Earnings Call Transcript - OSPN Q2 2024

Operator, Operator

Good day and thank you for standing by. Welcome to the Q2 2024 OneSpan Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Joe Maxa, Vice President of Investor Relations.

Joe Maxa, Vice President of Investor Relations

Thank you, operator. Good afternoon, everyone, and welcome to the OneSpan second quarter 2024 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. This afternoon, after market close, OneSpan issued a press release and filed a Form 8-K with the SEC announcing results for our second quarter 2024. In addition, the company plans to file a separate Form 8-K this afternoon announcing the appointment of Victor Limongelli as President and CEO. Victor has been the company's interim CEO since January 4, 2024. To access a copy of the press release, Form 8-Ks and other investor information, please visit our website. Victor Limongelli and our CFO, Jorge Martell, will join me on today's call. Following the prepared comments, 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 2024 and other long-term financial targets, are forward-looking statements. 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 filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties. Also 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 for and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in the earnings press release and in the investor presentation available on our website. In addition, please note that all growth rates discussed on this call refer to a year-over-year basis unless otherwise indicated. The date of this conference call is August 1, 2024. 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. I will now turn the call over to Victor.

Victor Limongelli, President and CEO

Thank you, Joe, and thanks, everyone, for joining the call today. Over the last 7 months, I've gotten to know the OneSpan team and it's been a real pleasure to work side by side with them as we've improved OneSpan's operational performance. I'm looking forward to further improvements. I'm excited to keep the momentum going, and I'm honored that the Board felt the same way in making my role permanent. As you know, we've made significant progress this year, underscored by a strong second quarter which included 9% revenue growth, 15% ARR growth, and adjusted EBITDA of $16 million, or 27% of revenue. We also generated $2 million in cash from operations in the second quarter, a tremendous improvement compared to the prior year period when we used $20 million in cash. And we ended the quarter with $64 million in cash on hand. Our focus on operational excellence and accountability throughout the company is driving profitable growth. Over the past few years, we've continued to grow our software business. And in the first half of 2024, we've reached the point where software and services represent approximately 3/4 of total revenue and hardware about 1/4 of revenue. In comparison, if you look at our business 3 years ago, the split was approximately 64% software, 36% hardware. Our sales team has done a great job in transitioning the company to more higher-margin software revenue. In particular, our sales team executed very well during the second quarter with bookings coming in ahead of our internal plan. The sales team has been working hard to stay close to customers so that we can continue to improve our performance in response to customer feedback. As you might imagine, I'm very pleased with the team's performance. In addition to the strong performance by the sales team, our renewals team has made strides in closing maintenance renewals in a timely fashion. Year-to-date, our on-time renewal rate has improved compared to 2023, and the rate of renewals closed within 30 days of the due date also improved year-over-year. That is good progress and a testament to the good work of our renewals team. Our R&D team has continued to make improvements to our SaaS offerings, and we expect to see improved operational efficiency reflected in increased gross margins as we move through the remainder of the year. Looking ahead, our R&D team in security is, I think it's fair to say, reenergized and is working on enhancements and new products such as FIDO hardware tokens. Turning to our two business units, I'm thrilled with the second quarter delivered by our team in the digital agreements business. Digital agreements grew strongly and became profitable, excluding one-time costs which Jorge will discuss in more detail. In Digital Agreements, we have substantially completed our transition to a SaaS model. Our strong second quarter revenue and ARR growth rates were driven primarily by expansion contracts and, to a lesser extent, new logos. In our Security business unit, we saw strong subscription revenue growth and overall revenue growth was on par with our low- to mid-single-digit growth rate expectation for 2024. It also continued to be a strongly profitable business. Our goal is to have both business units deliver growth and profitability, and we are well on our way to achieving that goal. I am, of course, thrilled with the strong ARR growth and our improved profitability and cash flow, as well as the strong sales quarter the team delivered. It would be too much to say the team closed every opportunity, but there were certainly deals that closed in Q2 that might have been expected to occur in Q3. That is great, of course, and we'd rather have the deals closed earlier, but it does make Q3 more challenging. Additionally, the third quarter, in terms of seasonality, is typically not a particularly strong bookings quarter for us. Given that context, coupled with the strong first half performance, for the balance of the year, we expect our subscription revenue to be up double-digits over the prior year, while we expect maintenance revenue to decline somewhat, largely due to the end of life of the Dealflo product as well as perpetual to term conversions. In addition, given our current visibility into our hardware pipeline and anticipated customer hardware delivery schedules, we anticipate a decline in hardware revenues in the second half compared to the prior year. That said, we expect both business units to be profitable in both the third and fourth quarters. So we now expect our full-year adjusted EBITDA to be higher than previously forecast. Finally, I'd like to note that the Board plans to undertake by year-end a review of our cash generation and capital needs, balancing those factors with a desire to return capital to shareholders. Overall, we remain committed to operational excellence and driving efficient revenue growth to ensure we achieve our annual profitability and cash flow commitments. With that, I will turn the call over to Jorge.

