Varonis Systems, Inc.

Greetings, and welcome to Verona Systems, Inc. Third Quarter 2023 Earnings Conference Call. At this time, all participants are on a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce Tim Peirce, Investor Relations. Thank you. You may begin.

Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis' third quarter 2023 financial results. With me on the call today are Yaki Fidelson, Chief Executive Officer, and Guy Mohamed, Chief Financial Officer and Chief Operating Officer of Varonis. After preliminary remarks, we will open the call to a question and answer session. During this call, we may make statements related to our business that would be considered forward-looking statements under federal securities laws, including projections of future operating results for our fourth quarter and full year ending December 31, 2023. 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. Ronis expressly disclaims any application 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 third quarter 2023 earnings press release, and investor presentation, which can be found at www.Veronis.com in the investor relations section. Lastly, please note that a webcast of today's call is 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 Keidelson. Yaki?

YAKI KEIDELSON, Chief Executive Officer, Yaki Keidelson, Thanks, Tim, and good afternoon, everyone. Thank you for joining us today. Let me start by saying Our thoughts are with our employees, customers, partners, and all of those impacted by the recent events in Israel. We will continue to do whatever it takes to support our employees. Today, I would like to review our Q3 results and discuss how AI can serve as a meaningful tailwind to our business in the years to come. But first, I would like to remind you why Valence exists and the problems we solve. is the prime target for bad actors because of its importance to a business. Data is also out of control. The explosion of the cloud and remote work has improved collaboration but has also made securing data more difficult. Voronis helps companies locate sensitive data, visualize who has access to it, and automatically lock it down. This allows companies to collaborate safely and get value from their data while managing risk and AI will only make this an even greater priority. Our third quarter results reflect the continued healthy adoption of Veroni SaaS. We saw further evidence that our transition to a SaaS business model is working, and SaaS ARR now represents approximately 15% of total company ARR. Third quarter SaaS mix came in at 59%, comfortably ahead of our guidance of 45%. ARR grew 16% year-over-year to $517.5 million, and we have generated $46 million of free cash flow year-to-date, up from $800,000 through the same period last year. Guy will review our Q3 results and our updated guidance in more detail. From a macro standpoint, we continue to see a high level of deal scrutiny and longer sell cycle this quarter, but remain encouraged by the progress of our SaaS transition against these headwinds. Now, I would like to spend some time on how AI presents a meaningful opportunity for Voronis. In my conversation with customers and prospects, AI comes up more and more. And my key takeaway for Voronis is that the growth of AI has the potential to generate significantly more data, significantly more risk, and significantly increase the need for data security. Stepping back, generated AI presents both opportunity and risk for companies. It has an opportunity to boost productivity and efficiency, but in order to safely realize these benefits, there are security risks that businesses must mitigate first. These risks present opportunities for companies like Voronis. The first risk is related to what I call self-inflicted risk, which happens when businesses start using AI to suggest content to employees. Unless data is locked down, there is little to prevent AI from analyzing the company's entire data estate and revealing critical business assets like customer lists, payroll files, or bank account information to the wrong people. Microsoft recommends mitigating this risk by securing sensitive data before deploying CorePilot, which is the company's AI system, and specifically recommend having the right information access controls and policies in place. This is precisely what Varonis does. Without Varonis, right-sizing access control is very challenging. Managing access controls only gets harder over time if the data support and AI will surely contribute further to this problem. Without the right controls in place, AI doesn't know who should see what and surface everything for everyone. This becomes a huge risk for organizations and bad actors who won't even need to search for content they want to steal AI will help them to find it automatically. AI will also increase the risk that companies face from external attackers. A few examples of this include helping bad actors create and translate phishing emails so they can use them in many languages, creating fake data sets in order to trick companies into paying ransoms and creating miles. Unfortunately, the use of AI will continue to lower the barriers to entry for hacking. Varonis helps organizations mitigate this risk by ensuring that only the right people have access to information that they need to do their job. Varonis can help organizations ensure that employees only see content suggestions that are relevant to their job function. If a bad actor bypasses perimeter controls, Varonis can lock out the compromised users or machines, preventing damage from happening. Although it is early and we are still quantifying timing and sizing, we see AI becoming a gross tail into our business as it gains momentum and has a detailed plan to execute it. Apart from demand opportunities that we see arising from security risks related to AI, we are also leveraging this technology in new ways to improve our customer experience. Varonis has been using machine learning and AI for many years in our analysis engine and threat models, for example, and today we are announcing two exciting generated AI capabilities in our SAS data security platform, AI system security operation center, or what we call SOC, and natural language search. Although we do not plan to sell AI as a separate SKU, Our AI Assistant SOC will provide security analysts with an intelligent AI Assistant specialized in performing investigations, remediating threats, and proactively hardening environments. Our SaaS platform can analyze alerts and provide context and next steps to help analysts more efficiently resolve security incidents. With natural language search, AI makes everyone's user a power user. from the help desk to CISO can use natural language to get fast and accurate answers to questions such as, do we have any files containing passwords that are exposed to everyone on the internet? Or, what users have been accessing our payroll files? Today's newly introduced generative AI features build upon the Voronix SaaS benefits that we have discussed with you over the past year and will further reduce the time to value for our customers and improve their experience with Vaughn's. I would like to spend a moment to remind you of the three key benefits of SaaS platform provider customers. First, customers are much better protected with much less effort with automated remediation and proactive incident response. Second, SaaS is quicker to deploy and has significantly lower infrastructure costs. And third, SaaS is easier to maintain and upgrade. Three of the key benefits that we realized are, one, shorter sales cycles, two, larger initial length, and three, margin benefits over time. This quarter, we continue to see additional proof points of these benefits. A large state government organization became a Voroni SaaS customer this quarter. We first gained a department of this state as a customer in 2022. Over the past year, we had a very successful deployment with the department that allowed us to build credibility and ultimately win the broader state government mandate. For this organization, SAS was a must-have because their security team is straight thin. Now, they will benefit from quicker time to value, faster deployment, and most importantly, they will be better protected with our proactive incident response team and automated remediation for Windows on-prem and Microsoft 365. We also continue to see healthy interest from existing self-hosted customers who converted to SaaS this quarter. One example was a multinational financial institution that first became a customer in 2020. Given the large volume of sensitive customer data, we needed to make sure that information was locked down. They originally purchased four on-prem subscription licenses to protect their on-prem Windows environment. This organization's success protecting on-prem Windows drove a desire to consume more of the platform by going both wider and deeper. Veroni SaaS will now help them shrink their blast radius in the cloud just as they did on-prem. Proactive incident response will supplement those thread detection capabilities and Varoni SaaS eliminates the need for this customer to manage their own hardware, which will improve their scalability. They converted their on-prem Windows licenses into a SaaS equivalent package, and they purchased an additional SaaS package for Microsoft 365, widening their coverage. The sustained momentum that we saw from our SaaS transition this quarter coupled with a faster pace of innovation, gets us closer to achieving a $1 billion ARR target and delivering meaningful stakeholder value. With that, let me turn the call over to Guy. Guy.

Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. It goes without saying that the health and safety of our employees is of paramount importance to us, and we will continue to do whatever it takes to support them. Before I discuss results, I want to briefly comment on the impact of the war in Israel on our operations. From a top-line perspective, Israel has historically represented less than 1% of our business. We have approximately a third of our employees located in Israel, which includes our principal research and development facility, as well as a portion of our support and general and administrative team. At this time, a low single-digit percentage of our global team members have been called up to active duty. We have executed business contingency plans to minimize the impact on our business. And at this time, we don't expect the material impact on our global operation. With that, I'd like to turn to Q3 results. We are pleased with the continued strong adoption of Verona SaaS against continued macro headwinds. Our SaaS transition continues to gain momentum and this quarter provided additional proof of the numerous benefits to our customers as well as the tailwind to our ARR and cash flow performance. As a reminder, ARR, free cash flow, and ARR contribution margin are the leading indicators for our business during this transition. The shift from on-prem subscription licenses where approximately 80% of the deal's value is recognized up front to a SAS model with fully ratable revenue recognition will cause initial headwinds on the traditional income statement metrics as the SAS mix and conversions of existing customers to SAS increases. And this quarter's impact was meaningful as the number of existing customers converting to SAS again increased. However, these headwinds are a function of accounting treatment and are not indicative of the health of our business. In fact, the greater these accounting-related hen wins are, the better it is for our business, as it means the transition is progressing at a faster pace. Our third quarter SaaS mix represented 59% of new business and net new upsell ARR versus our guidance of 45%, and after only three quarters into the transition, SaaS now represents approximately 15% of the company's total ARR. The average deal sizes realized in Q3 continue to provide us with confidence in the 25% to 30% pricing uplift and margin structure that we previously provided. In the third quarter, a significant amount of SaaS deals were sold to new customers. We again saw an increase in existing customers converting to our SaaS offering. In the third quarter, we had approximately $10 million in conversions of existing customers. impacting our Q3 revenue. To be clear, this is the renewal amount that was previously booked as an on-prem subscription that is now SAX, which causes a headwind to our reported revenue and operating margin, but does not impact ARR or free cash flow. The $10 million from this quarter does not include the uplift that we realized from these conversions, which is accretive to ARR and free cash flow. As we look to our revenue guidance for the fourth quarter, we're now assuming that approximately $12 million of existing customers' renewals will convert to SaaS in Q4, which is up from $10 million previously. In the third quarter, ARR grew 16% year-over-year to $517.5 million. Year-to-date, we generated $46 million of free cash flow, which was up from $0.8 million over the same period last year, reflecting the inherent leverage in our model, as well as our commitment to balancing top-line growth with improving cash flow generation. In Q3, we continued to see a macro environment that was similar to the first half of the year. We're still seeing deal scrutiny and longer sales cycles across the board, which is impacting customer purchasing patterns, and is constraining our near-term results. We expect these longer deal cycles to continue along with the associated budgetary scrutiny, and our updated guidance takes this into consideration. Turning now to our third quarter results in more detail. Before I get into the numbers, let me remind you of what we've said for a while now. ARR free cash flow and ARR contribution margins are the leading indicators for this transition. We take our commitments to the street seriously, and our revenue guidance is based on a combination of our expected SAS mix and existing customer conversion. As we said previously, the faster we progress throughout the transition, the more headwinds we will experience to our traditional income statement metrics. We view these headwinds in a positive light, as they show our customers are adopting our SAS solution more rapidly. Q3 total revenues were $122.3 million, down 