Good day, and welcome to the OneSpan Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Joe Maxa, VP of Investor Relations. Please go ahead.

Thank you, operator. Hello, everyone, and thank you for joining the OneSpan second quarter 2020 earnings conference call. This call is being webcast and can be accessed on the Investor Relations section of OneSpan's website at investors.onespan.com. Joining me on the call today is Scott Clements, our CEO, and Mark Hoyt, our CFO. This afternoon after the market closed, OneSpan issued a press release announcing results for our second quarter 2020. To access a copy of the press release and other investor information, please visit our website. Following our prepared comments today, we will open the call for questions. Please note that statements made during this conference call that relate to future plans, events, or performance, including the outlook for full year 2020, are forward-looking statements. We have tried to identify these statements by using words such as believes, anticipates, plans, expects, projects, and similar words, and these statements involve risks and uncertainties and are based on current expectations. Consequently, actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to today's press release and the company's filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties. Please note that certain financial measures that may be discussed on this call are expressed on a non-GAAP basis, and have been adjusted from a related GAAP financial measure. We have provided an explanation and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in the earnings press release. In addition, please note that the date of this conference call is August 11, 2020. Any forward-looking statements and related assumptions are made as of this date. Except as expressly required by the Federal Securities laws, we undertake no obligation to update these statements as a result of new information or future events, or for any other reason. With that, I will turn the call over to Scott.

Joe, thank you very much. Good afternoon, everyone, and thanks for joining us here today. There are a lot of moving parts in today's earnings release, so I'd like to start off by summarizing some of the key points for you. Number one, our transition from perpetual license to recurring revenue contracts is ahead of schedule. We're seeing strong growth in both subscription and term license categories. Though, this is in the near term, partly offset by the expected headwind from lower perpetual license sales. Second, year-to-date, we are ahead of our plan in most measures but there's still some quarter-to-quarter volatility in our P&L with some of the outperformance in Q1 impacting Q2's top line. Number three, our product investments are paying off with strong growth in OneSpan Sign and good early results from our OneSpan Cloud authentication offering, which was introduced earlier this year. The value of our software sales pipeline is growing over 50% compared to last year, and recurring order growth in Q2 was very strong. Number four, the surge in coronavirus infections and deaths in the U.S. and Latin America and resurgences elsewhere mean that banks now expect a deeper and longer economic downturn that will broadly impact the global economy and that will also pressure bank financial results. Therefore, OneSpan has determined it will withdraw its 2020 financial guidance until there's greater clarity on our customers’ plans. Number five, the strategic outlook for OneSpan remains strong. The need for digital channel security and digitizing the customer experience in financial services are only reinforced by the present new reality. Furthermore, major institutions are in the early stages of a generational shift to cloud platforms and infrastructure, which OneSpan began preparing for almost three years ago. Now let me turn to our update on Q2 results. In the second quarter, total revenues declined 2% to $55 million with strong recurring revenue growth, offset by lower authentication token sales, delays in some larger complex software projects and the period impact of our accelerated transition away from perpetual contracts. Recurring revenue accounted for 76% of total software and services revenue, up from 71% last year and 64% in the second quarter of last year. You will recall our goal for 2022 is for recurring revenue to exceed 75% of total software and services revenue. We now believe we will be close to that goal this year. We are also reporting annual recurring revenue for the first time this quarter. ARR grew 29% to $90 million in the second quarter. Adjusted EBITDA grew 24% to $3 million. We ended the first half of 2020 with revenue and adjusted EBITDA ahead of our 2020 plan. Turning to bookings. Software and service bookings increased in the upper single digits as perpetual contracts declined, offset by strong recurring contract bookings. Recurring contract bookings grew in excess of 50%, driven by term agreements up over 50% and subscription contract bookings more than doubling, driven by OneSpan Sign and demand for our cloud-based security solutions. OneSpan Sign logged significant wins globally across multiple verticals, including government, healthcare, insurance, and of course, financial services. We won a high six-figure ACV, annual contract value contract, with the US Department of Agriculture to support programs that distribute loans and relief funds to farmers. And we're seeing OneSpan Sign opportunities in every region and in the public and private sectors. During the quarter, e-signature transaction volumes increased sharply and we expect continued OneSpan Sign revenue acceleration in the second half of 2020. Now some updates on our solution portfolio. Our new OneSpan Cloud authentication offering is being well received by our customers. It can be implemented quickly at large scale from our public cloud and supports our full range of authentication devices and mobile security solutions. For example, we recently deployed OneSpan Cloud authentication for a Japanese financial services customer in under 30 days. Additionally, OCA utilizes our common set of API's that offer OCA customers a straightforward upgrade path to our more advanced risk-based intelligent adaptive authentication solution when they are ready. And we continue to be recognized by the industry for our technological advances. OneSpan was recognized by Frost & Sullivan as Company of the Year in Digital Identity and Risk-Based Authentication and we’re also awarded as Best Mobile Security Solution by SC Media Europe for 2020. As you know, we rescheduled our earnings release to allow time for our accounting team to assess possible accounting errors relating to a certain set of prior period software contracts. We of course take such matters very seriously. And even though the impact was immaterial, we want to ensure that it was fully understood and addressed before reporting our results. Mark will give you some additional details on that in just a moment. In fact, I'll turn the call over to Mark right now, and then I'll come back to provide some additional comments, along with an update on our outlook before opening the call to questions.

