Allot Ltd. (ALLT) Q2 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to Allot's Second Quarter 2019 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 at www.allot com. I would now like to hand over the call to Mr Gavirel Frohwein of GK Investor Relations. Mr Frohwein, would you like to begin, please.

Thank you, Operator. Welcome to Allot's Second Quarter 2019 Conference Call. I would like to welcome all of you to the conference call and thank a lot to the 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 our 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 to point out that this conference call may contain projections or other forward-looking statements regarding future events or the future performances coming. 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 and the competitive nature of the security systems industry as well as other risks identified in the documents filed by the company with the Securities and Exchange Commission. And with that, I would like to now hand over the call to Erez. Erez, please go ahead.

Thank you, Gavriel. Welcome everyone to our conference call, and thank you for joining us today. I would like to start with some key financial parameters for the second quarter. The second quarter was another quarter of solid growth. Our revenues grew 15% year-over-year for the second quarter, and our gross profit grew 12% year-over-year for the second quarter. This is our sixth straight quarter of double-digit growth year-over-year. I'm very pleased with the results we achieved during the second quarter, and the main message is that we are on track and successfully executing our plan. We see a growing number of opportunities, and we are continuing to close new deals, win against competition and grow our revenues. We expect this trend to continue through the second half of 2019 and beyond. While Alberto will provide more details on our financials later, I did want to start with the highlights that demonstrate our growth. I would like to turn now to discussion on our business. We are making great progress in many areas. And I would like to take this opportunity and discuss today, in a bit more detail, Allot's progress in the U.S., which has traditionally not been a strong market for Allot. Previously, we announced that we signed deals for 2 Tier 1 operators in the U.S. With one of the operators, we are providing our Allot Smart DPI product to enhance the quality of roaming services. With the other operator, we are providing our IoT secure product to protect IoT devices on their network. While processes for selection and eventually orders with CSPs in the U.S. are typically long and can stretch over 2 or more years, it is encouraging to see that we were recently selected to run several additional proofs of concept or POCs. Some of these POCs are in the security domain and some in DPI, some with an existing customer and some with new customers. While there is no guarantee that any of these POCs will result in an order, I think this demonstrates the interest in the U.S. market for Allot products, and I view it as important progress, and I'm very encouraged by it. Our progress is not limited to the U.S. Overall, we are signing new customers at a growing rate. During the first half of 2019, our bookings from new customers were 75% higher than during the first half of 2018. This is very good as it shows that we are winning new business and building a strong base for continued growth and expansion. As we work with more Tier 1 operators worldwide, we take upon ourselves additional commitments that span product development, delivery and customer support. This is the reason we are investing further in our R&D and customer success organizations. I believe this is the right thing to do as this investment enables us to fuel our growth and catch up on certain product gaps we still have. While today, the rate of growth in our expenses is similar to our rate of growth in revenues, I believe that next year the rate of growth of expenses will be lower than that of revenues. I will now discuss a bit the visibility and control domain. We are continuing to see an active market here, with a growing pipeline of opportunities for our Allot Smart product line. We see similar use cases to what we saw in previous quarters, such as smart traffic and analytics. We also see a growing need of government to curtail illegal traffic on the Internet, which results in regulations imposed on the operators who then require technologies such as ours. The type of illegal traffic targeted by these means includes, for example, child pornography and VPNs used by criminal organizations. We see a growing market here with more RFPs coming out globally. During the first half of 2019, we won several such new deals. While our main focus is on CSPs, a portion of our revenues comes from sales to the enterprise market. Two years ago, we established a customer-facing unit or CFU, focused on the worldwide enterprise market. The enterprise business is signing up new customers every quarter. During the second quarter, I am glad to note that we won our largest enterprise deal in over 2 years for a national post office network. Overall, we see a strong pipeline for our Allot Smart product line, serving the visibility and control domain and are comfortable with our continued growth in this area. I would like to now turn our attention to the security domain, which, as we stated in the past, is our main long-term growth engine. As I mentioned in previous calls, we see a growing number of CSPs who understand the need in providing secure broadband services and see value in 3 elements: one, an important an -- sorry, an important enhancement to their brand value, becoming a secure broadband provider; two, a potentially large new source of revenue; and three, a key element in their customer satisfaction. The number of RFP and RFI processes we are addressing continues to grow as well as the number of CSPs we are engaging without a formal process. This growing