Earnings Call Transcript - ATEN Q3 2023

Operator, Operator

Hello and welcome to the A10 Networks Third Quarter 2023 Earnings Conference Call. My name is Elliott and I will be coordinating your call today. I’d now like to hand over to Rob Fink with FNK IR. The floor is yours. Please go ahead.

Rob Fink, IR

Thank you, Operator, and 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’s President and CEO; and Brian Becker, CFO. Before we begin, I would like to remind you that shortly after the market close today A10 Networks issued a press release announcing its third quarter 2023 financial results. Additionally, A10 published a presentation and supplemental trended financial statements. You may access the press release presentation and trended financials 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 or future operating results, including their potential revenue share, revenue growth industry and customer trends and capital allocation strategy, supply chain constraint, and expectations, positioning, or repurchase and dividend programs and market share. These statements are based on current expectations and beliefs as of today, November 7, 2023. These forward-looking statements involve a number of risks and uncertainties. So much are beyond management’s control such as the potential impact that the COVID-19 pandemic and these could cause actual results to definitely 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 unless required by law. For a more detailed description of these risks and uncertainties, please refer to the company’s most recent 10-K. Please note that with the exception of revenue financial measures discussed today, all metrics 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 a substitute for results prepared in accordance with GAAP, and they 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 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 now 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. The industry headwinds we discussed on our previous earnings calls impacted our results in the third quarter resulting in revenue of $57.8 million, which is in line with our preliminary results. Despite these headwinds, year-to-date we have achieved our stated EBITDA goals of 26% to 28% and we continue to generate cash. For the past three years, we have been speaking about the importance of our diversified business model and A10's structural profitability. This diversification has enabled us to outperform the market, transition to consistent profitability and support a buyback program, and then a cash dividend. But the real value of our business model, both in terms of diversification and resource allocation relates to how we adapt to challenging macroeconomic circumstances. In February 2021, we had guided to a business model of 80% to 82% gross margin, 26% to 28% EBITDA and expanding EPS. In spite of a challenging topline environment, we are on track year-to-date to deliver on these as a result of our focus on execution and being customer-centric. To put it in perspective, our non-GAAP EPS for Q3, 2023 of $0.16 was higher than our full year non-GAAP EPS in 2018 and 2019. This demonstrates the progress we have made in establishing durable earnings power, building upon a strong technical foundation. We monitor growth opportunities and our sales cycles closely using multiple points of view. During the quarter and the first few weeks of the third quarter, we saw improving market conditions, but as the quarter progressed, decisions were delayed and our visibility decreased. Even so we expected higher revenue levels based on several late-stage opportunities that we expected to close in the last few weeks of the third quarter. As conditions worsened, these orders shifted from the third quarter into future periods during the last two weeks of the quarter. As a result, we made the decision to pre-announce our revenue just after the quarter ended. As has been widely reported, subsequent to our announcement, the North American market, especially with service providers, has been difficult for all of our peers. Buying decisions are being delayed, projects are being pushed back, and inventory gluts are being worked through in response to rising interest rates and inflation concerns. A10 has not been completely immune to these headwinds despite Enterprise segment growth both year-to-date and in the quarter. Visibility is reduced, customer cycles are elongated and quarter-to-quarter volatility has increased. However, our global reach, customer diversification and effective supply chain management has enabled us to navigate these challenges as evidenced by performance viewed over longer time periods, and we are confident that as the market normalizes our solid foundation and commitment to execution will help us to drive sustainable financial results. Our business model enables profitability even when we experience revenue challenges. A few years ago, such challenges would have resulted in significant losses and cash burn. Today that is clearly not the case as we reported GAAP profitability and generated cash, even as we continue to return capital to shareholders while driving innovation. In the last 12 months, we have returned $95.2 million to shareholders in the form of dividends and buybacks. In part, we have adjusted our business priorities to aggressively reallocate resources and reduce spending amidst a challenging revenue environment. We remain focused on preserving growth-oriented investments, while being cognizant of our overall spending. Subsequent to the end of the quarter, we launched a new component of our already strong security product portfolio. Our new A10 Defend Detector, available as part of A10 Solution portfolio, provides early warning capabilities to facilitate even more effective and advanced threat mitigation. This product targets the growing threat of DDoS attacks. A10 Defend Detector helps customers build DDoS defenses before attacks occur. We believe that our portfolio, including A10 Defend Detector, orchestrator and mitigator provides the highest levels of scalability and efficacy available in the market today, delivering automated DDoS defenses for the most demanding service provider and enterprise environment. We are also in early trials with Enterprise customers for our new DDoS Threat Intelligence Service, and we plan to integrate this into our solution portfolio in early 2024. Our security research team already tracked more than 15.4 million DDoS weapons globally. Our Threat Intelligence Service leverages this expertise. Our global pipeline of opportunities remains strong in both Service Provider and Enterprise segments. Projects have been delayed, but revenue has not been lost. In reality, security and network expansion remain business-critical investments, and while higher interest rates and broad economic uncertainty are impacting the sales cycle, these projects cannot be postponed indefinitely. Our visibility has been reduced but we continue to believe that we are well positioned to navigate these challenges and poised to rebound as the market normalizes. This is based on a customer-centric approach combined with innovation. With that, I’d like to turn the call over to Brian for a detailed review of the quarter and the first nine months of the year. Brian?

