Investment overview
I wrote about Varonis Systems (NASDAQ:VRNS) previously (16 Feb 2024) with a buy rating as management to show strong execution on the SaaS transition and that the growth outlook got better with the deal with Microsoft. I continue to recommend a buy rating for VRNS as the SaaS transition came even better than expected, with the expected completion date now pulled forward by 1 year. The new MDDR product should well support growth over the mid-term, and the demand for AI should positively impact VRNS in the long run.
1Q24 earnings (announced on 6th May 2024)
VRNS saw revenue of $114 million (6% y/y growth), and this trended towards the high end of guidance for $111–$115 million and also slightly above consensus estimate of $113.6 million. As expected, the SaaS transition continues to be a headwind to growth (900 bps headwind in this quarter), but has been significantly toned down from the 1600 bps headwind in 4Q23. By segment, subscription revenue grew 8% to $90 million, while maintenance & services were down 1% to $24 million. Moving down the P&L, non-GAAP gross margin came in at 83.3% due to headwinds from the transition to SaaS, and operating expenses saw an increase of 9% to $106 million. That said, non-GAAP EBIT came in above guidance at -$10.6 million. From a non-GAAP EBIT margin perspective, VRNS saw a -9.3% margin, which, if adjusted for the SaaS transition headwind of 800 bps, a like-for-like non-GAAP EBIT margin should come in at around -1.3%.
The SaaS transition remains solidly on track.
The focus for VRNS remains on how well it executes the SaaS transition. Encouragingly, it has gone very well (the timeline to completion has been pulled forward by 1 full year), and management has disclosed SaaS revenue for the first time at $34 million, representing 38% of total subscription revenue, with term license subscriptions comprising the remaining $65 million. In my opinion, the better way to assess the SaaS business is by looking at ARR growth, and VRNS did not disappoint. ARR grew ~7x to $168 million in 1Q24, now representing 30% of total ARR. Even more positively, SaaS is evidently margin accretive, as ARR contribution margin improved to 13.7% vs. 13.4% last quarter and 5.6% in 1Q23.
My outlook for the SaaS transition remains positive, as customer feedback has been good, supporting the idea that the SaaS product is just a much more superior product. Another evidence of this is the 90% decrease (mentioned in the JPM TMT conference) in support tickets among migrated customers, which I see as an indication that customers are satisfied with the product.
The bigger implication for this transition is that it has huge long-term financial benefits.
- Shorter sales cycle, which means lower customer acquisition costs, making the customer lifetime value [CLTV] to customer acquisition cost [CAC] economics much more attractive. Using the same marketing budget, VRNS could acquire more customers.
- Higher retention rate as this is a much better product, which means higher CLTV as customers stay longer. This also expands the opportunities for VRNS to up-sell more products.
- Higher pricing (potential pricing uplift of 25–30%, also mentioned in the JPM TMT conference), which should flow through down to the bottom line at a high incremental margin.
MDDR supports positive growth outlook
The new product, MDDR (managed data detection and response), introduced in 1Q24, should support growth as well. MDDR is a service to monitor and protect critical data on its SaaS platform that has been well received by both prospective and existing customers. Firstly, it helps VRNS accelerate its SaaS transition, as customers will get more discounts on MDDR if they commit to more SaaS licenses. It also drives overall higher revenue, which is positive for growth (remember, the friction to migrate customers to SaaS is the reason for net dollar-based retention dropping to 107% in FY23). Secondly, MDDR solidifies VRNS offerings, enabling it to capture customers that previously it couldn’t (more growth opportunities). I believe that this new product should continue to garner a lot of demand interest as there is an increasing trend of ransomware attacks, and VRNS’s MDDR product has shown assurance against ransomware attacks in less than 30 minutes—a very strong value proposition.
Demand for AI to drive long-term growth
Lastly, I continue to believe that demand for AI will drive long-term growth. The problem with adopting AI today is that it exposes enterprises to greater risks, particularly with regard to data exposure. This is where VRNS value propositions shine (Microsoft Copilot has come up in nearly every customer conversation), and I believe VRNS is well positioned to take advantage of this trend given its partnership with Microsoft (which automatically integrates with Purview), which is now in the top 8% of Microsoft partners on the marketplace.
Valuation
May Investing Ideas
Based on my research and analysis, my expected target price for VRNS is ~$67.
- My view for FY24 growth remains the same at 8%, but I have adjusted FY25 growth upwards from mid-teen percentage expectations to high-teens as I recognized the potential of the new MDDR product. Looking further out into FY26, I assumed growth would recover back to mid-20% as this was where VRNS was growing at pre-covid.
- Over the past few months, VRNS forward revenue multiple has derated slightly from 9x to 8x today. I believe this was due to the industry multiple getting downgraded from an average of around 8x to 7x. Note: I derived an estimated industry multiple by compiling other cybersecurity peers such as Palo Alto Network, Zscaler, Qualys, Fortinet, SentinelOne, Tenable Holdings, and Rapidy7. I expect VRNS to trade back to 9x forward revenue (where it was trading previously), as the business outlook has not deteriorated since my last write-up. In fact, I believe it has gotten better.
Risk
The positive traction seen in the new MDDR product may not be representative of a trend since VRNS might just be capturing the low-hanging fruits. There is also the risk of management messing up the execution of the SaaS transition, which I believe is a key focus of the market. Now that management has guided the earlier completion of the transition, if they go back on their words, it would hurt management’s creditability too. Aside from creditability, the impact of a delay in the SaaS transition is huge because it would mean further delay in growth inflection (remember that the SaaS transition is a growth headwind), and slower growth would also mean a longer timeline for operating margins to expand. Consensus is expecting VRNS to turn positive on non-GAAP operating margins in FY24; as such, any delay here will likely lead to consensus downgrading their estimates.
Conclusion
I give a buy rating for VRNS as it continues to execute the SaaS transition well, with faster completion timeline. The new MDDR product adds another growth driver and strengthens VRNS’s overall cybersecurity offering. While the valuation multiple has compressed recently, I believe the improved business outlook justifies a return to its previous valuation levels.
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