Earnings Call Transcript - VRNS Q2 2020

Operator, Operator

Greetings. Welcome to Varonis Systems Incorporated Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, James Arestia. Sir, you may begin.

James Arestia, Investor Relations

Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis' second quarter 2020 financial results. With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer. After preliminary remarks, we will open up the call to a question-and-answer session. During this call, we may make statements related to our business that will be considered forward-looking statements under federal securities laws, including projections of future operating results for our third quarter ending September 30, 2020. Due to a number of factors, actual results may differ materially from those set forth in such statements. These factors are set forth in the earnings press release that we issued today under the section captioned Forward-Looking Statements, and these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. These statements reflect our views only as of today and should not be relied upon as representing our views as of any subsequent date. Varonis expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements made herein. Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures is also available in our second quarter 2020 earnings press release, which can be found at www.varonis.com in the Investor Relations section. Also, please note that an updated investor presentation as well as the webcast of today’s call are available on our website in the Investor Relations section. With that, I’d like to turn the call over to our Chief Executive Officer, Yaki Faitelson. Yaki?

Yaki Faitelson, CEO

Thanks, Jamie, and good afternoon, everyone. Thank you for joining us to discuss our second quarter 2020 results. I will cover three topics today before I turn the call over to Guy. First, an update of our business for Q2; second, what we’re seeing in the current environment; and finally, how we believe the trends we are seeing will benefit Varonis over the long-term. While COVID-19 continues to impact many, and our thoughts are with those who have been affected and part of our team, we delivered strong financial results in the second quarter across all regions. The team is executing well in this virtual environment and our customers and prospects are extremely engaged. Virtual risk assessments and online activities are working well and we continue to see strong inbound interest. As always, we remain diligent in monitoring the business, and we believe that the return to more normal purchasing patterns we saw in Q2 will continue in the second half of 2020. As we enter the second part of the year, it is clear that from a competitive and financial standpoint, Varonis has never been in a better position. We believe our unique platform is a massive asset in this new world. And the transition to a subscription company in one year is allowing us to navigate the current environment from a much stronger position, with a 99% subscription mix in the second quarter. Almost all our revenue today is recurring, providing us better visibility and over time serving as a tailwind to profitability. I would like to turn now to the current environment and how we plan to capitalize on the long-term trends we are seeing globally. As we discussed in April, companies have now pivoted from emergency spend related to employee safety and business continuity, and are laser-focused on the continued elevated risk in a work-from-home environment. The powerful data security platform makes us uniquely positioned to address this risk inherent to this new normal. The risks stemming from overexposed sensitive data are not new, but reducing them is even more urgent today. As an example, prior to COVID, a Varonis customer had to worry about five offices for the 1,500 users with a handful of remote employees. Today, the CISO of that company has to worry about 1,500 vulnerable home offices. Remote employees frequently used unsecured computers to access critical data in both Teams and Office 365 and on-prem via VPN. This exposes a company’s sensitive data to enormous risks, and systems worldwide across all industries are facing the same elevated problems. At the same time, the threat environment is more dangerous than ever. Companies face extremely sophisticated advanced persistent threats from external bad actors and hackers, as well as growing threats from insiders. Organized hackers routinely bypass perimeters and endpoints, attack weaknesses in Active Directory, and even threaten to expose data and hold it for ransom. At the same time, employees are worried about job security and our customers are seeing more alerts and warnings of employees accessing sensitive data outside of their normal habits. This is why our platform is resonating with both new and existing customers, as we believe it provides much stronger data protection, alerting, and investigation capabilities. We are seeing that Varonis is very high on the list of priority spending for our customers and the path to double-digit licenses per customer is clearer now than it was just a few quarters ago. Before I turn the call to Guy, I want to highlight a few important customer wins this quarter that demonstrate the enormous opportunity we have in front of us. We signed a large global manufacturer in Q2 that needed to shore up data security and ensure compliance with GDPR. During our virtual risk assessment, Varonis was able to demonstrate our superior architecture and integration. This new customer purchased more than 10 licenses to support an on-prem and Office 365 cloud environment, addressing data protection, threat detection and response, and compliance. This is just one example of a new customer making a larger initial investment in the Varonis platform and more quickly deriving value because of our transition to a subscription model. While we see meaningful increases in adoption rates by new customers, our existing customer base remains significantly underpenetrated, which represents a significant go-forward opportunity for the company. A good example of lifetime value expansion is an agency that allowed a U.S. county to become a perpetual customer in 2017, buying four licenses to cover several departments. In 2019, we took advantage of our subscription offering to expand the Varonis platform across all employees. In January, they confirmed plans to migrate to Office 365 with 0.5 million folders in the cloud that were open to everyone. When the migration timeline sped up due to COVID, they renewed all current licenses and purchased seven additional ones ahead of the renewal. This includes DatAdvantage, Data Classification for their cloud data stores, as well as Automation Engine, allowing them to quickly remediate the open access issues and providing incremental protection. This is an excellent example of our subscription offering, coupled with a strategy to engage larger customers who can buy more from us over time, fueling the expansion opportunity within our base. We believe this crisis has cemented the need for our platform and the trends we are seeing should drive greater adoption. As we look to the back half of the year, we are very encouraged by our unique ability to solve problems that have only intensified with COVID and to capitalize on this long-term opportunity. With that, let me turn the call over to Guy. Guy?

