Cellebrite DI Ltd. Q2 FY2022 Earnings Call

Good day and thank you for standing by. Welcome to the Cellebrite Q2 '22 Earnings Call. At this time, all participants are in a listen-only mode. Please be advised that today's conference is being recorded. I'd now like to hand the conference over to your speaker today, Anat Earon-Heilborn. Please go ahead.

Thank you. Welcome to Cellebrite's second quarter 2022 financial results earnings call. Joining me today are Yossi Carmil, Cellebrite's CEO; and Dana Gerner, Cellebrite's CFO. This call is being recorded and a replay of this recording, as well as the presentation that accompanies this call, will be made available on our website shortly after the call. A copy of today's press release and financial statements, including GAAP to non-GAAP reconciliations, as well as supplemental financial information for the second quarter, are available on the Investor Relations website at investors.cellebrite.com. Statements made during this call that are not statements of historical facts constitute forward-looking statements. All forward-looking statements are subject to risks, uncertainties, and other factors that could cause matters expressed or implied by those forward-looking statements not to occur. They could also cause the actual results to differ materially from historical results and/or from forecasts. Some of these forward-looking statements are discussed under the heading Risk Factors and elsewhere in the Company's Annual Report on Form 20-F filed with the SEC on March 29, 2022, as amended on April 14, 2022. The Company does not undertake to update any forward-looking statements to reflect future events or circumstances. With that, I'd like to turn the call over to Yossi Carmil, Cellebrite's CEO.

Thank you, Anat, and thank you all for joining us today. I would like to start the call today by sharing that we continue to see a healthy business environment for digital intelligent solutions across our core markets. I’m pleased to share with you that in Q2 our ARR grew 35% year-on-year to reach US$214 million. Total revenue in the second quarter was up 6% to reach US$62.6 million. Our net retention rates for the quarter came in at 128%. This represents the 14th consecutive quarter that we've delivered NRR of greater than 120% as we continue to expand wallet share within our target accounts, mainly in the public sector. Additionally, we closed 29 large deals in the quarter compared to 18 in the first quarter of this year. I would like to spend some time today, first going through what we are seeing in our market and the go-to-market strategy, then updating some dynamics we saw in the second quarter, and lastly, outlining our expectations for the second half of the year. So I will start with a perspective on the market environment and its impact on Q2 results. Now while we're operating in a healthy environment, there are several factors that impacted our results in Q2. First, in Q2, we saw some longer sales cycles for some of our strategic customers, which impacted our ability to close some larger deals in the timeframe anticipated. The positive aspect of it is that we've built a robust pipeline that is increasingly focused on large deals. This is part of our growth strategy and it provides exposure to large budgets within our accounts. An important distinction here is that the vast majority of the delays we are seeing are not deals going away from that pipeline. In fact, some deals have already closed, with the majority expected to close in the third quarter. In addition, we are moving successfully and faster than planned from perpetual to subscription new deals. However, as a result, our revenue for the quarter was lower than we planned. These are the short-term impacts on the top and bottom line, but they support a healthy longer-term business. Thirdly, we also faced some hiring issues in our go-to-market organization that have been properly addressed. So that's a short update on the macro business environment and our go-to-market strategy. In the U.S., which is our biggest market, we continue to see federal funds going to law enforcement, as well as state and local governments, to support safety. Additionally, we generally see similar budget environments in Europe and the Asia Pacific, where spending on safety remains a top priority. The USA is a prime example of not only the willingness to spend but also the increasing pressure on governments to more effectively address and fight crime. These initiatives cannot be successful without addressing the massive growth in digital evidence by leveraging a solution like ours to modernize the investigative process. Our technology enables law enforcement to solve more crimes, ranging from child trafficking to homicide, by dramatically decreasing the time to evidence for investigators and analysts. Our domain expertise and scale of operation are critical to the effectiveness of our solutions. We are pleased with our ability to innovate and expand our offering both within and outside of Collect and Review. Premium as a service is an important offering that enables a much larger customer base to benefit from our advanced capabilities by lowering the total cost of ownership for the agencies, and we are seeing strong traction since it was released to the market earlier this year. We also recently released Physical Analyzer Ultra, the next-generation of our review solution, which today represents the de facto industry standard for digital data examination. Aside from its ability to process a high volume of data, the new release also advances Physical Analyzer towards an enterprise architecture, a crucial milestone as investigative centers around the globe continue to accelerate their digital transformation journeys. Our focus remains on significantly increasing our wallet share within our existing customers. We continue to deliver strong growth and best-in-class NRRs by selling more solutions and expanding into more buying centers or user groups within our existing customers. I would like to take you through a few examples. The first is an investigative analytics deal where we closed the sale of over $800,000 within an existing customer, a European state police force. This is the first expansion of this customer outside of our Collect and Review offering. The key success factors for this win were our ability to address their specific requirements with a tailored solution, including better results from extracting and analyzing mobile drive data, better performance in text and image analytics, and the fastest enablement to find critical evidence quicker. Another exciting wallet share increase is our largest Guardian contract to date. This deal was part of a larger seven-figure deal. The investigative management portion included 500 Guardian licenses to be used across this major U.S. Metropolitan Police Department. This was a competitive situation in which Guardian stood out with its superior cloud functionality and its compatibility with our Collect and Review solutions. Our solution fulfills the need for an evidence management solution that meets reporting and chain of custody requirements as a cloud-based system that can scale for the organization's needs. The third example is from our early access with premium as a service, which only became available in late Q2 and immediately resulted in a seven-figure multiyear win with a U.S. state police force. This win will bring our advanced Collect and Review capabilities to approximately 20 field units and is a significant upsell from this customer's previous spending with us. I'd like to add that during the first half, we will continue to transition our go-to-market organization to take the dual role of supporting larger strategic opportunities in combination with our classical velocity business. We believe that this transition will be completed by the end of the year. As for our 2022 plan and outlook, as you saw in the press release we issued today, we've made the strategic decision to recalibrate our expectations for the second half of the year to a level that reflects the internal initiatives we're undertaking to position Cellebrite for durable growth and continued innovation in the digital intelligence market. We believe that the trends that we have seen in the first half will continue in the second half. Therefore, we expect a healthy growth of ARR exceeding 30% in the foreseeable future, while revenue and bottom line may be impacted for the short term. So before I turn the call over to Dana, our CFO, I would like to emphasize the excitement I have for the opportunity that remains in front of Cellebrite. As we look at our broad product portfolio of industry-leading technology across our core markets, I think Cellebrite represents one of the best pure-play opportunities to invest in public safety and digital intelligence. This, in turn, supports public safety and saves lives and communities worldwide. At the end of the day, we could not be more excited about our positioning due to our technology, customers, and market penetration and look forward to updating you on our growth to come. And with that, I will turn the call to Dana.