Thank you, Scott. Before discussing our second quarter financial details, I do want to comment on the prior period adjustments that we noted when we rescheduled the earnings call to today. During Q2, we identified errors relating to certain contracts with customers involving software licenses that originated in prior periods. We investigated and the errors that we found resulted in overstatements of revenue of $2.2 million from the beginning of 2018 through Q1 2020. This $2.2 million represents less than one half of 1% of the $523 million of revenue we recognized over that same time frame. And while we don't make errors, we do consider these errors to be immaterial, and we are adjusting the prior period revenue and related amounts in our earnings release today and in future filings with the SEC. As Scott mentioned, we are externally publishing annual recurring revenue for the first time this quarter. ARR, which we define as the annualized value of all active recurring product contracts greater than or equal to one year in length through 29% to $90 million in the second quarter of 2020. Recurring revenue grew 35% to $23 million in the quarter. We believe that these non-GAAP metrics, in addition to our GAAP results when compared to prior periods, provide additional insight into our transition to becoming a majority recurring revenue company. Total revenue for the second quarter of 2020 declined 2% to $55 million. Product and license revenue declined 12% to $35 million, and services and other revenue grew 22% to $20 million. Looking in more detail at recurring revenue, our subscription revenue grew 15% to $6 million. This included approximately 30% growth in our e-signature revenue, offset by a lower transaction volume from auto finance customers using our Secure Agreement Automation solution due to the pandemic. Term-based software licenses grew 144% to $5 million in Q2 and maintenance grew 23% year-over-year to $12 million. So total software and services revenue is down 13% to $31 million, while our hardware revenue declined 17% to $24 million. Gross margin in the second quarter of 2020 was 67% compared to 72% in the prior quarter and 68% in the second quarter of 2019. The decrease in gross margin is primarily attributed to product mix. And I want to note that we expect gross margins to increase slightly in the second half of the year as our software sales grow. Operating expenses in the second quarter of 2020 were $38 million, a decrease of 5% from $40 million reported in Q2 last year. We expect that our operating expenses will increase in the second half of 2020, driven by increases in sales headcount and marketing investments as we enhance our solutions and invest for growth in future quarters. Adjusted EBITDA, or adjusted earnings before interest, taxes, depreciation, amortization, long-term incentive compensation, and non-recurring items, was $3 million, up from $2 million in the second quarter of 2019. Adjusted EBITDA margin was 6% this year versus 4% last year. Our GAAP loss per share was $0.05 in the second quarter of 2020 compared to $0.06 in the second quarter of 2019. Our non-GAAP earnings per share, which excludes long-term incentive compensation, amortization, non-recurring items, and the impact of tax adjustments, was $0.02 in the second quarter of 2020 compared to $0.01 in the second quarter of last year. We ended the second quarter with $111 million in cash, cash equivalents, and short-term investments compared to $110 million at the end of last year. Cash generated in operations was $7 million in the quarter. Geographically, our revenue mix for the second quarter included 52% from EMEA, 25% from the Americas, and 23% from the Asia-Pac region. This compares to 60%, 26%, and 14% in the same regions in Q2 2019 respectively.