Jorge Martell, CFO

Thank you, Victor, and good afternoon, everyone. I'll start by providing a brief update on our cost reduction activities. We realized $8.5 million in annualized cost savings from our restructuring efforts in the second quarter of 2024. Cumulative annualized savings totaled $73.5 million. We believe we are on track to achieve our goal of $75 million in cumulative annualized cost savings by the end of this year. Now turning to our second quarter results. ARR grew 15% to $165 million, and our net retention rate was 112%, up from 107% last quarter. During the quarter, we saw a strong increase in digital agreements in new annual contract value (ACV) and strong increases in contract expansions from existing customers in both business units. Second-quarter 2024 revenue grew 9% to $60.9 million as compared to the same period last year, driven by 4% growth in Security Solutions and 30% growth in Digital Agreements. Subscription revenue grew 29% to $29.6 million, including 19% growth from Security Solutions and 41% growth from Digital Agreements. The strong growth in subscription revenue was partially offset by a modest decline in maintenance revenue which is by design as we transition to a SaaS and subscription license model. Hardware revenue was flat year-over-year. Second quarter gross margin was 66.2% compared to 61.5% in the prior year quarter. Gross margins were impacted by 2.4 percentage points in Q2 2024 and by 2.8 percentage points in Q2 2023 due to one-time costs. Excluding these one-time costs, the increase in gross margin was primarily driven by favorable product mix due to growth in subscription revenue, partially offset by an increase based on depreciation of capitalized software costs. Second quarter GAAP operating income was $7.6 million compared to an operating loss of $17.8 million in the second quarter of last year. Increases in revenue and gross profit margin, combined with a decrease in operating expenses, primarily from lower headcount-related costs and lower restructuring costs, led to the improved performance. GAAP net income per share was $0.17 in the second quarter of 2024 compared to a GAAP net loss per share of $0.44 in the same period last year. Non-GAAP earnings per share was $0.31 in the second quarter of 2024. This compares to a non-GAAP loss per share of $0.18 in the second quarter of 2023. Second quarter adjusted EBITDA and adjusted EBITDA margin was $16.1 million and 26.5% compared to negative $3.8 million and negative 7% in the same period of last year, respectively. Turning to our Security Solutions business unit, ARR grew 9% in the second quarter to $105 million. ARR growth was negatively impacted by approximately 1.5 percentage points due to the relocation of identity verification products to our digital agreements business unit at the beginning of this year. Second quarter revenue increased 4% to $45.5 million. Subscription revenue increased 19% to $14.9 million, driven primarily by expansion of licenses from existing customers for authentication solutions. Maintenance and support revenue declined by less than $1 million year-over-year to $9.7 million with growth from on-premise subscriptions, offset by the expected declines from legacy perpetual contracts. Digipass hardware token revenue was basically flat with the prior year at $19.7 million. Q2 2024 gross profit margin was 67% as compared to 59% in the second quarter of 2023. The increase in margin is primarily attributable to favorable product and customer mix. In addition, Q2 2023 gross margin was impacted by approximately 3.5 percentage points related to an inventory write-off charge. Operating income was $20.7 million and operating margin was 46% compared to $8.5 million and 19% in last year's second quarter. The increases in revenue and gross profit margin, combined with reduced operating expenses, primarily attributed to restructuring and other cost reduction activities throughout the majority of the improved performance. Turning to our financial results for our digital agreements business, ARR grew 25% to $61 million. ARR growth benefited from approximately 3 percentage points due to the relocation of identity verification products to digital agreements at the beginning of this year. Second quarter revenue grew 30% to $15.5 million, driven primarily by both new contracts and expansion of renewal contracts and to a much lesser extent, the relocation of identity verification products. Subscription revenue, consisting of 100% cloud-based solutions in both Q2 2024 and in the prior year quarter, grew 41% to $14.8 million. Second quarter gross profit margin was 63% as compared to 72% in the prior year quarter. During the quarter, we made a decision to discontinue R&D investments in our Trust Vault blockchain product. Excluding one-time costs related to this decision, Digital Agreements' Q2 2024 gross margin would have been 10 percentage points higher. Operating loss was $0.2 million compared to an operating loss of $7.1 million in Q2 last year. The improved performance was driven by an increase in revenue and a decrease in operating expenses, primarily attributed to restructuring and other cost reduction activities and was partially offset by an increase in cost of revenues. Excluding one-time costs of approximately $1.8 million, Digital Agreements' second quarter 2024 operating income would have been positive. Now turning to our balance sheet. We ended the second quarter of 2024 with $64.3 million in cash and cash equivalents compared to $42.5 million at the end of 2023. We generated $2 million in cash from operations during the quarter and used $2 million in capital expenditures, primarily capitalized software costs. We have no long-term debt. Geographically, our revenue mix by region in the second quarter of 2024 was 41% from EMEA, 35% from the Americas, and 24% from Asia-Pacific. This compares to 48%, 33%, and 19% from the same regions in the second quarter of last year, respectively. I will now provide our financial outlook. For the full year 2024, we are reaffirming our previously issued revenue guidance. We are increasing our ARR guidance to reflect year-to-date strength, partially offset by some second half contraction related to previously sunset products, and we are increasing our adjusted EBITDA guidance to reflect an increase in operating leverage. More specifically, we expect revenue to be in the range of $238 million to $246 million; ARR to end the year in the range of $166 million to $170 million, as compared to our previous guidance range of $160 million to $168 million; and adjusted EBITDA to be in the range of $55 million to $59 million, as compared to our previous guidance range of $51 million to $55 million. Absent share repurchases, we continue to expect to end the year with more than $70 million of cash. That concludes my remarks.

