SecureWorks Corp.
Q2 2019 Earnings Call Transcript

Published: 5 Sep 2018

[Operator:]

Good morning and welcome to the SecureWorks Second Quarter Fiscal 2019 Financial Results Conference Call. Following prepared remarks, we will conduct a question-and-answer session. [Operator Instructions] At this time, all participants are in a listen-only mode. We are webcasting this call live on the SecureWorks Investor Relations website. After the completion of the call, a recording of the call will be made available on the same site. Now, I will turn the call over to Ms. Teri Miller, Vice President and Chief Accounting Officer. You may begin.

[Teri Miller:]

Good morning, everyone, and thank you for joining us today to review SecureWorks' financial results for the second quarter of fiscal 2019. This call is being recorded. This call is also being broadcast live over the internet and can be accessed on the Investor Relations section of SecureWorks website at investors.secureworks.com. The webcast will be archived at the same location for one year. This morning, SecureWorks issued a press release announcing results for its fiscal quarter ended August 3, 2018. You can access this press release on the Investor Relations section of the SecureWorks website. During this call, management will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, guidance with respect to GAAP and non-GAAP revenue and net loss per share as well as adjusted earnings before interest, taxes, depreciation and amortization. Our forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. You can find a description of these risks and uncertainties in this morning’s earnings press release and in the company’s annual report on Form 10-K for the year ended February 2, 2018, which is available on our Investor Relations website and on the Securities and Exchange Commission’s website. All forward-looking statements made on this call are based on assumptions that we believe to be reasonable as of this date, September 5, 2018. We undertake no obligation to update our forward-looking statements after this call as a result of new information or future events. Some of the financial measures we use on this call are expressed on a non-GAAP basis. These non-GAAP measures exclude stock-based compensation, the impact of purchase accounting, amortization of intangibles and the related tax effect of these items. We have provided reconciliations of the non-GAAP financial measures to GAAP financial measures in today’s earnings press release available on our website. Non-GAAP measures are not intended to be considered in isolation from, a substitute for, or superior to our GAAP results, and we encourage you to consider all measures when analyzing SecureWorks’ performance. Also, as a reminder, all financial information discussed is non-GAAP and growth rates are compared to the prior year periods, unless otherwise stated. With us on today’s call are Michael Cote, President and Chief Executive Officer of SecureWorks and Wayne Jackson, Chief Financial Officer. Following their prepared remarks, we will take your questions. We would appreciate you limiting your initial questions to two so that we may allow as many of you to ask questions as possible in our allotted time. In the event if you have additional questions that are not covered by others, please feel free to re-queue and we will do our best to come back to you. Thank you for your cooperation on this. Now, I would like to turn the call over to Mr. Cote.

[Michael Cote:]

Thank you, Teri. And thank you everyone for joining us this morning for our second quarter 2019 earnings call. This was our best quarter ever on many fronts. We’ve continued to build sales momentum and our financial results show significant improvement. Key highlights for the second quarter include

[Wayne Jackson:]

Thanks Mike, and good morning, everyone. Before I get into the details, let me say that our second quarter of FY2019 was a very good quarter. In addition to record sales and double-digit revenue and MRR growth, we improved our operating leverage, generated positive cash flow from operations of $29 million and we are free cash flow positive for the quarter. Moving on to the results of Q2 to FY2019. Revenue total of $128.8 million, a10.6% increase over Q2, FY2018 and a 2.1% increase sequentially. Our average annual subscription revenue per client increased to $100,000 this quarter, a 12.7% increase over the prior year. Sales results for contracts greater than $1million were up 30% year-over-year as we continue to see productivity gains and leverage the investments we made last year in our sales team. A couple of notable examples of new large deals that we signed in the second quarter include

[Michael Cote:]

Thanks Wayne. Today marks my 10th earnings call and I'm in my 17th year as SecureWorks' CEO. I'm honored to hold this position and to lead a team of employees that passionately works to stay ahead of threat actors and protect our clients. We are uniquely positioned in the industry. While pleased with our progress this quarter, we recognize that much work remains to stay on top of such a quickly evolving threat landscape. On behalf of the SecureWorks team, I appreciate your continued interest and support. I look forward providing further details on our progress next quarter. Before I turn it over to the operator for questions, I want to again express my gratitude for the hard work and dedication of all of our team members. And thank our clients for allowing SecureWorks to serve as their trusted cybersecurity partner. Operator, if you now open the lines of questions please.

