Earnings Call Transcript - CGNT Q2 2023

Operator, Operator

Good day and thank you for standing by. Welcome to Cognyte Second Quarter Fiscal Year 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. Please be advised that today’s conference call 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.

Dean Ridlon, Head of Investor Relations

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, 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.

Elad Sharon, CEO

Thank you, Dean. Welcome everyone to our second quarter conference call. Our Q2 revenue came in at $81 million. This supporting revenue performance represents a significant decline year-over-year and sequentially, reflecting further adverse changes in customer behavior that I'll discuss shortly. With regards to bookings, booking activity came in higher than reported revenue and drove an increase in our backlog. As a reminder, RPO is the amount of contracted revenue that has not yet been recognized and we are sharing this messaging with investors because we use it as a proxy to measure our backlog. As of the end of Q2, our RPO was $534 million, an increase of approximately $20 million from the end of Q1. We have a significant backlog. However, we are not able to convert more backlog revenue during Q2, and I'll also explain the reasons shortly. Our Q2 gross margin improved sequentially as a result of a better software mix, but given the relatively low level of revenue, we had an operating loss in Q2. David will provide further details and analysis of our Q2 financial results. Next, I would like to focus my comments on what we are seeing in the market and the corresponding actions we are taking to return to growth and profitability. Let me start with new deals. Despite the challenging macroeconomic environment, in Q2, we continued to win large multi-seven and eight-figure deals, and our booking activity exceeded reported revenue and resulted in a backlog increase. Let me talk about a few of the large deals we won in Q2. The first deal is for approximately $50 million from an existing law enforcement customer to expand the solutions used to combat drug trafficking and other criminal activities. The longstanding relationship we have with this customer and our differentiated solution drove this expansion order. The second deal is from an existing law enforcement customer for approximately $5 million to combat criminal activities. This customer is expanding its capabilities while replacing the solution of a competitor. The customers selected our solutions because of their previous positive experiences with Cognyte and our superior technology. The third deal is from a national security agency, which has been a long-term customer for approximately $5 million to help combat a variety of national security threats, including illegal immigration, drug trafficking, and organized crime. We won this deal because of our successful track record with this customer. We believe that these large orders highlight the confidence our customers have in our technology and our ability to deploy large complex solutions. Our competitive position remains strong, and we believe that we have not lost any significant deals to competitors during the quarter. In terms of our booking activity, while we won many deals, including large deals in Q2, we also experienced longer sales cycles across all geographies, and we had many more deals that we expected to close in Q2 but were delayed by customers. Let me explain further on the changes in customer behavior that we are seeing in the market. In addition to pipeline conversion delays, we have seen backlog conversion delays. Customers in many countries are facing reduced funding and budget constraints, which impact the ability to make payments prior to deployment. This changing customer behavior impacts our ability to accurately plan the deployment schedule for backlog. We believe this behavior is due to deteriorating macroeconomic conditions and related budget cuts in some countries and does not reflect a change in their interest in new analytics technology to address evolving security threats. While we believe security remains a high priority, the global economic slowdown has caused some of our customers to change behavior. Given the changes in the marketplace I discussed earlier, we are taking action in response across three main initiatives. First initiative is to maximize bookings by focusing the company on the areas with the highest near-term potential. This includes geographical priorities to focus on countries that are less affected by budget cuts. For example, we increased our focus on the U.S. government market, and I'm happy to report that our solution was recently selected by the Baltimore Police Force. We're also focusing on security use cases that currently represent higher customer agency. Second initiative is to reduce our cost structure. We are reducing operating expenses. We target to achieve below $70 million in Q3 and below $65 million in Q4. Third initiative is to regain visibility as soon as possible with a focus on predictable backlog deployments. Government contracts typically provide customers significant flexibility. Recognizing this flexibility, we are collaborating with customers to achieve a more predictable backlog deployment schedule. We expect this will help improve our visibility and increase our deployment efficiency. Our goal is to return to growth and profitability as soon as possible. Given the macro environment, I believe these three initiatives will help us achieve this goal. I also would like to mention that the actions we have taken previously to address operational and supply chain issues were successful, and we are now seeing minimal supply chain impacts on our operations. At this point, our visibility remains limited, and we are unable to resume guidance. However, to provide color on our near-term revenue expectations, we believe third quarter revenue will be similar to or lower than the second quarter, and the fourth quarter revenue will increase above the Q3 level. We intend to resume guidance as soon as practical. In summary, the global economic slowdown is affecting our near-term performance, and we are taking actions to focus the company on territories and use cases with the highest potential to reduce our cost structure and to improve deployment predictability of our significant backlog so that we can regain visibility. The Board and management team are laser-focused on returning to growth and profitability. We believe security threats are pervasive and customers need innovative solutions to address evolving threats. We are market leaders in investigative analytics, with a long history of growth, and a strong track record with customers around the world. Now, let me turn the call over to David to provide more details about our Q2 results.

