Allot Ltd. (ALLT) Q1 2018 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to Allot's First Quarter 2018 Results Conference Call [Operator Instructions]. As a reminder, this conference is being recorded. You should have all received by now the company's press release. If you have not received it, please contact Allot's Investor Relations team at GK Investor and Public Relations at 1-646-688-3559 or view it in the News section of the company's website, www.allot.com. I would now like to hand over the call to Mr. Gavriel Frohwein of GK Investor Relations. Mr. Frohwein, would you like to begin, please?

Thank you, operator. Welcome to Allot's First Quarter 2018 Conference Call. I'd like to welcome all of you to the conference call and thank Allot's management for hosting this call. With us on the call today are Mr. Erez Antebi, President and CEO; and Mr. Alberto Sessa, CFO. Erez will summarize the key highlights; followed by Alberto, who will review Allot's financial performance of the quarter. We will then open the call for the question-and-answer session. Before we start, I'd like point out that this conference call may contain projections or other forward-looking statements regarding future events or future performance of the company. These statements are only predictions and Allot cannot guarantee that they will, in fact, occur. Allot does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including as a result of changing market trends, reduced demand or the competitive nature of the security system industry as well as other risks identified in the documents filed by the company with the Securities and Exchange Commission. And with that, I will now hand the call over to Erez. Erez, please go ahead.

Thank you, Gavriel. I'd like to welcome all of you to our conference call, and thank you for joining us today. Our revenues in the first quarter of 2018 were $21.7 million, up 18% from that of the first quarter 2017. In addition, our book-to-bill was greater than one for the fifth quarter in a row. While Alberto will later go through our results in detail, I wanted to start with these because I believe they show that we are executing on our plan to return Allot to growth. During this quarter, we saw revenue growth and pipeline growth across both security and DPI segments. The operational changes we made last year, such as reorganizing our sales and customer success departments into customer facing units, or CFUs, changes in management at various levels and changes in internal processes are working. We are seeing new operator wins and an increased pipeline of opportunities across the different market segments, product lines and geographies. I will start with a few words on the visibility and control domain, another market in which our pipeline is growing. While the traditional DPI market is stable, as I shared with you previously, Allot is addressing today the growing use cases in which we are investing efforts. As a reminder, these include: smart traffic steering to effectively handle congestion or reduce connectivity costs; regulatory compliance to allow governments to block malicious or illegal sites, like the U.K. government is requiring of UK's CSPs; quality of experience where CSPs can understand what the real user experience is on the network, even on encrypted traffic such as YouTube or Netflix; and analytics to enable the CSPs to get significant detail and actionable analytics on their network to properly plan network build and configuration. As I said, we're seeing more opportunities and a growing pipeline in these areas. I believe, this is a result of both better execution on our part as well as the greater need from the market. Let's turn now to what we see in the security market, which as you know, is our main growth engine. In general, I can say that we are seeing more and more CSPs who understand that providing secure broadband services at a premium is something they, as operators, really need to do. I believe they understand this is a service they need to provide for two main reasons. First, it is of interest to their customer, to the mass market consumers who are increasingly worried about Internet security. And second, because their customers are willing to pay for such a service. Secured broadband connectivity is a real opportunity for revenue growth. We are seeing growing interest from operators in a wide range of security offerings to the mass market: antivirus, anti-phishing, anti- malware, parental control, IoT security and home CPE security, all of which could be provided today by the Allot Secure family. This increased level of interest was very clear at Mobile World Congress, which we attended back in February and resulted in quite a few first interactions with operators who are looking to launch a security service. I want to give you a general feel of the potential size of this market. In the OECD alone, connectivity revenues are approximately $600 billion per year. A modest increase of 5% or 7% for making this connectivity secure means an additional revenue potential of $30 billion to $40 billion for the CSPs. This means that the revenue potential for companies like Allot providing the required security technology and tools to enable the CSPs to deliver this service is in the billions of dollars. We can show that with Allot's technology and Allot's strong engagement tools, operators can reach penetration levels of 50% and even higher. This market has the potential to be huge. And Allot, with over 20 million consumers benefiting from the service today, is in a unique and leading position to provide the technology that CSPs require to deliver the service. I will remind us that our main security deals so far, Vodafone and Telefónica, were both based on sales of perpetual licenses per subscriber. We are striving to change this model with future customers and are offering OpEx-based deals. This offering is meeting positive response in most cases. Operators we talk to are looking at their approach to providing security. They are looking at this across mobile devices, fixed network and home use. Some are looking at security only when the customers are on their own network, while others are looking at a more holistic approach in protecting customers everywhere and anytime. Some are looking to provide a security service for all, while others are considering a more pointed premium offering. It proves that the market is indeed in formation mode and more operators understand that they should be a part of it. I do want to point out that our competitors in this area offer neither the breadth and depth of capabilities that Allot Secure provides nor the proven installed base and experience that Allot has. During the first quarter, we closed the acquisition of Netonomy, which we previously announced. Netonomy develops an innovative security app -- software app that can be downloaded to existing home gateways and is centrally managed. When combined with Allot's NetworkSecure, it enables fixed CSPs to extend security from within the network to the smart phone with additional security capabilities. Since the acquisition was closed, we successfully integrated Netonomy into Allot and we are now offering HomeSecure, our branding for the Netonomy software, with several new prospective customers. I expect to have the first trials of an integrated HomeSecure solution during the third quarter. Looking at the product development. We are enhancing our product capabilities and working on those things we hear from our customers that are important to them. One of the main technology trends we see with CSPs is a move to an NFV environment, where the operators will buy large and commercial off-the-shelf, or COTS, server farms themselves and install on them software for various vendors. Making our products NFV-compatible is a key development focus area for both DPI and security products. We have customers who have already ordered and NFV versions from Allot and we will have all our products NFV-compatible very soon. In summary, I can say that we see positive indications for the future. The revenue potential for CSPs offering secure broadband at a premium price could be substantial. Where security service based on Allot's technologies are offered, penetration levels grow significantly and can reach upwards to 50%. There is a growing number of CSPs showing interest and looking to offer secure broadband. And secure broadband is of interest across mobile, fixed, home and IoT segments. This is all very encouraging and indicates to me, we are heading in the right direction. Unfortunately, working with CSPs takes time and sales cycles typically exceeding 12 months. While we are advancing with the CSPs we are currently working with and starting to work with more CSPs on these exciting security offerings, it still takes a bit longer than we would like to close. Based on the results of the first quarter and the pipeline of deals we see, I would like to reiterate our guidance for the full year 2018. Looking ahead, we expect full year 2018 revenues in the $91 million to $95 million range, with the second half of 2018 better than the first half. We expect most of this growth to come from our security offerings. Furthermore, we expect our book-to-bill to be larger than 1 for the full year. I would like to add that we expect a similar double-digit rate of revenue growth to continue into 2019. Finally, I would like to summarize in a few words what I think are the key points. One, a growing number of CSPs are beginning to see the opportunity to provide security connectivity to their customers -- secure connectivity to their customers. This could create substantial revenue potential for the CSPs. Two, Allot, with our large and growing installed base and our wide product portfolio, is in a unique and strong position to capitalize on this opportunity by providing to the CSPs the software, customer engagement tools and marketing support they need. All this in an OpEx model. And three, we are delivering on our turnaround plan and have shown a return to growth and we expect to continue this growth going forward. And now, I would like to hand the call over to Alberto Sessa, our CFO. Alberto, please go ahead.

