Earnings Call Transcript - ATEN Q2 2020

Operator, Operator

Good day and welcome to the A10 Networks Second Quarter 2020 Financial Results Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Rob Fink of FNK IR. Please go ahead.

Rob Fink, IR Representative

Thank you, operator, and thank you all for joining us today. This call is being recorded and webcasted live and will be accessible for at least 90 days via A10 Networks website at a10networks.com. Hosting the call today are Dhrupad Trivedi, A10’s President and CEO; and Tom Constantino, 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 second quarter 2020 financial results. Additionally, the company published a presentation and supplemental trended financial statements to its website. You can access the press release, presentation and trended financial statements on the Investor Relations section of the website. During the course of today's call, management will make forward-looking statements, including statements regarding their projections for future operating results, continued reductions in operating expenses; continued efforts to improve operational efficiency; their focus on driving growth, business optimization and overall profitability; their belief that we can continue to build upon customer momentum going forward; and their expectations regarding future opportunities and their ability to execute on those opportunities; their expectations for future market growth and the general growth for its business; the development and performance of their products; and anticipated customer benefits from the use of their products, their expectations and priorities with respect to 5G. These statements are based on current expectations and beliefs as of today, July 28, 2020. 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 COVID-19 pandemic on the business and operations that could cause actual results to differ materially, and you should not rely on them as predictions for future events. A10 does not intend to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise. For more detailed description of the risks and uncertainties please refer to the company's most recent 10-Q and 10-K. 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 be different from non-GAAP financial measures presented by other companies. A reconciliation between GAAP and non-GAAP measures can be found in the company’s press release issued earlier 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.

Dhrupad Trivedi, CEO

Thank you, Rob. And thank you all for joining us today. During the second quarter, we continued to make progress on our business transformation. While the environment remains highly fluid, with sales cycles elongated by the COVID pandemic and business restrictions in different markets, A10 continues to focus on execution and fundamental progress. I want to thank our entire team of employees and partners for their professionalism and flexibility during this unprecedented environment. To date, we have experienced a modest and manageable COVID-related impact on our business, with only a slight impact on our supply chain. Customers are taking longer to make decisions, and some larger deployments have been delayed as our customers deal with business restrictions and challenges related to the pandemic. We do not believe we have lost any business, and we continue to enjoy strong and steady demand for our solutions. In fact, we have delivered increases in both product and service revenue compared to last year despite these COVID-related slowdowns and delays. Overall, our revenue in the second quarter was $52.5 million, up 6.7% year-over-year. From a regional standpoint, our revenue in Japan and Asia has been more impacted than in other areas. We were able to offset these challenges with strong revenue in other geographies. Increasingly, our geographic diversification with a global footprint provides resiliency and flexibility for the business. Additionally, our strong balance sheet with $143.4 million in cash and marketable securities, and no debt positions us well to weather the storms while investing in innovation for our customers. We continue to take structural actions to streamline our business model, which will further bolster this advantage. We remain laser-focused on improving our execution to maximize growth and profitability. As part of this, we continue to evaluate our investment decisions with a goal of actively aligning resources to the best opportunities and driving efficiencies in all functions. Our results in the second quarter demonstrate progress against these objectives. During the quarter, compared to the same period last year, and on a non-GAAP basis, we achieved an $8.2 million improvement in operating income, a $7.4 million improvement in non-GAAP net income or a $3.3 million improvement in revenue. We continue to believe we can reduce our total annualized operating expenses in line with our strategic initiatives and deliver sustained profitability. We previously stated we would reduce operating expenses for the full year by $10 million compared to 2019. We are raising that goal to at least $14 million for the full year, even as we expect sales and marketing expenses to go up, based on economies around the world beginning to open up in the second half of the year. Our gross margins in the second quarter were in line with our expectations. We added a total of 95 new customers in Q2 and believe that we can continue to build upon that momentum going forward with a strong focus on improving execution in all areas. To that end, I’m proud to highlight some significant wins from the quarter. First, we closed a deal with a new service provider account in Eastern Europe requiring network address translation technology to support network traffic growth. A10's solution was selected due to superior product performance. Second, a large investment bank requiring an upgraded secure application delivery solution selected A10 after a competitive proof-of-concept analysis performed by the customer. They awarded this business to us due to our demonstrated low latency, technical feature set, rich analytic capabilities, and reputation for providing strong customer support. Finally, a government agency in Latin America requiring a solution to enhance its visibility and security across its network traffic selected A10 to replace the incumbent vendor. A10 was selected based on its past ADC performance, demonstrated security enhancements, and a unified management platform with A10 harmony solutions. During Q2, the COVID-related disruptions had the most impact on Japan and Asia. In Japan, the postponement of the Tokyo Olympic Games shifted projects towards the end of the year or in some cases next year. Many other Asian economies were locked down due to COVID-19 concerns. In the second quarter, revenues in Japan and Asia-Pacific decreased by $3.2 million compared to the same quarter last year. This was offset by a $5.5 million improvement in North American revenues, and a $1.1 million improvement in revenue from Europe and the Middle East. Our improving results in America were driven by expected strong demand from a large service provider, accounting for greater than 10% of Q2 revenue and included in the service provider category. It is important to note that while we continue to have a strong market position with service providers, we are also dependent on their investment cycles, which can last multiple years and result in variable demand levels. We continue to drive demand from a diverse global customer base, and that gives us the best opportunity to deliver solid consolidated results even as short-term demand patterns fluctuate. In the meantime, we continue to take structural actions to improve our business model. I’m truly excited about the progress we have made on rapidly adjusting our product roadmap and portfolio to better align with market and customer trends and deliver the most meaningful business outcomes for them. These ongoing actions create a strong foundation for sustainable growth in the future, in conjunction with our adjustments in the go-to-market strategy. The recently announced partnership with Dell is an example of where we can create value while partnering with a strong player in the market.

