Earnings Call Transcript - OSPN Q4 2020

Operator, Operator

Good afternoon, and welcome to the OneSpan Fourth Quarter 2020 Earnings Conference Call. 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, sir.

Joe Maxa, VP of Investor Relations

Thank you, operator. Hello, everyone, and thank you for joining the OneSpan Fourth Quarter and Full Year 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 are Scott Clements, OneSpan's Chief Executive Officer, and Mark Hoyt, our Chief Financial Officer. This afternoon, after market close, OneSpan issued a press release announcing results for our fourth quarter and full year 2020. To access a copy of the press release and other investor information, including an updated presentation reflecting our fourth quarter and full year 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 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 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 conference call is February 23, 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, good afternoon everyone, yes, can you hear me? Okay, great. Thank you. Thanks, Joe. Good afternoon, everybody. Thanks for joining us on the call here today. Improving demand for mobile security and continued strong growth in e-signature solutions resulted in record bookings of recurring revenue contracts and stronger than forecast revenue in the fourth quarter. The FY'20 guidance we provided last quarter reflected uncertainty, given a material slowdown in business in Q3 and early Q4 as our banking customers addressed urgent issues related to the pandemic. As the quarter progressed, we saw customer engagement return to more normal levels with improved sales closure rates and sales pipeline flow. Now I will turn to the outlook for 2021 and reasons why I expect it to be a year of further progress toward our goal of becoming a profitable and fast-growing recurring revenue-centric company. First, our 2020 year-over-year ARR growth of 29% demonstrates that our growth strategies are working. To give you additional insight into our ARR performance, ARR specific to subscription and term-based contracts grew in excess of 50%. Second, fourth quarter total bookings were strong, on par with the PSD2 driven booking levels of Q3 and Q4 last year. Bookings on recurring revenue contracts increased more than 60% sequentially, and for the year, it grew by more than 40%. Third, our transition to recurring revenue streams and high-margin solutions and services is progressing faster than planned. Software and services accounted for a record 69% of total revenues in the quarter and 62% for the year. Recurring revenue accounted for a record 83% of total software and services revenue in the quarter and 76% for the year. And fourth, as the global economy recovers, we expect new account openings to trend toward more normal levels compared to last summer and early fall. As a reminder, due to the pandemic, many banks or most banks closed or restricted branch operations around the world, which substantially reduced new account openings and consumer churn, key drivers of demand for our hardware and mobile security software offerings. So branches in many parts of the world remain closed. We have seen that banks have made significant progress in adjusting their operations for the present circumstances. Bookings for both our hardware and mobile security software had their strongest quarter of the year in Q4. And finally, the value of our software and services sales pipeline, our opportunity pipeline increased by 40% through the end of 2020. Now let me discuss the specific cybersecurity threats that occurred during the fourth quarter, which highlight the importance of our mobile security solutions. In December, there was a criminal attack that targeted online bank accounts in the U.S. and Europe using a network of mobile device emulators to steal millions of dollars. This emulator attack enabled hackers to spoof thousands of mobile devices, automate the process of accessing accounts, initiate transactions, and intercept second factors of authentication to successfully steal money. This underscores that mobile banking attacks are becoming automated and can now increasingly be executed at scale. OneSpan solutions are designed to prevent such attacks. By using a layered approach to mobile banking security, including multi-factor authentication methodologies, strong device identifiers, application shielding and malware detection, risks from attacks like this can be mitigated. Before I turn the call over to Mark, I want to provide an update on our hardware product line. Last quarter, I noted that we were assessing the benefits of realigning our authentication token product line and assigning an executive to lead the effort while streamlining operations to match forward revenue expectations. We're making good progress in this area with an initial focus on areas including product line rationalization, operational streamlining, and targeted innovation designed to maintain market position and sustain profitability at lower revenue levels. We're also in the early stages of relocating some of our manufacturing from Southern China to Europe to reduce risk and time to market. An increase in Q4 bookings, combined with a sequential pipeline increase of 10%, gives us confidence that hardware's rate of revenue decline will moderate to somewhere in the single digits in 2021. We'll continue to update you on this as plans for the hardware business develop. After Mark takes you through our financials, I'll come back and provide some additional comments along with an update on our outlook before opening the call to questions.

