Commvault Systems Inc Q2 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to the Commvault Q2 Fiscal Year 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Mike Melnyk, Head of Investor Relations. Please go ahead.

Thanks, Andrea. Good morning, and welcome to our earnings conference call. I'm Mike Melnyk, Head of Investor Relations, and I'm joined by Sanjay Mirchandani, Commvault's CEO; and Gary Merrill, Commvault's CFO. An infographic with key financial and operating metrics is posted on the Investor Relations website for your reference. Statements made on today's call will include forward-looking statements about Commvault's future expectations, plans and prospects. All such forward-looking statements are subject to risks, uncertainties, and assumptions. Please refer to the cautionary language in today's earnings release and Commvault's most recent periodic reports filed with the SEC for a discussion of the risks and uncertainties that could cause the actual results to be materially different from those contemplated in these forward-looking statements. Commvault does not assume any obligation to update these statements. During this call, Commvault's financial results are presented on a non-GAAP basis. A reconciliation between the non-GAAP and GAAP measures can be found on our website. Thanks again for joining. Now I'll turn the call over to Sanjay for his remarks. Sanjay?

Thanks, Michael. Good morning. I'm pleased to share that we delivered record fiscal Q2 results, which I'll discuss in constant currency. Software and products revenue increased 16%. Growth was driven by strength in the Americas and our continued success in winning large transactions. Our best-in-class technology continues to resonate in the enterprise where data protection and ransomware remain top of mind. ARR growth continues to be strong, increasing 18% year-over-year. Combined, subscription and SaaS ARR grew over 40% year-over-year and now represents a healthy 66% of our total ARR. Metallic continues to fuel this growth. I'll share more shortly. These results are proof that our strategy is working in three ways. First, over the past three years, we've been focused on transforming the business and have returned the company to responsible growth. Our focus on driving ARR now over 600 million gives us a predictable model for future growth. Second, our unified software and SaaS portfolio is a differentiator and a competitive advantage because customers want and need both. This is helping us land marquee customers. I'll share some examples in a minute. In addition to transitioning to a subscription software model, we organically funded and delivered a hyper-growth and world-class SaaS platform. As a reminder, Metallic launched commercially in October of 2020. We see this as a marker against which to measure its success because, in two years, we have achieved phenomenal growth. Metallic is a logo acquisition machine that is complementary to our software business. We ended the quarter with over 2,500 Metallic customers. In Q2, 70% of Metallic customer additions were new to Commvault. Half of those have another Commvault product and one-third have multiple Metallic offerings, reinforcing that in today's world customers need both software and SaaS. Microsoft M365 and Metallic recovery reserve as part of our ransomware offering continue to drive adoption and our other offerings are gaining traction. Our Metallic SaaS offerings surpass 75 million in ARR in less than approximately two years. This makes Metallic one of the fastest-growing SaaS offerings in this industry. It's very clear that we're outpacing benchmarks and reinforces that Metallic will be a big part of our future. The third proof point that our strategy is working is our go-to-market execution. Through our investments in talent and operational excellence, combined with our partner ecosystem and a lot of smart work, we have reinvigorated growth, materially improved our efficiency and reinforced our leadership position as the number one ranked vendor in data center, cloud, and edge environments, but we're not done. In fact, I'm even more excited and confident of the opportunity in front of us because we offer elegant solutions to our customers' hard data problems in an increasingly difficult world. After all, our customers are relying on data to modernize and grow their businesses. Data is fluid, moving from on-prem to the edge to the cloud and back again, and it is remote, fragmented, and exposed to new threats every day. As a trusted and proven provider, we offer customers a future-proof data protection strategy to ensure that data is always available. This begins before the data is compromised. After all, an organization's ability to recover from a ransomware attack or other threat is only as good as the quality of the backup, which is why we launched Metallic ThreatWise, built on the TrapX technology that we acquired in February. ThreatWise is a SaaS delivered, intelligent early warning system that proactively surfaces unknown and zero-day threats to help ensure your backup copy is uncompromised. We believe that data security is nonnegotiable, which is why it is implicit in our offerings. Commvault is the only data protection provider with these proactive and responsive protection, security, and recovery capabilities today, and customers see the value. For example, a multinational Fortune 1000 company turned to Commvault software and Metallic to consolidate multiple data protection products to better protect its data and increase efficiencies. Commvault now handles all of the company's data in all locations while meeting its recovery point and recovery time objectives. Another great example of how customers are leveraging both software and SaaS for their data protection needs was our recent win with a Fortune 500 manufacturer. This company decided to close its global data centers and fully adopt a multi-cloud strategy. While multiple vendors, including the incumbent, valued the business, only Commvault could deliver an elegant solution to migrate workloads to the cloud and support a zero-loss strategy all on one platform. Both examples demonstrate how providing comprehensive enterprise-grade software and SaaS data protection across all workloads and environments is a distinct competitive advantage. Now, I'll turn it over to Gary for a discussion of our financial results. Gary?