Guy Melamed, CFO & COO

Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. I hope you and your families are all safe and healthy. Last quarter, given the uncertainty from COVID, I spent time on the earnings call providing some insight into how we think about the business focusing on our recurring revenues. ARR grew 52% compared to the second quarter of 2019, driven by our execution across the three pillars that drive our business: first, landing new customers; second, our expansion over time with existing customers, where we are still extremely underpenetrated; and finally, the renewals of both subscription and maintenance of our perpetual licenses. On the new customer front, we continue to see greater license adoption on average compared to the perpetual model. This is partially due to the ease of consumption under a subscription model, but also due to the fact that we are executing on our strategy of acquiring high-quality new logos. We now see the average number of licenses for a new subscription customer is close to five, roughly double what we saw under the perpetual model. On the expand side, our strategy of acquiring high-quality new logos is also generating greater lifetime value, and there continues to be a strong level of engagement from existing customers. As of June 30, 58% of our customers with 500 employees or more purchased four or more licenses, up from 48% a year ago; and 24% purchased six or more licenses, up from 16% a year ago. The rapid growth of these metrics speaks volumes to the value our customers see from a larger adoption of our platform. Turning to product families, 77% of all customers now purchase two or more, up from 74% a year ago; and 47% purchase three or more, up from 42% a year ago. And finally, the recurring portion of our revenues allows us to move through this time of uncertainty from a much stronger position. Ninety-eight percent of our total Q2 revenues were recurring in nature. As I mentioned, ARR at the end of Q2 grew 52% year-over-year and renewal rates of maintenance on perpetual licenses continues to be above 90%. Our dollar-based net retention rate, or NRR, was greater than 120% at the end of Q2. As of this quarter, NRR now accounts for the growth in ARR from all customers, and we plan to provide NRR on an annual basis. Turning to our second quarter results. Total revenues were $66.6 million, up 12% despite the headwind from the much higher subscription mix this quarter. Second quarter license revenues were $34.3 million, which included $34.1 million of subscription revenues, or a 99% subscription mix. Maintenance and services revenues were $32.2 million. To remind you, this line item was impacted by our strategic decision to have our channel partners take on more professional services work. Looking at the business geographically, North America revenues grew 15% to $45.8 million, or 69% of total revenue. In EMEA, revenues grew 7% to $18.7 million, representing 28% of total revenues. Rest of world revenues were $2 million, or 3% of total revenues. Turning back to the income statement, I’d like to point out that I’ll be discussing non-GAAP results going forward, which continue to exclude stock-based compensation and associated payroll tax, as well as FX gains and losses. This quarter and going forward, non-GAAP results also exclude the amortization of debt discount and issuance costs related to our convertible notes issuance in May. Gross profit for the second quarter was $57.6 million, representing a gross margin of 86.5%, compared to 87.3% in the second quarter of 2019. Operating expenses in the second quarter totaled $61.6 million. As a result, our operating loss was $4 million, or an operating margin of negative 6% for the second quarter, compared to an operating loss of $8.9 million, or an operating margin of negative 15% in the same period last year. Our Q2 operating margin was well ahead of our guidance, as we: A, meaningfully outperformed on the top line; B, benefited from COVID-related cost savings, primarily due to travel and marketing activities; and C, continued prudent management of expenses across the business. During the quarter, we had financial expense of approximately $296,000, primarily due to interest expense on our convertible notes, partially offset by interest income. Our net loss was $4.7 million for the second quarter of 2020, or a loss of $0.15 per basic and diluted share, compared to a net loss of $9 million, or loss of $0.30 per basic and diluted share for the second quarter of 2019. This is based on 31.5 million basic and diluted shares outstanding for Q2 2020 and 30.3 million basic and diluted shares outstanding for Q2 2019. We ended the quarter with $326.1 million in cash and cash equivalents, marketable securities and short-term deposits, which includes $215.8 million of net proceeds from the successful convertible debt offering we placed in early May, strengthening an already healthy balance sheet. For the first six months of 2020, we used $10.8 million of cash from operations, compared to generating $3 million of cash from operations in the same period last year, reflecting the revenue shortfall in the first quarter due to the impact of COVID and the headwind from the subscription transition. We ended the quarter with 1,574 employees, a 9% increase from the second quarter of 2019. Moving to our guidance for the third quarter of 2020, we expect total revenues of $68 million to $71 million. We expect our non-GAAP operating loss to range between negative $3 million to negative $2 million and non-GAAP net loss per basic and diluted share in the range of $0.14 to $0.11. This assumes a tax provision of $500,000 to $700,000, interest expense associated with the convertible notes of approximately $800,000 and 31.6 million basic and diluted shares outstanding. To provide more color on guidance, first, the low-end of guidance considers the possibility of broader macroeconomic volatility for the foreseeable future, given the potential direct and indirect effects of COVID. With that said, given Q2 results and what we see in the market, we plan to gradually resume investments in the business for 2020. Second, I want to remind everyone that we will be more apples-to-apples in the second half of the year, starting in Q3, where the subscription mix was 74% in 2019. As a result, ARR percentage growth will naturally be impacted. In summary, our philosophy of running the business has not changed. We want to take advantage of the opportunities in front of us in order to accelerate growth, while showing non-GAAP operating margin improvements, as well as cash flow generation. We are pleased with our second quarter results. And as we look to the back half of the year, the team is focused on executing on a strong close to 2020. Thanks for joining us today. And we hope you and your loved ones remain safe and healthy. With that, we would be happy to take questions. Operator?