Mark Hoyt, CFO

Thanks, Scott. As Scott mentioned, the fourth quarter of 2020 came in stronger than expected in Q3 driven by increased demand across our security and e-signature solution portfolio. And for the full year 2020, we exceeded the high end of our revenue guidance ranges that we provided in early November. Annual recurring revenue or ARR at the end of Q4 was $104 million, representing a growth rate of 29% in line with our 25% to 30% target growth rate for 2020. We define ARR as the annualized value of all active recurring product contracts greater than or equal to one year in length. Our dollar-based net expansion rate, which we define as the year-over-year growth in ARR from existing customers, was 120% in the fourth quarter. Now turning to recurring revenue. For the fourth quarter, subscription revenue grew 39% to $9 million. This included strong growth of e-signature, modest growth in identity verification and then increased contribution from cloud authentication. Term-based software license revenue grew 27% to $8 million, driven by a strong sequential increase in demand for mobile security solutions. And maintenance revenue grew 14% year-over-year to $14 million. We expect maintenance growth to moderate in 2021, as we continue transitioning our business model toward subscription and term-based licenses. In total, recurring revenue increased 24% to a record $30 million in the fourth quarter and 26% to $102 million for the full year 2020. Recurring revenue accounted for a record 83% of software and services revenue in Q4 and 76% for the full year 2020. This compares to 63% in Q4 2019 and 64% for the full year 2019 respectively. As you may recall, we recently increased our 2022 recurring revenue target from 75% to 85% of our software and services revenue. With the continued acceleration in our transition to recurring revenue, we now believe we can achieve that 85% target this year. In the fourth quarter, total software and services revenue declined 6% to $37 million. Hardware revenue declined to 49% to $16 million, and total revenue declined 25% to $53 million. As discussed previously, we expected a sharp decline in our non-recurring perpetual software licenses and in our hardware driven by our increased focus on recurring revenues and a difficult comparison to the year-ago quarter that was driven by large orders to satisfy PSD2 regulations in 2019 and the impact of the pandemic on our results. Gross margin in the fourth quarter of 2020 was 74% compared to 70% in the prior quarter and in the fourth quarter of 2019. The increase in gross margin is primarily attributed to product mix with software and services contributing a record 69% of total revenue. Operating expenses for the fourth quarter of 2020 were $41 million, 8% higher than the prior quarter and 6% lower than the fourth quarter of last year, reflecting lower travel and other operating costs. Adjusted EBITDA or adjusted earnings before interest, taxes, depreciation, amortization, long-term incentive compensation, and non-recurring items, was $3 million for the fourth quarter of 2020. This compares to $3 million last quarter and $13 million in the fourth quarter of 2019. Adjusted EBITDA margin was 6% in the fourth quarter versus 5% last quarter and 18% in the year-ago quarter. For the full 2020 year, adjusted EBITDA was $14 million and adjusted EBITDA margin was 7%. GAAP loss per share was $0.04 in the fourth quarter of 2020 compared to GAAP earnings per share of $0.11 in the fourth quarter of 2019. Non-GAAP earnings per share, which excludes long-term incentive comp, amortization, non-recurring items and the impact of tax adjustments was $0.03 in the fourth quarter of 2020 compared to $0.23 in the fourth quarter of last year. We ended the fourth quarter with $115 million in cash, cash equivalents and short-term investments, compared to $110 million at the end of last year. Cash generated from operations during the quarter and the year was $7 million and $15 million respectively. During the fourth quarter, we repurchased $5 million or 250,000 shares of common stock at an average price of $20 per share. Geographically, our revenue mix for the fourth quarter included 54% from EMEA, 27% from the Americas and 19% from the Asia PAC region, approximately the same geographic mix as the year-ago quarter.

