Cognyte Software Ltd. Q4 FY2022 Earnings Call

Good day and thank you for standing by. Welcome to Cognyte's Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Dean Ridlon, Head of Investor Relations. Please go ahead.

Thank you, operator. Hello, everyone. I'm Dean Ridlon, Cognyte's Head of Investor Relations. Thank you for joining us today. I'm here with Elad Sharon, Cognyte's CEO; and David Abadi, Cognyte's CFO. Before getting started, I would like to mention that accompanying our call today is a presentation. If you would like to view these slides in real-time during the call, please visit the Investors section of our website at cognyte.com, click on the Investors tab, click on the webcast link, and select today's conference call. I would also like to draw your attention to the fact that certain matters discussed on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other provisions of the federal securities laws. These forward-looking statements are based on management's current expectations and are not guarantees of future performance. Actual results could differ materially from those expressed in or implied by these forward-looking statements. The forward-looking statements are made as of the date of this call and, except as required by law, Cognyte assumes no obligation to update or revise them. Investors are cautioned not to place undue reliance on these forward-looking statements. For a more detailed discussion of how these and other risks and uncertainties could cause Cognyte's actual results to differ materially from those indicated in these forward-looking statements, please see our annual report on Form 20-F for the fiscal year ended January 31, 2021, filed with the SEC on April 29, 2021, and other filings we make with the SEC, including our annual report on Form 20-F for the fiscal year ended January 31, 2022, which we expect to file shortly. The financial measures discussed today include non-GAAP measures. We believe investors focus on non-GAAP financial measures in comparing results between periods and among our peer companies that publish similar non-GAAP measures. Please see today's presentation slides, our earnings release, and the Investors section of our website at cognyte.com for a reconciliation of non-GAAP financial measures to GAAP measures. Non-GAAP financial information should not be considered in isolation from, as a substitute for, or superior to GAAP financial information, but is included because management believes it provides meaningful information about the financial performance of our business and is useful to investors for informational and comparative purposes. The non-GAAP financial measures the Company uses have limitations and may differ from those used by other companies. Now I'd like to turn the call over to Elad.