1% year-over-year. During the quarter, as compared to the same quarter last year, we had approximately a 12% headwind to our year-over-year revenue growth rate as a result of having increased staff sales in our booking mix, which are recognized ratably versus the upfront recognition of our on-prem subscription products. Subscription revenues were $97.7 million, and maintenance and services revenues were $24.6 million, as our renewal rates were, again, over 90%. Moving down the income statement, I'll be discussing non-GAAP results going forward. Gross profit for the third quarter was $106.7 million, representing a gross margin of 87.3% compared to 88.3% in the third quarter of 2022, despite significant revenue headwinds. which were largely offset by greater efficiency on our SaaS platform than we initially expected. Operating expenses in the third quarter totaled $101.9 million. As a result, third quarter operating income was $4.9 million, or an operating margin of 4%. This compares to operating income of $9.8 million, or an operating margin of 7.9% in the same period last year. During the quarter, as compared to the same quarter last year, we had approximately an 11% headwind to our operating margin as a result of having increased fast sales in our booking, which are recognized fully ratable versus the upfront recognition of our on-prem subscription product. Third quarter ARR contribution margin was 11.1% up from 3.6% last year. The significant leverage improvement even during the early stages of the transition, reflects our ability to drive strong incremental margins while growing ARR and transitioning to SaaS. During the quarter, we had financial income of approximately $8 million, driven primarily by interest income on our cash deposits and investments in marketable security. Net income for the third quarter of 2023 was $10.4 million, or 8 cents per diluted share, compared to a net income of $6.7 million, or net income of 5 cents per diluted share for the third quarter of 2022. This is based on 126.7 million diluted shares outstanding and 126.9 million diluted shares outstanding for Q3 2023 and Q3 2022, respectively. As of September 30th, 2023, we had $731.5 million in cash, cash equivalent, short-term deposits, and marketable securities. For the nine months ended September 30th, 2023, we generated $49 million of cash from operations compared to $8.4 million generated in the same period last year. And CAPEX was $2.9 million compared to $7.6 million last year. During the third quarter, we repurchased 1.2 million shares at an average purchase price of $30.10, which completed our intended share repurchases. Over the course of the program, we repurchased approximately 4.4 million shares at an average purchase price of $22.64, for a total consideration of approximately $100 million. Turning to our guidance in more detail. We're raising our full-year SaaS mix of new business and upsell ARR guidance to 55%, up from 50% previously, and we expect Q4's SaaS mix to be 60%. We continue to take a prudent approach in building our SaaS mix outlook as the dollar value of deals we expect to close in the fourth quarter is the largest of the year, which is in line with historical trends. In Q4, we're assuming that $12 million of renewals will convert to SAS, which will serve as a headwind to revenue. Conversions to SAS, before considering any uplift to deal sizes, do not impact ARR. Our guidance continues to factor in the same level of macro headwinds that we've discussed at length in the past. Now turning to our guidance. For the fourth quarter of 2023, we expect total revenues of $150 million to $154 million, representing growth of 5% to 8%. Non-GAAP operating income of $25 million to $27 million, and non-GAAP net income per diluted share in the range of $0.22 to $0.24. This assumes 126.1 million diluted shares outstanding. For the full year 2023, we now expect ARR of $535 million to $539 million, representing growth of 15% to 16%. Free cash flow of $40 million to $45 million, which includes $8 million to $10 million of headwind related to the TCJA capitalization of R&D provisions. Total revenues of $495 million to $499 million, representing growth of 5%. Non-GAAP operating income of $26.5 million to $28.5 million. Non-GAAP net income per diluted share in the range of $0.31 to $0.33. This assumes 126.6 billion diluted shares outstanding. In summary, We continue to see solid demand for both new and existing customers who wish to consume Varonis through our SaaS platform. As a result, our transition continues to move quickly, and approximately 15% of our total ARR is now coming from SaaS. This is benefiting our ARR performance and cash flow generation, which positions us for a strong fourth quarter.

