Earnings Call Transcript - CVLT Q2 2022

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Commvault Q2 FY 2022 Earnings 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 follow the Operator Instructions. I would now like to turn the call over to your host, Mike Melnyk, Head of Investor Relations. You may begin.

Michael Melnyk, Head of Investor Relations

Thanks, Kevin. Good morning, and thanks for dialing in today for our call to discuss our second quarter fiscal year ‘22 earnings results. Before we begin, I'd like to remind everyone that the statements made during this call, including the question-and-answer session of the call, may include forward-looking statements, including statements from financial projections and future performance. All the statements that relate to our beliefs, plans, expectations or intentions regarding the future are pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations. Actual results may differ materially due to the risks and uncertainties, such as competitive factors, difficulties and delays inherent with development, manufacturing, marketing and sale of software products and related services and general economic conditions. For discussion of these and other risks and uncertainties affecting our business, please see the risk factors contained in our annual report on Form 10-K and our most recent quarterly report on Form 10-Q and our SEC filings and in the cautionary statement contained in our press release and on our website. The company undertakes no responsibility to update the information on this conference call under any circumstance. In addition, the development and timing of any product release, as well as features or functionality, remain at our sole discretion. Our press release related to today's announcement was issued over the wire services this morning and has been furnished to the SEC as an 8-K filing. The press release is also available on our Investor Relations website. On this conference call, we will refer to non-GAAP financial measures. A reconciliation between non-GAAP and GAAP can be found on our website. This conference call is being recorded, and a replay is available for the webcast. An archive of today's webcast will be available on our website following the call. Now with me on the call this morning are Sanjay Mirchandani, President and Chief Executive Officer of Commvault; and Brian Carolan, Chief Financial Officer of Commvault. Sanjay and Brian will each share opening remarks and commentary before we open the call for Q&A. Now, I'll turn the call over to Sanjay.

Sanjay Mirchandani, CEO

Thank you, Mike. Good morning, and thank you for joining us. I'll start again. This is Sanjay. Good morning, and thank you for joining us to discuss our Q2 '22 results. We continue to capitalize on the evolution of the hybrid cloud market, where Commvault is playing an increasingly important role in high priority, large IT transformation and ransomware remediation projects. While Q2's softer revenue growth didn't meet our guidance, the impact was mainly isolated to software opportunities that are part of larger IT transformation projects. We also believe that industry-wide supply chain issues are affecting our customers' sourcing of hardware components and related software opportunities. Although we don't see this as a long-term concern, we have factored in additional conservatism into our Q3 guidance, which Brian will discuss later in the call. Several key highlights reflect the strength of our business and the ongoing progress in executing our transformation. Total ARR grew 12% year-over-year to $543 million. Importantly, subscription and SaaS ARR grew more than 40% year-over-year to $278 million and now represents over half of total ARR. We're achieving this growth through market share gains, as shown by Q2 revenue from new customers, which reached the highest level in years. Additionally, our SaaS offering, Metallic, is growing rapidly and, just over a year after its launch, is now a significant contributor to our total ARR growth. I will now provide more detail on the quarter and our reasons for optimism, centered around four key indicators. First, our ability to win new business and gain market share are significant inflection points for Commvault. Our largest transaction this quarter, a multimillion dollar win at one of the largest healthcare organizations in the world, involved a new customer and a competitive displacement. Over 50% of subscription transactions were with new logos for Commvault, and more than 60% of Metallic customers were new to Commvault. Second, every indication shows that customers are embracing the power of combining software and SaaS to better support their hybrid cloud journeys. For instance, the total number of transactions involving more than one product increased 150% year-over-year. About half of our seven-figure software transactions involved multiple products and services, and Metallic secured its largest transaction to date, a high six-figure deal that included multiple product offerings. This brings us to our third indicator. Metallic is exceeding our internal expectations and outpacing the growth of leading SaaS startups. IDC projects that the data management as a service market will grow at a mid-teens CAGR over the next few years to over $15 billion by 2024. We believe that with Metallic, we have a first-mover advantage to continue capturing share in this space. Even though it has only been commercially available for just over a year, Metallic has already achieved significant milestones, including doubling its portfolio with new offerings for Salesforce and Microsoft Dynamics 365 and expanding availability to more than 30 countries, offering data protection for enterprise workloads on SAP HANA and Oracle, as well as for containers and Active Directory, adding flexible storage tiers for Metallic Cloud Storage and Commvault HyperScale X, launching Metallic Government Cloud, which meets the stringent FedRAMP High security protocols required by federal agencies, and now making Metallic available for managed service providers to create their own suite of value-added services. Last week, we announced an integrated solution with GM Sectec, a leading global managed security service provider, focused on ransomware readiness, backup, and data recovery as a service. Furthermore, our major cloud partners recognize the value Commvault brings to drive cloud consumption. For instance, Microsoft notes that Commvault/Metallic is a top global Azure co-sell, ISV Microsoft partner, and Google named us a leading backup and disaster recovery partner on Google Cloud. This is tremendous validation, and these relationships continue to strengthen. This is just the beginning. As customers transition to the hybrid cloud, they will require flexible and scalable solutions, which is why the ability to combine the best of both software and SaaS is crucial. We believe this gives us a competitive edge. Lastly, we operate in a large and growing market, and our portfolio is designed to align with market trends, including data management and ransomware recovery. The rapid growth of data across multiple ecosystems, applications, and hybrid environments presents risks that can hinder a company's growth and operational objectives. For example, today, every business faces the real threat of ransomware. At Commvault, we regularly assist customers in recovering from these attacks. Just last month, a well-known healthcare leader in the U.S. was hit by an attack that affected hundreds of servers, including their entire VM environment and three petabytes of application data. Our software ensured their backup remained secure, and with the help of our industry-leading customer support team, they were able to resume full operations within 24 hours. Simply put, one of the best defenses against ransomware is data protection with an immutable backup. Our new Commvault Ransomware Protection and Response Services offer customers a multi-faceted approach to ransomware protection. This is just one service that complements our data management capabilities to assist customers. The industry is also taking notice. Phil Goodwin of IDC remarked that given that more than 90% of organizations leverage public cloud in their backup strategies, Commvault is well-positioned to meet their extensive data protection needs across hybrid cloud, multi-cloud, and edge environments. In summary, while our Q2 results were mixed, I'm confident that we have the right long-term strategy and are making real progress, evidenced by the robust data I shared. We are capturing market share and expanding our presence with a more comprehensive portfolio, and we believe we are well-positioned with Metallic to meet the changing needs of customers as they navigate their cloud journeys. I will now turn it over to Brian for a closer look at the financials.

