Earnings Call Transcript - CGNT Q2 2022

Operator, Operator

Welcome to the Cognyte 2Q FYE'22 Earnings Conference Call. My name is John and I’ll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. I will now turn the call over to Matthew Frankel.

Matthew Frankel, Head of Investor Relations

Thank you, operator. Hello, everyone, and 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'd like to mention that accompanying our call today is a WebEx with slides. If you'd 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'd also like to draw your attention to the fact that certain matters discussed in 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 Jan 31, 2021 filed with the SEC on April 29, 2021 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, in 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, and 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 or comparative purposes. The non-GAAP financial measures the company uses have limitations and may differ from those used by other companies. Now, I would like to turn the call over to Elad. Elad?

Elad Sharon, CEO

Thank you, Matt, and welcome, everyone, to our second quarter conference call. I'm pleased to report another strong quarter with both revenue and diluted EPS coming in ahead of our expectations. In Q2, we continued to see the benefit of our software model strategy in our results. Revenue increased 10% year-over-year, while gross profit increased at an even faster pace of more than 13%. We are particularly pleased with our gross margin which increased 250 basis points year-over-year. Adjusted EBITDA came in strong at $18.5 million and non-GAAP EPS came in at $0.17. It's a similar strong story for the first half of the year with revenue going 11% year-over-year and gross profit growing 16%. We are pleased with the progress of our software strategy which is ahead of schedule and we’re raising our profit guidance for the year, reflecting the better software mix which David will expand upon later. Our strategy is to empower security organizations with an open analytics platform to help them address many different security use cases. To help bring this strategy to life, today I'll briefly review our market opportunity and discuss several large second quarter orders. Our customers are facing security challenges across many use cases. Well organized, well-funded adversaries are becoming harder to detect, as they take advantage of the latest technologies to hide in the shadows. At the same time, there is a growing volume and diversity of structured and unstructured data and data is augmented and spread across organizational silos, making investigations more difficult. Many customers recognize that the homegrown solutions can no longer keep pace with these evolving security challenges, and have increasingly sought open analytics platform that can support multiple use cases, solutions that can fuse data at scale from different sources and generate high-quality insights faster to mitigate a wide range of security threats before they unfold. Our open analytics platform provides many benefits to our customers, including faster innovation and more frequent updates with the latest analytics and artificial intelligence technology. We believe the security analytics market is in its early stages. And with nearly 1,000 people in R&D primarily based in Israel, we are focused on developing highly sophisticated security analytics software. Let me take you through several large Q2 wins that reflect the successful execution of our strategy. The first example is a $13 million order from an existing National Security Agency customer that is expanding the capacity of the platform. This is a good example of how our platform can scale and help customers address their growing needs to accelerate complex investigation with sophisticated analytics. The second example is a $10 million order from an existing National Law Enforcement organization customer that is expanding to a certain use case. This customer initially deployed our platform with real-time analytics for investigating drug trafficking and is now expanding our platform to investigate human trafficking. This is a good example of how our customers can use the platform to address multiple use cases and enables us to grow with our customers’ needs. The third example is a $7 million order from an existing Homeland Security customer that is using our platform to investigate cross-border smuggling of drugs and weapons. The customer decided to replace an ongoing system which they had used for many years but found it to be inflexible and expensive to maintain. Behind these wins is our ability to evolve our platform to address multiple use cases. Today, let me double-click into one investigating analytics use case that we are seeing a growing interest in, cybercrime. Cybercrime is becoming more frequent, and the methods that are being used are becoming more and more sophisticated, making verifying bad actors much more difficult. Our customer mission is to identify the bad actors and prevent cybercrime activities that can lead to significant economic losses and security breaches. Many security organizations today are using homegrown solutions that are unable to keep pace with current threats, are difficult to maintain and are expensive to operate. Our open analytics platform provides our customers with strong analytics tools to accelerate investigations, identify bad actors and prevent cybercrime. Our platform is built with deep domain expertise, easily integrates into our customers’ ecosystem and is frequently refreshed to keep pace with evolving technology and security challenges. Cybercrime is a good example of how our open analytics platform can address multiple use cases. In summary, we are pleased to have a strong second quarter as a pure-play security analytics company. For the current year, we expect approximately 12% gross profit growth on 10% revenue growth and are pleased to be in a position to raise our annual outlook for EBITDA and annual guidance for non-GAAP EPS due to the successful execution of our software strategy. Looking beyond this year, we believe market demand is strong for security analytics software, and we are well-positioned for continued growth. As discussed on past calls, we are pleased with the execution of our software strategy and going forward we will offer more use cases on our platform for a subscription model. We expect customers to adopt subscription model gradually over time. Now, let me turn the call over to David to discuss our results and outlook in more detail. David?