Thank you very much, Erez. Before I begin reviewing the financial results for this quarter, I would like to inform everyone that on this call, unless otherwise noted, I will refer entirely to the non-GAAP financial measure when discussing operational results, which is what we use internally to judge the performance of our business. Non-GAAP financial measure differ in certain respect from the generally accepted accounting principle and exclude share-based compensation expenses, revenue adjustment due to acquisitions, restructuring expenses, expenses related to M&A activities, amortization of certain intangible assets, change in tax-related items and change in deferred tax. And now with regard to the financial results. GAAP revenues for the first quarter of 2018 were 21.7 million, up 18% compared to $18.4 million in the first quarter of 2017. Now, I would like to give some detail regarding the revenue breakdown and the diversification. The geographic breakdown of revenues for the first quarter of 2018 was as follows: Americas was $3.8 million or 17% of revenues; EMEA with $13.4 million or 62% of revenues; and Asia-Pacific with $4.5 million or 21% of revenues. Product revenues for the quarter accounted for 60%. While service, maintenance and professional service revenues were 40%. This is compared to a 55% and 45% split in the first quarter of last year. Communication service provider, or CSP, revenue was 75% in the first quarter of 2018 compared to 77% as reported in the first quarter last year. It is important to note that revenue breakdown, whether geographically, by product segments or other may fluctuate from quarter-to-quarter depending on the specific revenues and deals recognized in the specific quarter. In terms of customer concentration, our top 10 customers made up 56% of our revenues compared to 57% in the first quarter of 2017. Book-to-bill ratio in the first quarter of 2018 was above 1 for the fifth consecutive quarter. Gross margin for the quarter was 69.6% compared to 67.5% in the first quarter of 2017, an improvement over last year. Operating expenses for the quarter were $17.5 million compared to $16.1 million as reported in the first quarter 2017. Our higher level of operating expenses in the quarter was due to a number of factors. Increase in headcounts, including the addition of some more experienced employee compared to the first quarter of 2017; the impact of the strong shekel compared with last year contributed to the increase in U.S. dollar terms because a large portion of our expenses are in shekels; and our first quarter include 2.5 months of the operating expense of Netonomy. Non-GAAP operating loss for the quarter improved to $2.3 million compared to an operating loss of $3.6 million in the first quarter of 2017. Net loss for the quarter improved to $2.5 million or $0.07 per share versus $3.6 million loss or $0.11 per share in the first quarter of 2017. Turning to the balance sheet. Our cash reserve comprised of cash, cash equivalents and investments as of March 31, 2018, totaled $104.7 million. The company recorded a negative operating cash flow of $1.1 million during the quarter. In terms of guidance, as Erez mentioned, we maintain our outlook, expecting revenue of between $91 million to $95 million for 2018, representing continued year-over-year revenue growth throughout 2018. We also expect our book-to-bill ratio to be above 1 for the year. Our OpEx in 2018 is expected to grow compared to 2017 for three main reasons. First, additional investments in R&D and marketing sales -- and marketing and sales; second, additional investment required in Netonomy for the HomeSecure products; and finally, the current level of the shekel versus the dollar increases our Israel-based costs in U.S. terms. We expect our OpEx to be in the range of $70 million to $71 million for 2018. That concludes my remarks. We would like to take questions now. Operator?

