Earnings Call Transcript - OSPN Q3 2020

Operator, Operator

Good day and welcome to the OneSpan Third 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. Please go ahead, sir.

Joe Maxa, VP of Investor Relations

Thank you, operator. Hello, everyone, and thank you for joining the OneSpan third quarter 2020 earnings conference call. My name is Joe Maxa and I am the Vice President of Investor Relations. 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 our CEO, Scott Clements; and our CFO, Mark Hoyt. This afternoon after market closed, OneSpan issued a press release announcing results for our third 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 the full year 2020, are forward-looking statements. We have tried to identify these statements by using words such as anticipates, plans, expects, projects and similar words, and these statements involve risks and uncertainties 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 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 November 2, 2020; 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, future events, or for any other reason. With that, I will turn the call over to Scott.

Scott Clements, CEO

Joe, thanks very much, good afternoon everyone, and thanks for joining us here today. Our results for the quarter reflected near-term impact from the pandemic as our banking customers temporarily shifted their attention and expenditures away from some security and authentication projects. Despite this shift, we continue to make progress in the execution of our strategy to transition to a recurring software and services-dominant revenue model. We are optimistic about the future, as we believe that the core drivers of demand for our solutions remain intact. Let me start by providing some insight into what we saw in the third quarter. We entered the quarter with elevated uncertainty about our near-term business outlook, as our global financial services customers reacted to the increased severity of the pandemic by adding $70 billion to their loan loss reserve levels. In addition to this financial pressure, banks reallocated IT resources to support work-from-home implementation, other critical digitization projects, and business continuity needs. This resulted in delays and uncertain timing for many other types of projects, including security and authentication improvements. These factors impacted OneSpan and other providers of software technologies to banks. Most banks also closed or restricted branch operations around the world, limiting their account openings and reducing customer churn, both of which are key drivers of demand for our hardware and mobile security software offerings. The biggest impact of the pandemic on our business has been a sharp drop in demand for hardware authentication products. This is a significant change compared to the third quarter of 2019, which was a record hardware token revenue driven by the implementation of Payment Services Directive 2 and strong customer authentication in Europe. This one-time surge in demand in Q3 '19 makes for a difficult comparison. A typical example is a major South American customer that temporarily closed most of its branches, resulting in a dramatic drop in new account openings and a reduction of two-thirds in the number of authentication tokens purchased in 2020. It's also important to note that in most cases, the sale of authentication endpoints also carries a user license for server or cloud-based authentication software. Celent, a respected financial services advisory firm, published its COVID-19 banking insights study confirming that the two most immediate priorities for financial institutions during the thick of the pandemic have been to support customers in financial distress and to enable remote work for their employees. The study also found that most banks do plan to increase their IT budgets in 2021, with customer onboarding and mobile and online banking expected to see the largest increases, which we believe will benefit OneSpan. We've already seen these trends in our OneSpan Sign e-signature business and in the growth of our opportunity pipeline for mobile security and identity verification. While uncertainties remain, our customers have moved past their immediate financial and business continuity responses to the pandemic. They are looking at 2021 and we're gaining better visibility into their security and digitization investment plans. As a result, we are today providing updated guidance for 2020 and some comments around our expectations for 2021. Now I'd like to look ahead and tell you why I'm optimistic about the outlook for OneSpan. As I've already noted, customers are re-engaging and there are several other positive developments. First, our sales opportunity pipeline is rapidly growing. Second, we're seeing sequential improvements in top line metrics. And third, our strategies are working. I'll touch on each of these for a moment. So first, our software and services sales opportunity pipeline grew in excess of 40% year-over-year with strengths in e-signature, identity verification, and mobile security. Our authentication token sales pipeline is presently at its highest levels since Q4 of 2019. Second, bookings in all major product categories increased sequentially during the third quarter. Subscriptions increased 14% quarter-over-quarter and more than 100% year-over-year, driven by urgent demand for process digitization solutions, such as e-signature and digital identity verification. Other categories improved more modestly. Third, our strategy to transform the business to focus on strong recurring revenue streams and on margin solutions and services continues to progress. Software and services will likely exceed 60% of total revenues this year and forward. Recurring revenue accounted for 74% of total software and services revenue in the quarter. Annual recurring revenue (ARR) grew at 27% year-on-year. Our dollar-based net expansion rate on recurring contracts was solid at 120%. Year-to-date, our bookings on recurring revenue contracts are up 50%. We're also working to expand our growth opportunities by improving and extending our solution portfolio, developing a partner ecosystem to access new customers, and increasing our focus on vertical markets beyond financial services. We had several significant wins during the quarter that illustrate these trends. We continue to see progress in the government space with a large six-figure win at the U.S. Department of Agriculture as they continue to digitize their services for farm assistance programs. We also booked a seven-figure opportunity in the digital healthcare space, working with a top three U.S. telecommunications provider. OneSpan also closed an opportunity in Latin America, where the customer acquired multiple cloud-based solutions simultaneously including identity verification for digital customer onboarding, e-signature for new contract signing, and cloud authentication for prepaid card transactions. Meanwhile, our partner ecosystem continues to expand; we announced the technology and go-to-market partnership with ForgeRock, with whom we are already pursuing several sales opportunities, and we've also added Superbanking and OneLogin as partners, continuing to expand our global network of ID verification and trusted service partners for e-signature, identity verification, and new account opening services. Lastly, before I turn the call over to Mark, I want to note that we are seeing evidence that financial institutions are accelerating their move to the cloud. The pandemic has made clear the value of the scalability, agility, and resilience of cloud infrastructure and services as we envisioned in our trusted identity strategy back in 2018. During the third quarter, we completed the deployment of our largest cloud project to date at a U.S.-based financial institution. While there are still regulatory and other challenges, bank adoption of cloud-based services is gaining momentum to OneSpan's benefit. After Mark updates you on our financials, I'll come back to provide some additional comments along with an update on our outlook before opening the call to questions.