With that, we would be happy to take questions. Operator?

Thank you. Ladies and gentlemen, at this time, we'll be conducting a question and answer session. If you'd like to ask your question, you may press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using future equipment, it may be necessary to pick up your handset before pressing the star key. In the interest of time, please limit yourself to one question only. Thank you. Our first question comes from the line of Sakhi Kalia with Barclays. Please proceed with your question.

OK, great. Hey, guys. Thanks for taking my question here. I just want to send our thoughts to the Varonis team and their families in Israel. Thank you. Thank you. Absolutely. You know, if I stick to one question, maybe I'll make it for you here, Yaki. You know, it just seems like great traction on SAS. For those customers that are moving to your SaaS tools, what are you seeing on usage of the different modules? Are you seeing any change in usage now that the tools are arguably easier to deploy and use?

Yeah, we see just dramatic change. We see what we call robotic value proposition. And the North Star was always what we call 10% of the effort, order of magnitude more value, and just works according to plan. We can measure everything from installation to update to remediation or ability to do threats. And the other thing, we also build the ability of our people, our professional services to support the customer is much more easy. We can provide a lot of the value of the platform with the customer almost doing nothing, you know, just very, very little in helping in terms of configuration. So it's just, completely different value proposition, literally unleashing robots to solve the problem.

Got it. Very helpful. I'll get back in queue. Thank you.

Our next question comes from the line of Hamza Fardawalla with Morgan Stanley. Please proceed with your question.

Hey, good evening. Thank you for taking my question. Yaki, I wanted to dig in a little bit more about your commentary around generative AI. I think A lot of the CIOs and CISOs that we're talking to more recently are talking about how data security and governance is a big hurdle to deploying these large language models. And I'm curious, to what extent are you starting to have conversations with customers on how they can deploy these generative AI models in a way that can prevent things like data leakage or poisoning from occurring?

I think that it's going to be a complete game changer. The reality is that we still haven't seen it completely, but just the initial release of Stoplight Co-Pilot for Business, think essentially what it does. It's mining all the data that people can access. And this is not me saying, Microsoft's saying that 90% of the access controls are excessive. You don't need them. So you have this tools that leverage large language models that are going and mining massive amounts of data, creating in tremendous rates high-value information products that are completely out of policy. So now think about it, if I take your credentials and 90% of the data you can access is not relevant for you, and you have these AI tools that are extremely sophisticated that creating these highly a valuable data. I just think that very soon what you will see is that organizations understand that they need to make sure that they have access control and data auditing and classification in place in order to make sure they can realize productivity gains and avoid disaster. So this is something that we're starting to see that customers are talking about it you know, that all the customers are talking about it. And I really believe that Voronis is the foundation to make sure that you can, that you will be able to use this AI-based product.

Thank you.

Our next question comes from the line of Matt Hedberg with RBC Capital. Please proceed with your question.

Well, thanks, guys. Congrats on the results, and we send our thoughts and prayers to all the Burroughs employees around the globe and Israel. Yaki, maybe as a follow-up to Hamza's question, I think in the prepared remarks you said you don't expect to sell a separate Gen AI SKU at this point. I'm curious, could that change in the future? And then maybe secondarily, as you're having these initial conversations with customers, how do you think it could impact deal sizes longer term?

So definitely it can change. If you think what we are doing with REI, one thing is that you can use the product with just natural language, which means that you don't need to learn syntax, which is tremendous. The second thing, really, if you look at the metadata that we are collecting, we are the only company in the world that has this metadata what we called a data-oriented threat detection and response and you can take a regular i.t person and he has now have the assistant to be world-class threat detection a threat detection person but with time maybe we'll monetize it but it's for us the the best way to monetize it is to sell the platform and this is really answering the other part of your question. Initial deals is great, but I really think that the way that we can grow ARR within our customer base, I think that it's significant and what we are seeing now is just the people of the iceberg. We're starting to have stability in the overall transition to completely different usage, able to leverage the unique data that we have to have AI being the foundation for really the digital world to make sure that can be prepared and benefit AI in a secure way. And then we'll decide if we are going to monetize this model. But at this point, we want to make sure that we have so much to sell to our customer that it will be very easy for them to use it and to gain value.

