A10 Networks, Inc. Q1 FY2022 Earnings Call

Good afternoon, and thank you for attending today's A10 Networks Q1 2022 Earnings Call. My name is Sam, and I will be the moderator for today's call. At this time, I'd like to turn the call over to our host, Rob Fink, of FNK IR. Rob, please proceed.

Thank you, operator, and thank you all for joining us today. This call is being recorded and webcasted live and may be accessed for at least 90 days via the A10 Networks website at a10networks.com. Hosting the call today are Dhrupad Trivedi, President and CEO; and Brian Becker, CFO. Before we begin, I would like to remind you that shortly after the market closed today, A10 Networks issued a press release announcing its first quarter 2022 financial results. Additionally, A10 published a presentation and supplemental trended financial statements. You may access the press release, presentation and the financial statements on the Investor Relations section of the company's website. During the course of today's call, management will make forward-looking statements, including statements regarding its projections for future operating results, including potential revenue growth, industry and customer trends, and its focus and investment in go-to-market strategy and infrastructure, our capital allocation strategy, M&A opportunities, supply chain constraints and expectations and positioning, and repurchases and dividend programs and its market share. These statements are based on current expectations and beliefs as of today, May 3, 2022. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond the company's control, such as the potential impact of the COVID-19 pandemic on its business and operations that could cause actual results to differ materially, and you should not rely on them as predictions of future results. A10 does not intend to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. For a more detailed description of these risks and uncertainties, please refer to our most recent 10-K. Please note that with the exception of revenue, financial measures today are on a non-GAAP basis and have been adjusted to exclude certain charges. The non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP and that may be different from non-GAAP financial measures presented by other companies. A reconciliation from GAAP and non-GAAP measures can be found in the press release that was issued today and on the trended quarterly financial statements posted on the company's website. With all that said, I'd like to turn the call over to Dhrupad. Dhrupad, the call is yours.

Thank you, Rob, and thank you all for joining us today. Driven by continued adoption of our security-led solutions, revenue increased more than 14% year-over-year, positioning us to deliver revenue growth at the high end of our full year guidance range. As expected, we continue to see leverage in our business model with improvement in gross margin, operating income and earnings per share. We generated $15.5 million to $15.9 million in cash from operations, ending the quarter with $164.7 million in cash and cash equivalents after repurchasing $28.3 million in stock and returning $3.9 million in cash to shareholders in the form of a dividend during the quarter. As discussed at our recent Analyst Day, we have developed a sustainable business model, and our goal is to achieve the Rule of 40, meaning a combined revenue growth and EBITDA margin of 40% or greater, in line with highly valued cybersecurity companies. The first quarter results continue to build the foundation and demonstrate that our model is working in spite of multiple macro headwinds. Security-led solutions continue to serve as a durable secular catalyst for our growth. We have built security into every facet of our business, helping differentiate our technology solutions with a focus on customer-centric innovation that delivers business value for our clients. We continue to see high-profile cybersecurity incidents, including recent ransomware situations impacting large technology organizations here in the States, as well as the several state-sponsored cyberattacks taking place around the world, including Ukraine. Headlines about cybersecurity intrusion seem to be a weekly, if not a daily occurrence with attacks moving beyond isolated incidents involving small groups or individuals through state-sponsored sophisticated and large scale, targeting key infrastructure, government agencies and utility companies alike. As a result, CIOs and IT leaders are increasingly focused on security first. Our ability to integrate security and encryption capability into all of our networking solutions sets us apart. A10 has differentiated itself as a leader in security-led infrastructure solutions, including the Zero Trust architecture with superior networking performance and best-in-class cybersecurity protection. As a result, we are winning in our target markets and applications. Our global customers also continue to expand their global IT networks in an effort to handle more traffic and data. A10's product suite allows our customers to increase traffic capacity and throughput without sacrificing security. In fact, we build DDoS recognition and mitigation capabilities as well as malware protection and privacy safeguards into nearly all our networking offerings, enabling our customers to improve their resiliency, while expanding their networks. Let me highlight some key areas of progress within our business. Security-led product revenue increased 20.1% year-over-year in the quarter with North America being the leading driver of this growth. From a geographical perspective, revenue from the Americas grew 25.5% year-over-year to $33 million, reflecting our investment in commercial initiatives in the Americas. EMEA revenue increased year-over-year from $8.6 million to $11.9 million. Asia, including Japan, declined from $20 million to $17.8 million. This is a consequence of the continued depressed economic outlook in those countries and the lingering impact of COVID-19. Within APJ, Japan went from $13.6 million to $11.5 million in Q1 2022, inclusive of a significant foreign exchange headwind and in line with our expectations. Our diversification continues to provide a resilient foundation. We continue to focus our investment in growth opportunities with balanced profitability and a focus on achieving our stated Rule of 40. A key part of this strategy is improving our ability to cross-sell solutions to our customers while continuing to reduce overall CAPEX and OPEX. Over the past year, our product revenue growth rate with existing customers has consistently exceeded our target growth rate, demonstrating our ability to successfully leverage our strong installed base and bolster our confidence in delivering 10% to 12% consolidated growth. We have proven our ability to grow, invest for future growth, return capital to shareholders, and bolster our fortress balance sheet. We will maintain a disciplined, flexible and opportunistic capital allocation strategy, exploring all options while demonstrating rigor in evaluating potential uses of shareholder capital. As I'm sure you are all aware, supply chain issues continue throughout our industry. A10 has been able to successfully navigate these issues to date. Our customers are looking for supply assurance, and we have been able to meet those requirements so far. A10 is well-positioned in a growing market, and this is proven by our strong financial performance. Cybersecurity remains the primary catalyst for our growth. We are now well positioned to achieve the high end of our full year target around top line growth of 10% to 12% and expanding EBITDA in the range of 26% to 28%. With that, I'd like to turn the call over to Brian for a detailed review of the quarter.

