Earnings Call Transcript - VRNS Q4 2022

Operator, Operator

Welcome to the Varonis Systems, Inc. Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. And it is now my pleasure to introduce to you, Tim Perz with Investor Relations. Thank you, Tim. You may begin.

Tim Perz, Investor Relations

Thank you, operator. Good afternoon and thank you for joining us to review Varonis' financial results for the fourth quarter and full year of 2022. I am joined on the call by Yaki Faitelson, Chief Executive Officer, and Guy Melamed, Chief Financial Officer and Chief Operating Officer of Varonis. After my opening remarks, we will have a question-and-answer session. Please note that some statements made during this call may be considered forward-looking under federal securities laws, including our projections for the first quarter and full year ending December 31, 2023. Actual results may differ significantly from our projections due to various factors, which are detailed in the earnings press release we issued today in the section on forward-looking statements. We encourage all investors to review our SEC filings for a more comprehensive discussion of these and other important risk factors. The statements we make today reflect our views only as of now and should not be considered as representing our views at any later date. Varonis will not undertake to publicly update any forward-looking statements made during this call. We will also discuss non-GAAP financial measures, and a reconciliation to the most comparable GAAP financial measures is included in our fourth quarter 2022 earnings press release and investor presentation available on our website under Investor Relations. Lastly, a webcast of today’s call can also be found on our website in the Investor Relations section. I will now turn the call over to our Chief Executive Officer, Yaki Faitelson. Yaki?

Yaki Faitelson, CEO

Thanks, Tim, and good afternoon, everyone. Thank you for joining us to discuss our fourth quarter and full year 2022 performance. I would also like to provide an update on our new SaaS offering and updated outlook. We are at a very exciting time in our story as we introduce Varonis SaaS to the world nearly 100 days ago. Varonis SaaS is a big milestone for us, as it is the first version of Data Advantage, the birth of our company. At the same time, there is a lot of uncertainty in the world, whether it is inflation, rising interest rates, growing layoff announcements, or just general economic slowing. In the midst of all of this uncertainty, one thing is certain – whatever will happen in the world, people will eat, sleep, and create data, and that data needs to be protected. Turning to our fourth quarter results, it is still very early, but the initial reception to our new SaaS platform was encouraging and that business performed better than we expected, though on a very small sample size. At the same time, the slowing macro environment continued to impact our customers. Our fourth quarter ARR came in above the high end of our guidance range that we provided you last quarter. Although our reported growth remains below the goals we had at the start of the year, Guy will review the quarterly results and our outlook in more detail, but the initial performance of Varonis SaaS gives us additional confidence in our ability to weather this current economic environment and emerge from this transition with healthy growth and profitability on our path to achieving $1 billion in ARR. Now, I would like to take a step back and take a moment to remind you of the importance of what we do. Data is the most valuable asset for any company, second only to its people. If you have data, someone wants it. Everything depends on it, but data is completely out of control. Companies that don't know what data they have or where it is, or employees who have too much access to too much data on too many systems, this is a problem for every organization today, regardless of size, industry, or geographic location. When we started, we needed to evangelize the problem. Today, everyone knows that data security is important, but without Varonis, they struggle to locate their sensitive data, see who has access to it, and safely lock it down without disrupting their business. Securing data continues to get harder as massive on-prem and cloud repository growth advances. In the past few years, with hybrid work, cloud and remote device usage exploded and together expanded their attack surface by an order of magnitude, whether it is APT, cyber criminals, or home insiders. There will always be a vulnerable system somewhere in this massive attack surface, and all it takes is one compromised user or machine to inflict a significant amount of damage, while the main attacker views will change, their end target, data, is always the same. You can replace an endpoint; you can rebuild infrastructure, but once an attacker gets to the data, it is all over. You can't enrich data. This is why data protection is the most important security problem to solve. With SaaS, we reduced the customer effort needed to solve this problem with significant automation built into the software. Although there are many benefits customers get from our SaaS platform, I would like to outline the top three. First and most importantly, customers are much better protected with much less effort. Varonis has much more automation to find and lock down exposures that come from oversharing, unneeded access, and misconfiguration. We have more visibility into usage and behavior on all data stores that matter the most, which enhances our ability to detect and respond to attacks. With our enhanced visibility, we now offer proactive incident response for SaaS customers, providing another layer of protection, again, reducing customer effort, continual automatic updates enable customers to stay in front of new and evolving threats and regulation, and all of this is delivered faster. Second, SaaS is easier to deploy and has significantly lower infrastructure costs, which should result in quicker time-to-value. And third, SaaS is easier to maintain and upgrade, which saves our customers time and headcount, two of the scarce resources for any season. I would like to spend another moment diving deeper into our proactive incident response, which is a key differentiator for Varonis' SaaS offering. As part of the growing SaaS subscriptions, customers get air cover from our world-class incident response team, who proactively watch suspicious activity, investigate alerts, and notify customers of potential incidents. This will reduce the pressure on customer security teams and improve their ability to stop threats, and the ability to provide this across our entire SaaS customer base makes the service orders of magnitude more powerful. On top of these critical benefits, we are making it easier to consume Varonis as we are doubling down on the bundling strategy we introduced at the beginning of last year. We have seen great reception from customers who received Varonis platform protection upfront, and our former sales force benefited from a simpler pricing discussion, both in the initial deal and the revenues. The new strategy is a win-win for our customers and our company. Our customers receive more value from our platform in the initial deal. For our sales force, it is an easier story to tell; our customers know that Varonis protects their largest and most important data store and application. They know the business outcomes that Varonis helps them achieve; this is what matters to our customers and why we are doubling down on our platform selling approach. Our updated packaging ensures that customers receive an autonomous data security platform that will help them achieve their business outcomes on day one. Now that I have provided you with an update on how we are making it easier for customers to see value in the Varonis platform, let me review some of the benefits that we expect to realize through our SaaS offering. First, we expect SaaS will result in a shorter sales cycle; risk assessments, the core of our go-to-market motion, are expected to be quicker and easier to deploy because customer infrastructure requirements are greatly reduced. Along with this, our updated product packaging should help simplify the pricing discussion, which we also think will result in shorter sales cycles. Second, our new customer launch will be largely driven by platform selling approach and a 25% to 30% pricing uplift, which is justified by the product's lower total cost of ownership as compared to our on-premise subscription offering. We expect that quicker time-to-value and improved customer satisfaction will lead to greater customer lifetime value and even better renewal rates in these larger initiatives. And SaaS helps us innovate faster and support our customers more easily, which we expect to benefit our margin profile as we scale. It is still very early in the transition, but we are beginning to see initial proof of this benefit. Before I turn the call to Guy, I want to briefly discuss the capital of key customer wins from Q4 with illustration. A global packaging company with over 4,000 employees became a Varonis customer this quarter. This organization wanted to improve its ability to detect and respond to threats on sensitive data and intellectual property and comply with GDPR and CCPA privacy requirements. This deal was originally an OPS deal that was switched to a SaaS deal during the fourth quarter because of infrastructure and resource cost savings we could realize. The purchase package is to protect Windows, Microsoft 365, and Active Directory, and we're already in discussions to supplement these capabilities with Edge to protect the Exchange Online and Box environment. At the same time, our existing customer base continues to serve as a key growth driver. A couple of weeks ago, a healthcare organization, originally a customer, will purchase a double-digit number of perpetual and OPS licenses and upgraded to our SaaS platforms to protect its hybrid Windows environment, showcasing the power of Varonis SaaS. This renewal was a win-win for the customer and Varonis. The customer will benefit from greater automation and will reduce its total cost of ownership due to lower infrastructure costs. We will recognize an uplift in ARR as a result of the conversion. We are excited by the initial reception of Varonis SaaS and look forward to sharing how we see this driving our growth in the coming years at our Investor Day on March 14. Finally, I would like to thank our team for their tireless efforts this past year, and we are excited to make this transition a success in 2023. With that, let me turn the call over to Guy. Guy?