Thanks, Yaki. Our next question comes from the line of Brian Ethics with JP Morgan.

Please proceed with your question.

Hi, good afternoon. Thank you for taking the question, and our thoughts are with you and your families in Israel as well. I just wanted to dig in a little bit towards maybe for Yaki, what you're seeing in the pipeline, particularly with regard to previous commentary reflecting elongated sales cycles and the impact of deals in flight as you or as those customers assessed moving to SaaS instead of term. Maybe if you can help us understand the impact in the quarter and how much visibility into the pipeline, what was growth like and how much confidence that gives you into your ability to execute in the last quarter of the year here?

We see very healthy pipeline across the board. And the other thing that we're starting to see is that organizations understand that data protection is inevitable. it's actually your first frontier and your last freezer. If you don't protect data, it will never be protected. And if everything else that you're doing will fail, it's the only thing that will save you. And I also think that many organizations didn't attack it head on because it was hard to do. And with the robotic value proposition that we are building, they understand that they can do it. And if you look at really enterprise projects, they can gain immediate time to value and ongoing value in a completely automated way. So I just think that I'm spending a lot of time with customers these days, and I definitely see that people understand that they need sophisticated data security platforms, and the only way that they can do it is automation, and we are very well positioned to take this budget.

Our next question comes from the line of Joel Fishbein with Truist.

Please proceed with your question.

Thanks for taking my question, and I'm also thoughts and prayers with all of you. I wanted to just follow up on these new SEC reporting rules, and if you are seeing it, your customer is starting to ask questions about them, and also is that a potential driver to your pipeline and new business?

It's definitely a potential driver. What we see all around is that people understand that they need to protect data. I think that in the last few years, organizations spend a fortune on security and a lot of them get, you know, not such great return on investment. You have a lot, a lot of security on the perimeter. And at the end of the day, if you will dissect the most breaches, or they are happening from an insider that is a user, or someone stole a credential and acting like a user, and really inflicting the damage on the data store. Attacks can come from anywhere and any device, but only going in one direction. And it's the data that essentially, you know, the most valuable assets that most organizations have, and the most vulnerable ones. So the SEC regulation is just another one, just inevitable. You want to have cybersecurity, you need to protect data. So this is really where we are and what we see, and definitely every regulation is helping.

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

Great. Thanks for taking the question, and congrats on another very strong quarter of SAS adoption. I don't think investors should be too surprised to see Varonis outperforming on a transition timeline. But just given the success you're seeing with SaaS and the meaningful outperformance on mixed expectations and conversions, any update to how you're thinking about the timing of phase two of the transition? And why not lean further into a more active plan to convert existing customers? Thanks.

I think that question can be broken into two. One is the overall timeline, and the second part is phase two. When we think about kind of the overall timeline, I think with a 5% SAS increase versus last quarter, you know, when you think about that math and kind of the way it extrapolates going forward, it definitely makes sense to reconsider our timeline, and that's something that we talked about last quarter, that we would revisit our guidance for that at year end. And we plan to do that. I think overall, when you think about the transition, it's moving very fast. We're very happy to have 15% of our ARR coming from SAS in just three quarters. It's happening fast because our customers and our sales force are adopting it very, very positively. So we definitely look forward to providing more color on that part in our next earning call. In terms of phase two, When you think about kind of the conversion of the installed base, and that's how we define phase two, it hasn't begun yet. But we are increasing the number that we expect in terms of conversion in Q4 to 12 million. And that's going up from 10 million that we guided last quarter. And when you think about the Q3 number, we actually came in at 10 million, which is a really high number as you think about it. And it's very positive, but still a very small percentage of our existing customer base. So as much as we're seeing very strong adoption that's happening in a natural way, we haven't prioritized it yet, but we plan to do that next year. So I think overall, as we look at the progression of the transition, it's been really positive, and we hope to continue to move in that pace going forward.

Thanks, Guy.

Our next question comes from the line of Andrew Nowinski with Wells Fargo.

Please proceed with your question.

OK, thank you for taking that question. I think last quarter your guidance was for SAS to account for about 45% of that new and upsell business because of the expected contribution from the US federal deals. So I guess given how much higher SAS was relative to your guidance this quarter, is it fair to assume that the Fed demand was not as strong as you expected? And if so, what happened to those deals? Thanks.

