OneSpan Inc. (OSPN) Q1 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. This is your conference operator. At this time, I would like to welcome everyone to the OneSpan First Quarter 2019 Earnings Conference call. [Operator instructions] Thank you. I would now like to turn the call over to Joe Maxa, Director of Investor Relations. You may begin your conference.

Thank you, Laurie. Hello, everyone, and thank you for joining the OneSpan first-quarter 2019 earnings conference call. My name is Joe Maxa and I am the Director of Investor Relations. This call is being broadcast over the Internet and can be accessed on the Investor Relations section of OneSpan's website at investors.onespan.com. With me on the call today and speaking first will be Scott Clements, OneSpan's Chief Executive Officer. Also on the call is Mark Hoyt, our Chief Financial Officer. This afternoon after market closed, OneSpan issued a press release announcing results for our first-quarter 2019. To access a copy of the press release and other information, please visit our website. Following our prepared comments today, we will open the call for questions. Please note that statements made during this conference call that relate to future plans, events or performance including the guidance for full-year 2019, are forward looking statements. We have tried to identify these statements by using words such as believes, anticipates, plans, expects, projects and similar words and these statements involve risks and uncertainties and are based on current expectations. Consequently, actual results could differ materially from the expectations expressed in these forward-looking statement. I direct your attention to today's press release and the company's filing with the US Securities and Exchange Commission for a discussion of such risks and uncertainties in this regard. Information regarding the names of OneSpan's directors, director nominees and executive officers is set forth in OneSpan's proxy statement for 2019 Annual Meeting of Shareholders to be held on June 12, 2019 as filed with the US Securities and Exchange Commission on April 26, 2019. Please note that certain financial measures that may be discussed on the call are expressed on a non-GAAP basis and have been adjusted from a related GAAP financial measure. We have provided an explanation and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in the earnings press release. In addition, note that the date of this conference call is May 7, 2019. Any forward-looking statements and related assumptions are made as of this date. Except as expressly required by the federal securities laws, we undertake no obligation to update these statements as a result of this new information for future events or for any other reason. At this time, I will turn the call over to Scott.