Tom Constantino, CFO

Thank you, Dhrupad. As Dhrupad shared, revenue in the second quarter was $52.5 million, up 6.7% year-over-year. Second quarter product revenue was $29.2 million, representing 55.6% of total revenue. Service revenue was $23.3 million or 44.4% of total revenue. Security-driven products revenue comprised 56% of total product revenue in Q2. As a reminder, beginning in the fourth quarter of 2019, we revised our reporting to include our largest web giant customers within the service provider vertical. Moving to our revenue from a geographic standpoint, revenue from the Americas increased 29% from the year-ago period to $24 million compared with $18.5 million in the second quarter last year. In Japan, revenue was $12.9 million, down $2 million from the year-ago period, partially due to the impact of the delay of the Tokyo Olympics. Specific revenues excluding Japan declined to $1.2 million from $9.2 million in the second quarter of 2019 to $8 million in the second quarter of this year. Finally, in EMEA, revenue was $7.7 million, an increase of 70% compared with $6.6 million in the second quarter last year. As we move beyond revenue, all further metrics discussed on this call are on a non-GAAP basis unless stated otherwise. A full reconciliation of GAAP to non-GAAP results is provided in our press release and our trended quarterly financial statements posted on our website. Our second quarter total gross margin was 78.8%. Second-quarter product gross margin was 77.7%, 328 basis points better than the year-ago period due to a favorable product mix from increased software revenue. Services gross margin in the quarter came in at 80.2% compared to 82.4% in Q2 of 2019 due to higher compensation-related expenses for services personnel. We ended the quarter with a headcount of 758 compared with 785 at the end of Q1, reflecting the actions taken to focus on the appropriate strategic priorities and maximize productivity. As Dhrupad indicated earlier, we entered 2020 with the stated goal of reducing operating expenses for the year by $10 million. Based on our progress to rationalize expenses during the first half of the year, we are revising that to a reduction of at least $14 million, even with an expected increase in sales and marketing expenses in the second half of the year as economies start opening up. We also continue to evaluate optimization of product-related investments aligned with our strategic objectives to drive growth and profitability. Non-GAAP operating expenses in Q2 were $34.1 million, down 10.2% sequentially from $38 million in the first quarter of this year and down 13.2% compared with $39.3 million in the prior year’s second quarter. Our continued focus on execution to maximize efficiency and profitability in all areas contributed to this year-over-year decline. We reported $7.2 million in non-GAAP operating income. We also continue to improve our adjusted EBITDA significantly, which came in at $9.8 million for the quarter, an $8.4 million swing from the year-ago period. As Dhrupad mentioned earlier, this reflects our focus and commitment to improving profitability. Non-GAAP net income for the quarter was approximately $7.1 million or $0.09 on a per-share basis. Diluted weighted shares used for continued non-GAAP EPS for the second quarter were approximately 80 million shares. On a GAAP basis, net income for the quarter was $3.8 million or $0.05 per share, compared to a GAAP net loss of $5.8 million or $0.08 per share in the second quarter last year. Moving to the balance sheet, average days sales outstanding were 80 days, compared to 73 days in the prior quarter. This trend reflects typical seasonal timings of our revenue and collections. At June 30, 2020, we had $143.4 million in total cash and marketable securities compared with $129.9 million at the end of December. During the quarter, we generated $10.5 million in cash from operating activities due to the structural changes in our expense profile and the financial leverage of our business model. Due to the uncertainty in the environment and the inability to predict the course of the current pandemic, we've decided to continue to suspend our practice of providing full quarterly guidance. We remain committed to advancing our goals for profitable growth in our efforts to advance initiatives to improve operational efficiency. As the global economies continue to reopen, we anticipate higher marketing and sales expenses compared to the second quarter of 2020. However, the structural changes we have made in our business already positioned us for a significant decrease in total operating expenses on a year-over-year basis. In addition, we expect to maintain profitability in the third quarter as we continue to make progress on a long-term operating goal. We expect gross margins to be consistent with our historical range of 76% to 78%.

