Earnings Call Transcript - OSPN Q1 2021

Operator, Operator

Good day, and welcome to the OneSpan First Quarter 2021 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Joe Maxa, Vice President of Investor Relations. Please go ahead, sir.

Joe Maxa, Vice President of Investor Relations

Thank you, operator. Hello, everyone and thank you for joining the OneSpan first quarter 2021 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 are Scott Clements, OneSpan's Chief Executive Officer; and Mark Hoyt, our Chief Financial Officer. This afternoon, after the market closed, OneSpan issued a press release announcing results for our first quarter 2021. To access a copy of the press release and other investor information, including a presentation reflecting our first quarter financial results, 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 2021 are forward-looking statements. These statements use words such as believes, anticipates, plans, expects, projects and similar words, and these statements involve risks and uncertainties and are based on current assumptions. 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 annual report on Form 10-K filed with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties. Please note that 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 for 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 call is May 4, 2021. Any forward-looking statements and related assumptions are made as of this date. Except as required by law, 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.

Scott Clements, CEO

Thanks very much, Joe, and good afternoon, everyone. Thanks for joining us on the call today. During the first quarter of 2021, our annual recurring revenue, ARR, increased 29% year-over-year and ARR specific to subscription and term-based contracts grew in excess of 50%. In addition, a record 87% of our software and services bookings and revenues were recurring. We’ve made tremendous progress in our shift to recurring software revenue, and we expect to be materially complete with this transition by the end of 2021. Subscription revenue grew 47%, driven primarily by strong demand for e-signature solutions. Term license revenue declined from last Q1's pre-pandemic record quarter, but Q1 2021 was the third highest term license revenue quarter in our history and just shy of Q4 2020's total. Mark will provide more detail on these revenue items during his financial review in a few minutes. Profitability was impacted in the quarter by planned growth investment, several one-time expenses and higher vacation accruals, which we expect to return to normal levels in future quarters as employees return to more typical vacation patterns. Now I will turn to business highlights from the first quarter. During Q1, we won the largest multi-million dollar e-signature subscription contract in our history, displacing a major competitor and a leading provider of digital lending solutions. And just a few weeks ago, we launched the OneSpan Sign Virtual Room, which enables financial institutions and other organizations to safely and securely collaborate with their customers via video conference and live interactive co-browsing in order to review and e-sign high value agreements in retail banking, corporate banking and wealth management as well as insurance and automobile financing use cases, to name a few. Instead of customers patching together multiple apps and tools, the virtual room is an out of the box solution that is unique to the market, combining video conferencing, e-signature, identity proofing, end-to-end audit trails and recording options. It can be completely white-labeled to put the spotlight on our customers' brand, which is particularly important for B2C consumer-facing transactions. We have initial interest from many top North American banks that are already using our e-signature solution, and pricing for the virtual room service will be at a significant premium compared to pricing for only e-signature solutions. We are also integrating our newest identity verification capabilities into OneSpan Sign, which, combined with our virtual room technology, will deliver remote online notarization capabilities. We expect these expanded offerings to be available to customers starting in Q2 and Q3 of this year. In Gartner's September 2020 market guide covering issues such as identity verification and identity proofing services, they stated that 'by 2023, 75% of organizations will be using a single vendor with strong identity orchestration capabilities and connections to many other third parties for identity proofing and affirmation, which is an increase from fewer than 15% today.' We are preparing OneSpan to benefit from this trend in the coming years. Next, I want to comment on a recent consumer study from Aite Group, which found that 47% of all U.S. citizens were victims of some type of identity theft in 2019 and 2020. There was also a substantial increase in new account opening fraud as criminal groups looked to launder funds stolen from emergency government, unemployment and stimulus programs. In 2021, the decline in opportunities for stimulus fraud is expected to drive hackers back to traditional banking fraud with a focus on account takeovers, which we believe will increase demand for our anti-fraud solutions. We believe we're well-positioned to respond to these fraud attacks through our complementary portfolio of mobile, cloud and hardware solutions. Turning to hardware for a moment. As many of you are aware, we are realigning and streamlining operations to match lower revenue levels and maintain gross margins. Today, 19 of our top 20 customers use some combination of our hardware and software authentication solutions, all of which contribute to our profitable maintenance revenue and ongoing upsell and cross-selling opportunities. I also want to provide you with some color on the progress we are making in adjacent regulated verticals within the government and healthcare sectors that require a high level of security. Our entry into these verticals is still early, but we are gaining traction. Bookings were up more than 40% in the 12 months ended March 31, and our pipeline was up approximately 70% at the beginning of this quarter. Before I turn the call over to Mark to go through our financials, I would like to discuss a couple of recent announcements from OneSpan. First, during the quarter, Garry Capers was appointed to our Board of Directors. Garry joins four other current independent and highly qualified directors who have been added to the Board over the last 2 years. Garry has significant fintech and SaaS experience. He is Division President of Cloud Solutions at Deluxe Corporation, where he has full financial and operational responsibility for the company's SaaS and cloud solutions that are primarily targeted at end markets in the financial services industry. Second, as we announced on April 23, our CFO, Mark Hoyt, is leaving OneSpan to become the CFO at a private company. Mark has been an important contributor to OneSpan's transformation as we shifted to an emphasis on recurring software and services revenue, expanded our disclosure of relevant financial metrics and rebuilt our information systems architecture. On behalf of OneSpan, I'd like to congratulate Mark on his new role and wish him the greatest success. We are fortunate to have a very strong finance and accounting team that will provide continuity during the interim period. We've already begun our search process for our next CFO and are seeking highly qualified candidates with deep cloud-based software solutions experience to help continue the transformation of our company. Mark will now take you through our financials, and then I'll come back to provide additional comments along with an update on our outlook before opening the call to questions.

