Earnings Transcript for SCWX - Q3 Fiscal Year 2024

Operator: Good morning, everyone. My name is Bruno, and I'll be your conference call operator today. At this time, I would like to welcome everyone to the Secureworks Third Quarter Fiscal 2024 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. A supplemental slide presentation to accompany the prepared remarks can be found on the company's website. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] At this time, I would like to turn the call over to Kevin Toomey, SecureWorks' Vice President of Investor Relations. Mr. Toomey, you may begin your conference.

Kevin Toomey: Thank you, operator. Good morning, and welcome to Secureworks' third quarter fiscal 2024 earnings call. Joining me today are Wendy Thomas, our Chief Executive Officer; and Alpana Wegner, our Chief Financial Officer. During this call, unless otherwise indicated, we will reference non-GAAP financial measures. You will find the reconciliations between these GAAP and non-GAAP measures in the press release and presentation posted on our website earlier today. Finally, I'd like to remind you that all statements made during this call that relate to future results and events are forward-looking statements based on current expectations. Actual results and events could differ materially from those projected due to a number of risks and uncertainties, which are discussed in our press release, web deck and SEC filings, which you can also find on the Investor Relations website at investors.secureworks.com. We assume no obligation to update our forward-looking statements. With that, I'll turn the call over to Secureworks' CEO, Wendy Thomas.

Wendy Thomas: Thank you, Kevin, and welcome, everyone. I'm pleased to share that our Taegis business continued to yield industry-leading results in 3Q, with Taegis revenue expanding 41% year-over-year to over $67 million in the quarter. Taegis annual recurring revenue or ARR now stands at $279 million, a 25% growth over last year. In the context of this growth, we recently were recognized as having the largest market share of cloud-native XDR at 32% as published in the IDC Worldwide Cloud-Native XDR Marketshare report this quarter. And we are delivering on our drive to profitability, with a sequential improvement in adjusted EBITDA, narrowing our loss to $1 million in 3Q with a clear path to breakeven next quarter. In the third quarter, we also advanced across several priorities. We accelerated expansion of our platform features and capabilities to provide superior security outcomes for customers and partners, added key partners to the Taegis ecosystem, broadening our reach and expanding our addressable market, and reinforced our market leadership role with new recognition in the marketplace for our platform and solutions. In fact, we are one of only two providers in the leader quadrant in the recent Forrester Wave

Alpana Wegner: Thanks, Wendy. Good morning, everyone. I'm pleased we delivered against our financial commitments in the third quarter and the progress we've made on our path to profitability and cash flow generation. I'll start with the highlights of our Q3 financial results, and then I will provide expectations for the remainder of the year. Total revenue for the quarter was $89.4 million, slightly above the midpoint of our guidance of $88 million to $90 million. Total revenue continues to be impacted by the wind-down of our other MSS business. Taegis subscription revenue was $67.3 million, up 1% sequentially and 41% year-over-year, in line with our expectation. Taegis ARR increased 25% year-over-year to $278.7 million, now representing 92% of our total ARR. Average revenue per Taegis customer expanded sequentially to $139,000, driven by higher new logo ARPC and continued expansion of spend by our existing customers. Taegis ARPC remains a premium to both the industry average and to our historical other MSS average, underscoring the value that Taegis provides our customers. Non-GAAP Taegis gross margin expanded 200 basis points sequentially to 72.7% this quarter, and showed an improvement of 510 basis points versus third quarter a year ago, demonstrating the scale opportunity within the Taegis business. As Wendy shared earlier, our unique cloud architecture allows us to improve our operational efficiency to drive Taegis margin expansion by using automation, investment in AI and machine learning. Adjusted EBITDA loss was $1.2 million compared to a $17.2 million loss in the prior-year period, reflecting the expansion of gross margin within our Taegis business I just discussed, as well as the benefit of the restructuring activities from earlier this year. Turning to the balance sheet and capital allocation. We ended the third quarter with a strong balance sheet with $58.1 million in cash, no debt and an undrawn credit facility. We used $4.5 million of cash from operations compared with $26.8 million used in the prior-year period, which primarily reflects decrease in our net loss and the timing of working capital. Now turning to our guidance. Before I go through a detailed guidance, I'd like to provide some commentary on what is shaping our full year outlook for Taegis ARR. First, we continue to experience a challenging macro environment that is leading to elongated sales cycles. We don't see any evidence of this changing in the near term. And second, we are not expecting the same magnitude of fourth quarter budget flush that we've seen historically. For the full year, we now expect Taegis ARR to end at $280 million or greater. We continue to expect other MSS ARR to represent 5% or less of total ARR. And we expect Taegis revenue to end between $264 million to $266 million and a total revenue between $363 million to $365 million, reflecting the continued wind-down of our other MSS business with an expected end of life in first quarter of next fiscal year. Our outlook on profitability has slightly improved, taking into consideration our Q3 results. We now expect for the full year Taegis gross margins to be greater than 71%. With Q4 margins remaining relatively flat to the third quarter, we expect adjusted EBITDA to be between negative $31 million to $33 million with Q4 adjusted EBITDA of breakeven to slightly positive. We expect full year non-GAAP EPS loss to between $0.33 to $0.35. And we continue to expect net cash used in operating activities to be between $70 million and $80 million and CapEx of $6 million to $8 million. In terms of fiscal 2025, we will provide guidance for Q1 and the full year on our Q4 earnings call in March. In closing, we remain confident in the ability to drive sustainable profitable growth based on the progress we've made in building a strong partner ecosystem, the customer outcomes from the investments in our unique Taegis XDR platform, the continued opportunity for scale, driven by our cloud architecture and the upcoming end of life of our other MSS business. Thank you for joining us on the call today. Wendy will now rejoin us, as we begin Q&A. Operator, can you please introduce the first question?

