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Edited Transcript of VRNS earnings conference call or presentation 29-Apr-19 9:00pm GMT

Q1 2019 Varonis Systems Inc Earnings Call

New York May 17, 2019 (Thomson StreetEvents) -- Edited Transcript of Varonis Systems Inc earnings conference call or presentation Monday, April 29, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Guy Melamed

Varonis Systems, Inc. - CFO & COO

* James Arestia

Varonis Systems, Inc. - Director of IR

* Yakov Faitelson

Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* Daniel Harlan Ives

Wedbush Securities Inc., Research Division - MD of Equity Research

* Daniel Robert Bergstrom

RBC Capital Markets, LLC, Research Division - Analyst

* Erik Loren Suppiger

JMP Securities LLC, Research Division - MD & Senior Research Analyst

* Gur Yehudah Talpaz

Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst

* Jonathan Blake Ruykhaver

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

* Joseph Anthony Gallo

Jefferies LLC, Research Division - Equity Associate

* Melissa A. Franchi

Morgan Stanley, Research Division - VP and Research Analyst

* Rishi Nitya Jaluria

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Saket Kalia

Barclays Bank PLC, Research Division - Senior Analyst

* Shaul Eyal

Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst

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Presentation

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Operator [1]

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Greetings, and welcome to Varonis First Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note that this conference is being recorded.

I would now like to turn the conference over to your host, Jamie Arestia, Director of Investor Relations. Thank you. You may begin.

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James Arestia, Varonis Systems, Inc. - Director of IR [2]

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Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis' first quarter 2019 financial results. With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer. After preliminary remarks, we will open up the call to a question-and-answer session.

During this call, we may make statements related to our business that would be considered forward-looking statements under federal securities laws, including projections of future operating results for our second quarter and fiscal year ending December 31, 2019. Actual results may differ materially from those set forth in such statements. Important factors such as risks associated with anticipated growth in our addressable market; competitive factors, including increased sales cycle time, changes in the competitive environment, pricing changes, transition and sales from our perpetual licenses to a subscription-based model and increased competition; the risk that we may not be able to attract or retain employees, including sales personnel and engineers; general economic and industry conditions, including expenditure transfer data and cyber security solutions; risks associated with the closing of large transaction, including our ability to close large transactions consistently on a quarterly basis; our ability to build and expand our direct sales efforts and resell our distribution channels; new product introductions and our ability to develop and deliver innovative products; risks associated with international operations; and our ability to provide high-quality service and support offerings could cause actual results to differ materially from those contained in forward-looking statements.

These factors are addressed in the earnings press release that we issued today under the section captioned Forward-Looking Statements, and these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. These statements reflect our views only as of today and should not be relied upon as representing our views as of any subsequent date. Varonis expressly disclaims any application or undertaking to release publicly any updates or revisions to any forward-looking statements made herein.

Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures is also available in our first quarter 2019 earnings press release which can be found at www.varonis.com in the Investor Relations section. Also, please note that a webcast of today's call will be available on our website in the Investor Relations section.

With that, I'd like to turn the call over to our Chief Executive Officer, Yaki Faitelson. Yaki?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [3]

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Thanks, Jamie, and good afternoon, everyone. Q1 was a successful one. As you know, it was our first full quarter of selling subscription licenses across the company, and we significantly outperformed our expectation with 31% of license revenues of $7 million coming from subscription. While it is early in the process, we are very pleased with what we are seeing so far. Feedback from our customers, from our sales force and from our channel partners has been very positive.

We will talk more about the transition shortly, but let's start with our results. First quarter total revenues were $56 million. Q1 perpetual license revenues and subscription was $23 million while maintenance on our perpetual license and services revenues were $34 million. Our reported license revenues this quarter were clearly impacted by the greater mix of subscription revenues, but we see this short-term cost as very small relatively to the long-term value we are creating for the business. We estimate that had the subscription mix been in line with our initial expectation, our Q1 reported revenues would have been approximately $62 million, nicely above the high end of our guidance range. Guy will discuss this in great detail in few minutes.

The strong subscription adoption in the first quarter further reinforced that this change was the right one for our customers and for Varonis. We are particularly pleased with the adoption in North America, and so the sales team begin to fully embrace this new sales methodology. Our guidance contemplated that the adoption of subscription by our sales teams in Europe would be slower. However, the results in the quarter lagged even our expectation. Some of this was because of resistance to change which caused unnecessary distraction and took the focus off selling. We have made a couple of changes, and we are already seeing improvement in EMEA in the second quarter in embracing this model and its advantages.

While we are only 1 quarter into the transition, which will take time and which will not be linear, I want to convey that moving to subscription model as quickly as possible is our top priority. The move to subscription is driven by customer demand for more protection and was our way to unleash the platform potential. To better protect the organization, our customers require more licenses off the bat, and our subscription model provides exactly that while leaving room for expansion over time.

Consistent with the pilot, in the first quarter, customers purchased a higher number of licenses than what we typically see with the perpetual model. Let me give you some examples. A large, independent medical group with over 0.5 million patients in dozens of locations turned to Varonis because they were concerned their data wasn't locked down well enough, and they wouldn't be able to detect insider threat. A breach could have result in HIPAA fine with serious damage to their reputation. They were also in the process of acquiring an additional medical practice, and our risk assessment show exposed PII on their newly acquired servers. 90% of the files were open to everyone in the company.