Scott Clements, CEO

Thanks, Mark. I appreciate it. We made quicker than expected progress in transitioning to recurring revenue in 2020. We plan to continue this transition in 2021 with the aim of largely completing it by the end of this year. Now, let me discuss our growth investments for 2021, the decrease in hardware revenues, and our ongoing shift to recurring revenue, which reduced our overall profitability in 2020 and will continue to impact us this year. Nonetheless, our objective is to maintain high subscription and term license growth rates of over 40% in 2021, which is essential for achieving higher profitability in the future. As we move out of the pandemic, we see this as an ideal moment to invest for growth following reductions in sales, marketing, and R&D expenses in 2020 compared to 2019. Given the strong growth in recurring revenue, we are ramping up our investments in these areas to support strong growth in 2022 and beyond. In sales and marketing, we expanded our sales team in the latter half of 2020 with an emphasis on acquiring new customers and are complementing this with increased lead generation investments this year. In R&D, we will invest in our core TID platform to reduce customer time to value, enhance solution flexibility, and simplify integration with third-party technologies. We also plan to improve our mobile security solutions with better usability and enhanced data collection capabilities to provide next-generation authentication and fraud prevention. Furthermore, we will be adding valuable extensions to our fast-growing e-signature product line, which we believe will increase the average transaction value in that segment. As we have mentioned earlier, the profit-generating potential of our business model is fundamentally robust, as shown by our solid gross margins. As we finalize our business model transformation and improve our internal business systems, we are heightening our focus on operational efficiency and structural cost reduction. In the coming months, we will identify opportunities for significant cost savings to enhance profitability without hindering our growth outlook. We will refresh our multi-year financial goals and provide updates on them later this year. Now, I will summarize our guidance for fiscal year 2021 and share some expectations for the first quarter and the full year. We are providing the following guidance, which includes about $15 million to $20 million in revenue headwind due to the recurring revenue transition in 2021. We anticipate acceleration in total software and services revenue growth in 2022 alongside improving profitability as we finish the transition period. We expect second-half revenue for 2021 to surpass first-half revenue, similar to our long-term historical revenue distribution. Additionally, we expect the decline in hardware revenues to slow down to the mid-single-digit range this year. Gross margins are expected to remain approximately flat, as the increased mix of software and services revenue offsets the impact of our transition to recurring revenue. In the first quarter, we expect Annual Recurring Revenue (ARR) growth to align with our long-term target range of 25% to 30%. Q1 recurring revenue is anticipated to exceed a strong Q1 in 2020, although the year-over-year growth rate may fall slightly below our full-year guidance. We also expect perpetual license and hardware revenue to decrease as we continue to move toward the recurring revenue model. To sum up, our core value propositions in security, productivity, positive digital user experience, and regulatory compliance remain robust. We believe that over time, the pandemic will enhance the value of what we offer. As more economic activities transition to digital platforms, this will drive long-term demand for our security and e-signature solutions. Overall, banks are in good financial health and have successfully navigated the negative effects of the pandemic. Therefore, we expect demand to rise as banks refocus on new account growth and respond to emerging cyber threats. Recent significant cyber incidents, such as SolarWinds and the mobile emulator attack, underline the increased importance of identity-centric security. With that, Mark and I are ready to take your questions.

Operator, Operator

And the first question will come from Catharine Trebnick with Colliers. Please go ahead.

Catharine Trebnick, Analyst

Hi, thanks for taking my questions, very impressive quarter. Can we talk a little bit about going forward? You had record bookings this quarter, but could you maybe parse a little bit more on the 22% to 26% ARR growth? I expect that maybe with the record bookings, it might be a little bit stronger.