Okay, thanks very much Mark. As I already noted, our software and services sales opportunity pipeline grew substantially in the first half of 2020, demonstrating that we're offering solutions our customers need. However, there is increased uncertainty about the timing of customer projects as we enter the second half of 2020. The surge of coronavirus infections and deaths beginning in early June in U.S. and Latin America and continued flare-ups in Europe make it clear the virus will not be quickly contained. Most banks are now expecting a deeper, more extended economic downturn and have increased their loan loss reserves and expectation of more bankruptcies in small and medium businesses in the quarters ahead. Late in Q2 and into early Q3, we saw some lengthening of sales cycles as banks evaluate impacts to their operations from the pandemic. Nevertheless, many banks are anticipating increased fraud losses and the need for continued digital channel expansion. Based on our discussions with both customers and industry analysts, we believe that banks will be more cautious about technology investments, but the projects that facilitate a better and more secure digital experience will continue to be a priority. As I've noted before, it's important to understand that a majority of our revenue is driven by additional sales to existing customers, and that we generally have significantly net positive retention rates with those customers. Given the global economic uncertainty, we believe it's prudent to take the following two steps. First is to withdraw our full year 2020 guidance as have many of our technology and cybersecurity company peers. Our present outlook is for 2020 full year recurring software and services revenue growth to be consistent with the three-year outlook we gave at the end of last year, offset by perpetual license revenue declines as expected. We also expect hardware revenue will decline at a 20% to 25% rate this year rather than our initial estimate of a mid-teens decline as banks work down inventory they accumulated last year in anticipation of PSD2 and delays to hardware upgrade projects in favor of mobile security. Second, OneSpan's Board of Directors has approved the share repurchase plan of up to $250 million through June 2022 to ensure the flexibility to drive shareholder value across a range of economic conditions. The repurchase plan is designed to offset equity issuance for compensation purposes and repurchase additional shares when we believe it to be a prudent choice. I want to be clear that our priority remains using our cash for growth investment. But given the present economic uncertainty, I want the maximum flexibility for capital allocation. Finally, there are several important well-documented and sustainable trends that define the future of our business. First, the ever-present need for regulatory compliance, which we help our customers with all around the world. Second, digitization of business processes to reduce costs, improve the user experience, and increase agility through solutions like e-signature and digital identity verification. Third, the need to respond to elevated and more sophisticated fraud risk while preserving a responsive user experience with approaches like our risk-based authentication. And four, banks are beginning to transition more of their operations to the cloud, which was one of the foundations of our TID strategy. This is the newest but potentially the highest impact of these trends. In recent weeks, we've seen announcements from Deutsche Bank about their agreement to form a strategic multiyear partnership with Google for cloud platforms and services, and from BNP Paribas describing their new plan to adopt IBM’s Cloud for financial services. These are watershed events in the banking industry, and we fully expect to see others moving to the cloud as the impacts of the pandemic have made clear that the old ways of doing business are no longer sufficient. Let me also note that we are beginning to leverage our cloud-based offerings in adjacent markets given the growing needs for identity, security, and digitization solutions in government, insurance, and digital healthcare. So despite the near-term economic uncertainty, I believe OneSpan is well positioned for the future, and we continue to invest in the solutions, people, and capabilities that we need to compete, win, and grow. With that, Mark and I will be happy to take your questions.

Thank you. We will now start the question and answer session. Our first question comes from Gray Powell with BTIG. Please go ahead.