Operator, Operator

Thank you. We will now begin the question-and-answer session. And our first question will come from Anja Soderstrom with Sidoti. Please go ahead.

Anja Soderstrom, Analyst

I can just maybe elaborate a little bit on the expense reduction. You sound like you did a good job there and took out more than you had anticipated. Can you just elaborate on sort of what expenses that is? And are there any COVID-related expenses taken out now that are irrelevant to traveling and marketing? Are there any other things to think about there in terms of expenses?

Dhrupad Trivedi, CEO

So I think there are two categories, right, Anja. From a COVID-19 perspective, you are correct; the main impact would be related to the idea that during the second quarter particularly, there was almost a complete freeze on travel and sales and marketing activities and so forth. Also, marketing events that were typically part of that spending pattern, we had to really adapt to a more digital presence. So that I think is a COVID-related impact that would obviously start to come back and we would look for it to come back to support organic growth going forward. So that's the only one in that type of category. The structural cost changes that we are driving have to do with, if you look at the different categories on the sales and marketing side and engineering side, they have more to do with making changes in the organization and leadership to drive a higher performance level and higher expectations for productivity. Secondly, creating a tighter focus on what are the biggest customer problems we are solving and how do we take it to market in the most effective ways. In that process, we continue to look for ways to leverage channel partners versus direct sales, how do you best leverage the territory structure. And then on the G&A side, I think our thinking relates to driving productivity and efficiency, and secondly, preventing spending on functions that are not customer-impacting service or support functions so that we are best positioned to continue to fund innovation that our customers see value in, which is good for employees and customers alike in the long term.

Anja Soderstrom, Analyst

And then you mentioned the partnership. So you made some good progress on that over the past year. What can we expect? How important is that and what can we expect going forward? Like how much are you pushing that partnership?

Dhrupad Trivedi, CEO

I would say, first of all, I'm very excited because that's a way for us to get effective market coverage, better reach, and more cost-effectively as well. That is probably one area where we saw a slight impact from COVID. In the sense that all sales cycles are elongated. So typically our sales cycle may be six months, and with the new partners, we are seeing the same impact as anyone else in any other business. But we do see that as an important part as we build up the pipeline and start seeing those materialize, most likely next year and hopefully somewhat showing up in the fourth quarter as well. But typical sales cycles take six months, and we are engaged with partners on actual opportunities. They need to mature, and then we'll have a steady pipeline. So it will be a significant part of our go-to-market strategy in terms of reach, as well as efficiency of reaching those customers. And we talked a little bit about on the enterprise side particularly; we think that leveraging partners and channels is certainly an area of opportunity for us in addition to driving productivity.

