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OneSpan Inc. (OSPN) Q2 2019 Earnings Call Transcript

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OneSpan Inc. (NASDAQ: OSPN)
Q2 2019 Earnings Call
Jul 25, 2019, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Hello and welcome to the OneSpan second-quarter 2019 earnings conference call. [Operator instructions] I'd now like to introduce your host for today's call, Joe Maxa. You may begin.

Joe Maxa -- Director of Investor Relations

Thank you, operator. Hello, everyone, and thank you for joining the OneSpan second quarter 2019 earnings conference call. My name is Joe Maxa, and I am the Director of Investor Relations. This call is being broadcast over the internet and can be accessed on the Investor Relations section of OneSpan's website at investors.onespan.com.

With me on the call today and speaking first will be Scott Clements, OneSpan's chief executive officer. Also on call is Mark Hoyt, our chief financial officer. This afternoon after market close, OneSpan issued a press release announcing results for our second-quarter 2019. To access a copy of the press release and other investor information, please visit our website.

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Following our prepared comments today, we will open the call for questions. Please note that statements made during this conference call that relate to future plans, events or performance, including the guidance for full-year 2019, are forward-looking statements. We have tried to identify these statements by using words such as believes, anticipates, plans, expects, projects and similar words, and these statements involve risks and uncertainties and are based on current expectations. Consequently, actual results could differ materially from the expectations expressed in these forward-looking statement.

I direct your attention to today's press release and the company's filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties in this regard. Please note that certain financial measures that may be discussed on this call are expressed on a non-GAAP basis and have been adjusted from a related GAAP financial measure. We have provided an explanation and reconciliations of these nonfinancial measures to the most directly comparable GAAP financial measures in the earnings press release.

In addition, please note that the date of this call is July 25, 2019. Any forward-looking statements and related assumptions are made as of this date. Except as expressly required by the federal security laws, we undertake no obligation to update these statements as a result of new information or future events or for any other reason. At this time, I will turn the call over to Scott.

Scott Clements -- Chief Executive Officer

Thanks very much, Joe, and good afternoon, everyone. Thanks for joining us here today. We reported 13.5% year-over-year revenue growth in the second quarter, with double-digit growth in both hardware and software, including 40% growth in subscription software. Bookings remained strong with hardware up nearly 10% and software up nearly 30% year over year.

Adjusted EBITDA improved $4.7 million sequentially to $2.5 million on higher gross margin, partially offset by higher operating expenses. In the second quarter, we launched our Trusted Identity based Secure Agreement Automation solution and already have a pipeline of customer opportunities that numbers in the double digits. During the quarter, we also released an update to our Intelligent Adaptive Authentication solution, extending support to all key OneSpan authentication technologies. Our overall pipeline of global Trusted Identity opportunities presently exceeds 50, including Intelligent Adaptive Authentication, Risk Analytics and agreement automation solutions.

These customer opportunities range from small institutions to tier 1 global banks. We expect our TID pipeline to continue to grow and for production deployments to be in the double digits by the end of 2019, with material revenue contribution occurring in 2020. During the quarter, we strengthened our e-signature product line with the release of our Qualified Electronic Signature capability for Europe and Asia. We can now meet the requirements of the European eIDAS regulation for all three classifications of e-signature in a more scalable and efficient manner.

Partly as a result, our international pipeline of e-signature products is expanding -- I should've said our international pipeline of e-signature opportunities is expanding. In addition to positive customer feedback on our new solutions, we continue to be recognized by the software and security industries for our new solutions. Intelligent Adaptive Authentication was recognized with the SIIA CODiE award for the Best FinTech Solution and by Frost & Sullivan with their Global Customer Value Leadership Award.Finally, we're hard at work expanding our partner ecosystem to enable our Trusted Identity solutions and to expand our market access. We recently announced a new relationship with Avaloq, a major European provider of core banking software as a service solutions.

Several other as yet unannounced partnerships were also recently finalized and more are in negotiation. I'll now turn the call over to Mark to provide financial details about the quarter, and then I'll come back to provide a few additional comments and guidance before opening the call to questions. Mark?

Mark Hoyt -- Chief Financial Officer

Thank you, Scott. Total revenue for the second quarter of 2019 grew 13% year over year to $56 million. Product license revenue grew 15% to $40 million, and services and other revenue grew 11% to $16 million. Software license revenue grew 6% to $11 million, including double-digit growth in the Mobile Security Suite.