Mark Hoyt, CFO

Thank you for the kind words, Scott. Before I get into the results, I want to acknowledge that it has been a privilege to serve as part of the OneSpan team, and I want to thank all of my colleagues for the support and collaboration over the years. We've made tremendous progress in transforming the company, and I’m confident that OneSpan is well-positioned to continue that progress. Turning to the quarterly results. Annual recurring revenue at the end of Q1 was $108 million, representing a growth rate of 29% in line with our 25% to 30% target growth rate for the quarter. Our dollar-based net expansion rate, which we define as the year-over-year growth in ARR from existing customers, was 119% in the first quarter. Turning to recurring revenue. For the first quarter, subscription revenue grew 47% to $8 million. This included strong growth in e-signature and an increased contribution from cloud authentication. Term-based software license revenue declined 13% to $8 million compared to an unusually strong first quarter of 2020 that benefited from strong pre-pandemic demand and had an average contract duration approximately 60% longer than the average contract duration in the first quarter of 2021. This impacted our term license revenue in the quarter, which was still our third highest term-based software license revenue quarter ever. Maintenance revenue grew 14% year-over-year to $13 million. We expect maintenance growth to moderate over the balance of 2021 as we continue transitioning our business model toward subscription and term-based software licenses. In total, recurring revenue increased 12% to $29 million. Recurring revenue accounted for a record 87% of software and services revenue in Q1 compared to 71% in the first quarter of 2020, ahead of our expectation to achieve 85% this year. In the first quarter, total software and services revenue declined 10% to $33 million, impacted by our shift to recurring revenue. Hardware revenue declined 10% to $18 million and total revenue declined 10% to $51 million. Gross margin in the first quarter of 2021 was 70% compared to 71% in the first quarter of 2020. The difference in gross margin is primarily attributed to product mix. Operating expenses for the first quarter of 2021 were higher than expected at $45 million. The total increase in operating expenses resulted from planned growth investment, several one-time expenses and significantly higher vacation accruals as employees delayed vacations due to the pandemic. Adjusted EBITDA, or adjusted earnings before interest, taxes, depreciation, amortization, long-term incentive compensation and nonrecurring items, was negative $5 million for the first quarter of 2021. This compares to a positive $5 million in the first quarter of 2020. GAAP loss per share was $0.23 in the first quarter of 2021 compared to GAAP earnings per share of $0 in the first quarter of 2020. Non-GAAP earnings per share, which excludes long-term incentive compensation, amortization, nonrecurring items and the impact of tax adjustments, was negative $0.16 in the first quarter of 2021 compared to $0.08 in the first quarter of last year. We ended the first quarter with $115 million in cash, cash equivalents and short-term investments, consistent with the end of 2020. Cash generated from operations during the quarter was $4 million. Geographically, our revenue mix for the first quarter included 53% from EMEA, 33% from the Americas and 14% from the Asia Pacific region. This compares to 60%, 22% and 19% in the same regions last Q1, respectively.