Operator: Sure. [Operator Instructions] Our first question comes from Mike Cikos from Needham. Mike, your line is now open.

Mike Cikos: Hey, guys. You have Mike Cikos here, and thanks for taking the questions. I did just want to follow up since I know Alpana just went through the guidance considerations here and I know you're -- we have this revised ARR guidance for Taegis with respect to the elongated sales cycles and the now -- we're expecting not a similar budget flush to previous years. Like, can you help us unpack those two items as far as inputs for the ARR guide? How much is coming from the elongated sales cycles versus the reduced budget flush expectations? And really, if you could also qualify that sales cycle elongation we're seeing, is that even on a sequential basis or is it more of a year-to-year comment?

Wendy Thomas: Sure. Good morning, Mike. Thanks for the questions. So let me break those two apart for you. In terms of the elongated sales cycles, that continues to be up versus last year, not a material change sequentially from 2Q. So the majority for us is looking as we head into the fourth quarter, not seeing the normal sort of seasonal shift in pipelines as we come in from the normal kind of budget flush. I think that's just related to the continued caution around making investments. Right, these are multi-year investments in security and it's important, and the additional layers of review and approval to make sure that those decisions that lock them in are good ones. And that's just the piece that we see along with not getting to kind of use your budget this year, it's kind of more lose it than use it in the fourth quarter.

Mike Cikos: Got it. And I did just want to come back to the comment as well. I believe Wendy, in the prepared remarks, and correct me if I'm wrong on go to market, but more than 90% of global Taegis new logo business in the quarter was driven from quarters -- from partners, I'm sorry versus 40% last year. And I just wanted to make sure I'm interpreting that correctly. The Taegis customer count, I think, has been relatively stable, around 2,000 customers now for the last four quarters. And I'm trying to just figure out, does it take time for those new logos to show up in the customer count? Or how is -- I guess, when can we expect broader market traction with Taegis, just given that customer count for Taegis has been relatively stable for, I guess, a year now?

Wendy Thomas: Sure. So part of our partner go-to-market strategy is going to market with managed security partners. And as I talked about, we continue to sign larger, high profile partners in that space because they see the efficacy of the platform. But currently in our customer counts, we only count those partners, no matter how many end customers they add as one customer in our accounts. So, we have highlighted the expansion in average revenue per customer. So, as you saw, that was $139,000 versus -- up from 135-or-so last quarter. And that's why we measure both of those is because that's an important measure of market traction that isn't necessarily reflected in the way we report our customer counts today.

Alpana Wegner: Yeah. And Mike, this is Alpana. One other thing I might just add. The logo count also don't -- as Wendy said, don't give us the reflection from an overall sort of scale. And one of the other things that we do look to is endpoint. And I would say that, what we see sequentially there, quarter-over-quarter is growth, again just underscoring the expansion may not be able to be seen through the logo count, but we are -- we're pleased with the progress that we're making.