Hardware revenue grew 18% to $29 million; subscription revenue grew 40% to $5.3 million; and maintenance, support and other revenue increased 4% to $9.9 million. And finally, professional services revenue declined 27% to $800,000.Gross margin for the second quarter of 2019 was 68%, compared to 66% in the prior quarter and 73% in the second quarter of 2018. The sequential and year-over-year changes were primarily driven by revenue mix, with increased cloud-based infrastructure costs affecting the year-over-year change. Operating expenses for the second quarter of 2019 were $41 million, an increase of 5% from $39 million reported in Q2 last year.

The year-over-year increase was largely driven by investments in research and development. We expect total second-half 2019 operating expenses to approximate those in the first half of the year. Adjusted EBITDA, or adjusted earnings before interest, taxes, depreciation and amortization, long-term incentive compensation and nonrecurring items, was $2.5 million, in line with plan and $2.8 million lower than the second quarter of 2018. Adjusted EBITDA margin was 5%, compared to 11% in the second quarter of 2018.GAAP loss per share was $0.06 in the second quarter of 2019, compared to $0.03 in the same quarter of last year.

Non-GAAP earnings per share, which excludes long-term incentive comp, amortization, nonrecurring items and the impact of tax adjustments, was $0.01 for the second quarter of 2019, compared to $0.09 in the second quarter of last year. Our cash balances declined by $20 million in the quarter, primarily consumed by working capital due to the timing of payables and receivables and the buildup of inventories in response to near-record hardware orders in the first half of the year. We expect working capital balances to normalize over the next two quarters with a commensurate recovery in cash balance. Geographically, our revenue mix for the second quarter included 60% from Europe, Middle East and Africa; 26% from the Americas; and 14% from the Asia Pacific region.

This compares to 43%, 27% and 30% in the same regions last Q2, respectively. I will now turn the meeting back to you, Scott.

Scott Clements -- Chief Executive Officer

Thanks, Mark. The year is progressing in a positive manner for OneSpan. We expect double-digit revenue growth for both software and hardware for the full-year 2019. Our strong bookings in the first half of the year and a solid pipeline of opportunities support our optimism.

Hardware revenues will continue to benefit from PSD2-driven demand through the end of the third quarter before softening in Q4.For the second half of 2019, we anticipate solid adjusted EBITDA growth will result from higher revenue and increasing operating leverage. We expect gross margin in Q3 will be consistent with Q1, with stronger margin returning in Q4 based primarily on changes in revenue mix. As a result, we affirm our full-year 2019 revenue and adjusted EBITDA guidance. Revenue is expected to be in the range of $229 million to $237 million and adjusted EBITDA is expected to be in the range of $22 million to $27 million.

As we look to the future, the growth drivers of our company remain visible. Demand for identity security is becoming most urgent in the mobile channel. Recent studies have found that the incidence of mobile malware is exploding, now accounting for approximately 1/3 of all malware with the number of mobile malware attacks nearly doubling in the last year. These attacks are causing financial institutions billions of dollars every year.

Meanwhile, other research shows an overwhelming majority of mobile banking applications are still vulnerable to reverse engineering and code injection attacks. Our advanced mobile security technologies are effective in preventing such broad attacks, and we see additional opportunity to expand our offerings in mobile fraud prevention. Turning to regulation. The European PSD2 regulatory requirement for strong customer authentication and transaction-based risk analysis are having a positive impact on our business, and we anticipate that other regions around the world are likely to follow suit.

Financial institutions across Europe are responding with announced plans to drop SMS-based one-time passwords as a method for login and transaction verification, methods that are less secure than OneSpan's various authentication technologies. And many governments around the world are finally getting the message that they need to act to improve their own identity security and to establish regulations and laws to do the same for their citizens. With that, Mark and I will be happy to take your questions.

Questions & Answers:


Operator

[Operator instructions] Our first question comes from the line of Dan Drawbaugh with B. Riley. Your line is open.