Mark Hoyt, CFO

Thank you, Scott. As Scott mentioned, we are in the third quarter of 2020 with uncertainty around the near-term business outlook for customers. We experienced reduced demand for our hardware and term licensed products; however, there are some bright spots I want to share. We made a strong quarter of annual recurring revenue growth. We find ARR as the annualized value of all active recurring product contracts greater than or equal to one year in length. Compared to the end of Q3 2019, ARR grew 27% to $96 million. Recurring revenue declined 5% year-over-year to $22 million due to diminished Q3 revenue from term licenses. However, when looking at our total software and services revenue, recurring revenue accounted for 74% of the total, up from 52% last year. We remain on track to exceed our initial goal for recurring revenue to be 75% of total software and services revenue by 2022. In fact, we may reach that goal this year. Our dollar-based net expansion rate, which we define as the year-over-year growth in ARR from existing customers, was 120% in the third quarter. We believe that these operational metrics like ARR and DBNER, and our non-GAAP financial results provide additional insight into our transition to becoming a majority recurring revenue company. Total revenue for the third quarter of 2020 declined 35% to $51 million. Product and license revenue decreased 51% to $30 million, while services and other revenue increased 15% to $21 million. Let me talk a little bit about our three recurring revenue components: subscriptions, term licenses, and maintenance in a bit more detail. Subscription revenue grew 34% to $7 million. This included strong growth in e-signature, improved growth in identity verification, and a modest contribution from cloud authentication. Term-based software license revenue declined 68% to $2 million, driven by pandemic-related delays in security projects, as Scott mentioned. Maintenance revenue grew 70% year-over-year to $12 million. Total software and services revenue declined 21% to $30 million, and hardware revenues declined 48% to $22 million. Again, the steep decline in year-over-year total revenue reflects large orders a year ago driven by the PSD2 regulation deadline. Note, while Q3 revenue declined from Q2, bookings in all major product categories grew in Q3 from Q2. Of note, subscription bookings grew 40% and total software and services bookings grew 3%. Gross margin in the third quarter of 2020 was 70% compared to 67% in the prior quarter and the third quarter of 2019. The increase in gross margin is primarily attributed to our product mix tilting towards software. Operating expenses in the third quarter of 2020 were $38 million, flat with the prior quarter and 7% higher than Q3 2019. Adjusted EBITDA, or adjusted earnings before interest, taxes, depreciation, amortization, long-term incentive compensation, and non-recurring items was $3 million, compared to $3 million last quarter and $19 million in the third quarter of 2019. Adjusted EBITDA margin was 5% in the third quarter versus 24% in the same quarter last year. GAAP loss per share was $0.04 in the third quarter of 2020 compared to the GAAP earnings per share of $0.30 in the third quarter of 2019. Non-GAAP earnings per share, which excludes long-term incentive compensation, amortization, non-recurring items, and the impact of tax adjustments, was $0.30 in the third quarter of 2020 compared to $0.36 in the third quarter of last year. OneSpan's cash and equivalents at the end of the third quarter was $130 million, compared to $110 million at the end of last year. Cash generated from operations during the quarter was $3 million. Geographically, our revenue mix for the third quarter included 52% from EMEA, 24% in the Americas, and 24% from the Asia Pacific region. This compares to 1%, 20%, and 90% in the same regions in Q3 2019, respectively.

