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Edited Transcript of FSCT.OQ earnings conference call or presentation 6-Nov-19 9:30pm GMT

Q3 2019 ForeScout Technologies Inc Earnings Call

CAMPBELL Nov 12, 2019 (Thomson StreetEvents) -- Edited Transcript of ForeScout Technologies Inc earnings conference call or presentation Wednesday, November 6, 2019 at 9:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christopher Harms

Forescout Technologies, Inc. - CFO

* Michael P. DeCesare

Forescout Technologies, Inc. - CEO, President & Director

* Michelle Spolver

Forescout Technologies, Inc. - Chief Communications Officer

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* Fatima Aslam Boolani

UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software

* Joshua Alexander Tilton

Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst

* Melissa A. Franchi

Morgan Stanley, Research Division - VP and Research Analyst

* Sterling Auty

JP Morgan Chase & Co, Research Division - Senior Analyst

* Walter H Pritchard

Citigroup Inc, Research Division - MD and U.S. Software Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to the Q3 2019 ForeScout Technologies Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host, Ms. Michelle Spolver, Chief Communications Officer. Please go ahead.

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Michelle Spolver, Forescout Technologies, Inc. - Chief Communications Officer [2]

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Thank you, Sarah, and thank you all for joining us on today's conference call to discuss our financial results for the third quarter of 2019 and provide guidance for the fourth quarter and full year 2019. This call is being broadcast live over the Internet and can be accessed from the Investor Relations section of our website at www.investors.forescout.com.

A few minutes ago, we issued a press release announcing our financial results for the third quarter of 2019 as well as guidance for the fourth quarter and full year 2019. The release can be found on our Investor Relations website, along with supplemental financial information that accompanies today's remarks.

Before we begin, let me remind you that we will make forward-looking statements during this call, including statements relating to the guidance and expectations for the fourth quarter and full year 2019; the market for our products, our competitive position; the use of our products by our customers, changes in the threat landscape and the security industry; the ramping and success of our sales organization and our growth profitability and the impact of the security matters and Dojo acquisitions on our market and company.

These forward-looking statements involve risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply only as of today, and we undertake no obligation to update these statements in the future. For a detailed description of risks and uncertainties, please refer to our SEC filings as well as our earnings release. Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section of our website.

Additionally, certain non-GAAP financial measures will be discussed on this call. We have provided reconciliations of these non-GAAP financial measures against the most directly comparable GAAP financial measures in the Investor Relations section of our website as well as in our earnings release.

Before I turn the call over to Mike, I'd like to mention that this quarter, we'll be presenting at the Crédit Suisse Technology Conference in Scottsdale on December 2, the Nasdaq Investor Conference in London on December 4 and the UBS Technology Conference on December 10 in New York City.

And now let me hand things over to Mike to discuss our business and provide a review of our third quarter performance.

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [3]

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Thanks, Michelle, and thanks to everyone for joining us on the call today to discuss our third quarter 2019 results. Third quarter revenue came in at $91.6 million at the high end of the range that we preannounced in October, but lower than our original guidance range communicated in August. We experienced extended sales cycles across several of our customers that pushed out deals and which did not become apparent until we entered the final days of the quarter. We do not believe that any of these deals have been lost to competitors. In fact, our win rate remained stable in Q3, we've already closed some of these deals, and we are optimistic and working hard to close others in Q4 and future quarters.

Our Q3 revenue shortfall was most pronounced in EMEA against the more challenging macroeconomic environment, where several 7-digit deals did not close as expected. However, we experienced some of the same dynamics globally, which impacted close rates. We continue to believe that we have a large market opportunity ahead of us in device visibility and control, which is becoming a more strategic priority for customers.

With 24% of the Global 2000 as customers, Forescout leads this market with differentiated technology of the world's largest enterprises and government entities view as an essential component of our robust cybersecurity posture. We have been moving from selling a single product to selling a multiproduct solution, inclusive of eyeSight, eyeControl, eyeExtend and SilentDefense. Large deals have long been a part of our business, and they continue to grow, as evidenced by the number of our $1 million-plus transactions increasing 38% year-to-date. The large deal nature of our business gives us a strong foothold within our customer base, but can have a more pronounced impact on our results, depending on the size and timing of these deals because of our historical perpetual license model.

We are taking a number of steps within our business to work on areas we can control, such as strengthening our sales execution and shaping our revenue model for better predictability. First, let me discuss our plans to increase the mix of ratable and recurring revenue within our business.