Brian Carolan, CFO

Thanks, Sanjay, and good morning, everyone. Hopefully, you had a chance to review the results we released this morning. Now, I will briefly recap and provide some additional color on the quarter. In fiscal Q2 '22, we reported total revenue of $178 million versus an increase of 4% year-over-year. Software and products revenue increased 4% year-over-year to approximately $75 million. As a reminder, in FY '22, we've moved to a software-only model. In Q2, software-only growth without hardware would have been approximately 9% year-over-year. Revenue from software transactions over $100,000 increased 6% year-over-year and represented 67% of software revenue. The volume of these transactions grew 9% year-over-year, and the average deal size was approximately $311,000. Software revenue from new business approximately doubled quarter-over-quarter and finished at the highest level in several years. Fiscal second quarter services revenue increased approximately 4% year-over-year to $103 million. The growth in services revenue is being driven primarily by Metallic. Let me now discuss our transition to a recurring revenue-based model. Second quarter subscription software revenue increased 24% year-over-year to approximately $48 million. Subscription licenses represented 63% of total software revenue, an increase from 53% a year ago. Total annual recurring revenue, or ARR, increased 12% year-over-year to approximately $543 million led by growth in new subscription customers and Metallic. As Sanjay noted, subscription and Metallic ARR of $278 million now represents 51% of total ARR and is growing at over 40% year-over-year. This is an important proof point in the transformation of our company. We believe ARR is the best measure of the underlying health of the business. It represents the strength of our land, expand, and renewal motions and is a barometer of our potential for future growth of our software and SaaS platform. Total recurring revenue, which includes subscription software, maintenance support services and SaaS, was $141 million, representing 79% of total revenue in the quarter. This compares to 75% in Q2 '21. Now, I'll discuss expenses and profitability. We reported fiscal second quarter gross margins of approximately 86%, an increase of 80 basis points year-over-year. The expansion of gross margin resulted from the decrease in pass-through hardware and royalties associated with the legacy version of our HyperScale products. These savings were partially offset by an increased mix of Metallic revenue, which carries a higher cost of sales, especially as we scale up the infrastructure. Total expenses, including both cost of sales and operating expenses, increased approximately 3% year-over-year to $145 million. Expense growth was driven by strategic investments in Metallic, a targeted ransomware campaign, and headcount additions. Non-GAAP EBIT was $31 million, and non-GAAP EBIT margins improved 50 basis points year-over-year to 17.4%. Now, I'll discuss cash flows and the balance sheet. For the quarter, we generated approximately $26 million of free cash flow. We ended the quarter with approximately $296 million in cash, and we have no debt on the balance sheet. Deferred revenue was $372 million, an increase of 14% year-over-year. Growth in deferred revenue was primarily driven by Metallic. During the quarter, we repurchased approximately 1.2 million shares of our common stock for $90 million. As we outlined during our investor event in January, through FY '22, we are committed to spend $200 million plus 75% of fiscal '22 free cash flow on share repurchases. Since the investor event and through September 30, we have repurchased approximately 3.4 million shares for $242 million. Now, I'll discuss our financial outlook for Q3 FY '22. For Q3, we expect software revenue of approximately $92 million. As Sanjay discussed earlier, we're winning new business, including competitive displacements. This new business may take longer to close, especially if part of larger IT transformation projects. In addition, we are modeling software more conservatively for any transactions tied to customers' delayed hardware orders. For modeling purposes, I'd like to remind you that Q4 software revenue historically approximates Q3 levels. We expect Q3 total revenue of approximately $195 million. Now, let's shift to expenses. We expect Q3 gross margins to be similar to Q2 levels or approximately 85% to 86%. We expect total expenses, including cost of sales and operating expenses, to be up approximately 2% year-over-year. This should result in EBIT margins of approximately 21% to 22%. Our projected share count for Q3 is approximately 47 million shares. With that, I will now turn the call back to Sanjay for some closing remarks.

