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Edited Transcript of FSCT.OQ earnings conference call or presentation 7-Aug-19 8:30pm GMT

Q2 2019 ForeScout Technologies Inc Earnings Call

CAMPBELL Aug 13, 2019 (Thomson StreetEvents) -- Edited Transcript of ForeScout Technologies Inc earnings conference call or presentation Wednesday, August 7, 2019 at 8:30:00pm 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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* Fatima Aslam Boolani

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

* Jonathan Blake Ruykhaver

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Joshua Alexander Tilton

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

* Robbie David Owens

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Sarah Emily Hindlian

Macquarie Research - Senior Analyst

* Sterling Auty

JP Morgan Chase & Co, Research Division - Senior 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 Q2 2019 Forescout Technologies Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Michelle Spolver. Please go ahead.

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

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Thank you, operator, and thank you all for joining us on today's conference call to discuss our financial results for the second quarter of 2019 and provide guidance for the third 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. Also, joining me today are Forescout's Chief Executive Officer and President, Michael DeCesare; and Chief Financial Officer, Criss Harms. A few minutes ago, we issued a press release announcing our financial results for the second quarter of 2019 as well as guidance for the third quarter and full year 2019. The release can be found on the Investor Relations website along with supplemental financial information that accompanies today's remarks.

Before we begin, let me remind you that we'll make forward-looking statements during this call, including statements related to our guidance and expectations for the third 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 security industry; the ramping and success of our sales organization; and our growth, profitability and the impact of the SecurityMatters acquisition 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. Please note that at the conclusion of this afternoon's call, we will post our supplemental information. Before I turn the call over to Mike, I'd like to mention that this quarter, we'll be presenting at KeyBanc's 21st Annual Technology Leadership Forum in Vail and the Citigroup Global Technology Conference in New York City.

And now let me turn things over to Mike to discuss our business and provide a review of our second 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. We delivered a solid Q2 with results that demonstrate the pervasive need for device visibility and control. At the same time, we also showed some really nice operating leverage in the business. Before I give you some color on the second quarter, let me review some of the financial highlights.

On the top line, revenue was $78.3 million, up 16% year-over-year and above the midpoint of our guidance range. It is important to point out that within the $78.3 million of revenue was $11.2 million of term-based licensing revenue from almost 20 deals whereby customers chose 1-year term-based licensing over our traditional perpetual license with 3 years of maintenance. Had all of these customers selected the perpetual option, we estimate that our Q2 total revenue would have been approximately $92 million, an increase of 36% year-over-year.

Given that we just introduced term-based licensing in April, Q2 was impacted by some pent-up demand, and while it's still too early to predict a trend, we are encouraged by early customer receptivity. I'm pleased with our progress and transitioning our revenue base towards a more recurring revenue. First, we decoupled our software and hardware to enable customers to purchase them separately via centralized licensing. Our next evolution point was term-based licensing as an alternative to our perpetual licensing and later this year, we will begin to deliver SaaS-based offerings.

Turning to the bottom line. Non-GAAP operating loss came in at $14.7 million, well ahead of the $20.4 million midpoint to our guidance range. We are continuing to benefit from operational efficiencies in our go-to-market engine and strong gross margins, which remain the primary drivers towards the near- and long-term profitability targets.

Now let me discuss some of the highlights in the second quarter. During the quarter, we significantly expanded our footprint within our core market. We landed [19] new customer logos across industries and geographies with more than a quarter of those coming from the G2K. And we added a record 6.1 million devices under management, up 123% year-over-year, bringing our total installed base to over 73 million.

We also continued to diversify revenue beyond our core offering and increased our potential customer lifetime value by attaching eyeExtend software products in approximately 39% of all Q2 deals. This underscores the powers our customers derive from the seamless integration with their existing security solutions.

Device visibility and control is a critical security challenge facing organizations around the globe. Forescout solved this by giving customers complete integrated visibility and control of all devices on their network from campus to data center to cloud and OT environments. We've been talking about 3 major trends that are the driving need for our solutions. These are explosive growth in network-connected devices, the interconnectivity of IT and OT networks and the move towards security automation. We're seeing each of these play out in varying degrees across our business.