Operator, Operator

At this time, we will be conducting a question-and-answer session. Our first question is from Sterling Auty from JPMorgan. Please proceed with your question.

Sterling Auty, Analyst (JPMorgan)

Yes, thanks. Hi, guys. Yaki, I’m wondering if you could give us a little bit more color on your statement that the priority for spending on Varonis solutions has started to increase. I’m particularly interested — I understand the environment and the demand. But is this existing budget that was already there for Varonis solutions that are now just closing in deals? Are you seeing that companies are actually taking budget from other projects to purchase your solutions?

Operator, Operator

Please make sure your lines are unmuted.

Yaki Faitelson, CEO

Can you hear us now? We just saw that after a lot of urgency from work-from-home to add VPN capacity and urgency around laptops and things of this nature, and a lot of adoption of Office 365 and Teams, we’re starting to see this acute risk of people working remotely who can access a lot of data in many repositories on-prem and in the cloud. Customers understand that in order not to have diminishing returns from this very fast digital transformation with scarcity of talent, they need tremendous visibility and automation. At this point, we are the only ones that provide it. In terms of budgets, it’s not always completely earmarked, but we see that organizations have budget for data protection, insider risk, and cloud security, and we can almost always fund the Varonis project from one of these budgets. Every day that goes by, it’s becoming a bigger priority. You see all the workloads in the cloud connected to on-prem and the data sprawl; an organization understands if they don’t have something like this in place, they have huge risk.

Sterling Auty, Analyst (JPMorgan)

That makes sense. And then one follow-up to Guy. So just give us a little bit of color around what you saw on the linearity? Obviously, given the pandemic, we would expect that to push some of the business later in the quarter. But just given the strong revenue and subscription results, can you comment anything to linearity as a whole?

Guy Melamed, CFO & COO

So there was nothing unusual in terms of linearity; similar enterprise companies were back-end loaded, but there was nothing unusual this quarter compared to our norm.

Sterling Auty, Analyst (JPMorgan)

Great. Thank you.

Operator, Operator

And our next question is from Saket Kalia from Barclays. Please proceed with your question.

Saket Kalia, Analyst (Barclays)

Okay, great. Hey, guys, thanks for taking my questions here. Maybe first for you, Yaki. Longer-term product question. Now that the transition to subscription is largely complete, I think you said a 99% mix in the quarter, how are you thinking about new product introductions in the next six to 12 months as part of this easier consumption model? What areas could they touch on from a high level?

