Earnings Call Transcript - ATEN Q1 2023

Operator, Operator

Hello and welcome to the A10 Networks’ First Quarter 2023 Financial Results Conference Call. My name is Alex, and I will be your moderator for today. I would now hand over to Tom Alan of FNK IR. Please go ahead.

Tom Alan, Company Representative

Thank you. Thank you all for joining us today. This call is being recorded and webcast 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, A10 Networks' President and CEO; and CFO, Brian Becker. 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 2023 financial results. Additionally, A10 published a presentation and supplemental trended financial statements. You may access the press release, presentation, and trended 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 projections for future operating results, such as our potential revenue growth, industry and customer trends, our capital allocation strategy, supply chain constraints and expectations, our positioning, our repurchase and dividend programs, and our markets. These statements are based on current expectations and beliefs as of today, May 4, 2023. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, such as the potential impact of the COVID-19 pandemic on our business and operations that could cause actual results to differ materially, and you should not rely on them as predictions of future events. A10 does not intend to update the 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-Q. Please note that with the exception of revenue, financial measures discussed 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 may differ from non-GAAP financial measures presented by other companies. A reconciliation between GAAP and non-GAAP measures can be found in the press release issued today and on the trended quarterly financial statements posted on the company's website. Now I would like to turn the call over to Dhrupad Trivedi, President and CEO of A10 Networks.

Dhrupad Trivedi, CEO

Thank you, Tom, and thank you all for joining us today. Our first quarter results were in line with the estimates we shared on April 3. While revenue was impacted by the economy and slowing purchasing decisions, the team moved quickly to respond to these changes, and we maintained our profitability at historical levels, better positioning us to achieve our full-year targets for non-GAAP EPS. This was due in large part to the focus on driving a more resilient and durable business model. As previously communicated, we believe the first quarter will represent a floor for our results this year, and we expect sequential improvements as we move through the balance of 2023. While large enterprises, especially Tier 1 service providers, are more carefully considering investments due to the economy, security solutions remain a priority and are increasingly not a discretionary consideration. Companies around the world, even those with robust security processes and controls, are experiencing an ever-growing threat of cyber attack. During the first quarter, we further augmented our already robust security infrastructure to enable us to better support our customers against these threats. Cyber attacks are simply a business reality for even the most prepared organizations, and deploying solutions to mitigate this risk and the associated disruptions they cause is a priority even during challenging times. Like others, we are seeing longer sales cycles, particularly among larger North American customers due to concerns about the economy. We do not believe we have lost any meaningful forecasted deals to competitors, but they are taking longer to close, impacting our normal revenue cadence. Indeed, North America declined 9% in the first quarter compared to last year, and revenue in the rest of the world was down 7% year-over-year. Effectively, all of this revenue decline was due to Tier 1 customers who postponed buying in the quarter with expectations of resumption in the second half of the year. Our diversification, both in terms of geography and customers, helped us mitigate the macro environment as we believe we are navigating the economy better than most, but we were not immune from the conditions. Proactively, we have taken steps to align our cost structure. We deployed select austerity measures to reduce operating expenses by 10.3% year-over-year in Q1 in light of these macro headwinds. I want to note that we were mindful of our long-term goals, particularly related to growth as we reviewed our near-term spending. Over the long term, I don't believe this effort will materially impact our business trajectory or our ability to achieve multiyear targets as market conditions normalize. In reality, our ability to maintain solid profitability and cash generation even during a quarter with significant revenue challenges speaks to the durability of our business model and execution. As a result, we maintained our gross margins in excess of 80% and significantly expanded our adjusted EBITDA margin to 26.8%, versus 21.6% in last year's first quarter. This is in line with our business model goals of achieving 26% to 28% EBITDA and 80% gross margin. As we have previously communicated, our ability to proactively manage investments and certain expenses enables us to maintain robust profitability even when revenues are under external pressure. We have continued to methodically plan these actions, including supply chain, sales and marketing investments, and selected strategic investments in R&D. In an effort to improve the security and resiliency of our hybrid cloud offering, we recently announced a strategic partnership with Fastly, an industry leader in next-generation web application firewall. By combining our leading ADC solution with their next-generation WAF, this first-to-market integrated solution can provide our large enterprise customers a single solution to enhance web defenses across software and hardware appliances within their hybrid cloud environment. We believe this partnership strengthens our portfolio and unlocks further diversification of our revenue stream. Additionally, our collaboration should broaden our go-to-market strategy for this type of solution as we leverage the reach and capability of both A10 and Fastly teams. Moreover, in Q1 and in line with these diversification efforts, a large partner in Japan introduced A10's cloud access controller into their security operations center service package. A10 Networks' cloud access proxy is a complete enterprise solution designed specifically to help organizations optimize the performance and security of their SaaS applications, enhance user experience, and provide comprehensive visibility into branch offices and the cloud. With a partner enabling this as a service, it is further proof that we continue to invest in comprehensive security solutions delivered through multiple form factors for our customers. In the first quarter, our revenue was negatively impacted by the combination of macroeconomic headwinds and internal company priorities to strengthen our security posture. However, our business model and focus on execution enabled us to preserve our profitability. We are confident that we will show improvement as we move through the year, and we continue to expect full-year EPS expansion. We also continue to maintain a disciplined, flexible, and opportunistic capital allocation strategy. Today, our Board approved a quarterly dividend of $0.06 per share. With that, I'd like to turn the call over to Brian for a detailed review of the quarter.