Just 18 months ago, Forescout was predominantly an appliance-based company. Our path towards becoming a subscription model with greater recurring revenue began in April 2018 when we announced Flexx licensing. This decoupled our software from the hardware to enable customers to purchase them separately. Since we announced Flexx, more and more of our deals are being sold this way, and within our third quarter, approximately 70% of our total deals were sold via Flexx.

In April, we introduced term-based licensing as an option for all of our products. In just the past 2 quarters, 15% of our total license revenue has been term based, which has increased our recurring revenue mix. And third, a key step in this journey happened today with the introduction of eyeSegment, Forescout's first SaaS and cloud-delivered product.

We are hard at work on our path towards deliver product portfolio as cloud-delivered solutions, beginning with our core product eyeSight in late 2020. To accelerate the pace of development, last month, we completed the acquisition of Dojo Labs and brought on approximately 20 of their R&D team members with tremendous cloud and machine learning expertise.

In 2020, we expect to recognize a nominal amount of eyeSegment revenue as the product begins to ramp to much larger levels in future years. And we also have plans to meaningfully accelerate term-based licensing adoption via customer and sales force incentives.

Over time, we expect these initiatives to significantly increase the amount of recurring revenue on our financial model and improve visibility into future revenue streams.

Let me now spend a few minutes on sales execution. We need sales leadership with the track record of execution at our scale, with the ability to navigate large deals spanning multiple products across all industries and regions. To accomplish this, we recently created the role of Chief Revenue Officer and appointed Steve Redman, a world-class operational leader with strong experience in scaling multibillion-dollar companies.

During the third quarter, we also brought on Burney Barker, a top-notch VP of Global accounts, to drive the teams that own our largest 100 global customers. And lastly, we recently created the role of Chief Customer Officer and promoted Jason Pishotti, to lead our customer advocacy and support group charter with nurturing and migrating our larger installed base as we add and transition to new products, including eyeSegment and future SaaS offerings.

We have also improved our processes around pipeline development and management as well as forecast accuracy, which we expect to give our team incremental structure and consistency. While both Steve and Burney are early in the stages, they are bringing a higher level of operational rigor to our sales organization. What needs to be improved in our go-to-market activities is well understood, and we now have the right team in place to execute. I assure you that the entire executive team is laser-focused on these efforts.

Most importantly, Forescout's products and technology continue to be very well positioned in the market and is resonating with customers. This is evidenced by some of our successes during the third quarter. For example, we added nearly 110 new logos across industries. We added approximately 3.9 million new devices under management. This brings total devices under management to more than 76 million. We had a strong quarter in federal with largest deal of the quarter was with the DoD under the Comply-to-Connect program. We also closed one of our largest OT deals ever and continue to have a robust pipeline in our OT business. And we saw a very strong adoption and attachment of eyeExtend, as 9 of our top 10 deals in Q3, land deals included at least 1 of our eyeExtend products. eyeExtend and our ability to integrate with security technologies across the stack are key differentiators for Forescout in the market.

Now let me quickly touch on a few of our key customer wins from the third quarter. In the financial services vertical, a new logo from Q2 significantly expanded with us in Q3, nearly tripling the devices under management to 300,000, and adding eyeExtend products for ServiceNow and Rapid7 to bring our total eyeExtend products to 5. This customer had originally expected to expand with us in a year, but was able to achieve full device visibility and classification in just a matter of days with their recent prior investments, so they decided to accelerate the phase of the next-generation of the project with us.

Within the federal government vertical, we closed our largest deal of the quarter with a branch of the Department of Defense under the Comply-to-Connect program. The 7-figure expansion deal included eyeSight, eyeControl and eyeExtend products in an environment with nearly 800,000 devices under management with Forescout. Recognizing the importance of the Comply-to-Connect program and securing their massive number of traditional IT and IoT devices as well as mission-critical devices like ICS, SCADA and combat weapon systems, the DoD reprogrammed funds from other areas of their budget to accelerate implementation. We believe Forescout's asset visibility and control capabilities are foundational to the objectives of Comply-to-Connect and anticipate closing additional deals as the program ramps.

Within our new logos, we closed 2 highly strategic OT deals with our SilentDefense product. First, 1 of the world's largest utility companies purchased SilentDefense for asset inventory and threat detection across more than 1,000 locations covering their relays, human machine interfaces and PLCs.

And second, one of the world's largest online retailers purchased our OT product for visibility and threat detection in their global fulfillment centers for OT devices ranging from conveyor belts, robots to sorting machines. Both of these deals were highly competitive wins involving a very thorough assessment of our SilentDefense product.