These drivers, along with a rising nation-state threat landscape, have prompted governments and regulatory bodies around the world to elevate the need for device visibility and control. Government mandates such as CDM, Comply-to-Connect, GDPR and NIS Directive continued be strong tailwinds for our business with significant opportunities still ahead of us.

For example, during the second quarter, we closed an expansion deal with one of the largest U.S. civilian government agencies. They added additional eyeSight and eyeControl licenses to address the rapid device growth within their environment, bringing the total number of devices under management with us to approximately 1.8 million. As agencies implement Phase 3 of the CDM program, they are focused on mitigating threats and moving beyond device visibility to control automating control actions across their IT and security tools. To achieve this, the customer also purchased 5 of Forescout's eyeExtend products, including the modules for Splunk, ServiceNow, IBM BigFix and Tenable.

The need for device visibility and control extends across all geographies and verticals. For example, in the second quarter, we closed a seven-figure competitive bake-off against a legacy network provider at one of the world's largest media and entertainment companies.

I want to point out that this customer has made a major commitment to using the 802.1X network protocol and still chose Forescout. The customer is planning to use us side-by-side with its competitor's networking gear. They chose us for our far superior approach to visibility and control of unmanaged devices and our ability to deliver better value from the existing tools by integrating with them across other products in the Forescout platform. They purchased our eyeSight, eyeControl and eyeExtend products for Splunk, CyberArk, Palo Alto Networks across 100,000 devices.

In another Q2 Americas net new win, we displaced a legacy vendor with a U.S. large financial institution that brought eyeSight, eyeControl and our eyeExtend modules for CrowdStrike and Splunk. They plan on managing traditional IT devices as well as nontraditional IoT devices such as ATMs and surveillance cameras with anticipated plans to expand to include more devices in other areas of their network.

This customer was initially looking for just a Mac solution, but the deal quickly expanded in magnitude after they realized the Forescout platform could also solve for audit compliance and incident response, while delivering operational efficiencies through automation.

In APJ, regulatory oversight helped to drive a net new logo win with the public health system of one of Australia's largest states. The customer purchased eyeSight, eyeControl and eyeExtend products for Tenable and ServiceNow to gain real-time asset management and rogue device detection across 340,000 managed and unmanaged devices within the IT portion of their network.

Forescout's robust device visibility, control and orchestration platform was the key differentiator in their purchasing decision as no competitor could offer the breadth and true integrations across managed and unmanaged devices. This win also highlights the substantial opportunity with governments abroad as we are still in the very early innings.

In EMEA, we landed one of the world's largest and highest profile industrial manufacturing companies. This was a competitive win against a long-entrenched network -- legacy network provider. The customer purchased eyeSight, eyeControl and 7 of our eyeExtend products, including those for Palo Alto, IBM QRadar and McAfee.

The initial deployment will be within a segment of their network housing their most high-valued intellectual property. We won this deal based on our ability to seamlessly provide device visibility and control across both managed and unmanaged devices, the ease of implementation compared with the competition and improved productivities in their existing IT tools using our security orchestration solutions.

As I mentioned earlier, the convergence of IT and OT represents a growing and significant threat factor and a business driver for Forescout. During the second quarter, we landed a deal with one of the world's largest cruise lines that purchased our eyeSight, eyeControl, eyeExtend and SilentDefense products for integrated visibility and control of IT and OT devices in their fleet of ships.

These include traditional IT devices as well as OT devices like fleet navigation, propulsion, fire and safety and power generation systems. The initial deal includes a few ships, but we expect to drive expansion opportunities across the fleet because the U.S. Coast Guard has recently issued an advisory urging commercial vessels to assess their cybersecurity posture following a malware incident earlier in the year.

Our differentiated technology and unification between IT and OT set us apart from the competition in this strategic deal. Our strong technology advantage was key in winning all these deals. During the second quarter, we continued to deliver cutting-edge innovation across the Forescout portfolio. On the OT side, we released SilentDefense 4.0. This brings the number of new capabilities to customers, including our new Enterprise Command Center, which is a single dashboard for managing multiple sites, centers and operations as well as our new ICS patrol, which collects and inventories OT devices for asset management compliant purposes.