When we offer the subscription model, we were able to sell them the product they originally wanted, plus DatAlert Suite and support for Box, 6 products in total. The customer embraced the subscription model, and it was a win for everyone.

Another new customer in the quarter is a major professional sport league that sought to monitor their file shares for accountability and security and to classify and protect sensitive data. The customer was impressed by Varonis' ability to monitor their critical business data on NetApp, and they are now positioned to protect data on other platforms. The customer will leverage DatAdvantage for Windows, OneDrive and SharePoint online; Data Classification Engine and GDPR Patterns for data visibility and control; and to define their data permission process with business owners. Both of these are great example of customers who, with the perpetual model, would have likely purchased 2 or 3 licenses in the initial sale.

With our subscription model, they purchased additional licenses to protect themselves in a hybrid environment, deriving more value and using their large OpEx budget. At the same time, both customers can buy many more licenses down the road, be it for enhancing alerting capabilities, remediation or protection for additional data stores. In both example, our subscription offering are accelerating the process where our customers can benefit from greater protection, and we can unleash the full value of our platform for them.

This case study validate our plan to play a more sizable role in our customers' security and compliance strategies, and we believe this is where our advanced technology and sophistication of our products are second to none.

Specifically, the machine learning, connection to data and comprehensive forensic capabilities on top of our metadata framework allow our platform to detect threats that other technology miss with very few false positives and accelerated investigation and time to resolution. Our customers detect and conclusively investigate insider threat, external attacks, advanced persistent threat and malware. For example, one investigation led to our discovery of a new variant of Qbot, a strain of malware that enables financial fraud.

Our efforts are particularly focused on our larger customers. We have an existing customer base that has moved rapidly up the adoption curve and we realize that we can help them with, among others, data protection in the cloud and on-prem, which is critical in a hybrid world, and compliance with new and pending regulation. They remain underpenetrated, and we want -- and want to buy more of the platform play. And by elevating ourselves within these larger customers, we can deliver on that demand. The more value we can show, the more products they buy. The results from the pilot and first quarter proved that the economics make sense for them to do so through subscription.

As I said, moving to subscription as quickly as possible is our top priority. This transition is not something we can be half committed to, and the discipline in making this move is where we are focused. There were deals in flight in the first quarter that we needed to convert from perpetual, and we expect this dynamic to continue over the next few quarters. We also saw outsized revenue growth in Europe in the first half of 2018 that we are cycling past.

Regardless, the more rapidly we move through the transition, the more momentum our flywheel gain from the compounding benefit of the subscription model and the stronger the underlying business. In short, we are extremely pleased with our first quarter result. The transition to subscription is well underway, and we expect this momentum to continue in Q2 and for 2019.

With that, let me turn the call over to Guy. Guy?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [4]

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Thanks, Yaki. Good afternoon, everyone. I'll begin today by recapping our Q1 result, followed by an update on the first full quarter of our transition to subscription. I'll then discuss our second quarter and full year 2019 guidance before we open for Q&A.

When we announced the transition last quarter, we told you we would provide more detail on adoption trends as they unfold, and that's what I want to go through today. Specifically, I'll discuss the impact of the business mix, our expected break-even periods for selling subscription versus perpetual, ARR metrics and the potential impact on revenues if subscription is higher than expected in future quarter.

For Q1, total revenues were $56.4 million, an increase of 5% year-over-year. First quarter license revenues were $22.5 million which included over $7 million of subscription revenue. This number, which far exceeded our expectations, validates why the move to subscription makes so much sense for our customers and for Varonis.

We were pleased to see strong subscription license adoption during the quarter for both new and existing customers. New customers who purchased subscription products purchased a higher number of licenses compared to perpetual, in line with the pilot we ran in the second half of 2018. We were also pleased with the subscription purchases from existing customers which again exceeded our expectations.

To remind you, our subscription price list is set as 40% to 45% of the perpetual price list, including first year maintenance which equals a 3-year break-even period. This quarter, the payback period overall for subscription sales to both new and existing customers was 3 years. This is a number we're happy with. We expect the payback period to remain around these levels for the next several quarters, but believe it can improve as we go through quotes that have been introduced under perpetual pricing. To remind you, our sales cycle are 3 to 9 months and can be closer to 12 months for larger deals.

Turning back to our results. License revenues decreased 10% from the first quarter of 2018 due to the much-higher-than-expected mix of subscription. As Yaki mentioned, 31% of license revenues during the first quarter were subscription compared to 4% in the first quarter of 2018 and a significant increase over our 10% guidance at the beginning of the year.

We understand that the faster we transition to subscription business, the greater the near-term headwind to reported revenues we'll experience, but the stronger the underlying trends for the business. Incorporating the payback period math I just discussed, we estimate that the higher-than-expected subscription mix reduced Q1 total revenues by approximately $5.4 million as compared to the guidance, impacting our license revenues. In other words, as Yaki mentioned, had the subscription mix been in line with our 10% guidance, our revenue would have been nicely above the high end of the guidance range.