Yaki Faitelson, CEO

Yes. For us as a company, what we do most is innovate. Thankfully, we’re in a space that there’s just so much meat on the bone. We believe that there is more ahead of us than behind us. You have different platforms and you can go very deep in each one of the use cases that we cater to and in integration between the products. We put a lot of effort on Office 365 and Azure, which is a massive problem for customers. There’s a lot on content automation and behavior analytics — identifying any abnormal behavior with user behavior analytics. In terms of innovation, we feel that we’re firing on all cylinders. Most of the areas we play in have many ways that we can innovate and add value to our customers and also integrate all the functionalities. The other thing that is happening is that every repository that’s starting to have a lot of data that users are using, we can apply the same game plan of the whole platform with DatAdvantage, Classifying Data, Automation Engine and so forth. So we feel that we can innovate a lot and we have a lot of innovation planned for the next few years.

Saket Kalia, Analyst (Barclays)

Got it. Got it. Maybe for my follow-up for you, Guy. Good to see the net revenue retention at 120%. Can you just maybe touch on anecdotally what you’re seeing from customers on gross retention? And then what licenses are perhaps driving a bigger part of the upsell, cross-sell performance? Does that make sense?

Guy Melamed, CFO & COO

Absolutely, Saket. We’re very happy with the Q2 NRR being larger than 120%. I think it’s indicative of what we’ve said all along — existing customers are not just renewing, but are expanding. Our move to subscription really allows our existing customers to consume more of the platform. We see many customers buying Office 365-related licenses. There are a lot under the DatAdvantage product family, including Automation Engine. Our broad license offering really allows our existing customers to continue to buy. Overall, it reflects the commentary on the environment and the need for the platform, and it also shows the tremendous opportunity we have to expand within our existing customer base. So overall, we’re pleased with those results.

Saket Kalia, Analyst (Barclays)

Very helpful. Thanks, guys.

Operator, Operator

Our next question is from Brent Thill with Jefferies. Please proceed with your question.

Brent Thill, Analyst (Jefferies)

Thank you. Yaki, just curious if you could talk a little more around the work-from-home portfolio and what tailwinds you’re seeing there? And then for Guy, just on EMEA, obviously, the growth rates are a lot slower than what you’re seeing in North America. Can you just talk about how you see a follow-through coming potentially for that region in the back half of the year and what you think needs to happen for growth to accelerate? Thanks.

Yaki Faitelson, CEO

So for the work-from-home environment, there are several critical aspects. One is massive adoption of Office 365 and Teams where Teams is a client that enables a lot of collaboration on top of OneDrive and SharePoint, and a lot of configuration in Azure AD, which many organizations have no visibility into. It’s much harder to manage data protection and understand everything that’s going on. The other thing we see is Azure and AWS: many organizations are running a lot of workloads there that are connected to on-prem and through RDP and other mechanics are open to the world, creating tremendous problems for our customers. This is something, in terms of data protection and infrastructure protection, that is urgent for our customers to manage. With Office 365 repositories, we’re growing very, very fast — something that would have taken three to four years now takes six months. In parallel, the data is growing rapidly in the cloud. Another issue is customers working from unsecured home offices; people are online a lot of the time. There are a lot of advanced persistent threats and cybercrime is thriving. We see a lot of compromised machines; it’s very easy for sophisticated hackers to bypass endpoints, and within the user space, users with excess permissions try to access and steal a lot of data. We really see that across all of these aspects, organizations understand they have a constantly increasing risk and they need to act. For us, what happened is that with Office 365 we have many licenses there — classification licenses, SharePoint, OneDrive, Exchange and Azure AD — this is a big platform sale. We can go to customers and do fairly larger deals for the whole Office 365 and Azure environment; this is huge. They also want to protect the data on-prem that is connected to the cloud. We see an environment where people access data from all over the place. Lastly, unfortunately, insiders sometimes act problematically when worried about job security — employees may take data when they leave or are terminated, which is a huge problem for organizations. Privileged users, administrators and DevOps people can sometimes engage in risky behavior. If you don’t have something like Varonis, it’s virtually impossible to protect these digital assets and infrastructure.

Guy Melamed, CFO & COO

Just to give some color on EMEA: EMEA in Q2 grew 7%. If you look at the history through the subscription transition, when we announced the transition at the beginning of 2019, the European team was slightly slower to adopt, and we discussed that last year. The North American team was much quicker to adopt the transition. We’re starting to see the flywheel effect in both territories. We’re very happy with the pipeline in Europe, we’re happy with the team there, and we feel we have a tremendous opportunity to capture market share.