David Abadi, CFO

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 Matt mentioned, in our earnings release and in the Investors section of our website. As Elad mentioned, we had a strong second quarter with revenue, gross profit and EPS coming ahead of our expectations. During Q2, we won multiple seven and eight-figure orders from existing and new customers, driven by ongoing demand for our analytics software and our strong differentiation. Revenue for Q2 came in at about $116 million, up approximately 10% year-over-year. Non-GAAP gross profit came in at $85.6 million, up more than 13% year-over-year. And non-GAAP diluted EPS came in at $0.17. Adjusted EBITDA was $18.5 million in the second quarter. Behind our strong results was the demand for our solutions and the successful execution of our software model strategy, which I'd like to discuss in greater detail. In the first half of the year, over 50% of our revenue was recurring and 89% of our revenue came from software, up 200 basis points year-over-year, reflecting the adoption of our analytics platform and the reduction of hardware reselling and professional services. Our H1 non-GAAP gross margin increased over 300 basis points to 73%, and our non-GAAP gross profit increased approximately 16% year-over-year as a result of this improved mix. Over the last few years, we have made investments to transition from a system integrator model to a software model. These investments are now behind us, and we are seeing the benefit of this investment in our software mix and gross profit growth. Now, let us turn to our FY '22 outlook. Starting with revenue, our outlook for FY ‘22 is $490 million of non-GAAP revenue with a range of plus or minus 2%, reflecting approximately 10% year-over-year growth. We expect our annual recurring revenue including subscription and support revenue to represent approximately 50% of our total revenue. As Elad mentioned, we're offering more for our platform use cases through a subscription model, and we expect gradual adoption of subscription over time. Regarding profitability, we are pleased that our software strategy is ahead of plan, and we are raising our annual outlook for gross margin and adjusted EBITDA, and our annual guidance for diluted EPS. For non-GAAP gross margin, we now expect slightly above 72% for the year, more than 100 basis points improvement over the prior year, with non-GAAP gross profit growing approximately 12% year-over-year. We expect our non-GAAP diluted EPS to come in at $0.82 at the midpoint of the revenue range, up from our prior year guidance of $0.80. Our diluted EPS guidance reflects $87 million of adjusted EBITDA, up from our prior outlook of $85 million. Our outlook for $87 million of EBITDA reflects 18% year-over-year growth, normalized for the spin-off dis-synergies. Let me also discuss how we see the year progressing. We are pleased with our strong first half and ended Q2 with more than $500 million of RPO reflecting strong demand for our platform. When looking at our backlog and the timing of our customer deployment, we expect Q3 revenue in the range of $112 million to $117 million and to finish the year with our typical strong fourth quarter. Regarding EPS, as I just mentioned, we're raising our outlook for the year to $0.82. And based on our revenue mix and OpEx level for H2, we expect EPS of about $0.10 in Q3 and EPS of about $0.35 in Q4 at the midpoint of our revenue outlook. With that, I would like to hand over to the operator to open the line for questions. Operator?

Operator, Operator

Our first question is from Mike Cikos from Needham & Company.

Mike Cikos, Analyst

Hey everyone, this is Mike Cikos. Thank you for your time. I have a question about the revenue. You've shown strong growth in the first half of the year and you're keeping the fiscal '22 guidance. Could you explain the revenue guidance for the third quarter? The range of $112 million to $117 million suggests a year-on-year decrease at the lower end of that guidance based on sequential analysis, and it appears to be flat compared to last year's results. Can you break down the factors at play and discuss the typical seasonality you expect for the fourth quarter? My main focus is on the third quarter.