Maintenance and services revenues were $33.8 million, increasing 19% compared to the same period last year. Our maintenance renewal rate was again over 90%.

Annualized recurring revenues, or ARR, defined as the annualized value of all recurring revenues related to active contracts at the end of each period, was $138.7 million at the end of the first quarter compared to $103 million last year, representing growth of 35%. ARR excludes revenues related to deals that are not renewable such as perpetual license and professional service.

Before I discuss our first quarter operational and financial results in greater detail, I would like to make 2 housekeeping points related to the subscription revenue. The first is to remind everyone that maintenance on subscription revenues is recognized ratably and will appear as part of our subscription line item we now break out in the financial statement, and that maintenance related to perpetual license appears in the maintenance and services line.

Second, we have added a slide to our investor presentation providing an example of the way in which we recognize subscription and associated maintenance revenues with a subscription deal.

Turning back to our results. Looking at the business geographically, North America revenues increased 20% to $37.8 million or 67% of total revenues.

In EMEA, revenues decreased 19% to $16.4 million, representing 29% of total revenues due in part to the challenging comp we faced in the first quarter of 2018, where we grew 60%, as well as the subscription transition issues Yaki noted. While the pipeline in Europe is healthy and customer demand in the region is strong, I would like to remind you that we again face a difficult comp in the second quarter. However, we do see improvement in the adoption of subscription with our sales team in that region.

Lastly, Rest of World revenues were $2.1 million or 4% of our total revenues.

For the first quarter, existing customer license and first year maintenance revenue contribution was 56%, up from 49% in Q1 2018. During the quarter, we added 133 new customers, and we ended Q1 with approximately 6,700 customers. While we saw the total and 1,000 plus number of new customers grow nicely in North America, the overall lower number of new customers is due to the distractions caused by the adoption of the subscription model in EMEA.

As of March 31, 2019, 73% of our customers had purchased 2 or more product families, up from 70% as of the same date last year. 41% of our customers purchased 3 or more product families compared with 37% in Q1 of 2018.

Moving to the income statement. I'd like to point out that I'll be discussing non-GAAP results going forward, unless otherwise stated, which for the first quarter of 2019 exclude a total of $9 million in stock-based compensation expense and $1.9 million of payroll tax expense related to stock-based compensation. Also excluded are foreign exchange losses of $600,000 related to new leasing accounting standard, ASC 842, adopted in the first quarter of 2019. We exclude foreign exchange gains or losses associated with the revaluation of financial lease liabilities in foreign currencies as they do not reflect the true performance of the company.

Gross profit for the first quarter was $48.8 million, representing a gross margin of 86.5% compared to 89.1% in the first quarter of 2018. This was slightly lower given total revenues were lower due to the transition and as a result of investment in our teams that are supporting it.

Operating expenses in the first quarter totaled $59.9 million. As a result, our operating loss was $11.1 million, or an operating margin of negative 19.8% for the first quarter, compared to an operating loss of $6.7 million or an operating margin of negative 12.5% in the same period last year. As you are aware, the move to subscription does impact our reported revenue while our cost basis is relatively fixed which is putting downward pressure on our operating margin during the transition. We do expect this to continue throughout the transition, but our philosophy and commitment to profitability has not changed. The faster we move through the transition, the quicker we believe we can show healthy, positive improving margin and the stronger our long-term position will become.

During the quarter, we had financial income of $454,000 primarily due to interest income, compared to financial income of $978,000 in the first quarter of 2018 primarily due to foreign exchange gains. As you know, foreign exchange gains and losses can fluctuate. Our guidance does not consider any potential impact to financial and other income and expense associated with foreign exchange gains or losses as we don't estimate movements in foreign currency rates.

Our net loss was $11.2 million for the first quarter of 2019, or a loss of $0.38 per basic and diluted share, compared to a net loss of $6.3 million or $0.22 per basic and diluted share for the first quarter of 2018. This is based on 29.8 million and 28.4 million basic and diluted shares outstanding for Q1 2019 and Q1 2018, respectively.

Turning to the balance sheet. We ended the quarter with approximately $164 million in cash, cash equivalents, marketable securities and short-term deposits. One reminder as we discuss the balance sheet. Deferred revenues do not include multiyear subscription contracts with an automatic renewal component for which the associated revenues have not been recognized and the customer has not yet been invoiced.

For the quarter, we generated operating cash flow of $14.1 million compared to operating cash flow of $17.4 million in the first quarter of 2018. We ended the quarter with 1,451 employees, a 10% increase from the first quarter of 2018.

Moving to guidance. Given the success we are having with subscription adoption, we are now meaningfully increasing our expectation for subscription mix as a percentage of license revenue. For the second quarter and full year 2019, we now expect this to be 25%, up from our previous guidance of 10%.

For the second quarter of 2019, we expect total revenues of $61.5 million to $63 million, representing flat year-over-year growth at the midpoint. We expect our non-GAAP operating loss to range between $9.5 million and $8.5 million and non-GAAP loss per basic and diluted share in the range of $0.33 to $0.30. This assumes a tax provision of $500,000 to $700,000 and 30.3 million basic and diluted shares outstanding.