Sanjay Mirchandani, CEO

Thank you, Brian. As I mentioned earlier, we're making progress. And in Q3, we intend to remain focused on attracting new customers, taking share from our competitors and continuing to deliver solutions that help customers do amazing things with data; and in doing so, return to the consistent and predictable results we've achieved over the past year. Now, I'll open the call up to Q&A.

Operator, Operator

Our first question comes from Jason Ader with William Blair.

Jason Ader, Analyst

I would like to know if there is any update on your two-year growth forecast from the 2021 Analyst Day, which I believe indicated a compound annual growth rate of 9% to 10%.

Brian Carolan, CFO

Good morning, Jason. It's Brian here. We're not updating any targets at this time. I'll just remind you, though, if you look back since that investor event and assuming that the guidance of Q3 and Q4, that implies a double-digit software growth and mid-single-digit total revenue growth since the investor event. Also, our ARR is tracking very well to well ahead of that 10-plus percent target that we laid out. So at this point, we're not updating any targets, and we still are standing by those two top CAGRs that we put out.

Jason Ader, Analyst

Got you. And you're saying for Q4, if I heard you right, the software product should be about the same.

Brian Carolan, CFO

Usually, it aligns with historical trends for Q3.

Jason Ader, Analyst

Got you. And what about the services line? Do you expect that to continue to grow sequentially?

Brian Carolan, CFO

That will grow sequentially driven by Metallic.

Jason Ader, Analyst

Okay. So just maybe, Sanjay, for you, this is more of a broader question. As we consider some of the positive factors in the data protection market, particularly regarding ransomware and cloud backup, you've experienced some strong results with Metallic. You're increasing your salesforce and enhancing channel engagement. You have a rising proportion of renewals. It seems unexpected to have this kind of quarter, especially after Q1, which also appeared somewhat softer. It feels like something has declined here, and I'm trying to grasp what is happening in the business.

Sanjay Mirchandani, CEO

It was a mixed quarter, and we fell short on revenue. However, key business indicators are performing well. The most critical aspect is our involvement in significant IT transformation projects. We're focusing on attracting new customers during their transition to the cloud, and we are winning that business. Unfortunately, closing these deals is taking longer than expected, leading us to adjust our internal closing cycles. Additionally, we've encountered some supply chain issues related to hardware for these transformations, causing delays in certain projects. We're adopting a more cautious approach for Q3. Nonetheless, nothing fundamentally has changed in our business; it remains strong, and we are committed to returning to our previous performance levels.

Jason Ader, Analyst

Yes. I mean, just from a devil's advocate standpoint, though, there is a lot of competition in the market as you guys well know, and you deal with every day. There's a lot of private players, in particular, who have been very aggressive. Do you think that the competitive landscape has impacted your ability to execute here in the first half?