Thank you, Dean. Welcome, everyone, to our fourth quarter conference call. In Q4, revenue was $125 million, about a $7 million sequential increase from Q3 and approximately $3.5 million below the midpoint of our guidance. Non-GAAP EPS was $0.16. Our results reflect the continued supply chain issues that we discussed during our last earnings call, as well as a lower conversion of our pipeline than we expected at the time of our last conference call. I will discuss both issues in more detail in a minute. During the quarter, we won many large deals, reflecting the strength of our portfolio and the market needs for cutting-edge investigative analytics to address evolving security threats. Also, we continue to execute well on our software strategy. And in Q4, our non-GAAP gross margins increased by 180 basis points year-over-year to 73%. I would like to start today with a review of our Q4 booking activity. In Q4, we continued to win large deals from existing customers that demonstrate the strength of our customers' relationships and how they look to us to help them address evolving security threats. The first is an approximately $10 million deal from a law enforcement agency that is replacing the homegrown solution due to our technology's ability to keep pace with evolving threats. This is a good example of how our customers are facing security challenges that are constantly evolving and come to us to modernize their investigative analytics technology with an open analytics platform. The second deal is for approximately $8 million in connection with the platform capacity expansion. This is a good example of how our customers look to us for the latest in investigative analytics capabilities to keep pace with the increasing variety and volume of data. The third deal was also for $8 million, and we presented it to an existing customer adding another solution from our portfolio and displacing an incumbent vendor. This is a good example of how our customers are replacing solutions from other vendors due to the confidence in our ability to deliver value and our track record in previous deployments. These large orders from existing customers highlight our long-term relationships, the evolving needs of our customer base, and the confidence our customers have in our technology. We continue to win large deals in Q4 as in prior quarters; however, overall Q4 bookings came in lower than we expected at the time of our last earnings call. While we still ended the year with significant RPO of $512 million, this RPO level is $40 million lower than the prior year. We identified two main issues contributing to lower-than-expected Q4 booking, and I would like to discuss these issues and how we are addressing them. First is the supply chain issues we discussed during Q3 that continued into Q4. As a reminder, on average, approximately 20% of our revenue comes from appliance solutions that consist mostly of software but include some heavier components. We are currently having difficulty sourcing some components, which affects our ability to timely deliver backlog orders and impacts our revenue. In addition to revenue impact, we have started to see some customers delay placing new orders for other solutions until we deliver the prior orders. We are executing on a couple of initiatives that will address these supply chain issues. We are working with suppliers to build up inventory to minimize the impact of the component shortages. The cost of such inventory is minimal, but it is hard to find suppliers with available stock. In addition, we have started the hardware redesign and expect to finish the redesign by Q3 of this year. The new designs will, among other improvements, include components that are more readily available. The second issue is lower pipeline conversion. We concluded that we need to strengthen our leadership team to drive better conversion of our pipeline. Looking back at Q4, we entered the quarter with a large pipeline, and based on analyzing the conversion performance, we do not believe we have lost any key deals to competition and do not see significant changes in the competitive environment. It's also important to note that most of Q4 pipeline deals that we expected to close were from existing customers. Our relationship with our customers remains strong, and we hope to close these deals in the future. Based on this analysis, we initiated a search, and I'm happy to report that in Q1, we already hired a new Chief Revenue Officer. The new CRO brings to Cognyte extensive experience in driving growth and leading large teams. We believe the actions we have taken will help mitigate the identified issues and support our long-term growth strategy. Next, I would like to discuss our visibility at the present time. In addition to the issues we just discussed, we believe the conflict in Ukraine may be causing a pause for some government customers around the world, especially in EMEA. While we do not derive any revenue from Russia, it's unclear at this point what the impact will be on our business this year, and it could result in more or less spending as customers reevaluate their security budgets. At this time, our ability to focus this year with any level of precision is limited, and we are not providing guidance. We will continue to monitor the market and resume guidance as soon as practical. We are clearly disappointed that we are not in a position to provide guidance. Near term, we have taken specific steps to address the issues we identified, and we are confident in our long-term growth opportunity due to first, market fundamentals have not changed. The market is largely growing, security threats are increasing, and governments are seeking innovative solutions to address these threats. Second, we are a market leader with a long history of growth and innovation. Third, we have deep relationships with our customers around the world. And fourth, we have successfully migrated our business to a software model, which drives gross margins well above 70%. Now, let me turn the call over to David to provide a bit more color about our results.

Thank you, Elad, and hello, everyone. Our discussion today will include non-GAAP financial measures; reconciliation between our GAAP and non-GAAP financial measures is available, as Dean mentioned, in our earnings release and in the Investors section of our website. Non-GAAP revenue for Q4 came in at $125.3 million, up slightly from the previous year but below our expectations due to the issues we experienced in the quarter that Elad discussed earlier. Our software strategy continued to have a positive impact on our results. Our non-GAAP gross margin increased 180 basis points over the previous year; non-GAAP gross profit came in at $91 million. We were able to drive non-GAAP operating income of $15.7 million, adjusted EBITDA of $20.3 million, and non-GAAP diluted EPS came in at $0.16. I would like to mention that our EPS loss on a GAAP basis reflects a valuation allowance we took on our deferred tax asset in the amount of $12.7 million. This valuation allowance was triggered by the expected realization timing of our deferred tax asset. Cash used in operations in Q4 was approximately $7 million, mainly due to our booking activity, timing of collection, and lower advanced payments. Now let me turn to our full year results. Our full year result reflects the execution of our software strategy. Total non-GAAP revenue increased 6.4% year-over-year to $475.6 million. Non-GAAP software revenue grew faster than our total revenue at 8.5% year-over-year. Our gross margin increased 200 basis points over the previous year, and our non-GAAP software gross profit grew 12.4% on the 8.5% software revenue growth. From a mix perspective, non-GAAP recurring revenue was 49% of total revenue or $232.5 million, an increase of 3.2% year-over-year. Non-GAAP repeat revenue from existing customers was about 95% of total revenue at a similar level to last year. Regarding RPO, we ended the year with $511.6 million, down $40.1 million year-over-year. Our short-term RPO was $300.2 million, down $53 million year-over-year. Adjusted EBITDA for the year was $82.1 million. Non-GAAP diluted EPS was $0.74. Turning to the balance sheet, we ended the year with $163 million of cash, cash equivalents, and short-term investments. This balance includes $100 million withdrawn from our existing credit facility, which we put in place at the time of the spin-off for working capital and potential M&A. As we look ahead to FY '23, let me summarize where we stand today. We believe the recent issues we are facing are short-term in nature. The fundamentals of our business are solid, the long-term opportunity remains intact, and we are well-positioned to capture the opportunity in front of us.