interest is across the breadth of the Allot Secure product family, including network secure, IoT secure, home secure, DDoS secure and the combination with our partners' endpoint secure. I would like to remind you that Allot's ability to provide protection at several locations in the network, while seamlessly providing the same service across customer location and platforms, is one of Allot's key advantages and that we see a growing number of opportunities that combine 2 or even 3 different products of the Allot Secure family. This is a strong testament that our strategy of enabling operators to provide "anywhere, any device, any threat" protection to the consumer & SMB markets is gaining acceptance. In Vodafone, our largest security customer, total number of subscribers is continuing to grow, albeit at a lower rate than before as some markets reached saturation levels. In markets where security services were launched in recent years, such as the U.K., Turkey and Germany, we are seeing healthy, consistent growth every month. Telefónica Spain, which launched the Niji security service for consumers in December of 2018, is seeing good growth. This was a service that bundled speed, capacity and security together. Recently, Telefónica launched the service in Argentina, and a similar -- services are scheduled for launch by Telefónica in Brazil later this year. For the SMB segment, Telefónica Spain launched a security service about 3 months ago. I will remind you that Telefónica Spain SMB customers enjoy network-based security provided by Allot technology together with endpoint app protection provided by McAfee. In this deal, the security revenue is shared between Telefónica Spain, Allot and McAfee. This service was launched in a "try and buy" method, and it is worth noting that the conversion rate from customers trying the service to those signing up and paying for it is in the tens of percent. This is a very -- this is very encouraging and is a testament to the appeal of security services to SMB customers. Six months ago, we announced signing a network secure revenue share deal with a Tier 1 European mobile operator. In the three months that passed, the system was installed and tested, and we expect the service to be launched very shortly. We are engaged at various stages with a large number of additional operators for more security deals on all the various elements of the Allot Secure family. And I am very encouraged by the size of our pipeline, the continuous growth in number of CSPs we are engaging and the interest within the CSPs to launch such security services for the mass market. Working with CSPs takes time, typically exceeding 12 months and often more time than we would like it to take. While we are engaging with more CSPs, we are still challenged by the time it takes to close the deals. To view this market, I look at the combination of several indicators, including: one, the initial security OPEX deals we signed; two, the growth in tenders and RFPs that are being issued; three, the healthy pipeline we have in hand; and four, the penetration rates and speed of adoption where the service is launched. Looking at all the above, I am confident that we are heading in the right direction, and I'm optimistic about this market segment and our future growth in it. As a reminder, to help us measure the potential of the aggregated security OPEX deals we sign and our progress in this area, I introduced in the previous earnings calls a metric we use internally that we call maximum annual revenue or MAR for short. MAR reflects the annual revenue Allot will receive should 100% of the CSP's relevant customer base sign up for the security service. Of course, we do not expect 100% of the operator's customers to sign up for the security service. So the actual revenues Allot will get are expected to be the MAR multiplied by whatever the penetration rates will be. Building a base of this size with operators deploying security as a service for their customers is extremely important. Upon signing the deal, we don't record bookings or revenues, but as the service is launched and penetration levels grow, a recurring long-term revenue stream is gradually built. These deals should form a base for continued and sustainable growth of Allot. I would now like to summarize the overall picture and the key messages. We are proceeding according to plan and growing the business. I believe our second quarter numbers are a testament to that. In the visibility and control area, we have a growing number of opportunities in various areas. We see long-term opportunities as operators move to NFV, as 5G networks are deployed and as government demand more regulation on Internet access. Based on the pipeline, I expect this growth to continue into 2019 and 2020. In the security area, which we see as our major long-term growth engine, we have signed initial deals for Allot Secure products, including several security OPEX deals. Our pipeline of security OPEX deals is very encouraging. It is expanding, and most operators are accepting of the OPEX or revenue share model we offer. I expect we will sign additional security OPEX deals in the second half of 2019. From a product perspective, we are progressing well on achieving advantages over our competition, such as an NFV capability. As discussed in previous calls, we are also investing more in artificial intelligence and machine learning technologies to create further technological differentiation in both visibility and control and security domains. Based on our results so far and on the growing and strong pipeline of new deals, I would like to reaffirm our expectations for 2019 revenues to be between $106 million and $110 million. We expect book to bill for the full year 2019 to be above 1. Regarding security OPEX deals, I believe we are on track towards our goal to sign security OPEX deals with an aggregate MAR of $100 million during 2019. And now I would like to hand the call over to Alberto Sessa, our CFO. Alberto, please go ahead.