[Operator:]

We'll take our first question from Sterling Auty of JPMorgan. Your line is open.

[Ugam Kamat:]

Hey, guys. This is actually Ugam Kamat on for Sterling this morning. So, for the first half of this year, we are seeing an uptick of the consulting activity that you are seeing. What specifically are the areas where you are seeing the pickup in demand in terms of the consulting?

[Michael Cote:]

So this is Mike Cote. Our consulting picked up a little bit. I think it was 1% or 2% greater from a percentage of revenue. And it's really tied to our focus in the large enterprise space, I’d say the enterprise and large enterprise space where we picked up some increased incident response work, as well as where clients have looked for a-- I'll say a more holistic solution that ties our subscription solution along with our consulting business -- I'd say in a more larger holistic-type solution.

[Ugam Kamat:]

Got it. And if we look at the MRR outlook that you gave for the full year, it is below what you had guided previously. How much of that would you actually attribute to the increased churn versus I would say a lower demand for ongoing MSS services?

[Michael Cote:]

So I would, this is Mike Cote. I wouldn't phrase it in either of those manners and it doesn't relate to either of those two. The demand is high as we mentioned. As I mentioned in my prepared remarks, we had record sales in Q2 after having the best Q1 we've had in the history of the company. It really related to the large contract that Wayne referred to in his prepared remarks which was a client we've had for many years. The service we did for them was firewall management services, not a key value add in many instances, and we refined that but move those solutions to more leveraged model and some consulting solutions. And what goes into MRR is our subscription business. So it really related to the change in the makeup of that contract.

[Ugam Kamat:]

Got you. And if I could squeeze one last one in, just a small question -- is there any of the SRC revenue uptick that we are seeing, any of that is recurring in nature?

[Michael Cote:]

Didn't -- first of all, I'm not sure what a small question is. Could you repeat the question for us please?

[Ugam Kamat:]

Yes, sure. So I was saying it's like a very quick question. So, I was --in the sense like the SRC uptick that you are seeing, is any of that recurring or is it more like one time in nature?

[Wayne Jackson:]

So this is Wayne. Good morning. Relative to SRC, we do have some of our revenues related SRC that is recurring. They are longer-term contracts, and we've mentioned that before. Some of those --some of those are two to three-year contracts. So, yes, the answer is yes. We have some.

[Michael Cote:]

Let me just add, this is Mike again. But just to add to what Wayne said, if you looked at our overall SRC, Strategic Risk Consulting business, the vast majority of it is long-term contracts meaning a year, much is longer than a year. It is not shorter -- for the most part shorter transaction contract things like incident response clearly would be in that bucket, but the majority of it is longer-term contracts.

[Operator:]

Your next question comes from the line of the Gabriela Borges with Goldman Sachs. Your line is open.

[Gabriela Borges:]

Hi, good morning. Thank you for taking my question. Maybe for Mike to start a follow-up on some of the commentary you’ve mentioned in the prepared remarks on the endpoint side. Maybe you could talk a little bit about how does the adoption of next-gen endpoint technology impact the customers' propensity to buy, manage security or advanced threat services from SecureWorks? And maybe just walk us through the decision process when a customer does adopt next-gen endpoint technology. How do they decide between a third-party services provider like Secureworks versus maybe buying, that managed services from the next-gen technology provider itself. Thanks.

[Michael Cote:]

So, Gabriela, there were a couple of different questions in there. So, hopefully I'll answer them all for you . If I miss one, please come back to me. I think the first thing that you touched on was basically in the endpoint world what we have found is and the reason we announced the partner program is there's a couple of different aspects of it. There's the better detection, first of all, there's the prevention side in the endpoint, and what can be prevented. But, as we know, not everything will be prevented. So then the question becomes using analytics to detect what's happening, and then you've got the response and the ability to hunt. Effectively, a lot of our – a handful I'll say or a lot of our clients have approached us looking for us to help them in that process rather than just simply putting a tool out there. And to get involved in ensuring that we can respond appropriately and periodically hunt on their network for bad guys to ensure that the network is clean. So what we've done is taken the Red Cloak which was initially as I said in the prepared marks use from an incident response engagement perspective or outside of incident response where somebody may ask us to do a targeted threat hunt across their network, and realize that a lot of the secret sauce in our clients, as I mentioned is in the analytics to detect and the models to detect what's going on bad on the network. So we announced the partner program, and it's much like one of the partnerships that we have today on the endpoint front with Carbon Black. We’re going to look to expand where we can apply our analytics to their endpoint technology and have the ability to hunt on their network on their behalf. So, we've seen a strong demand for this from the marketplace and we're excited about the opportunity and look forward to sort of showcasing some of the things that we'll be announcing in the future. Did I touch on your questions?

