Radware Ltd Q2 FY2023 Earnings Call

Welcome to the Radware Conference Call Discussing Second Quarter 2023 Results, and thank you all for holding. As a reminder, this conference is being recorded August 2, 2023. I would now like to turn the call over to Yisca Erez, Director, Investor Relations at Radware. Please go ahead.

Good morning, everyone, and welcome to Radware's Second Quarter 2023 Earnings Conference Call. Joining me today are Roy Zisapel, President and Chief Executive Officer, and Guy Avidan, Chief Financial Officer. A copy of today's press release and financial statements for the second quarter are available in the Investor Relations section of our website. During today's call, we may make projections or other forward-looking statements regarding future events and the performance of the company. These forward-looking statements are subject to various risks and uncertainties, and actual results could differ significantly from Radware's current forecasts and estimates. Factors that could cause or contribute to such differences include, but are not limited to, impacts from changing or severe global economic conditions, the COVID-19 pandemic, general business conditions, and our ability to adapt to changes in our industry, changes in demand for products, timing and amount of orders, and other risks, as well as differences from time to time in Radware's filings. We refer you to the documents that the company files and submissions from time to time with the SEC, specifically the company's last annual report on Form 20-F filed on March 30, 2023. We undertake no commitment to revise or update any forward-looking statements to reflect events or circumstances after the date of such statements. I will now turn the call over to Roy Zisapel.

Thank you, Yisca, and thank you all for joining us today. We ended the second quarter of 2023 with revenues of $65.6 million and non-GAAP earnings per share of $0.10. Total ARR growth accelerated to 8% year-over-year, which was $208 million compared to a 5% growth recorded in the first quarter of 2023. Our cloud security business had another strong quarter. Cloud ARR growth accelerated to 23%, reaching $59 million at the end of the second quarter. This strong cloud performance was reflected across multiple metrics, including cloud bookings, new logos, and the total number of cloud customers, which all grew by double digits. The growing cloud business and the growth in our product subscriptions are gradually forming a sustainable and durable SaaS business model. This progress is reflected in the steady growth in recurring revenue, which increased by 7% in the quarter and now accounts for 79% of total revenues, compared to 65% in the second quarter of last year. While the cloud security business produced strong results in the second quarter, the appliance segment encountered strong headwinds, which we believe is a temporary pullback. The spending patterns of large customers have impacted CapEx purchases. Over the last few weeks of the second quarter, we witnessed increased delays in closing large on-prem deals globally, primarily among large enterprises and carriers. To the best of our knowledge, we have not lost any contracts for the environment and we have to be prudent in managing our expenses. To that end, we have proactively taken steps to optimize and align our costs and maintain stronger profitability. We reduced sales and marketing expenses and reallocated spend towards growth markets in our cloud delivery and go-to-market efforts. Guy will elaborate more on this in his remarks. While large service providers consider their investments more carefully, strengthening cyber defenses remains a business priority. Organizations around the world are experiencing a dramatic increase in the sophistication of cyber-attacks. In the first half of 2023, we observed a significant shift in the DDoS market pattern. Increasingly, DDoS attacks are incorporating a mix of Layer 3, 4, and Layer 7 attack vectors. The Layer 7 DDoS, or Web DDoS attacks, are not about sheer capacity of traffic. Rather, they are encrypted, high-volume requests per second that evade standard web application firewalls and network-based DDoS tools. The attacks hit many large enterprises across different countries and industries, including services, airports, and health care organizations. Microsoft, which was among the affected organizations, disclosed multiple waves of Layer 7 attacks that caused outages in services like Azure, Outlook, and OneDrive. To mitigate these Web DDoS attacks, we introduced our new Cloud Web DDoS Protection Service. The Web DDoS service is based on two years of AI algorithms and has uniquely positioned us to combat this emerging generation of aggressive Layer 7 attacks, which are leaving companies vulnerable. Our behavioral-based solution mitigates the attack vector by two orders of magnitude higher than any on-prem solution. And unlike any other solution in the market, it surgically blocks threats without obstructing legitimate traffic. With the fast training of our algorithms and excellent proven results in dozens of customers, we have a market differentiator that will set the groundwork for future DDoS cloud and appliance growth for our business. In the second quarter, we announced enhancements to our Bot Manager, which are part of the 360-degree cloud application protection. The advanced solution prevents bots from bypassing additional security controls to gain unlawful access to native Android and iOS mobile applications. It offers first-to-market integrated authentication for both iOS and Android devices and new identity algorithms, allowing organizations to defend themselves against bot attacks with the highest accuracy and performance. Our investment in cloud innovation continues to pay off. I would like to share with you a few examples of the deals that demonstrate the critical value we bring to our customers and that contributed to our cloud ARR growth in the second quarter. We closed the deal with one of the largest transportation hubs in North America. This customer didn't have active DDoS protection for its data centers. Instead, it was using a public cloud solution. While we were engaging with the customer, it was hit with a wave of DDoS attacks that were targeted in the region. When the cloud provider was unable to sustain the attack, the customer recovered under our emergency service; this enabled us to showcase our capabilities in real-time and win the business. We also closed an important cloud DDoS deal with a large Tier 1 carrier and managed security service provider in Asia Pacific. Recent challenges in business and government organizations impacted the provider's ability to protect some of its customers properly and exposed weaknesses in the incumbent solution’s ability to mitigate this new wave of attacks. Our leadership in DDoS mitigation and proven expertise in these verticals position us as the go-to vendor to replace the incumbent and pave the way for strategic seller partnership agreements. Going forward, we intend to continue enhancing our cloud security strategy in our SaaS business model, which is an even more resilient and durable business model. Together with continuous improvement in our go-to-market strategies, our expectation for recovery in on-prem purchases gives us trust in strengthening our company performance. We are confident in our leadership position in technology and products, and we have significant advantages in mitigating real-time cyber-attacks for large enterprises and materials. We have a superb customer base, and we are becoming more and more critical to our customers' operations. All these assets position us very well to achieve our long-term targets. With that, I will now turn the call over to Guy.