Yes, so I guess I had a couple. So it sounds like there was a lower than expected mix of perpetual license revenue in Q2. Was that more a function of deal delays that you talked about related to the macro environment, or is that something that you see potentially recovering over the next six to 12 months? So maybe I'll start there.

I'll take a crack at that, Mark, and you can certainly add in. I think one of the things that's been pretty clear through the second quarter is that the transition towards recurring revenue contracts has gone faster than we assumed it would at this point in time. So I think that transition is happening faster. That means more recurring opportunities and fewer perpetual license contracts. I think there was the slowness that I mentioned in my comments, I think was not limited to perpetual contract types. It was I think over a more general effect. So I'm not sure that had a lot to do with this shift towards more recurring. Mark, I don't know if you have anything to add to that?

I think just adding on Scott. We have seen the faster transition to term licenses has been a perk, so I think that's a big driver of the quarter’s results.

And so on the subscription line. So I thought the commentary on 30% e-signature growth was good. And I guess I'm a little bit new to the story. I thought that your business was the bulk of the subscription line. So I was confused by the difference between that 30% growth rate and the headline growth, which I think was more like in the mid-teens. So can you maybe just talk about the subscription line, or I guess, first of all, the difference in those two numbers? And then just your confidence level in getting growth in the subscription line back above that 25% pace? It sounds like you had pretty good bookings on that business.

Yes, let me take the last part of that and Mark can talk about the composition of the subscription line. I think the answer to the question is yes. We had triple-digit bookings growth in the subscription category in the second quarter. So we also had, I know, I don’t remember in total, but I know with OneSpan Sign, we also saw triple-digit bookings growth in the first quarter. So, we do expect that to continue and to come through in the P&L over the coming quarters. So Mark, you want to talk about the composition?

Gray, in that subscription line, I tried to allude to this in my comments. It's not just the subscriptions but also one-time overage charges that we see. So from quarter to quarter, it can be a bit lumpy. And one of the transaction-based book of business we have from our secure agreement automation with auto financing, we saw some of those one-time overages decline quarter over quarter in Q2.

So essentially, that's a transaction-based business on the auto sector, and that automotive asset finances the biggest component of the Secure Agreement Automation business. So I think as we all know, there have been fewer automobiles sold over recent few months, and that shows up in that number.

Our next question comes from Andrew King with Colliers Securities. Please go ahead.

Just looking at the ARR growth of 29%. I just want to get an idea of how sustainable that is through the year? And then also if you could talk about what e-signature was, if you talk about expanded use cases that you're seeing in the quarter that will be great. Thanks.

I'll let Mark go into some of the detail on the numbers, but the outlook is we have it right now is that we will see continued solid ARR growth for the full year. So we have said that over the period through 2022, we would see sort of 25% to 30% annual compound average ARR growth. I think we are going to see that this year. So I think that's the headline. And then in terms of e-signature, there were a couple of areas that were perhaps interesting. I mentioned in my comments earlier the USDA project. We are seeing and have seen a significant interest in other parts of the government for increased use of e-signature. And we talked a little bit I think in the first quarter release about the small business administration as another example. And then we're also seeing elevated interest and saw some books and business around healthcare. There is a real demand and a real need around various elements of healthcare telehealth, as well as other healthcare use cases for e-signature type products. So I think the interesting thing is that we're seeing these trends in e-signature really on a global basis. We have a real solid growth of bookings and opportunities for e-signature really in almost every region of the world. So we feel very good about the direction of that business. I don’t know Mark if you want to add any comments about the ARR outlook?

You asked if the 29% ARR growth is really sustainable. We published a table in our investor presentation that just went out to show the growth of the quarterly ARR since the beginning of 2019. And we've seen pretty consistent growth in that figure that is driven by subscriptions, term licenses, and then maintenance on both term licenses and maintenance on our perpetual contracts. The fourth component that really drives that number up is our strong retention rate, our lack of churn. So I think the combination of those four items will continue to push ARR forward. And that's one of the metrics we want to get out to the investors. The other item I want to note, Andrew, is that our term-based license revenue line is still relatively lumpy because of the 606 rev rec and driven by the term length of those licenses. So that's why we're publishing ARR, because we think that that gives a better representation of the growth of our recurring revenue streams.