Thank you [Operator Instructions]. The first question is from Joseph Wolf of Barclays.

I have a couple of questions about the competitive landscape and your customers in the security market. There was a customer who got the Vodafone Mobile and Family Security contract. I know it was just -- it was in Czechoslovakia, but I'm just wondering how you're looking Vodafone as a partner across its regions? And if you could go through some of the -- or do you think they're looking at different approaches maybe technology-wise or application-wise, compared to Allot? And that also looked like it was a subscription deal. So -- you made a comment about subscription so I'm wondering if you could just put all that together.

Look, Vodafone is by far a major customer today for security services. And they're continuing to grow across, I think, 10 geographies that we're installed in today. As they are looking at various other alternatives, of course, as I would expect that they have to do their job and check alternatives. But I -- at this point, I still see them -- the massive growth of security services in Vodafone is with us.

And then -- and this was late last year so maybe it subsided a little bit, but there were some customer complaints about the additional -- I guess, there's a pound or euro charges for some of these security offerings and I'm wondering how you feel about that impacts. You mentioned the OpEx opportunity for Allot. Is that playing a role in terms of your customers' ability to pass-through cost and your dialogue with them about moving to a subscription-based model?

No. I don't think it's a major issue. Yes, you'll see -- I mean, if you look at the complaints levied by consumers to operators, you'll see a whole wide variety of things. And some customers complain that here they are, they're paying extra for security or something. But I don't see it as any major trend or anything that has a significant impact on either the operators' business or on ours to the best of my understanding.

And then just on the positive commentary on the book-to-bill being greater than one for the duration of the year. Just -- can you make any comments about the components of your backlog? How long it lasts? Most of the growth is coming from security. Is there a pretty good pipeline of security in the backlog? And then, I guess, if you look at the gross margin, should we be thinking about that the transition to software is what the -- is the reason for the uptick this year in the quarter, in the 1Q versus 1Q? And should we expect similar results across the year?

I need to remember what was the first question.

Comments on backlog and what's in there and gross margin implications, I guess, is the summary.

Yes, maybe, I can take this at least partially. First of all in terms of the backlog, book-to-bill is above one. We said that. We're excited to be above one for the whole year. We are not giving right now any breakdown between security -- I mean, what parts of the security. What I can say is that generally, we are able to recognize approximately, I would say, 80% of our backlog during the first 12 months. We disclosed at the beginning of the year that we started 2018 with approximately $55 million of backlog which gave us quite a good visibility for this year. In terms of the gross margin, this quarter was better than what we did actually last year. The main reason actually is because we were able to recognize order with a bigger portion of software, mainly last year. I'm sure you remember that we did recognize a significant portion of the order that was sent to Telefónica which added some impact in our margin and actually in Q1. But this portion was lower than that.

Is that going to be the trend? Or it's hard to say at this point?

It's hard to say at this point. It will be very much depending on what kind of deal will come in and what kind of deal we will be able to recognize. Again, a deal with a bigger portion of order will impact our -- negatively, our -- I'm sorry, our gross margin. So it will be very much depending on what kind of deals will come in.

The next question is from Alex Henderson of Needham & Company. Please go ahead.

This is Dan Park on for Alex. So just starting with the housekeeping item, could you just let us know what the post-quarter ending headcount was?

The headcount at the end of the quarter were 490 people.