As for our new estimate for the full year 2019 subscription mix, I would like to remind everyone that Q4 is still CapEx heavy, and we are factoring this into our full year subscription mix expectations. In addition, while we're still gathering customer adoption trends and metric, we currently estimate that for every incremental $1 million of subscription revenues we generate versus our guidance, we will see $1.2 million to $1.5 million headwind to reported revenues. This is consistent with the break-even math I discussed and assumes the payback period trends we currently see continue for the next few quarters. At the same time, even though we are aggressively managing expenses, given that our expenses base is relatively fixed, we expect incremental subscription adoption on top of the -- our 25% guidance to impact our non-GAAP operating profit by the same amount.

As a result, for the full year 2019, we now expect total revenues in the range of $271 million to $278 million, representing year-over-year growth of approximately 2% at the midpoint. We now expect our full year non-GAAP operating loss to be in the range of $14.5 million to $10 million and non-GAAP net loss per basic and diluted share in the range of $0.54 to $0.42. This assumes a tax provision of $2.2 million to $3.2 million and 30.2 million basic and diluted shares outstanding.

In summary, Q1 subscription results greatly exceeded our expectations, and we are pleased with the adoption of customers, buy-in of our sales force and the excitement of our partners. While we understand that we are still in the early stages of this transition, this quarter gives us confidence to be able to execute against our targets this year. Moving forward, we expect to become a subscription-based software company with a growing platform for our customers while generating greater value for our stockholders.

With that, we would be happy to take 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 Matt Hedberg with RBC Capital.

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Daniel Robert Bergstrom, RBC Capital Markets, LLC, Research Division - Analyst [2]

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It's Dan Bergstrom for Matt Hedberg. See the subscription transition got off to a nice start with much better traction than expected, just curious if anything surprised you or was different than your assumptions given the strong initial adoption.

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [3]

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Yes. We didn't know at the beginning exactly what to expect, but as the quarter started to -- when we started Q1, we just understood several things. The first thing we understood very well is that we need to be very disciplined with it. We really need to make sure that we are very disciplined and we are converting a lot of the deals. Remember, we are entering -- enter the year with multi-hundred million dollars of perpetual pipeline. We also understood very fast that all the assumptions regarding the adoption curve of the platform were right, and that it was also the right timing.

So overall, we -- it's still not earmarked. But our customers have any -- have many budget -- buckets of budgets for Varonis inside of data protection, compliance budget under the CISO and a lot of them becoming more and more OpEx. So the timing and the discipline, the budget and the platform, everything worked very well, and we have high level of confidence that we can be a fully -- a very strong recurring revenue business.

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Daniel Robert Bergstrom, RBC Capital Markets, LLC, Research Division - Analyst [4]

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Great. And then you mentioned some changes in Europe following some softer new customer additions there with the subscription model. Could you elaborate on those a bit?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [5]

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Yes. So Europe was slower to adopt is something that we definitely anticipated, but Q1 was below expectations. We saw some resistance to change. Overall, it was a great quarter, 31% mix in terms of subscription was over and beyond our wildest expectation. But we had a couple of managers we needed to change and some reps just to make sure that everybody will be on board, understand very well to over communicate. Without a doubt, we're in the right direction, and we are pleased with the pace and everything that's going on in Europe.

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Operator [6]

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Our next question comes from the line of John DiFucci with Jefferies.

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Joseph Anthony Gallo, Jefferies LLC, Research Division - Equity Associate [7]

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This is Joe on for John. It was great to hear your overall commentary that results would have exceeded the high end of the revenue range for the quarter, and thanks for the reconciling to the 10% subscription mix. But taking it a step further, when we're trying to think about the equivalent license growth as compared to last year, we calculate the business was a little shy of 20% license growth, approximately in line with what we saw last quarter. Is that roughly correct and then in line with what you're seeing as far as business momentum?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [8]

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When we finished Q4, a lot of investors and a lot of the analysts were asking for some information and to provide some of the metrics that we're providing now, but we didn't have the same supporting and the same data that we have now. So when we look at that 3-year breakeven, and when we look at how we price that -- the subscription price that being at 40%, 45% of the perpetual and first year maintenance purchase, when we do that and use that factor into our Q4 numbers, we feel very good with license that would have been north of 20%. And that 2 -- 2.2 to 2.5 factor that we see throughout 2019, we feel very good with that breakeven here.

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Joseph Anthony Gallo, Jefferies LLC, Research Division - Equity Associate [9]

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Great. That's very helpful. And then just moving on, you briefly touched on why 4Q would be impacted by it, but you reported 31% of license was subscription this quarter, but guided 25% next quarter and for the year. So just wondering why you now expect a lower percentage for next quarter and the year. And the reason we ask is the business momentum appears to be holding steady. So I'm just wondering optically whether next quarter we're going to have to raise the percentage of subscription again and then lower estimates for the year.

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [10]

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No problem. So first of all, 31% is a number we're very, very proud of. And if you've asked us 90 days ago, we -- definitely not a number we would have thought of. So in essence, the move from 10% and to the guidance of 25% for the year basically means we're a year ahead of the transition, and we're really aiming to rip the Band-Aid off as quickly as we can.