Innovation continues to differentiate Forescout and was key in winning all of these deals. To that end, we are very pleased to announce the general availability of eyeSegment, our first true cloud-delivered offering and making an important milestone in our company's history. We believe eyeSegment meets a unique need in the large market for network segmentation and will expand our long-term TAM. The landscape today for network segmentation consists of infrastructure-based approaches, next-generation firewall approaches and agent-based approaches for controlling network communications between connected devices, but each of these approaches only solves for one specific part of the network and doesn't provide complete enterprise-wide network segmentation.

At Forescout, we believe truly solving macro segmentation involves being able to work across a massively heterogeneous network environment. Managing these multi-vendor policies creates complexity and operational cost, resulting in a lack of confidence for organizations to move forward with network segmentation as an enterprise-wide strategy. We believe eyeSegment will change that, making segmentation easier and better.

Forescout's roots began in network access control, by taking device and network context, enabling policy-based control in an infrastructure agnostic way. What we've done with eyeSegment is to marry our device visibility and policy engine to traffic and flow information, which enables customers to design and implement policies about communication paths across users, applications, systems and devices, in an automated fashion across disparate technologies and throughout our vast partner ecosystem.

Early feedbacks from our beta program has been very promising. For example, one of our beta customers in an untrained proof-of-concept was able to identify several PHi and PCI regulated applications that are required to be on segmented servers and quickly implemented the appropriate segmentation controls to ensure proper compliance. We look forward to introducing eyeSegment to our entire installed base as many of our customers are in the midst of network segmentation projects, and these customers believe eyeSegment can play a meaningful role in their environments.

I'll share some closing remarks in a bit. But first, let me call -- turn the call over to our Chief Financial Officer, Chris Harms, to discuss the detailed financial results for our third quarter as well as our guidance for fourth quarter and the full year 2019. Chris?

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Christopher Harms, Forescout Technologies, Inc. - CFO [4]

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Thanks, Mike, and thanks to everyone for joining us on our call today. Following Mike's remarks, let me dive deeper into Forescout's third quarter 2019 financial results and our outlook for the fourth quarter and the full year 2019.

I'll begin by reminding you that except for the revenue results, which are GAAP, all financials we will speak about are non-GAAP, unless stated otherwise.

As Michelle mentioned at the start of this call, non-GAAP to GAAP reconciliations of these financials can be found in our earnings press release and supplemental financial information, both located on our Investor Relations website.

Now let me review our third quarter results. Total revenue for Q3 2019 was $91.6 million, an increase of 7% on a year-over-year basis. License revenue was $50.2 million, a decrease of 2% on a year-over-year basis. eyeSight and eyeControl reflected 71% of license revenue in aggregate.

Subscription revenue in the third quarter grew 21% year-over-year to $36.6 million. Professional services revenue in the third quarter grew 15% year-over-year to $4.8 million. Looking at Q3 revenue mix by region, the geographic mix of revenue was Americas at 78% of total revenue compared to 74% in Q3 2018, EMEA was 16% and APJ was 6% compared to 16% and 10% in Q3 2018, respectively.

Turning to our recurring revenue rate, which comprises our subscription revenue, plus the portion of our license revenue that is recurring via our term-based licensing contracts. On a trailing 12-month basis, as of September 30, 2019, our recurring revenue rate was 46% of total revenue, up from 44% as of June 30, 2019.

Moving to margins. Gross margin for Q3 2019 was 78%, a decrease of approximately 200 basis points sequentially and flat year-over-year. Margin for our license revenue was 81%, a decrease of approximately 600 basis points sequentially and approximately 100 basis points year-over-year. The margin decrease on our license revenue and the associated gross margin decrease was driven primarily by an increase in customer buying preferences during the quarter towards more deployments that utilized hardware being provided by Forescout.

Margin for our subscription revenue was 87%, an increase of approximately 100 basis points sequentially and a decrease of approximately 100 basis points year-over-year. Margin for our professional services revenue was negative 24%, an improvement of 200 basis points sequentially and approximately 1,400 basis points year-over-year.

Total operating expenses for Q3 2019 were $72.7 million, an increase of 17% year-over-year. Looking at the components of OpEx, sales and marketing expense for Q3 2019 was $44.2 million or 48% of revenue, an increase of 11% year-over-year. This reflects continuing investments in our direct and channel selling resources as well as sales engineering and sales enablement teams.

Our research and development expense was $17.5 million or 19% of revenue, an increase of 40% year-over-year, reflecting continuing investments in our development teams. General and administrative expense was $11.0 million or 12% of revenue, an increase of 11% year-over-year, reflecting additional investments in infrastructure related to being a public company.