Thank you, 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, expenses related to M&A activities, amortization of certain intangible assets, change in deferred tax and exchange rate differences related to the revaluation of assets and liability denominated in non-dollar currencies. With regard to the financial results. Revenues for the second quarter of 2019 were $26.6 million, growing by 15% compared with those of the second quarter 2018. Regarding the details of the revenue breakdown and diversification. The geographic breakdown of revenues for the second quarter of 2019 was as follows: Americas, with $2.3 million or 9% of revenues; EMEA, with $14.4 million or 54% of revenues; and Asia Pacific, with $9.9 million or 37% of revenues. The breakdown of revenues by type were as follows: product revenues for the quarter accounted to $16.8 million or 63% of total revenues compared to $12.8 million or 56% of total revenue in Q2 2018; professional services revenue were $2 million or 7% of total revenues compared to $2.1 million or 9% in Q2 2018; support and maintenance revenue were $7.8 million or 30% of total revenue compared to $8.1 million or 35% in Q2 2018. Communication service provider or CSP revenues were 86% in the second quarter of 2019 compared to 79% as reported in the second quarter of 2018. I note that revenue breakdown whether geographical or by product segment or other, typically fluctuates from quarter-to-quarter depending on the specific revenue and deals recognized in the specific quarter. On the second quarter of 2019, our top 10 end customer made up 71% of our revenues, and this is compared with 61% in Q2 2018. Gross margin for the quarter was 69.8% compared to 72.2% in the second quarter of 2018. Overall, while the gross margin may fluctuate from quarter-to-quarter based on the deal recognized in the specific quarter, we do expect an average of around 70% over this current full -- of this current full year period. Operating expenses for the quarter were $20.6 million compared to $17.9 million as reported in the second quarter of 2018. The increase in operating expenses is mainly due to the increase in headcount, particularly in R&D and customer success departments. The total number of full-time employees as of June 30, 2019, was 551, up 16 full-time employees since the end of the last quarter. Non-GAAP operating loss for the quarter was $2.1 million compared with an operating loss of $1.3 million in the second quarter of 2018. At the end of this quarter, we reevaluate the earnout provision for the Optenet acquisition, which we completed in 2015. This revaluation brings into account that in projecting the security OPEX deal, revenue will be recognized only when subscribers actually enjoy the service. As a result of the revaluation, a reduction in the earnout estimation of approximately $1.9 million was recorded, generating this quarter a reduction in G&A expenses for the same amount. I note that this transaction, since it is part of an M&A activity, is excluded from our non-GAAP financial statements. Net loss for the quarter amounted to $2.1 million or $0.06 per share. This is compared with $1.2 million loss or $0.04 per share in the second quarter of 2018. Turning to the balance sheet. Our cash reserve comprised of cash, cash equivalents and investment as of June 30, 2019 totaled $101.6 million compared to $101.5 million as at March 31, 2019. The number of basic shares for the second -- 3 months of 2019 was 34.2 million and the number of fully diluted shares was 36.1 million. In terms of guidance, as Erez mentioned, we are reaffirming our guidance and expect revenue to grow to between $106 million and $110 million in 2019, with the second half of the year higher than the first, representing continued year-over-year revenue growth. Due to the potential opportunities we see ahead, Allot is increasing its investments in those area that will serve the growth of the company, mainly R&D and customer success. We are recruiting more resources and a results -- and as the result of that, we expect the operating expenses for the full year 2019 to be slightly above $83 million. And that concludes my remarks. We would be happy to take your question now. Operator?