Thanks, Sanjay, and good morning, everyone. I will start with a quick recap of the quarter with growth rates on a year-over-year basis, unless otherwise stated. Total revenues for the quarter increased 6% to $188 million. On a constant currency basis, total revenue growth was 12%. Our growth in the quarter was driven by strong execution, even though currency and the macro continued to be headwinds. Continued strengthening of the U.S. dollar since our first quarter call adversely impacted Q2 revenue by approximately $3 million. Software and products revenue for the quarter was $82 million, increasing 10% year-over-year and 16% on a constant currency basis. From a geographical perspective, both our Americas and international regions delivered strong year-over-year constant currency growth. Specifically, our Americas region increased 20%, which was driven by large new customer transactions. Data protection and related security concerns are key spending priorities for organizations, and our ability to support large enterprise workloads across a mix of environments is a key driver for our growth. On a constant currency basis, our international region drove 9% year-over-year growth in software and products revenue. The increase was also driven by strength in larger enterprise transactions. On a consolidated basis, revenue from software transactions over $100,000 increased 18% year-over-year and represented 72% of software revenue. We were pleased to see both a 6% increase in the volume of such transactions combined with an 11% increase in average deal size reaching $346,000. Our technology continues to resonate with enterprise customers looking to modernize their data protection approach to enable a hybrid cloud strategy. Subscription software revenue increased 32% year-over-year to $63 million and represented 76% of total software revenue, which compares to only 63% of total software revenue in Q2 of the prior year. Our progress to a subscription-led software business has given more predictability and resilience to our business model. Moving from reported revenue results, I will now give some insight to our annualized recurring revenue, or ARR metrics. Our total ARR increased 11% to $604 million as reported and accelerated to 18% year-over-year growth in constant currency. ARR growth is being driven by Metallic and subscription software. The combination of only subscription and Metallic ARR is now $400 million, with growth of 44% and representing two-thirds of our total ARR. As Sanjay mentioned, Metallic recently crossed $75 million in ARR, which is about 50% higher since the start of the fiscal year. Now, I will discuss expenses and profitability. Gross margins for the second quarter were 83.5%, which is consistent with the prior quarter despite the foreign exchange pressure. Total operating expenses were $119 million, flat versus the prior year and down 3% sequentially. We are managing our people, facilities, and third-party expenses by focusing investments on our most critical priorities. Non-GAAP EBIT was $35 million, resulting in an EBIT margin of 19%. Free cash flows for the quarter were $49 million. In Q2, we repurchased 703,000 shares of our common stock for $40 million. Through the first half of the year, we repurchased 1 million shares of common stock, returning $59 million to our shareholders. The first half repurchases represented 83% of our first half free cash flows. We ended the quarter with no debt and $262 million in cash on the balance sheet, of which 60% is located outside of the United States. Our foreign cash balances support the operating needs of the business spread across over 35 countries. I would now like to give a brief update on the progress against our Investor Day objectives from January 2021. As a reminder, those objectives included compounded annual total revenue growth in the range of 6% to 7% and the combination of total revenue growth and EBITDA margin of 32 by the end of fiscal 2023, which is our current fiscal year. When measured on a constant currency basis, I am pleased to report that we've achieved these objectives six months ahead of the expected timeline. Over the last four quarters, on a constant currency basis, total revenues increased 11%. And we delivered an EBITDA margin of 22.6%, resulting in a rule of calculation of 34, which is two points ahead of our original target of 32. Continued progress against the rule of 40 over the long term will remain a key objective. Now, I will discuss our financial outlook for the fiscal third quarter. With the stronger U.S. dollar since our July call, we expect an additional $4 million of headwind on total revenues. As a result, we now expect fiscal Q3 total revenues to be in the range of $202 million to $205 million. At the midpoint of guidance, this represents 7% constant currency total revenue growth. Considering current foreign exchange rates, we expect Q3 software revenue to be in the range of $97 million to $100 million. On a constant currency basis, the midpoint of our software revenue guidance would be up 7% year-over-year. As I mentioned earlier, we are winning net new business, including competitive displacements. We continue to closely monitor customer spending patterns, changes in budget priorities, and other potential risks to our business due to the ongoing macroeconomic uncertainty. As a result, we are aware this new business may take longer to close, especially parts of larger IT transformation projects. In light of global uncertainty, we continue to be maniacally focused on managing expenses, balancing profitability, while investing in growth initiatives such as Metallic. At these revenue levels, we expect Q3 consolidated gross margins to be up slightly on a sequential basis to approximately 84%. Q3 operating expenses are expected to be approximately $125 million, down 2% year-over-year. At the midpoint of our revenue guidance, Q3 EBIT margins will be approximately 21.5%. Our projected share count for Q3 is approximately 45.5 million shares. One item I would like to point out is that second half free cash flow will include approximately $7 million of incremental federal tax payments related to the capitalization of research and development provisions enacted as part of 2017 tax reform. Our team is focused on execution. We will maintain our responsible growth operating philosophy and expect to continue to return at least 75% of free cash flow to our shareholders through repurchases, all while continuing to accelerate our Metallic business. I will now turn the call back to Sanjay for his closing remarks. Sanjay?