As a reminder, the operating expenses associated with the security matter acquisition had and will have an impact on the year-over-year changes in operating expenses through the end of 2019.

We posted an operating loss for Q3 2019 of $1.4 million or 1% of revenue compared to a Q3 2018 operating income of $4.9 million or 6% of revenue. Our net loss was $0.8 million compared to net income of $5.1 million in Q3 2018.

Net loss per share for Q3 2019 was $0.02 compared to net income per share of $0.10 in Q3 2018. We ended the third quarter with total deferred revenue of approximately $176.7 million, an increase of $3.5 million sequentially. The combination of revenue plus sequential change in deferred revenue provided Q3 billings of $95.2 million, a decrease of 5% year-over-year.

Free cash flow in the third quarter was negative $16.2 million compared to negative $13.6 million in Q3 2018. Free cash flow margin was negative 18% compared to negative 16% in Q3 2018. From a cash perspective, we finished the third quarter with cash, cash equivalents and investments of nearly $94 million.

Moving to guidance. I'm going to start by providing updated ranges for both the fourth quarter and full year 2019, followed by a detailed explanation of the influencing factors within it.

For the fourth quarter 2019, we expect total revenue to be in the range of $93.5 million to $96.5 million, representing year-over-year growth of 12% at the midpoint. We expect operating loss in the range of $3.3 million to $2.3 million, and loss per share to be in the range of $0.08 to $0.06, based on approximately 47.4 million weighted shares outstanding.

For the full year 2019, we now expect total revenue to be in the range of $335 million (sic )[$339 million] to $342 million, representing year-over-year growth of 14% at the midpoint. Operating loss in the range of $37.2 million to $36.2 million, and loss per share in the range of $0.82 to $0.80, based on approximately 45.9 million weighted shares outstanding.

Since our IPO, we have attempted to appropriately balance the large deal volatility of our business into our guidance. Customers invest in Forescout with large strategic transactions, and 7-digit and 8-digit deals have been a large and meaningful part of our top line. This is both a positive as it reflects the critical and integral role that Forescout serves in our customers' cyber security fabric, and it also presents a challenge, as it manifests itself in our financial results in less predictable patterns.

In both 2017 and 2018, we closed 3 or more 8-digit strategic deals, which comprised a meaningful portion of our revenue. In comparison, we have only closed 1 8-digit deal so far this year. Our Q4 forecast previously included some 8-digit deals that though they continue to be in our pipeline are no longer expected to close during the fourth quarter due to customer environmental dynamics that elongated deal cycles and internal forecasting that we just recently learned was too aggressive. We do not believe these deals have been lost, but the team does have a higher degree of confidence in being able to close them in 2020, and we believe the prudent thing is to remove them from our current guidance.

Now I'd like to elaborate on what Mike discussed in regards to our transition to a ratable and more predictable revenue model that will reduce the volatility we are experiencing in our business. In Q2 2019, we introduced a term-based form of subscription licensing for our on-premise software products to provide our customers with an OpEx licensing option to our legacy CapEx perpetual licensing options.

2019 has been an initial launch period that we wanted to use to gain insight on customer adoption and pricing. Thus far, we haven't been incenting our customers to choose term licensing but rather priced it to be neutral to our perpetual offering. Similarly, we haven't been incenting our field to date, with commission incentives towards term licensing and have provided them equal treatment based on total contract value.

As Mike shared, in 2020, we will be taking the insights we have gained to date on term licensing adoption and executing customer and sales force incentive plans to meaningfully drive further adoption. Additionally, we will begin to drive revenue from our first SaaS offering, eyeSegment, and also releasing our core product, eyeSight, in a cloud-delivered version. In time, we will offer a broad product portfolio of cloud-delivered SaaS offerings.

We are not sharing medium-term model guidance today, but want to provide some color regarding how this will impact future revenue mix. We currently believe the recurring portion of our subscription business, which includes the SaaS offerings I just discussed, maintenance contracts and the license value of our recurring term licenses will increase from the 40% of total revenue, where it stood at the beginning of 2019, to more than half when we exit 2020. And we continue to meaningfully increase and will -- and we believe will continue to meaningfully increase in the 2 years thereafter.

This shift will dramatically improve the visibility and predictability in our financial model. On our February earnings call, we will provide our full year 2020 guidance and begin sharing with you the annual recurring revenue metric to measure our progress against the path to more recurring revenue.

While we are not giving 2020 guidance today, we would note that we do not believe our revenue growth rates in Q3 and Q4 are representative of market demand for our products and our opportunity.