Our next question comes from Roger Boyd with Needham and Company. Please go ahead.

Just wondering if we could dig into the comments on deal push outs. I'm wondering if we can get any more info on the conversation kind of with your customers. Is this mostly budget related or there are some architecture-driven decisions where customers are rethinking their longer-term regional strategies and maybe pushing deals out from that perspective?

As far as we can tell, this situation is primarily linked to economic factors and the uncertainty that banks are currently facing. Over the last quarter, many banks have significantly altered their loan loss reserves, which affects their capital ratios. They want to ensure they can effectively manage their operations in the upcoming quarters to restore those ratios. I have not seen any indication that this is related to technology issues; it's mainly economic. In June, we noticed an interesting trend. The quarter was progressing normally through May, but by the first week of June, there was a surge in coronavirus infections in California, Texas, and Florida. By the second week of June, the national infection rate began to rise rapidly, following the period when some areas reopened after flattening the curve. It became evident that the pandemic challenges would continue, leading banks to recognize potential impacts on small and medium-sized businesses, necessitating increased reserves. We are observing similar behavior, albeit at a slower pace, in Europe, while banks in emerging markets, particularly in Latin America, are facing challenges as well. These economic factors are driving the current situation. As I mentioned earlier, discussions with analysts in the banking sector and our customers reveal that they are reworking their priorities and budgets for the latter half of the year and into 2021. Nevertheless, they acknowledge that the digital channel and the importance of security and user experience in that space will remain their primary focus and will likely be their fastest growing area, which aligns with our services. There seems to be some slowdown as banks are reassessing their loan loss reserves and adjusting their plans for the remainder of the year and next year. This may also lead to a longer-term reduction in technology investments, though it's difficult to determine right now. Our opportunity pipeline at the end of the second quarter and the beginning of the third quarter has increased by more than 50% compared to the same period last year for our software and service offerings. Therefore, the pipeline is strong, and our products align well with customer needs. However, there remains uncertainty about the conversion rate and timing, prompting us to withdraw our guidance. We are optimistic about our software and services in the latter half of the year, though we are less optimistic about hardware, as indicated in my earlier remarks. Overall, the situation is not driven by technology; it primarily concerns economic factors and the timing of project advancements.

Regarding your comment on hardware and the revised guidance, do you view the current hardware refresh cycle as an opportunity to increase sales of software and subscriptions to customers who previously used hardware?

I believe that's a possibility. There is definitely a long-term trend where technology is replacing mobile security with hardware tokens. This isn't a new development; it's been occurring for some time. It seems likely that this trend will become even more noticeable. Recently, we've experienced significant strength in this area, particularly at the beginning of this year. As for the hardware business, there may have been some inventory accumulation last year related to advanced PSD2, as banks were uncertain about their needs. Currently, a large majority of their new account openings are probably happening online and through mobile, which favors mobile security and our offerings in that space rather than hardware. There are major projects for hardware updates and refreshes that are expected soon, but those developments are likely more relevant later this year or next year. However, we anticipate easier comparisons for next year.

Our next question comes from Anja Soderstrom with Sidoti. Please go ahead.

A lot of good questions asked already, but you were talking about the sales and marketing, expect that to increase in the second half. Are you still hiring and what are you intended to do in marketing that you haven't done in the first half? And you also mentioned that you are seeing more opportunity now in the adjacent markets. You've been mentioning that before but it hasn't really been a big driver. Are you going to make a bigger push there perhaps now and banking is sort of slowing down?

I believe we're currently at about $8 million for the marketing spend, which is roughly $8 million less than our anticipated operating expenses for the year so far. Mark, feel free to correct me if I'm mistaken.

Yes. That’s right.