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 Dean mentioned in our earnings release and in the Investors section of our website. Revenue for Q2 came in at $81.1 million with three components: software revenue of $27 million, software services of $45.4 million, and professional services and other of $8.6 million. This revenue mix has changed as follows: software revenue declined by $20.9 million year-over-year, and increased sequentially by $2.1 million. We see a change in our customer behavior, which disrupts planning for the backlog conversion into revenue. As Elad said, government contracts typically provide customer flexibility. We are working with customers to achieve a more predictable backlog deployment schedule. This will help improve our visibility and increase our deployment efficiency. Software service revenue declined by $8.5 million year-over-year and remained at a similar level to Q1. Professional services and other revenue declined by $5.5 million year-over-year. Booking activity during Q2 came in higher than our reported revenue and drove an increase in our backlog. As of the end of Q2, our RPO was $534 million, an increase of approximately $20 million from the end of Q1. We believe that our significant backlog will drive our future revenues. Turning to gross margin. In Q2, gross margin improved to 65.1% on a non-GAAP basis, up approximately 400 basis points sequentially, primarily as a result of the increase in software revenue and mix. Our Q2 non-GAAP operating expenses were $70.4 million and $4.4 million lower than Q1 level, reflecting our cost control activities, which we plan to continue in the second half of the year. Despite the sequential improvement in gross margin and operating expenses, the lower revenue level resulted in a non-GAAP operating loss of $17.4 million for the quarter. Below the operating line, we incurred approximately $1 million in interest and other expenses, and had non-controlling interest expense of approximately $1 million, and our non-GAAP tax expense, which I would like to discuss further. For purposes of non-GAAP tax expense, we have consistently used a methodology that starts with our estimate of total cash tax payments for the year compared to our forecast of pretax income to create an annual effective tax rate. Each quarter, the year-to-date tax expense is adjusted based upon changes in the full-year estimates of tax payments and pretax income. For Q2, these adjustments resulted in a positive contribution to income of $16.7 million. Our actual cash tax payments in Q2 were $4.8 million. Turning to the balance sheet, we ended the quarter with about $55 million of cash, cash equivalents, and short-term investments. Cash used in operations was $18.8 million, inclusive of a one-time payment of $6.2 million related to the settlement of a patent claim that I talked about last quarter. In Q2, we reduced borrowing under our credit facility, and as of July 31, we had $20 million of outstanding debt. Also, during Q2, we renegotiated some of the credit facility covenants to provide us more future flexibility. Given the macro environment, we recognize that we faced ongoing uncertainties relative to the timing of our return to profitability. As a result, credit facility actions as well as other actions we might take will be evaluated frequently. As we look ahead, we are taking steps in response to the current macro environment. We expect revenue in Q3 to be similar or lower than Q2, and fourth quarter revenue to increase above the Q3 level. Cognyte has a long history of delivering profitable growth and managing through superior volatility. We look forward to resuming guidance as soon as practical. We have a long-term opportunity in front of us in helping our customers to address the evolving security threats. With that, I would like to hand the call over to the operator to open the line for questions.

Operator, Operator

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

Mike Cikos, Analyst

Hey, thanks. You have Mike Cikos here from Needham. I just wanted to make sure that I heard you guys correctly. Can you comment again on what was the revenue expectation for Q3 and Q4?

David Abadi, CFO

Hi, Mike. Yes, sure. So, we expect Q3 to be similar or lower than Q2, and Q4 to be better than Q3.

Mike Cikos, Analyst

4Q better than Q3. Okay. And so, one of the things that I'm struggling with on my side and hopefully you guys can help with this, but I know that we're calling out the more difficult macro environment today, but at the same time, you guys were also talking about the increase to RPO. If I go back last quarter, you guys also had noted a slight increase to RPO sequentially, right? So, can you help us better understand, I guess, what gives you that confidence to start at least directionally guiding to the revenue in Q3 and Q4?