Sanjay Mirchandani, CEO

Nothing has changed. We've always been in a very competitive market. If anything, I would say that our strategy and what we're offering our customers is resonating very well. Our ability to provide world-class on-premise capabilities through HyperScale X combined with Metallic and the cloud is exactly what they're looking for. This enables them to select our technology for their cloud journeys without compromise. I believe we're winning a lot of new business. I shared some examples in my prepared comments about winning against competitors. A significant portion of our business closed last quarter was competitive displacements. These are real opportunities, and they take time. We feel optimistic about our current position, although it's taking a bit longer, and combined with some downstream supply chain issues, we need to adjust our closing timelines.

Operator, Operator

Our next question comes from Aaron Rakers with Wells Fargo.

Aaron Rakers, Analyst

Yes. I got a couple as well. First of all, just on a housekeeping basis. I think, last quarter, there were some metrics executing on the subscription renewal cycle that I was curious if you guys are still giving, which is talk a little bit about net dollar retention on the subscription. I apologize if I missed it. And then you also gave a metric around, I think it was ARR for subscription and SaaS offerings at 278 million. Can you just help me appreciate what that was last quarter?

Brian Carolan, CFO

Sure. Good morning, Aaron, it's Brian here. There hasn't been any significant change in our net dollar retention rate that we have previously mentioned. We prefer to evaluate this on a rolling four-quarter basis rather than comparing it quarter-to-quarter, which is why we didn't specify it. However, we are very pleased that our subscription and SaaS business has now surpassed and become the majority of our annual recurring revenue. It now accounts for over 50%, and this high growth is increasing at more than 40% per year.

Aaron Rakers, Analyst

Yes, that's helpful. Looking at the guidance for the next quarter, it appears to be $92 million in software revenue, which suggests about 22% sequential growth. Historically, the average growth has been in the mid to slightly above mid-teens range. While I know there have been periods of higher sequential growth in December quarters, I'm curious if this anticipated growth exceeds typical seasonal patterns for software. Does this reflect your expectation that some of last quarter’s issues will ease, including component constraints, which you factored into the guidance? I'm trying to understand the level of conservatism in your estimates given the variables from last quarter.

Brian Carolan, CFO

Yes. So a couple of things there, Aaron. I mean, we're confident in this guide. Our renewal opportunity is much larger in the second half of the fiscal year. That's starting in fiscal Q3. Our pipeline is healthy. The way we see it today, it's up versus Q2. We're focused on new business. We have a tremendous amount of momentum going into the quarter. But we're modeling things a little bit more conservatively. I mean, we're starting to see longer closing cycles as we get into larger IT transformation projects. And we can't control the hardware delays that are out there. So there could be some potential delays in customer deals, and we're just trying to be a little bit more conservative with the guide.

Aaron Rakers, Analyst

And then the final real quick question. Relative to the expectation in the September quarter, I think it was $184 million that you endorsed this last quarter. The delta from there, relative to the reported results, how would you bracket that between delays in large IT projects versus component constraints? And then I'll leave the floor.

Sanjay Mirchandani, CEO

There is overlap. If a new customer is involved in a large IT transformation, they consider the entire stack, which includes hardware. It's difficult to separate them as they're quite interconnected. However, when hardware isn’t involved, things progress smoothly. And if cloud is included, progress is very smooth.

Operator, Operator

Our next question comes from James Fish with Piper Sandler.

James Fish, Analyst

Just building off of Aaron's last question, understanding it was roughly a $7 million miss versus your guide, but is there any way to quantify how much in bookings or revenue were delayed? Meaning, was it actually more delays than that $7 million, and you guys really have that strong in the new business? And any sense of the timing of when these delays could come back and why it really looks like it was primarily felt in APAC and EMEA more than the U.S.?

Brian Carolan, CFO

So James, it's Brian Carolan here. How are you? There will always be deals that carry over from one quarter to the next, and delays are inevitable. We believe these are mainly delays. We have already closed some of that business and will continue to do so throughout the quarter. We have also taken into account our more cautious guidance for any delays related to hardware or new IT transformation projects that we are engaging in this quarter.

James Fish, Analyst

Right. But can you help me understand why these issues were primarily felt in APAC and EMEA instead of the U.S.?

Brian Carolan, CFO

There's no common theme there.

James Fish, Analyst

Okay. ARR increased by 12%, and you mentioned some strong new customer wins. What was the contribution of new customers to software revenue this quarter? I know you provided that information in the Q. Also, what were the net new customer additions this quarter? I'll leave it at that.