With that, let me turn the call over to Mike for some closing comments. Mike?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [5]

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Thanks, Chris. Before turning the call over for Q&A, I want to close off by saying that we continue to be confident in the opportunity that lies ahead of us. The need for device visibility and control is real, and although early in its evolution, it is becoming increasingly important for organizations and solves an important problem.

The market opportunity is large, and Forescout is best positioned to win. Though our Q3 performance and Q4 outlook is disappointing to me, I'm excited about our opportunity of long-term growth runway. The largest and most sophisticated enterprise and governments in the world buy from Forescout. We have a solid plan in place now to improve what needs to be improved. My management team and I and the entire company are laser-focused on improving on our go-to-market execution, increasing the predictability of our revenue model and delivering on our Q4 commitments to help rebuild shareholder trust.

With that, I want to thank you again for joining us today for your continued support. And we will now open the call for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Melissa Franchi with Morgan Stanley.

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Melissa A. Franchi, Morgan Stanley, Research Division - VP and Research Analyst [2]

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Mike, I just wanted to dig into some of the issues that you saw in the quarter. So you mentioned some macro factors in EMEA. It sounds like there were some execution issues perhaps? And then just company-specific factors like the volatility you typically see in large deals? But just across those issues, can you just maybe put a finer point on what had more of the impact in the quarter? Or was it more company specific? Or was it more macro? And then the second related question to that is if you could just put a finer point on maybe like the 1 or 2 things that you're doing that you feel like will be the most meaningful to improve execution?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [3]

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So first of all, as far as Q3 goes, and it really was an issue -- it wasn't 1 issue. I mean, there's a category of transactions inside of this that, quite frankly, we just need to do better on. Kind of dig in deeper on making sure that we understand the situation before things get in guidance, and we are well working on our way to make sure that we deliver on that.

The other side, though, is there were some macro and customer-oriented issues, right? As we talked about in the prepared remarks, kind of saw a higher concentration in the EMEA region. Just been a little bit more difficult to get, especially larger, higher-profile deals across the finish line. And then without going into too many details, I mean, there's customers where a project sponsor leaves or something happened that caused that. So kind of when we look at this from a numbers perspective, we kind; of -- we had a good chunk of deals that were above $500,000 in our guidance, and none of those closed in -- before the 9/30 day. When we look back at that list of transactions, about 80% of those are in our guide for the fourth quarter, with about 25% of those being closed already.

If I kind of switch over to your second part, which is really around the execution side, there's obviously a lot that we're doing. We acknowledge again some of the transactions that we just need to be -- maybe we're a little bit too aggressive on putting them into guidance, and we need to do better on those. When we kind of click down on that level, that was a big part of naming Steve Redman as the Chief Revenue Officer role. Steve comes with a whole bunch of discipline and operational vigor that we think will really help this issue, not just across our top deals, but across every deal that we do in every sales rep. We were being disciplined about forecast accuracy prior, but in light of what we saw in the third quarter, we're digging in much deeper making sure that we get to every executive sponsor before things get into guidance, that type of thing. These are the natural activities that you would expect from us. And we're working on all of those things concurrently.

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Operator [4]

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Your next question comes from the line of Sterling Auty from JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [5]

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All investors that I talk to are definitely on your side in terms of the move to more recurring and definitely better visibility in terms of results, but I just want to make sure that I'm clear in understanding the term license still under ASC 606 is still going to have an upfront revenue treatment, correct? Or is there something that you can do to smooth out even the term license so you get both recurring and the visibility of the ratable?

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Christopher Harms, Forescout Technologies, Inc. - CFO [6]

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So yes, Sterling, you're correct that the license value gets recognized upfront. But if you, without getting into the technical, what most firms are doing PTC and Varonis and others, is staggering the payment terms as well as giving the customer an out to whether they do a 1-year contract or give a 3-year PO, you're basically breaking it up into 3 consecutive 1-year values or you're taking a 3-year value and you're splitting it up.