Brian Becker, CFO

Thank you, Dhrupad. First quarter revenue was $57.7 million, a decrease of 7.9% year-over-year, reflecting the headwinds Dhrupad described earlier. Product revenue for the quarter was $31.2 million, representing 54% of total revenue. Services revenue, which includes maintenance and support revenue, was $26.5 million or 46% of total revenue. Moving to revenue from a geographic standpoint, revenue from the Americas was $30 million, down 9.1%. As Dhrupad described, this reflects slowing purchasing from larger customers, primarily service providers due to economic concerns. As you can see on our balance sheet, our deferred revenue was $128.5 million as of March 31, 2023, up 5.9% year-over-year. On a constant currency basis, deferred revenue would have increased 8.3% year-over-year. 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 for the first quarter was 83.1%. This reflects strong execution overcoming input cost pressures and is due to our product mix. We expect our revenue mix to normalize in future quarters. We reported $13.4 million in non-GAAP operating income, up 14.3% compared with $11.7 million in the year-ago quarter. Adjusted EBITDA was $15.5 million for the quarter, reflecting 26.8% of revenue. We were able to achieve our targeted adjusted EBITDA margins even as revenue declined by nearly 8%. Non-GAAP net income for the quarter was $9.9 million or $0.13 per share, which is relatively flat compared to $10 million or $0.13 per share in the year-ago quarter. Maintaining our non-GAAP net income on 8% lower revenue is a significant accomplishment, demonstrating the earnings power we have built into the business. Diluted weighted shares used for computing non-GAAP EPS for the first quarter were approximately 75.5 million shares compared to 79.3 million shares in the year-ago quarter. On a GAAP basis, net income for the quarter was $4 million or $0.05 per share compared with net income of $6.3 million or $0.08 per share in the year-ago quarter. Turning to the balance sheet, as of March 31, 2023, we had $144.5 million in total cash and marketable securities compared to $150.9 million at the end of 2022. During the quarter, we paid $4.4 million in cash dividends, and we continue to carry no debt. As Dhrupad mentioned, the Board approved a quarterly cash dividend of $0.06 per share to be paid on June 1, 2023, to shareholders of record on May 15, 2023. As Dhrupad indicated, we believe the first quarter represents the floor for our financial results, and we anticipate sequential improvements throughout the year. I'll now turn the call back over to Dhrupad for closing comments.

Dhrupad Trivedi, CEO

Thank you, Brian. There is no doubt this was a challenging start to the year, but our team responded effectively, delivering strong execution and solid profitability despite revenue headwinds. Our security-led solutions are in demand across all customer segments and in each of our target geographies, and our solutions are aligned with durable secular catalysts. Operator, you can now open the call up for questions.

Operator, Operator

Our first question for today comes from Christian Schwab of Craig-Hallum. Christian?

Christian Schwab, Analyst

Great. So as we think about sequential revenue growth from here through the rest of the year, would you expect that to be kind of a linear event? Or how should we think about that?