Thank you, Roy, and good day, everyone. I'm pleased to provide the analysis of our financial results and business performance for the second quarter of 2023, as well as our outlook for the third quarter of 2023. Before beginning the financial overview, I'd like to remind you that unless otherwise indicated, all financial results are non-GAAP. A full reconciliation of our results and non-GAAP basis is available in the press release issued earlier today and on the Investors section of our website. Revenue for 2023 was $65.6 million compared to $75.1 million in the same period of last year. As Roy mentioned, the decline in revenue was due to large enterprises and service providers delaying the closing of large on-prem deals. The behavior pattern intensified in the last weeks of the second quarter. We believe that some of the slowdown is attributable to the macro environment and budget constraints. Despite the macro headwinds and in accordance with our strategy, our cloud business continued to perform well also in the second quarter. Cloud ARR in the second quarter of 2023 grew 23% year-over-year to $59 million compared to $48 million at the end of the second quarter of 2022. Cloud ARR accounted for 28% of total ARR compared to 25% last year. The growth in our cloud business is reflected in our recurring revenue, which increased 7% year-over-year and now accounts for 79% of total revenue compared to 65% in Q2 2022. In terms of regional breakdown, revenues in the Americas in the second quarter of 2023 were $27 million, representing a 10% increase on a trailing 12-month basis. Americas revenue decreased by 6%. EMEA revenue in the second quarter was $23 million compared to $30 million in Q2 2022, a decrease of 24% year-over-year, an 11% decrease on a trailing 12-month basis. The decrease in the Americas and EMEA region is related to the decreased sales of appliance-based products in the quarter, predominantly to carriers and large enterprises. Finally, APAC revenue in the second quarter was $16 million, which represents an increase of 3% year-over-year. On a trailing 12-month basis, APAC revenue was flat. The Americas accounted for 41% of total revenue in the second quarter, EMEA accounted for 34% of total revenue, and APAC accounted for the remaining 25%. Gross margin in Q2 2023 was 82.3% compared to 83.3% in the same period in 2022. The change in gross margin is mainly attributed to higher costs related to the cloud security center launched during the last year and the decline in revenue. Operating expenses in the second quarter were $52 million at the lower end of guidance, representing a decline compared to the same period in 2022. Financial income continues to grow and reached $3.4 million in the second quarter as a result of higher interest rates in the market. Net income in the second quarter was $4.5 million as compared to $8.1 million in the same period last year. Radware's adjusted EBITDA for the second quarter was $4.1 million, which includes the negative impact of the Hawks business. Diluted earnings per share for Q2 2023 were $0.10 compared to $0.18 in Q2 2022. Turning to the cash flow statement and the balance sheet, operating activities in Q2 2023 were $4.9 million compared to $32 million in the same period of last year. The lower cash flow from operation is attributed to the lower net income in Q2 2023 compared to Q2 2022. During the second quarter, we repurchased shares in the amount of approximately $19.7 million out of the $100 million share repurchase plan that we have in place. As of now, $35 million remains in our share repurchase plan. We ended the second quarter with approximately $35 million in cash equivalents, short-term bank and marketable securities. I'll conclude my remarks with guidance. Although we acknowledge that the macroeconomic headwinds are temporary, the timing and intensity remain uncertain. During this time, Radware is mindful of these challenges and is agile in adjusting its cost structure as needed. We are taking a few steps, including resource reallocation and headcount reductions. These steps will help us manage expenses with changing market conditions and will enable us to maintain profitability over time. We expect revenue for the third quarter of 2023 to be in the range of $61 million to $64 million. We anticipate Q3 2023 non-GAAP operating expenses to be between $51 million and $52.5 million, and with headcount reduction, we expect our OpEx to decrease to approximately $50 million by the close of 2023. We expect non-GAAP diluted net earnings per share to be between $0.06 and $0.10 in the third quarter of 2023. I'll now turn the call over to the operator for questions.