Our move towards term licensing in both a 1- and a 3-year option, it at least takes 1/3 of that value and only that first 1/3 gets recognized upfront in the first year, and that same license value gets recognized upfront at the beginning of year 2, and then again in year 3. So it does spread the value of that deal out over 3 years, though it is not fully ratable and even as you would in a SaaS or cloud-delivered offering.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [7]

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Okay. That makes sense. And then 1 follow-up, Mike, for you. Talking about scrubbing the pipeline and maybe some being a little bit too aggressive on timing of deal closures. Do you think that impacted some of your top-of-funnel activities? So if you had known that earlier in the year, do you think you would have been focusing more on programs to bolster the pipeline? So maybe you had a little bit bigger coverage ratio. And now that you have kind of discovered it, is that what you're intending to do in the coming quarters?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [8]

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So the short answer is absolutely, yes. And if we had realized that there might be a shortfall towards the end of the year, we would have looked kind of deeper into the pipeline earlier to make sure that we know and we kind of filled that. We're very disciplined about pipeline generation. We have a lot of operational controls in place all the way through the process of generating pipeline, kind of getting to a technical win, a business win and closing it. But in light of what we saw in the third quarter, we're even doubling down further on this.

And this doesn't just include what we're doing for the fourth quarter on the guidance we provided, it's to get in front of Q1 and Q2 and just make sure that we get all those Ts crossed and I's dotted earlier in that process, so that we hopefully avoid the situation that we're in right now.

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Operator [9]

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And your next question comes from the line of Fatima Boolani from UBS.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [10]

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Maybe to start with the extended sales cycles. Mike, I know you called that EMEA as being particularly acute in terms of sales cycles, even though it was broad-based, but I did notice that your APJ business was down year-on-year based on the splits of revenue mix that Chris provided. So I'm wondering if you can comment on that. And just to piggyback on that, if there are any certain verticals or particular end markets that are feeling the pain in terms of procurement, that would be helpful? And then I have a follow-up for Chris, please.

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [11]

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Sure. So just, first of all, on the APJ region, just acknowledge that, that's a relatively small part of our business and is more impacted on a quarter-by-quarter basis from the impact of 1 or 2 larger deals. But yes, we did see some of the shortfall in APJ from this quarter. We're quite pleased with what APJ has done kind of since we started investing a couple of years ago. But again, it can have a more material impact in any given quarter. As far as the second part of that, no, there's not really anything about size of account or vertical, where things were highly concentrated. We've just -- we've been -- we're having to kind of push harder on trying to get some of these larger, more strategic deals across the finish line.

But I will just remind you, and for everybody on the call is, we are moving from a single product solution in the world of network access control to a much broader offering in this device visibility and control category, and now we're trying to broaden ourselves even further from being in the IT part of those networks to the OT parts on top of that. And just as such, it's becoming more common for us to have, to have a direct touch into more people inside a single account to have that degree of confidence to be able to put things into guidance. And that's a lot of what we're working on at this stage. It's just really making sure that we've kind of crossed all the Ts and dotted the Is, as I said, to make sure we kind of get that news earlier in the process.

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Christopher Harms, Forescout Technologies, Inc. - CFO [12]

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Fatima, before you give me my question, I want to add a little bit to what Mike provided. Because I expect it will be a common question. As you alluded to, yes, the contribution of EMEA was consistent on a year-over-year basis in terms of its mix. But as we've signaled in the pre-announcement in October, that the role that we expected EMEA to play in Q3, as was weaved into our guidance, was definitely higher. And that's why we pointed to elongated sales cycles in EMEA as major contributor to the shortfall on our guidance.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [13]

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I appreciate that clarity. And then, Chris, just sticking with you. Last quarter, you gave us a lot of helpful bridging comments as it relates to term-based licensing uptake. I'm wondering if you can kind of reiterate some of those comments for this quarter? So just give us a sense of term-based licensing adoption to the extent it was an incremental headwind to reported revenues? And to what extent you're expecting term-based adoption for the rest of the year and your fourth quarter guide? And between both 1-year and 3-year term, because those were the 2 factors that impacted the second quarter results? So any incremental updated views on the term mix would be super helpful.

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Christopher Harms, Forescout Technologies, Inc. - CFO [14]

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Yes. Those are great clarifying questions because we did not put them into the prepared remarks. So I'm going to begin with a recap of Q2, just in case there are others on the call where this is new information.

So the Q2 contribution of roughly $11 million in term-based licensing value built into our subscription, those were almost all 1 year. And so that pro forma I gave was to give a kind of a bridge to, have those 1 years come in as a perpetual and what that factor would have been to help people understand the demand trajectory that was implicit.

Unlike Q2, Q3 was much smaller in magnitude. As you'll see in the 10-Q, it only totaled $2 million. And unlike the Q2 '11 all of this, almost all of it was -- were 3-year contracts, where we didn't have the clauses into place and the contract terms to stagger it, to break it up into thirds. So the full 3-year value is included in that 2-year. That's why I didn't break it out specifically.