So the growth driver this quarter was overall the enterprise business. And when you look at the 59%, it was driven by the enterprise business. It's a strong reflection of how customers in the enterprise business are adopting SAS. When you look at the federal industry as a whole, we definitely see the opportunity there, but it's still small, mid-single-digit percentages out of ARR. But when we look at the opportunity, we feel very confident about our ability to grow there.

Our next question comes from the line of Fatima Baluni with Citi.

Please proceed with your question.

Thank you for taking my questions and our prayers are with you and the entire employee base in the conflict zone. You asked me a question for you, a bigger picture one, actually, you know, we've been hearing a lot about data protection, data security, posture management, and sort of all these new monikers that are coming up as well as, you know, more traditional backup and recovery vendors on the infrastructure side, talk a lot about the importance of data protection and data recovery. I wanted to get your perspective on how you are interfacing with buyers as a buying psychology changes around data protection. I wanted to get your sense of how those conversations are changing for you, if at all, and if these sort of quote-unquote changes in the competitive landscape are benefiting you in a way, in providing a spotlight to what you've been saying all along with respect to the importance of data protection.

I think that we just don't see the backup and business continuity in data protection. We are much more on data security. But people understand that they need to protect valuable data. Regarding posture management and all of this stuff, I think that the organization understands very well that this is the first time that we are benefiting from other people doing marketing. And in order to solve the problem, you really need these three use cases and you need the metadata and something that is very hard to do. And everything really eventually, in order to solve the problem, you need to be under one umbrella of the data security platform. You think it's most breaches, people are doing this lateral movement between a data store and you need to enrich the data. So you definitely see that the marketplace understand that they need one big platform. You need to be able to classify in one place and then all repository to do it at scale, to have the profile of our people and identity are using data and to be able to do remediation in a very reliable, automated way. So we definitely see that everything that is happening in the ecosystem benefiting us, and we are, you know, very excited to have a tailwind from the marketing that other vendors do.

Our next question comes from the line of Chad Bennett with Craig Hallam.

Please proceed with your questions.

Great. Thanks for taking my question. So just on, I know it's early, but just in terms of kind of the type of customer converting from on-prem subscription to SaaS, I think you've talked before about that 25% to 30% uplift, and I think you gave a couple examples on the call already, but is there any commonality in terms of where the on-prem subscription customer is in their license journey when they're converting? And are you seeing significant cross-sell upsell on that conversion from a license standpoint? Or is the hope, obviously, like a lot of conversion stories, that once you get them to SaaS, like for like product, that whole cross-sell upsell just becomes easier and kind of accelerated?

I think that's a very good question. I'll start by saying that the SaaS offering is so much better for our customers, but it's a no-brainer for them. And we're seeing that with the amount of conversions that are happening in a natural way. When conversions happen, we can get an uplift in the number of licenses that they buy because we're selling the platform. They don't have the opportunity to buy individual licenses. We can get an uplift in the fact that the number of users goes up, and we can get an uplift in their ability to consume more of the product. It really depends on the situation of the customer, where they are in terms of the renewal, whether they want to speed it up or wait for the actual renewal date to come to place. So it's very individual, but at the end of the day, once we get them to the SaaS offering, their ability to see value, And the simplicity of the usage of the product gives us a tremendous opportunity to continue to sell them more and more licenses. So I would say there's no one straight answer on how it happens. But at the end of the day, it just works in our favor to get them to SaaS with good confidence in our pricing methodology as we see it so far.

Our next question comes from the line of Rob Owens with Piper Sandler.

Please proceed with your question.

Great. Thank you for taking my question. I was curious if you could comment on just what the channel response has been regarding the move to SaaS, and are you getting the breadth of channel participation that you would hope in new transactions? Thanks.

Yeah, you know, it's the channel reaction is usually just saying direct correlation to the customer reaction. So definitely they understand that it's much easier to sell. And it requires significantly less professional services, and this is something that they will need to adapt to. The whole thing of this platform is tremendous automation, but we're definitely getting a lot of help with the channel to take this platform to market.

Our next question comes from the line of Jason Adder with William Blair.

Please proceed with your question.

Yeah. Hi, guys. I wanted to ask you on first a clarification. You said a 12% headwind to revenue growth in Q3, I believe. That's 12 percentage points, correct?

Correct.

Okay. And then just on the kind of following up on the channel question, Can you remind us how you go to market, how much is direct, how much is indirect? And then where are you seeing the most success right now in terms of finding new customers?