Thanks, Gary. Before we turn to questions, I want to invite you to join us at our upcoming Connections event. Over the next few days, we'll be virtually hosting thousands of customers, prospects, and partners as we highlight our portfolio, including many new offerings and announcements. I hope you tune in. Now, let's open it up for questions.

Thank you. At this time, we will conduct a question-and-answer session. Our first question comes from Jim Fish with Piper Sandler. Please go ahead.

Hi, guys. Nice looking quarter on the constant currency basis and the ARR. Gary, you just mentioned that it's taking a bit longer to close new business. I guess what are you guys seeing with the customers' desire to consolidate more onto one data management vendor? And what do you see as the whitespace opportunity specifically within your install base for replacing multiple solutions in kind of the customer environment, including with Metallic?

Hi, Jim. It's Sanjay. Let me take a stab at it. So one of the examples I gave was the Fortune company that took out several products over the years that they had and replaced it with one architecture, ours, using both Metallic and software. We see this every day. Over the course of last quarter, roughly 50% of our Metallic customers also had Commvault technology. So it's both. And we see this every day. And with ransomware, our premise is less is more. The fewer layers of technology or different technologies that you put in, the safer you can be because you have a single pane of glass and you have a singular way of dealing with it. And that's what we're seeing. We're seeing our technology being pulled in to unify, to bring one layer of visibility and protection into customers. We see this every day. That's how we win.

Hi, Jim. It's Gary. Good to hear from you. A couple of quantifications. From a land perspective, we saw one of our best land, so new customer on the software side in over six quarters, so really strong results in the land in the Americas driven by some of that consolidation. We've had a really strong focus on landing net new customers. And those efforts in that pipeline are building on the larger deals.

Yes, so that also helps. The deals are getting larger and as a result, that's because we're replatforming across multiple products.

That's helpful, guys. And what are you seeing with customers' willingness to sign multiyear durations? I understand the typical duration on the term subscription side is roughly three years. But really what I'm asking is if you're seeing any desire to move that three years down, actually closer to two, just given the macro environment? And just also confirming here that really on a billings basis here, it was primarily just FX issues on the deferred revenue, because if I take off the cash flow statement for a change in deferred revenue, you actually end up with a billings beat. Was there any pressure on the duration side of things though? Thanks, guys.