Brian Carolan, CFO

Yes. So we don't disclose exactly what the new customer revenue is, but I will tell you that we added well over 200 net new subscription customers in the quarter. We added over 300 Metallic customers in the quarter. 60% of those were new. We now broke through 1,000 total customers for Metallic, and the power of AND is really resonating. About 50% of our Metallic customers have another Commvault solution. So we're getting a lot of traction here. We believe Metallic is complementary to our strategy, and we're trying to continue to drive subscription and Metallic customers, and that's showing up in the form of our ARR results.

Operator, Operator

Next question comes from Jack Andrews with Needham.

Jack Andrews, Analyst

I was wondering if you could just maybe drill down a little bit. Are there any sort of commonalities that you’ve noticed in these larger IT transformation projects, whether it's specific partners opportunities or specific industry verticals? Are there some common themes that you can point to that have impacted your business?

Sanjay Mirchandani, CEO

We're noticing that as customers engage in digital transformation and transition to hybrid or public cloud models, they often reevaluate their entire application stack. Our solutions play a significant role in this process, providing a comprehensive view that covers both on-premise and cloud environments. This capability helps us attract new clients. For some, it begins with Metallic and expands to the data center, while others start with total HyperScale X and grow from there. Another trend we've observed is customers undertaking large ransomware remediation projects to enhance their protection against such threats. These efforts sometimes involve transitioning to the cloud or upgrading their on-premise systems. Both digital transformation and ransomware protection are significant trends we're witnessing, and they typically involve larger, more complex projects that often replace existing providers. This extended timeline can include hardware, which is a newer factor we haven't encountered in previous quarters. This trend spans across various industries, with notable examples including our largest deal last quarter with a major pharmaceutical company and another significant engagement in the healthcare sector. Overall, we are seeing a diverse mix, which can differ by region.

Jack Andrews, Analyst

Sure. I appreciate the color around that. Just as a follow-up question. As we think about the renewal opportunity here in the second half of your fiscal year, do you have a sense as to whether that is tied into similar IT transformation projects that some of your existing customers are engaging in?

Brian Carolan, CFO

It's probably a little less, Jack. I mean, it's a renewal opportunity. So in theory, it should not be tied into larger, although it is an opportunity for us to have a conversation with the customer. We view that as a positive is that, that factors into our net dollar retention rate that we can go in there and talk about Metallic and talk about some of our other offerings. So we view that as an opportunity.

Operator, Operator

Next question comes from Max Michaelis with Lake Street Capital.

Unidentified Analyst, Analyst

I just want to touch on the supply chain issues again. At what point in Q2 did you guys begin to see the large IT transformation projects experience delays?

Sanjay Mirchandani, CEO

Leading into the second month of the quarter and beyond is when we really started noticing it. I honestly wish we had seen it earlier, but that’s how it unfolded.

Unidentified Analyst, Analyst

Okay. And then I just got two more follow-ups to that. And then when do you guys expect hardware component issues to resolve as well as do you believe these issues were more or less Commvault specific or more macro in nature?

Sanjay Mirchandani, CEO

No, they’re macro. It's like this. If a customer is refreshing hardware or buying new hardware when deploying the project, they tend to want to wait for everything to come together so they can roll it out at the same time instead of buying the software, then waiting three months to get the hardware, and then getting the integrator in. So they tend to say they'll just calibrate and do everything at one time. When you're part of a bigger stack, it's hard to control that decision point. Even though we've won the business, it doesn't actually happen until the customer is ready. We saw that in Q2, and we factored it into our numbers for Q3. It's not a perfect science. I wish I could tell you when we would see results, but we're just in the mix with everybody else. We're downstream. Our personal dependency is very low, but if the customer needs to attach our software to some kind of storage or server, we're in the mix.

Operator, Operator

Our last question comes from Steve Enders with KeyBanc Capital Markets.

Steven Enders, Analyst

I want to better understand the large deals that are in progress. What does it take for those deals to close at this point? Is there an effort to convert those to Metallic to ensure they get completed? Also, how much of the deals that were delayed or pushed this quarter are expected to come back in fiscal Q3 compared to Q4 or later?

Sanjay Mirchandani, CEO

Sure. I believe we are already noticing a number of those deals. Some have been completed, while others are anticipated to close this quarter. As these come in, I can't specify exactly which deals will close in Q3 or Q4. In Q3, this business similarly relies on certain factors that we are doing our best to account for. Metallic primarily complements our on-premise offerings. It's not just a matter of swapping one for another; in some cases, customers evaluate both options and make a decision. Generally, they have an established architecture and possibly an existing installation of our technology, and they may be replacing something with our offerings. Therefore, it's not a straightforward swap. Additionally, Metallic excels at handling cloud-native workloads like no other.

Operator, Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.