Elad Sharon, CEO

Yes. So, maybe I'll give you some color, Mike, about what we see in the market and then I'll address the Q3. So, we do see economic slowdown and this results, of course, in budget cuts and customers' preparedness. It has an impact on the deployment schedule of already committed orders, and actually, we are unable to convert some of the backlog to deployments and recognize the revenue. So today, if you look at the situation, we do see two different customer behaviors. The first one is related to slow pipeline conversion. And the second one is backlog conversion issues, and both of them are related to budget cuts and the macroeconomic slowdown. However, we’re still able to increase our backlog in Q2, as you mentioned, and in Q3, in Q2, it was increased by approximately $20 million of RPO. When we look at Q3, we do have the backlog, and that's the reason we believe that it can be similar to Q2. However, we do see the issues that are related to backlog conversion and customer readiness; some of them are not ready with the hardware that they need, some of them are not ready with the resources, and some of them are deferring some payments. So, that's the reason we believe it can also be lower than Q2. In terms of Q4, we had some orders and deployments that were shifted from Q2 to Q3, and the backlog entry point in Q4 seems to be stronger than previous quarters, and that's the reason we believe Q4 will be better than Q3. Does this answer your question, Mike?

Mike Cikos, Analyst

Yes, yes. That is helpful. And I know that we've spoken to the pipeline conversion before. That also came up on the last quarter as well. Can you just remind us what Cognyte is doing to help customers or I guess help convert that pipeline and drive that increased visibility? I know that you guys have a new Chief Revenue Officer and you're working on higher priority areas, but what is it specifically that you guys are doing to help increase visibility and convert that pipeline?

Elad Sharon, CEO

Yes, sure. So, we are proactive in this respect. Late last year, we discussed the need to strengthen the management team, and we hired a new COO at the beginning of this year. I believe we have now the key leadership to execute the plan and, of course, make changes as necessary in response to changes in the market. We are also focusing on where the high potential is related to first countries that have budgets. Second is the more pressing security use cases that customers are facing. Our sales force is focused now more efficiently in areas where we believe the pipeline can be converted faster and in countries that have the budget to support these orders.

Mike Cikos, Analyst

If I could just build on that a little bit more, and I don't mean to poke here, but if I'm just thinking about it like the – let's talk about those two initiatives that we spoke to, right, the idea that you're going to focus on countries with budget and focus on customers with more pressing use cases? Like in my head, shouldn't that be something that the sales force is already executing against? And so, the question becomes, is that something that you guys weren't doing previously, or I'm just confused by how that's going to help you guys drive better execution? So, those two things I would think is what the sales organization is doing on a continual basis. If you could just clarify those two pieces.

Elad Sharon, CEO

Yes, sure. Let me give you an example of one of our customers, and I believe it will give you some color. I've been with the company for more than 20 years and I know our key customers personally. I visited one of them at the beginning of the year and we discussed the plan for this year. The customer indicated that business was as usual; it's a country without budget issues usually and sticking to the schedule of deployment. When I visited them again two months ago, the situation was totally different. They updated us on budget cuts and informed us that they had to defer some payments, which will affect existing orders' deployments. This shows that only in a few months’ time, the situation has changed. The macroeconomic slowdown is affecting some countries more than others. Some security threats are more important today than others, so it's a dynamic situation that we have to adjust to and focus our resources and efforts on the right places. Our objective is very clear. We want to return to growth and profitability. For that reason, we are focusing on converting the pipeline in a more efficient way. Given the current situation, we focus on areas where we see the opportunities more mature and customers being able to fund, while also discussing with our customers to firm up deployment schedules and their readiness, whether it's hardware resources or payments, to be able to convert the backlog more efficiently. So, those are the two initiatives we are focusing on, and it's a dynamic situation we have to monitor and act accordingly, but we are proactive on this.

Mike Cikos, Analyst

Understood. Thank you. I'll turn it over to my colleagues.

Elad Sharon, CEO

Thank you, Mike.

Operator, Operator

Thank you. One moment. Our next question comes from Peter Levine with Evercore ISI. Your line is open.

Peter Levine, Analyst

Great. Thanks for taking my questions. Maybe just a follow-up on the last one: did you guys experience any higher level of sales churn within the sales force? And then second to that, can you just maybe share the sector sales funnel for us? If the sales force was not successful converting leads or adding leads at a similar level as planned, do you feel like you have enough reps in place, or is it just folks not hitting quarters?

Elad Sharon, CEO

We do look at our sales force and the focus now, as I mentioned before, is to focus on areas where the higher potential is. Another example is our initiative to expand our business in the U.S. This is an example of where we see more opportunities. Yes, we hired more sales force in the U.S. and we contracted with the channel. We are taking actions according to where the potential is. So, yes, we do take actions relevant to the current situation.