Jim, it's Gary. I'll handle both of those. From a term perspective on subscription, we're holding pretty steady. We're seeing a little bit of term pressure, but we're managing through it. And the range of our terms still is consistent with the growth metrics and the term metrics that you mentioned. Your second point was on, correct me if I'm wrong, deferred revenue. So deferred revenue was actually up 18% constant currency. So if you look at deferred revenue, I think deferred revenue generally on a constant currency basis will align with ARR growth. And both of them on a constant currency basis was 18% and strongly driven by Metallic on both sides.

Thank you. One moment for our next question. Our next question comes from Eric Martinuzzi from Lake Street Capital Markets. Please go ahead.

Andrea, we're having audio problems with Eric's question. Eric, can you redial in? We're unable to understand the question from the audio.

Sure. One moment please.

Andrea, I'm not seeing any more questions. We'll give Eric one more minute. And if not, we will end the call and deal with his questions offline.

We have Eric Martinuzzi calling right back in. One moment, please.

Perfect. Thank you.

Okay. Is the audio any better?

Much better, thank you.

Okay. My question was regarding the macro color that you gave now versus kind of the initial slowdown that you saw at the end of June. You got four months since then. Just wondering if you could juxtapose the two, or if there's been no change?

Hi, Eric. It's Sanjay. I'll start and I'm sure Gary will have a point of view. We've been super focused on what we control, which is execution. And really looking at everything we're doing, we learned a lot from the supply chain earlier last year. And so to apply those best practices to how we're looking at the pipeline, close rates, things like that. So there's a lot of inspection and we're focused on getting that right as part of our execution. I will say to you that between the two quarters, we thought we probably saw deals that are taking longer to close. Okay. Just across the board, a lot more scrutiny, a lot more conversation, challenging some of our data science models on closed rates and predictability. But we were focused on execution and came through. I will say it got harder over the course of the quarter. Europe, in particular, got harder over the course of the quarter. The Americas had a strong quarter, but again, scrutiny was across the board. So I'll say that was a common theme. Gary, anything you want to add to that?

Yes. And as we look at even, Eric, into fiscal Q3, we're expecting some of that to continue. And that's somewhat reflected into our outlook for Q3. Fiscal Q3 is our strongest seasonal quarter, generally for Commvault, tied to year-end budget timing. But we're factoring some of those macro headwinds we see on timing. The demand is there. It's just really about the time to close factored into our outlook.

Yes, the pipeline is good. It's just the timing.

Yes. And you're expecting the situation in the U.S. to continue improving while the challenges in EMEA are anticipated to persist?

I think, Eric, we're not expecting necessarily worse in EMEA. I think continued as what we've seen, and on a relative basis relatively stronger in the U.S.

Okay. And then I saw that you kind of stepped up the repurchase program here in Q2. Was that simply tied to the better cash flow in Q2, or was that just opportunistic on the price point?

Yes, Eric, to highlight on the cash flow, we had very strong free cash flow during the quarter. And even for the first half of the year, our free cash flows are at double digits, I think approximately 15%, and our commitment to return at least 75% of free cash flows back to our shareholders. And at the first half mark, we're at 83%. So we've aligned our Q2 repurchases to make sure we stay ahead of our objectives.

Okay. And then final question for me comes on the services gross margin. I did notice they're relatively flat sequentially, but a slight downtick on the gross margin. What's behind that?

Yes, Eric, when you think about services gross margin, there's two pieces to that gross margin. The first piece is our customer support revenue, okay, the customer support revenue. And the biggest driver on the headwind there is actually FX. If you look at our press release, we disclosed the customer support revenue and it was down approximately 12% year-over-year. But FX adjusted is only down about 5%. So currency being the biggest on services and customer support, that's being really fully offset by the other services, which includes our Metallic revenue. So that's where you'll see major growth year-over-year and quarter-over-quarter as we start to accelerate Metallic.

Thank you. One moment for our next question. Our next question comes from Jim Fish with Piper Sandler. Please go ahead.