Guy Melamed, CFO and COO

Thanks, Yaki. Good afternoon, everyone. Today, I will provide insights on our fourth quarter performance and update our 2023 full-year outlook, with a focus on our SaaS transition progress and the impact of the macro environment on our customers. Let’s begin with the early indicators from our SaaS rollout. Although it is still early, the customer and sales force behavior observed in the fourth quarter gives us greater confidence in our transition trajectory compared to our initial announcement nearly 100 days ago. Regarding the macro environment, we experienced some deterioration, though it was not as severe as we had anticipated in our guidance. Despite the general economic softening, our fourth quarter results exceeded the upper range of our guidance for both ARR and net income. We concluded the year with an ARR of $465.1 million, reflecting a 20% year-over-year increase, or 24% if adjusted for currency fluctuations and Russia. In the fourth quarter, we nearly broke even on free cash flow, improving from a negative $6 million last year, which underscores the operating leverage in our business and the steps we took to control expenses. SaaS performance was better than expected, making up about 10% of new business and upsell ARR. For the year, we achieved approximately $3.5 million in DA Cloud sales, slightly below our expectations, influenced by our new SaaS product launch as sales representatives leaned towards promoting Varonis SaaS. While it's still early in the process, we are encouraged by the fourth quarter performance, leaving us cautiously optimistic about our outlook for 2023. Now, let's delve into the macro perspective. As expected in our Q4 guidance, economic pressures negatively affected our European business, and a deteriorating macro environment began to influence our North American operations as well. We noticed increased scrutiny of deals and extended sales cycles. Some deals that were delayed in Q4 have now closed, yet we anticipate longer deal cycles as budget scrutiny persists. Despite this, our sales pipeline remains strong, as the delayed deals are not lost to competitors and still count in our pipeline. Even with economic uncertainty and the widespread focus on optimizing cloud spending, we see healthy interest from new customers and engagement from existing ones. As of December 31, 2022, 78% of our customers with 500 or more employees purchased four or more licenses, an increase from 73% last year and 63% two years ago. Half of these customers acquired six or more licenses, up from 41% last year and 30% two years ago. Due to modifications in our SaaS packaging, this will be the last quarter for these metrics; we will introduce new KPIs at our Investor Day next month to clarify business trends. Our dollar-based net retention rate for subscription customers was 115% in 2022, or 117% when adjusted for currency fluctuations and Russia. Now, let's examine the details from our fourth-quarter results. Before going into numbers, I want to emphasize the significance of ARR, which has been the leading metric for the past six quarters, reflecting the company's direction. Moving ahead, this metric will gain even more importance. During this transitional phase, we are shifting from term licenses to a SaaS model, which means our income statement will represent the business's health less accurately than before. Throughout this transition, ARR and free cash flow will be crucial metrics, unaffected by the pace of change. To illustrate the accounting treatment differences for SaaS versus on-prem subscription deals, we included a slide in our investor presentation. Now, for the numbers: Q4 total revenues reached $142.6 million, growing 13% year-over-year, or 17% when adjusted for currency fluctuations and Russia. This quarter, we faced approximately a 2% headwind to our year-over-year revenue growth due to an increased mix of SaaS sales. Subscription revenues amounted to $116.7 million, while maintenance and services revenues were $25.9 million, with renewal rates exceeding 90%. In discussing the reported maintenance and services growth rate year-over-year, it’s essential to note three headwinds: first, currency fluctuations accounted for a 200 basis point headwind; second, exiting our Russia business added another 200 basis points; and third, converting perpetual maintenance to on-prem subscription added a 100 basis point headwind, totaling around 500 basis points. In North America, revenues grew 17% to $104.3 million, or 73% of total revenue, reflecting economic slowdown and SaaS mix headwinds. In EMEA, revenues grew 1% to $34.4 million, or 24% of total revenue, translating to a 16% growth after adjusting for currency and Russia. The rest of the world saw revenues grow 19% to $3.9 million, making up 3% of total revenue. Moving down the income statement, I will focus on non-GAAP results going forward. Fourth quarter gross profit was $128.3 million, yielding a gross margin of 89.9%, compared to 89.6% in Q4 2021. Operating expenses for the quarter totaled $102.3 