Scott Clements, CEO

Thanks very much, Mark. As I noted earlier, we have improving visibility to customer demand compared to the end of the second quarter. So, we'd like to give you some updated views on 2020 and 2021. In the fourth quarter, we expect sequential year-over-year growth in recurring revenue to be partially offset by a sharp decline in hardware authentication, as Mark described, and a continued shift away from perpetual license revenue. We expect ARR to be at or near our 25% to 30% goal for 2020. More specifically for the full year 2020, we expect software and services revenue of $126 million to $128 million, hardware revenue of $77 million to $79 million, and total revenue of $203 million to $207 million. Looking into 2021, our software and services sales opportunity pipeline is strong, indicating that our product strategy is working and that our core value propositions in security, productivity, positive digital user experience, and regulatory compliance are intact. Banks are overall financially strong and while exact timing is difficult to assess, we believe these delayed projects will proceed in 2021, and that the demand for end-point products, especially mobile security, will improve as banks refocus on consumer account growth. This will be influenced to some degree by the course of the pandemic. Like other businesses, banks are learning how to operate in this environment. In 2021, we also expect the revenue headwind from the transition to recurring revenue to diminish with continued strong ARR growth consistent with our long-term target of about 25% to 30%. We now expect at least 85% of software and services revenue will be recurring by the end of 2022 compared to the prior outlook of 75%. We also expect that hardware revenues will stabilize in 2021, but it's not yet clear whether we will see further decline or growth in that area. The revenue mix shift to software and services will be accretive to gross margins. We are still evaluating our operating expense investment for next year. Given the uncertain path of the pandemic, the quarterly P&L spread is difficult to call at this point, but certainly, we would expect progressive improvements in growth across the year. I also want to note that we're assessing the benefits of realigning our authentication token hardware product line. We even assigned an executive to lead this effort while also streamlining the operation to match revenue expectations and reviewing its organizational structure. We will update you on this as our plans develop. In the meantime, we're focused on four areas to strengthen our company for the future. Number one, we continue to use our digital infrastructure to engage with our customers to address their immediate and evolving needs. We'll increase our focus on e-signature, identity verification and agreement automation solutions, which are in high demand, and continue to build our overall sales pipeline. Number two, we'll continue to invest in our solution portfolio, increasing our capacity for innovation and differentiation in security, fraud management, customer onboarding, and process digitization. Number three, we’ll expand our partner ecosystem, focusing on accessing complementary technologies and expanding market access. And number four, we'll develop targeted adjacent markets to increase our opportunity set and lessen our concentration in financial services. Finally, I want to remind you that we have prepared a third quarter update presentation available on our investor website right now. So, with that, Mark and I'd be happy to take your questions.

Operator, Operator

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

Gray Powell, Analyst

Thanks for taking the question here. Maybe just a couple. So, high level and I think you did a good job of adjusting to this, but just how do you feel about the visibility you have on the business today versus three to six months ago?

Scott Clements, CEO

Yes, hi Gray. It's Scott. I would say it's much better than it was at the beginning of the third quarter. At that point in time, you'll recall, we were through our guidance. The reason we did that was because we were having trouble working with our customers and understanding what their plans were going to be. They couldn't tell us what their plans were for projects that we knew about and had been working on. They really had a lot of uncertainty about when or what the timing would be on those projects. Those organizations were very focused on other areas like business continuity, work from home, and so on that I mentioned before. If I go back to the beginning of the year, I would say visibility right now is not yet as good as it was in normal circumstances or at the beginning of the year. But certainly, I think it's significantly improved from what we saw three months ago. We have spent a great deal of time and effort really engaging with our customers deeply, working with all of our sales organization around the world to understand what's likely for the fourth quarter and, to some degree, for next year. So, in short, visibility has significantly improved from the end of Q2; it’s not yet where we would like it to be normally.

Gray Powell, Analyst

Got it. Okay, that's very helpful. And then on the hardware business. So, I mean, obviously understand that headwinds there. I think that correct me if I'm wrong, but I think you said the pipeline on the hardware business is the best it has been since Q4 '19. Is that correct? And then how should you think about the potential for that to recover as the economy gets better at some point? Is that something that will just naturally happen? Or will you try to push more of that business into software form factors?