Our first question comes from Mike Cikos with Needham & Company. Your line is open.

I wanted to follow up on the guidance. I'm considering how you have been discussing the visibility of the business and the recurring revenue from existing customers. I'm trying to understand the contrast with the current lack of visibility we are addressing. Can you explain what has changed in the last three months that prevents you from providing guidance for the upcoming year or even just this quarter? I assumed most of that business would be predictable due to your established relationships with your customers.

Yes. Thanks, Mike. So actually, let me remind you that there are three issues that we discussed earlier in the call: the shortage of components, the low pipeline conversion, and also the geopolitical developments that are leading to uncertainty. We are taking proactive actions to improve our visibility and capture the long-term growth. I want to give you more color about each one of those. So let's start with the shortage of components. We discussed it early in Q3 call. We saw that some of the components related to the appliance solutions are not available. We took two action items: the first one is to increase inventory. Actually, we were able to do some of it, but it seems that it's difficult to find more stock, and we initiated the redesign of the hardware. This is a temporary disruption that we expect to resolve later in the year. It's also influencing new bookings from customers that are waiting for those orders to be fulfilled. When it comes to the conversion of the pipeline, it's important to say that we see no change in the competitive landscape. We didn't lose any customers, and in the examples I gave earlier in the call, we can see that customers come to us again and again with large deals. Analyzing the pipeline conversion, we do see a longer sales cycle resulting in the lower-than-expected bookings in Q4. The decline in RPO and the bookings weakness is mainly related to Q4. We took a few steps, one of which is related to leadership, and after our global sales kickoff in February, we focused on improving pipeline conversion. We need to take steps, including an adjustment of the commission plan to incentivize faster deal closure and reprioritizing resources based on opportunities. The recent geopolitical situation in Ukraine is also a factor. As I mentioned in the call, we do not generate any revenue from Russia; however, we expect that it will create disruption for the short term. It could create headwinds or tailwinds, both directions are possible, and we are monitoring the situation. Overall, the combination of these factors has led to uncertainty, and because of that, we are not able to provide meaningful guidance. Having said that, all these disruptions are believed to be temporary. We believe that our long-term opportunity remains intact.

Yes. And if I just step in to two of those real quickly. I know we spoke about the inventory last quarter and the supply chain constraints being a continued headwind. But if I look at the balance sheet, your inventory balances are still lower even sequentially. Can you just give us an update, I guess, are we really waiting for the redesign to be completed in Q3 for that supply chain to normalize at this point?

Yes. So actually, the inventory is similar to what it was before, and the price of those components is quite marginal. The revenue impact is mainly for the software portion of this solution. So, it's unrelated really to the inventory. Inventory is quite a marginal cost. So, we don't expect the inventory to go up dramatically. It's small numbers.

Okay. So, the question is whether you can recognize that software revenue before having the inventory and delivering the appliance to your customer. Is that the right way to think about it, and what is the current behavior of customers?

Yes, that's correct. Some of the customers are waiting for the previous orders to be fulfilled before they can receive value from the solution, and for us to recognize revenue. We need to install our software on the appliance, and once the appliance is not available, we cannot deliver and deploy, and customers cannot generate value. For that reason, some of the customers are holding new orders until they get the previous ones. But we have a very good relationship with customers. So, it's under control. We are managing it. We maintain communication with our customers and believe it is a timing issue. Once it resolves, the business will be back on track.

Thank you. Our next question comes from Kirk Materne with Evercore ISI. Your line is open.

This is actually Peter Burkly on for Kirk. I appreciate you taking the questions here. So I guess I want to double-click on the conversion issues a little more. I appreciate you calling out the longer sales cycles you're seeing and maybe some leadership changes you've made. But I'm just curious, are those deals that are sort of getting pushed out a quarter, and you'd expect to close next quarter, or are these more projects that are getting delayed indefinitely?