Brian Becker, CFO

Thank you, Dhrupad. The results we are announcing today are in line with preliminary results reported on October 3rd. Third quarter revenue was $57.8 million, a decrease of 20% year-over-year, reflecting the headwinds Dhrupad described earlier. Product revenue for the quarter was $30.3 million, representing 52.4% of total revenue. After modest improvements in the second quarter, market conditions deteriorated with several projects that we expected to close at the end of the quarter being pushed into future periods during the last month. Services revenue, which includes maintenance and support revenue, was $27.5 million or 47.6% of total revenue. Moving to our revenue from a geographic standpoint, revenue from the Americas, including Latin America was $25.8 million, down 28% year-over-year. This reflects slowing purchasing from large customers, primarily service providers due to economic concerns. Revenue from the Americas was down 36% primarily related to reduced spending from Tier 1 service providers. As you can see on our balance sheet, our deferred revenue was $135.7 million as of September 30, 2023, up 8% year-over-year. With the exception of revenue, all the metrics discussed on this call are on a non-GAAP basis unless otherwise stated. A full reconciliation of GAAP to non-GAAP results are provided in our press release and on our website. Gross margin in the third quarter was 81.8%, in line with our expectations. Adjusted EBITDA was $14.4 million for the quarter, reflecting 24.9% of revenue. I’d like to note that we were able to maintain EBITDA margins in excess of 20% even as revenues declined by 20% in the quarter. Non-GAAP net income for the quarter was $12 million or $0.16 per diluted share, down from $15.9 million or $0.20 per diluted share in the year ago quarter. Maintaining our non-GAAP net income on lower revenue is a significant accomplishment, demonstrating the earnings power we have built into A10. Diluted weighted shares used for computing non-GAAP EPS for the third quarter were approximately 75.8 million shares, compared to 77.7 million shares in the year ago quarter. On a GAAP basis, net income for the quarter was $6.5 million or $0.09 per diluted share, compared with net income of $12.1 million or $0.16 per diluted share in the year ago quarter. Turning to the year-to-date results, revenue was $181.2 million down 10.6% year-over-year. Product revenue was down 18.7%, representing approximately 55.5% of total revenue and services revenue was up 2%, representing about 44.5% of total revenue. Year-to-date, non-GAAP gross margin was 81.6%. Adjusted EBITDA was $47.2 million, reflecting 26.1% of total revenue in line with our profitability targets. Non-GAAP net income for the first 9 months was $36.5 million or $0.48 per diluted share, compared to $39.3 million or $0.50 per diluted share in the year ago period. On a GAAP basis, net income for the first nine months was $22.1 million or $0.29 per diluted share, compared with net income of $28.9 million or $0.37 per diluted share in 2022. Year-to-date we have generated $41.8 million in cash from operations. Turning to the balance sheet. As of September 30, 2023, we had $169 million in total cash, cash equivalents and marketable securities, compared to $150.9 million at the end of 2022, an increase of 12% compared to the end of 2022. In the quarter, we paid $4.5 million in cash dividends and repurchased 168,000 shares at an average price of $14.52 for a total of $2.4 million. We continue to carry no debt. The Board has approved a quarterly cash dividend of $0.06 per share to be paid on December 1, 2023, to shareholders of record on November 17, 2023. The Board also approved a new $50 million share repurchase plan. As discussed in our preliminary results, we expect Q4 2023 revenue to be between $70 million and $80 million and year-over-year growth in full year 2023 non-GAAP EPS. Based on current market conditions and in line with our broader peer group, we expect 2024 for revenue and EPS growth.