Thanks so very much, Joe. Good afternoon, everyone. I'm pleased to have the opportunity to speak with all of you today. First-quarter revenue for our company met our overall plan of 5% growth with hardware growing at a robust 39%. European financial institutions focused their investments on hardware in order to provide strong authentication to their full customer base by the September deadline for compliance with Payment Services Directive two or PSD2. Hardware orders in the quarter were more than double the same period of 2018 and we now expect hardware revenue to grow modestly for the full year. As we expected, software license revenue declined in the first quarter of 2019 after an extremely strong first quarter of 2018 and as the North American e-signature business shifts away from software licenses toward subscriptions. Mobile security suite first quarter revenue declined year over year after a record first quarter of 2018. Mobile security suite license revenue varies from quarter-to-quarter and first-quarter 2019 results were within the normal range of quarter-to-quarter variation. We expect mobile security software license revenue to return to double-digit growth over the balance of 2019, based on a strong opportunity pipeline. Subscription revenue grew 77% in the first quarter, driven by OneSpan sign and Dealflo. OneSpan's total recurring revenue consisting of subscription and maintenance grew 36% year-over-year and accounted for a record 31% of total revenue in the quarter, up from 24% in the first quarter of last year. The higher than trend line mix of hardware revenue suppressed our gross margin and profitability in the first quarter and we'll continue to impact margins in the second quarter though on a materially higher level, total revenue level. We expect profitability to improve over the course of 2019 on higher revenues and increasing revenue contribution from software and services. Now I'd like to take a moment to speak a little bit more about PSD2 and the broader regulatory environment's impact on our business. First PSD2 requires multi-factor customer authentication to access payment accounts and dynamic transaction data-specific authentication to make online payments in both consumer and commercial banking. As a result, banks are upgrading all their non-compliant authentication methods, as well as providing authentication to previously unprotected customers. The short timeline to the compliance date in September, drove high demand for hardware authenticators in Q1. Second, PSD2 requires the application of transaction-based risk analysis as provided by our new risk analytics offering that was officially launched in the first quarter. The risk analytics solution uses machine learning to help financial institutions evaluate transaction and customer risk and real-time, in order to support step-up authentication use cases and respond to evolving attack vectors better than older static rules-based approaches. A risk analytics solution also helps organizations comply with GDPR requirements for protecting the personal data and privacy of EU citizens. Third, PSD2 requires mobile applications to be protected against cloning and to operate inside a secure execution environment as supported by our mobile security suite. We expect this requirement to result in positive impacts on our mobile security sales in 2019 and forward. Finally, there is a growing global trend to increase protections for consumers and support digital commerce, which has influenced and continues to shape regulatory developments in North America, Asia, Latin America and other regions in ways that are positive for our business. For example, the Hong Kong Monetary Authority is calling for identity verification and biometric authentication for digital account opening, as well as adopting a risk-based approach to customer due diligence. In Mexico, regulators are moving to require that banks prove the authentication of transactions or face potential liability for fraud losses. And in Singapore, the Monetary Authority has provided guidance that is best satisfied with real-time fraud monitoring using risk analysis. These are examples of where we believe our emerging solutions are a great match for the regulatory requirements. The confidence our customers have in us to help them meet complex regulatory requirements demonstrates our deep and lasting relationships, which will benefit the growth of our mobile and cloud software and service offerings in the coming years. The long-term drivers of demand for our trusted identity solutions remain intact. These include the evolving threat environment, increasing use of mobile devices, new regulations that encourage digital commerce and protect consumers, and aggressive competition among digital financial service providers. This battle for banking consumers is being waged based on the quality of the user experience, which demands that financial institutions provide low or no friction transparent security, like the kind delivered by our intelligent adaptive authentication and risk analytics offerings, which will soon be joined by our innovative secure agreement automation and enhanced e-signature capabilities. Our secure agreement automation offering combines identity verification, e-signature and security capabilities into an integrated solution designed to reduce costly false positives and consumer abandonment rates that commonly are in excess of 65%. The customer experience has also improved by transparently addressing regulatory and security requirements. This solution builds on the technologies that we acquired and OneSpan's Dealflo transaction in 2018. We have a growing number of TID production and pilot deployments and an expanding pipeline of global opportunities, consistent with our expectations for 2019. I'll now turn the call over to Mark to provide some financial details about the quarter, and then I'll come back to provide a few additional comments and guidance before we open the call to questions. Mark?

Thank you, Scott. Total revenue for the first quarter of 2019 grew 5% year over year to $47.6 million. Product and license revenue declined 5% to $31.9 million and services and other revenue grew 32% to $15.7 million. As discussed previously, hardware revenue grew a strong 39% year over year, primarily driven by European customers. Subscription revenue grew 77% year over year. OneSpan sign grew in excess of 20% and Dealflo increased sequentially in line with our expectatons. Software license revenue declined 53% year over year. As we discussed in our prior calls, our North American e-signature customers are now primarily deploying solutions in the cloud through a recurring revenue model. This shift from on-premise license led to an expected year-over-year decline in new license revenue in the quarter. We also saw a decline in our mobile security software license revenue, as Scott discussed earlier. Maintenance, support and other revenue increased 21% to $9.7 million. Professional services revenue declined 16% to $800,000. Moving to gross margin. For the first quarter of 2019, we had 66% gross margin, compared to 65% in the fourth quarter of last year and 76% in the first quarter of 2018. The year-over-year decline in gross margin percentage was primarily due to lower software license sales and the increase in cloud-based infrastructure cost related to our new solutions that we discussed last quarter. Operating expenses for the first quarter of 2019 were $37 million, an increase of 12% from $33 million reported in Q1 of last year. The year-over-year increase was largely driven by investments in R&D and the acquisition of Dealflo. We expect the growth rate of operating expenses to moderate over the balance of the year, well below the rate of revenue growth. Adjusted EBITDA or adjusted earnings before interest, taxes, depreciation, amortization, long-term incentive compensation and non-recurring items, was negative $2.2 million, $8.3 million lower than the first quarter of 2018. Adjusted EBITDA margin was negative 5%, compared to a positive 13% in the first quarter of 2018 with the difference, primarily driven by lower license sales. GAAP loss per share was $0.14 in the first quarter of 2019, compared to earnings per share of $0.04 in the first quarter of 2018. Non-GAAP loss per share, which excludes long-term incentive comp, amortization, non-recurring items and the impact of tax adjustments, was $0.07 for the first quarter of 2019, compared to non-GAAP earnings of $0.12 per share in the first quarter of last year. Geographically, our revenue mix for the first quarter included 54% from EMEA, 27% from the Americas and 19% from Asia-Pac region. This compares to the 40%, 35% and 25% in the same regions last Q1 respectively. Moving to the balance sheet. We have admitted a new ERP system during the quarter, which had a short-term effect on our accounts receivable and accounts payable balances. We do expect these balances to trend toward typical levels in Q2. We ended the quarter with $95 million in cash, cash equivalents and short-term investments, compared to $99 million at the end of 2018 and $166 million at the end of Q1 last year. The acquisition of Dealflo accounted for majority of the year-over-year balance. Scott, the meeting is back to you.