million, resulting in an operating income of $26 million, giving us an operating margin of 18.2%, up from $22.4 million or a 17.7% margin in the same period last year. Accounting for the 50 basis points headwind related to our shekel hedging program, the margin expanded by 100 basis points. We faced about a 1.5% headwind to our operating margin due to the higher SaaS sales mix. Financial income for the quarter was approximately $5.2 million, primarily from interest income on cash and short-term investments. Net income for Q4 2022 was $26.1 million, or $0.21 per diluted share, compared to $18.5 million, or $0.16 per diluted share, in Q4 2021, based on 126 million and 118.6 million diluted shares outstanding, respectively. As of December 31, 2022, we had $732.5 million in cash, cash equivalents, marketable securities, and short-term deposits. Over the 12 months ending December 31, 2022, we generated $11.9 million in cash from operations, up from $7.2 million in the same timeframe last year. CapEx for 2022 was $11.4 million, compared to $10.5 million the prior year. Free cash flow improved from a negative $3.3 million in 2021 to $0.5 million in 2022, despite a $4 million headwind from the Tax Cuts and Jobs Act capitalizing R&D provisions. In Q4, we repurchased 2.9 million shares at an average price of $19.37, with $43.6 million left on our repurchase authorization. We ended the year with around 2,150 employees, down from the third quarter, reflecting the 5% headcount reduction completed in Q4. Briefly, our full year 2022 results showed total revenues growing 21% to $473.6 million, or 25% when adjusted for currency and Russia. Our operating margin for the full year was 6.2%, a slight decline from 6.5% in 2021. Adjusting for the 200 basis points headwind from our shekel hedging program, there was a 170 basis point expansion. Now for our guidance: we anticipate continued economic challenges, reflecting four quarters of softness in both EMEA and North America, in contrast to two to 2.5 and one quarter, respectively, in 2022. We also expect further budget scrutiny, longer sales cycles, and increased unemployment as the economy worsens. From a SaaS transition viewpoint, we are estimating a six-month ramp-up period that began in January with our new sales compensation plan. Our guidance includes expected sales force turnover in the first half of the year, lower sales productivity as the team adjusts to the new product, and prolonged sales cycles, as on-prem subscription deals may shift to SaaS. These assumptions mainly impact the first two quarters and are based on insights from previous transitions. While these factors create uncertainty, they are accounted for in our guidance. For our first quarter and full year guidance, we now anticipate a 15% SaaS mix of new business and upsell ARR, up from 5% previously, reflecting positive initial customer reactions to our new SaaS offering in Q4. We have a two-phase approach to the transition. Phase 1, which is underway, focuses on selling SaaS to new customers, while Phase 2, which involves converting our existing customer base to SaaS, will come later. However, if a current customer desires to access our SaaS offerings sooner, we will assist as always. To clarify, the SaaS mix calculation counts new business and upsell ARR divided by total new business and upsell ARR. For instance, if we renewed a $100,000 contract that switched to SaaS for $150,000, we would only count the additional $50,000 of upsell in both the numerator and denominator for the SaaS mix calculation. Now for our guidance: In the first quarter of 2023, we project total revenues between $106 million and $108 million, indicating a growth of 10% to 12%, a non-GAAP operating loss of $7 million to $6 million, and a non-GAAP net loss per share between $0.05 and $0.04. This assumes 108.5 million basic and diluted shares outstanding. For the full year of 2023, we expect ARR to fall between $513 million and $523 million, with a year-over-year growth of 10% to 12%. Free cash flow is projected to be between $20 million and $25 million, factoring in a $6 million to $8 million headwind from the TCJA R&D capitalization. Total revenues are expected between $519 million and $529 million, reflecting growth of 10% to 12%. Non-GAAP operating income is projected between $36 million and $41 million, with non-GAAP net income per diluted share ranging from $0.33 to $0.35. This assumes 127.3 million diluted shares outstanding, and we expect CapEx to be between $8 million and $10 million. In conclusion, we are committed to executing our SaaS transition effectively while managing our business for long-term growth regardless of economic conditions, which will create considerable value for all Varonis stakeholders. Thank you for being here today. I look forward to seeing you at our Investor Day on March 14 in New York. We are now ready to take questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. And our first question comes from the line of Matt Hedberg with RBC Capital Markets. Please proceed with your question.