We're currently under budget by about $8 million in operating expenses, primarily due to reduced travel and other related costs. As we look toward the second half of the year, especially considering the challenging economic outlook, we're focused on maximizing our opportunities. One key strategy is to increase our marketing investment. In the first half of the year, we observed a strong return from our lead generation activities, thanks to the fantastic work of our CMO, John Gunn, and his team. This has contributed significantly to the expansion of our opportunity pipeline, which I've mentioned previously. We have put considerable effort into enhancing our lead generation program, and due to the savings we achieved in the first half, we plan to reinvest some of that into marketing, particularly in the third and fourth quarters, to benefit not only this year but also in 2021. We believe we're seeing a good return on that investment, so we will continue to ramp up our lead generation efforts. Additionally, we are selectively adding more salespeople; we have already brought in new sales staff in the first half and will keep that momentum going. As we enter the latter part of this year and into early 2021, we expect to have a larger sales force with improved coverage. We believe we are on the right path with our products and solutions, and there are many indicators pointing to growth opportunities, which we will aggressively pursue. What was the second part of your question?

Yes, about the adjacent market mainly focusing on financial industry, but are you maybe pushing more for that now or…

I would say we're in the early stages of that. I have mentioned several times over the past two to three years that our primary focus has been to ensure that our new products and strategy keep us relevant to our core financial services customers. That was our main priority. We feel pretty good about our progress at this point, although there is certainly more work to be done. We continue to invest in our products and in research and development, and we believe we've made significant strides in that direction. Now seems like an appropriate time for us to start exploring adjacent markets more seriously. We've already ventured into several adjacent areas, especially in the e-signature business. With our new cloud authentication products and capabilities in mobile security, the importance of digital communication in healthcare is becoming much more pronounced, especially with increasing government activity. We believe we have the right products and the right timing to explore these adjacencies. We are making initial efforts in marketing and selling in these areas. This process will take time, and we want to ensure that if we commit to new verticals, we do so thoughtfully and make the right investments without wasting time. We are going to pursue these verticals in a disciplined manner and are at the early stages of that effort.

The next question comes from Matthew Furnas with Mandias Capital. Please go ahead.

I guess I'd like you guys to address the term immaterial in the context of your revenue misstatement. And I guess, I look back and I see you guys have been revenue estimates by $2.4 million over the last nine quarters and your Chairman sold $23 million of stock subsequent to the end of the quarter, at the end of Q1. And your stock is down 30% after hours. So for longtime shareholders, maybe you could define the term immaterial.

Mark, I’ll let you take that from an accounting point of view?

Matthew, as I mentioned in the investor deck, we have included a table in the earnings press release that outlines the quarterly impact on revenue. We reviewed each quarter and confirmed that there was no quarter where the results were affected by these revenue changes over the past nine quarters. This analysis supports our conclusion that the revenue adjustments were immaterial when considering the $525 million in revenue during that same period.

I guess, if you're sure enough about those numbers, you would be able to file your 10-Q on time. and I guess you've lost a certain amount of trust here. And again, I guess I'd like you to address the $23 million of stock sold by your former chairman since the end of March.

I’ll address that. First of all, please note that he is no longer our chairman. He is still a board member and was the founder of the company. He is approximately 75 or 76 years old. He has a long-term estate plan that has been in execution for the past couple of years.

Since the end of March. That's clear.

I assume that he has likely sold more in that time frame, which is his right to do. We work closely with our board and executives to ensure that trading occurs only when appropriate, and I believe that is how Ken has managed it. I'm unsure what he will say regarding this, but these decisions are personal to him and relate to his estate planning, which we are not heavily involved in.

All right. Well, thank you for answering my question. And I'm obviously a disappointed shareholder. So thank you.

I totally understand. Absolutely.

This concludes our question-and-answer session. I would like to turn the conference back over to Scott Clements for any closing remarks.

Thank you. Thank you, operator. Thank you all for joining us on our call here today. We are making I think tremendous progress in terms of transitioning our companies to recurring revenue and a more stable, higher value mix of revenue. We're going to continue to do that in the quarters ahead. And we are, I think confident and excited about the future of OneSpan. So thank you all for listening in today.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.