Hi, guys. Couldn't resist asking another just quickly. With over 2,500 customers now in Metallic, my math would imply we're actually seeing a deal size uplift for Metallic versus the last few quarters. I guess, trying to understand what's causing that specifically?

Hi, Jim. It's Gary. I wouldn't say a deal uplift. I think it depends on the segment. Where we're seeing really good strength and focusing on is building a velocity business, right? So there'll be some timing quarter-to-quarter on maybe some of the larger Metallic deals, but our real focus is driving a velocity and really getting that tailwind going tied to both renewal cycles and landing new customers. So at times, we're a little less focused on the actual ASP overall, but making sure we're building that repeatable expansion and driving kind of best-in-class net dollar retention. One of the things, Jim, we're most proud of is this quarter alone on a unit basis, 70% of the new Metallic customers were new to Commvault. So which doesn't show up necessarily in the financial statements, this quarter will show up over time as we onboard and expand and really drive that growth.

Thanks, Gary.

Thank you. One moment for our next question. Our next question comes from Aaron Rakers with Wells Fargo. Please go ahead.

Yes, thanks for taking the questions. Congrats on the solid execution. I apologize if I missed this, but the 2,500 customers on Metallic, can you just help us appreciate what that was maybe exiting the last fiscal year, just to kind of think about the trajectory of that? And I think in addition, I'm just curious like as you compete with Metallic in the market, who do you see?

It's Gary. I'll start with the first question. And maybe Sanjay, you can talk a bit about the competitive side from the standpoint. Yes, as we mentioned, at this point, we're well over 2,500. Exiting the fiscal year, we were well less than 2,000. To kind of give you a benchmark at the clip, we're kind of growing at kind of broad strokes.

Yes, that's a significant part. Aaron, it's Sanjay. Regarding how we achieve success, it's our capability to provide a common and unified platform with software and SaaS that ensures we win consistently. When you examine smaller SaaS providers, they struggle with handling enterprise workloads and cannot effectively address ransomware threats. Traditional software companies also fall short as their architecture does not adequately extend into the cloud and SaaS, which leaves customers wanting more. This is a key reason for our success. Our strategy, which we've followed for the past two years, focuses on integrating these aspects to enable customers to make natural transitions to the cloud instead of forced ones. Metallic is a remarkably strong next-generation SaaS solution, and when combined with our software architecture, it becomes virtually unbeatable.

And I think if you think about the financial implications, so about half of them are customers today that also have Commvault software. So driving that software growth today through that install base, while building this ARR now 75 million and growing is securing our visibility on future revenue growth.

When I talk to CIOs, when I talk to CEOs, and they say, well, should we go SaaS or should we go software? And I go, that's the most unnatural choice for you to make. You need both. And depending on where you are in your journey, you need both. And any provider that makes you choose unnaturally isn't doing you much of a service. So we go in with an architecture and customers can start with software or start with SaaS, change back and forth, move workloads back and forth, change their minds, and our software and our SaaS offering allows them to do that transparently. And that's why we win. That's why we win every time.

Yes, that's very helpful. And that 50% of Metallic customers having another Commvault product, where do you think that you can ultimately drive that to? Do you think that 75% of those customers ultimately over time purchase Commvault products? Do you think it stays at 50%? Just curious to how you think about that monetization kind of flywheel of expanding your Metallic customer base?

I believe that over time, every customer will require both options. It's crucial if you're on a long-term journey. I have experience as a CIO, and in a multi-year journey—whether impacted by the pandemic, supply chain issues, or other factors—having flexibility is essential. We provide our customers with that flexibility. Therefore, there's no reason to think that either our traditional software customers or our SaaS customers wouldn't need both options. Notably, if 70% of our customers for Metallic in the last quarter were new to our company, each of them is a potential candidate to adopt our software. This is our strategy and the way we approach the market.

Yes, that's helpful. And then a final question and I'll leave the floor is on the partnership ecosystem. Any kind of updates, if there's been any changes that you're excited about on the partner side, if it's Microsoft or Azure, just curious of how that develops?

