Rapid7, Inc. Q2 FY2022 Earnings Call

Good afternoon. My name is Chris, and I will be your conference operator today. At this time, I would like to welcome everyone to the Rapid7 Q2 2022 Earnings Call. Sunil Shah, VP of Investor Relations, you may begin.

Thank you, operator, and good afternoon, everyone. We appreciate you joining us today to discuss Rapid7's second quarter 2022 financial and operating results in addition to our financial outlook for the third quarter and full fiscal year 2022. With me on the call today are Corey Thomas, our CEO; and Tim Adams, our CFO. We've distributed our earnings press release over the wire, and it is now posted on our website at investors.rapid7.com, along with the updated company presentation and financial metrics file. This call is being broadcast live via webcast. And following the call, an audio replay will be available at investors.rapid7.com. During this call, we may make statements related to our business that are forward-looking under federal securities laws. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include statements related to the company's positioning, our future goals and financial guidance for the third quarter and full year 2022 and the assumptions underlying such goals and guidance. These forward-looking statements are based on our current expectations and beliefs and on information currently available to us. Actual outcomes and results may differ materially from the future results expressed or implied in these statements due to a number of risks and uncertainties, including those contained in our most recent quarterly report on Form 10-Q filed on May 5, 2022, and in the subsequent reports we filed with the SEC. The information provided on this conference call should be considered in light of such risks. Actual results and the timing of certain events may differ materially from the results or timing predicted or implied by such forward-looking statements. And reported results should not be considered as an indication of future performance. Rapid7 does not assume any obligation to update information presented on this conference call, except to the extent required by applicable law. Our commentary today will be primarily in non-GAAP terms. And reconciliations between our historical GAAP and non-GAAP results and guidance can be found in today's earnings press release and on our website at investors.rapid7.com. At times, in our prepared remarks or in responses to your questions, we may offer incremental metrics to provide greater insights into the dynamics of our business or quarterly results. Please be advised that this additional detail may be onetime in nature, and we may or may not provide an update in the future on these metrics. With that, I'd like to turn the call over to our CEO, Corey Thomas. Corey?