Scott Clements, CEO

Thanks, Mark. Before we open it up to questions, I'd like to provide a bit of perspective on the current market landscape. The global economy is improving, but it is still uneven. In North America, profitability at large banking institutions improved substantially, and new account opening trends are improving as we expected. In Europe, travel restrictions and physical lockdowns continue, but with expected improvements in vaccine distribution, we should start to see sequential improvement going forward. The Asia Pacific region also had a soft first quarter, but as in other regions, we expect improvement as the year progresses. The outlook for e-signature remains strong around the world with continued demand for digitization services in today's economic environment. At this time, we are reaffirming our FY '21 objectives and full-year guidance, consisting of the following: total revenue of $215 million to $225 million; recurring revenue to be in the range of $120 million to $125 million; ARR growth of 22% to 26%; and adjusted EBITDA to be approximately breakeven. In the second quarter of 2021, we expect ARR growth of 25% to 30%, and for recurring revenue to increase sequentially and year-over-year. While perpetual license and hardware revenues decline as we continue to shift to a recurring model. We expect profitability to improve in the second quarter on higher revenue with increasing contributions from software and services. The second half of 2021 revenue is expected to exceed the first-half revenue led by continued growth in recurring software and services. And as previously indicated, we expect hardware revenues to decline in the mid single-digit range for the full year. We also continue to expect $15 million to $20 million of revenue headwind resulting from our transition to recurring revenue for the full year of 2021, and then we expect to see acceleration in software and services revenue growth in 2022 with increasing bottom-line profitability. Our core value propositions in security, productivity, positive digital user experience and regulatory compliance remain solid. Our transformation from a hardware-centric technology business to a modern cloud based software and solutions company is well underway and is driving positive results. Along with this transition, our Board has evolved with the addition of significant expertise and experience matched with the businesses' changing risks and opportunities. Our goal over the next 2 to 3 years is to drive increased revenue growth as the recurring revenue transition wraps up and we expand our solution portfolio, along with increased profitability and greater shareholder value creation. In the coming months, we will be identifying opportunities for structural cost reductions that we expect to improve profitability in the 2022 to 2023 timeframe, and we plan to refresh our multiyear financial goals and update you further later this year. Before we open the call to questions, I just want to remind everyone that this call is to discuss our Q1 results and outlook. We won't be taking questions about our annual meeting election, but I encourage those of you who are interested to visit www.onespanvalue.com for our proxy materials. With that, Mark and I will be happy to take your questions.

Operator, Operator

Thank you. Please note that we will now begin the question-and-answer session. And the first question will come from Andrew Nowinski with D.A. Davidson. Please go ahead.

Andrew Nowinski, Analyst

Great. Thank you. I will start with a question on the e-signature business. So was there any more details you could provide on the record contract that you won in the quarter, maybe the size of the contract or the length of the contract?

Scott Clements, CEO

Andy, yes, I think, Mark, that's a 3-year contract, correct?

Mark Hoyt, CFO

This was the initial phase one, yes, that's correct. The total value of the project is around mid single-digit millions.