Peter Levine, Analyst

Have you experienced higher sales churn this year versus historically?

Elad Sharon, CEO

Yes, we did.

Peter Levine, Analyst

Okay. And then the final question here is, can you give specifics on your cost reduction plans? Like where those costs are coming from in sales and marketing or R&D? And just kind of how you're thinking about balancing the near-term impact from those cuts towards the longer-term initiatives to accelerate the top line?

Elad Sharon, CEO

Yes. We reduced operating expenses already in Q2, and we started to take the operating expenses below $70 million in Q3 and below $65 million in Q4. The cost reduction is more in R&D than in SG&A, and we designed the cost reduction so that it will not impact customer commitments and will not impact our ability to return to growth and profitability. For example, we are reducing investments in technology foundation improvements that can wait for a later stage. That’s how we view the cost reduction initiative.

Peter Levine, Analyst

Great. Thank you for taking my questions.

Elad Sharon, CEO

Thank you.

Operator, Operator

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

Brian Ruttenbur, Analyst

Yes. Thank you very much. A couple of follow-up questions to the previous. In terms of cash burn over the next couple of quarters, what are you looking at? I believe that you burned a couple of million this period, as well as the previous. Can you give us any kind of indication of where cash burn will be in Q3 and Q4 and what your plans are to maybe increase credit facilities or what your cash flow balance sheet look like?

Elad Sharon, CEO

Yes. So, we used cash in our operations in Q2. During Q2, we had a one-time settlement payment of $6.2 million, which we don't expect will continue later on. When you look at cash, there are two major aspects of cash from an operational perspective. There is the expense side and we discussed that we are reducing our cost structure, and we aim to be under $70 million in Q3 and under $65 million in Q4. On the collection side, we have two major pillars that drive our collection: our accounts receivables, which are sitting in our balance sheet, and we are actively collecting these receivables, and on top of that, we have our backlog, which is off the balance sheet and is very significant. We are taking action to convert this backlog faster, which would be another source of cash for us. So, if you think about cash, we are aiming to return to positive cash flow by aligning our cost structure and accelerating our backlog conversion. We have a track record of generating cash.

Brian Ruttenbur, Analyst

Okay. Just as a follow-up to that, so you're talking about $70 million of operating expenses in the third quarter and $65 million in the fourth quarter, is that correct?

Elad Sharon, CEO

Yes, non-GAAP operating expenses in Q3 and Q4.

Brian Ruttenbur, Analyst

Okay. Thank you. That's very helpful. A couple of other follow-up questions. Can you talk about headcount? You talked about a 5% cut, and I know everybody's been asking about this, and you cut some R&D in a variety of other things. Can you talk about what percent cut you're talking about in this next series of cuts?

Elad Sharon, CEO

Yes. When we look at cost reduction, we manage carefully all aspects of operating expenses reduction, it's not just resources. In this environment, it's clear to us that the company needs to be very lean and to focus on the higher potential opportunities we have. We are aligning the organization and resources accordingly.

Brian Ruttenbur, Analyst

Okay. Do you have a specific percentage like you gave last quarter?

David Abadi, CFO

We are sharing with you the operating expenses. I think the key is the OpEx we will end the year with. We are driving the operating expenses down quarter-over-quarter in Q3.

Brian Ruttenbur, Analyst

No, that's helpful. The last question I have is understanding that governments are pulling back and it's primarily international governments, not the U.S., so you're getting growth out of the U.S. Can you talk a little bit about what percentage of your total revenue right now is U.S. facing?

Elad Sharon, CEO

Yes. We have less than 10% of our revenues coming from the U.S., and obviously, we see higher opportunity in the U.S. That's why we decided to expand operations there. I am very happy that we were able to win the Baltimore Police Force deal recently.

Brian Ruttenbur, Analyst

Okay. And then where is the biggest growth opportunity for you guys? EMEA, where is it that you're seeing the most cuts or pullback?

David Abadi, CFO

Actually, when we look at the market, we don't see a real regional trend in relation to the macroeconomic slowdown. What we see is that it is country by country, and some countries are more affected than others. In some countries, there is almost no impact, in others, there is a major impact. So, we don't look at it in a regional way because there isn't a regional trend. We go one-by-one.

Brian Ruttenbur, Analyst

Okay. So, there's no region that you can point to that says there's more cutbacks happening in this region in Europe, Western Europe or anything else, but it's a country by country situation. Is that correct to summarize?