Thank you, Sunil, and good afternoon to everyone on the call today. Thank you for joining us for our second quarter 2022 earnings call. Rapid7 ended the second quarter with $658 million in ARR, representing 35% year-over-year growth while exceeding both our revenue and operating income guidance for the quarter. Our team is executing well even as macroeconomic pressures begin to surface for some customers and corporate budgets come under greater scrutiny. Despite growing pressure on our key budgets, it is clear from discussions with our customers and prospects that security remains a critical focus and priority. As a result, during the second quarter, we continue to see robust customer demand for our best-in-class Insight platform, driving strong ARR growth in our security transformation solutions as customers look for a cloud-native approach to securing their shifting IT environment. However, despite ongoing momentum for our security transformation solutions during Q2, our total ARR was impacted by a growing macroeconomic uncertainty affecting customers internationally, particularly in Europe, where the majority of our international business is concentrated. As we progressed through the second quarter, we began to see increased levels of deal inflection as customers and prospects in the region manage record inflation, softening demand and FX pressures. As we navigate an evolving economic backdrop, there are a few key dynamics that I'll highlight to you to give us confidence in our near- and long-term outlook. Starting with our security transformation solutions. Even as customer budgets come under greater stress, this area of our business has proven more durable as we focus on solving customers' most urgent security challenges. As customers seek better efficacy of security outcomes and lower total cost of ownership, we're helping them automate their security programs while leveraging our Insight platform to minimize risk across their expanded attack surface and detect and respond to threats across traditional and cloud environments. Our market-leading security transformation solutions are resonating with customers amid continued IT shortages and staff limitations and an escalating threat landscape due to our quick time to value and compelling ROI. We saw the clear benefits of this in our second quarter security transformation ARR, which continued to grow well over 40% organically year-over-year. This platform traction is illustrated by a recent six-figure deal with a financial services customer, whose current vendor was unable to scale to meet their detection and response needs. At the same time, the customer is actively shifting towards the cloud and needs to expand their security infrastructure despite a tight budget. Rapid7's ability to consolidate enterprise-grade detection response, cloud security, vulnerability management, and automation on a single platform was a huge differentiator. We won on the strength of our best-in-class platform while enabling this customer to effectively manage their budgetary constraints while creating a seamless, efficient process for onboarding new solutions. The value and usability of our platform were key differentiators in winning this deal. And it speaks to the sustained high growth we see for our security transformation solutions. Given the consistent performance and momentum of our security transformation solutions, we continue to maintain a strong outlook for their growth as we look ahead. Turning to VM. Vulnerability management remains a foundational priority for customer security programs. But as customers apply greater scrutiny to budgets and quickly shift their technology to the cloud, we saw lower relative urgency for VM during the second quarter. This was reflected in our VM ARR, which decelerated from high teens growth to mid-teens growth during the quarter, with the most notable deceleration in our international region as we saw higher levels of deal inflection and delays driven by heightened macro sensitivity. However, as customers increasingly look to rationalize spending, we believe Rapid7 is incredibly well-positioned to accelerate customers' path to consolidate security spend and increase their efficacy by utilizing our Insight platform to help solve their most urgent security needs at the highest ROI. This fuels our optimism for delivering sustained long-term growth in our business. Amidst a quickly shifting IT environment, customers want to spend their budgets and time around the most strategic areas of their security programs. Increasingly, their focus is on detecting and responding to threats across their expanding digital footprint and managing security of their growing cloud environments. We continue to see great traction with our Insight platform vision as customers prioritize areas like XDR and cloud security, which is reflected in our security transformation solutions now approaching 70% of our new ARR. We see a compelling opportunity to build on this momentum. And over the second half of the year, we plan to optimize our customer engagement strategy to accelerate consolidation by attaching critical but lower urgency areas like vulnerability management to high-growth security transformation solutions. This will enable customers to more efficiently bridge the security needs across the modern and traditional environments while focusing their security budgets around the higher strategic value areas like the cloud. A great example of how customers are leveraging our platform to consolidate around strategic spending focal areas was a $200,000 ARR deal with a hyper-growth retail company during the second quarter. The newly hired CISO has to build out a security program. We had a competitive process where our Insight platform stood out with best-in-class capabilities and strong value proposition. Our detection response also won. And later in the process, the customer chose to add VM to the deal, attaching full coverage of their environment as they justify increasing their budget to gain additional coverage. This enabled the customer to consolidate their security operations back at lower cost while enabling Rapid7 to accelerate its share of market gain. A core part of Rapid7's value proposition is driving productivity and scale for resource-constrained customers of all types. In today's environment, most customers have some form of security-centric resource constraints. We believe we are strongly positioned to win with these customers. And the time to value of our advanced analytics and automation capabilities are meaningful, competitive differentiators. Looking forward, we expect to increasingly anchor our go-to-market motions in areas of high customer urgency while driving a simple and accretive path for products like VM. We continue to invest in our platform experience while building on the product and packaging work our teams have been doing during the second quarter. Returning to the current environment. As we look out to the rest of the year, we have factored in the current macroeconomic climate into our second half expectations. While we do not see customers removing or reducing their budgets, we have observed the slowing or delay of decisions in the current budgetary environment. While this has not changed the critical need for these customers to secure increasingly complex and modern IT environments, we do anticipate their implementation timelines may continue to be affected by budget timing and visibility. Despite the evolving economic backdrop, we expect Rapid7's ability to close the gap in customer security environment with comprehensive best-in-class solutions will remain strategic and continue to drive solid underlying demand. The net result of these dynamics is the expectation for sustained high growth in our security transformation business balanced against the impact of macro and used budget scrutiny means that we are reiterating our original ARR guidance range for the year. While the environment has changed from our expectations at the beginning of the year, our ability to sustain durable ARR growth while executing against our profitability outlook for the year speaks to our strong value proposition for customers, the leverage in our model, and our commitment to our growth and profitability framework. Tim will share more details on our guidance in his remarks. Looking at the security landscape today, our strength in adjusting vast amounts of data, analyzing it in a security context, and responding to that information in a productive and efficient way is more valuable than ever. As we lean into the consolidation of spending around extended detection response, cloud security, and VM in a comprehensive way, we're continuing to meet customers' operational challenges in both traditional and cloud environments. And we're doing this with a focus on productivity and time to value. Lastly, we continue to execute on our evergreen goals: to enable our customers to secure the transition to the cloud; to expand the capabilities and value proposition of our best-in-class Insight platform; and to balance our dual mandate of scaling profitably while strategically investing to drive durable growth. Our strategy to better align our VM and security transformation solutions value proposition will help customers transition more securely and efficiently into the cloud in a holistic way while enabling them to consolidate spending and gain greater leverage from the Insight platform. We continue to pursue balanced, durable growth and remain committed to our profitability framework. With that, thank you all, and I will now turn the call over to our CFO, Tim Adams, to share additional details on our financial results. Tim?