Okay. Thanks, Mark. A few wrap-up items here. According to a recent ISMG survey of 150 banking executives from leading financial institutions, 93% reported that improving the customer experience with new methods of authentication is one of their top spending priorities along with increased investment and adaptive authentication technologies, biometrics and machine learning based risk analytics. With our hardware bookings on to a strong start in 2019, a solid opportunity pipeline for our software and service solutions and the upcoming release of our e-signature, I'm sorry, a secure agreement automation and qualified e-signature offerings, we anticipate solid growth and increasing profitability over the balance of 2019. As such, we affirm our full-year 2019 revenue and adjusted EBITDA guidance with revenue expected to be in the range of $229 million to $237 million and adjusted EBITDA expected to be in the range of $22 million to $27 million. Before I open the call to questions, I want to highlight an announcement that we made today of two new nominations to our board of directors, Marc Boroditsky is the senior vice president of sales at Twilio and formerly president and CEO at Authy pior to its acquisition by Twilio. He had significant commercial and product experience in cloud and cybersecurity technologies. Also being nominated is Dr. Marc Zenner who is a former managing director and a global co-head of corporate finance advisory at JP Morgan. He has extensive investment banking and capital markets experience along with a distinguished academic background at the University of Carolina Chapel Hill, Kenan-Flagler Business School. Both candidates bring a wealth of experience that complements the strengths of our existing board members and we expect them to make important contributions to our business strategy to our capital allocation policy and to our acquisition program. With that, Mark and I will be happy to take your questions at this time.

[Operator instructions] We have a question from the line of Catharine Trebnick from Dougherty. Please ask your question.

Hi. Thanks for taking my question. Mine has to do with this persistent headwind your -- that you used to have with the license revenue down 53% year over year and subscription up, which is positive 40 -- 77% year over year. How long do you think this headwind will be around? And any other details you can provide us around that? Thank you.

Sure. Sure, Catharine. How are you? Nice to hear from you. Yeah, we started really talking about this actually in the third quarter last year that we were expecting for a few quarters this headwind on license to exist driven really by the shift that's taking place in our e-signature product line. And we reminded about, I think from a reported fourth quarter and of course that is now here in the first quarter. And that's really related to a very, very strong set of license orders, three very large projects that booked in the first quarter of 2018. The first quarter of 2019 which we just completed, is really the last quarter of that type of a headwind. I think we have a little license revenue or we had a little bit of license revenue for e-signature in the second quarter of '19 -- but at '18, but it's much lower than it was in the first quarter. So Q1 is really the final quarter where we would expect to see that.

All right. Thanks. And then the other question is, you have several new products that you're launching. So how long do you think it will take you to generate from marketing to sales to generate revenue for some of the new launches? Is that a six-month, nine-month type of process, 12 months?

Yeah. As you know I think in large institutions, the buying cycles and the implementation cycles can be quite long. These solutions are being delivered over a period of time. We really first launched the adaptive authentication solution in the third quarter of last year. We do actually already have some customers and deployments are deployed in production on that product. We have a number of others who are in the pilot phase for that product. The same can be said for the risk analytics offering. We have a number of customers who are in the pilot phase on that. And then in both of those, we have good opportunity pipelines and customer engagements that are happening really in every region of the world. The new products which are really just coming out at risk analytics was in the first quarter and the Agreement Automation coming out here in the second quarter, as well as some new qualified electronic capabilities for e-signature. Those latter two, I think would actually move forward probably more quickly than the first two. Our goal and our objective has been and continues to be for 2019 that we will have revenue from these new products in 2019. We have set modest expectations for that revenue. We have, we continue to see growth in some of our existing business areas, but we do, we do want and we do expect to see revenue contribution in 2019 from these new products and we expect that to accelerate that in 2020 as we engage with increasingly larger customers for these new products and as we deliver enhanced versions and new features for these products.