With that said, Q1 is still our smallest quarter. We have deals in flight, and we're trying to convert with a sales cycle that is between 3 to 9 months. The way we're looking at this from a breakdown in terms of the quarters, we see Q2 being 25%, Q3 being slightly higher. And just like I said in the prepared remarks, Q4 is still kind of CapEx heavy, so we are baking that in with some caution. But overall, we're very happy with kind of the uplift and how quickly we're moving with this transition.

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Operator [11]

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Our next question comes from the line of Saket Kalia with Barclays.

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Saket Kalia, Barclays Bank PLC, Research Division - Senior Analyst [12]

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Maybe first for you, Yaki. Just thinking in a little bit more on subscription. I think you talked last quarter about some of the different subscription bundles to really drive that more adoption of different tools for -- using subscription pricing. Now that you've had a full quarter of really a full effort, can you just recap what some of those bundles are? And maybe qualitatively, which ones are maybe doing a little bit more successful than the others?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [13]

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We have a -- we have many bundles and really we sold all the configuration, but some of the more popular ones are the security bundles, the dls, directory services and Edge. Everything that related to Office 365 protection with a classification, Automation Engine, a lot of them just work together and definitely for new customers, they can buy more right off the bat. In terms of the up sales, we also sometimes because we have so many deals in flight, we are really converting apples-to-apples in terms of the number of the actual licenses. But all the bundles worked well and the -- overall, the plan to move to subscription, the way that we executed and how we are positioning it and the way that customers want to consume the platform, we're okay, according to plan.

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Saket Kalia, Barclays Bank PLC, Research Division - Senior Analyst [14]

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Got it. Got it. Maybe for my follow-up for you, Guy, and I think you touched on this in the last question, just ask it slightly differently. Obviously, the subscription mix as a percentage of license is off to a faster start than I think any of us expected. But I think the guide for Q2 being at 25%, still much healthier than the 10% we expect at the very beginning of the year, but down sequentially. You touched on what that cadence looks like through the year, Q2 25%, maybe Q3, slightly higher, and then Q4 being a little bit more CapEx heavy on perpetual. But why the sequential downtick in Q2? Is that related to sort of the deals in flight, or any color you would shed on Q2 specifically?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [15]

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Absolutely, Saket. So first of all, talking about the transition for a second. The fact that we put so much thought, and it was so detailed in terms of the process, and we've really worked hard over the last year and a half. And I think the 31% really proves how much thought was put into this. We wouldn't have reached that percentage otherwise. But when I look at Q2, and the fact that Q1 is still historically the smallest quarter of the year, when you look in absolute dollar terms, we're still seeing a meaningful number with that 25%.

And just looking at the evolution, we are trying to move as quickly as we can. And just to point out, this 31% is only from selling to new and existing customers. We're not converting the maintenance portion. So that 31% is just from new deals. We feel very good about the transition and how quickly we can do that transition. But we're just being very cautious because Q1 has been historically the lowest quarter of the year.

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Operator [16]

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Our next question comes from the line of Alex Henderson with Needham & Company.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [17]

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I was hoping you could talk a little bit about the pipeline of deals in flight that are perpetual and how that declines over the course of the year. I assume that you came into the year with virtually everything being deals in flights that are perpetual and that gradually, as we move through the year, fewer and fewer perpetual deals are started. And therefore, the mix rapidly over the course of the year changes to a pipeline that's predominantly the subscription-related transaction. Can you talk to that -- those percentages that of the pipeline? Do you think you'll exit the year with no perpetual deals in flight? Or will it be still a meaningful percentage?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [18]

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We are -- first, we are giving guidance and the guidance is what is important in terms of the percentage and this is what we can talk about in confidence. But Alex, what we see now is really that we can be a subscription business and a very strong one, a platform-based subscription business. We have massive pipeline. So as we are cycling through this and converting this massive pipeline, we don't want to do -- to harm the businesses in any way and to harm critical stakeholders which are the customers. Having said that, we are extremely disciplined and the top priority is to move to subscription.

So as we move throughout the year, yes, a lot of the pipeline, more and more of the pipeline will be subscription. But to tell you exactly how it will play out, as you see, we will provide more insight as we have it. And 90 days, it's a lot of time. And so far, the transition is -- overall, is really moving forward with flying colors. And I think that you guys have every benchmark of companies, the big transition. And so far, it's very strong, and we anticipate it will continue to be strong. But again, massive pipeline, a lot of customers, well over a decade that we sold perpetual, we just want to make sure that we are careful.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [19]

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Okay. Well, we didn't really address that question. Let me try a different angle. If we look at the deals that you've closed that are subscription-based and have include the Automation Engine in them as well as DatAlert, I would assume that you're getting faster time to install, and therefore, time to value and significantly more value for your customer. Can you talk a little bit about whether you're seeing faster installations because the automation is included upfront as opposed to the other -- the traditional model that usually you sold that as an add-on?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [20]

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In terms of the Automation Engine, specifically, yes, when we put the Automation Engine, there is just tremendous acceleration in the excessive permission remediation. But this works both in perpetual and subscription.