Dan Drawbaugh -- B. Riley FBR -- Analyst

Thanks for taking the question, guys, and I appreciate the time. I'd just like to start on -- hey, doing well, guys. Can we start with the Avaloq partnership? Can you provide a little more color on how exactly that came about and if there's any way for us to think about the revenue opportunity potential there? It sounds like there's some other stuff in the pipeline. Would that be sort of similar-sized opportunities to Avaloq? Or larger or smaller? Anything you can help with there would be useful.

Scott Clements -- Chief Executive Officer

Sure, Dan. Yeah, I don't think we can give specific you a revenue number on Avaloq in particular, but a core part of the strategy, the trusted identity strategy as we build these more open cloud-based platforms and mobile tools is to really access a wide range of partners and ecosystem partnership model really across multiple phases of the business. So these partnerships include companies that provide technology into our Trusted Identity solutions, our Secure Agreement Automation solutions, for example, to help us with ID scanning and ID recognition. It extends to companies that will provide data that bolster our Risk Analytics capabilities, and it extends to technology and channel partners that will open up new markets for us.

I think this is -- in the last year or so, this is a relatively new theme for OneSpan. Historically, the company did not do a lot of this, but it really is a manifestation of the strategy and of the new products that allow us to do more of this. And so we think about Trusted Identity and Intelligent Adaptive Authentication and Risk Analytics not only as products for our traditional customer base but also products that are -- and solutions that are really relevant to the emergence of new types of online-only banks and other participants in -- nontraditional participants in the financial and the payment system. So this is how we think about it.

We think Avaloq will be a fantastic partner for us in building our business and accessing new opportunities across Europe, and there are a number of other partners that we are working with right now that -- where technology integration will be part of what we do with them and then go to market with them into the spaces that maybe we have not penetrated quite as much in the past. So that's the strategy. And I think it's a core part of how we want to continue to drive strong top-line growth for the company.

Dan Drawbaugh -- B. Riley FBR -- Analyst

OK, thanks for the color. That's great. Software licenses had a nice rebound in the quarter. Can you give us a little more color there? Anything in particular you'd like to call out? And what are you thinking about for the balance of the year in the mobile security license business?

Scott Clements -- Chief Executive Officer

Yeah, I think it's -- certainly, the first quarter was a slow quarter in terms of mobile security, and I think that was partly based on the magnitude of the order increase in hardware authentication, right? So institutions, I think many of them were very focused on that during the first quarter and didn't order quite as much mobile security. We see that starting. I think we said at the end of the quarter that we expected that to normalize a little bit more as we got into the second and the third quarters, and I think that's exactly what we're seeing. The fundamental demand for mobile security and mobile applications security is not going away.

So we think that there is a real opportunity, continuing opportunity going forward for mobile security, and we do expect that to deliver double-digit growth for us in 2019 across the full year. I'm not going to tell you that it will be the same rate of growth that we saw in 2018, which was extraordinary, growing in excess of 50%, but I certainly do expect that we will get double-digit growth out of mobile security, because it's highly relevant to our customer base and it's a product, a platform almost, that is really a unique combination of capabilities in our space.

Dan Drawbaugh -- B. Riley FBR -- Analyst

OK, great. I'm going to step back in queue. Thanks very much for the time, guys.

Scott Clements -- Chief Executive Officer

Yep.

Operator

Thank you. Our next question comes from the line of Anja Soderstrom with Sidoti. Your line is open.

Anja Soderstrom -- Sidoti and Company -- Analyst

Hey. Good afternoon, everyone. And thank you for taking my questions and congratulations on a good quarter. So I wanted to start --

Scott Clements -- Chief Executive Officer

Hi, Anja.

Anja Soderstrom -- Sidoti and Company -- Analyst

Hi. I just wanted to start talking about the pipeline you mentioned of about 50 -- over 50 customers for the TID platform, I think you said. How should I think about the realization of that pipeline and how that would affect revenue in the future, and when it would affect the revenue?

Scott Clements -- Chief Executive Officer

Yeah, I think that it's pretty consistent with what we've been saying since the beginning of the year in terms of what our objectives and goals are for this year. We do expect there will be some revenue contribution from these new solutions in the course of 2019. We expect that to certainly become more material in 2020. As you probably know, banks, when financial institutions are implementing new systems and products and things like that, they are fairly long-cycle projects.