Dhrupad Trivedi, CEO

Yes. I think I'll let Brian add context to that. So as we noted in the last call, our normal seasonality is being impacted certainly by the economy. I think our results for this year from the first half to the second half are likely to be more back-end loaded. We certainly see that reflecting some of the orders scheduled for at least in the second half, if not earlier. I would say we expect sequential improvements into Q3 and beyond, probably sequential improvements that are in line or slightly better than historic seasonality.

Christian Schwab, Analyst

I don't know, Brian, anything to add?

Brian Becker, CFO

Yes. I think we've talked about 2021 as a similar pattern where the pandemic was challenging revenue growth in the first half of the year. Last year, we saw a 45% mix first half to second half in terms of how much revenue was recognized from first half to second half. We believe this year will be a similar pattern to what we saw in '21 with a little bit of a slow start. But as Dhrupad mentioned, we haven't seen any meaningful cancellations or pullbacks. So we think it will be a sequential growth quarter.

Christian Schwab, Analyst

Okay, great. And then some of the things that you mentioned and highlighted partnerships, Fastly and a large partnership in Japan. Is that directionally helpful? Or is that material revenue that could come this year?

Dhrupad Trivedi, CEO

Yes, good question, Christian. I would think of it in two different ways. One is, obviously, we continue to maintain and invest in differentiating solutions for large service providers around the world. But at the same time, as we see more uncertainty or pause in their spending related to economy, we are also accelerating our efforts to be more relevant to large enterprise customers. That's an example of where we are partnering, and we have a compelling value proposition. The typical sales cycle could be a 6-month kind of timeframe in enterprise or large enterprise sales. We are certainly in the mode of building the pipeline, which makes us optimistic to call that out as a meaningful partnership, that gives us more durability and broadening of revenue but in line with our differentiation. The example related to Japan highlights our progress in terms of supporting customers in hybrid environments, and we are able to deliver cloud-leading applications as well. So that's a diversification in terms of gaining more customers and partners, and we expect that to be more relevant for pipeline generation in the near term but certainly not irrelevant on revenue either for the year.

Christian Schwab, Analyst

Okay, great. And then just one last question. The tight controls on operating expenses, should we anticipate that operating expenses will grow with revenue on a sequential basis? How should we be thinking about either operating expenses to revenue growth on a sequential basis going up? Or do you have a level of operating expenses you're targeting this year?

Dhrupad Trivedi, CEO

Yes. There are two reasons. One is, with our shortfall in revenue, there's a natural reduction in commission expenses and partner costs and other things on the sales and marketing side. Second is, we are adjusting discretionary spending to be in line with revenue and pipeline potential versus just spreading it equally. The third is, the decisions we are making about our investments in product are more driven by ensuring we protect our long-term growth and security portfolio and hybrid solutions. We are doing this in a way that we think flexes, and our business model philosophy—when revenue grows a certain percentage, our OpEx growth is lower than that. Unfortunately, when revenue drops a certain percent, our OpEx is lower too. That said, we still focus on delivering 80% gross margin, 26% to 28% EBITDA, and flexing our cost structure with those kind of business model goals.

Christian Schwab, Analyst

Great. Perfect.

Operator, Operator

Our next question comes from Gray Powell of BTIG.

Gray Powell, Analyst

Okay, great. Just a couple on my side—can you maybe talk about the linearity you saw throughout Q1? And did you see any material improvement in activity over the course of April? Any deals that slipped from March into April that have since closed?

Dhrupad Trivedi, CEO

Yes, good question. In terms of linearity in Q1, we saw probably a slower January than expected, and probably by March, things came more in line with what we would expect. As we exited the quarter, from a linearity order rate perspective, things were better than at the beginning of the quarter. I wouldn't suggest everything is completely normal, but we saw that trend. As we have gone through this quarter, we have been in line with what we expect and not seeing a worsening versus that expectation, so we'll continue to monitor it as the quarter goes on.

Gray Powell, Analyst

Okay, really helpful. And then just high level, if we were to take a blended average across your primary target markets, what do you think the growth is this year? And how should it shake out once things normalize?