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [21]

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And just to add to that, Alex. In terms of the sales cycle, we still see the sales cycle being 3 to 9 months; and for the larger deals, up to 12 months. We haven't seen any change in the sales cycle with selling subscription.

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

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But does the installation time get reduced?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [23]

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No. No. We're selling on-prem subscription, so it's basically the same process. We're selling the same licenses, just for a different time period.

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Operator [24]

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Our next question comes from the line of Shaul Eyal with Oppenheimer.

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Shaul Eyal, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [25]

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Similar to what you had seen in the West Coast, that was back in the third quarter of last year, do you think this is a similar situation currently taking place in Europe or is there different dynamics? I know you've mentioned some resistance to change. But can you provide us with a little bit of more color in that respect? And do you think you should be able to overturn that as quickly as you've done last year?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [26]

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Shaul, so let me give some color as to what the impact of the transition was on Europe. And basically, we expected a slower adoption in Europe and it was baked into our guidance. But when we rolled the plan globally, we couldn't provide the same incentives as we did when we kind of did the pilot. So it's definitely still a year where reps can make significant amounts of money. But from a commission perspective, in the pilot, we paid on TCV; and when we rolled this out, we paid on ACV on year 1. And then on auto renewal on year 2, we paid 50% and on the third year auto renewal, we paid another 50%.

Some of the other changes that we had were kind of introducing a concept of a grading system where reps can make more money if they sell at the right discount and they get penalized if they sell at hefty discounts. And all of this, together with kind of the payment terms that we have in -- with the subscription, where we pay 50% in year 1 and 50% in year 2, all of that caused a lot of, kind of, commotion with the rest. We had a lot of conversations with European teams. Unfortunately, that resulted in distractions and kind of taking the eye off the ball. But the positive thing is that the teams in Europe now better understand the opportunity, I think they've -- they're seeing how well North America sales teams are doing, and that's absolutely a motivating factor. And we believe that subscription adoption in Europe will be better in Q2.

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [27]

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And Shaul, of the quality, yes, we know how to solve problems very fast. The teams are good, the customers are great, the overall demand is very strong. Remember, Q2 last year, it was 60% growth, but we're in the right direction in Europe. To do this transition and to do the transition aggressively, it's a big undertaking. You need to be very disciplined, and you need to make sure that everybody are on board, and this is the top priority. The top priority is to move to subscription as fast as possible and really to build this flywheel. And very early we understood that this is what we need to do and to make sure that to remain everybody on board and everybody will execute in lockstep. We just didn't want to be just in between. We are committed to subscription, and this is where we are going.

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Shaul Eyal, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [28]

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This is a great color both, Guy and Yaki. And my second question, I think in your prepared remarks, you've mentioned a number -- I think you brought up a number of examples of customers that are shifting to a higher number of subscriptions. I believe one of them even adopted 6 subscriptions, if I'm not mistaken. But do you have currently some sort of average number of products per customers, that if you aggregate, I know it's been such a long duration, but any updated thoughts or even numbers on products per customers?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [29]

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Absolutely, Shaul. I'll give you some color and also kind of on the 3-year breakeven, I'll tie it in together. Where -- when we built the price list to subscription, it was priced as 40%, 45% of the perpetual price list, including that first year maintenance. And when we -- the whole intention of moving to subscription was to unleash the potential. So what we saw selling to new customers is that we very much mimic what we saw during the pilot. We were able to sell to new customers between 4 to 5 licenses where initially, under the perpetual license, the initial purchase usually was with between 2 to 3 licenses. So very nice improvement there which basically brings kind of the break-even period to be shorter.

On the flip side, the upsell that worked very well in the pilot also continue to work very well with our existing customers, selling more licenses to them. But that really -- that break-even period was slightly higher. So the kind of the mix of both is a 3-year breakeven, which by the way, we're very happy with that number.

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Operator [30]

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Our next 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 [31]

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Congrats on the subscription transition. Yaki, thinking about the 30% or 31% of license that came in subscription. How is it that business wasn't in the original pipe that was going to come as perpetual license? And do you feel it's like completely net new just simply due to the subscription offering?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [32]

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Melissa, a lot of it was perpetual that we converted. A lot of it was perpetual that we converted, and North American team did unbelievable job. And our leadership really was behind it and then executed. And we -- the other thing that is very important to understand is the overall adoption curve with new customers that want more licenses right off the bat and for the customers that have a path to consume -- that they have a path in several years to consume the whole platform. They want to go with us to the cloud and every regulation that they have, they want to make sure that all the vast security analytics features are working. So clearly, the adoption curve, where we sit within our customers, is very strategic to the seesaw, a lot of automation and our ability to execute on this market demand. I can tell you that at the beginning of the quarter, it's still 31%. We didn't think that something like that is possible, but we really saw that a lot of the pipeline we can compare, and we have a lot of confidence that we can do very well with the subscription.