[Gabriela Borges:]

Yes. I think that covers it, thank you very much. And the follow-up is for Wayne which is also on my MRR outlook for 4Q. Understand the delta between last quarters because of the one large contract that's been renewed. Maybe just taking a step back, it implies a little bit of a deceleration relative to the 12% that you just put up this quarter. Could you explain the puts and takes us to why MRR would be decelerating even when adjusted for that one large contract? Thanks.

[Wayne Jackson:]

Correct. So, MRR, we guided for the year $38 million, $39 million and we really, just as Mike mentioned earlier, reduce the bottom side. MRR quarter-over-quarter ebbs and flows a little bit based on the sales that we have for the quarter and our renewal rate. So when we look at it for the full year, we love to top in the same but just really reduce the back -- the bottom end.

[Operator:]

Your next question comes from the line of Jonathan Ho of William Blair. Your line is open.

[Jonathan Ho:]

Hi, good morning. I just wanted to maybe delve a little bit into the new package offerings that you guys described. Can you maybe give us a sense of how that would potentially impact your ASP as well as potentially win rates when we start looking at the bundled offering?

[Michael Cote:]

So, Jonathan, this is Mike, appreciate the question. On the win rates have clearly gone up as I mentioned it's 2.5x what our historical win rates were. And it's for no other reason because it's a more comprehensive solution that's an easier package to buy, and it's been easier for the CISOs to explain up through their senior management team and the board where the cases they're explaining to board. ASPs have also gone up because it's not a bespoke type solution. And the sale cycles have been shorter to date.

[Jonathan Ho:]

Got it. And then just a follow up. Can you talk a little bit about what's driving the strength in international and how sustainable that is as we look at the course of the year?

[Michael Cote:]

So this is Mike again Jonathan. Thanks for the question. The strength is in international is really a combination of a few things. The experienced sales leader that we hired or general manager that we have in the region that's been driving it for the last few years now. I think he has done a tremendous job and continues to do a good job. From an operating perspective, we are --the operations of the value we're providing is being seen. I mentioned earlier that we are GDPR- compliant, which is helped in the market. And there is clearly --as there is in North America this but is clearly a large demand throughout Europe, the Middle East and in the Asia-pacific market. But I would say in the Asia-pacific market, clearly the largest of those in that market is Japan. And we've got leadership positions in those markets. Our investments are working well and our execution.

[Operator:]

Your next question comes from the line of Rob Owens of KeyBanc Capital Market. Your line is open.

[Rob Owens:]

Yes, good morning. Question around customer count and I'm just curious with the success you're seeing with regard to some of the record sales. Is that coming from increased velocity in terms of customers or larger deals in terms of customers? I don't think you actually gave a customer count. And that only counts as one question and there was like three different things in that.

[Wayne Jackson:]

Yes. Hi, Rob. This is Wayne. I'll take the --good morning, I'll take the customer count. So we didn't mention it but what we did talk about was with the 12% increase in ARPU year-over-year as we focused more and more on the enterprise space. We've talked about that before. You will see in the Q that we will file later today the customer count actually rounded down this quarter to 3,300.

[Michael Cote:]

4,300

[Wayne Jackson:]

I'm sorry, 4,300, I keep saying that. 4,300 from 4,400. So a little bit of rounding down there, but again our focus, we've shifted to the enterprise 12% year-over-year ARPU is how I would address that.

[Michael Cote:]

Not shifted to the enterprise, increase the investment in enterprise from growth perspectives as we've talked about.

[Rob Owens:]

Sure. And as I look at that 37% growth in total contract value that you guys talked about with a record bookings quarter. Are you seeing --is that enterprise with duration extension then? Is that how we should think about that that you're getting larger customers to commit to longer deals?

[Michael Cote:]

It is larger customers; clearly, we've seen a growth as I mentioned 19 over a $1 million. From a deal term perspective, Rob, I would tell you most of the larger contracts are going to be in the two to three year term. I think we've got a few of the bigger ones we negotiated from a five-year term prospective.