Dhrupad Trivedi, CEO

Thank you, Brian. A10 remains well positioned to generate improved results as market conditions improve and we expect our performance to benefit from our diversification and global presence. Our security-led solutions remain in high demand, aligned with durable secular catalysts. Additionally, our investments in supporting hybrid solutions that work on-prem and in the cloud are well aligned with customer’s business outcomes. Operator, you can now open the call up for questions.

Operator, Operator

Thank you. The first question today comes from Gray Powell with BTIG. Your line is open.

Gray Powell, Analyst

Thank you for taking my question. I have a couple of points to discuss. Some companies in the network security space, like Fortinet, have mentioned that part of their growth over the past few years was influenced by temporary factors such as COVID and supply chain issues, and they are now experiencing a digestion phase. Although your situation may be different, how long do you expect this digestion phase to last? I realize this is a challenging question, but what do you anticipate growth will look like when we emerge from it?

Dhrupad Trivedi, CEO

Thank you, Gray. I will address those points separately. Regarding the supply chain, you are correct. In the past 12 to 18 months, many networking infrastructure and security companies experienced an inventory correction phase where they couldn't supply adequately, faced backlogs, and are now normalizing. For A10, we managed our operations in a way that prevented us from having excessive backlogs. This reflects our actual market opportunities since most of our business is book and turn, which allows us to respond quickly. Our challenges in Q3 were not significantly related to supply chain or inventory levels, though we remain mindful of the situation. We track equipment usage closely among our customers, who are primarily Service Providers or large Enterprises, allowing us to monitor these trends effectively. While it's harder to predict when customers will slow down on utilizing their existing inventory, we anticipate a deferral of new capital expenditure projects, like building new datacenters, rather than cancellations. Looking at peer companies, their growth over the past three years shows noticeable fluctuations that are now stabilizing. We understand that customers might take longer to consume what they have purchased previously, but that doesn't imply they won’t buy new products. With respect to COVID, we've noted that our core business remained stable. As companies shifted to more remote work models, those more reliant on work-from-home solutions saw a significant impact. However, for us, the critical factor was that data continues to flow into the network core, and we did not observe a drastic change in demand due to customer types that generate more data, whether from home or the office. Distinguishing between the impacts of these external factors and normal capital expenditure cycles is challenging, but I hope this gives you some insight into A10's situation. Regarding our growth outlook, our business is composed of two-thirds Service Provider and one-third Enterprise customers, with the latter primarily being large Enterprises. We see this segment stabilizing and not declining further. Our segment results reflect this. We expect growth to be driven by two main factors: Enterprises are requiring more complex configurations as they seek mixed operating environments, which we've invested significantly in, and our Enterprise segment has been growing around 5%-6% year-to-date, slightly better in the quarter, even though overall growth remains negative. On the Service Provider side, we've made some progress with Tier 2 and Tier 3 providers, which tends to be more volatile, while we anticipate that Tier 1 Providers will resume growth eventually, though not immediately returning to previous levels. We forecast a gradual recovery early in the year, and as a supply-demand imbalance becomes more apparent, spending is expected to increase.

Gray Powell, Analyst

Understood. Okay. Great. And I guess just one follow-up question. I mean, you guys have always done a good job controlling costs. How much more room do you have to squeeze on the OpEx side and grow EBITDA and EPS in excess of revenue growth?

Dhrupad Trivedi, CEO

Yeah. I think a great question, Gray. And of course, EPS growth is always more fun with revenue growth. So for us, I think, this year, because of the revenue impact versus last year, obviously, there are temporary cost changes that will resume when we are back in growth mode, such as right variable, selling costs, commission, channel, all of that. So we expect that obviously to float up again with revenue growth. On G&A side, I think, we continue to look for efficiencies. So nothing dramatically different, but it will always be better as a percent of revenue. And all OpEx will grow slower than revenue growth, right? The part that, I think, obviously comes back fastest would be variable comp on sales side with revenue growth. On R&D, I would say, the biggest focus for us is reallocating resources to where we see the most growth opportunities, right? So a lot of our new announcements around capabilities and products will be not more engineers per se, but the ones who are there are working on the most important things, right? So that’s the way we balance it and when growth resumes, we grow OpEx, but not as fast.

Gray Powell, Analyst

Understood. All right. Thank you very much.

Dhrupad Trivedi, CEO

Yeah. Thank you, Gray.

Operator, Operator

We now turn to Hamed Khorsand with BWS Financial. Your line is open.

Hamed Khorsand, Analyst

Hi. I just want to understand the conversations you are having with your Service Provider customers. How does that relate to your guidance commentary about 2024, when it sounds like early in your comments that you still don’t have enough visibility even for Q4?