Unidentified Analyst, Analyst

Yeah. Thank you. This is Matt Johnson on for Matt. And congratulations, guys, on the quarter in this macro, especially on that fast transition. I guess, Guy, you made a comment about your guidance that you're using some of the insights you learned from your subscription transition. And I think just given the rapid pace and success of that subscription transition, it might be helpful for us to hear a little more about what you're seeing that's the same and maybe what's different in these early stages in the SaaS transition based on your conversations with customers and with your sales force?

Guy Melamed, CFO and COO

That's a great question. I think when we look at the introduction of the SaaS offering that we really only introduced 100 days ago, the feedback that we're receiving from both our customers and our sales team is very positive. With that said, it's very early in the transition. So there are a lot of lessons that we've taken from the previous transition. And that's why, when we build the guidance, we factored in some deterioration in the macroeconomic environment, and we factored a lot of longer sales cycles and more deal scrutiny. But from the SaaS perspective, we factored in a six-month ramp-up period that really just started in January when we introduced the new comp plan. But on top of that, we also kind of assumed increased sales force turnover in the first half of the year, lower sales productivity as our sales force gains comfort in selling the new product. And on top of that, we also assumed that our sales teams are going to try and convert some of the deals that are in the pipeline as on-prem subscription and try and convert them to SaaS. All of these assumptions are baked into our guidance, and the expectation is that they will impact us mostly in the first six months of the year. But I can tell you that overall, the feedback that we've received has been extremely positive.

Operator, Operator

Thank you. And the next question comes from the line of Hamza Fodderwala with Morgan Stanley. Please proceed with your question.

Hamza Fodderwala, Analyst

Hi, everyone. Good evening. I appreciate the opportunity to ask a couple of quick clarifying questions. It appears that the growth rate in EMEA on a constant currency basis was quite consistent with what was observed in Q3. Would it be accurate to say that this region performed slightly better than you anticipated? Additionally, Guy, you mentioned a commitment to the bundle strategy. Can you elaborate on your thoughts regarding discounting in 2023 to encourage SaaS adoption? Are we looking at potentially increasing those discounts to promote SaaS adoption upfront, or will they remain roughly the same compared to last year? Thank you.

Yaki Faitelson, CEO

Overall, the adoption in Europe was what we expected. And regarding the bundles, it's just all about the value. With the bundles, customers get a lot of automation, which works extremely well with our SaaS strategy. The SaaS is still in the early innings. And we need to see how it will evolve. But so far, the initial reaction is very, very encouraging.

Guy Melamed, CFO and COO

Matt, to just touch on the actual percentages, EMEA revenue was at 1% in Q4. And yes, as you mentioned, when we factor in the FX, the effect of the FX and the exit of the Russia business, when you kind of look at it on a constant currency basis, excluding Russia, we were at 16%. With that said, we definitely saw kind of the macroeconomic environment in Europe with longer sales cycles and more deal scrutiny, and we definitely saw that in Q4 as well as in Q3. And when we look at the 2023 guidance, we baked in kind of continued deterioration from this point for the rest of the year. And the fact that we're ramping up kind of the SaaS transition and taking that into consideration as well.