Andrew Nowinski, Analyst

Great. Thank you. Maybe shifting gears then, I know you said you had record demand for term-based licenses in Q1 of 2020, but it looks like the term-based revenue is still down a bit more than hardware this quarter. Were you surprised by the magnitude of the decline? And was there anything in term-based licenses that may have impacted that decline other than the tough comp?

Scott Clements, CEO

No, I don't think so, Andy. When you look back, it was within the range of what we expected for the quarter. If you compare it to Q1 of last year, our term license revenue increased significantly from around $500,000 in Q1 2019 to approximately $9.5 million in the first quarter last year. That increase was due to some specific large contracts, especially in mobile security. Additionally, we had a very strong fourth quarter of 2020, as we typically do with back-end loaded results. As Mark mentioned, it was still our third highest quarter for term licenses. We are encountering some challenging comparisons, but this does not alter our outlook for the business or our expectations.

Andrew Nowinski, Analyst

Okay, great. And then maybe just one last question from me quickly. Is it possible, I know you reiterated your hardware guidance for the year of a mid-single digit decline. But as the economy starts to reopen, do you think there could be some pent-up demand for hardware and possibly a pending hardware refresh cycle that might provide a little bit of upside to that guidance?

Scott Clements, CEO

I think the first quarter performed quite well compared to our expectations. As we progress through the year, we recognize there are some larger opportunities available. However, it's uncertain if these will align with the right timing to positively impact revenues this year. Larger projects usually have long cycles regarding manufacturing and delivery. Once we navigate through that cycle, which takes a few months, we might see better hardware performance if some projects are booked early in the year. However, it's still too early to make a definitive call on that. Historically, this part of our portfolio can be somewhat volatile. We feel confident about the guidance we've provided, but a significant portion of hardware performance tends to materialize later in the year. So there’s still much to unfold ahead.

Andrew Nowinski, Analyst

Okay. That makes sense. Thanks a lot, guys and best of luck, Mark.

Mark Hoyt, CFO

Thank you, Andy.

Operator, Operator

The next question will come from Gray Powell with BTIG. Please go ahead.

Gray Powell, Analyst

Okay. Great. Thanks for taking the questions. Yes, just a couple, if I can. So maybe a follow-up on Andy's question. So I mean, it definitely seems like sentiment in the banking sectors improved a lot this year. Do you see that impacting purchase decisions or sales cycles at your larger customers for any part of the product portfolio? And then just how should we think about that recovery playing out over the rest of the year?

Scott Clements, CEO

Yes, we expect conditions to improve sequentially throughout the year. We've noticed positive movement in our sales pipeline, with more opportunities reaching the later stages compared to the beginning of the first quarter. North American banks have seen significant improvements in profitability, as they reverse some of the reserves they set aside last year. Additionally, there have been increases in new account openings at some of the major banks for the first quarter. However, there are still concerning areas, particularly in Europe, where we have an inconsistent situation marked by some returning lockdowns and rising infection rates. I believe that with vaccination efforts over the coming months, we should see improvements in that region and in our business, similar to what we are starting to witness in the U.S. Japan is more uncertain due to a current spike in infection rates, and there are also issues in Brazil that raise concerns. Overall, we anticipate progress in these areas in the months ahead. Since the fourth quarter of last year, we have indicated that we expect better business conditions as the year progresses, and I see no reason to alter that expectation now.

Gray Powell, Analyst

Understood. That's really helpful information. Can you help us understand how the duration affects term licenses? I assume we should mainly focus on the ARR metric, but how should we view multiyear term license deals in light of your 2021 guidance? Additionally, you mentioned that duration decreased by 60% in Q1. Can you provide a direct comparison of constant duration Q1 term licenses versus last year?