There's a selection period that can take a number of months, and then there's usually a prototype or a pilot deployment before there's implementation into full production. So it's not unusual for these to be sort of six, nine, 12-month type projects before you start to really scale them up. And so I think when we look at that number of projects that are in the pipeline, first of all, the pipeline is very diverse, as I mentioned a little bit in the comments earlier. It covers very small institutions to some of the very largest, and it is really in every region of the world in Asia, in Europe, in Latin America, in North America, quite broad in that respect.

So I think the two biggest drivers of that pipeline right now are Risk Analytics and Intelligent Adaptive Authentication. The other couple of solutions have been launched a little bit more recently. And so those pipelines are just filling now, but I think we're out of the gate pretty well on agreement automation, Secure Agreement Automation. And so we do have a number of customers that -- a single-digit number of customers that are in production already.

And we will see some additional number of those go into production in the third quarter and the fourth quarter, and I would expect that we'll get into the -- somewhere into the low double digits in terms of these customers in production in Q4. Now many of these we will be recurring-revenue type contracts and so the revenue contribution, as you know, builds gradually over time. There will be a mix. So some of these we will be more of a license opportunity, but the major emphasis is really more toward recurring revenue.

So we'll see that revenue then start to build over 2020.

Anja Soderstrom -- Sidoti and Company -- Analyst

OK, thank you. And then if we could talk a little bit about the gross margin. You expect third quarter to be sort of in line with the second quarter, I think you said. And the hardware orders to come in the third quarter and then sort of wane off into fourth quarter.

So I guess that's going to make the gross margin being a bit lower than at least I had expected. But how is the investment in the cloud infrastructure sort of cycle out? And how is that going to impact the gross margin going forward? When are we done with that? And how should we think about the fourth-quarter gross margin?

Scott Clements -- Chief Executive Officer

Sure. So just maybe a comment on the gross margin. Mark jump in here, if you need to. What we said is that Q3 will look a little more like Q1 and then Q4 will look more like Q2 or in that neighborhood, maybe better, probably better in the fourth quarter than Q2.

And that really is just being driven by mix. We have very, very strong orders for hardware in the first half of the year. Hardware will make a significant contribution in Q3. We do expect to see software and services continue to grow at the same time.

And then hardware will not be as strong in the fourth quarter and software and services should continue to grow. So that's really the simple explanation for the margin shifts over the next couple of quarters. And then as far as the cloud cost, the cloud deployments, that is having an impact on margins this year. And I think as you would guess and understand that when we have a new customer, say, in a new location or new region, very often that means that you have to stand up a new cloud -- a new set of cloud infrastructure.

We don't own that usually. We're working through cloud services provider, like AWS, but nevertheless, there are still fixed costs to get up and running. And then as you add customers, add volume, things like that, then you start to amortize those sort of what we might call fixed costs, I guess, over more customers and more revenue and so on. So that's really the effect you're seeing is that we are in the course of launching a number of new solutions and products and in different regions of the world.

We have to make that initial investment to get the cloud infrastructure in place. And then I think that's more or less what we had expected this year. It varies a little bit depending on when we actually launch certain products and when we start to get first customers in production.

Anja Soderstrom -- Sidoti and Company -- Analyst

OK, thank you. And one last question about the research and development and the run rate for that, what to expect for the remainder of the year. Should it sort of stay on the same level after second quarter? Or...

Mark Hoyt -- Chief Financial Officer

We expect to see R&D costs temper a little bit in the second half of the year, but not too far off from where we are in the second quarter.

Anja Soderstrom -- Sidoti and Company -- Analyst

OK, thank you. That is all for me.

Mark Hoyt -- Chief Financial Officer

Thank you, Anja.

Scott Clements -- Chief Executive Officer

Thank you.

Anja Soderstrom -- Sidoti and Company -- Analyst

Thank you.

Operator

[Operator instructions] Our next question comes from the line of Matthew Galinko with National Securities. Your line is open.

Matthew Galinko -- National Securities -- Analyst

Hey. Good afternoon, guys. Thanks for taking my questions.

Scott Clements -- Chief Executive Officer

Hey, Matthew.

Matthew Galinko -- National Securities -- Analyst

So just a couple for you. One, I think you talked about the significant ramp in the e-signature pipeline in Europe, which I think is kind of long awaited now. How does that shake out? Or can you say in terms of cloud versus premise, will that be predominantly cloud? Or is Europe going to be slower as you look into the pipeline?