David Abadi, CFO

Correct. It's a country by country. As I mentioned earlier, we use the grid of what countries are less affected by budget cuts and what the pressing security use cases are they have. This combination focuses us on where to put our resources and on the highest potential opportunities that we want to look after.

Brian Ruttenbur, Analyst

Okay. And then last question. In the U.S., I know that the federal government has been hesitant to buy from Israeli-based firms in the past at least, but are you getting traction at the federal level? It seems like you're getting traction at state and local levels, but can you address what the federal government is looking for?

David Abadi, CFO

Yes. When we look at the U.S., we have been doing business here for quite a while. It's not new. We are just now expanding and we want to go for federal, state, and local. That's our plan. For now, we are focusing more on state and local, and we'll see along the way whether there is an appetite to invest more if we see, of course, customers coming to us. I do believe that given our differentiated technologies, we will be able to expand also in the U.S. across different government agencies.

Brian Ruttenbur, Analyst

Great. Thank you very much.

David Abadi, CFO

Thank you.

Operator, Operator

Thank you. And we have a follow-up from Mike Cikos with Needham & Company. Your line is open.

Mike Cikos, Analyst

Hey, guys. Just a couple more questions if I could. First, I know that we spoke about the revenue for Q2 and then this outlook for the rest of the year. Can you help us understand what happened with the decline that we saw in professional services revenue this quarter? Just because I think that's understanding what happened in Q2 and potentially your outlook for professional services in Q3 and Q4 is obviously going to impact our assumptions around how gross margin tracks just because so much of the gross margin improvement from Q1 to Q2 came from the mix shift with professional services falling off in Q2. So, can you help us think about that?

Elad Sharon, CEO

I would take all the questions, but there were a few questions on the same topic. So, let's start first from the composition of our revenue. We are working under our software model, which means that we are driving more software revenue, and we want to reduce the level of professional services and other revenue. This means that, from a mix perspective, we want to have less revenue from professional services and much more revenue from software. Any incremental software revenue will deliver better margin, and even when converting our backlog, it drives much higher gross margin. The main reason for the improvement in the sequential gross margin was because of this incremental software revenue. So, when you look at professional services, in Q2, we had relatively low revenue from professional services, which is partly due to the deployment of the backlog. We are currently not as efficient as we want to be with the professional services because of delays in the deployment of the backlog. The more we can firm up the backlog, the more efficiently we will be able to manage revenue and subsequently improve gross margins.

Mike Cikos, Analyst

Yes. The professional services revenues were around $8 million to $9 million here. I know that you guys have been talking about this transition to the software model. Should we expect professional services to remain around $8 million to $9 million now, or will that move higher as revenues come back?

Elad Sharon, CEO

So, there is a proportion between the overall mix of the revenue. The revenue of the professional services should be taken into consideration with the overall revenue. At the end of last year, we were close to 88% of total revenue from software and around 12% from professional services. We believe that the improvement in the overall mix will continue, and as I look at our H1 performance, I think that our booking performance and backlog by the end of H1 supports our software model.

Mike Cikos, Analyst

Understood. Thank you for that. And I know coming back to the operating expenses and the color you provided there, if I go back to Q1 and the transcript, you guys had said that you expected to get to around $70 million in Q3. If I'm looking at how you executed in Q2, you're just about there. You were at $70.4 million, right? So, just help me think about what went right when thinking about the operating expense cuts in Q2. It just seems like you guys are realizing these cost savings in a way that is ahead of what we had previously expected.

Elad Sharon, CEO

Yes. When we spoke at the end of the Q1 earnings call, we were targeting to be around $70 million in Q3. We also mentioned that we executed part of the savings plan already. We looked at our operating expenses and analyzed them, and we kept that savings plan in mind. Yes, we were already there in Q2, and we are pleased with that because we want to cut costs and be as minimal as possible while allowing the company to continue to grow and be successful. We aim to be under $70 million during Q3 and under $65 million in Q4. It's a process that we plan and execute as part of market adjustments.

Mike Cikos, Analyst

Thank you for that. And then just a final question if I could. I know there was a letter from Neuberger Berman a couple of months ago. Can you provide us an update on what Cognyte’s response was to that letter?

David Abadi, CFO

Yes. We received the letter, and the Board discussed it. The Board is determining the right response, and that’s being handled between the board and Neuberger.

Mike Cikos, Analyst

Got it. Thank you very much.

David Abadi, CFO

Thank you, Mike.

Operator, Operator

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