Dhrupad Trivedi, CEO

I think, Gray, just to be clear, you are asking relative to our infrastructure market and cybersecurity markets or geographically? Certainly, we are seeing now that our security-driven portfolio continues to be the lead for conversations, and that is where we are seeing some adjustment in top budgets but much more resilient than the rest of the portfolio. On the infrastructure side, projects that tie to customer revenue generation are moving along, slightly slower and with more scrutiny around them but still moving. The most affected category negatively relates to new projects to replace infrastructure and nice-to-have projects. Then when I look at growth rates near term and long term, I think on the security portfolio, we still expect low single digits or better annual growth. On the infrastructure side, the first half looks challenging, but we have projects lined up for the second half. North American infrastructure sees the most impact, while our projects in EMEA and Asia are less impacted by that. We expect to resume to mid-single-digit or better growth on that side in the second half. Yes, and just one last thing to add. Obviously, if you look at those as market growth rates, but expect to do a little better with commercial execution, slightly above those rates.

Operator, Operator

Our next question comes from Hamed Khorsand from BWS Financial.

Hamed Khorsand, Analyst

Could you just be a little bit more specific as to your cost levers that you pulled in the quarter? And why is it that you waited until revenue is starting to slow to pull those levers instead of in a good environment?

Dhrupad Trivedi, CEO

Good question, Hamed. Over the last 12 quarters, we have improved EBITDA continuously. It's not a matter of not. The way to think about it is we are responding to a changing market. A year ago, our spending profile was linked to a market environment supporting a certain growth rate. We flexed our spending to grow slower than that while helping to support that growth rate. When faced with a change in market and customer spending, it is responsible for us to respond to maintain our commitments on profitability. The nature of reductions was due to less revenue, which saves us on commissions, rebates, and partner costs. Discretionary spending was deferred to outer quarters when it aligns with projected growth. On the R&D side, we are focused on our portfolio. I fully expect that as revenue improves, we will continue investing in those priorities.

Hamed Khorsand, Analyst

Okay. And then has the average sales or request for decline in the quarter?

Dhrupad Trivedi, CEO

If anything, it's improved. I mean that in our margins, but it's not a meaningful improvement. We're not seeing pressure in competitive situations, just delays. The size of the spend is stable; customers are still spending the same amount, just taking longer.

Hamed Khorsand, Analyst

Okay. And as for your commentary about sequential improvement, what gives you the confidence that you could see that further into Q3 and Q4 given the hiccup in January?

Dhrupad Trivedi, CEO

That's a good question. If you connect back, our sales cycle is usually 6 to 8 months, typically on the longer side for bigger deals. When we look at our customer mix and pipeline planned for Q3 and Q4, we have higher confidence that is based on a broad set of customers and solutions, not driven by one region or product. Our continued diversification and more security-led sales add to our confidence. Many wins could be in EMEA, Asia, or Japan as well.

Operator, Operator

Our next question comes from Ana Odometer; your line is now open. Please go ahead.

Stefan Gianni, Analyst

Can you go over customer sentiment change over the past couple of weeks?

Dhrupad Trivedi, CEO

Yes, customer sentiment behavior over the last weeks has shifted. We've seen a little more clarity around budget cycles. In Q1, we experienced difficulty in observing visibility into customers' budgeting cycles due to delays in their processes. We are now observing better clarity and visibility. We think the pipeline is shaping up nicely to deliver on our internal plans in the next few quarters. That's the biggest shift we've seen this quarter.

Brian Becker, CFO

A good point to add is that typically, we would have had clarity in January or February, but with many customers undergoing size reductions and other events, those were pushed out, leading to the absence of clarity at the normal time. We are witnessing a bit more of that now.

Stefan Gianni, Analyst

Can you speak about your capital allocation priorities?

Dhrupad Trivedi, CEO

Certainly. Our priorities remain unchanged. We continue to fund organic growth first and foremost. We aim to ensure that we meet the growth targets outlined in our Investor Day presentation from February 2022. That said, 2023 is shaping up a bit differently. Investing in organic growth is our first priority. The second is returning value to shareholders and employees through repurchases and dividends, and the Board approved another $0.06 dividend for this quarter. Lastly, we always remain opportunistic about our cash on hand.

Stefan Gianni, Analyst

Thank you.

Operator, Operator

At this time, we have no further questions. I’ll hand back to Dhrupad Trivedi for any further remarks.

Dhrupad Trivedi, CEO

Thank you, and thank you to all of our shareholders for joining us today and for your ongoing support. Thanks.

Operator, Operator

Thank you for joining today's call. You may now disconnect your lines.