David Abadi, CFO

Thanks, Mike. It’s David. So we ended Q2 with more than $500 million of RPO. And when looking at our revenue backlog and timing, we expect Q3 to be between $112 million and $117 million and finish the year with a typical strong Q4. The timing of a few deals that we had originally modeled in Q3 are currently scheduled to be in Q4. And for the year, as we mentioned before, we are raising our outlook for EPS on $10 million revenue growth. That gives you like the core on Q and why we’ve guided this first.

Mike Cikos, Analyst

That's helpful. You were breaking up a bit, but I have another question. You've mentioned multiple seven and eight-figure deals for back-to-back quarters, and I'm curious about the $500 million plus RPO exiting Q2. Can you provide insights into the current deal activity pipeline? Would you say that visibility for your business is improving due to the successful transition of the software model? It seems that customer demand might be strengthening compared to three to six months ago. Any details on the demand dynamics would be appreciated.

David Abadi, CFO

So let me give you some color and let know if the line is there okay. So we started the year with strong Q1 and Q2. In H1, we completed 47% of our revenue for the year, already done, which is good. We see the demand remains strong and our solution continues to be used and we ended Q2 with more than 500 million in RPO. And again, it is a very significant figure, which gives us a significant level of visibility. And by doing that, we have like a strong level of visibility.

Elad Sharon, CEO

Yes, Mike, this is Elad speaking. Regarding market demand, our customers are encountering increasingly complex security challenges. We continue to see a strong demand for our open analytics platform, with a primary focus on replacing homegrown solutions. These were examples I mentioned earlier in Q1 and in this call. As David stated, we had a strong start, and we have good visibility for the second half of the year, driven by our recurring business, which constitutes about 50% of the repeat business from existing customers. This is roughly 9%, and we also have a strong remaining performance obligation of $0.5 billion that David just mentioned. Overall, I feel quite positive about this outlook.

Mike Cikos, Analyst

And one more if I could just real quick on the subscription. I know that you guys are very early in the process and that is going to be a gradual process for you guys. But the question is, I guess as your sales force is talking to either existing customers or prospective customers, can you help us understand how those customer conversations have been trending and how receptive has your customer base been to potentially transitioning to a more subscription-oriented offering?

Elad Sharon, CEO

Sure. Thanks, Mike. So currently, around 50% of revenue is recurring, and about a quarter of which is already a subscription. We have an open dialogue with our customers. We are discussing with them their transition to subscription. In some government agencies, we see more openness to transition, while others are not yet ready. And given what we see in terms of customer behavior, the existing backlog and pipeline, we expect recurring revenue to stay around 50% next year. Going forward, beyond next year, we expect subscription revenue to grow faster than overall revenue. We have to remember that government customers are a little bit conservative. We saw that also when we transitioned to software. It took them some time to adjust. They are lagging behind the global market. But we believe that at a certain point, they will accelerate the adoption. It's just about the amount of time and we’re ready; we already are offering subscription. Some of them already adopted subscription. But as you mentioned Mike, it will be a gradual and slow process.

Operator, Operator

Our next question is from Daniel Ives from Wedbush.

Daniel Ives, Analyst

So, regarding the last question, can you elaborate on deal sizes and pipeline? Are you noticing a clear shift in the larger deals you're pursuing, particularly in terms of them becoming more strategic and comprehensive?

Elad Sharon, CEO

This is Elad. We don't see any change in the market. It remains consistent with what we observed previously. There are deals in the seven and eight-digit range, as well as some smaller deals. Generally, we are focusing on our existing solutions, allowing customers to decide whether to start big and evolve over time or to purchase our comprehensive platform that covers many use cases simultaneously. Overall, there is no change in the ecosystem, and we are observing similar trends in the market as before. I hope this helps.