Thank you, Dhrupad. As Dhrupad mentioned, revenue in the first quarter was $62.7 million, up 14.3% year-over-year. Product revenue, which is a lead indicator for future revenues, was $37 million, representing 59.1% of total revenue, up 21.3% year-over-year. Services revenue, which includes maintenance and support revenue, was $25.6 million or 40.9% of total revenue. Moving to our revenue from a geographic standpoint, revenue from the Americas, including Latin America, was $33 million, which was up 25.5%. Revenue from EMEA was $11.9 million compared to $8.6 million last year. Revenue from Asia, including Japan, was $17.8 million, down 10.8% compared to $20 million in the first quarter last year. This is inclusive of the strong headwind from foreign currency exchange rates mentioned by Dhrupad earlier. As you can see on our balance sheet, our deferred revenue was $121.3 million as of March 31, 2022. That's up 7.2% year-over-year. Please note that this is in line with typical seasonality. Recurring revenue, defined as support and subscription revenue, grew 8.9% year-over-year to $27.9 million in the first quarter, which is within our target range of between 45% and 50% of revenue. With the exception of revenue, all of the metrics discussed on this call are on a non-GAAP basis unless otherwise stated. A full reconciliation of GAAP to non-GAAP results is provided in our press release and on our website. Gross margin in the first quarter was 80.2%. As Dhrupad mentioned, thus far, we have been able to successfully mitigate the impact of industry-wide global supply chain constraints and input cost increases. Non-GAAP operating expenses in Q1 were $38.6 million compared to $32.5 million in the first quarter last year, reflecting increasing investment in our growth priorities, including cybersecurity and commercial execution. We reported $11.7 million in non-GAAP operating income compared to $10.8 million in the year ago quarter. Adjusted EBITDA was $13.5 million for the quarter or 21.4% of revenue. Non-GAAP income for the quarter was $10 million or $0.13 on a per share basis. Diluted weighted shares used for computing non-GAAP EPS for the first quarter were approximately 79.3 million shares. On a GAAP basis, net income for the quarter was $6.3 million or $0.08 per share compared with net income of $2.7 million or $0.03 per share in the first quarter last year. For the quarter, we generated $15.9 million of cash from operating activities. We generated $12.8 million of free cash flow for Q1. As a reminder, we define free cash flow as net cash provided by operations, less capital expenditures. Capital expenditures is the purchase of property and equipment. As of March 31, 2022, we had $164.7 million in total cash and cash equivalents, which compares to $161 million in the year ago quarter, growth which includes $32.2 million of share repurchases and dividends during the quarter. We continue to carry no debt. During the quarter, we repurchased 2.1 million shares at an average price of $13.35 per share, totaling $28.3 million. We have $64.6 million remaining in our $100 million share repurchase program. Since January of 2020, we have repurchased 8.7 million shares at an average price of $9.06, totaling $79.1 million. In addition, the Board has approved a quarterly cash dividend of $0.05 per share to be paid on June 1st to shareholders of record on May 16th. In total, we have returned more than $30 million to shareholders in the quarter between share repurchases and the dividend. As Dhrupad mentioned, we are now well positioned to achieve the high end of our full year revenue target of 10% to 12% growth and full year adjusted EBITDA of 26% to 28%. I'll turn the call back over to Dhrupad for closing remarks.