SilentDefense 4.0 also includes more tailored protocols for utility systems like smart meters and deeper integration with key OT automation partners such as AVD, Yokogawa, Emerson and Siemens. We also broadened our eyeExtend portfolio with a new extend module for Microsoft Intune, which will help drive mobile device onboarding and enrollment by discovering devices previously not seen by Intune and removing visibility gaps on the network.

Continuing on the theme of innovation, our upcoming SaaS product, eyeSegment, which we first discussed at our Analyst Day in March is now in beta and is on track for delivery later this year. With eyeSegment, we believe we have developed a truly unique approach to network segmentation by marrying valuable device classification context for both managed and unmanaged devices to the traffic details of communication on the network.

This will enable device-based segmentation for managed and unmanaged devices and the ability to dynamically apply controls across multiple vendors' technologies. We're excited about eyeSegment and expect it to accelerate and simplify network segmentation projects for our customers by helping them quickly understand the efficacy of their existing segmentation controls across multi-vendor environments.

Beta customer feedback has been very positive with customers impressed by how quickly they've been able to implement the product, determine how devices are communicated on their network and design segmentation controls to limit traffic. We think the combination of our unmatched technology and scale capabilities will widen the competitive mode in our core market against both legacy competitors and emerging vendors.

Only Forescout can provide a single integrated platform for deep, agentless end-to-end device visibility and control across the campus, data center, cloud and OT. We are increasingly expanding our footprint in the market, adding new products, new customers and devices under management and also making strides in our path towards profitability.

Before I turn the call over to Criss , I also want to share some positive news that we have appointed Steve Redman to the newly created role of Chief Revenue Officer, reporting directly to me. Steve will drive our global sales and marketing efforts focused on growth, scaling Forescout from $300 million to $1 billion and beyond. Steve joined us in early 2017 to run APJ sales and has since built and led his team to nearly triple revenue in that region.

Last year, we gave Steve the added role of Chief Marketing Officer, who among other things, he's done a great job of increasing and accelerating our sales pipeline. Steve's experience includes leading and scaling a 2,000-plus global sales organization at McAfee and large fast-growing APJ sales organizations at Palo Alto Networks and EMC. He is one of the very best operational leaders I have ever worked with and has an incredible passion for helping Forescout realize the significant market opportunity that is ahead of us. Steve has the respect of our entire organization, and I am highly confident of the very smooth transition to this new role. As part of this change, Brian Gumbel, our SVP of Worldwide Sales, will be transitioning out of his role at Forescout and will serve as an advisory role for the company.

Let me now turn the call over to our Chief Financial Officer, Criss Harms, to discuss the detailed financial results for our second quarter as well as our guidance outlook for the third quarter and full year 2019. Criss?

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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 second quarter 2019 financial results and our outlook for the third quarter and 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. As Mike shared, we delivered a solid Q2 as we executed well across our business to capitalize on our growing market opportunity. Total revenue for Q2 2019 was $78.3 million, an increase of 16% on a year-over-year basis and above the midpoint of our guidance range.

License revenue was $38.8 million, an increase of 13% on a year-over-year basis and driven by strong sales of our core eyeSight and eyeControl offerings. As Mike shared, we had $11.2 million of term license revenue from almost 20 deals, whereby the customers chose the newly released 1-year term license option over a perpetual license with 3 years of maintenance.

Subscription revenue in the quarter grew 20% year-over-year to $34.8 million. Professional services revenue in the second quarter grew 8% year-over-year to $4.6 million. Looking at Q2 revenue mix by region, the geographic mix of revenue was Americas at 75% of total revenue compared to 83% in Q2 2018, EMEA was 14% and APJ was 11% compared to 13% and 4% in Q2 2018, respectively. We are continuing to diversify our business geographically.

Moving to margins. We achieved a very strong gross margin for Q2 2019 at 80%, an increase of approximately 300 basis points sequentially and 100 basis points year-over-year. The sequential gross margin increase was driven primarily by the continuing shift of customers' buying preferences toward deployments of our software that do not require incremental hardware being provided by Forescout .

Margin for our license revenue was 87%, up approximately 100 basis points year-over-year and approximately 600 basis points sequentially. Margin for our subscription revenue was 85%, a decrease of approximately 300 basis points year-over-year and 100 basis points sequentially. Margin for our professional services revenue was negative 26%, an improvement of 700 basis points year-over-year and an improvement of 1,500 basis points sequentially. A reminder that professional services revenue comprises a very small portion of our business, and we offer these services only in conjunction with license sales.