Okay. Great. And speaking about the step-up in OpEx investments for the year, should we think about this as being back-half weighted as you've noted on prior calls? And also as a follow-up, at what point should we expect some greater operating leverage as you step down the elevated investment levels?

I think that in terms of investment, operating expenses in the second quarter will be a bit -- a little bit high…

The second half.

The second half, I'm sorry. It will be a little bit higher that the first one. Also, in terms of revenue by the way, we said that the first half would be better than…

The second half.

The second half would be better than the first one. In terms of profitability, I mean, we anticipate the operating expenses this year to be in the range of $70 million to $71 million. That will bring the company to a loss in 2018, a lower loss than we had in '19 -- in '17, I'm sorry. Regarding 2019, I think that it's a little bit too early to make any projection for that year.

I think we can say, Alberto, and we've said that the -- maybe we -- while we expect significant double-digit revenue growth into '19, we don't expect that kind of expense growth. So we'll see a lot better leverage in -- on the bottom line for '19.

And just one more, if I could. With the acquisition of Netonomy closing during the quarter, have you seen any material impact to revenues, given your flat revenue guide for full year '18?

Netonomy has no revenues and we don't expect any material revenues from -- specifically from the Netonomy software that we acquired during '18. I'm not sure what you referred to flat revenue guide. Because we've guided upwards on revenue. So maybe I didn't understand the question.

I meant, reordering your prior expectations. Sorry about that.

It's fine. We just reiterated our prior guidance.

[Operator Instructions] The next question is from [Eric Jarvis] of Jarvis Consulting.

It's actually Derek Jarvis. Question from the past I think this [previous year] but there's some [indiscernible] some years ago about that partnership with Intel and McAfee. Did anything ever come off that? Or is that fallen by the wayside?

Actually, it still exists. We have a -- maybe remind in a sentence that in order to provide a holistic security solution for customers, anywhere, anytime on any device, then we also need to solve the problem of what happens when a consumer is connecting via Wi-Fi, for example, I don't know, he's in a coffee shop or something. And then he's not going through necessarily his operator's network. So in order to enable protection in those instances as well, we require an application that needs to be downloaded to the phone that will protect him in those cases. In order to do that we partnered with McAfee and we provide, together with McAfee, a complete solution that is integrated and allows the operator to provide the same level of protection whether -- should the customer is on -- the mobile devices are on the network or off the network. So that's what we've done with McAfee. This is something that we've been offering. And I think, it's interesting to some CSPs. It's less interesting to others but we do not have any significant revenues from this at this point.

So is that something that you would envision selling through the CSPs as well?

Yes. Yes. For us, for Allot, as a strategy, we are the enabler or as if you like, the technology partner of the CSP. And we enable the CSP to offer a CSP-branded security service to their customers. So everything we do on the security, whether it's the network security part or the endpoint security, for example, with McAfee; or it's the home router security like what we acquired with, like what we bought, when we bought Netonomy; or an IoT-type security or anything else. All of this falls under the umbrella of enabling technologies that enable the operator, the CSP, to offer a CSP-branded security service to its customers.

Okay. And then what about the enterprise side? Does Netonomy play into that? Or this partnership with McAfee at all, if you're an enterprise that needs to secure your own internal network?

I think that the McAfee partnership is not relevant for the enterprise market. And the Netonomy acquisition or that software app will have very limited appeal in the enterprise market. I mean, I can think of some outlying cases, but as a general concept and market, no. Not relevant for the enterprise market.

Okay. Also, you had alluded to opening, perhaps a new R&D center outside of Israel. I think for -- not just because you needed capacity, but also to provide sort of a natural hedge for some of your cost. Is that in the numbers? Well, first of all, do you still intend to do that in -- is that in your OpEx guidance for this year?

We do intend to do that. It's in the OpEx guidance for this year. We're still investigating where to do that. The main motivation for us to do this is to enable ourselves to grow on our R&D capabilities with some minimal impact on the OpEx. Because this will be a low-cost location. So I think, we're pretty much advanced in looking at the various alternatives. But we have not yet opened this center. We do expect to do that during this year at some point. And it is in the OpEx guidance numbers.

One more, quick one here. Netonomy, was that based in Israel? And did you keep the employees? And how many of them were there?

We kept, I think, almost all of the employees. And yes, it's in Israel. It's based in Tel Aviv. I don't have the complete number so it isn't -- it was a single-digit number of employees. So under 10.

There are no further questions at this time. Mr. Antebi, would you like to make your concluding statement?

Okay. I want to thank you -- thank everybody for listening in and joining us. And I look forward to seeing you in person, and if not, on our next conference call. Thank you very much.

Thank you. This concludes the Allot First Quarter 2018 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.