[Wayne Jackson:]

That's right.

[Operator:]

Your next question comes from the line of Matt Hedberg of RBC Capital Markets. Your line is open.

[Matt Swanson:]

Yes. Thanks for taking my questions. This is Matt Swanson on for Matt. Wayne, this is a really solid quarter for revenue billings and MRR but also profitability kind of looking back to the investments you guys made last year. How are you thinking about investing for growth versus margin right now? Or I guess how do you feel about investment you've already made in sales capacity?

[Wayne Jackson:]

So, Matt, good morning. I think relative to growth versus-- revenue versus margin, we clearly, as we talked about several quarters, we made the investments in the sales and marketing group. From a gross margin perspective, we're still investing both for internal solutions, as well as external solutions. We are investing in automation and orchestration all to help drive efficiency. So that long term we'll see the margin improvement that we've discussed over the quarters.

[Matt Swanson:]

Thanks. And then you've talked before about trying to take some of the positive things that you've been doing in international regions, and bringing them to the US. It seems like the domestic execution has been a bit better, just some update on how that's gone?

[Michael Cote:]

So, Matt, Mike Cody. You're correct. The leadership under Geoff Haydon and the changes that he's made as we've set the groundwork over the last, let's say, 6 to 12 months are clearly showing that there's a large opportunity. Geoff runs our global sales organization. We have all of our -- almost all of our leaders in place from a global perspective, sales leadership perspective. And are building the team out and we've seen strong results with increased productivity, strong demand in the marketplace. And I would say I'm pleased but not satisfied that the productivity will --I'm pleased but not satisfied in that the productivity will continue to increase.

[Operator:]

Your next question comes from the line of Melissa Franchi of Morgan Stanley. Your line is open.

[Anjelo Austria:]

Hi. This is Angela Austria in for Melissa. Thanks for taking my question. I just want to speak to you at large deals again. Another strong quarter of double-digit deal is greater than a $1 million, how does this compare to your expectations? And I guess put into in other words looking forward, as we think about the level of large deals that are baked into forward targets?

[Michael Cote:]

So this is Mike Cody. We've pretty consistently continued to - well let me back up about a year or so maybe 18 months ago we invested heavily in the enterprise space. And have clearly begun to see more traction in that space. And I would expect that we will going forward continue to see more traction in the enterprise and large enterprise space, some of which will be and we say large deals, deals over a $1 million I was-- and mentioned it in my prepared remarks, I was pleased that it was a good distribution across verticals and clients. So there was a lot more contracts let's say in and around a $1 million rather than some bigger whales that will move it. We still got some deals. We're chasing in that area, but if we can continue to grow the contracts that are about a $1 million in annual contract value a year, I would be pleased and that will be our plan and our product support plan.

[Anjelo Austria:]

Got it, thank you. That's helpful. And just a quick modeling question. Obviously, a big EPS beat on Q2. Full-year EPS guidance is raised at the bottom end but not at the high end. Is that just the reorganization costs or where the incremental expenses that we weren't taking account of before?

[Wayne Jackson:]

You got it, it's in Q3, it's the $0.02 and that flows in full year as well $0.02 related to the reorg.

[Operator:]

Your next question comes from the line of Fatima Boolani of UBS. Your line is open.

[Fatima Boolani:]

Good morning, everyone. Thanks for taking the questions. Wayne maybe for you, you both even Mike, both have talked about the contract of value and then the strength and the growth they're both in excess of 30%. I'm curious how I should be interpreting the delta between the 30% plus growth in contract values and MRR and also total revenue growth, and a follow up if I may.

[Wayne Jackson:]

So relative to MRR, we had the guidance for the full year $38 million to $39 million which included an assumption of the revenue growth that we're now seeing. I know we've improved the revenue growth over guidance in each of the last two quarters, but basically that was considered in the $38 million to $39 million that we guided to earlier. The sales comps year-over-year, again was anticipated. The renewal rate, if you think about what impacts MRR, it's new sales and renewals. Our renewal rate for the year-to-date is pretty much in line with the last several quarters. So renewals about the same. Sales were anticipated in the MRR guidance to begin.