Mike Cikos: Got it. Thank you. Thank you both for qualifying that last comment. Thank you.

Wendy Thomas: Thanks, Mike.

Operator: [Operator Instructions] Our next question comes from Hamza Fodderwala from Morgan Stanley. Hamza, your line is now open.

Matt Saltzman: Great. Thanks. This is Matt Saltzman on for Hamza. So I know you mentioned that the Q4 pipeline might be a little bit lighter, just since you're not expecting that same level of budget flush this year. But could you talk a little bit about pipeline early into fiscal '25? I know you're not ready to formally guide yet, but how are demand trends looking as the pipeline builds for next year? And anything we should be thinking about in terms of demand dynamics that you're seeing in the market today? Thanks.

Wendy Thomas: Sure. Thanks, Matt. Good morning. We absolutely see the total pipeline remaining healthy. What we didn't see was the kind of pull into fourth quarter that we typically see around trying to take advantage of end of year budgets. So that's one thing for us. The other is that for our go-to-market shift here, the increasing mix from partners is also pretty important. What we see around other things of kind of the pace of the win rates on sort of technical approvals and win rates on proof of value or proof of concepts remain steady. So, it's just that same sort of cautious multi-layered assessment of things and not the rush to buy inside of that pipeline that we may have seen in years past.

Matt Saltzman: Got it. And maybe if I could just ask a quick follow-up just around go-to-market orientation being more skewed towards partners now. Do you feel that maybe, things might actually not be as -- I guess, maybe there aren't as many headwinds in Q4 as you would usually expect, but maybe there's just less visibility because you're going through that partner channel?

Wendy Thomas: In terms of the pipeline?

Matt Saltzman: Yeah. Just in terms of customer spend intention since a lot of those engagements are happening at the partner level now. Perhaps, there is just lower visibility and things may not actually be that bad or kind of -- I guess, to ask a better question, how do you think about assessing the demand environment when more of the go-to-market is going, via external sources?

Wendy Thomas: So, it's a good question. And we have been cautious in terms of learning the win rates and cycle times with relatively new partnerships. So, there's certainly a learning curve that we're on there in terms of predictability. We do engage with those deals and have some amount of visibility into the pipeline from deal registration and such, but it is true. It is a different motion, and therefore our sort of range of outcomes on that can be a little more dispersed than it was when we were a pure direct model a couple of years ago.

Matt Saltzman: Got it. Thank you.

Operator: Our next question comes from Tal Liani from Bank of America. Tal, your line is now open.

Unidentified Participant: Hi, team. You have Madeline on for Tal this morning. Just one quick one for me. I just want to go back to the budget flush commentary. If we look across cyber peers over the last year budget flush, the lack of the 4Q budget flush also happened last year. And some would argue to a bigger extent because it was definitely more unexpected last year. I feel like though, given the macro environment that we've been in over the last 12 months and potentially even more, budget flush was -- the lack of budget flush was expected, right, we thought last year. So I guess I just want to understand why it's new for just you guys this year, or why maybe the impact is greater for you this year versus peers who aren't feeling the same. Thanks.

Alpana Wegner: Yes. Good morning, Madeline. This is Alpana. Thanks for the question. I would say that for us, it was more in our commentary is really around the change in the guide. Last year in Q4, we did see a good amount of budget flush come through. You can see sequentially when you look from Q3 to Q4 last year, we had a nice quarter from an ARR growth perspective. And really the commentary was just around when we set our guide last quarter, we had some expectations, not the same level as last year, but we did think we'd see some. And so, the revised view is really as we move through Q3 and as we've looked at the pipeline and the demand that we're seeing, while there's a lot of good activity and good discussions with prospects and we're seeing those sales cycles in the demand holding. We didn't see that natural increase, albeit at a lower level than last year that we were expecting when we had previously set our guide.

Unidentified Participant: Got it. Thank you.

Operator: We currently have no further questions. So I would like to hand the call back to Kevin Toomey for closing remarks. Kevin, please go ahead.

Kevin Toomey: Okay, thank you. That wraps the Q&A and today's call. A replay of this webcast will be available on our Investor Relations page at secureworks.com along with our supplemental web deck with additional financial tables. Thanks again for joining us today.

Operator: Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines. Thank you.