Varonis: Good Progress On The Transition To SaaS

Thesis

In my March post, I had been concerned that Varonis's (NASDAQ:VRNS) stock would come under pressure as investors shied away from it due to the company's dismal near-term outlook in terms of growth and declining gross margin. This is especially true in FY23, when the transition will have the greatest impact on ARR for VRNS and the company prints much lower than expected ARR growth. Now that 1Q23 results are out, I think we may be in the first innings of a strong inflection, as early transition progress was positive and SaaS mix accounted for a decent portion of new business and upsell ARR. As a result, management raised FY23 SaaS mix and ARR guidance, which, in my opinion, is probably conservative given that it implies ARR growth will decelerate despite an increased pipeline in 2Q23. I believe this conservative guidance reflect the uncertain macro environment in the coming quarters, which gives management some breathing room to beat expectations. All in all, I am encouraged by the transition progress, particularly in light of the macro headwind. Despite the macro headwinds, I am heartened by the current state of the transition. I still believe that moving VRNS to SaaS will have positive long-term effects, such as improved unit economics, shortened sales cycles, quicker deployment, etc. However, I'd like to see a few more reports before concluding that the transition is proceeding smoothly and the positive trend is not an outlier. I reiterate my hold rating recommendation on VRNS stock.

Shift to SaaS is ongoing well

VRNS's performance in 1Q23 was encouraging in light of the company's move to SaaS, as it showed strong early adoption and a higher-than-anticipated SaaS mix of new business and upsell ARR (37% vs. the guided 15%). In addition to exceeding expectations, I appreciate that management provided insightful qualitative updates about how the company's SaaS solution has reached 80% feature parity with on-prem and how the remaining 20% will be completed in the coming quarters. The fact that management has pointed out that SaaS provides customers with better value, lowers the friction to adoption as VRNS host the solution now, and enables VRNS to enjoy more operating leverage on its IT cost, in my opinion, the most important takeaways. I believe these factors were collectively well received by the market as the share price reacted positively - trending up, post the earnings. The update of 2Q23 and FY23 guidance, now assuming a 35% SaaS mix of new business and upsell ARR, was also a positive message sent to the market. In addition to a smoother transition, VRNS's first-quarter ARR contribution margin increased by 150 basis points to 5.6%, a figure that I believe reflects the company's ability to generate incremental margin as a result of its shift toward a higher proportion of SaaS revenue. This further solidifies my conviction that the change will improve unit economics.

Guidance

The midpoint increase of $6 million in VRNS's ARR guidance for FY23 indicates year-over-year growth of 12.7%. As the company undergoes a period of transition in which traditional metrics of success, such as revenue and profitability, become less relevant, I believe that ARR is a crucial metric for VRNS. Given that VRNS has strong momentum in the transition (as seen in 1Q23), I think there is a chance that the company will be able to beat its guidance. Although, it is true that ARR slowed to 18.2% y/y. It may be too soon to tell how well the company will adapt to SaaS, but early reports on the health of the pipeline and interest from early adopters are encouraging. Sales teams are being encouraged by management to introduce SaaS solutions whenever possible to push ahead the transition. The obvious financial impact from this transition is that SaaS has the potential to increase attachment rates and price points. Therefore, I anticipate a future inflection in ARR growth as a result of SaaS adoption. In addition, I think the guidance reflects a number of headwinds, such as increased oversight of government budgets, elongated sales cycles, and higher unemployment, among other factors. In my opinion, management is making a macro call that is no better than a random guess. If the economy improves, I anticipate hearing management increase guidance as performance exceeds expectations. I think the consensus will see through the conservative guide and revise their estimates upwards even if they don't raise guidance.

Conclusion

VRNS 1Q23 results indicate that the company's transition to a SaaS model is progressing well. The early adoption and higher-than-anticipated SaaS mix of new business and upsell ARR demonstrate strong momentum in the transition. Importantly, the increase in ARR contribution margin further supports the belief that the shift to SaaS will improve unit economics for VRNS. While the guidance for FY23 reflects a conservative stance due to uncertain macroeconomic factors, I believe the company has the potential to exceed expectations and beat its guidance. That said, I maintain a hold rating recommendation on VRNS stock as I would like to see more updates to ensure the transition proceeds smoothly and the positive trend is sustained.