So the second part of your question, it did not contribute to the underperformance relative to guidance in Q2. To the last part of your question as it pertains to Q4, the TBL contribution for Q4 that's embedded in our guidance is very nominal, more of approximate value of what we saw in Q3, even actually a little smaller. This was part of the narrative that Mike and I bedded into the prepared remarks about, look, we did things neutral this year and clearly to drive adoption. We're going to need to put customer incentives and sales force incentives, that we did treat 2019 as our petri dish, we did learn a lot, and we did learn that unless we change those levers, we will not be able to drive the adoption rates that we're seeking.

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Operator [15]

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(Operator Instructions) Your next question comes from the line of Alex Henderson from Needham.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [16]

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Just a couple of simple housekeeping questions first, if I could. You said 50% by the end of 2020, I didn't catch what you said the trailing number was?

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Christopher Harms, Forescout Technologies, Inc. - CFO [17]

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The trailing as of September 30 was 46%.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [18]

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46%. And then if you had turn to profit in the quarter, what would the fully diluted share count be for valuation purposes, please?

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Christopher Harms, Forescout Technologies, Inc. - CFO [19]

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I will definitely take it offline, and we can do it in the callback, I didn't do the math in advance, Alex.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [20]

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No problem. And then the question I wanted to address here is there was a product introduction over at Qualys. I know you are familiar with it. They're essentially giving away a free version of device identity access management. Have you seen any impact on that? Was it a variable that might have caused some delays in timing of transactions? Obviously, there's a big gap between what they offer and what you offer, but free does have a way of slowing things down for people to take a look at it.

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [21]

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Yes. So I'll take this. Qualys just released their product after it has been delayed for over a year. It's still in beta, so we haven't had a chance to evaluate it yet. We are quite confident that passive scanning is a very difficult thing to do to try to do this in an agentless manner is one of the core differentiators of our product. And to be most direct about it, no, we have not seen a single customer yet that has evaluated that product against us or has given us any indication that, that is going to be a concern for us in the future.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [22]

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Okay. We if I could ask one last quick question. You talked about increasing incentives from neutral. In what form factor will that come in? Is that a reduction in pricing? Is it more compensation to the salesperson? How do you mechanically achieve that?

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Christopher Harms, Forescout Technologies, Inc. - CFO [23]

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Yes. Great clarifying questions. First, recap our breakeven between a license and maintenance really and a term-based in 2019, is at 3 years, that there are definitely other companies that are at 3 years, but it is the more vendor favorable breakeven point. We are definitely looking at a longer breakeven point, and are assessing where is the optimal spot for us, but definitely will not remain at the vendor beneficial 3-year.

The second part of that to mechanics is in compensation and commission quota rates and relief points. As I said, for 2019, we structured those as neutral. So there was no incentive for our team one way or another. What we would be doing is giving greater quota relief and/or a combination of different rates for term-based licensing over our traditional license and maintenance structures. Those are the 2 primary mechanics.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [24]

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So just to be clear, does that increase the compensation to the salesperson, neutral to the salesperson? Or is it just a mix shift between what you're doing? I mean, is there any change in the aggregate cost?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [25]

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We are assessing -- this is Mike. We are assessing all of those things at this point. At an absolute minimum, what we will do is we will fracture the average commission rate, so that it is higher for the term-based products than for the perpetual products. But we're assessing whether that is done neutral inside of our commission model or whether it's additive.

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Operator [26]

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Your next question comes from the line of Walter Pritchard from Citi.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [27]

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Two questions. First, on the term trend here. I guess, are your customers ready for that or asking for that? Or it seems like some of these transitions have gone smoother than others based on sort of how the customer is thinking about the value it provides and how they pay for it? I'm curious what sort of work have you done to get comfortable with that aspect?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [28]

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So just remember, we only introduced this in April of this year, right? So kind of since April, in all the deals where we aren't at a place yet where the bill of materials is finalized and the budgets finalized because, obviously, CapEx and OpEx are quite different inside organizations. We have been introducing this quite aggressively to our installed base. There is definitely demand inside of our installed base for term-based licensing.

But as Chris mentioned earlier, we've kind of viewed this as different weapons for a different fight, like way, if a customer wants, CapEx versus OpEx, we now have both kind -- of both of those,

As we move into 2020, and we get a chance to get in at the front end of these sales cycles instead of interjecting this into the middle of existing sales cycles, that's when we get some more confidence that we'll be able to influence those customers in one direction or another.