Operator, Operator

And the next question comes from the line of Saket Kalia with Barclays. Please proceed with your question.

Saket Kalia, Analyst

Thanks for taking my question. Yaki, I'd like to direct this to you. There’s a lot happening with SaaS in its early stages, and I’m curious about the initial customer feedback you’ve received. You mentioned some points, but are customers purchasing this mainly because it’s easier to support since Varonis is hosting it, or is it because Varonis Cloud might support more applications, or is there another reason? I understand it's still early, but what do you think have been the main selling points from the customers' perspective?

Yaki Faitelson, CEO

The primary selling point is undoubtedly the outcomes. They have transformed the way we approach results. When we developed this, we established a principle of achieving ten times the value with only ten percent of the effort. We successfully realized our vision in its entirety. The installation process is very straightforward. Additionally, the system can automatically classify data and identify which data is crucial and at risk. With the integration of 365, our technology automatically sizes permissions, enabling us to detect all unusual behavior in our cloud environment. We are being proactive for our customers, allowing them to gain significant value effortlessly, as everything operates automatically. Furthermore, the overall time to value has decreased, and there are no hardware requirements involved. While there's a considerable amount of data on-premises that requires a collector, the setup is much quicker, and our capability to detect attacks closer to the data set is functioning exceptionally well. We are excited about everything we've achieved regarding the outcomes, automation, stability, and our effectiveness in addressing issues so far. There are many encouraging signs.

Operator, Operator

Thank you. Our next question comes from the line of Fatima Boolani with Citi. Please proceed with your question.

Fatima Boolani, Analyst

Hi, good evening. Thank you for taking my questions. Guy, this one is for you. You talked about introducing a new compensation program and sales incentives to drive selling behavior around the SaaS platform. I'm curious, does that mean that you've completely deemphasized and more or less created these incentives around selling term business? I mean, are you sunsetting that entire program entirely to shift 100% to SaaS selling? Any clarification there would be great. I'd appreciate it. Thank you.

Guy Melamed, CFO and COO

Fatima, that's a great question. When we create the compensation plan, we aim to align it with the company’s strategic goals. We’ve worked hard to ensure this alignment. As we look at the company’s direction, it relates back to our focus on Phase 1, where we target new customers and sell them SaaS. Building the compensation plan is a mix of both art and science. Our goal is to keep our sales representatives focused on selling SaaS to new customers. If they succeed in this, it will reflect positively on our progress. We intend to monitor this closely and provide more updates over time. Ultimately, the concept behind the compensation plan is to support our objective of selling SaaS to new customers in Phase 1.

Operator, Operator

And the next question comes from the line of Joel Fishbein with Truist Securities. Please proceed with your question.

Joel Fishbein, Analyst

Thank you for your question. Yaki, you mentioned that the SaaS is primarily focused on selling bundles through the platform. I'm interested to know if you can share, even though it's early, how the offering compares to what you're selling on-premises, particularly regarding the price increase of 25% to 75%. This is a topic that many people are thinking about in relation to how this transition will work.

Yaki Faitelson, CEO

I believe this is not directly related to the bundle, but we can easily justify it because it reflects the total cost of ownership on-premises. We have developed a sophisticated and coherent calculator to demonstrate this to customers, and their understanding has been positive so far. For customers, purchasing the bundle is straightforward because ultimately, they seek automation. Looking at the bigger picture in security, the ultimate goal is data. However, protecting data is quite challenging. By providing extensive automation, we can eliminate bottlenecks in the process. The only way to achieve this level of automation is to purchase all the bundles. With these bundles and licenses, the value often multiplies significantly. In most situations, this approach proves to be very effective. The total cost of ownership largely consists of the extensive automation provided, which offers a strong return on investment. Everyone recognizes the necessity of data protection, and thus far, we find our offering to be very appealing.

Guy Melamed, CFO and COO

And just to touch on the bundling, like Yaki said, we're basically doubling down on the success that we saw with the on-prem subscription bundling. So customers, they'll see more value in the initial deal, and they'll buy more over time, which really increases the initial deal size, but also the retention metrics and the customer lifetime value. But it also helps our sales force because really, it's a simpler discussion both on the initial deal and on the renewals as well. So we're not trying to sell 40 different products. We're trying to sell the outcomes. We're trying to sell the Varonis platform, and that really both helps our customers and helps our sales force.

Yaki Faitelson, CEO

The discussion is just about the value, and then you can represent it with one SKU, rather than to start and say, this is a license and that is a license; people are trying to solve problems, and this is what we are going to do.

Operator, Operator

And the next question comes from the line of Brian Essex with JPMorgan. Please proceed with your question.