Dhrupad Trivedi, CEO

Sure. We are not providing guidance for 2024. Regarding the Service Provider customers, particularly in North America, our discussions largely revolve around projects that are being delayed rather than being canceled or reduced. Additionally, some customers have mentioned concerns about the cost of capital and their expected returns on borrowing. As conditions stabilize, these customers will need to meet demand, even if they are currently postponing projects; they still intend to expand capacity for new services and data. Furthermore, in North America, some Service Providers face structural capital expenditure and complexity issues that we don’t expect to resolve quickly. We know these projects are still in the works for Q3 because we are collaborating with them on testing and deployment, rather than assuming that major customers have completely halted their plans.

Hamed Khorsand, Analyst

Okay. And my other question was, you have always been a Service Provider-centric company. What are you doing to expand your presence and market share in Enterprise and how fast could that segment grow for you?

Dhrupad Trivedi, CEO

Good question. If you look at our financial trends, our Enterprise segment is actually growing between 5% and 7% this year. While it’s not as large as our Service Provider segment in terms of revenue, our Enterprise revenue for Q3 was approximately $29 million, which is pretty significant for us. We don’t want this growth to be simply due to a decline in the Service Provider segment, but it is a strong performance compared to the last seven or eight quarters. Many large Enterprise customers have determined that it is more efficient and less risky for them to operate in both on-prem and cloud environments, and our ability to provide these solutions is helping us regain growth in that market and maintain credibility with those customers.

Hamed Khorsand, Analyst

Okay. Great. Thank you.

Dhrupad Trivedi, CEO

Yeah, Thanks. Thank you, Hamed.

Operator, Operator

We now turn to Christian Schwab with Craig-Hallum Capital. Your line is open.

Christian Schwab, Analyst

Hey, thanks for taking my question. If we assume Enterprise stays stable at 5% and Service Provider is uncertain but should eventually bounce back, does that imply a flat year-over-year or maybe a modest increase, around 5%? Given the visibility you have, it seems that’s what you’re suggesting. Did I understand that correctly?

Dhrupad Trivedi, CEO

Good question, Christian. We've already discussed Q4, so let's focus on that. One of our key principles is to consistently outperform our peer group by a few hundred basis points through our execution and strategy. Looking at the earnings that have been released so far, you are correct in noting that the peer group is projected to see a year-over-year growth of 3% to 4% next year, and we expect to exceed that. While we are not providing specific guidance, we are aware of the current market conditions and are actively working on strategies to perform better than that.

Christian Schwab, Analyst

Okay. Given the current growth rates and considering our goal to achieve double-digit growth, how long would it take before we might need to permanently adjust the company’s cost structure if the business trends back to mid-to-high single-digit growth?

Dhrupad Trivedi, CEO

Good question. Currently, we are taking measures to achieve results even without high double-digit growth. I expect our new products and security-focused offerings can achieve that level of growth. While our Enterprise segment is smaller, it also has potential in that range. In terms of Service Provider, we are working on reducing risks. The spending in that area is unlikely to rebound quickly, but we are shifting focus to regional providers globally. Many in our industry believe that Service Provider spending will pick up in the first half of next year and return to more typical levels by the second half of 2024. We will continue to monitor the situation with the aim of returning to double-digit growth, though I cannot specify a timeline for that.

Christian Schwab, Analyst

Yeah. That’s extremely fair. Great. I don’t have any other questions. Thank you.

Dhrupad Trivedi, CEO

Thanks. Thank you, Christian.

Operator, Operator

Our next question comes from Anja Soderstrom with Sidoti. Your line is open.

Anja Soderstrom, Analyst

Hi. Thank you for taking my questions. Most of them have been addressed already. But are you starting to see any lost deals or is it just a matter of them being pushed out, you think?

Dhrupad Trivedi, CEO

What we primarily observe, Anja, is a pushout. Given the nature of our customers, the design cycle lasts between six to nine months, so we usually have a solid understanding if they are planning to make a switch. We support these products continuously for several years. While we do encounter pushouts, they are not akin to canceled modernization projects. Instead, they relate more to supporting subscriber growth, where customers intend to invest a certain amount but choose to wait another quarter or two to evaluate the situation. We continue to monitor this closely through win-loss analysis. Although we occasionally lose some deals globally, the main factor affecting our results is the deferment or slowdown in capital expenditures rather than outright losses.

Anja Soderstrom, Analyst

Okay. Thank you. And then just maybe touch on capital allocation and returning cash to shareholders. Have you changed anything in your strategy on buybacks?