Thank you, Corey. Good afternoon, everyone, and thank you for joining us on the call today. Before I turn to the results, a quick reminder that except for revenue, all financial results we will discuss today are non-GAAP financial measures unless otherwise stated. Additionally, reconciliations between our GAAP and non-GAAP results can be found in our earnings press release. Rapid7 ended the second quarter with ARR of $658 million, representing 35% year-over-year growth. This reflects continued momentum in our high-growth security transformation solutions as customers prioritize areas like detection and response and cloud security coupled with durable double-digit VM growth. The breadth of our Insight platform continues to resonate with customers who are increasingly tasked with detecting and assessing risks across both traditional and cloud environments. Many of the customers we engage with are looking to consolidate a fragmented set of security tools. Our value proposition stands out in uncertain macroeconomic environments given our time to value and ease of use amidst persistent resource constraints on security teams. These dynamics drove healthy growth in both new customer ASPs and expansion business during the second quarter as we saw ARR per customer grow 18% year-over-year to $62,000. Our customer count grew 14% year-over-year as we ended the quarter with over 10,600 customers globally. This was driven by strong growth of over 20% in higher-value platform customers, which now represent over 80% of our customer base, while we continue to defocus on lower-value legacy transactional customers who represent a small minority of our ARR. Second quarter revenue of $167 million grew 32% over the prior year and exceeded the high end of our guidance range on the strength of our security transformation solutions. Revenue outperformance was driven by product revenue of $159 million. International revenue saw growth of 52% year-over-year and now represents 21% of total revenue driven by continued strong momentum in security transformation. North America revenue grew 28% over the prior year and comprised 79% of total revenue in the quarter. Turning to operating and profitability measures for the second quarter. Product gross margin was 75%, and total gross margin was 72%, both in line with our range of expectations. Sales and marketing expenses represented 41% of revenue compared to 40% in the prior year period, while R&D and G&A expenses were 21% and 8% of revenue, respectively, compared to 20% and 8% in the second quarter of last year. We generated over $3 million of operating income in Q2, coming in ahead of our guidance range due largely to revenue overperformance. This underscores both the natural leverage in our business model and our ongoing commitment to balancing growth and profitability within our stated framework. Our second quarter adjusted EBITDA was $8 million. Net loss per share was $0.01 and better than our guidance range on higher operating income. Moving to the balance sheet and cash flow statement. We ended the quarter with cash, cash equivalents, and investments of $254 million. Operating cash flow was $7 million, and free cash flow was just under breakeven. This brings us to our guidance. As Corey detailed earlier, we saw robust growth in our security transformation business driven by the scope and quality of our Insight platform and our ability to enable better outcomes for customers on their most urgent security challenges. This is being counterbalanced by macroeconomic uncertainty and the associated impact of increased budget scrutiny for customers, which mitigates upside potential to our prior expectations. Given these dynamics, we are reiterating our full year 2022 ARR guidance of $740 million to $750 million, year-over-year growth of 24% to 25%. Our ARR outlook now embeds approximately $5 million of FX translation headwinds for the full year given recent foreign exchange volatility and anticipates sustained but moderated VM growth in the current macroeconomic climate. We are optimistic about our unique opportunity to increasingly attach VM alongside higher-priority security transformation solutions while helping customers consolidate their security budgets to drive better efficiency of their spending. In terms of ARR linearity in the back half of the year, we now anticipate third quarter net new ARR dollars to be down modestly over the prior year period on an organic basis before returning to net new ARR growth in the fourth quarter. Turning to revenue. We are narrowing our full-year revenue outlook to a range of $686 million to $690 million driven predominantly by a decline of approximately $3 million in our services revenue outlook. We now expect our full-year operating income to be $20 million to $24 million in the upper end of our prior guidance range as we remain committed to executing against our growth and profitability framework. We expect net income per share to be in the range of $0.08 to $0.15 based on an estimated 60.2 million diluted weighted average shares outstanding. Our free cash flow outlook is maintained at $40 million to $45 million, and we remain confident in our ability to ramp free cash flow in the second half of the year. Turning to quarterly guidance. For the third quarter of 2022, we expect revenue in the range of $175 million to $177 million, which represents growth of 25% to 27% over the prior year. We expect operating income to be in the range of $6 million to $8 million and non-GAAP net income of $0.03 to $0.06 per share, which is based on an estimated 66.2 million diluted weighted average shares outstanding. We expect the new convertible debt accounting rules, which require the use of the if-converted accounting method, to impact EPS for the first time in the third quarter, adding roughly 6 million shares to our share count while also adding back cash interest expense associated with the debt in order to calculate earnings per share. In closing, we started 2022 with a strong outlook and maintain confidence in our ability to deliver within our guidance ranges as we navigate the evolving macroeconomic climate. We continue to balance high-return investments and growth with our focus on delivering consistent annual improvement in operating margin and free cash flow. And we remain committed to our profitability framework and medium- to long-term financial targets. Thank you for joining us on the call today, and we will now open the line for questions.