Scott Clements, CEO

Yes, I think that when we look at the sales pipeline, we look at it every month and every quarter. That pipeline really bottomed out in the early part of last year; a lot of orders coming in at that point in time whittled down the opportunity pipeline. The value of the pipeline we see today is slightly above where it was at this year, nearing the fourth quarter last year. So, I see that as some stabilization of demand looking forward. It does take improved new account opening trends for banks to be bringing in new customers into the branches, which will start to drive demand for hardware along with increased demand for mobile security. We're already seeing significant improvements in the opportunity pipeline around mobile security. I think we continue to focus on driving our growth in software and services and in the endpoint space for mobile security. Nevertheless, if you looked at the data, roughly 80% or 82% of our customers still use our hardware token device. So that's a meaningful part of our business. It is important to a lot of our customers. We have understood for quite some time that this won't be the growth engine of the company going forward; that growth will come from mobile security and other solutions that we have to offer. I believe this answers your question, Gray.

Andrew King, Analyst

So, thanks for taking my question. So, obviously, it sounds like the hardware piece is still pretty important for some of your customers, but it doesn't sound like you’d consider selling it. Given the unpredictability and volatility of it, have you considered breaking out the hardware software from gross margins and operating margins to get a little bit more visibility into what seems to be the real strength of the business behind the software?

Scott Clements, CEO

I’ll make a couple of comments there, Andrew. Good evening, by the way. Mark, you may have some additional things you want to add here. As I always say, we as a management team and as a board are constantly looking at our portfolio of solutions, trying to assess the right path to maximize value. I think it's not appropriate for me to talk about private M&A activity until they become public. I would reiterate what I said in the conference script that we've put an experienced executive in charge of that business. He's taking a look at the operation itself, how to streamline it, how to focus on the right products, and how to size it for the level of business we see going forward. I think regardless of what we ultimately do, these are all positive steps as we think about how to structure that business going forward. Mark, I don't know if you have anything you want to add.

Mark Hoyt, CFO

Sure. I think, as Scott mentioned, we're focused on looking at that business. One challenge we have is that the shared back-office functions support all our business lines. That's one of the things we’re going to take a look at—what is necessary to support hardware versus software services, based on the trajectory we are headed toward.

Andrew King, Analyst

And then just briefly looking at the go-to-market strategy, typically it has been focused on the banking vertical. How do you see that going forward?

Scott Clements, CEO

No, I wouldn't say we really had to adjust that much for COVID at this point. These were strategies we were in the early phases of exploring a couple of new markets, like healthcare and government. We look at these verticals in terms of identifying use cases that are similar to what we do in banking and financial services, where our technology and products can offer value without creating a completely new set of products. There's a real increased focus on digital identity and services in government, both in the U.S. and globally. And those can, in their own way, represent very high-value transactions, maybe not in the same monetary sense as a bank but certainly in other respects. That's an area where we can apply much of our core technology. The same goes for healthcare, particularly regarding digital healthcare and telehealth. We're just in the early phase, but demand has increased because of the pandemic. It's typical for sectors to digitize quickly, and as they do, their security often lags behind. There are tremendous opportunities in these areas without having to change our products or business models significantly.

Anja Soderstrom, Analyst

Hi, good evening, everyone, and thank you for taking my question. Just wanted to follow up on the government and healthcare areas. Are there any additional investments you’ll need to make in terms of the sales team, or how do you see that playing out?

Mark Hoyt, CFO

Hi, Anja. That's a good question. First of all, I think we already have some sales coverage in the government market in North America and other parts of the world. The government sector is not completely new to us, but we believe there's really expanding opportunities there. We'll take that bit by bit. If we look at the healthcare space, we are likely to use a partner strategy, a go-to-market approach that identifies existing players in that market. The healthcare market is very fragmented, and it requires substantial effort and resources to build a direct sales model. We're still at the early stages. But I think our approach going forward will be to find the right channel partners to where we can add security and digital tools to their existing value propositions.

Scott Clements, CEO

No, I don't think it has really been affected significantly. We added several new partners in the quarter, and there will be more to come. There are many different types of partners we're engaging with. The pandemic has had the most significant effect on trying to land new customers and accounts. We have longstanding relationships with existing customers and can manage those through our digital network. It's a little tougher when accessing new customers and building relationships. That's not a very big part of our business today, but we want that to grow in the future. So, while it's not particularly helpful right now, it has not been a significant problem for us currently.

Operator, Operator

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

Scott Clements, CEO

Thanks very much, operator, and thanks everybody for joining the call today. The pandemic has created some challenges for our customers and in turn for us here in the third quarter, but we see our opportunity pipeline continuing to grow. We're making great progress on our transition to recurring revenue and exploring these adjacent spaces. Looking ahead, I see tremendous opportunity for our company, and we will continue to do our best to execute against that. We aim to not only deliver on our current opportunities but to find new ones that will expand our horizons. Our goal is to become a company with high stable, and growing recurring revenue, and I think we are making great progress towards that despite the current challenges. So thank you, everybody. I appreciate it, and I look forward to talking to many of you in the days ahead.

Operator, Operator

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