Daniel Ives, Analyst

And then just like on the subscription model transition, obviously trying to accelerate that more and more. I mean, is that something where you're continuing to drive that even to the next level through the go-to-market strategy as we're thinking about that transition over the next 6, 12 months?

Elad Sharon, CEO

Yes, I can provide more details about our subscription model. As I mentioned earlier, we are actively communicating with our customers, and government clients tend to be more cautious. Based on our insights, we anticipate a modest level of market adoption. Additionally, we have a robust remaining performance obligation of over $0.5 billion and ongoing proposals under a perpetual model. Transitioning to this model takes time for government customers, but we believe they will eventually adapt. Currently, it's difficult to determine the exact duration of this transition. We think pushing government customers to adopt changes too quickly, when they are not ready, could have adverse effects. We noted similar patterns during the software transition, which also took time for government organizations to embrace, but ultimately, they did, and the results have been positive. The software shift is progressing better than expected, and our gross margin remains strong. We anticipate this process will be gradual, but we are confident it will lead us to our desired outcome. I hope I’ve addressed your question.

Operator, Operator

And our next question is from Brad Rebeck from Stifel.

Brad Rebeck, Analyst

I think you guys mentioned that you've had some early success or some early customers move to subscription. Can you give us a sense of what the revenue uptake is when a customer does that?

Elad Sharon, CEO

Yes, some of the use cases we offer in subscription, we do see about one-third of our recurring revenue in the subscription. When we go to customers, existing customers, that have been with us for more than 20 years, are still in the perpetual model and we are discussing with them to shift. For new customers, it's easier to adopt the subscription. So that's the reason we expect a gradual process. Have I answered or any other comments?

Brad Rebeck, Analyst

I'm sort of interested, if the customer spending $1 historically with you on license and maintenance, and they move to subscription, what's that $1 become?

David Abadi, CFO

It's David. I want to provide some additional context on that. Historically, we began our transition to a software model a few years ago without any subscription offerings. In recent years, we have introduced some subscription options for certain services, allowing customers who are willing to shift to move in that direction. Generally speaking, for every dollar spent on perpetual licenses compared to subscriptions, the equivalent value was around three dollars, though this varies based on specific use cases and what we can offer to our customers. It's important to note that we are still in the early stages of this process; we are currently fostering more open discussions with customers and working internally to make our offerings more appealing.

Operator, Operator

Our next question is from Kirk Materne from Evercore ISI.

Kirk Materne, Analyst

Elad, could you elaborate a bit on the opportunity in crypto and whether it represents a significant potential for your product offerings and existing customer base? I'm interested in hearing more about that opportunity. Thank you.

Elad Sharon, CEO

Sure. So, we discussed cryptocurrency in the previous call. We discussed that it's becoming very important for our customers to have this use case because illegal transactions are done in the cryptocurrency ecosystem. It's another use case. Actually, our growth plan is relying on evolving the platform to support more and more use cases, and cryptocurrency is one of them. In terms of where we are today, we launched it last quarter. We see this as an opportunity for both expanding with existing customers, as well as acquiring new customers. And obviously, lots of customers will have an interest in this use case. At this point in time, we are running multiple POCs with customers and the results so far are encouraging.

Kirk Materne, Analyst

That's helpful. And then David just two quick ones for you. One was just sort of a follow-up on the earlier question around just the seasonality in 3Q and 4Q. And sorry if I missed this. But is that just more of a revenue rec issue or are just the bookings also more fourth quarter weighted, meaning, last year it looked like it wasn't quite as pronounced, but going back two years ago, it looked like you guys had more seasonality from 3Q to 4Q. So, I'm just trying to get a sense on, those are deals that have been, you’ve been selected but haven't invoiced or booked yet, or is it more just that the pipeline builds or buyers are more pronounced in the fourth quarter?

Elad Sharon, CEO

So, as we spoke before, like we gave an RPO of about $0.5 billion, and it's a matter of timing of revenue. Q4 is typically strong. And again, when we look at the Q3 and Q4 ahead of us, we are still guiding for a 10% year-over-year growth. Recurring revenue continues to be a significant element of our business with more than 50% of our business, and the strong RPO gives us a direct level of visibility towards the end of the year.