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Melissa A. Franchi, Morgan Stanley, Research Division - VP and Research Analyst [33]

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Okay. Okay, great. And then you talked a lot about sales force selling subscription, really they're fully ramped in the U.S. But can you talk about the channel of engagement here in subscription, how they're coming on board? Because I know that most of your business does come through the channel or at least they're channel touched at some point, but are they fully ramped on selling subscriptions at this point?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [34]

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Channel love the subscription because you know this, the recurring revenues from the subscription are high, they know. Think about it, it's like a much, much bigger renewal business, and it makes a lot of sense. And the way that we are catering to this new hybrid world works very well for the channel partners. So it just works for everybody, works for our customers, first and foremost, works for the channel partner and works for our sales force. And we believe that it can work very well also for the shareholders. So it just works for the whole food chain of the stakeholders.

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Operator [35]

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Our next question comes from the line of Gur Talpaz with Stifel.

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Gur Yehudah Talpaz, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [36]

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Yaki, last quarter, you mentioned sort of the notion of sticker shock being an issue within the license sales. Is it fair to say now, with what you've seen in the last 90 days or so, that at least a good portion of that has been ameliorated with this migration to subscription?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [37]

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Yes, without a doubt. Customers now, they can get things -- they understand very well that they can get more licenses right off the bat, and they can also plan and say, okay, this is what I want from Varonis for the next 3 years. This is how it works. We have a big OpEx budget for it, and it's much better to do multiyear planning. So -- and as I said, with the adoption curve and the features that they want and a lot of automation and sitting on more platform, the model works very well.

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Gur Yehudah Talpaz, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [38]

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Then a question for both of you and Guy. I know it's early, but obviously, the migration's happening faster than you anticipated. Is there a period when you kind of foresee ripping the Band-Aid off and going fully to subscription? And what would you be looking for to kind of make a decision like that?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [39]

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Gur, we're not a management of both statement, but our commitment is for subscription. This is where we are going. This is -- we are very disciplined, but we need to cater to our customers. But we know that subscription is the recipe for happiness for our customers and for us, for everybody. So this is what we are going to do. We are going to be very, very, very focused. But to come now and tell you when we are not going to sell perpetual, it's not something -- it's irresponsible.

So give us some time, every 90 days, we'll have more color. And just think what happened in the last 90 days. We're sitting here, look at the results, look at the level of confidence, how we can talk about what is working, what we need to do. We have done a lot of just the right decisions and introduced a lot of discipline and it's really a different place in terms of the subscription and our ability to build the supply with -- and execute. And every 90 days, we'll give you more color as we see -- as we have more visibility of how this thing is playing out.

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Operator [40]

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Our next question comes from the line of Dan Ives with Wedbush.

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Daniel Harlan Ives, Wedbush Securities Inc., Research Division - MD of Equity Research [41]

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So my question, what maybe surprised you as you went through this transition, both good and bad? I mean in terms of your conversations with customers, sales throughout the last 90 days.

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [42]

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It's what -- the main thing that it's -- you always know it, but like 2 years ago, we sell completely on discretionary funds on CapEx is how much budget the customers had. As I said, it's still not earmarked, but there are these big budgets. Also, the ability for customers to plan, we are doing a lot of EBCs with customers and what we call value should be ours and we're just becoming more strategic for our customers. And once you have it, it makes more sense to spend time with them and the overall business is becoming more predictable.

I think that what surprised me more than anything else is the overall speed and also we learned, like mid-February, that if we'll be very disciplined about it, the market is ready for it. So the customers are ready, there is a lot of demand, this is how they -- and a lot of the stuff are related to us. We need to be very disciplined, we need to make sure that everybody are executing the plan. But overall, the surprise was the market reaction to the move.

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Daniel Harlan Ives, Wedbush Securities Inc., Research Division - MD of Equity Research [43]

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Yes. Okay. And then, just maybe a follow-up. I think it was Melissa that asked it. But do you find now with the transition that there's deals maybe that are starting to come into the pipeline, maybe deals that 6 months ago were kind of cold and are now customers are coming back to you? I guess in terms of like new deals just because of the transition?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [44]

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Not the actual transition. Some customers that wanted more licenses and they needed to -- and they had more OpEx budget can definitely buy. But I just think that overall the adoption curve, we have the Automation Engine and Edge and 365 which is huge for us. So customers can come and we sell more in the security side. So a lot of it is the cyber security and alerting is compliance reporting on all the platform and then very effective remediation. And customers understand that they can really buy and use OpEx and subscription to cover all the infrastructure and the data is positive.

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Daniel Harlan Ives, Wedbush Securities Inc., Research Division - MD of Equity Research [45]

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Great. Solid quarter managing this transition.

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [46]

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Thank you.