Brian Essex, Analyst

Hey great. Thank you. Good evening. Thank you for taking the question. Maybe my one question for Yaki, if you will. It sounds like guidance is kind of on the conservative side if you're modeling it kind of incremental deterioration and conversations with CIOs that we're having indicate kind of more back half-weighted seasonality as they're taking a cautious approach to spending this year. Could you help us understand what your conversations with customers are like with regard to spending intentions for the year? It sounds like your backlog is building quite nicely. And how to think about how they might be prioritizing data security within this, I guess, stratification of security spending that they have, what does that fall on the priority scale? And are you just assuming deferrals into the back half of the year and then deterioration on top of that? Or what might your outlook be for a better-than-expected spending environment in the second half as it relates to customer conversations that you're having?

Yaki Faitelson, CEO

Most customer security initiatives aim to safeguard digital assets. We now have a technological platform with SaaS that operates automatically. While addressing this complex issue, organizations often delay action. Currently, we observe progress with the SaaS, although we are still in the early stages. However, it is becoming easier for us to secure budgets and demonstrate value, with minimal effort required from customers. We believe that as our sales team learns to effectively present this solution, customers will recognize its value. We have significantly minimized friction at every step of the sales process and throughout the customer experience, which is very promising. Historically, during challenging times, organizations rigorously assess where to allocate their funds, and we usually benefit from this as they prioritize data protection. In the post-COVID environment, it has become increasingly difficult for organizations to identify their critical data and determine appropriate actions. Where critical data coexists with substantial collaboration and proper directory services, we can now confidently state that we support nearly all critical data repositories, both on-premises and in the cloud. We believe that over time, there is a strong likelihood that more budget will be directed toward us, as this is a pressing issue for customers. Automating this process should be a primary concern for many organizations. Data protection and safeguarding digital assets are top priorities for nearly all organizations today. I also anticipate that, over time, we will demonstrate a robust long-term strategy, whereas many other security expenditures are more cyclical. The volume of data is rising across various repositories, which is exactly what malicious actors target, whether through advanced persistent threats, insider threats, or ransomware attacks. Their goal is to gain access to data, and once customers lose their data, it's irreversible. Our technology is ideally suited to address this challenge with minimal effort for our customers.

Operator, Operator

Thank you. And our next question comes from the line of Roger Boyd with UBS Securities. Please proceed with your question.

Roger Boyd, Analyst

Great. Thank you for taking my question. Guy, you talked about the sales force attention maybe drifting to the Varonis SaaS offering over Data Advantage Cloud in the quarter. Just curious, what sort of synergies are there for Advantage Cloud to be sold now that Varonis SaaS has been launched? Is there a broader bundling opportunity there? And maybe as you think about the 15% SaaS mix for calendar '23, how should we think about DA Cloud versus SaaS contributing there? Thanks.

Guy Melamed, CFO and COO

Well, I'll try to address the sub-questions within the question. First of all, we increased the SaaS mix from 5% 100 days ago to 15%. Going forward, we're going to talk about SaaS sales as a whole. We definitely see reps and our account managers trying to sell to customers, both Varonis SaaS and the DA Cloud. I've talked a lot about the fact that the DA Cloud takes time from an adoption perspective. And we've seen that in the past with other licenses where until it takes some time. We saw that with Office 365; it took some time, and then it started becoming a major contributor. We feel very positive about the DA Cloud being a tailwind for us in the years ahead. I think when you look at the synergies there, the fact that we protect data wherever it resides is a great advantage, and we can enter into new customers that had applications that we couldn't support before, and now we can support them. And that, combined with the Varonis SaaS, gives significant value to our customers that Yaki talked about before.

Yaki Faitelson, CEO

And also, if you look at what we are supporting, it's very easy to understand what is the adoption of the SaaS applications and the cloud data repository. You see that it's something that almost every organization has. So what's happening today is that Varonis is really protecting data. And we want to protect critical data wherever you have it with all the access to all the data flows that users are doing in applications, APIs, and to do it automatically. So we believe that the whole platform is something that is prevalent in almost every organization.

Operator, Operator

Thank you. And our next question comes from the line of Shaul Eyal with Cowen & Company. Please proceed with your question.

Shaul Eyal, Analyst

Thank you, hi. Good afternoon, guys. Congrats on the SaaS and the rapid progress. Are you seeing similar SaaS buying behavior between U.S. and EMEA? Or is SaaS, for some reason, more pronounced in the U.S.?

Yaki Faitelson, CEO

Hi, Shaul. So in Q4, we did it only in terms of the Varonis SaaS; we've done it only in the U.S. We have now opened it for EMEA, and the pipeline is encouraging. We will give you more details as it's progressing. But in general, we just see that it's just non-existent in terms of the objections; I don't have time, I don't have hardware, or I don't have people. We really eliminated all the major objections. So if you have critical data and you want to protect it, the way to do it is to use our platform.

Operator, Operator

And our next question comes from the line of Joseph Gallo with Jefferies. Please proceed with your question.