Thank you, Yossi. As Yossi mentioned earlier, ARR grew 35% year-on-year reaching $214 million by the end of June 2022. As we continue to move customers to a subscription model from our traditional perpetual licensing model, we saw incremental ARR growth in the quarter reflective of our transition efforts. The variance between our revenue and ARR growth was driven by two factors. One, we experienced better-than-expected adoption of new business sales in a subscription model and made significant progress in this area during the quarter. Two, because the quarter was very back-end loaded, a high proportion of the wins that are included in ARR represented a very small percentage of revenue recognized in the second quarter. Subscription licenses also continue to be an important growth driver for Cellebrite, as they help create a long-term incentive to increase customer spending with us. Revenue for the second quarter was up 6% from the second quarter of last year and reached $62.5 million, where subscription revenues were up 20% and continue to be a primary driver of total revenue. I would note that our transition from perpetual to subscription has been quite successful, with more than 98% of our software revenue now being subscription-based. Total subscription represents 80% of the quarter's total revenue in comparison to 70% in the second quarter of last year. We saw strong performance in professional services revenue, which was up 16% compared to a strong Q2 last year, as in-person training activities resumed to pre-COVID levels in most countries. Supporting growth in professional services remains important to us, as it helps drive larger deals and retention. Our GAAP gross margins were 79% in Q2 compared to 83% from the second quarter of last year. That is mainly a result of introducing costs of goods sold expenses related to our SaaS and cloud solution infrastructure and hosting services, a business that is still in the early stages. Moving to operating expenses, I will discuss this on a non-GAAP basis. The share-based compensation, amortization of intangible assets, acquisition-related expenses, and one-time expenses are all excluded. Non-GAAP operating expenses were $50.8 million in the quarter. Similar to last quarter, although expenses increased significantly compared to last year, they only grew marginally on a sequential basis. The year-on-year growth reflects our cost structure as a public company, the resumption of in-person activities, the operational costs associated with adding a SaaS offering to our development efforts, and our ability to execute on hiring. Adjusted EBITDA in the quarter was $0.7 million, or 1% on a margin basis. Our Q2 adjusted EBITDA results are reflective of our continued investment in headcount to capture the large growth opportunity Cellebrite sits at the forefront of while maintaining our technical leadership. Looking at the remainder of the year, we are focused on optimizing our spending for efficiency while supporting our go-to-market efforts and ongoing commitment to product innovation. This includes prioritizing hiring key positions and investing in areas that will help us achieve our goals in the near and long-term while responsibly managing to profitability. We ended the month of June with 969 employees, up 18% from the end of June last year, and we expect to end the year with over 1,000 employees. Non-GAAP net income in Q2 was $0.2 million, and non-GAAP fully diluted EPS was breakeven. Operating cash outflow in the second quarter was $4.1 million, and in the last 12 months, we generated $7.1 million of cash inflow. We ended June with approximately $165 million of cash, cash equivalents, and investments. Turning to guidance, as Yossi mentioned, we have made the decision to update our fiscal year 2022 guidance. We now expect the December 2022 ARR to range between $245 million and $260 million. We expect full year 2022 revenue to range between $270 million and $285 million. We expect gross margins to be between 80% to 82%, and we now expect adjusted EBITDA in the range of $20 million to $27 million. As we enter the second half of the year, which has traditionally been stronger than the first half, we remain confident in overall market demand and our ability to execute on these targets. Cellebrite remains well-positioned to capture the demand for modern digital intelligence solutions, and we see a long runway for growth within our business. With that, I will turn the call to the operator to open the Q&A session.