We've also got the benefit here of many of our large organizations now they buy subscription services for many other Tier 1 products. So we've got that insight into ones that either are or are not more open to that.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [29]

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Great. And then probably another question for you, Mike. On the productive sales side, you've given us stats in the past talking about percentage of your reps that are productive. And I'm curious, obviously, that this probably sets you back a bit, but it's some large deals. I'm just wondering if you give us a sense as to where rep productivity stands? And how that impacts how you're thinking about hiring?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [30]

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Yes. So I mean, rep productivity has actually been fairly consistent year-over-year. Obviously, the absence of the 8-digit deals, which would kind of have an average across the entire cohort, will have an impact on this. But when kind of we look at the -- every rep individually, productivity has been quite consistent with years past. As far as hiring goes, I'm not sure it has that big an impact on hiring one way or another. Because we have a large -- kind of a large deal nature, we have lots of reps that finish substantially above the average. And we just kind of keep working on making sure that we get as many of those reps above that mark as possible. So it's not directly tied to whether we are or are not hiring?

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Christopher Harms, Forescout Technologies, Inc. - CFO [31]

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Yes, I think this is an important point, so I'm going to add [the answer] to what Mike provided. As part of what we've been looking at here, October and the first week of November, when we look at the cohort of kind of first year sales productivity, it has stayed consistent with what we saw last year and the prior years.

When we look at the kind of second year cohort productivity, it has remained relatively consistent with what we saw last year and what we saw in prior years. What has changed from just a measurement of productivity have been what we call those tenured reps. Those who have been here over 2 years. And it's not that they are not still doing well with a lot of million-dollar-plus transactions.

As Mike alluded to in his remarks, the number of those deals actually increased, 38% year-to-date. But what we haven't had are those 8-digit deals that really swing that needle for us.

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Operator [32]

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(Operator Instructions) And your next question comes from the line of Joshua Tilton from Berenberg.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [33]

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Could you possibly just comment on the puts and takes to the top line growth next year, if we see customers choosing 1-year term licenses? Are you possibly going to incentivize the sales force to maybe push 3-year deals?

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Christopher Harms, Forescout Technologies, Inc. - CFO [34]

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Okay. So I'm going to just tackle the latter part of your question. We are definitely going to be incenting the sales force towards TBL over the perpetual and maintenance model.

In terms of then how we structure between 1 and 3, like our objective is to get all of those, to get them on an annual recurring revenue basis. So a 1-year deal balance straightforward. On a case where a customer wants to give us a purchase order for 3 years, we are going to put the clauses in place so that we can see that revenue in 3 equal 1-year chunks, where the license value is recognized on day 1 of each of those 3 years.

In terms of incenting customers between those 1 and 3, that is still a point of discussion in terms of what we should optimize in terms of how customers want to plan for this and budget their dollars with us.

In terms of the first part of your question, we are -- we provide annual guidance in the February cadence. I recognize, given the dynamics, people would like to have it now. But we will be providing that in February.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [35]

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Okay, that was helpful. And then just a follow-up. Is it possible that maybe some of the execution issues could just be a function of going from one product-focused on IT to then being able to focus on OT and then unbundling the product into a suite of products? Maybe the product story has just gotten a little noisy, are you guys still seeing the customers resonate with the value proposition of the offering?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [36]

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Yes. I mean, the part about it becoming noisy. The product suite is actually quite easy to understand. I mean, the decoupling that we did of our visibility in our control products has actually been quite well received by the market. Still the vast majority of our customers buy both of those at the same time, so I would kind of say that's a nonfactor. But what is a factor in this is that we have broadened our eyeSight products to work across IT and OT. Within the IT side, we have more and more customers using us in the data center in the cloud. And then as we continue to roll out eyeExtend products, we are touching more people inside organizations. And that is a contributing factor to this is whereas, maybe we were owned by security or network a couple of years ago, there's more deals now where we need to be coordinated with the security team and the network team and potentially the OT team, that is often different as well. So I think that's 1 of the lessons that we've learned relative to kind of the mega deals that are out there is to be more diligent about making sure we understand all of the players inside companies that might have a chance to weigh in and to make sure that we do a better job of covering all that real estate before we get to the quarter that we're putting something in guidance.

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Operator [37]

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(Operator Instructions) And I'm showing no further questions at this time. I would now like to turn the conference back to Michelle Spolver. Please go ahead.

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Michelle Spolver, Forescout Technologies, Inc. - Chief Communications Officer [38]

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Thanks, Sarah, and thank you, everybody, for joining our call today. I know that we will be talking to a lot of you in the coming hours, days and weeks ahead on calls and then also on the conference circuit, so we look forward to be able to do that. And as always, reach out to me if you have further questions. Thanks a lot, and have a good evening.

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Operator [39]

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Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may now disconnect.