Victor Limongelli, President and CEO

Thanks, Jorge. We had an excellent second quarter and first half of 2024. Looking at the second half of the year, we know that we have more work to do in order to deliver an excellent year. I'm excited and proud to be leading the OneSpan team, and we're going to continue to focus our efforts on delivering value to our customers and thereby creating value for our shareholders. Jorge and I will now be happy to take your questions.

Operator, Operator

Our first question comes from Gray Powell with BTIG.

Gray Powell, Analyst

Okay. Congratulations on the good set of results.

Victor Limongelli, President and CEO

Thank you.

Gray Powell, Analyst

Yes, absolutely. So maybe Victor, to start off. I mean you've been at OneSpan as CEO for 7 months now. You posted 2 good reports. Do you see anything major that needs to be changed, or are there any areas where you want to maybe increase your focus and level of investments?

Victor Limongelli, President and CEO

Yes, let me discuss those results. We're very pleased with our ARR growth and the overall performance of our software business. My experience has primarily been in software for over 20 years, so hardware is relatively new for me. However, I'm finding that business quite promising as well. It has good margins, and we have established long-term relationships with our customers. Although it's not as predictable as a SaaS business, it's still a solid operation. We're investing in this area, and my objective is for both business units to be growing and profitable. We've made significant progress in that direction. I believe the Security business could benefit from further investment in product updates, and we are beginning to implement this as we prepare our 2025 plan.

Gray Powell, Analyst

Understood. Okay. That's helpful. And then just in general, across software, it's been a fairly rough Q2 so far. And you kind of alluded to this on the call, or the prepared remarks but I mean you just added more net new ARR this quarter than the prior 3 quarters combined. So I mean, like, what surprised you the most? What drove the upside? And has anything changed within the business?

Victor Limongelli, President and CEO

I think if you consider the results we shared, there were many positive outcomes. One aspect that stands out to me is the net retention rate. When you're in the range of 1.10 to 1.12, it's very advantageous for the business, making it significantly easier to grow ARR. The strength in this area was evident on both sides of the business, including strong NRR results in Security, which was impressive. The team did an excellent job.

Operator, Operator

Our next question comes from the line of Rudy Kessinger with D.A. Davidson.

Rudy Kessinger, Analyst

And Victor, congrats on the permanent title.

Victor Limongelli, President and CEO

Thank you. Thanks, Rudy.

Rudy Kessinger, Analyst

I would like to further explore Gray's question. The $10.3 million in net new ARR is more than what you added over the past three quarters combined. Additionally, your NRR, being a TTM figure, seeing a five percentage point increase in one quarter indicates you likely had either a price increase or significant customer expansion. Could you elaborate on the $10 million in net new ARR, the increase in ARR, any customer concentration, and any large expansions or pull-forwards? The numbers are quite impressive compared to previous quarters and what is suggested in the guidance for the second half.

Victor Limongelli, President and CEO

Yes. Thanks, Rudy. I alluded to this in the prepared remarks a little bit. We closed a ton of business, including some large deals, and it was really a great performance by the sales team. I'll let Jorge dive into any numbers that he wants to address, but the bookings performance was really strong by the team in the second quarter.

Jorge Martell, CFO

Yes, to add to that, we experienced significant expansion. Notably, we completed a low seven-figure deal that involved cross-selling. This contributed to our net revenue retention, particularly on the DA side. Additionally, we saw strong growth in our authentication products and software this quarter, even stronger than last quarter. Furthermore, it’s important to highlight that we experienced lower churn and contraction this quarter compared to previous ones. The impact of end-of-life was not substantial, amounting to about $0.5 million this quarter, whereas last quarter it was more significant. Overall, we saw excellent expansion from the cross-sell on the DA side, along with reduced churn and contraction, benefiting us in multiple ways.