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

Hi, team. Thanks for taking the questions here. I did want to circle up on the commentary that you guys had about some of these longer sales cycles. And I just wanted to get some more color there. Can you help us think about when you started seeing those lengthening sales cycles? And has there been any change even within Q2 as far as going from April to May to June? Did the cycles extend? Or did you see that lengthening take place throughout the quarter? And what has customer behavior been like in July and now in the first couple of weeks of August?

Thank you for the question. I will start by saying that the fact that we are going into larger accounts, with a dedicated focus on strategic accounts, and penetrating more buying centers within Collect and beyond Collect and Review enables us to grab opportunities for larger budgets based on the extended offering. Over time, we see a larger amount of such larger deals, which are typically characterized by high-end six, seven, and even eight digits, often tied to strategic accounts. They include extended digital intelligence solutions with an enterprise impact and are normally multiyear deals. Those processes involve decision makers and take time; sometimes longer than anticipated in order to come to decisions. Some of these deals that we referenced were already established in 2021, and some started in Q1. Dana, would you like to add on top of that?

Yes, thank you for asking this question. With more large deals coming on board and with a higher dollar value per deal, we are seeing a longer approval level of requirements by our customers. This means that they are not always being closed in the timely manner we used to have with the mid-sized, larger deals. That said, we have seen very large deals closing right at the end of the quarter, which led to us being backed up, with some deals not having been signed within the quarter. We're confident because we have already seen some of them closed in the first six weeks of July, and we are still ramping up with new large deals in our pipeline.

That's great. And if I could just build on that. I want to be very specific to this question. When I think about longer sales cycles, we've heard about this from several different companies in our coverage universe. So I'm trying to get a better sense: Are these longer sales cycles because your deals are getting bigger as you work with some of these larger, more strategic accounts? Or is there a higher level of requirements for some of these budgeting and programs because we're in a more difficult economic backdrop today?

It's the first one. I will eliminate the second one because we do not see any impact from the political climate whatsoever. I do need to mention that we had two specific deals in Q2 that were delayed or influenced by the political climate: one in the North American federal area, and one in one of the largest Western countries. But in general, I don't think there is a trend. I am confident that the longer cycles are mainly due to more decision-making involved, more decision makers, larger budgets, and the approval processes that create the longer cycle.

Thank you for that. If I could squeeze one more in. I know that you spoke about some of these go-to-market issues, which have now been rectified. Can you help me understand what needed to be corrected and what steps have been put in place to address that issue or dynamic?

Mike, I'll start and maybe Yossi will add afterward. We spoke about the intention to increase our go-to-market sales force in '22. We started working on this already in late '21. We've seen a little bit higher-than-expected turnover, which does impact execution of deals with larger customers, not the disappearance of deals or budgets, which is quite natural in such an environment. We are well-equipped entering Q3 with the headcount, especially on the strategic accounts level to execute that. This is one aspect. The other is really the dual effort of servicing both strategic and long-term accounts, ensuring that we have the right people in front of the right customers in this perspective, which is an ongoing investment. Again, we feel that we are in a very strong position towards the second half of the year.