Joseph Gallo, Analyst

Hey, guys. Appreciate the question. I just wanted to follow up on DA Cloud since I think that's such an important growth vector for you guys. Guy, you mentioned that it takes time. You specifically mentioned the office product. What is it that takes time? Is it a product feature issue? Is it an awareness issue? Is it a sales comfortability issue? Just kind of curious if you could provide a little more detail on that.

Yaki Faitelson, CEO

I understand. Regarding the DA Cloud, we aimed to ensure the product is fully developed and includes all necessary features. The releases we've rolled out in the fourth quarter have been significant, addressing various use cases like threat detection and response and data protection. We also have strong capabilities in configuration management and classification. However, it takes time for our sales team to become proficient in selling these features. As Guy noted, when we introduce something new like Varonis SaaS, there can be some initial challenges, which is why we mentioned that major updates typically require about two quarters to fully align everything. Nonetheless, we see DA Cloud as a powerful growth engine for us. It houses a substantial amount of data with a complex permission structure and extensive configuration, along with robust API connectivity. These platforms present various risks, and our unique intellectual property is highly effective in this context. We believe DA Cloud represents a significant opportunity for the company as we move forward, and we have made the necessary investments in development and support to ensure we can achieve substantial benefits from this platform in the future.

Operator, Operator

And our next question comes from the line of Rob Owens with Piper Sandler. Please proceed with your question.

Rob Owens, Analyst

Thanks for taking my questions. Just curious on the roadmap for the SaaS solution. And are you currently at feature parity with on-prem? And what's to come down the pike in the near term? Thanks.

Yaki Faitelson, CEO

Thanks for the question. So we are not at complete feature parity, but starting the SaaS, some aspects are much more advanced than on-prem. Some features in on-prem, we need to achieve parity. We are moving very, very fast with the cloud. It's a fit to 70%-80% of the Varonis on-prem customers, and it's a fit for every new customer we acquire to achieve parity. We also have many new advancements in this platform, so we really prioritize. The beauty of the cloud is we can see the usage. You can see how the features we are implementing are affecting our customers, and we can prioritize effectively.

Operator, Operator

And our next question comes from the line of Chad Bennett with Craig Hallum. Please proceed with your question.

Chad Bennett, Analyst

Great. Thanks for taking my question. So maybe for Guy. It seems like you're obviously seeing pretty significant early traction in the SaaS platform. And so you upped kind of your sales mix or ARR mix from 5 to 15. And assuming that price lift sticks of 25 to 30, I think you effectively reiterated ARR for this year relative to what you talked about before. Wouldn't that be a lift or a tailwind to overall ARR if, in fact, you're seeing a higher mix of SaaS ARR that's higher priced?

Guy Melamed, CFO and COO

Yes, as you mentioned, we certainly experienced significant momentum with the SaaS introduction, which gave us the confidence to raise the SaaS mix from 5% to 15%. However, it’s important to note that we are still in the early stages of this transition. This is why the Annual Recurring Revenue (ARR) number hasn’t shifted much; while there was a slight increase, it was minimal since we are just at the start of the year. We had anticipated a six-month ramp-up period. Nonetheless, we are optimistic about our SaaS offering, and in the past 100 days, we received valuable feedback from both our customers and our sales team.

Operator, Operator

And our next question comes from the line of Andrew Nowinski with Wells Fargo. Please proceed with your question.

Andrew Nowinski, Analyst

Thank you. I have a question about the SaaS mix. I noticed you generated 10% of new business from SaaS in Q4, then 15% in Q1, and you're projecting 15% for the year. I'm curious why the mix isn't expected to increase throughout the year as more sales representatives get up to speed. Why is it remaining flat at 15% after Q1?

Guy Melamed, CFO and COO

100 days ago, it was a 5% mix, and we again, like I said before, we gained a lot of confidence. But again, we're very early in this process, and we do expect some friction that will happen in the first six months of the transition, which is already baked into the guidance. We will obviously update everyone as we progress through this transition, and we'll give more color as we see kind of the pipeline build. But because we're so early in this transition, we moved it up from 5% to 15%, and we want to start with this. We will be as transparent as possible throughout the transition and give metrics that can allow everyone to see the progress and the progression within the transition.

Operator, Operator

And our next question comes from the line of Shrenik Kothari with Robert W. Baird. Please proceed with your question.

Shrenik Kothari, Analyst

Good evening. It's great to hear about the progress in SaaS. Thanks for taking my question. I have one for Yaki and a quick follow-up for Guy. Yaki, you mentioned that the ongoing macroeconomic conditions continue to affect customers negatively, particularly in EMEA and increasingly in North America. Last quarter, you talked about EMEA revenues, but you also noted some issues with U.S. Federal trends. Can you share your thoughts on the U.S. federal trends? Are they performing above your expectations or in line with them? Just a brief comment would be appreciated. Also, regarding operating margins, you mentioned a 1.5% headwind. Could you break down the contributions from hosting and support costs versus the sales incentive structure? Thank you.