The first question is from Rob Owens with Piper Sandler.

Maybe you can unpack a little bit just that net new ARR growth that you saw during the quarter here. And you talked about some of the challenges you're seeing in EMEA, but North America did slow a couple of points quarter-over-quarter relative to growth. So maybe you can just help us understand what you're seeing domestically, what you're seeing internationally right now?

Rob, thanks for the question. So Tim and I may tag team. So the first point is that we saw the highest impact in EMEA from an overall perspective in terms of the pressure on the net ARR growth. The flip side is we saw incredibly strong performance in security transformation solutions. And that was across the globe but also specifically in North America. Now part of what you're seeing there in North America and around the world is sort of like the VM, where it's incredibly healthy, but you did see that deceleration on the high teens to the mid-teens. The way that we think about this is, look, VM's a fundamental demand driver. You know that we've said for a while that as environment priority shifts, if people move to the cloud more, we expected VM to decelerate over time down to the 10%-ish percent range. Now that happened faster than we expected this year. But the good news is that we're well positioned for that because when you think about the priority for visibility and risk analytics is we can address those critical areas of highest priority, which is in the cloud right now. And so the dollar dynamic that we actually saw was that shift accelerating, and we think that we're set up well with our strategy to address that in the mid to long term.

Corey, I would add to that just for Q2 ARR. Look, I think we're seeing this across all the industries, the macroeconomic pressures that are happening predominantly over in Europe. And that certainly did impact us in the quarter and as we lay out the outlook for the full year. We also saw about $1 million of the $5 million FX that I referenced earlier hitting in Q2 against ARR. If it were not for this economic impact and the FX then our ARR would have been up on a year-over-year basis.

The next question is from Jonathan Ho with William Blair.

I just wanted to dig a little bit into your comments around the bundling and packaging of the high customer urgency sales with VM. Can you talk a little bit about how that changes from your prior sales motion? And what that could mean for something like net retention or maybe some larger lens here?

Yes, that's a great question. We've seen a steady evolution in how we introduce new capabilities to the market. In terms of our security transformation, which we've been delivering over the last five years, it now accounts for over 50% of our total annual recurring revenue and nearly 70% of new annual recurring revenue. We generally start with a focused sales effort that expands over time. Additionally, we've brought in sales reps dedicated to security transformation and gradually expanded our sales team to cover all our capabilities. This approach has been effective. Our goal is to concentrate our sales efforts where we can achieve maximum efficiency on our highest customer priorities. Customers prioritize areas like detection response and want visibility and risk analytics in crucial aspects of their organizations, particularly in the cloud. It's important to note that there remains a strong demand for visibility into traditional and on-premise environments, which is where our vulnerability management excels. Customers are currently seeking to optimize their spending while achieving the best results and economic leverage. They desire end-to-end visibility to understand risks and visibility both in the cloud and in traditional environments. Our strategy is straightforward: we provide the best visibility in the cloud through our top-rated cloud security solution and also ensure excellent visibility in traditional environments via our vulnerability management, all at an economical cost. This scenario presents a great opportunity for consolidation to better meet customer needs. Looking at our experience with the journey to XDR and SOAR technology, we found that by connecting these technologies to our risk and analytics solutions, we achieved significant acceleration and increased average selling prices over time. Our sales team is familiar with this approach, where we offer comprehensive risk and analytics solutions at the lowest possible cost, utilizing the best technology. This is precisely what customers are seeking right now.

The next question is from Matt Hedberg with RBC Capital Markets.

I guess, Corey, or for either of you regarding increased budget scrutiny that you talked about. I'm curious, when did that start to happen in the quarter? And I guess I'm just curious, has it kind of stayed stable through July? And then maybe around reiterated ARR guidance for the year, how should we think about, I guess, second-half conservatism within that framework?

Yes, Tim and I will address that together. We began noticing this in Q2, particularly in Europe where the scrutiny was evident. We looked into it and identified an area of concern that needed attention. However, we found reassurance in two aspects. First, every company we spoke with indicated that security was a top priority. Additionally, they mentioned that they were focusing their budgets on security, with detection response capability and cloud security being their highest priorities. This information gave us confidence and context regarding how these customers prioritize their overall spending. While we observed variations in the urgency for security transformation solutions versus vulnerability management, we took that into account. In Q2, our leadership team decided to simplify things for customers, so we committed to the necessary work. We began developing the packaging to eliminate the artificial choices customers faced and to provide them with the solutions they truly needed. We initiated this process in Q2 and have started to implement it as we move into Q3.