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Operator [47]

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Our next question comes from the line of Erik Suppiger with JMP.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [48]

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Can you talk a little bit about what kind of billings we could factor in? Your deferred revenue declined from $88 million to $82 million, sequentially. How can we think of the contribution from billings in the deferred revenue?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [49]

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So first of all, in terms of the deferred, I think the right way to look at it is Q1 '19 versus Q1 '18. Remember that Q4 is the largest quarter of the year. So obviously, the deferred there, if you compare Q4 to Q1 would be slightly skewed. And when you look at Q1 '19 to Q1 '18, it was close to 20%. And that only includes the ACV portion. So the fact that we sell 3 years with the-- year 2 and year 3 auto renewed, it's not part of our deferred amount. The only part of the deferred -- and we have a slide in the investor deck that kind of breaks down the recognition and the deferred portion, the deferred part is only of that first year, the maintenance part that hasn't been recognized. So it's actually very good growth in terms of the deferred.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [50]

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Okay. And then secondly, given the customers have some flexibility using a consumption-based model, has that made a difference in terms of the initial deal size? Do customers scale back the initial purchase more than they would have with the perpetual license? Or has that made a difference?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [51]

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So in one of the previous questions, I talked about the fact that the new customers, really in unleashing the potential, bought more licenses under the subscription model than what they usually bought in that initial purchase under the perpetual license. So it was close to -- it was between 4 to 5 license on the subscription where we used to see on the perpetual between 2 to 3 licenses which that basically shortens that 3-year break-even period.

On the flip side, on the upsell side, which we were very happy during the pilot seeing our existing customers taking advantage of this model, and we continue to see that in Q1, many of our existing customers bought more licenses through that model, and they're happy to unleash the potential and buy licenses through that as well. When we look at the -- at the break-even period for the upsell, that was slightly over 3 years and the mix of those 2 together puts us at a 3-year break-even period which we're very happy with. It's a very good number.

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Operator [52]

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Our next question comes from the line of Jonathan Ruykhaver with Baird.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [53]

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Yes. I'm wondering if you could talk about Version 7.0 of the Varonis Data Security Platform, and in particular some of the enhanced functionality within the 3 dashboards. And what products do customers need to buy that they don't have that will deliver on that full functionality within the dashboard? My understanding is that it could be a catalyst to higher ASPs. Is that true?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [54]

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Version 7.0 was a monumental milestone for us in terms of the overall infrastructure and the dashboard, the Directory Services dashboard and everything that's related to GDPR. But so far, it's working very well and exceeding our expectations. There is also a lot of enhancement to Office 365. So once you have it, obviously, we have Edge that is GI on this platform, on top of Solr, so it's working very well and we believe that it has tremendous potential.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [55]

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Do you see a higher attach rate around SharePoint DatAdvantage for Office 365 data classification, OneDrive, which are all relevant to that Office 365 dashboard?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [56]

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Yes. I think so, that with time, we will see a very strong attach rate.

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Jonathan Blake Ruykhaver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [57]

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Okay. Good. And how quickly would you anticipate the installed base upgrade to Version 7.0? Would that happen rather quickly?

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [58]

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Yes. I think that overall, yes. But give us -- we have -- we are starting to do it. It's going well. But give me another 90 days, and I will have more empirical evidence and I will be able to talk about it in the actual upgrades in more confidence. But the version so far is working great and just exceeding our expectations. As I said, it's just a monumental milestone for us, and it gives customers so much value.

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Operator [59]

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Our next question comes from the line of Rishi Jaluria with D.A. Davidson.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [60]

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I really appreciate all the disclosures and details. And with that, let me start with ARR. I guess first, from a housekeeping perspective, this is tracked really just on subscription license, subscription maintenance and then professional maintenance, correct? No other buckets that would be considered recurring, nothing like recurring services. Is that a fair statement?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [61]

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Yes.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [62]

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Okay. Great. And then so the last 2 quarters, ARR has been in low to mid-30s grower. Directionally, how should we think about ARR growth rates going forward?

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [63]

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So as you know, this is the first quarter, we're providing ARR as we said we would as part of the transition, and we're looking at this metric and happy to share it with investors and with the analysts. Looking at kind of the progression, obviously, our desire is to move as quickly as we can through this transition, and Yaki talked about that. We're very committed in doing so. And obviously, the more we can sell subscription, the higher that ARR number will be. So we're very happy with the number we have in Q1, but expect that number to continue to grow throughout the year as we increase the subscription mix. So it's hard for me to give you an exact guidance right now. But as we progress, and we'll look at the numbers, and hopefully, -- and as we expect, they will continue to grow.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [64]

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Got it. That's helpful. And then just on the perpetual maintenance line which I know it's included along with professional services as well. But that still meaningfully grew year-over-year in the quarter. I understand there's not the conversion elements just yet, but is there a certain point at which we should expect this to meaningfully decelerate or even turn negative? Just any color you can give directionally on that line item would be really helpful.

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Guy Melamed, Varonis Systems, Inc. - CFO & COO [65]

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No, that's a great question. Now that we're breaking out the subscription line item in the financial statements, and we are including both the license of the subscription and the maintenance of the subscription. And the higher we sell subscription and the higher that mix, obviously, the maintenance line item, that is the maintenance of perpetual, should be impacted. So I would expect that line item on the maintenance side for perpetual to be affected. And it definitely depends on how quickly we can transition and the pace that we go there.

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Operator [66]

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Ladies and gentlemen, we have reached the end of our question-and-answer session, and I would like to turn the call back over to management for closing remarks.

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Yakov Faitelson, Varonis Systems, Inc. - Co-Founder, Chairman, CEO & President [67]

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I would like to thank all of our customers and partners for their continued support. Thank you for joining us today. We are looking forward to speaking with you soon again.

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Operator [68]

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This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation.