Cognyte Software Ltd. Q3 FY2023 Earnings Call

Good day. Thank you for standing by. Welcome to Cognyte’s Third Quarter Fiscal Year 2023 Earnings Conference Call. 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, sir.

Thank you, operator. Hello, everyone. I am Dean Ridlon, Cognyte’s Head of Investor Relations. Thank you for joining us today. I am 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, 2022, and other filings we make with the SEC. 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 the third quarter conference call. In Q3, we continued to win large orders. Our booking came in higher than revenue, and our backlog increased sequentially. At the same time, slow backlog conversion drove a sequential revenue decline. We believe Q4 will be a turning point and we expect to resume sequential revenue growth. We also expect fiscal '24 revenue to grow by approximately 5% compared to the current year. I will discuss the trends driving our growth outlook in a few minutes. Revenue decline year-to-date drove significant losses. As a result, we took actions to reduce our losses and cash burn, and we are targeting to achieve about breakeven cash flow from operations in Q4 and for next year. Operationally, we improved the focus of the company during a period of tough macroeconomic conditions. In that regard, as previously announced on December 1, we successfully completed the divestiture of our Situational Intelligence Solutions, which we refer to as SIS. Looking forward, we believe our differentiated technology and strong customer relations position us well for long-term growth and profitability. We have been navigating the business through the current storm and continue to engage closely with our customers to drive new business and improve visibility by firming up the backlog conversion schedule. With that, let me now give you a little bit more color about Q3 trends. In Q3, like in previous quarters, despite the challenging macroeconomic environment, we continued to win multiple large deals. We operate in approximately 100 countries and saw different demand dynamics across countries. We currently see that in some countries, there are customers having temporary challenges related to budget and operational readiness. At the same time, we continue to operate in many countries that are not significantly disrupted by these challenges. I would love to share some of the large deals we won during Q3. Our investigative analytic solutions help customers address a variety of security use cases across national security, law enforcement, national intelligence, and cybersecurity agencies. The first deal is for over $20 million with a government agency to combat cybersecurity threats. This is a new customer for Cognyte. Our solutions will enable the customer to view, analyze, and enrich data to investigate cyber threats. We were selected due to our superior technology and domain expertise. The second deal is for approximately $3 million from an existing National Intelligence Agency. We were selected based on the strength of our technology and the deep relationship with this customer. The customer is using our solution to investigate and combat organized criminal activities. The third deal is also for approximately $3 million and is a follow-on order from an existing National Security Agency. We were selected based on the value our solution generates. The customer is now adding new capabilities to address anti-terror and border security. We have increased our sales focus in geographic areas where we believe the best opportunities exist. We make these decisions on a country-by-country basis, focusing on customers with budgets and operational readiness, and we are pleased with our booking activity, achieving another quarter of a book-to-bill ratio greater than 1. Next, I would like to discuss the dynamics we see in our backlog conversion. As you know, while our backlog has been growing this year, some customers have been delaying deployments. We have been actively engaged with all of our backlog customers to discuss the firm commitment to the delivery schedule. I am pleased to report that as a result, our visibility into backlog conversion has improved, positioning us to provide guidance for Q4 and for next year. We believe the improved visibility is due to customers' progress in budget planning as well as prioritizing their urgent needs to deploy innovative technology to address the evolving security threats. The work we have done with our customers provides us with better understanding and more confidence regarding the timing of backlog deployments. Turning to our cost structure, over the last few months, we took actions to reduce our expense levels in line with our outlook. We started the year with non-GAAP operating expenses, excluding SIS, of about $70 million in Q1 and expect to end the year with Q4 operating expenses of $55 million. These cost-saving actions will continue to gradually reduce our operating expenses in the next two quarters across R&D, selling and marketing, and G&A. We believe these actions are necessary in the current environment, and this cost structure will support our outlook for growth. Turning to our Q4 outlook, given the divestiture of SIS, we are providing pro forma results excluding SIS, which David will discuss later. Excluding SIS, non-GAAP revenue is currently expected to be in the range of $63 million to $72 million in Q4, up from $61 million in Q3. On this basis, we expect revenue for the year ending January 2023 to be in the range of $275 million to $294 million. The combination of higher Q4 revenue and lower expenses is expected to result in improved profitability. Our cash flow from operations for Q4 is expected to be above breakeven. For fiscal '24, we expect revenue to grow approximately 5% year-over-year. Our view is based on current expectations for a similar demand environment next year and the discussions we have with our customers regarding the timing of backlog deployment for next year. While we are not assuming better macro environment conditions, our backlog has been growing this year, and the conversion of this backlog supports our revenue growth outlook for next year. Turning to margins, our cost reduction actions this year will benefit next year's profitability outlook. As a result, we are targeting above breakeven cash flow from operations next year. In summary, we are pleased to regain visibility and be in a position to provide guidance. We expect sequential revenue growth in Q4 and year-over-year growth in fiscal '24. We believe that the actions we took to focus the business and reduce costs position us for growth next year with significantly improved profitability and cash flow. We also believe security threats are pervasive, and customers need our market-leading solutions to address these growing threats. I would like to thank our employees for their strong dedication to customer success. We are managing the company through the current storm and look forward to returning to profitable growth. Now, let me turn the call over to David to provide more details.

Thank you, Elad, and hello everyone. Our discussion today will include non-GAAP financial measures. A 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. Our website includes a financial dashboard with a tab that details our historical results, excluding the recently divested Situational Intelligence Solutions. Revenue for Q3 came in at $71.3 million. Looking at the revenue mix, software services came in at $43 million, reflecting strong renewal rates. Total revenue came in at $22 million, a significant decline from last year, reflecting backlog conversion delays, as Elad explained. Professional services and other revenue came in at $6.3 million, impacted by our software revenue level. As a result of the SIS divestiture, I will discuss our results for the current year without SIS. Non-GAAP revenue for Q3 came in at $61.5 million. During Q3, our booking activity came in higher than our reported revenue and drove an increase in our backlog. Q3 RPO was $527 million, an increase of approximately $20 million from the end of Q2. RPO for the next 12 months is $248 million. The RPO reflects all adjustments to our contractual obligations. Turning to gross margin, Q3 gross margin was 61.1% on a non-GAAP basis, primarily due to a loss of professional services. We expect to improve the margin on professional services as a result of our cost reduction initiatives and improved deployment efficiency due to better visibility. Our Q3 non-GAAP operating expense was $59.6 million, $5.8 million lower than Q2 and $9.5 million lower than Q1, reflecting our cost control activities. Despite the improvement in OpEx, the lower revenue level in Q3 resulted in a non-GAAP operating loss of $22 million for the quarter. Cash used in operations was mainly driven by EBITDA loss and an increased level of inventory. Turning to the balance sheet, we ended the quarter with net cash of about $11 million. Following the divestiture of SIS, our current net cash increased to about $55 million. Next, I would like to provide more detail on the SIS divestiture. Historically, SIS was about 10% of Cognyte’s consolidated non-GAAP revenue. During FY '22, SIS generated non-GAAP revenue of about $35 million, and during the first 9 months of FY '23, SIS generated non-GAAP revenue of about $28 million. Our dashboard provides further information on Cognyte’s results, excluding SIS. As a result of this divestiture during the fourth quarter, we received $42.3 million in cash. We expect to receive an additional few million dollars next year related to the holdback and other price adjustments. Also, there is a potential to earn future payments over the next 3 years related to an earn-out. At this time, we cannot be certain whether and to what extent any earn-out will eventually be received. Turning to Q4, we are currently expecting revenue to increase from $61.5 million in Q3 and be in the range of $63 million to $72 million in Q4. Our cost reduction efforts are expected to result in further decreases in our operating expenses from the Q3 level. As a result, we expect Q4 operating expenses, excluding SIS, to be about $55 million. The combination of higher Q4 revenue and lower expenses is expected to result in improved profitability. As a reminder, Q4 will also include 1 month of contribution from SIS of approximately $2 million in revenue and about $1.5 million of incremental operating expenses. Let’s turn to Q4 cash flow from operations. We expect improved profitability and also sequentially improved working capital due to better collection activity and reduced inventory level. This will result in about breakeven cash flow from operations. I would like to add more color about our FY '24 outlook. We expect next year's revenue will grow approximately 5% from FY '23 levels, and you can assume in your model a modest sequential increase throughout the year. Our revenue outlook is driven by our current view of backlog deployment schedule for next year's best customers’ dialogues. Our cost structure will continue to improve from the Q4 level into the next year. During our next earnings call, I will provide more details on our profitability expectations for FY '24. We expect next year's cash flow from operations to be about breakeven, primarily driven by projected revenue growth and our lower cost structure. In addition, we expect about $10 million in payments for CapEx partially offset by additional receipts from the SIS divestiture. We believe security threats are pervasive and our customers need our innovative solutions to address evolving trends. We are a market leader in investigative analytics and have a strong track record with customers around the world. We have long-term opportunities in front of us, and we are managing the business through the current environment to return to growth and profitability. With that, I would like to hand the call over to the operator to open the line for questions.

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

Hey, guys. Thanks for taking the question. You have Mike Cikos on the line here. So appreciate you guys calling out this visibility in the guidance that you have. But maybe can you just provide us a little more color? I know you have been working with customers on better understanding the deployment of that backlog that’s been building this year. But can you provide additional details as far as what gave management the confidence to reinstate guidance at this time?

Yes. So, hi, Mike, this is Elad. Yes, we are at a turning point. We expect to grow sequentially in Q4 and very next year. In the past few quarters, we have been working with our customers to confirm the deployment schedule. Remember, we were able to increase backlog and RPO each and every quarter this year. However, we experienced some backlog conversion delays related to customers' readiness of budgets. So we spent a lot of time with our customers in intensive meetings and discussions to better understand what are the reasons behind it and also try to be helpful and prioritize with them the deployments going forward. Remember that at this time, they are also planning their budgets for the future. So the results of the discussions were that today we have visibility toward the deployment schedule for the next quarters and for next year. And this actually provides us with a high level of confidence in the outlook, and that’s the reason we resumed guidance. Just a little more color, if you look at our RPO, we had an RPO of about $530 million. And if you look at the short-term RPO after the discussions with our customers, it stands at about $250 million, which is more or less 50% of the total RPO, but also reflects more than 80% of the outlook for next year. So, this gives us the confidence that we have in order to provide guidance this time.

That’s great. I appreciate that. And if I could just ask one more question with respect to that confidence that you guys have in the guidance here. It’s just interesting to me. Like I know this year, we have obviously seen delays to that backlog conversion. Is it fair to think that customers are behaving differently or thinking differently about next year? Now, I am trying to understand why that backlog convert – why we would have more confidence in that backlog conversion for next year, just given maybe some of the delays that we have experienced this year?

Yes. So we have to remember that the macroeconomic environment affected our customers. For them, it took time to digest and they are now planning their budgets again. They looked into their availability and readiness. Our discussions with them gave us the confidence that we now have a more realistic deployment schedule. So it’s a combination of strong backlog that increased over the year, together with many discussions we had with them to reconfirm the deployment schedule and prioritize it. Also keep in mind that not all countries were affected by this. Some countries were affected more, others less, and some were not affected at all. So overall, now we have a very good view of the deployment schedule. And obviously, when the market turns and revenue hopefully goes up, once this storm is behind us and considering the high software margins, I would also expect the growth rate to increase and the margins to expand. So this is it in a nutshell. I hope I answered.

You did. That’s great. That’s great. And a final question before I turn it over to my colleagues, but I just wanted to make sure I was clear on the gross margins. Obviously, we saw that professional services and other, I think, was below what we had been forecasting on our side. So can you help us think about what led to the professional services gross margin contracting this quarter? And then the other comment is historically from Q3 to Q4 gross margins have compressed. And I just wanted to see, should we expect a similar pattern as we think about Q4 gross margins? And that’s all. Thank you, guys.

Okay. Hi, Mike, it’s David. So, when we look at the gross margin, the main driver for our gross margin is actually the software revenue, and that affects our ability to improve gross margin over the years. When you look at Q3, we had professional services with negative gross margin, and it was mainly driven by two things. One of them is the low level of software revenue. The other is the cost structure associated with the deployment schedule that we were planning. Given now that we have much better visibility and the cost reduction that we have already made, this will allow us to improve the gross margin on professional services over time. In the long term, we will be able to return to the level of overall 70% software gross margin. Looking at your question about Q4 and future periods, we believe that it will take some time to recover. From a gross margin perspective, I would assume slight improvement from the current level that we are seeing right now.

Okay. Thank you very much, guys.

Thank you. And our next question comes from Peter Levine with Evercore ISI. Your line is now open.

Great. Thanks for taking my question here. Maybe just to follow-up on the prior question: Can you help us understand what’s the recession playbook for you guys? Obviously, we have seen other companies take steps in terms of employees willing to kind of dial that back. Obviously, you have built in some efficiencies this year. But if the economy gets worse, what’s the recession playbook? What cards do you have in your back pocket to offset some additional headwinds that you might face next year?

Yes. So, I assume you are asking, I just want to make sure I understand the question, Peter. I assume you are asking what are our assumptions for next year in terms of the macro environment that’s the question?

You are right. Yes. I am assuming, obviously, no one knows what’s going to happen. But I think you have still the guide for next year. But what’s the offset to that, right? Where is the risk? And what do you see as the risk in terms of you may perhaps not hitting those numbers?

Yes. When we built our guidance, we assumed similar macro environment conditions as this year. So, we didn’t assume that the situation will be better. We also don’t have any signs that it will be worse. So, the assumption was that it will be similar to this year. Obviously, we took some actions related to the cost structure to make sure that we align the organization to the outlook and generate breakeven cash flow from operations. This was the goal. The thinking behind it was that first, we have to stand behind our commitments to our customers and second, that we preserve the opportunity to resume growth when market conditions improve. So, overall, the assumption is a similar macro environment as this year.