Mark Hoyt, CFO

The 60% decrease reflects the term license duration we've observed over the past couple of quarters, which is nearing around 12 months. Last year, the first quarter was an outlier due to a few sizeable three-year deals that raised the average to about 1.6 years. This quarter, we've returned to a median duration of about one year, which is not unusual. This one-year average duration is integrated into our guidance and figures for 2021 and aligns with what our sales team is offering and what customers are requesting as they increasingly move towards one-year agreements. While we are willing to accommodate customers who prefer three or five-year deals, we are noticing a significant shift towards one-year agreements that closely resemble subscription terms.

Scott Clements, CEO

In general, we have been trying to move toward 1-year terms to reduce revenue volatility from one period to the next. As we transitioned from perpetual to recurring license models, we aimed to keep things simple while also minimizing the historic revenue fluctuations the company experienced. Looking into 2022, we may fine-tune this approach. As Mark mentioned, we welcome customers who prefer multiyear contracts, but we've intentionally focused on a 1-year average duration. We will assess whether to maintain this strategy or adjust it in the future, but for now, we believe it's the best direction to take.

Gray Powell, Analyst

Got it. Okay. That’s really helpful. Thank you very much.

Mark Hoyt, CFO

Thanks, Gray.

Operator, Operator

The next question will come from Anja Soderstrom with Sidoti. Please go ahead.

Anja Soderstrom, Analyst

Hi. Thank you for taking my question. I just had a follow-up first on the e-signature contract you mentioned. You said the total value was in the mid-single millions. But in context to sort of your average contract, are you going after these kind of deals? Or how did this come about?

Scott Clements, CEO

I believe this customer was previously with a competitor and had a significant deployment of e-signature across various use cases within their organization. When they looked for alternatives, we were well-positioned to win their business. Consequently, our average contract value in e-signature has increased significantly over the past year as a result of our intentional focus on securing larger contracts. We had previously been too focused on pursuing numerous smaller contracts, so we made a strategic shift to prioritize larger deals. I don't have the specific numbers on hand, but I can say that the average is not in the million range.

Anja Soderstrom, Analyst

Okay.

Scott Clements, CEO

It's much smaller, but we have had other contracts over $1 million. This one is particularly remarkable in terms of its size and reflects the progress we are making in that business, both with our product and our go-to-market model.

Anja Soderstrom, Analyst

Okay. That was good color. And then in terms of the other virtual meeting room that you launched, I would assume there's a good use case for that in your adjacent businesses. Well, are you going after that initially, or are you just pushing it to your existing customers in finance or?

Scott Clements, CEO

I'm sorry, Anja, I didn't quite hear the other business, what you said. Could you just repeat that?

Anja Soderstrom, Analyst

I'm curious about your marketing strategy for that. Are you attempting to upsell to your current customers, or do you see a broader application for that product in adjacent markets?

Scott Clements, CEO

There are numerous opportunities for that product, and banking is certainly a high-demand area. This solution has been specifically requested by many of our customers to help them personalize their interactions with key clients, even in the digital realm, allowing them to associate a face with a transaction and engage in a more personal manner, especially for higher-value transactions. When you think about the best value proposition, you can see it has applications across various use cases that involve discussion, negotiation, or agreements that require strong identity verification. Therefore, it is very much a versatile solution. Initially, most opportunities will likely arise in banking due to our background, but we also see potential in government, healthcare, and other sectors we are exploring.

Anja Soderstrom, Analyst

Okay. Thank you for the color. That was all from me.

Scott Clements, CEO

Right. Thanks, Anja.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference over to Scott Clements, President and CEO, for any closing remarks. Please go ahead, sir.

Scott Clements, CEO

Thank you for joining the call today. We are looking forward to the remainder of this year and the continued progress. As you know, we are making significant investments in our solutions and our go-to-market model this year so that we can continue the transition to recurring revenue and aim to complete that transition this year. We should start to see this reflected in the overall growth rates of the company as we move into 2022. Thank you again for your attention, and I hope you all have a good evening.

Joe Maxa, Vice President of Investor Relations

Goodbye.

Operator, Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.