Yes. So, we don't think we lost any deal. The pipeline is solid. It's about the timing of the execution and closing deals. I do believe that over time, we'll be able to close the deals. We are taking actions to improve the execution of our sales efforts, including refreshing processes and leadership, to accelerate sales.

Got it. That's helpful color. And then maybe just one other quick one, if I could sneak in. Just as it relates to the geopolitical concerns in Ukraine, I just kind of want to make sure I'm understanding this correctly. So it sounds like it's more uncertainty at this stage for you guys, not necessarily a definite headwind or tailwind moving forward? Obviously, as security becomes more of a focus, there could be uncertainty in spending.

Yes. First of all, I hope that the situation with Ukraine resolves soon. You have a good understanding. The situation could have both headwinds and tailwinds. It's early to say what the impact will be. Historically, after conflicts, demand for security tends to increase; however, for the short term, we expect disruptions.

Our next question comes from Brian Ruttenbur with Imperial Capital. Your line is open.

So one of the comments that you guys made was on the market growing, and you expect to kind of grow with the market. So, I'm just trying to get from maybe a long-term perspective beyond '23, looking at '24, '25, the market's growing, what, in the mid-single digits? Is that the right number?

So we believe that in normal circumstances, the market is growing in double digits. The market fundamentals have not changed. Security threats are increasing, data is growing in volume and diversity, and for that reason, the demand for investigative analytics solutions is healthy and expected to grow over time. We also don't see a change in the competitive environment. If you look at the recognition from our customers regarding our technology and innovation, along with repeat business from existing customers, that's a good vote of confidence. Our large customer base will drive long-term opportunity. Additionally, we launched an initiative to expand our presence in the U.S.

That's good. Thank you very much for the additional color. So maybe on the reason for you taking out the $100 million revolver, I think you drew that down during this period, and as an additional question regarding that, now you're sitting on a whole lot of cash. Do you anticipate being cash flow positive in fiscal 2023?

Yes. At the time of the spin-off, we established a credit facility specifically for working capital as well as M&A. Since then, we have drawn from the revolver several times, and in Q4, we decided to draw the entire revolver. We could easily return the funds if needed. Regarding cash flow, yes, we expect to be cash flow positive next year.

Our next question comes from Brad Reback with Stifel. Your line is open.

I think during the prepared remarks, you talked about lower advanced payments for one of the reasons cash flow has declined significantly year-over-year. Can you go into a little more detail on that? And what do you think happens on that front in fiscal '23?

Yes. The main reason is the transition to a software model. As we move to a software model, we see fewer advances and less perception of completion revenue recognition. This is the main reason for that.

But hasn't that transition been occurring for the last three years?

It's David. The transition has taken place over the past few years, but we still had some projects that continued to fulfill our obligations. Over the last few quarters, we see less and less advance payments from customers. In a project model, it's typical to receive advances at the beginning of a project. Once we move into a software model, it's less easy to convince customers for such advances.

Our next question is a follow-up from Mike Cikos with Needham & Company. Your line is open.

I just did want to circle up. I know that we're talking about the longer sales cycles today. Can you give us a sense of how much longer sales cycles are today? Are we talking about another month to that sales cycle, or is it still elongating in the current environment?

No, it's not a dramatic increase, just a slight increase. We want to address it now and ensure that pipeline conversion is more efficient. We have a healthy pipeline, and we aim to improve the pipeline conversion.

Okay. And can you remind us of those action items? I know that you hired the new Chief Revenue Officer, but what other processes have you instituted to ensure that the pipeline is converting at a more normalized level?

Yes. We have the new CRO, as I mentioned before. We also had a global sales kickoff in February, which focused on how to convert the pipeline faster. We adjusted the commission plan of the sales team to incentivize faster closures. We are scrutinizing the pipeline to reprioritize resources more effectively. With the lifting of travel restrictions, we are also able to be closer to our customers, which is very important in our industry.

Thank you. This concludes the question-and-answer session. I'd now like to turn the call back over to Dean Ridlon for closing remarks.

Thank you, operator, and thank you, everyone, for joining us on today's call. Should you have any additional questions, please feel free to reach out to me. We look forward to speaking with you again next quarter. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.