Yes. Matt, let me just address the second part of your question. When we think about the ARR guide for the full year, we're really in a difficult macroeconomic environment, certainly predominant over in Europe. And we think that will continue to persist for the foreseeable future. I mean, no one has a crystal ball on how this is going to play out. If it were not for that environment that we're in, that really would give us an opportunity to think differently about guidance, but we don't see the same upside opportunity that we had in prior years given the environment that we're in. The FX is very real. That's another $5 million that's hitting us pretty hard. And to the earlier point that Corey made, it's just the timing of customer budgets and when they will release those dollars to deploy the new products and services, which is out of our control. So that becomes somewhat unpredictable.

The next question is from Joel Fishbein with Truist.

One for Corey and hopefully, just a quick follow-up as well. So Corey, love to just get a little deeper into the managed detection and response business. Obviously, big priority with security personnel turnover, et cetera, and lack of people. Also, I just wanted to follow up and see what are your hiring plans going into the back half of the year, and if you've muted those as well?

Great question. So in regards to managed detection and response, I remind folks that we have sort of two plays. We do some of that directly, high-margin managed detection response. And we're increasingly doing a lot more with the partners over time, which is our real focus area. As you say, look, this is a big demand area for customers. We luckily have a massive demand from our partners to deliver the technology. We have a high focus on quality because that's incredibly important to us. But we see this as an ongoing area of customer focus. And this is definitely a contributor to the strength in security transformation solutions. Now I would also just point out that when you think about what customers are looking for, you have customers that have teams and staff that also need the higher levels of productivity, which is a core part of Rapid7's value proposition. So again, we do some, our partners do some. And we're really focused on building a high-quality partner ecosystem. And I would say we're well oversubscribed for the partners that we can actually onboard today, but we're focused on building the capacity to actually add more and more partners over time. And that's going to be our priority. The next question that you asked is just around the staffing and how we actually think about that. I'll remind you that we actually didn't start the year that we were preloading lots of our staffing for the year. So even before we saw from the pressure of the environment, we actually planned to actually really step up in the first half of the year, especially from a year-over-year comparable perspective and then ramp that staffing down. We are still hiring. I just want to be clear about that. We're discerning. We're hiring in quality. We're focused on our profitability on both client work, but we are still hiring. But we already planned to have more of our hiring funnel for the first half of the year.

Yes. And Joel, look, we just want to give you the comfort and all of our investors as well that we are very mindful of the economic times that we're in and this pendulum moving more toward profitability that goes along with the growth. And I can assure you, between Corey and our COO, Andrew Burton, and myself, we spend a lot of time really looking at all the investments we make across the business, headcount being one of the larger ones. And we think we are appropriately invested, but we're very mindful of profitability goals that we've set with our shareholders.

The next question is from Fatima Boolani with Citigroup.

This is Joel on for Fatima. So just wondering if you could give us some detail on your 3Q guide, given it's come in below Street, more so on margins, that's EBIT and EPS. So is this entirely macro? And can we perhaps get a breakdown of some specific sources of margin pressure?

Yes. Tim and I will tag team in it. I may ask you for a clarification about the margin question. But there's a couple of different things that I would actually sort of like to point out at the top line. One, we have a focus on linearity. And we think we're being fairly consistent with our approach to linearity overall. The second thing is that we are really focused on simplifying things for customers. I think customers, in the early discussion that we've actually had with customers about what they're actually looking for is, they are looking to actually figure out how to get the most leverage from security spend in this environment. We think that our approach of attaching VM to security transformation solutions gives customers the leverage that they want. We're rolling that out to our teams. And so when you think about the linearity for the year, there's two things. One, it's consistent with our plan as we actually started the overall year. But it also allows us to have the ability to actually adapt to what we're seeing in the environment and make sure customers are getting the solutions how they want and the way that they want them.

And just to the margin point, we really do focus the operating income and margin on a full-year basis. And as you can tell from the prepared remarks that we've increased the low end of that range, and we feel very confident with that. But we do take a look at this on a full-year basis.

Yes. And just earlier, the expense management and our profitability growth framework is a significant area of focus has been, and I think the team has very good control and visibility into this.

The next question is from Michael Turits with KeyBanc Capital Markets.

This is Eric Heath on for Michael. Just wanted to ask a broader question on InsightCloudSec. So can you just talk more specifically about this product? I mean in terms of traction you're seeing, be curious how large these deals tend to be and really how you're differentiating in cloud security with your kind of heritage and VM versus several of the other vendors that are out there kind of tackling this market from a lot of different approaches.