Yaki Faitelson, CEO

We are building a very healthy pipeline in the federal market. This sector in general has a lot of critical data that they need to protect, and many organizations want to secure that data. If you wish to protect these massive data stores with new solutions like ours, we believe that we can do very well in the federal market. And when you have an economic slowdown, it usually impacts IT spending. But again, if you have critical data, someone wants it; it's essential for every business. So we believe that we can weather any economic slowdown very effectively.

Guy Melamed, CFO and COO

In terms of the margins, one of the things that we've talked a lot about, and you've probably heard me mention ARR as the leading indicator for the last six quarters. We wanted to ensure that everyone understands that when we're shifting our business from term licenses, where we recognized approximately 80% of the deal's value upfront, to a SaaS model with kind of a fully ratable revenue, will make our income statement metric less indicative of the health of the business than it's been in the past. So the headwind we discussed impacted us mostly by the way revenue is recognized between the two models. This is why we said that throughout the transition, ARR and free cash flow will be our north stars because they're not impacted by the speed of the transition. So obviously, as we highlighted at our Investor Day on March 14, we'll give more color, including details on the headwinds and KPIs to allow analysts and investors to work with us during this transition.

Operator, Operator

Thank you. And our final question comes from the line of Joshua Tilton with Wolfe Research. Please proceed with your question.

Joshua Tilton, Analyst

Hey, guys. Can you hear me?

Guy Melamed, CFO and COO

Yeah.

Joshua Tilton, Analyst

Great. Just one quick one for me. I think we all walked away from the last earnings call with a message that the Q4 guidance and the initial 2023 guidance was derisked that you guys indicated it could only be 5%. I know there's no real change to the growth outlook for 2023. I guess is the message still the same? Should we walk away feeling that you guys have tended to derisk the growth outlook for 2023?

Guy Melamed, CFO and COO

It's challenging to hear, but I believe I understood your question about our confidence in our guidance and whether we have considered macroeconomic uncertainties. If that's correct, the answer is yes to both. We are more confident about our position today compared to 100 days ago. The response to our SaaS offering has been very positive, as discussed by both our customers and sales team. However, when we review our guidance for 2023, we did incorporate expectations of worsening economic conditions overall. We anticipate reduced activity in EMEA and North America, increased budget scrutiny, longer sales cycles, and general further decline in economic conditions. While we feel more optimistic about the business, we also wanted to acknowledge in our 2023 guidance both the potential macroeconomic decline and some challenges that may arise with the launch of the SaaS offering, along with an expected ramp-up period of about six months.

Operator, Operator

And our next question comes from the line of Erik Suppiger with JMP Securities. Please proceed with your question.

Erik Suppiger, Analyst

Yeah, thanks for taking the question. Can you just talk a little bit about the linearity that you saw through the quarter? It sounds like things may have eroded. So did the end of the quarter slow? And then you also talked about some turnover in the sales organization. Can you comment on what kind of turnover are you expecting in the sales organization?

Guy Melamed, CFO and COO

So the quarter actually behaved very similarly in terms of seasonality. We didn't see any abnormal behavior when we look at kind of the seasonality; we're similar to other software enterprise businesses, and we do have a large component of the business that comes in the last couple of weeks of every quarter. So we didn't see any major trends there. In terms of the turnover, I can tell you that the reception of the SaaS offering has been extremely positive, but some of the lessons that we've taken from the move from perpetual to on-prem is some increased turnover, which we baked into our guidance and factored that in. So that's kind of the way we thought about it. But as of now, everything is going in line with our expectations.

Operator, Operator

And our final question comes from the line of Shebly Seyrafi with FBN Securities. Please proceed with your question.

Shebly Seyrafi, Analyst

Yes. Thank you very much. So I want to delve into the 13-point deceleration in North America growth, from 30% to 17%. How much of that was the SaaS headwind? Can you talk about the different trends you saw between large customers and smaller customers? And finally, did you see in January or February, early February this month, a noticeable pickup in North American business versus the end of last year?

Guy Melamed, CFO and COO

When we gave guidance last quarter, we said that we expected to see some spillover from the macroeconomic conditions in EMEA to North America with some increased deal scrutiny and longer sales cycles in the region. The results we saw in Q4 were kind of in line with our expectations. There was about a 300 basis points of headwind from the SaaS mix shift that impacted our North America reported revenue in Q4. In terms of January and February, February has only just started. But I could tell you, we provided guidance, and we feel good about the guidance we have provided, and we'll update as we progress and we'll give some color on the SaaS transition during our Investor Day on March 14.

Operator, Operator

At this time, there are no further questions. Now I'd like to turn the floor back over to Tim Perz for any closing comments.

Tim Perz, Investor Relations

Thanks for joining us today. We look forward to seeing you all at our Investor Day on March 14 in New York.

Operator, Operator

This concludes today's teleconference. You may now disconnect your end at this time. Thank you for your participation. And have a great day.