Aaron, over the past six months, we have focused heavily on this area. We have welcomed Alan Atkinson, a highly experienced industry leader, to our team, and he is dedicated to developing our next-generation ecosystem. We've enhanced our relationships with cloud providers, especially Microsoft and Oracle. Recently, we had a strong presence at their customer events. It was the first trade show I've attended in person, the Oracle event, since the pandemic, and our booth was extremely popular, attracting many people interested in our collaborations with OCI, Oracle workloads, and ransomware-related issues. These topics are very relevant. I can confidently say that we are more focused on our partner ecosystem than ever before as a company. Our success with Metallic is heavily reliant on our partners. For example, our upcoming Connections event, which I mentioned during the prepared remarks, has received remarkable sponsorship from our partner community. This illustrates the strength of our relationships, and we have never been more committed to partnerships than we are today.

Yes, very good. Thanks, guys.

Thank you. One moment for our next question. Our next question comes from Thomas Blakey of KeyBanc Capital Markets. Please go ahead.

Hi, guys. Thanks for taking the questions. I have a few. I believe, Gary, you mentioned that the Metallic gross margin headwinds should be abating. Solid ARR, great numbers here. I was just wondering if you can maybe just comment from an updated perspective on Metallic gross margin. I have a couple of follow-ups after that.

Hi, Tom. It's good to hear from you. So we're making great progress on Metallic gross margins. I'm really pleased that our gross margin for Metallic is improving every quarter, quarter-over-quarter. So we're on the trajectory that we need to be at. We're probably still another, as we said before, one to two years out from testing SaaS margins, but we're on our path and we're making the progress we need to make just to stay on track. So from a consolidated gross margin, the comments I think I made last quarter is I thought we were at the low point for the year on consolidated gross margins. And that continued to hold. Even for the guidance I give for fiscal Q3, I'm expecting some modest gross margin improvement on the consolidated standpoint. And I expect that to continue through fiscal Q4 as well.

Very clear, Gary, and solid progress on Metallic, if not ahead of expectations here. On the maintenance ARR, it looks like maybe exiting last year like a negative teens number. It looks like it might have accelerated to the negative 20% kind of levels, if I'm doing my math correctly with your disclosures on Metallic and subscription in Metallic ARR. Just again looking for kind of a bottom there, any updates you can kind of talk about there on the maintenance subscription trend transition would be helpful?

Absolutely. It's all about foreign exchange. Let me quantify it for you. If you examine our maintenance revenue for fiscal Q2, which is detailed in our earnings release, we are down 11% year-over-year on an actual basis. Adjusting for foreign exchange, we are down 5%. So, the decline is 5%. For the last two quarters, it has also been approximately 5%. If you are considering what to expect moving forward, we are experiencing a low single-digit decline in maintenance revenue, which reflects some of the strategic choices we are making in converting our customers to our new modern subscription offerings.

Very helpful and clear, as usual, Gary. And then my last question, and thank you for taking all the questions, is on large deals, continued success there, understanding the macro headwinds that might be creeping up here. Is the large deal kind of metrics you shared with us actually maybe being capped by Metallic? It's interesting that you say half the Metallic customers are also taking Commvault software. As I understand it, those are like relatively smaller deals, the Metallic deals. Maybe I'm wrong in that characterization. But maybe the large deals are actually larger. That's my final question. Thanks, guys.

Let me provide a business perspective on this. Tom, the way our workloads function between software and Metallic is quite complementary. Part of our ransomware protection, which we refer to as Metallic recovery reserve, is facilitated through Metallic but originates from our software. You can access it through the software, but the immutable copy is stored in the cloud via Metallic. Therefore, we are intrinsically linking these as complementary capabilities. Generally, customers will consider an on-premise solution and request ransomware protection, which then activates a Metallic delivery. Additionally, over 30% of our customers utilize more than one Metallic offering. They may begin with ransomware protection and later add services like Office 365 or virtual machines. So far, these solutions operate effectively together and complement each other.

No, it is helpful. Driving the deal size up.

It actually does. They complement each other, obviously not to the same level of software but more and more we see attach. To me, that's the most important motion that for the future is seeing customers naturally attach both things depending on workload.

Excellent. Very helpful, guys. Thank you.

Thank you.

I'm not seeing any more hands in the queue. I think we can end the call, please.

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