Brent Thill, Analyst (Jefferies)

Thanks.

Operator, Operator

And our next question is from Rob Owens with Piper Sandler. Please proceed with your question.

Rob Owens, Analyst (Piper Sandler)

Great, and thank you, guys, for taking my question. I’m wondering if you could update us relative to hiring and specifically sales capacity? And if we are seeing this inflection around your business, do you have the capacity to meet demand in the second half? And I guess, to that end of this work-from-home environment, maybe you could also talk about sales productivity? Thanks.

Yaki Faitelson, CEO

We started to hire across every department in the company — sales, support, customer success, engineering — because we feel there is a lot of demand. The company changed completely within a year: it became almost 100% subscription business with high renewals and the platform play is really working. We have a clear path to get many of our customers to 10 or more licenses and we spend more time with them. We’re starting to see a direct correlation between the value we deliver and how much they buy. We want to keep innovating and make sure customer success is working very well. So the short answer is that we are hiring across the organization. We have a great team in place and they adapted well to working from home. So far, we don’t see any impact to productivity.

Guy Melamed, CFO & COO

And just to give some color on quota-carrying reps: when we talked at the end of Q1 about the hiring freeze, we continued to hire quota-carrying reps across the geographies because we saw the opportunity ahead, and we will continue to do that going forward. We feel we have the right capacity to meet demand and we will continue to hire as appropriate.

Rob Owens, Analyst (Piper Sandler)

Great. Thank you.

Operator, Operator

And our next question is from Matt Hedberg with RBC Capital Markets. Please proceed with your question.

Matthew Hedberg, Analyst (RBC Capital Markets)

Hi, guys, thanks for taking my questions. Yaki, when we talk to partners, it shows that you’re increasingly being brought into deals in a post-COVID world. I think one of the bigger drivers is the expanded use of collaboration tools, which you’ve talked about on this call. Can you give us a few examples of how customers that moved to applications like Microsoft Teams are then made aware of Varonis and might partners start to increasingly drive demand for you guys?

Yaki Faitelson, CEO

Yes. When customers start to use Microsoft Teams extensively, they have channels in OneDrive and a lot of data in SharePoint Online, and a lot of automation and configuration in Azure that is hard to maintain. It becomes impossible to understand who can access what and who can access from outside the organization. Once a customer has a lot of data, they understand they have zero visibility and no ability to remediate the data to understand what is critical, so they come to us. They come to us via organic web search and our webinars, which are working very well. In terms of partners, with the shift to subscription and the increase in customer lifetime value, partners understand this is where the market is going. The subscription model creates more predictable, recurring revenue and customers are willing to invest in professional services to implement the platform. Partners see that customers are delighted with the value and that the solutions are relatively non-contested, allowing partners to maintain margins and pricing. Over time, partners can drive a lot of revenue from customers who are pleased with the value they receive. Thankfully, it’s working well for everyone.

Matthew Hedberg, Analyst (RBC Capital Markets)

That’s great. And then Guy, when you guided the Q2 quarter, there was a fair amount of conservatism given the unknowns in COVID. Obviously, you’re coming off a very strong quarter. Has your methodology around guidance changed since last quarter? How do you think about the potential risk of COVID or uncertainty relative to how you guided the Q2 quarter?

Guy Melamed, CFO & COO

To remind everyone, we’ve always guided in a thoughtful and responsible way. When we guided in Q2, guidance was more an extrapolation of the end of Q1 and not the improvement we saw in April, because there were a lot of uncertainties. Q3 guidance is much more based on Q2 customer behavior. We’re pleased with our Q2 performance, but we remain thoughtful and responsible in our guidance. The low-end of the guidance reflects the potential for incremental macroeconomic volatility. That said, we’re going into Q3 with much more confidence than we did going into Q2.

Matthew Hedberg, Analyst (RBC Capital Markets)

Super helpful. Congrats on the results, guys.

Operator, Operator

And our next question is from Alex Henderson with Needham. Please proceed with your question.

Alex Henderson, Analyst (Needham)

Great. Thank you very much. I was hoping you could talk about what the risk assessment pipeline looks like and what the appetite in the field is? Are you still seeing record numbers of assessment requests and how does the close rate look on that? And then I was hoping you could give us an update on Automation Engine uptake rate? I know you’ve given a lot of detail on various subscriptions, but that’s a key piece and I didn’t hear any data on it.