Scott Clements, CEO

Catharine, good afternoon, I'll take a crack at that. And Mark, you can add too. Catharine, I think it really comes down to a couple of things. There is still some uncertainty that remains about the pace of the recovery and the economic recovery globally and the impact that that has on banks. I think we all feel optimistic that it's moving in the right direction. Certainly, there seems to be good news, some more good news each day in that area. But how our ARR number turns out after the year will depend to some degree on how that proceeds and the pace with which that recovery happens. Also, as you go into the back of the year, obviously, the compares get tougher. And so we want to be aware of that. So I don't think it's anything more than we want to be sure that we have a good handle on the progression of bank spending on security and technology as the overall economy recovers and as the pandemic impacts start to lessen.

Catharine Trebnick, Analyst

All right. Thank you.

Mark Hoyt, CFO

I'll just add on there, Catharine, this is Mark. Reminder that recurring revenue can be driven in a lumpy manner. If we get both year contracts to come in and we did get one of those that came in Q4, then that did rub up recurring revenue that we won't see necessarily driving as much on the ARR. But overall, as Scott said, we want to make sure that we can now hit these numbers.

Catharine Trebnick, Analyst

All right, thanks gentlemen.

Operator, Operator

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

Gray Powell, Analyst

Thank you for addressing my questions and congratulations on the strong performance. I wanted to follow up on some points. In recent conferences, you mentioned that large banking clients postponed deals in mid-2020, and now there's a sign of that trend reversing. How quickly do you expect this to unfold? Additionally, do you anticipate the recovery shifting more towards software and recurring revenue rather than just hardware? Also, I want to clarify your guidance regarding hardware. Did you indicate that hardware will decline by mid-single digits for the entire year, or will it trend there at some point during the year? I just want to ensure I fully understand that detail.

Scott Clements, CEO

There's a lot to cover, so I'll address it in reverse order. Our guidance for hardware indicates we expect a mid-single-digit decline for the full year, which is a significant improvement compared to the decline we experienced in 2020. We have observed some positive developments in the hardware sector, with our strongest booking quarter of the year occurring in the fourth quarter. Additionally, our opportunity pipeline is stronger now than it was at this time last year. We'll monitor how this progresses in the coming days. We've invested considerable effort in creating a detailed bottom-up forecast for hardware, and we aim to manage expectations reasonably. We will strive to exceed these expectations, but this seems a fair outlook for the time being. Regarding the recovery in banking and financial services, our sales team believes that conditions will improve through the first half of the year, and ideally by mid-year, we should see a return to a more normal business environment. This recovery is likely to benefit software and services more than hardware. As we enter this year, we have a sales pipeline that is 40% higher than at the end of last year. We have high expectations for growth in term licenses and subscription revenue in 2021, which will be key drivers of ARR growth. We'll assess how this evolves through the first and second quarters and into mid-year. Our current outlook suggests that by mid-year, we should be approaching a more typical environment regarding banks and their adoption of security technology.

Gray Powell, Analyst

Understood. Okay. Thank you very much.

Scott Clements, CEO

Sure. Thanks, Gray.

Operator, Operator

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

Anja Soderstrom, Analyst

Yes. Hi everyone. Thank you for the question and congratulations on the good numbers. If you could elaborate on the investment growth required to keep the gross margins flat? Are you primarily looking at increased investment in sales or do you also need to invest more in infrastructure compared to 2019 and 2020?