[Michael Cote:]

Fatima, let me try and add to that because I wasn't sure --wasn't sure Wayne answered your question because I wasn't sure I understood it clearly. But I think one of the things is you've got to start with the recurring revenue basically have in the business each year. And what will be added to that will be the sales and subtracted would be any business that we lose or clients that leave us. Of the churn that we've had, most of it is service churn or clients may be buying something different, but I think the point when we talked about the good sales growth. And I mentioned the record Q2 that was a record in history of the company and Q1 was the best Q1 we've had in a history of the company that is incremental sales that will be added to the current base. So I think because of the way we're a subscription-based business, it's the recurring revenue that gets added to the base that we have. So the reason is a disconnect between the sales number of 30% or 36% growth versus our revenue growth. Does that make sense?

[Fatima Boolani:]

Yes. That's very clear. Thanks for that. And then maybe just on the cost front, Wayne. You mentioned in the prepared remarks that as you transact larger and larger deals, it is starting to push a little bit of pressure on gross margins. I just wanted to understand and flesh out that comment a little bit. And as a follow up just if you can clarify the scope of their reorganization costs in the quarter that would be very helpful. Thank you.

[Wayne Jackson:]

Okay. So first relative to the large contract. We see two things in --with the enterprise, with the larger enterprise contracts. First is, many of these contracts have a combination of subscription and consulting. And the consulting generally comes with a little bit lower margin. So that's one item. And then for the larger contracts, we do see some pricing pressure for the larger deals. And we make the assessments based on the value that brings to our company and to our client. So that's what that was relating to. And then the restructuring, the $0.02 per shares we have --we had a long-term contract. We were pivoting the services to both a combination of subscription and consulting. And in that pivot, we anticipate we will leverage our delivery model a little more, but we'll need to take out some costs related to that contract as well.

[Michael Cote:]

I think the other thing for clarity though is that that $0.02 in that reorganization is a Q3 event not a Q2event.

[Wayne Jackson:]

Correct.

[Michael Cote:]

And to touch on the gross margin, we still believe in our long range gross margin target of 60% or greater. Near-term, we're focused on offerings that can add the maximum value to our clients. And we're doing a lot of work with regard to automation and orchestration to improve our efficiency over time.

[Operator:]

Your next question comes from the line of Gur Talpaz of Stifel. Your line is open.

[Christopher Speros:]

Hi, this is actually Chris Spiros on for Gur. You noted the launch of the Red Cloak partner program this quarter. Can you talk about how you balance these partnerships with these key end point players while also competing against these same players in the endpoint space?

[Michael Cote:]

So, Chris, this is Mike Cote. We partnered -- I'll give you an example of this. We partnered with Carbon Black for many years now. And most of where Red Cloak in the proprietary aspect of Red Cloak and the value in the marketplace is the behavioral analytics. And the analytics we can have from a detection capability. So we don't sell Red Cloak as a product directly competing with those players in most instances. And we found with other partners that have approached us in the endpoint market that are market leaders and our clients, there has been a strong demand for us to take and to use our analytics and support quite frankly the process that we've had or the mantra we've had which is to use the best of breed solutions from a point product perspective to secure our clients in a holistic manner, applying our intelligence to the various components. And I think we did the same thing in the network area. And as the endpoint area has matured, we have found it's maturing in a similar manner where people have basically our clients and the partners in the marketplace have asked us to work with them in a complementary fashion. If I actually touched on this from a larger industry perspective, quite frankly, I think that the threat actors and people on the -- I'd say other side of the spectrum that are trying to attack our clients, tend to work very well together in an orchestrated and coordinated fashion. And I am excited about the fact that parts of the security industry are starting to realize that we need to work better together instead of viewing each other from a competitive perspective. And need to do what's in the best interest of our clients. I am really excited about the opportunity here.

[Christopher Speros:]

That's a great color. And I know this has been touched on prior in the call, but with SRC revenues expected to remain at a similar percentage of the top line through the near term. How should we think about the gross margin profile and the potential for gross margin expansion going forward in the near term?

[Wayne Jackson:]

Yes. I think it's back to something Mike just said earlier. Long-term, we're still focused on expanding the margin. We're making the investments that we talked about that provide and that will help us provide maximum value to our clients, but also move the margin in the direction we'd like to see it go.

[Michael Cote:]

So I think that was our last question. This is Mike Cody. I just want to thank everybody for their time and attention and interest in SecureWorks. We are very pleased with the quarter we had and excited to report to you at the end of third quarter in the coming months. Have a great day. Thank you.

[Wayne Jackson:]

Thanks everyone.

[Operator:]

Ladies and gentlemen, that concludes today's call. You may all disconnect at this time.