Thank you, Brian. The first quarter represented a strong start to the year for A10. Our position as a trusted partner with security-led solutions is helping us to deliver consistent results and outpace the market. We are well diversified in terms of product mix, regional sales, and customer mix, enabling a more durable business model in spite of macro headwinds. I would also like to thank all employees, customers, and shareholders of A10 for their continued support. Operator, you can now open the call up for questions.

Our first question comes from Christian Schwab of Craig-Hallum Capital. Christian, your line is open.

Great. Thank you. Congratulations once again for another solid report and consistent results here. Can you help us? Almost every company I follow is facing some challenges in the supply chain in one way or another, and you guys have just done a wonderful job of handling the supply chain issues. Can you help us better understand what you saw or what you've done to be able to perform at such a consistent level and then continue to raise expectations?

Yes, thank you, Christian. Let me talk to that a little bit. So of course, if you look at the broader picture, our suppliers, especially on things like silicon, are the same suppliers you hear about, right? Some of the things that I think have helped us mitigate this, I'll walk through some of those examples that hopefully help. About 2 to 2.5 years ago, we started really putting in much more stringent, longer-term planning processes around supply demand, commercial initiatives and operational capabilities, etc., so that we are delivering a mix in line with customer needs that we can deliver. So that was a good foundation for us to start from. The second thing we had to do, as things got harder from an input cost and delivery perspective, was take initiatives around our footprint and simplifying it as well as regionalizing it where it makes sense with our footprint, right, obviously in Japan, the U.K., Taiwan and the U.S. The third thing for us is, as we saw early signs at the beginning of 2020, anticipating what could be the worst-case scenario on non-silicon components, we started developing at least more second sources for some of those components around the world. Lastly, I would say we have been much more deliberate in focusing on what portfolio is most relevant to our customers, simplifying some of our SKUs if we have to, but then putting ourselves in the best position to deliver, right? And so far, it has not obviously impacted our ability to deliver, and we'll continue to monitor it closely and try to find new levers as we need to.

Yes. Congratulations on that. Thanks for that clarity. I guess my last question is, in the current security environment where you guys are outperforming, can you just give us an update on who you're competing against most often? Is it different in different geographies in the Americas versus Japan, for example?

Yes. Good question. So I think, I'll answer your question directly and then give you the context as well. Typically, we are competing with companies that have an installed footprint in the DDoS marketplace. Oftentimes, we run into competitors like Arbor Networks, which is part of Netscout now. Other times, we would be competing with broader solutions, which includes many different elements as well. For our service provider customers, it could be working on a solution where we are competing with someone like Juniper Networks, for example. It does not vary tremendously by geography. It changes a little bit in the sense that in some of the developing nations, you will see local competitors who are purely price-driven. But when we look at the customer set we target, those customers are generally looking for high reliability and resilience, and high level of expertise versus the lowest cost, which may be true for the small to mid-enterprise segment. By virtue of our product positioning and performance, we are typically competing with high-end performers. Those are most often the companies that we would run into. However, it does change the landscape when we also sell products for SSL encryption. We also integrate all those products with our other product platforms, so that creates a different competitive landscape.