Scott Clements, CEO

Thank you for your question. Good afternoon. The additional investment we're making is focused in two main areas, which are a bit different for sales and marketing compared to research and development. In sales and marketing, we entered the year fully staffed with the sales team we believe we need for 2021, which is a positive change from 2020 when we still had some vacancies to fill. We made a concerted effort to fill those positions by the second half of 2020, ensuring we started 2021 fully prepared. The primary increase in our sales and marketing expenses this year is due to the full-year costs of the new hires we onboarded in late 2020. Additionally, we want to enhance our lead generation efforts to support these sales personnel in the field. Over the past couple of years, we’ve dedicated substantial effort to developing a robust lead generation process. We observed positive results from this in 2020, contributing significantly to our recurring revenue growth that year. As we gain confidence in our lead generation, we intend to invest more in 2021 to stimulate growth not just for this year, but also for 2022 and beyond. In regards to R&D, our investments aim to strengthen our software and services product lines. I discussed some of these initiatives in May during a conference call. We see an opportunity to bolster our mobile security offerings, modernize certain components, and enhance our data collection capabilities to advance our analytics and fraud detection features. Last year was very successful for our e-signature product, and we anticipate another strong year in 2021. There is considerable potential to expand this product into high-value areas such as notarization and ID verification, significantly increasing the transaction value. These investments should expedite our time to market, enhance our differentiation, and open new opportunities that we haven't previously targeted.

Anja Soderstrom, Analyst

Okay, thank you. And then you alluded to that you were going to revisit your longer-term guidance later this year. It would be safe to assume that the sales that would have recurring revenue should accelerate in 2022, we will have a lot of these investments behind you. So we would also see that margin fashion in 2022. Is that how you expect to think about it?

Scott Clements, CEO

Yes. You're breaking up a little bit, Anja. I don't know if it's on my end or your end. But I think I got the general gist of the question. Yes, we believe that for several reasons, as we go into '22, '23 and forward, we have the opportunity to drive higher levels of profitability in the business, as we grow. We continue to target 25% to 30% ARR growth over the period through 2022. I think we have a very good shot of achieving that or doing better than that. But as we sustain our margins, we see the benefits of the investments that we're making this year. We really put that recurring revenue headwind behind us. All of those things should help to improve the profitability of the business as we look ahead to '22 and 2023. So we take that very seriously. We made a very conscious choice in '21 to make some of these incremental investments because we liked the momentum in the business. And we think that these are investments that can really continue to build the story and the differentiation of what we offer to our current customers and hopefully to a lot more new customers as we go forward.

Anja Soderstrom, Analyst

Okay. Thank you. And then just one last question in your investor deck, or the presentation for the fourth quarter on Slide 10, you are talking about adjacency expansion. Can you just expand on that a little bit? What you mean by that?

Scott Clements, CEO

Sure. As you know, Anja, we have been primarily focused on banking and financial services for most of our history. I think we're roughly 75% of our revenue comes from banking and financial services still today. We believe there are good growth opportunities that remain and exist in banking and financial services, but we also know that there's a lot of work being done and progress made in digitization in the areas of digital healthcare, tele-health, and government. If you really look at the use cases there and the needs in those spaces, they look in many ways very similar to what we do in banking and financial services. So we believe we have the opportunity to target some of these adjacencies with our existing technology, without having to make major changes to that technology and really expand our total available market. Then hopefully, our growth rates as we go into '22, '23 and beyond.

Anja Soderstrom, Analyst

Okay. And now you also announced repositioning some of your resources to go after that, or is that something you would have to do down the road?

Scott Clements, CEO

We are already active in both of those areas and are exploring various market strategies. In the healthcare and telehealth sectors, for instance, we are likely to focus on working with channel partners and OEM partnerships instead of relying on a direct sales model. In the government sector, our approach may differ slightly, but for 2021, our objective is to undertake some groundwork and validate opportunities to identify strategies that will enhance our market penetration in 2022 and beyond. As previously mentioned, we already have a substantial government business, which I anticipate will grow in 2021. We are also collaborating with partners in the healthcare and telehealth sectors to gain insights that will help us establish the most effective approach. Thanks very much, operator. Again, I appreciate all of you joining the call today. We had, I think, a good finish of the year of 2020 after a tough spot in the middle of the year. We're really optimistic about 2021 and the continued shift of our business to recurring revenue. We've learned a lot, and I think we'll be largely done with that transition by the end of 2021, and that should really help both our growth and our profitability as we complete that transition. Thanks again everyone. Have a good day.

Operator, Operator

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