To add, the employment market is challenging overall. Our sales force experienced the same trend, with some groups experiencing about 25% to 35% new headcount. As Dana said, we are mostly beyond that situation, closing the gaps. Onboarding to full scalability and execution maturity in Cellebrite takes about 3 to 6 months, especially regarding managing strategic accounts. We have a well-structured onboarding process in place and believe we have taken the necessary steps to support the growth.

Thanks for that. I guess the implication is with some of that higher attrition that you guys saw in the second quarter, you're probably a little bit behind where you wanted to be in terms of headcount? And I guess the follow-up would be that when you say you've taken necessary actions to rectify these issues, it really seems to be a matter of improving retention or reducing attrition?

Yes, and I would say that it's mostly behind us. In Q1, you wouldn’t see the actual impact until you reach April, when you notice that it affects our ability to bring in new business that you would have expected. Overall, it’s behind us now, and we are well equipped.

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

And your next question comes from the line of Jonathan Ho from William Blair.

Hello, good morning. I just wanted to maybe start out with trying to understand the magnitude of the deals that have subsequently closed. What was the impact from those delays? Can you quantify for us what the revenue impact was, what the impact to deferred revenue was? And how to think about that.

I think we've spent time detailing three main drivers. Each of them had a similar portion in the delays. The first was the much lesser perpetual deals, which comes with immediate revenue recognition. Secondly, we've seen some slippage of deals. Lastly, the longer sales cycle. All in all, I would say that each of these factors contributed to a third of the revenue delay compared to how we planned to finish the quarter.

Got it. And then regarding the reduction in guidance, I am a little surprised to see the magnitude, given that you've subsequently closed some of these deals. Can you help us understand how much of the guidance reduction is coming from each of these factors or other factors? And why the continued reduction if you've subsequently closed these deals?

An important part of this is actually a faster-than-expected reduction in perpetual business. We projected a certain dollar amount for perpetual sales and revenue, which currently stands at less than 50% of what we expected. This does not impact the ARR but immediately affects the revenue portion. We assume that the trend we've seen in the first half will continue in the second half. Every deal that closes later in a subscription model impacts revenue for the entire year. I would say that half of the guidance reduction comes from the perpetual business and the rest from the sales cycle.

Got it. Just one last question for me. I'm trying to understand if there was a specific type of product involved in these delays. Were the delays associated with newer products or product bundling? Can you provide some color on the nature of these delays?

The good thing about this slippage is that these are large and enterprise-level tailored deals that involve more sophisticated digital intelligence solutions. They may not be only focused on Collect and Review; they may involve our Investigative Management Solutions or Investigative Analytics Solutions. The slippage may happen if we have closed the deal, but revenue recognition is delayed because we are awaiting installation and acceptance of those systems. Some of the deals actually closed in the quarter, but their fulfillment might extend to the next quarter.

To your question, we’ve seen a little bit more slippage in Europe than in the Americas.

Thank you.

Your next question comes from the line of Shaul Eyal from Cowen.

Thank you. Good afternoon, guys. Yossi or Dana, considering that your business is driven predominantly by upsell expansion with your existing customer base, did you acquire any new logos this quarter? I have a follow-up.

To emphasize the strategic part, we are primarily focused on executing large customers where we see more wallet share in the entire Digital Intelligence suite of solutions. We are not primarily looking for new logos, but we definitely had new buying centers within the same logo. An example is that $800,000 deal that was executed with the European police force. Additionally, as for the long-tail prime, we have a dedicated target related to new logos, including net new logos, resulting in approximately 130-150 new logos among our long-tail customers.

Understood. Thank you for the color. My follow-up question is regarding EMEA. EMEA was the only territory that declined year-on-year. Was there any specific country that stood out, or was it a broad-based phenomenon? We've seen many companies reporting solid performance in Europe, so I want to understand if it was country-specific or a broader trend.

To begin, it is not one country specific. Most of our business in Europe is done in the Western regions, including Italy, Spain, the U.K., Germany, France, and Scandinavia. We mentioned fluctuations from existing employees in Q1, which affected hiring in Q2, especially in Western European countries, but this is behind us now. We are well-equipped moving forward. Another contributing factor to the decline in EMEA is the shift in our business model from perpetual to subscription, which has affected how we report our sales and recognize revenue in that region.