Yes, absolutely. So one, I would say that we have one of the more comprehensive cloud security solutions in the market today. That includes cloud security across the management, cloud workload protection, cloud identity analytics. We also complemented that using some of our market-leading technology from VM to add to it, which lots of the other newer players and entrants don't have. And we're going to be accelerating over time, leveraging the technology from our detection response team. If you look at the setup, if you think about cloud security as, in general, just another form of security operations for the cloud, where you have to have visibility. You have to have automation. You have to be able to detect, respond, assess, analyze. We are well-suited to actually continue to be a leader in that overall market. And so we look at the entire spectrum of that when we think about cloud security. And we think about all of our technologies actually delivering capabilities to the cloud that should allow us to have both the breadth and the depth, which is incredibly hard to do from a cloud security perspective. That's why we're still confident leaning into this overall strategic priority. So when we think about the setup, we think about like we can be best in both breadth and depth on the cloud security. It's about data analytics and automation, which are our core sweet spots. We're not learning in this new domain; we're accelerating our current capabilities that we've been building on for the last two years.

Great. And I could just squeeze one in on the VM side. So I appreciate the color on the dynamics for the quarter. But just wanted to clarify, this was just purely kind of an issue with tighter budgets and people trying to be more efficient with their budgets and their security spend? Or just want to make sure it's not necessarily a change in the competitive landscape in any regard.

No, we see no change in the competitive landscape. However, we still view vulnerability management as a high priority for customers. One way to think about it is that our customers have accelerated their transition to the cloud. As VM focuses primarily on visibility and risk analytics, companies are starting to consider where to prioritize their efforts, especially as their most valuable assets move to the cloud. We believe this presents a significant opportunity for us. While people are still engaged in vulnerability management, they are increasingly concentrating on cloud-related areas. They need to ensure that they are meeting all necessary requirements in that environment, where more of the company's key assets are located. Yes, VM takes a slight backseat, but the overall need for it has not diminished.

The next question is from Brian Essex with Goldman Sachs.

Corey, could you provide more details on the demand side? We're discussing foreign exchange as a concern and longer sales cycles. What insights can you share about the effects on our results and guidance? Is one factor more significant than the other? Are we seeing deals being pushed back? Are customers scaling back to finalize deals or reducing attachment rates? Is this trend more prevalent in the mid-market compared to large enterprises? Any additional context would be appreciated to help us understand the situation better.

Yes, those are important questions. I'll address a few key points as I understand them. One major factor affecting our guidance is foreign exchange, which has a $5 million impact. Additionally, Europe has been our fastest-growing region, yet we remain underexposed to its potential compared to our company's size. We have heavily invested there over the past few years, and you can see a steady increase in the proportion of our business coming from global and European clients. We are positioned to continue making those investments this year. However, the high level of investment we planned for Europe has not aligned with demand, especially given the current challenges in that market. There are numerous factors affecting Europe, and it's a common theme among various companies that have discussed these market conditions. Despite these challenges, we continue to prioritize Europe due to its long-term growth potential. Another point to emphasize is that we view security as a long-term opportunity that we plan to seize. Every customer we engage with identifies security as a top priority, although they also mention that their IT budgets are under pressure, leading them to seek greater efficiency. Not all areas of security are prioritized equally; we see significant differences in urgency between security transformation and vulnerability management. We believe that by enhancing our sales and channels around our attach strategy and new offerings, we can gain a competitive edge at Rapid7. Overall, considering the $5 million impact from FX, the pressures in Europe, and the speed of updating our packaging for our channels, we think our guidance range remains solid, particularly in this challenging economic environment. While we could have been more optimistic without these changes, we believe our response is appropriate and positions us well for the midterm and beyond.

Got it. That's really helpful. And maybe just a quick follow-up on the cloud side. Who are you seeing competitively? Are you seeing some of the larger platform vendors that have acquired their way into the space? Are you seeing some of the kind of cloud-native emerging vendors that are coming out kind of in the best of breed or maybe neither of those in that you have a different approach in the go-to-market strategy with a foot in the door with the customers that are adopting?

Yes, I believe you'll see both aspects. We are definitely recognizing customers where we can leverage our existing relationships, which is a key focus area for us. You can consider this our top priority as we respond to the changing market. Additionally, we observe a mix of competitors, such as Palo Alto, which has made significant acquisitions, as well as several niche players. However, there are only a few companies that have the same breadth and quality of capabilities that we do, likely just one other company at our level. We have been ramping up our sales and marketing efforts in the cloud sector. While we have been gradually expanding, it has not yet reached our entire sales team or partner ecosystem. We are quickly shifting that approach by increasing our focus on marketing and boosting the number of salespeople promoting these services. These decisions were made in the last quarter and we are currently implementing them to align with our customers’ changing priorities. We have been cautious about how we introduce new technologies. However, since customer priorities are evolving rapidly, we see this as both an advantage and an opportunity for Rapid7 in the current market environment.