[Operator Instructions]. The first question is from Alex Henderson of Needham & Company.

So just wanted to talk a little bit about the gross margins in the quarter and the commentary for the full year. So as I understood it, the June quarter had a little bit more hardware in it than normal, and therefore, you were expecting quite a bit lower gross margins in the quarter. It came in nicely above what we'd modeled. So I'm assuming that maybe that shifted out a little bit. Is that why you're giving a little lower gross margin guidance implied in the back half of the year by the 70% for the full year?

Yes, as you mention, I mean -- and I mentioned in my -- in the -- when I said before, I mean I think that gross margin depends very much on the deals that are recognized during the quarter. So we were able this quarter to have a mix of deal that -- I mean that brought us to not have this downsize in gross margin that we did expect. We still have a few deals in our backlog, which are hardware related, probably that will be recognized in the future quarter. But overall, we are satisfied with the fact that we succeed also this quarter to keep our gross margin around the 70%, which we believe is the level of the full year.

As we look out into the following year, I assume that the percentage going out as hardware will gradually decline, is that reasonable to expect a gradual improvement in gross margins over time?

I think, yes. Look, as customers order from us more software and less hardware, either because they're going to NFV topology or they are deciding to buy their own hardware, whatever. I think that over the years, we should be -- we should see some improvement on gross margins. Although I'll admit, it's very hard to forecast these numbers accurately.

I believe you guys signed a fairly interesting contract with the guys over at Rakuten. And I was hoping you could just describe whether that had -- was a pure CapEx transaction or whether it had elements of OpEx in it given the expected ramp of that kicking in as a customer rules out there services in the fourth quarter and into 2020? How does that contract -- how is that contract structured over time? Is it all OpEx? Or it's been all CapEx? Or is there a piece that will shift to OpEx over time?

I think it's something in the middle, I would say, between OpEx and CapEx. It's mainly -- it's a CapEx deal, but it's limited in time. It's not based on the usage or subscription on a specific quarter or -- here, but it's a CapEx deal limited in time. And of course, what Rakuten bought from us, is limited to a certain number of subscriber as the deployment of network will succeed, and they will have additional subscriber. So we do -- we may expect to have additional order for software results.

If I could. So the OPEX deals, sound like they're running a little bit stronger in the pipeline. I know you haven't given the guidance beyond the $100 million MAR this year, but is it reasonable to think that given the strengthening pipeline that, that would be a low watermark for 2020? And that additional transactions would be similar or more than that in 2020? Is that -- I mean are you building enough of ahead of steam to think that way?

I think that, that's what the pipeline would show. Yes, I think we should be able to sign in 2020 deals of larger -- a larger impact or larger value, I would say, than what we'll sign in 2019.

The next question is from Marc Silk of Silk Investments.

And it's nice to see continued progress. I guess I had one quick question. When you are -- on the side of security, if your end customer -- if let's say, someone is a customer of a phone company, is that something that this is going to be added to their offering, like a package? Or it's going to be something that they're going have to buy on their own through the phone company? I'm just trying to check out like the potential penetration of your -- the product to the end user.