Total operating expenses for Q2 2019 were $77 million, an increase of 26% year-over-year. Looking at the components of OpEx. Sales and marketing expense for Q2 2019 was $48.5 million or 62% of revenue, an increase of 24% year-over-year. This reflects the continuing investments in our direct and channel selling resources as well as our sales engineering and sales enablement teams.

Our research and development expense was $16.7 million or 21% of revenue, an increase of 36% year-over-year, reflecting continuing investments in our development teams, for which the results of those investments are evidenced by our recent and upcoming product releases.

General and administrative expense was $11.8 million or 15% of revenue, an increase of 25% year-over-year, reflecting additional investments in infrastructure related to being a public company. Operating loss for Q2 2019 was $14.7 million or 19% of revenue compared to a loss of $7.3 million or 11% of revenue in Q2 2018. This is well ahead of the midpoint of our guided range of $20.4 million, resulting from strong margins on our license and subscription revenues, continuing leverage from our go-to-market engine and effective expense management, as we strive towards our profitability goals. As a reminder, the operating expenses associated with the SecurityMatters acquisition had and will have an impact on the year-over-year changes in operating margin through the end of 2019.

Our net loss was $15.1 million compared to a net loss of $7.5 million in Q2 2018. Net loss per share for Q2 2019 was $0.33 compared to net loss per share of $0.18 in Q2 2018. We ended the second quarter with total deferred revenue of approximately $173.1 million, a decrease of $5 million sequentially. The combination of revenue plus sequential change in deferred revenue provided Q2 billings of $73.3 million, an increase of 61% year-over-year. A reminder that Q2 2018 billings were impacted by the nonstandard deal completed in Q1 2018 and which provided for the anomalous year-over-year comparisons for Q1 and Q2 2019.

Free cash flow in the second quarter was negative $27 million compared to negative $7.9 million in Q2 2018. Free cash flow margin was negative 34% compared to negative 12% in Q2 2018. From a cash perspective, we finished the second quarter with cash, cash equivalents and investments of nearly $105 million. I'd like to now spend a minute walking you through 2 new metrics we will be providing quarterly and the associated insights that explain the Q2 impact of term-based license adoption upon revenue.

To start, this is the first time we're discussing in our earnings call our subscription revenue rate and our recurring revenue rate, which we believe are important metrics to measure the impact of ratable revenue products and recurring revenue products on the business.

As you know, we just recently started offering customers the choice of 1-year or 3-year term licenses as an alternative to a perpetual license. So first, our subscription revenue rate, which is based on our ratable revenue. Subscription revenue currently includes the revenue from our support and maintenance offering. And in the future, will include revenue from SaaS products, such as our upcoming eyeSegment product.

On a trailing 12-month basis, as of June 30, 2019, 41% of our total revenue was comprised of our subscription revenue, up from 40% as of March 31, 2019. The second metric, recurring revenue rate, 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 June 30, 2019, our recurring revenue rate was 44% of total revenue, up from 40% as of March 31, 2019.

The approximate -- approximately 300 basis points delta between the subscription revenue rate of 41% and the recurring revenue rate of 44%, both of which are measured on a trailing 12-month basis reflects the approximately $11.2 million of Q2 license revenue, generated from 1-year term-based licensing agreements.

While we don't want to create 2 scorecards, we do think it's insightful this quarter to share with you the approximate pro forma results that would have been reported had these customers selected a perpetual license with 3 years of maintenance rather than the 1-year term license.

First, as Mike indicated earlier, our Q2 revenue would have approximated $92 million, reflecting the 2.2 conversion factor implicit in the approximate 3-year breakeven pricing point between a 1-year term license and a perpetual license with 3 years of maintenance. On a pro forma basis, we estimate that our year-over-year growth on total revenue would have approximated 36% rather than the 16% I reported earlier. Similarly, on a pro forma basis, we estimate that the year-over-year growth on license revenue would have approximated 52% rather than the 13% I reported earlier.