The next question is from Hamza Fodderwala with Morgan Stanley.

This is Matt Saltzman on for Hamza. Corey, just a quick one for you. So there's obviously been a ton of growth in the MDR market in recent years. And with that, you've had a ton of new entrants into the space. So I'm just curious from your perspective today how you see the competitive environment trending on a go-forward basis? Are you expecting further bifurcation for the new entrants to go after the opportunity? Or are you expecting to see some more consolidation to a few key players?

There is an interesting dynamic with many new entrants in the market, each with varying levels of quality. Our focus remains on high-quality, high-margin managed detection and response services. We do not consider all segments of the market, as we are not interested in low-margin, low-quality offerings. We aim to work primarily in partnership with strategic, high-quality partners. We see this as a significant opportunity, and yes, the market has become more competitive. However, despite the tightening labor force, demand has likely continued to grow in line with or ahead of the number of interested high-quality players. Our strategy is centered around understanding the overall market demand and specifically the demand for the segment we focus on, which has seen tremendous growth in high quality and high margin solutions over the past couple of years. Our outlook remains optimistic even in a more competitive landscape, particularly since the competition tends to be more intense at the lower margin and lower quality end. We anticipate that there will be consolidation over time, as many players in that lower margin segment, often funded by venture capital, struggle to scale their businesses successfully. That’s why we pursue a strategy that emphasizes initial sales in our high-margin services while fostering high-quality partnerships that can meet the expectations of both our needs and those of our customers.

The next question is from Shebly Seyrafi with FBN Securities.

So you said that net new ARR is expected to be negative in Q3 and then go positive in Q4. Can you segment that out between VM and STS? And it looks to me, in my model, that your VM ARR growth might decelerate to flattish. I'd like to hear your thoughts on that in Q3. And then do you expect it to accelerate after Q3? And why would it do so?

Yes, let me respond to that. Tim and I may discuss this together. We have several questions to address as we proceed. First, regarding linearization, I believe we are experiencing our usual calendar linearization. More importantly, a key reason for our confidence in Q4 is that we are increasing our sales force focused on what we anticipate will be more customer filling packaging with the VM attached. We made a decision to enhance our infrastructure last quarter, which we are now implementing. Although the full benefits won’t be realized until Q4, we expect positive outcomes. Additionally, as is common in the industry, we implemented a price increase in the middle of the year, while still honoring existing quotes. We expect to see more benefits from this in Q4 as well. These two factors contribute to our visibility and confidence heading into Q4. The second question you raised was about VM. I’ll address this along with Tim. To clarify, VM remains a priority in demand. We mentioned earlier that we observed a decrease from the high teens to the mid-teens. Our overall outlook for VM, in the mid-term and long-term, has not changed; we still expect it to contribute about 10% to overall growth. We don’t foresee any alterations to that outlook. Companies continue to have complex and diverse environments, requiring visibility into risks and prioritization of vulnerabilities, which will drive demand. However, if more of that demand transitions to the cloud, we will likely see a more balanced distribution of spending. The cloud expenditure, initially from a lower base, holds greater growth potential moving forward.

It's Tim. I would just add to that. I think Corey brought it up in his prepared comments. Look, STS, the security transformation solutions have continued to perform very well for us, overall growth rate and as a percentage of the new. And that's the high-value strategic element of the product set. VM is still critically important to many of our customers. But as you see this shifting to the cloud, security transformation solutions continue to grow at a very nice rate.

Right. And on this price increase, what was the percent increase? And when did that happen?

I’m not sure how we've communicated the percentage increase, but it actually took place in the middle of the year. Tim?

Yes, it's going to be effective this quarter. We have not disclosed it publicly yet, but it will be a modest price increase that we think is certainly in line with what's happening in the market with inflation.

The next question is from Joshua Tilton with Wolfe Research.

Does the back half guidance assume that the environment gets worse? Or that it kind of stays the same as what you're seeing in 2Q? And how does what you're seeing now compare to what you saw during the first months of COVID?

That's a great question. I would say our guidance assumes that it stays consistent with the exit rate from Q2. We observed a dynamic shift during Q2, so it remains aligned with that exit rate. It's a pertinent question because we experienced similar dynamics. For those who may recall, we mentioned that VM would accelerate. While it did decelerate, it bounced back much quicker than we anticipated, within about a year. When people had to make prioritization decisions, we noticed that security was important, but its priority level varied among different individuals. Part of our adjustment is based on those lessons learned. During the pandemic, when faced with tough choices, we facilitated the decision-making process for our customers. We are applying what we learned regarding packaging and our approach to attachment, focusing on minimizing complexity for customers. When customers face budget and staffing challenges, our aim is to make the process as easy and simple as possible for them. We believe strong financial results will follow this approach.