Your next question comes from the line of Anja Soderstrom from Sidoti & Co. Your line is now open.

So just wanted to follow-up with a, -- Christina's question about the software headwinds. Just to confirm that those are sort of left behind now in the first quarter and we shouldn't see much more of that going forward.

Yes, I think that's right. We had -- if we go back and we look at the first quarter of '18, it was extremely strong as I mentioned for OneSpan sign. It was also actually a very, very strong quarter for the mobile security suite. It was easily the highest quarter of 2018 in terms of mobile security suite revenue. So we do expect certainly more favorable comparisons if we do it into Q2 and forward. And so we do believe that the majority of that is behind us and we should start to see license, better license performance in Q2, Q3, Q4.

And then, as we talk about the hardware products that came in a little bit higher I guess. Was that a surprise to you or had you anticipated this with this new regulations coming or, and it feels like it's going to be a little bit elevated continuing as you were expecting a modest growth in for the full year rather than a slight decline. So how should we think about that?

Yes. So I think first of all, let me just say that the long-term view that we have of the hardware business declining modestly overtime, is still the case. That is still our planning assumption. I think we did expect to see significant opportunity PSD2 driven hardware opportunity this year. I think the amount of that that hit in the first quarter was probably more than we expected. I thought it would be a little more spread out over, certainly over the first couple of quarters in terms of the order patterns, but I think that a lot of institutions are really regarding, as far as authentication is concerned, they are regarding the September deadline as a pretty hard deadline and they want to meet that. We really weren't sure whether they would treat it frankly, as a hard deadline or a little bit of a softer deadline that they could be maybe a little bit past deadline to become compliant. In any event a lot of institutions really appeared to have decided that it's a hard deadline that they want to meet. And so when you sort of looked at the timeline between when an order of the hardware happens, the time it takes for us to manufacture it, ship it, get it in the inventory, deploy it to the bank's customers and all of that that kind of pushes you into the summertime, pretty getting -- pretty close to the September period. So I think it was a lot of institutions just really felt like they in order to get this done in time that Q1 was the time to get the orders at. So we do expect to see on a revenue base, a very strong second quarter for hardware as well as we did actually maybe stronger revenue in the second quarter than we even saw in the first quarter. But then as we go into the third quarter and the fourth quarter, we do expect that to start to taper off and we'll probably be back as we look into the second half of the year toward more of the longer-term trend line of decline in the hardware business. I would say one additional factor I want to point you here on the -- maybe the medium term is that, we are also coming to the end of life period for hardware devices that we sold in years 2013, '14 and '15. Some of you who have been around a little longer will remember those years as pretty good years from a hardware point of view. And so all of that hardware, those things generally have a five-year or six-year battery life and so we're getting into that period where we know that our customers -- we're already talking to our customers about replacements for those devices that we sold five years, six years ago. So I think when we -- as we go into 2020 and forward, we're going to start to see some benefit from that and I think that's why we think that will sort of moderate maybe the pace of decline in the hardware and the hardware business to something that's like what we have -- not projecting and talking about for a long time. Nevertheless, I think hardware probably will be up a little bit this year and then probably start to decline again at a more gradual rate in 2020. But we will be smarter about that I think when we get into the second half of this year.

So you think those reorders are going to happen this year then and not the next year?

No, I think the reorders for the devices from a few years ago, those really won't start in earnest until next year and in 2021. So I don't think the...

But you still think hardware is going to be down next year even though you see this reorders may be coming in?

That's our best guess right now, because those will -- there's no deadline, specific deadline for that kind of replacement like there is for PSD2. So we would expect that to [indiscernible] slowly over time.

Your next question comes from the line of Matthew Galinko from National Securities. Please ask your question.