Yes, that's great. Congratulations on a solid quarter in this environment and for raising guidance. That's it. Thank you.

Thank you, Christian.

Thank you, Christian. The next question is from Anja Soderstrom of Sidoti. Anja, your line is open.

Hey, thank you for taking my question. Congratulations on the continued great results. I'm just curious about the product gross margin; it's sort of contracted at least sequentially. What drove that? And what can we expect from that going forward?

Yes. I think I'll let Brian comment on it more. Nothing unusual, Anja, to note on that. I think, of course, there is a little bit of variation with the product mix and it's not a lot, it's very low that we see, slightly quarter-to-quarter. As we look at the year-over-year trend, you will see some impact of volume if you look at sequential Q4 to Q1, obviously. But if you look from Q1 to Q1, you can see that trend line. Within that margin, obviously, we are also absorbing or accommodating all the input cost inflation in the market right now, from FedEx to chip suppliers. We think net inclusive of those impacts as well as product mix is kind of where we end up. Brian, anything to add?

Yes, that's exactly right. Our product gross margins are relatively consistent while fluctuating very slightly; it's really just a matter of the mix of products and services that we're selling.

Okay, and then in terms of input cost inflation and I would also assume to some extent, labor, including labor cost, how are you able to mitigate that?

Sure. Yes. I think several things we've been doing are relevant to us. Over the last several quarters, we have continued to simplify the business, continuing to address structural changes that we could make for a better cost structure. We have initiatives in place around PPV and logistics that ultimately have been required to offset input costs. Those have helped us maintain our portfolio and improve margins. On labor and operational cost inflation, we face the same phenomenon, but we focus a lot on delivering productivity that helps us offset some of those inflationary costs. It's not 100%, but that has helped us mitigate those costs across materials, operations, or the people side.

Okay, that was helpful. In terms of, I mean, it looks like the Americas were very strong for you. What are you seeing in Europe given the geopolitical environment here and the increased cyber work going on there?

Yes. So far, as EMEA grew year-over-year. We are seeing two things. We don't have any direct impact from the conflict there, so that's not relevant to us either plus or minus. But one, as people become more conscious of cybersecurity, whether it's a budgeted topic or not, there is increased importance in doing more to protect themselves. We are beginning to see that activity; the typical sales cycle is 6 to 9 months. We expect this to result in more people prioritizing cybersecurity in their budgets. We see a little bit of hesitation because customers are uncertain of the economic outlook and what can happen. However, we observe that the interest and importance of cybersecurity is higher than the uncertainty causing them to be worried right now.

And how sensitive do you think you are to a flat economy and inflation? It seems like you have a pretty critical solution, right?

Yes. You're right. For us, we see cybersecurity as a leading factor, and our products around network build-out and throughput are strong secular trends. Whether inflation is slightly up or down, people are still going to use the Internet and want to be more secure. Additionally, as they see more public incidents, it raises awareness. I think more on the mid-enterprise side you will see caution with interest rates and economic slowdown about initiatives toward digital transformation or more ambitious IT projects, where cybersecurity needs to remain urgent and critical. We definitely see this as a more secular phenomenon right now.

Okay, thank you. That was all for me.

Thank you.

Thank you. The next question is from Hamed Khorsand of BWS. Hamed, your line is open.

So first question was, given that security has about a 6 to 9-month lead time, what is the conversation that starts now? How are you doing promotions? Is it all security-related even for service providers?