Kirk Materne, Analyst

Okay. And last one for you. Just on the professional services side of the equation, where it's less emphasized at this point in time. But is this a good run rate do you think going forward for us to think about from a modeling perspective? Meaning is this around 14 million sort of the new base for you all or can that grow or kind of how should we think about that, as it relates to your longer-term aspirations to accelerate?

Elad Sharon, CEO

Yes. So, again, our strategy is to reduce professional services and hardware reselling over time. We started the journey like a few years ago, and we’re able to grow from the level of 80s this quarter to like more than 89%. From a modeling perspective, the long-term, I would assume that 90% of our revenue will be from software and the remaining 10% will be from professional services and hardware reselling. This is in the long-term. In the coming years, I think that we will gradually go there. I think that 86%, 87% of our revenue on software is a good range for this phase of transition.

Operator, Operator

Our next question is from Brian Ruttenbur from Imperial Capital.

Brian Ruttenbur, Analyst

Thank you very much. I have one housekeeping question and one broader question. Regarding the housekeeping, I may have misunderstood, but I believe you mentioned that total subscription revenue is currently a quarter or 25%. I had noted down that last quarter, you mentioned subscription revenue was around 16% to 17%. Am I mistaken with my figures or accurate?

Elad Sharon, CEO

The current subscription portion of the total recurring revenue is one quarter. So, around 12% to 13%.

Brian Ruttenbur, Analyst

Got it. That's where I didn't calculate the total revenue correctly. Okay, so that's the first point. The second point is discussing the replacement of homegrown solutions as a major factor. What is the primary decision-making factor for these government agencies? Is it cost savings, available resources, or ease of use? What are the main reasons for them discarding their current solution in favor of yours?

Elad Sharon, CEO

Yes. So actually, homegrown solutions have many downsides for customers; I'll focus on the top ones. The first one is that it cannot keep pace with technology changes. When you do a tailor-made solution developed to one time for yourself, it's very easy to develop it, modernize it and keep pace with technology when you'll have to invest only for one single solution. When you go to an open analytics platform from a global vendor that is for many other customers. So, you grow together with the pace of technology. This is one. The second is related to the high costs in order to maintain it. And the third issue that it’s very difficult to add more and more use cases and the world is changing. We discussed that the use cases, the trivial ones were the different criminal activities. Another example is cryptocurrency, and you have to develop and evolve. And taking all of it together, this is becoming very inefficient, the value of the system is declining over time, and it's ineffective economically. So altogether, actually, they don't get the value they need and they pay a lot of money. So, this is the formula for them to transition and replace it with an open analytics platform.

Operator, Operator

Thank you. Our next question is from Louie DiPalma from William Blair.

Louie DiPalma, Analyst

Good morning, Elad and David. Is there an opportunity for you to partner with mobile forensics extraction software providers, like Grayshift or MSAB? Magnet Forensics recently IPOed in Canada and they have a solution called AXIOM Cyber, that is very similar to yours for cyber incident response software. And they have partnered with Grayshift for mobile forensics extraction. They have built-in integrations to help law enforcement and they have significant customer overlap with you for intelligence communities and law enforcement. So, I was wondering in terms of your go-to-market strategy, if that's an area that you could pursue partnership opportunities to accelerate your growth?

Elad Sharon, CEO

Thank you for the question. Our platform integrates various data sources, both structured and unstructured, at scale, and performs robust analytics to address a wide range of security use cases. The digital forensics solutions we offer capture data for our customers, who can also input this data into our platform along with other sources like social networks, the dark web, criminal records, and vehicle records. However, it’s up to the customer to determine which data they have access to and what to input into the platform, in compliance with regulations. This additional data source can enhance analytics, investigations, and insights. I hope this clarifies things.

Operator, Operator

And I have no further questions at this time.

Matthew Frankel, Head of Investor Relations

Alright. Thank you, operator. And thank you everyone for joining us today. Of course, feel free to reach out with any questions and we look forward to speaking to you soon. Have a good day.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. And you may now disconnect.