Moving back to Q2 insights embedded in our results. Inclusive in our results, we saw a very strong acceleration of our core business, as reflected by eyeSight and eyeControl offerings, which, as Mike shared earlier, was evidenced by us adding a record 6.1 million devices under management, up 123% year-over-year.

As it pertains to license revenue, license revenue from eyeSight and eyeControl reflected 75% of license revenue in aggregate in Q2 and was up 77% on a year-over-year basis. Additionally, contract duration was impacted by customer selection of 1-year term licensing agreements rather than a perpetual license with 3 years of maintenance. As a result, the weighted average contract length on new business, as measured on a trailing 12-month basis, moved from a consistent historical average of between 31 and 32 months, down to 28 months. This directly impacted the deferred revenue balance as of June 30, 2019, and the associated measurement of Q2 billings.

Moving to guidance. As we shape our Q3 and fiscal year 2019 guidance, we are applying the insights that we gained in the first half of 2019 and the indicators that are taking further shape as it pertains to the second half of 2019. Our guidance continues to reflect our confident outlook and takes into consideration the potential for some continued mix shift in the second half of 2019 towards 1-year term licensing, although at a smaller rate than what we saw in Q2. Accordingly, we are maintaining our full year revenue and operating loss guidance. With regard to the loss per share guidance, we are slightly improving the top end of our guidance range, primarily reflecting our updated outlook on interest income.

For the third quarter 2019, we expect total revenue to be in the range of $98.8 million to $101.8 million, representing year-over-year growth of 17% at the midpoint. We expect operating income in the range of $2.6 million to $3.6 million, and income per share to be in the range of $0.04 to $0.06 based on approximately 46.4 million weighted shares outstanding.

For the full year, we expect total revenue to be in the range of $365.3 million to $375.3 million, representing year-over-year growth of 24% at the midpoint. Operating loss in the range of $15.6 million to $11.6 million and loss per share in the range of $0.41 to $0.33 based on approximately 45.8 million weighted shares outstanding.

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, Criss. We are pleased with the continued expansion, diversification and business leverage that translated into a solid second quarter on both top and bottom lines. We continue to be in the very early innings of a large market opportunity, and we look forward to building on our momentum in the quarters and years ahead.

Thank you again to everyone for joining us on the call today and for the continued support from our investors, our employees, customers and partners.

We will now open the call up for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Sterling Auty with JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [2]

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Can you hear me okay?

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

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We can hear you perfect.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [4]

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All right. Great. So it sounds like with the acceleration in the core business that's -- the close rates must have been decent, can you just maybe peel back the onion just a little bit and kind of talk to you what you saw in terms of close rates both in the government and commercial side of the business vis-a-vis what you saw last quarter?

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

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We definitely saw an acceleration in close rates this quarter. We had some deals that were in the pipeline that we had kind of -- we're still thinking about when they were going to close, and we were able to get some of those orders in kind of earlier for us, so the close rates remain very strong here.

We don't really disclose it by industry. I'm not sure that we'd even have that broken out exactly by industry, but overall, they remain very healthy.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [6]

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That make sense. And then one follow-up. You talked about the mix of churn in the back half, not quite as high as what you saw in the second quarter. Just curious, why not? Why wouldn't we see just the same uptake? Or did you run some spiffs or something special just to kind of jump start the program?

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Christopher Harms, Forescout Technologies, Inc. - CFO [7]

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So we didn't run any incentives and we don't have any incentives through 2019. I think -- so when you and I talked, we really wanted to get through 2019 and see what our customers' preferences were, one way or the other, given the large-deal profile that we do. Our kind of postmortem on Q2 was really reflective of some pent-up demand. And as we looked out across Q3 and Q4, we have incorporated term-based licensing, specifically 1-year term-based licensing into our guidance structure, but definitely, it's not at the same levels that we experienced in Q2.

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Operator [8]

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And your next question comes from the line of Rob Owens with KeyBanc Capital Markets.

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Robbie David Owens, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [9]

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And following on Sterling's question on the term front end. Given the many puts and takes that your model has relative to deferred revenue and that balance, how do we think about that then sequentially and throughout the back half of the year kind of given some of those expectations around term versus perpetual caring maintenance?