Yes, so typically... One of the things in cybersecurity is that for every incident that is public, there are many more incidents that occur that are not public. Companies themselves see different ways they are trying to be attacked and compromised on data. The focus for us is more about having a more secure integrated infrastructure. For a mobile carrier, it would be, 'You have so many subscribers, you now want to have so many more and offer new revenue services. Here is how we can help you do that with your infrastructure and make you more secure.' As they encounter more and more cyberattacks, we work with them to build and deploy something like the Zero Trust framework, which is not only our product but includes elements outside of what we do as well. As a trusted adviser, we help them monitor cybersecurity and publish a lot of threat intelligence that discusses the threats we see and how to mitigate them. Much of this is about being a trusted expert in security while also delivering network infrastructure build-out that allows for lower capex and opex for data management. We usually have three or two clear commercial initiatives focused on what's relevant to our customers and solving their problems.

Okay. Given that there are no COVID restrictions in markets, are you looking to spend more on sales and marketing going forward? Are you looking to attend more conferences and similar activities?

Yes, if you look at it on a trended basis, over the past year we certainly see a resumption of sales and marketing activities, travel, etc. It's not going back to 100% of what it was a few years ago, but maybe 70% to 75%. We can see that reflected in our sales and marketing costs, which now include some discretionary spending that had been halted previously, hopefully focused on lead generation. The only other aspect we have with sales and marketing is on incremental revenue. We'll incur variable sales expenses as we grow. While we gain productivity, we also expect increased revenue to result in higher variable sales compensation, and on a year-over-year basis, travel and entertainment expenses will increase roughly $2 million a year.

Okay, D&A, 10% customers this quarter?

We had one.

And my last question is, are you winning large deals or are they mostly in the smaller range on the sales side?

It's both. If you look at our average deal size, it may be around $100,000, but there are deals that are $20,000 and some that are several million. Many of these deals progress; typically, we will get a first deal that's for one location and then they deploy it and try it out, adding more later. So it's a progression, and even within an existing customer, our first deal will not be the largest, but they will typically continue delivering revenue every year.

Okay. Thank you.

Yes, thank you.

Thank you, Hamed. Next question is from Hendi Susanto of Gabelli. Hendi, your line is open.

Good afternoon, Dhrupad and Brian. Congrats on strong Q1. Dhrupad, some companies talk about longer lead times and stronger order visibility that give higher convictions on their pipeline and continued strength throughout 2022. Can you talk about order visibility and your conviction on the pipeline?

Yes, no problem. For us, as we continue to refine our processes, we typically look at our sales forecasts and our revenue outlook from several viewpoints, one of which is our own 12-month funnel, and understanding the rates at which those translate. Secondly, we look at market lead indicators, not necessarily what happened last quarter and how those lead indicators might affect IT spending on cybersecurity, capex, etc. We also consider other factors like customer maturity and shifts in customer preferences toward security. Lead times are extending from our suppliers; customers are concerned about this. However, our outlook when thinking of Q2 or the full year is not based on specific customer orders but rather on our engagement levels and deal visibility. We track projects individually rather than one large macro basis, and so far compared to one year ago, visibility is slightly better and is definitely improved compared to two years ago.

Thank you, Dhrupad. That's very insightful. You stated that the main growth driver this year is security. Can you break down the growth in security in service providers versus enterprises? And what's the state of application delivery controller outlook? I assume that you're still gaining market shares in that area.

Yes. In our Analyst Day, we talked about three categories: stand-alone ADC, CGN, CFW, or firewall, and DDoS, SSLi. Your observation is correct; for us, stand-alone ADC is not declining, but it is less than the fleet average. The reason it is not declining is because we are continuing to invest and innovate in it with more security-embedded features. If you look at DDoS, SSLi, CFW, all the security-oriented products, those are certainly growing north of the average. I would say we saw growth this quarter in both service provider and enterprise, in security and non-security. However, our enterprise focus is on large enterprise customers who are concerned about critical data availability and security.

Thank you, Dhrupad. Thank you, Brian.

Thanks, Hendi.

Thank you, Hendi. There are no further questions waiting at this time. So I'd like to turn the call back over to Dhrupad for any closing remarks.

Thank you, and thanks to all of our shareholders for joining us today and for your continued ongoing support of A10. Thank you.

That concludes the A10 Networks Q1 2022 Earnings Call. Thank you all for your participation. You may now disconnect your lines.