So we sell 100% through channel, but our outside sales force really does all the heavy lifting of doing the risk assessment, talking to the customers, explaining where the risks are. So the channel helps us in getting the meetings. And they help us in closing the deal. But all the hard work in between is done by our outside sales force. When we look at the opportunity with our SAS offering, it opens up new markets. It opens up new territories. It opens up new industries to basically new customer opportunities that we didn't have before. And all of the reception that we have to date received on the SAS offering has been positive. And we expect that to continue as we kind of really went through the toughest part of the transition, kind of clearing through the pipeline and now introducing every new customer with a quote that is SaaS only and not really on-prem subscription as we had in the past. So I think overall, we're very well positioned to take advantage of that opportunity going forward.

Our next question comes from the line of Joseph Gallo with Jefferies.

Please proceed with your question.

Hey, guys. Thanks for the question, and appreciate the AI commentary. You guys have a large M365 footprint. Can you just give us an updated size and growth profile of that business? And then maybe just to be clear, given the rollout of Copilot this week, does your existing solution capture that opportunity now, or is it more just that you guys are perfectly positioned to capture that opportunity long-term? Thanks.

Regarding the product, in terms of preparing an organization for AI, it's already here. So just the basic value proposition. Understand what data is critical. Make sure that only the right people can access the right data. Alert and stop any abnormal behavior. It's the basics. Without it, you can't use it in a secure way. And this is 100% us.

Just to touch on the first part of the question, when we look at the Office 365, Office 365 contribution, it's definitely become a significant tailwind for us going forward. But if you go back to our investor day in March, we actually showed in one of the slides there that our penetration within the overall 365 opportunity was at the time in March, it was 1%. Hasn't grown too much since then. So when you think about the opportunity going forward, There's so much for us to capitalize on, and we see the reception of our customers very positive when we sell that license.

Our next question comes from the line of Rudy Kessinger with DA Davidson.

Please proceed with your questions. Hey, great.

Thanks for taking my question. Guy, what was SAS as a percentage of the mix if you exclude federal in Q3? And then just how much higher is federal as a percentage of new and upsell ARR in Q3 relative to Q4 and the other quarters?

So like I said before, the actual driver this quarter was the enterprise business. And that's really what drove the 59%. To remind you, we're not FedRAMP certified yet. So we didn't have SAS sales that were sold under the federal business, but we do expect to have FedRAMP for next year's cycle, which can become a significant opportunity for us. And when you think at the overall opportunity from a new business and an upsell in that market, we fit like a glove to that type of use case. The amount of malicious actors that have happened only in the last couple of months has been tremendous. And our product fits there very, very nicely. And we feel that we can capitalize on that opportunity and grow our ARR coming from that industry going forward.

Our next question comes from the line of Joshua Tilton with Wolf Research. Please proceed with your question.

Hey guys, thanks for sneaking me in, and I'll just say my thoughts and prayers with your employees and just all the people of Israel. I'm actually going to sneak in two and a half questions really quickly. My first question is just, how should we think about the implied Q4 net new ARR seasonality, and are the macro impacts baked into 4Q worse than they were a quarter ago? And on the AI front, which is my second question, Why won't Microsoft offer these capabilities? And if so, do you expect this to bring you into more competition with them going forward?

So in terms of Microsoft, you know, we are the only company in the world today that taking three streams of metadata, the permissions, the content, and the activity to build these robots for tribe-sized access. So we need to build completely different type of solutions in order to do that. So I just think that we can, for a long time, leverage remote and maintain a tremendous competitive advantage in this space.

And when we kind of think about the guidance, our philosophy hasn't changed. So we're definitely thinking about the guidance in the same way that we've talked about it throughout the year. I think in terms of where we are In Q3, we definitely saw things stabilize compared to previous quarters, and that's a good sign for us. But our assumptions in terms of guidance have stayed the same, and we think that we are set up well for having our large Q4 in terms of seasonality. We don't see any change compared to the on-prem subscription. should be the largest quarter. Q4 should continue to be the largest quarter of the year as it has been in previous years. Obviously, from a revenue recognition perspective, it does change because it's ratable. But you've heard me talk millions of times about the fact that ARR, free cash flow, and ARR contribution margins are the right metrics for this transition. And especially in Q4, they should be viewed as the leading indicators of the business.

Our next question comes from the line of Shelby Serafi with FBN Securities. Please proceed with your question.

Yes, thank you. So your headcount really was flattish in terms of growth in Q1 and Q2, and it looks like it grew around 50, which is a decent pace for the first time in like a year. So my question is, is this a sign that the environment is better for you? You talked about deal scrutiny, et cetera, but at least is it better and therefore you're hiring more? And relate to this, talk about your headcount growth expectations going forward.