I have a quick follow-up. I assume that the full year ARR guidance, with the shift between VM and security transformation, is likely different now than it was at the end of the fourth quarter. If we shift our focus more towards security transformation ARR over the next 12 months because people may not prioritize VM as much, how does that affect your profitability profile during the same period?

Yes. So I will give an extended view versus a precise view about the next three to four months just because this will be a continuing train of thought. There's a couple of concepts to separate. I'm going to separate out sort of like revenue and attribution from customer usage. We think this is going to accelerate customer usage of VM because with the attach strategy, what it really allows us to do was we get a larger ARR from customers faster. And so it accelerates the consolidation of the share of wallet that Rapid7 has. The customer gets a net better deal because they're spending a larger amount of money with us. Therefore, they get more capability, more coverage, faster and broader. It's a win for Rapid7 as part of the consolidation, and it's a great win for the customer overall. Now what that means is from a revenue perspective and from an ARR perspective, the attribution that goes to VM continues to shrink and shrink at a faster rate. But the opposite is true from a usage perspective. We expect that the usage of our overall technologies to accelerate, and we expect more people to actually be using more VM. And I get the case study on the call that the customer attached themselves, and that was one of our programs. But as they attached, they covered 100% of their environment for VM. And as you know, VM typically still starts off with a smaller percentage of the environment and grows over time but rarely gets to 100% of the environment. So part of what we actually get is customers get the visibility at the right price for the entire environment. So you want to net it out is that our ARR customer should increase over the medium-term and long-term at a faster rate. Our share of wallet should actually increase. That should drive customer economics to be a positive trend on profitability because our customer economics improve. For customers, that allows them to actually get better efficacy and get a better deal because they consolidated their spend overall. Because they're getting better efficacy and consolidated their spend, they're actually using the product higher. So our usage share of the market should actually increase.

Josh, all of that aligns with the profitability framework and guidance we've provided, where we indicated that product gross margins are expected to be in the mid-70s range.

The next question is from Alex Henderson with Needham.

Great. So I understand the environment in Europe has gotten more difficult. But I was hoping you could give us a little bit more clarity on how they're thinking about transactions, and what percentage of your sales in Europe are, in fact, in dollars versus local currency. But if I'm a CISO or CFO in a European environment, I'm looking at an 18% to 20% currency translation plus price increases on a wide variety of goods, and I'm looking at pressures on my budget. So how am I exactly approaching that? What are they telling you they're going to do? Is it they're spending the budget they'd already committed to this year and then they expect to tail in the budget next year? Are they downsizing the spend to get better quality products but in smaller volumes? And how are you handling that 20% currency translation that they experienced as a price increase in the U.S. dollar purchases as a result of the exchange rate swings? Are you giving them more breaks, more discounts or anything to offset that?

Yes. Alex, this is a great question. So you got a couple of components there, and I'll tag team with Tim again. So the first thing I'll start with sort of like the customer. You actually pretty much nailed the complex conversations that we're having with the customers about the pressure that they're under. Here's what they'll say, if you do a generic survey, everyone is going to say security's top of the list and priority. That can be taken to mean like there's no issues or pressures on security; it's actually fine. When we did, what we actually find is that what it means is that security is the top of the priority only likely shrinking IT budget. And so it is a top priority, but especially if you're a European customer, a shrink IT budget for all of the factors that you did. What customers are trying to figure out is how do I get more value; how do I get more bang for my buck, so to speak? How do I get more leverage out of my investments? This is where we were paying attention, and we're actually listening. What they're saying is, listen, I need to find a way to get the maximum amount of security and, frankly, a better economic value. I mean customers are very clear about that around the world, but especially in Europe where they actually have lots of the pressure. That's part of the reason that we've actually taken the approach that we've actually taken is how do we make it first a win for the customer, and then secondarily a win for Rapid7. Now I think the next part of your question, I'm going to actually tag team and bring Tim into it.

Yes, Alex, I think it's a great question. So we've said 20% of our revenue is outside the U.S. Let's just say, bookings follows that general 20%. Half of that is denominated in U.S. dollars, and half of that is denominated in the local currency. So to your point, it is the contracts that are in local currency when the customer comes up for renewal. They're going to look to the price they paid last year in local currency. You see that we've got a strengthening dollar, so that number is going to move up on them. Yes, we do entertain those conversations on discounting with customers because we believe the retention value of that customer is highly critical to us. So there is some pressure from the customer point of view because of currency.

We have no further questions. At this time, we'll turn it over to Corey Thomas for any closing remarks.

Well, thank you all for joining us for the call this quarter. We appreciate the time, and have a good day.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.