Guy Melamed, CFO & COO

I’ll cover those components. First, our risk assessments are virtual. We’ve done that before COVID and we’re doing it now; we haven’t seen any impact. Our pipeline is really strong and very healthy. We feel very good about the second half of the year with the pipeline we have generated. In terms of closing, our sales cycle is generally between three to nine months, and on larger deals it can be up to 12 months. As expected, only a small portion of the pipeline related to COVID closed in Q2. The pre-COVID pipeline closed in a similar sales cycle, so we haven’t seen much change and that is encouraging. Regarding Automation Engine, it’s consumed by customers very nicely and it’s part of the DatAdvantage product family. We don’t provide specific attach rates, but a reason we moved to subscription was because customers wanted to consume more of our licenses that are geared towards automation, and Automation Engine was a big component of that. We’re seeing customers enjoy the value of that product and we plan to continue to sell it going forward.

Alex Henderson, Analyst (Needham)

Great. Thank you very much for the clarity, and thanks for the great quarter.

Operator, Operator

Our next question is from Shaul Eyal from Oppenheimer. Please proceed with your question.

Shaul Eyal, Analyst (Oppenheimer)

Thank you. Good afternoon, guys. Congrats on the quarter. Yaki, last quarter I asked you about ASP trends or any unusual discounting. Can you provide an update? I think also in light of your commission strategy I mentioned last time where salespeople could be penalized if they provide too high of a discount. Any change on that front? What’s the latest?

Yaki Faitelson, CEO

Regarding pricing, pricing is holding extremely well. We were pleasantly surprised how well customers pay when they decide to buy and understand they need the solution. They may negotiate, but almost all the time we get the price we want. Pricing is holding very well.

Guy Melamed, CFO & COO

Shaul, just to give color on the grading system you mentioned: when we announced the transition at the beginning of 2019, we introduced a grading system where reps can make more when they sell at appropriate discounts or are penalized if they sell at higher discounts. That grading system has worked very well for us. It allows reps to do the right thing for the company and to make more money when they act in favor of company objectives, and that’s been holding up well.

Shaul Eyal, Analyst (Oppenheimer)

Got it. And another long-term question: you’ve spoken in the past about a path to $1 billion in revenue without committing to a specific timeframe. The model has changed and COVID has appeared more recently and appears to be benefiting you. Are you still thinking longer-term about this revenue threshold? Without committing to a timeframe, could it be accelerated?

Yaki Faitelson, CEO

We think about it all the time. The main thing is what happened with the subscription model and the innovation; we’ve increased customer lifetime value dramatically and we need less volume to get there. I believe we have many of the investments and a large part of the organization that needs to be in place to reach the $1 billion goal already in place. The fact that we moved to a subscription business in one year, cloud platforms working well for us, regulation being favorable, and the threat landscape giving traditional security a hard time — all of these factors increase our ability to reach the $1 billion strategic goal. We think about it 24/7.

Shaul Eyal, Analyst (Oppenheimer)

Thank you. Good luck.

Operator, Operator

And our next question is from Hamza Fodderwala from Morgan Stanley. Please proceed with your question.

Hamza Fodderwala, Analyst (Morgan Stanley)

Hi, guys, thank you for taking my question. Could you comment a little bit more about early pipeline trends you’re seeing in Q3? And what was specifically the decision around not giving a full-year or Q4 guidance?

Guy Melamed, CFO & COO

COVID initially impacted us at the end of March when customers were focused on work-from-home and VPN. We were impacted and then started seeing the pipeline build and purchasing patterns return to more normal trends. Q2 results reflect those trends continuing. With that said, there’s still uncertainty with COVID, and that’s why we’re giving guidance for Q3 only. The guidance we provide is thoughtful and responsible. We’re optimistic going into Q3 with much more confidence than we had going into Q2.

Hamza Fodderwala, Analyst (Morgan Stanley)

Got it. And clearly, the NRR was really strong. Could you comment a little bit more about new customer business growth? Did that still decline year-over-year? And when would you expect it to rebound to year-over-year growth?

Yaki Faitelson, CEO

Our strategy is to go to bigger customers, the 1,000-plus employee accounts, and that has worked well. We also have a massive customer base that is underpenetrated, which we continue to expand into. We feel comfortable with the way this strategy is working so far.

Guy Melamed, CFO & COO

Just to add, last year we still had a 56% subscription mix. When you compare this quarter to last year, it’s not apples-to-apples. The strategy to move up-market is working very well.

Hamza Fodderwala, Analyst (Morgan Stanley)

Thank you.