Anja Soderstrom, Analyst

And then the last one, the weakening U.S. dollar, you have a lot of international exposure. How are you seeing that playing out? Are you hedging anything? Or is that something that we should be concerned about?

Dhrupad Trivedi, CEO

Yes, no, it's not a concern based on that. Our transactions are U.S. dollar denominated except for Japan, and that's where demand is at risk.

Tom Constantino, CFO

Yes. And we do deploy hedging strategies to the extent that we have risk because of the Yen to U.S. dollar ratio.

Operator, Operator

Our next question will come from Hendi Susanto with Gabelli Fund. Please go ahead.

Hendi Susanto, Analyst

Good evening, Dhrupad and Tom, and congrats on the positive Q2 result. Dhrupad, could you talk more about the enterprise and business environment? I assume that visibility is low. At the same time, many companies talk about digital transformation taking place in enterprises. So what is your view on the enterprise segment?

Dhrupad Trivedi, CEO

Yes, certainly. I think the way I would probably split that is as you mentioned correctly, you will hear several enterprise companies comment on the enterprise market being either really good or really bad. The way I segment it further is that a lot of the enterprise IT projects were originally scheduled and planned and budgeted based on the pre-COVID idea of everything becoming digital, and selling more services, microservices, etc. Those plans are where we are seeing possibly a slowdown or push-out because customers are dealing with more urgent topics. In the enterprise part, there is a second portion where with more remote work and the need to move faster to the cloud, companies are investing more in things that add capacity, flexibility, and more security with people working remotely. That’s where we see positive enterprise exposure. So far, that is really the way we focus on that market, especially with large enterprises where there is a premium on performance, low latency, high security, and ease of use which leads to better OpEx for the customer. We certainly see this as a positive trend and expect that to be the case. If you see one of the cases I highlighted was a large financial firm that added capacity and more security while being worried about latency. In cases where there is a premium for that, there is a path for us that we see as having positive trends in the enterprise. We do see a slowdown when enterprises base their additional budget on pre-COVID planning horizons, which are typically pushed out by a couple of quarters right now because IT groups are dealing with more urgent topics. So I hope that answered your question.

Hendi Susanto, Analyst

Yes, that's very helpful. As the economy reopens, do you prioritize certain markets among different geographies?

Dhrupad Trivedi, CEO

Sure, as you know, we have a strong presence in Japan and they’re going through a difficult period as well. We hope that comes around and we are positioned very well with our products and customers. Secondly, we have made progress last quarter by expanding our footprint and design scope in the European market, which is good progress for us as a company. As the economy opens up in Europe, even though it is currently restricted to within Europe, we expect that to be an area for us, especially focused on critical applications with high priority. And on the North American side, in terms of the service provider part of the business, we saw some business fluctuations where companies were shut down for several weeks and therefore unable to proceed. However, we also saw many Telcos, MSOs, and cloud companies actively looking to add capacity and security features. What we see there again is the focus, where we can help them with all the 5G-related strategies while also engaging them to enhance their existing infrastructure and gain more value from 5G. Lastly, in enterprises, as I said, it will not happen overnight, but I feel confident about the foundations we are building with partners and channels. This will create solid opportunities for us to focus on high-value applications where we provide the most value for customers.

Hendi Susanto, Analyst

And then Dhrupad, regarding the partnership with Dell, how should we think about the targets? Will your focus be on the enterprise, service provider, or both?

Dhrupad Trivedi, CEO

So I think it can be both. The enterprise has a great footprint and exposure, so we will collaborate with them on both fronts. The major thing about it is a typical service provider sale is high touch, high technology, because that's the nature of what they do. On the enterprise side, we expect to gain more out of their reach and access, as well as integration with other solutions. We see positive outcomes in those ways. A typical sales cycle is about six months, and while I wish it were much faster, we are very actively engaged with finding opportunities and building a pipeline that is advantageous and attractive for both of us. I can’t give you a number yet, but I’m certainly happy to provide updates as we move forward into the next quarter and beyond regarding the pipeline and progress we are making.