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Christopher Harms, Forescout Technologies, Inc. - CFO [10]

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Yes. So with the exception of Q2 and with the exception of the anomalous activity we saw in Q1 and Q2 2018, you generally see a fairly tight correlation on billings relative to revenue. And you definitely see an extremely tight correlation as it relates to license bookings relative to license revenue.

As it pertains to kind of the second half of '19, I think you should maintain that same kind of relationship that existed between billings and revenue.

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Robbie David Owens, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [11]

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And Mike, as we enter Phase 3 of CDM, and you mentioned some of your success there, was it unique from the standpoint of seeing a lot more build relative to Forescout's opportunity? Or as Phase 3 gets deployed much more broadly, would you expect more departmental wins like that?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [12]

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So just, I mean, for everybody's benefit here, that Phase 3 is when the CDM program moves from device visibility into control, which obviously is very positive for Forescout.

We're definitely -- I mean, the expansion that we're seeing across CDM is kind of comprised, both of original customers that are deployed on the product that are now experiencing the same device growth in their environments than any commercial customer is, so we certainly see the benefit there.

We, absolutely, are benefiting from customers as they move into control, having to continue to buy our products to be able to support that. And then there are actually still agencies, even though we're quite deep into this program, there's agencies out there that are still deploying for the first time. So we really see business across all 3 of those categories.

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Operator [13]

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

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [14]

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Just with regards to your guidance for the next quarter, and I appreciate the context around the assumptions you're making on a term-based licensing mix. But as I think about you entering what is a very seasonally strong quarter for you in the government vertical, are you expecting any changes in buying preference within the government vertical that's typically bought perpetual in lieu of term-based? And then I have a follow-up.

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [15]

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So the short answer is that our approach towards term-based license for the balance of this year is that this is an option that our sales organization now has the ability to have both perpetual and term, and that different approaches fit different customers. So we are not going and assuming there's going to be a massive shift to term-based licensing or perpetual. Every customer is different, and we're in conversations with each of them separately. And then -- the second part of your question, I think I missed there, sorry. Is there a second piece in there too?

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [16]

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Yes. Just trying to understand, in terms of the seasonally strong government period in the third quarter, why we wouldn't see perhaps a better revenue growth outlook as the government vertical has typically indexed to buying perpetual and hardware-oriented [flavors]? And then I have a follow-up.

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [17]

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So that there -- the answer on this is that we have both headwinds and tailwinds here. The benefit, obviously, is we've been baked into CDM, which is on the civilian side of the U.S. government as well as Comply-to-Connect, which is on the DoD side, so we've got the benefit of coming in on the back of congressional mandates. But also, there's uncertainty in the U.S. government. There are new customers and new people leading organizations and then we've tempered that appropriately. So -- we're very comfortable in our pipeline, rolling in both the third and the fourth quarter, but we think we've kind of measured those 2 things appropriately in our guidance.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [18]

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Got you. And Criss, last quarter, there was a lot of conversation around some of the deal slippage dynamics you saw in the second quarter. I wanted to get an update on how those transactions shook out? And how you're thinking about large-deal dynamics in the back half of this year, especially as we, again, consider that this -- the perpetual to TDL dynamics? And that's it for me.

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

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Yes. I'll try to hit all 3 facets of that. So as it relates to the kind of handful of deals that we called out in the May discussions, those are all still tracking well towards the second half, more specifically Q4. We still have high confidence that all to most of those will contribute to our Q4 revenue.

As it relates to kind of the big deal profile for the year taking shape in Q4, we've tried to consistently share with you the visibility that we have that unlike prior years, the cyclical seasonality will be more weighted towards Q4 this year than what you've seen historically.

All of our pipeline analytics, all of the probing that Mike and I are doing about how those deals are taking shape across new logos and expansion also give us a great confidence about the contributions of big deals in the Q4 time frame.

As it relates to the third facet of your question, look, we are different definitely spending time with the field, asking the additional question as it relates to customers' buying preference across perpetual with 3-year maintenance versus a 3-year term-based license versus a 1-year term-based licensing. We've taken the insights that we've garnered. We've been doing the analysis. All of that is baked into how we are guiding for the full year and clearly, that's what implicit for Q4.

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Operator [20]

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(Operator Instructions) And we have a question from Jonathan Ruykhaver with Baird.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [21]

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Criss, I'm wondering if you could help us understand the impact to deferred revenue and billings from the shift to term from perpetual in the quarter.