Operator, Operator

And our next question is from Jason Ader with William Blair. Please proceed with your question.

Jason Ader, Analyst (William Blair)

Yes, thanks. Good afternoon, guys. Is there any change in the mix in the quarter between enterprise and SMB? And then also, if you could comment on average deal size and the outlook for U.S. Federal for Q3?

Guy Melamed, CFO & COO

When we look at strategic customers, we shifted about three years ago to customers with more than 1,000 employees. Conducting a risk assessment for a 400-user shop and a 1,500-user shop takes about the same time, yet the lifetime value from the larger customer is much greater. That was the reason for going up-market: to sell more licenses and have customers consume more. We obviously still have small business customers, but they are a small portion of our business. Reps selling to smaller companies often use that experience to train and improve before moving up-market. That strategy has been working very well. In terms of Federal, Q3 is typically their largest quarter. We have a very good team in place and we will provide more commentary at the end of the quarter.

Yaki Faitelson, CEO

What happened in the last two to three years is that the sales process and campaigns became more strategic, a bit simpler and much more predictable. It makes sense for us to go up-market and spend time with customers who buy more across several years.

Jason Ader, Analyst (William Blair)

Do you see evidence of that in your trends on average deal size over the last three years?

Guy Melamed, CFO & COO

In terms of ASPs, with the transition it's not apples-to-apples, but when you think about new customers historically buying perpetual licenses, they would buy between two to three licenses in the initial sale. Now with subscription, new customers are buying closer to five licenses — almost double. Existing customers are also embracing subscription and buying more through subscription. Overall, we’re very happy with this change because it allows us to sell more over time to our customers.

Jason Ader, Analyst (William Blair)

Thanks.

Operator, Operator

And our next question is from Gur Talpaz with Stifel. Please proceed with your question.

Gur Talpaz, Analyst (Stifel)

Thanks for taking my questions. Yaki, you talked about the path to double-digit licenses. Can you walk us through what that path looks like? And then Guy, how should we think about customer lifetime value and the age of subscription? Thank you.

Yaki Faitelson, CEO

Customers often need many of the capabilities we offer across different data stores. With Office 365 you can easily have five or six licenses after you have core coverage on-prem — DatAdvantage, data classification, user behavior analytics, and so forth. Because we are not selling in silos to IT but often as a CISO-led policy to protect the whole enterprise, it’s much easier for us to expand. With subscription and the way customers see the platform, we see multi-year budgeting and a much more predictable adoption rate across the enterprise.

Guy Melamed, CFO & COO

On customer lifetime value: one of the drivers for the transition was that customers wanted to consume double-digit licenses. Over the last couple of years we started seeing customers heading that way but it was harder under the perpetual model. The shift to subscription, and the initial purchase being close to five licenses, gives customers automation and visibility they can benefit from immediately, and it allows continued consumption in following years. NRR being greater than 120% indicates how existing customers are consuming more licenses and how we can generate higher customer lifetime value over time with this model.

Gur Talpaz, Analyst (Stifel)

Thank you.

Operator, Operator

And our next question is from Nick Mattiacci with Craig-Hallum. Please proceed with your question.

Nick Mattiacci, Analyst (Craig-Hallum)

Hi, this is Nick Mattiacci on for Chad Bennett. Thanks for taking my questions. How should we think about ARR growth for Q3 and throughout the second half of the year now that we are comping off a higher subscription mix? And then how should we think about contribution from new versus existing customers in terms of the guide for Q3? Thanks.

Guy Melamed, CFO & COO

In terms of ARR growth, when you move quickly through this transition and get closer to the second part of the year, ARR will be impacted as we start to be more apples-to-apples. We had a 74% subscription mix in Q3 2019. ARR comparisons will naturally be affected. In terms of new and existing customers, we’re happy with both contributions. New customers are buying increased numbers of licenses, and existing customers with NRR >120% are also consuming more. The metrics that point to how much more we have to sell in our existing base are the customers with 500-plus employees who have four or more licenses (58% vs. 48% a year ago) and six or more licenses (24% vs. 16% a year ago). That growth shows how much more we have to sell to our existing customer base.

Nick Mattiacci, Analyst (Craig-Hallum)

Got it. Thank you.

Operator, Operator

Our next question is from Erik Suppiger from JMP. Please proceed with your question.

Erik Suppiger, Analyst (JMP)

Yes, thanks for taking the question. One, can you talk a little bit about timing to get to break-even? Do you have any thoughts on when we might see break-even earnings? Or if you don’t want to share timing, can you talk a bit about your criteria for balancing growth investments and how you’re making that decision?