Hendi Susanto, Analyst

And Dhrupad, may I know how do you plan to position A10 Networks for OTT applications?

Dhrupad Trivedi, CEO

When you think about the OTT industry, the intersection with all the top applications is essential. As those providers are creating data centers and handling massive amounts of content, they need to process that efficiently while maintaining high quality of service. The backend requires building large data centers, servers, etc. Our goal is to work with the OTT providers on the backend where they are trying to handle a lot of data in a secure way. That is really our intersection point; it's not at the device level but at the core level.

Hendi Susanto, Analyst

And then one last question, I will ask Tom. So, Tom, A10 increased its annual cost reduction target to $40 million. If I look at last year’s operating expense, it was about $163 million. It will run, let's say, about $148 million. If I look at the first half and then do some calculations, it will imply that second-half operating expenses will be $76 million. So does that mean that all the cost action plans have been completed?

Tom Constantino, CFO

We're constantly looking at how we optimize, and we're always focusing on getting as lean and efficient as possible. So we're going to continue to monitor that. But we felt comfortable enough with where we're at right now to raise that bar for the full year. The numbers you mentioned are accurate, and we expect to meet those.

Dhrupad Trivedi, CEO

I would say the plans are not completed, because the original plan for the $10 million was based on a full-year impact. So they were not completed in Q1, for example. But I would say the two elements are that it is a structural element, and then there was a time-based element, where we had a temporary downturn in sales and marketing and travel expenses. So I would say the fundamental structural actions are still ongoing, as they were planned for the full year, and in Q2, we obviously benefited from reduced travel.

Operator, Operator

Our next question will come from Hamed Khorsand with BWS Financial. Please go ahead.

Hamed Khorsand, Analyst

I want to start off. Is there a specific area where you're seeing the most amount of new customer additions this past quarter?

Dhrupad Trivedi, CEO

I think so on different fronts. For us, it was pretty broad-based. When you look at our addition of 95 customers that we announced, I would say they came from Japan, Asia-Pacific, EMEA, as well as America. There was nothing particularly notable or different than usual in that sense.

Hamed Khorsand, Analyst

What you're seeing with customers on the positive side, you guys have a lack of revenue outlook, and is it purely the long game process or are budgets being cut?

Dhrupad Trivedi, CEO

Good question. I would say it's more the latter. There are places today where we sell that are in lockdown, making it impossible for them to even pick up goods. In those cases, the uncertainty is coming from trying to predict when they might be able to reopen. Those can be material dollars. So that's more a question of business disruption rather than anything else. The budget side we have not seen as a major issue so far and part of it likely has to do with the fact that the sweet spot for us is where service providers are trying to deal with more subscribers, more capacity, more data on their network. On the enterprise side, large enterprises are managing increased demand as well. We're not seeing budgets being canceled, but of course, there's a slowdown when an MSO is closed for two months in Q2. We don't see any progression in our sales cycle, which largely results from business lockdowns around them.

Hamed Khorsand, Analyst

Okay. And then what is your sales team cannot achieve during lockdown that requires a higher marketing expense?

Dhrupad Trivedi, CEO

A couple of things. One is if you think about how our sales team operates with existing customers, they have been effective at calling on them and continuing to sell more products or the same product. The hardest thing is to add significant new customers because those engagements typically need on-site demos, etc. The aspect where it could impact us is in generating opportunities for the future. While we're fine on the near-term demand, and we feel good, I always want to ensure we're bringing in enough new opportunities, new customers, and new streams to continue growing. So getting to where we need to be in the near-term is not the crux. It's more about how we continue to enhance and build upon that for the future.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference over to Dhrupad Trivedi for any closing remarks. Please go ahead, sir.

Dhrupad Trivedi, CEO

Thank you. And thank you to all of our shareholders for joining us today and for your support. A10 continues to execute well amidst a challenging and uncertain environment, and our strong balance sheet, global presence, and improved profitability position us for continued success. Thank you again for your support, and have a good day.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.