We'll take our first question from George Notter at Jefferies.

I guess I wanted to ask about the change in the sales incentive plans. I know that you made some changes coming into the year. I know you tilted the plan more away from appliances and towards the cloud business. But is that having an impact on appliance sales? Is that part of the narrative here also? And then on the macro environment, I guess I'm just wondering why you only started to see this kind of trends towards the end of the quarter? Was there something about the environment that kind of changed the dynamics for you in the marketplace? Or has this been something that's been building over time?

Yes. So first, regarding the compensation plan, we did move the focus towards the cloud business, which likely had some impact, but I don't think that's the major cause of the decline. It's clear that our sales force is adapting to prioritize cloud-based sales as we want. I don't believe it significantly affected existing customer relationships; it may have impacted new customers. Our decline came primarily from existing customers. Regarding the way the quarter progressed, we started with guidance that took into account the environment and the challenges, and as we've mentioned, the main difficulties were with existing customers where we felt we had a good understanding of the processes. Therefore, we were surprised in the last several weeks of the quarter by pushouts and budget cancellations. We tried to incorporate these factors into our guidance for Q3, taking a more cautious and conservative view of the existing customer business where we think we are still well-positioned. The value is proven, we are blocking attacks in real time, and there is high user satisfaction given our retention rates. We feel confident about our position, but we need to find a way to accelerate those on-prem purchases with our existing customers.

And we'll move next to Tim Horan of Oppenheimer.

This is Graham Hawes on the line for Tim Horan. So just on the AI front, I just wanted to hear about what kind of trends you've seen across the security landscape this year versus last year? You mentioned AI with regards to some of these cloud DDoS services and Layer 7 attacks, so how are you thinking about the impact of AI on your business going into the second half of this year and really into 2024?

So first, regarding real-time detection and mitigation, we are continuously enhancing our algorithms. We have developed a comprehensive set of algorithms across our DDoS and API security systems over the years. We believe this gives us a competitive advantage. We are leveraging AI not only for mitigation but also for actual detection. This is somewhat unique in our market. It enhances our capabilities, efficacy, and overall performance. However, it’s important to note that attackers are also increasingly leveraging algorithms and AI. For example, the Layer 7 Web DDoS attacks are becoming more advanced and mimic real user traffic more closely than ever, which poses a significant challenge for defense mechanisms. This increased sophistication on the attacker's side does present a challenge for security providers, but competitively, it makes it more crucial for us to invest in our defenses, creating higher barriers to entry in effectively mitigating real-time attacks.

Got you. And just as one quick follow-up, looking at ARR, specifically the non-cloud portion of ARR. It seems to have fluctuated around that $145 million range. I’m curious, as customers move to the cloud, what kind of uplift are you seeing in ARR? For every dollar of non-cloud ARR, what kind of conversion are you seeing to cloud ARR? Or is that not the right way to think about it?

I think there are three main components in our ARR. The first is the cloud which has accelerated. The second involves product software that we sell as a subscription; that’s also been growing consistently. Lastly, there’s the maintenance of appliances, which is more tied to the installed base. We’re seeing attractive growth in all our subscription products and cloud segments. The maintenance revenue is more aligned with our product sales. Our cloud offerings, like hybrid DDoS systems, can also contribute to appliance sales. However, in most of our segments, for example, ADC and on-prem DDoS solutions, the cloud business doesn’t cannibalize or significantly support appliance sales today. We are working to create bridges between our cloud security, ADC, and on-prem DDoS solutions to accelerate growth. As the year progresses, we plan to develop several modules to strengthen these interconnections.

We'll take our next question from Tavy Rosner of Barclays.

I wanted to touch on OEM and also on EMEA. I wanted to check if the traction with OEM is in line with the broader revenue dynamics that we've seen. I also noticed that the decline in EMEA was somewhat larger than the rest of the geography, so I wanted to get some color on both of these points, please.

Regarding OEM, we continue to see good traction with our partners. We mentioned during the Analyst Day that Cisco is integrating our cloud DDoS solution into their offerings. We're starting to notice more activity from our OEMs in the cloud, and they continue to significantly contribute new customers. We're seeing good year-over-year growth from this channel.

And regarding your question about EMEA, compared to last year, we had one extraordinary deal in the second quarter of '22 which affected the comparison. Additionally, the challenges were intensified due to macro headwinds on large enterprise sales. All in all, we believe our business is still on a solid footing.

And just looking at capital allocation given your significant cash position. Have you considered changing the pace in terms of buybacks and any other considerations there?

As mentioned, we're operating under a $100 million share repurchase plan. As of June 30, we still have $35 million remaining. Obviously, changes in share prices will also influence the pace of repurchases.

And we have no further questions at this time. I'll turn the call back to Roy Zisapel for closing remarks.

Thank you, everyone, and have a great day.

And this concludes today's conference call. Thank you for your participation. You may now disconnect.