Okay. And then maybe can you kind of touch upon the competitive landscape? And what your customers are doing today? I think the deals that are getting deferred, are you seeing more companies compete in RFPs? Are these customers just pulling back completely, or do you get a sense that they are allocating their budget elsewhere? Can you give us a sense of the appetite from your customers in terms of their budgets and where that allocation is heading?

Yes, sure. We still see demand also this year. If you look at the bookings and RPO, it was increasing. The problem was not the bookings; the main issue was backlog conversion, mainly the backlog conversion. So, the purchase orders that the customers gave us, and when customers give bills, they do it because they need a product and solution to address their challenges. This gives us confidence that the demand is there. We run the company in a tough macro environment, and we do have very good relationships with our customers. We maintain market leadership in terms of product differentiation, and we operate globally in more than 100 countries. Overall, our leadership position remains. Of course, some customers are having budget issues and have to slowdown either purchasing or delaying backlog conversion, and that’s what we are focusing on. About competitors, I tend to believe that competitors will face the same challenges that we do. Different competitors operate in different parts of the market, and not all of them have the rich portfolio that we do to address the many use cases. It depends on what competitor and what area they are serving. I do believe that by the end of this macroeconomic storm, some competitors will be struggling, and it may be interesting for us to consider M&A in the future.

Okay. That’s very helpful. I can squeeze one last one in. We talked about backlog convergence. But can you talk about what you are seeing at the top of the funnel today, meaning like net new RFPs coming in on top? Are you seeing an uptick in activity when looking at the funnel today compared to six months ago, or even three months ago?

Yes. So, if you—I'm assuming you are asking about the funnel, right?

Yes.

As part of our decision to focus our efforts on areas where we can maximize opportunities, we know that in certain territories—certain countries, they are facing budget constraints and are not ready, etc. So, our decisions are to focus the business on where the opportunities are and maximize the ROI. What we are doing now is we are focusing on a subset of the funnel that will generate the highest potential for us. The funnel we have today is big enough to support a book-to-bill greater than one alternative; it was that way this year, and we expect the same for next year.

Great. Thank you for taking my questions, and enjoy the holidays and New Year.

Thank you, Peter.

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

Great. Thank you very much. A couple of follow-up questions along the lines of guidance for fiscal '24. With the divestiture, and you are talking about 5% growth back of the envelope, I come up with a $270 million to $280 million number. Is that the right ballpark to be thinking about in terms of total revenue?

So, we shared the guidance for Q4, which gives you a range between $63 million to $72 million. If you take the midpoint and consider 5%, you will be around $290 million. So, this should be the number that you should be looking at.

Okay. Thank you. So, it’s roughly ballpark $290 million. I didn’t know how things would ebb and flow quarter-to-quarter; there’s certain seasonality in there. So, that’s why I was trying to get clarity on that. So, roughly $290 million in revenue, gross margins should be in the low-60s. I didn’t catch it; should be up from previous high-60s, what was the number on gross margin?

So, let’s separate the discussion about overall gross margin. Gross margin is driven by our software model, and as revenue grows, we will be able to drive more dollars with higher profitability. When we look at Q4 and next year, we expect a slight improvement in the gross margin due to the increase in the top line. So, I would say low-60s for modeling perspective.

You said low-60s instead of, is that correct?

That’s correct, low-60s.

Okay. And then there should be a decrease. I saw a drop in R&D from the second quarter to third quarter. I am just trying to understand the breakdown of those operating expenses, SG&A, and R&D going forward. Now that you have completed the divestiture, just trying to understand what kind of levels we are looking at in terms of R&D and SG&A moving forward?

In general, we will provide much more color on our cost structure during our next earnings call. We do think that overall, Q4 operating expenses will be around $55 million, and we will continue to benefit from our cost-saving initiatives over the next year.

Okay. Is there a percentage breakdown? It’s roughly historically close to 50-50, but a little higher SG&A versus R&D? And that’s how—of that $55 million, how should it still be weighted, like historically?

You should say the trends would be similar.

Perfect. And then you also said cash flow breakeven in 2024. Is there a specific timeframe, second half of 2024, or is it all going to be fourth quarter? Any guidance along those lines?

Well, cash flow from operations, we expect it to be breakeven in Q4 this year and also for next year. As you look at next year, we think that there will be sequential growth in revenue throughout the year, and the OpEx benefit we will enjoy will also apply during the year. Given this trend, you should expect that H2 will be better than H1 from cash flow from operations.

Great. Thank you very much.

Thank you.

Thank you. And I am showing no further questions. At this time, I would like to hand the conference back over to Mr. Ridlon for any closing comments.

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, and we look forward to speaking with you again next quarter.

This concludes today’s conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day.