It depends on the go to market of the operator, right? I think that the main theme here is that this is a service offered by the operator as an operator-branded service to their customer. So they will get this from the operator, whoever their operator is. Now there are a couple of ways to do this. And one way which is what Vodafone is doing today. They tell their customers, here's a new service, you can get instead of broadband, you can get secure broadband and for that secure broadband, you, the end user customer, will be charged an additional, in this case, EUR 1 per month for the security services. Telefónica is doing in a different way, and they're bundling security with -- the security service with higher packages and with speed, and they're offering a bundle in that way. There can be operators that decide to just include it as part of their baseline service offering to customers. But at the end, if you look at the penetration rates. I think the best example is, again, Vodafone because they've been doing this for the longest time. We're seeing penetration rates that go anywhere after -- after 3 years, they go anywhere from countries that have not pushed this aggressively and are -- do not have a good go-to-market strategy. So they get penetration rates up 15%, 1-5 percent. And the countries that have been more aggressive about it, took a better go-to-market approach, are gaining penetration rates of 50%, 5-0 percent, and above. I hope that answered your question.

No, no. That gives some -- me some good clarity for the future. And the last thing is, obviously, you have basically minimal analyst coverage, although it's good coverage. And I've been in this position for -- building it for like over 4 years. My question is this -- and I think that having the big balance sheet is fantastic. But it sounds like, when I look at something like, something like CrowdStrike that's going crazy. And it's in obviously, the security space, if you're seeing that your stock is way undervalued and you see yourself really getting to sustain profitability and the stock stayed at these levels, it won't be the worst thing to use about $10 million to buy back shares. I'm not saying that's an urgent thing. But I think in the back of your mind, if you're upset with your stock prices based on what you guys see, announcing a stock buyback for a small portion of your cash on hand is not the worst thing because I think you're one of the most undervalued stocks out there on Wall Street, and that's kind of my last comment.

Okay. Thank you.

[Operator Instructions]. The next question is from Jeff Bernstein of Cowen.

So just wondering with all the controversy about network equipment from different providers being allowed into specific networks. Are people starting to look at your technology just for monitoring of equipment and making sure that there's no rogue communication going on with equipment? Is that going to be a market?

That's not a segment that we serve. Our products don't do that.

The next question is from Alex Anderson of Needham & Company.

So I wanted to go back to the comment you made on the call that the first half of the year you saw bookings that were 75% greater than your bookings in the first half of '18. I was looking back through my notes, and you made the comment after the third quarter of '18 that your bookings were 2x that of all of '17. It seems like your book to bill is not just over 1, but way over 1, could you give us a little bit more qualification around that? And what was the book to bill in the quarter per se?

Okay. So let me first correct a bit, the statement you made. What I said was that our bookings in the first half from new customers, not from -- not the total bookings, but the bookings that come from new customers in the first half were 75% larger than the bookings that came from new customers in the first half of '18. So it's not -- it's more -- in my opinion, it's more an indication that we're winning business and growing and growing in the number and value of new customers, and it's less an indication on the total bookings as such. Now we said that we think that we -- that bookings on any specific quarter are not necessarily the right indication. And like we said at the end of last year, we're going to give you our book-to-bill ratio for the year, and we're going to give you our target for the year, but we're not going to spell it out each and every quarter. So our target for the year's book to bill is over 1, and we believe that we will meet that.

Okay. Second question, the shekel has been strong. Obviously that has implications for your cost structure. Can you talk about to what extent you're hedged? To what extent that's a factor in your thinking on the OpEx outlook?

Yes. First of all, I mentioned that in previous calls, I mean we generally hedge something like six months ahead of time. The shekel had been stronger lately. But in -- I mean, up to now, we're not -- have any ink out of that. I mean because we were hedged due to the hedge structures that we did the last quarter and the quarter before. So we do not see right now any impact, as of today, in the stronger shekel. Going forward, it will be much depending on how the shekel will continue to be evaluated compared to the U.S. dollar. We do have some exposure, as we -- as you know, some of our expenses, mainly the salary expenses are here in Israel and are certainly exposed to exchange rate changes. But again, up to now, we did not suffer off this in our numbers.