Dhrupad Trivedi, CEO

No. I think we talked about it, right? So the Board has approved another new buyback for $50 million and we continue to be active in the market. Of course, right, there are some constraints for us around volumes and kind of results and dates and all that. But we expect to be active in buyback, and as I noted earlier, right, we have invested a lot in buyback and dividend activity even in the last 12 months.

Anja Soderstrom, Analyst

Okay. Okay. That was all for me.

Dhrupad Trivedi, CEO

Thanks, Anja.

Operator, Operator

We now turn to Hendi Susanto with Gabelli Funds. Your line is open.

Hendi Susanto, Analyst

Good evening, Dhrupad and Brian. I have a question regarding the recovery of telco Service Provider demand. Do you believe that the recovery will happen around the same time in different regions, or might a region that is currently experiencing a slowdown recover earlier?

Dhrupad Trivedi, CEO

That's a great question. From our observations globally, we experienced the most significant impact in North America regarding service products. This region has been particularly affected by various factors, including capital expenditures, inflation, and interest rates. While we noticed some slowdown in certain areas of Europe, particularly among large providers, the overall decline has not been dramatic. I expect stability or alignment with expectations outside of North America. However, we are closely monitoring the macroeconomic environment in North America as it continues to affect our visibility. Overall, the other regions appear to be performing closer to our plans.

Hendi Susanto, Analyst

Okay. And then as far as the market recovery and telco Service Providers, what can trigger the resumption of the demand? I think, one, maybe the capacity you can only hold on like existing capacity until a certain point. But I am wondering like what else, I’d say, if interest rates remain high, the concern on inflation is growing, I am wondering what can trigger the demand resumption.

Dhrupad Trivedi, CEO

Yeah. So I think there’s two elements to that answer, right? So one is, as you said, which is a pure business case around the products that they used to buy from us. And I think one is obviously customer demand and network traffic growth, which requires them to invest more to support that traffic and that I think is harder to predict because it comes down to their priorities and even if their budget is cut, they still have to choose like what is not cut or funded. So that’s harder. The second part of it, right, that we have talked about before is, we are also with those existing customers continuously trying to expand the number of categories we sell to them, as well as the different parts of those businesses where we sell, right? So in that case, we are not dependent on a single business unit, who does certain things in a big company. But it’s more distributed around their mobile network, their wireline network, their security, infrastructure, all of those. So for us, from what we can control and execute, the ability to sell them more categories even if there is depressed spending is an important driver and in terms of when they resume reinvestment, I think it’s a function of where the network traffic growth is to a point where they cannot sustain the service level to their customers.

Hendi Susanto, Analyst

I see. And then a question for Brian. Brian, product gross margin is outstanding despite the revenue decline. I am wondering what contributed to the strong gross margin primarily. I am wondering whether that also reflects a more favorable mix of Enterprise versus Service Providers? And then I am wondering how much discipline, cost cutting, supply chain improvement play into generating that strong gross margin?

Brian Becker, CFO

Thank you for the question, Hendi. You're absolutely correct. The improvement in gross margin isn't due to the mix between Service Providers and Enterprise. It's primarily a result of our execution and demand planning. We've worked extensively to create various channels for product acquisition and to keep our cost structure in check, even with the rising input costs we are encountering. Ultimately, it's about executing our plans effectively, the product and service mix, and closely managing our supply chain.

Dhrupad Trivedi, CEO

And I think in a different way, Hendi, think of it as, right? We said we will have gross margins of 80% to 82% and that is in the category of things we can control, right? So, interest rates, we cannot control so much, but what we can control, we will do our best to do what we can.

Hendi Susanto, Analyst

Yeah. And then Brian, if I am not mistaken, I think you mentioned earnings growth remains impacted for 2023, which means that full year earnings will be above $0.73 of last year. May I verify that?

Brian Becker, CFO

That's correct. We continue to drive business.

Dhrupad Trivedi, CEO

That’s fully a non-GAAP EPS.

Brian Becker, CFO

Full non-GAAP EPS. As I mentioned, we expect to do $70 million to $80 million in revenue in Q4 and we will continue to maintain our margins of 80% to 82%, which will fall through and expand EPS year-over-year for the full year.

Hendi Susanto, Analyst

Okay. Thank you.

Dhrupad Trivedi, CEO

Thank you.

Operator, Operator

This concludes our Q&A. I will now hand back to Dhrupad Trivedi, President and CEO, for closing remarks.

Dhrupad Trivedi, CEO

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

Operator, Operator

Ladies and gentlemen, today’s call has now concluded. We would like to thank you for your participation. You may now disconnect your lines.