We know how to do this transition. And it was very important for us when we did it just to be focused on just the right moving parts to make sure that it will work. We definitely see just more stability in the transitions. And despite of the economic headwinds, we definitely see that there is just, you know, inevitable demand for data security. This is something that the organizations need. And we have A lot of pipeline in what we can do in terms of a roadmap of features and products. We have a massive total available market, so we need to cover it with a sales force and make sure that our customers succeed and we keep building the organization. So, you know, the business is performing and we are investing against a massive opportunity.

And if you go back to our last quarter's earning call, you could hear in the commentary that we talked about the fact that we're hiring. So obviously, the fact that we grew the headcount was part of our planning. We want to continue to increase the headcount, but we obviously want to do it in the right way. And we want to make sure that we generate increased productivity. And I think we can do that going forward. So it's a balancing act of increasing headcount at the right pace, in the right positions, in the right locations, but also improving our leverage as we have done when you look at kind of the fact that the ARR contribution margin is now 11.1%, an increase of 750 basis points year over year, which is pretty significant.

Our next question comes from the line of Srinik Kothari with Robert W. Baird. Please proceed with your question.

Hey, thanks for taking my question. Again, thoughts and prayers to our entire team out there. Just a follow-up to the previous Microsoft question. You mentioned the tailwinds and the growth runway in implementing the access controls and governing policies. And there was a previous question on the competitive advantage versus Microsoft as well. Just trying to understand, of course, as the significance of data security rises, as you just pointed out, and especially in the realm of generative AI, which where you're anticipating kind of more traction, particularly for data access governance. Is it the right way to think that we're on this kind of focusing on a comprehensive data protection platform? including data security, access control, governance, versus what Microsoft is offering, just kind of more narrow kind of DLP, and this urgency around data security, and of course, with respect to the data protection tailwinds, like, is this the competitive advantage that you guys have, and is that the right way to think about the competitive dynamic? From your perspective, I have a quick follow-up there as well.

Yeah, it's It's essentially completely different. You know, what we're just giving you automated outcomes regarding, you know, this access control classification and threat detection. We have very little features that overlap and a lot of very good synergy to work with the way that they can label for DLP, as you mentioned, and other stuff. And, you know, but it's different. We actually... you know, work very well with them, and we have a very good partnership regarding generative AI, which is the foundation, the building blocks. If you want to use generative AI in the right way and not to introduce a lot of risk and can end up in disaster, you need to use our solution to make sure that, you know, you're ready. So this is, except of all the AI features that We can deliver using technologies with large language models. We are the foundation to make sure that businesses can use it in order to extract value from the data.

Our next question comes from the line of Hugh Cunningham with TD Cowen.

Please proceed with your question.

Hey, guys. Thank you for taking my call. And, you know, I'll echo that. You know, everyone here on our team, our thoughts and prayers are with you and your families, your friends, and your coworkers there for Otis. Thank you. I do have two quick ones. The first one is the 25% to 30% uplift that we're talking about, that's just on pricing of subscription versus SaaS. That doesn't include any assumptions that you mentioned before, more licenses, users go up, anything like that.

Apples to apples only, so yes.

Okay, and then these conversions of existing customers, are these taking place at the end of their existing contracts? What I'm trying to figure out here is if when you quote a number, 10 or 12 million, that number includes a sort of accelerated recognition or the initial period in that subscription. Is that right?

No. That relates only to the deals within the quarter. Okay. Our next question comes from the line of Brian Colley with Stevens.

Please proceed with your question.

Hi, guys. Thanks for taking my question here. Can you talk about how the SaaS platform has impacted the pipeline for new logos, you know, as well as sales cycles for those new customers. I'm just curious if you're seeing an acceleration in new logo ads or, you know, sales cycles.

So I can tell you when we look at the new customer ad, we've definitely seen positive signs this quarter. And I think that as we look at our ability to sell SaaS to new customers, As I said in one of my previous answers before, it opens up opportunities that we didn't have before with the on-prem subscription. So I think overall, the signs that we're seeing are healthy and positive and definitely gives us the ability to show value. I said before, we're kind of past the challenging part of the transition where we have to clean, quote unquote, clean through the pipeline where Some of the quotes were introduced to customers in the past as on-prem subscription. Now we're just starting with the SAS as part of the quote, and it's been very well received by customers because the value of the RSAS product is much greater than the on-prem subscription.

That's the end of our Q&A session. I'd like to hand it back to management for closing remarks.

Thanks for your interest in Varonis. Look forward to meeting you all at our conferences this quarter.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.