Going back to you -- the competitive landscape for a second. Can you talk a little bit about what's going on with the competitors that have now merged? And whether you're gaining share against them as a result of that and picking up distribution, picking up competitive wins where the customer might not want to have ownership by a private equity firm? Can you talk a little bit about what's going on with Sandvine and Procera?

Sure. So as you know, Sandvine and Procera have merged. They're called Sandvine now, and that's our main competitor in the visibility and control domain or the DPI domain. We are winning deals against them. We are winning more deals than not against them. We are, in some cases, even replacing their installed base where they have a customer that has already Sandvine installed, and there's a refresh required or whatever, so we have won deals to actually replace their systems. And yes, we're also picking up distribution channels because in certain -- in some areas, Sandvine had one distribution partner, Procera had another distribution partner. Now that they've merged, one of them is looking for a product. And this -- and we are a very, very good candidate to do -- to fill that. So we're feeling very strong against them. And we're -- by our count, we're taking up market share from them.

Have you seen any change in their competitive response and behavior as a result of those share losses? Or is it fairly stable? How do -- how are they responding?

I don't think I can characterize an overreaching view worldwide. I think it's really more dependent on each salesperson or each region, what they -- to what degree they have suffered from us or to what degree they are seeing us or not seeing us and what -- and the result of that. But generally, we -- one of the things that we have not -- that I would say, honestly, we have not seen from them, we have not seen any, for example, significant price drop around the market. They're not -- I don't see that as any kind of general response with that -- of that sort.

We have a follow-up question from Jeff Bernstein.

Just following up on that subject. Have you seen any NFV product from them yet? And is NFV becoming a real differentiator in more deals?

NFV is definitely becoming more and more important requirement. It's -- I think with all the major operators, we have to be, if not NFV compliant today, we have to have a full commitment. We or anybody, right? Have to -- has to have a full commitment to NFV in the future, and whether it's current or future and to what degree depends on where that operator is with their own NFV plans, right? That's -- now there's some, I would say, some confusion between NFV and virtualized. Those words seem similar, but it's -- in the market, the people, sometimes, they get confused by them. Virtualized really means that -- or if you want to sort of simplify it, it really means I can run on a standard platform. And it really means that, okay, you can have a software that requests an orchestrator to bring it up, to tear it down, provide more resources, less resources and so on. The fact that we know how to run on NFV, and we're installed in several operators on NFV systems, I think that is -- and we're doing that right now. I think that's a differentiator for us, yes.

Got you. And then you talked about the differences in penetration of security products depending on the carriers go to market. And I'm wondering if you have enough experience now to really know best practices. I would guess, maybe there are cultural differences in different areas about what the best go to market is, but have you got -- have enough statistical experience to be able to go to the customer and say, "Listen, if you do it this way, you're going to be very successful, if you do it another way, you're not going to be and can impact what kind of penetration you get."

I think as the word enough is -- when you say enough experience, it's hard for me, but we definitely have a lot of experience with it and I would say, significant. And we've -- within our marketing team, we've put together a small group that is focusing on a B2C marketing for cellular operators. And that's exactly their -- is their value. When we work with an operator, we bring this team on to sit with their marketing people and tell them here is the best practices, here's what we know works, here's what we know doesn't work, here are ideas that were tried, here are ideas that were not tried, et cetera. Of course, the -- the go to market is dependent on the operator itself at the end. It's not ours to choose. It's their branded service. But we do have a group that we've recruited and built exactly -- to do exactly that, bring those best practices to bear and work with the operator so they know how to approach this better.

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

Thank you. On behalf of myself and the management of Allot, I'd like to thank you for your interest and long-term support of our business. Alberto will be in the U.S. in the next week or so, meeting with investors in Boston and New York. If you'd like to meet him, please contact our Investor Relations team. Thank you very much for joining us today, and I look forward to talking to you in the next quarter. Thank you very much.

Thank you. This concludes the Allot's Second Quarter 2019 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.