product manager for the home secure product is a different person than the product manager for the Allot Smart product. By bringing leadership focusing on each of these groups, they will be positioned to innovate and find the right vision going forward. Therefore, they will be in a better position to create value and advance the products and strategy properly to be more successful in the coming years.

Eric Martinuzzi, Analyst

I appreciate that. Thank you for taking my questions.

Marc Silk, Analyst

Thanks for taking my questions and congratulations on your continued success in your strategy. In the last few calls, you've said that on the recurring revenue model, some customers will accept it while others won't. So the two recent deals you mentioned in Asia-Pac, was that recurring revenue?

Erez Antebi, President and CEO

The latest deal that we announced in Asia-Pac was part of our Home Secure product.

Marc Silk, Analyst

So because the new deal is announced, I'm assuming that it has been launched?

Erez Antebi, President and CEO

Yes, it was launched just recently.

Marc Silk, Analyst

So, besides the changes in the R&D structure, is there anything else that structurally has changed due to COVID-19 that might lead to more efficiency or cost reduction?

Erez Antebi, President and CEO

I don't think structurally much will change as a result of it, at least not that I see right now. I do expect some practices that we learned during COVID will continue with us. I believe we will know how to work better with much less travel. This will enable us to save both time and hopefully expenses. But I don’t see any structural change as such. The way we generate leads has changed; instead of relying on physical meetings, we are now utilizing targeted marketing campaigns for lead generation.

Marc Silk, Analyst

How has that been successful in generating leads or showing support for your customer base?

Erez Antebi, President and CEO

It has been successful, and we've generated quite a few new leads as a result of these campaigns and seminars, connecting companies we hadn’t talked to before.

Marc Silk, Analyst

That's great. I see that you have one tomorrow on the long-term play in 5G. Would that be more of a second-half 2021 story or more of a 2022 story?

Erez Antebi, President and CEO

I think it's starting now, but it's hard to tell if it's going to be first half or second half 2021. It’s definitely starting, and we're really active in this area right now. However, it's going to grow. The projections for 5G and how the number of operators launching over the next year are clear, making this a growing market.

Marc Silk, Analyst

In the past, you've had discussions with U.S. telcos. Are you in talks about a recurring revenue model with any of these companies?

Erez Antebi, President and CEO

We are in talks with U.S. telcos about the recurring revenue model, but at this stage, I can't say much further on that.

Marc Silk, Analyst

Finally, you mentioned in your press release that management continues to expect to close additional recurring security revenue deals in 2020. Are you optimistic it will be more than two or greater than three?

Erez Antebi, President and CEO

I'm always looking to have one more deal than whatever we've closed, so yes, I'm optimistic.

Marc Silk, Analyst

Your stock is down 25 percent since your last conference call even though your guidance has stayed the same. Management and the board should know that it would really boost the stock if they showed some confidence, and it would be good for you to buy some shares to demonstrate that confidence.

Erez Antebi, President and CEO

Thank you, Marc.

Operator, Operator

If there are any additional questions, please press star one. If you wish to cancel your request, please press star two. Please stand by while we poll for more questions. There are no further questions at this time. Mr. Erez Antebi, would you like to make your concluding statement?

Erez Antebi, President and CEO

Yes, thank you. On behalf of Allot and the management team, I'd like to thank you for your interest and long-term support in our business. We are currently not traveling, as you can imagine, but we will be holding virtual meetings with investors. We will be presenting at Needham on November 17 and at the ideas conference on November 18. Beyond that, of course, we are open to speaking with investors until the end of the quarter. If you want to speak with us, please be in touch with our investor relations team. I look forward to talking to you next quarter. Thank you very much for joining us today. Have a great day and stay healthy.

Operator, Operator

This concludes the Allot third quarter 2020 results conference call. Thank you for your participation. You may go ahead and disconnect.