Yaki Faitelson, CEO

Profitability is important and we strive to balance growth and profitability. The move to subscription gives us a flywheel to be more profitable over time in a predictable way. We won’t give a timeline now, but we always adjust spend to the top line. Every cell of our business with high renewal rates improves future profitability, and we want to ensure we can scale profitably.

Erik Suppiger, Analyst (JMP)

You also mentioned higher confidence in the pipeline entering Q3. Can you quantitatively compare the size of the pipeline from Q3 to Q2 at all? Any metrics around that?

Yaki Faitelson, CEO

The commentary is that the pipeline is healthy and we feel good about it. We don’t really quantify the pipeline publicly, but going into this quarter we are more confident than last quarter. That’s reflective of Q2 purchasing patterns and the increase in customers needing our product and purchasing us. Overall, we feel very good about the second half pipeline.

Erik Suppiger, Analyst (JMP)

Very good. Thank you.

Operator, Operator

And our next question is from Srini Nandury with Summit Research Partners. Please proceed with your question.

Srini Nandury, Analyst (Summit Research Partners)

All right, thank you for taking my question. I’m looking at the competitive landscape. Are you seeing any new vendors such as some foreign entrants showing up in your deals? What about companies such as Broadcom (CA), Zscaler, or Proofpoint that have DLP and CASB solutions going after insider threats? Any color would be helpful. Thank you.

Yaki Faitelson, CEO

We don’t see competitors for everything related to unstructured data protection and classification at scale. Ninety percent of the time, we are alone. We don’t see CASB vendors competing in most of our deals unless there is confusion about product fit. So far, we don’t see any material change in the competitive landscape.

Srini Nandury, Analyst (Summit Research Partners)

Thank you.

Operator, Operator

And our next question is from Daniel Ives with Wedbush Securities. Please proceed with your question.

Daniel Ives, Analyst (Wedbush Securities)

Yes, thanks. My question: when you think about licenses and some trajectories, does this still feel like eight to 10 licenses per typical customer is achievable?

Guy Melamed, CFO & COO

I think the path to double-digit licenses per customer is much clearer now than it was under the perpetual model. The fact that new customers are consuming more in the initial purchase and existing customers are consuming through subscription gives us more confidence in reaching double-digit licenses.

Yaki Faitelson, CEO

Adoption of Office 365 and Azure due to COVID has accelerated the timeline because adoption happens very fast; customers understand they need protection for all data stores. This provides a platform sale that can quickly get customers to five licenses in one chunk and then drive more adoption. The demand drivers are many — cloud migration, unsecured home networks, sophisticated threats — and each has become stronger, creating increased demand for our platform.

Daniel Ives, Analyst (Wedbush Securities)

Great. Thanks.

Operator, Operator

We have time for one final question. That last question is from Rishi Jaluria with D.A. Davidson. Please proceed with your question.

Rishi Jaluria, Analyst (D.A. Davidson)

Hey, guys, thanks for sneaking me in at the end. Two quick ones. First, with your services mix decreasing, it makes sense to offer more on to partners. From your perspective, how do you do that without having a meaningful impact on customer success or customer satisfaction? What have you seen so far? And then on the NRR number: last quarter I think you mentioned 105% for subscription customers. Is the 120% here for all customers? Can you help us understand the difference in what you provided as NRR last quarter versus this quarter? Thank you.

Yaki Faitelson, CEO

Regarding customer success, it was a major focus as we moved to subscription. We architected processes that work with partners and built checks and balances to ensure partners adhere to our standards for customer success. It’s working well; we’ve designed a model to ensure customers are happy and projects advance according to plan.

Guy Melamed, CFO & COO

In terms of NRR, Q1 NRR showed year-over-year expansion of subscription ARR. Q2 NRR accounts for subscription ARR and maintenance of perpetual licenses and it really accounts for timing. Q2 is a much larger sample and therefore is more reflective of the overall business.

Rishi Jaluria, Analyst (D.A. Davidson)

Great. That’s helpful. Thank you, guys.

Guy Melamed, CFO & COO

Thank you.

Operator, Operator

We have reached the end of the question-and-answer session. And I will now turn the call over to James Arestia for closing remarks.

James Arestia, Investor Relations

So thank you all very much for your interest today. We hope everyone is safe and healthy, and we look forward to speaking with all of you soon. Have a good night. Thank you.

Operator, Operator

And this concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.