Hey, good afternoon. Thanks for taking a couple of questions from me. Maybe the first being just -- I guess a follow-up to that conversation around the reorders. It was pretty interesting 2015. Was there anything in kind of the prior deployment cycle that accelerated the refresh or is there something different about what -- how you're thinking about 2020, 2021 that would cause a different pace of refresh than you saw?

Well, I wasn't around back then, so I'll do my best. Okay? I don't know exactly what the pattern was back in 2013 and '14, but these devices, of course, are not all going to run a battery fail at the same time, right. They will they will happen over time. Some customers will make a decision that they want to just do a, proactively do a replacement of the existing tokens that are with their customers. So I think some Japanese banks for example, are likely to do that. Some others will take a view that they will maybe replace more gradually as devices, as the battery went out and different devices. So we don't know exactly what that pattern is going to look like, but I'm talking about the reorders related to something that happened really over a three-year period. So I don't, I would not necessarily expect that to happen, to repeat in kind of a two-year period. I think it will probably play out maybe it's a similar timeline. The other thing that I think to remember here is that some proportion of those hardware tokens will be replaced by mobile security tokens in mobile security suite over that time. I don't, I think it will still, the replacement of those hardware devices will, a majority of them will be replaced by new hardware devices. But some portion of that will shift probably to mobile security suite. So we do want to keep that in mind as well.

Got it. Thank you. And then maybe just an accounting question on the license decline in the mobile security business, if that, if you had recognized the quarter under 605, can you say or do you have a sense of whether that would have been a higher number on the license line than what was reported under 606?

Yes, this is Mark. Thank you for dusting off 605. I thought we buried it in Q4 of last year. But you're asking if the MSS license revenue that we saw in Q1, what would that have been, what would that look like under 605 versus 606?

Correct, yes.

Yes. So we're on an apples-to-apples basis under 606 or 606. So as we compare these two, I'd like to use the same metrics for both. So it would not have impacted the, it would not have impacted the delta between the two years.

Between 2017 and 2018, 606 was positive with this license revenue. So the first quarter was, I don't remember how much, but it was helped to some degree Q1, 2018. It was held to some degree by the change to 606. But as Mark said, now comparing Q1 '19 to Q1 '18, it should be apples-to-apples.

Okay. Yes, I don't think we'll ever forget 605 though. But okay, well you know what I'll leave it there. Thanks for the, thanks for the clarification.

We have a follow-up question from the line of Anja Soderstrom from Sidoti & Co. Your line is now open.

Yes, hi. I just had a question regarding your guidance, since you're maintaining it for the full year even though it came in a little bit softer for, in terms of margins for this quarter and the revenue was sort of I guess, in line. How should we think about the rest of the year in terms of the guidance and margins and the hardware affecting the margins or is the software going to come in stronger and make up for that or?

Yeah. I'll take a crack at it, and maybe Mark will have some additional comments. I would think about it this way. When we constructed the plan, we constructed the plan, and that plan I think had a revenue number for the first quarter almost exactly equal to the one that we delivered. It did assume a lower mix of hardware, higher mix of software and that. So I think that the margins in the quarter coming in a little bit lower than we would have expected. On the other hand, when we looked at the full year, what we see happening is that the way that we had laid out the plan, we expected hardware to maybe be a little stronger in the latter part of the year and less so on the first part. We've really now shifted hardware forward in the year. So -- and that has a negative impact in the first quarter, but actually has a positive impact when we start to look at Q3 and Q4 when it comes to the gross margin rate of the business. So I think we expect to see hardware revenue moderate as I described a little bit earlier as we go through the year, well into the second half really if this Q2 will still be strong. But we do expect the software and services part of the company to grow quite nicely over Q2, Q3 and Q4. So we will see an improved mix and higher margins certainly in the second half, maybe in Q2 we'll see, depending on or based on this growth that software and services and a moderation in terms of hardware revenue.

[Operator instructions] There are no further questions at this time. Speakers, you may continue.

OK. Well thank you very much everyone for joining us today. Thank you for your questions. I know we'll be talking to many of you over the coming days and I look forward to taking your questions and talking more about OneSpan. Thanks again. I wish you all a good afternoon and evening.

This concludes today's conference call. Thank you everyone for your participation. You may now disconnect.