Got it. Thank you.

And your next question comes from the line of Jamie Shelton from Deutsche Bank. Your line is now open.

Hi, guys. Can you hear me okay?

Yes, so far so good.

Apologies if I cut out; my signal is playing up a little bit. I just wanted to double-click on the three factors you mentioned: the transition away from perpetual, slippage of deals, and longer sales cycles. Regarding the slippage of deals, are you speaking about distractions from headcount and go-to-market attrition impacting that?

The slippage of a deal refers to when we closed the deal, but revenue recognition is delayed due to the installation process. This is particularly true for larger, more complex deals which require longer time frames to fulfill after closing than regular evolving business.

Apologies if I'm being unclear. Isn't that the same point as longer sales cycles? Specifically, could you quantify any revenue headwind from headcount attrition?

The distinction is that sales cycles pertain to signing off deals while slippage pertains to the fulfillment and revenue recognition process. The larger the deal, the more extensive the approval process required from customers, which can lead to longer timelines overall. We've also noted that a strong sales team in front of key accounts helps drive closures.

Understood. Just one more on the guidance. With everything you've said today, what gives you confidence that you won't have to lower guidance again in 90 days? I appreciate everything that you're saying, but can you assure us that the current guidance is achievable versus what it took place in 2021 when conditions were more favorable?

We did not build aggressive guidance. We relied on seasonal modeling to determine our revised guidance based on business trends over the last few years. We believe this approach gives us confidence in our ability to execute moving forward.

I want to clarify that we have confidence in our revised guidance. The level we've set is designed for us to execute effectively. Our pipeline coverage aligns not only with our historical performance but is also robust enough to meet our updated guidance. We've introduced three significant new solutions that bolster our offerings and provide us the necessary confidence to pursue our goals.

And just one last one – more on the premium enterprise. You guys have provided some color over the last couple of quarters on the momentum there. If it's not quantitative, just anecdotally, how is momentum getting existing users on to premium enterprise? Any percentage of that existing base would be great.

We are very excited about the adoption of premium enterprise. The number of endpoints and users enjoying the best-in-class capabilities of the premium enterprise has exceeded our expectations for the first half of the year. This is driving significant growth for the company, alongside the positive reception of our Premium as a Service.

And your next question comes from the line of Louie DiPalma from William Blair. Your line is now open.

Yossi, Dana, and Anat, good afternoon.

Good afternoon.

Yossi and Dana, you discussed revenue pressure from the shift from perpetual licenses to the subscription model. How much longer should we expect this shift to continue? When should we expect perpetual revenue to hit a bottom and stabilize?

This is very challenging to predict. We had anticipated a reduction in our perpetual business of about 50% year-over-year, but we see an even faster decline. We assume this trend will continue, stating that it may take us about two years to reach a situation where perpetual business is a minor component of our overall sales.

Great. Yossi, you mentioned that you have robust pipeline coverage in the second half. Currently, the low end of your guidance implies a strong 17% revenue increase in the second half compared to the first half. Does the guidance account for potential further deal delays as well as the more complex nature of product bundles? Or are you assuming a close rate that resembles what you saw in 2021 when conditions were healthier?

Firstly, I want to emphasize that the market conditions remain healthy, as reflected in our ARR. There is a distinction between timing gaps affecting deal closures and our confidence in budget allocations. If we analyze seasonality, H1 is normally around 42%-45% of total revenue while H2 is typically 55%. When reviewing the midpoint of our revised guidance, we find it reasonable and achievable in current conditions.

Sounds good. Thanks for the color. You highlighted wins for Guardian, and Dana just discussed the traction for premium enterprise. Can you provide any commentary on the adoption of the enterprise endpoint inspector?

Regarding Pathfinder, we are pleased with the market's overall health and with the expanding pipeline for Investigative Analytics. Pathfinder is leading in this area due to its value proposition and the product maturity we've achieved. However, the sales cycle is longer and requires customer education. As for the enterprise endpoint inspector, we are currently below our plan in that private sector area. We missed some headcounts but are close to filling our open positions. The opportunity in that space remains, and we are optimistic about achieving the breakthrough in future quarters.

Great. Thanks, everyone.

Thank you very much. Thank you all for joining us for the participation and great questions. Have a great day. Goodbye.

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