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Christopher Harms, Forescout Technologies, Inc. - CFO [22]

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Well, Jonathan, look our traditional profile for new business is perpetual plus 3 years, right? Our contract duration for new business consistently run at 31- to 32-month range. But that -- definitely by doing a more heavy 1-year term-based license in Q2, it definitely did not contribute the same level of deferred revenue add and did not contribute the same level of Q2 billings that, that traditional model would have had for us.

We've tried to give you a little bit of pro forma, how it played out on the P&L, and I've tried to give you a little bit of direction about how to think about Q3 and Q4 in those billing relations. I'm happy to go deeper into it when we do our callbacks about how to think about it from a modeling perspective.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [23]

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Okay. That's fair. And the other question I have is just -- can you talk about the impact you're seeing from the splitting of counterACT and eyeSight and eyeControl? I know you've talked about the opportunity to accelerate the sales motion for customers that are interested in visibility, and then they come back later for control. I'm just wondering what you're seeing along those dynamics? And if it's having any kind of impact to ASP?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [24]

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It's not having a notable impact, both from an ASP perspective as well as a close perspective. We divest -- as we told you when we kind of rolled this out, the vast majority of our customers really buy into the concept of device visibility and control as a single integrated use case. So we still are seeing and expect to see most of the customers buying both eyeSight and eyeControl at the same time.

The reason we split those is both to allow ourselves the opportunity for customers that want to start with visibility only to be able to come back and kind of upsell them on Control when they're ready to actually implement. And when you look at the new upcoming eyeSegment product, it fits very nicely between eyeSight and eyeControl because typically, customers want to see what's on their network, eyeSight, segment what's on their network, eyeSegment, and then be more aggressive about taking actions against devices. But specifically to your question, it has not had an impact on pricing or sales cycle length.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [25]

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Okay. Good. Just one last question. You released version 8.1, I believe, in March. And I'm wondering if you could just talk about it as a potential catalyst for expansion into IT and OT. And also for a further expansion with eyeExtend, and are there certain capabilities that can accelerate that motion?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [26]

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So 8.1 came out, again as you said, in the first quarter. One of the bigger kind of pieces of functionality that was inside that release was the first time that we released a fully integrated version of our IT and OT offering, the SilentDefense product that we pulled in from the SecurityMatters acquisition, and then the eyeSight product that we had in our core portfolio. So that was a very big thing for us, and there's been a lot of pipeline that's been generated that include both products as a result, so we're quite happy with that.

A lot of our R&D efforts are going into products that are coming out. We -- it's very important for us to keep our installed base current on the current releases, so we're quite happy with the traction that we're seeing with 8.1 so far for sure.

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Operator [27]

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And your next question comes from the line of Sarah Hindlian with Macquarie.

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Sarah Emily Hindlian, Macquarie Research - Senior Analyst [28]

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All right. Great. So I don't want to beat a dead horse here, Criss, but I think what would be really helpful, given the number of questions you're getting in that $11 million you saw in new term license in period, which is going to adversely impact revenues beyond more -- and given the outlook and what you're saying about the mix shift to 1-year term license, can you say what fiscal year '19 guidance would have been without this shift? Because it sure looks like you're raising guidance off of Q2. But it would be helpful to have a little bit of context in how to quantify just how much more term license you're factoring into the annual outlook. And then I have a follow-up. I'd like to know how you're seeing yourself post-maturity progressing?

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Christopher Harms, Forescout Technologies, Inc. - CFO [29]

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Yes, Sarah. Look, it's a fair question, so let me try to break down some pieces. On the pro forma I gave you, it's substantively was -- would have been $13.4 million more had customer selected perpetual. And that clearly -- excuse me -- no, it would have been $13.4 million more had they selected perpetual. And so that was the basis by which we did the pro forma on both license revenue and total.

So when you're thinking of the full year guide, yes, there's $13.4 million that had customers purchased from us, we would have been building into our full year guide because it would have taken the Q2 beat. What we've done is hold our previous guidance because that revenue isn't going to be coming in until 2020 after they renew in 2021.