Rudy Kessinger, Analyst

Okay. And just a quick follow-up on that and then I've got another question. A low-7-figure cross-sell, that was low-7 figures of net new ARR from a single cross-sell on the DA right?

Jorge Martell, CFO

Correct.

Victor Limongelli, President and CEO

Yes.

Rudy Kessinger, Analyst

That's helpful. Regarding the EBITDA guidance, I understand that in Q1, you had some significant multi-year licenses. In the second half, it seems your hardware sales will be somewhat lower than usual due to seasonality. However, the EBITDA guidance for the second half suggests approximately $20 million compared to $36 million in the first half. You mentioned that gross margins will be stronger and that you're implementing cost reductions. It appears that operating expenses will actually increase in the second half. Could you elaborate on that?

Jorge Martell, CFO

Yes, I can provide some insight here. I believe the adjusted EBITDA will be slightly higher than the figure you mentioned. However, EBITDA is largely dependent on revenue. As Victor pointed out, we anticipate year-over-year declines in the hardware sector due to the current stability we have. This is mainly associated with the schedule of customer deliveries. We recognize revenue upon delivery, so as we noted, this business can be unpredictable. There are lead times for production and deliveries, and we must coordinate these with our customer base. It requires significant effort to maintain consistency. Given the uncertainty surrounding revenue in the hardware segment, we have been cautious in our guidance. However, we have adjusted that according to our forecasts and are optimistic about aiming for the higher end of our range. We will keep you updated as we make progress.

Operator, Operator

Our last question comes from the line of Anja Soderstrom with Sidoti.

Anja Soderstrom, Analyst

Congratulations on the great quarter and the announcement, Victor.

Victor Limongelli, President and CEO

Thank you. Thank you very much.

Anja Soderstrom, Analyst

For this quarter, your undertaking of changes within the sales organization. So how much of this tailwind is driven by demand versus your changes in execution do you think?

Victor Limongelli, President and CEO

Well, it's hard to pull that apart. I think the team has executed better. We did see good performance across the board. It was both in security and in the digital agreements business. So it's hard to say how much of that is due to underlying demand. I don't know if I could give you a precise number on that. I'm really happy with how we're engaging with customers and making sure that we're spending time meeting with them face-to-face and seeing what problems we can solve for them. But I can't give you a precise number on demand versus execution.

Anja Soderstrom, Analyst

Okay. Understood. And let me ask you in a better way maybe. How is the macro environment for you? Like do you still see that as challenging? And once you're getting the execution up and running and the macro environment improving, hopefully, eventually, what engine of the customers and...

Victor Limongelli, President and CEO

That's a good question. For us, Europe is a significant market, and while the European economy hasn't been doing particularly well, it isn't experiencing a severe recession either. I prefer not to discuss macroeconomic conditions unless they are extreme. If the economy is booming, that could provide some benefit; conversely, a serious recession clearly has negative effects. I don't believe the macro environment is great, but we need to be able to perform well despite these economic conditions. This situation is far from the worst economy I have faced while running a public software company during the Great Recession. I see it as manageable, I suppose. Does that make sense?

Anja Soderstrom, Analyst

Yes. And in terms of the cost savings, it sounds like you almost reached your target here for the year. Are you still looking for potential further ways or you've been kind of pushing it already?

Victor Limongelli, President and CEO

Jorge, do you want to cover that one?

Jorge Martell, CFO

Yes. We are nearly at our cost savings target, Anja. As mentioned previously, the recent incremental measures we announced in the last couple of earnings calls affected digital agreements, which were tied to the requirement of achieving profitable growth for both businesses. We are there now. There may still be some adjustments needed, possibly involving one or two business units and overall corporate operations. However, I don't think this warrants any major announcements; it is simply part of managing the business. We need to be aware of this and work on improving and expanding our operating margins. So, to your point, we are close to our goal and will continue to fine-tune rather than expecting another significant number to be released.

Anja Soderstrom, Analyst

And then on the cost side, Victor, you mentioned you will invest in some products and have them. Will there be any significant cost increases because of that?

Victor Limongelli, President and CEO

We are trying to keep a close eye on expenses, as Jorge mentioned. We haven't finalized our 2025 planning yet, and there may be a small incremental investment in that area. However, for the most part, we are focusing our team, which is strong, into areas that can provide the most benefit for our customers rather than simply increasing spending. I don't believe that's the right strategy.

Operator, Operator

Thank you. I'm showing no further questions at this time. I would now like to turn the call back to Joe Maxa for closing remarks.

Joe Maxa, Vice President of Investor Relations

Thank you, everyone. We appreciate your time and look forward to sharing our progress with you again next quarter. Thanks again and have a nice day.

Operator, Operator

Thank you. This does conclude the program, and you may now disconnect.