That TBL is one of the many factors that we consider as we shape the rest of the guidance, just as we -- I'll focus on headwinds. Return to TBL, look, there's a lot of macro considerations as it relates to tariffs, as it relates to kind of global markets, as it reflects to Brexit. But we've got a lot of great headwinds as well. The pipeline is absolutely taking shape very effectively. The dynamics with Comply-to-Connect, with CDM and the federal spin having to use that in our historical very strong presence, all of that is baked into how we've been thinking about guiding you for Q3 and for the full year.

To the second part of your question, no, I don't want to break out how we're thinking about Q3 and Q4 and the role of TBL, just as I don't want to think -- break out the level of pipeline conversion. Those are just things that we're going to manage internally here and try to guide you at a high level. There was a third-party question (inaudible).

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

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Okay. I'll take the last part, which is around the sales force maturity. On an annual basis, I'll remind you that we disclose kind of what percentage of our sales organization that we see that we deem as ramped. And just to remind you that our definition of ramped is they've been with Forescout for more than 2 years and they're in the territory for more than 2 years. That was 50% at the end of 2018, up from 35% the year prior. And although it's tracking very well for us, we're going to hold off on disclosing what that percentage is until we finish 2019.

With that said, and you're kind of looking at like softer data points that are underneath that, we're quite happy with the level of pipeline we're building, the percentage of our sales reps that have been hired in the more recent cohorts like Asia Pacific that did very well this quarter for us. I mean there's a lot of indicators for us inside the business that are pointed in the right direction. You can always do better here. And until you're at a place, where every single sales rep is making their numbers and producing results, there's always more to be done. But we're quite happy, in total, with what we've seen so far.

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Operator [31]

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(Operator Instructions) We have a question from Joshua Tilton with Berenberg.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [32]

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The first one, in regards to the adoption of the term-based license, was it a specific vertical that was choosing term? Was it all new customers with some of the existing customers as well? Any color on that would be great.

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Christopher Harms, Forescout Technologies, Inc. - CFO [33]

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So it's a combination across all. But as you'll see in our net revenue retention rate, which is in the 10-Q, which I'll share, was 121%, up from 111%, you'll see in the narrative that, that was driven a lot by the TBL. And so by inference, most of those TBLs were expansion deals.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [34]

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That was helpful. And then just, I wanted to touch on the OT opportunity. How should we think about the competitive landscape? So we're hearing companies talk about having success with products from vendors like [Mizomi], [Dragoste] and Clarity. So I'm just curious if you're seeing any of those players when you compete for business?

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Michael P. DeCesare, Forescout Technologies, Inc. - CEO, President & Director [35]

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So we know the space quite well. When we originally set out for kind of our OT strategy, we were thinking more about OEM-ing one of those vendors. And as we got into that analysis, we just believe that SecurityMatters was by far the top player in that part of the market. So we know them quite well. We compete with them on a daily basis.

But I will just remind you that Forescout, before the acquisition of SecurityMatters, was quite successful in the OT market. So when we look at our kind of OT success, in most cases, it's a combination of the Forescout original product set, eyeSight as well as the SilentDefense product that came from SecurityMatters. And again, we're quite comfortable that we compete very favorably.

Outside of win rates, I will tell you that we're really excited about the work that's being done on the engineering side. As I mentioned in the prepared remarks, SilentDefense 4.0 is the next step of integration between that product set and Forescout. We really believe that the opportunity for us in OT is to substantially go into customers that have already chosen our eyeSight product and our eyeControl products in the campus or IT part of their world and now give them one lens of visibility across both IT and OT, because we're really the only ones that can provide that and give them east-west visibility of traffic that is moving back and forth between those different network wings as well.

So we're still in the very early innings. There's still a lot of customers evaluating more than there are customers actually spending big money on these areas. But when we look at the pipeline and the ramping of our own sales organization, both the SecurityMatters piece as well as kind of the core Forescout side of things, we're really pleased about the direction this is pointed.

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Operator [36]

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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 our host for closing remarks.

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Michelle Spolver, Forescout Technologies, Inc. - Chief Communications Officer [37]

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Thank you, operator. Thanks, everybody, it's Michelle, for joining the call. If you have follow-up questions, please reach out to myself or Nate Pollack, and we look forward to speaking more to you this quarter. Thanks a lot.

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Operator [38]

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