Scott Clements -- Chief Executive Officer

Yes. So first of all, I would say it's not limited to Europe. It's a more global affair than that. Certainly, opportunities in Asia are coming to the fore.

So it's a little bit broader than just Europe. And I think there will be a higher propensity in some respects to -- for customers that are outside of North America to do on-premise or license deals. We do expect a significant proportion of them to be cloud-based. I would say in North America, we've gotten to not completely exclusively, but new projects in North America are really heavily weighted toward cloud and SaaS implementations.

I think, that'll be a little more balanced outside of North America and we'll probably see, I would guess, more than half will still be -- over time will still be subscription, but it'll certainly be more license than in North America. I would guess -- if I had to guess, I would say somewhere between 25% and 35% will probably be more license type projects outside of North America.

Matthew Galinko -- National Securities -- Analyst

Got it. Thank you. And then on the R&D line, obviously, continuing to invest there. Can you talk -- are you willing to talk about how much of that is in the Trusted Identity suite versus ongoing kind of evolution in mobile security products? And how much has started going toward the hardware business just given the resurgence we've seen this year?

Scott Clements -- Chief Executive Officer

Well, I'm not -- I won't -- I guess I could just say no, but I'll try to give a little more color.

Mark Hoyt -- Chief Financial Officer

Don't say no.

Scott Clements -- Chief Executive Officer

Let's not say no, right? I think -- I would perhaps think about it this way. Hardware, first of all, let me start with that. Hardware consumes a modest amount of R&D. And it's -- I think, I would characterize it as similar to other hardware product businesses in terms of the level of R&D that they consume or it consumes.

In -- the balance of R&D is going to TID-related projects, to e-signature projects and to some of our legacy on-premise authentication software products. The shift -- there has been a significant shift toward TID R&D. There continues to be a relatively robust level of investment in e-signature. We are doing some pretty significant things with that product and that platform.

And so I would say that two biggest consumers of our R&D dollars right now are in those two categories. TID -- and TID, when I say that, I include platform investment as well as the development of the particular solutions and then also at a remaining high level of commitment in e-signature.

Mark Hoyt -- Chief Financial Officer

And I'll just add on here for Mr. Galinko's benefit here. Actually, we want to say no. The reason I think there's a little bit of blending of these R&D projects, so it's becoming more and more difficult to delineate and say which one's for TID, which one's for e-signature, which one's for mobile, because really those teams are working more and more closely together.

Scott Clements -- Chief Executive Officer

That's right. Yeah, I think as we go forward, we'll start to see many of these products, and not only the new ones for some of the legacy products, start to have common user interface designs and in some cases, common platform infrastructure components. So we're trying to be -- we're trying to balance speed to market with decisions, good decisions that allow us to become more cost-effective in terms of leveraging our R&D investment across the solution portfolio.

Matthew Galinko -- National Securities -- Analyst

Got it. Really appreciate the answer. That's it for me.

Scott Clements -- Chief Executive Officer

Sure. Thanks.

Mark Hoyt -- Chief Financial Officer

Thanks, Matt.

Operator

Thank you. We have a follow-up from Dan Drawbaugh with B. Riley. Your line is open.

Dan Drawbaugh -- B. Riley FBR -- Analyst

Hey. Thanks for sneaking me back in here. I just wanted to follow up on capital-deployment priorities. You mentioned a recovery in the second half from a working capital standpoint.

I know inventory kind of ran up on this quarter on the PSD and the hardware demand. What are you sort of thinking about as far as where the cash balance should be going? What are you looking at? Is there an acquisition pipeline that you are seeing anything in? Or what are the priorities you're focused on right now?

Scott Clements -- Chief Executive Officer

So it's a good question, Matthew. It's something that we talk about a lot. We, in fact, had a discussion about this with our board last week. I said Matt.

Mark Hoyt -- Chief Financial Officer

You said Matt.

Scott Clements -- Chief Executive Officer

I'm sorry, still on the last call. Sorry, Dan.

Dan Drawbaugh -- B. Riley FBR -- Analyst

It's fine.

Scott Clements -- Chief Executive Officer

So as we do every quarter, essentially, we just had a pretty robust discussion with the board last week about capital allocation. We think about it from where do we think we can get the best return on investment for our shareholders. How can we create the most value that on a discounted cash flow basis creates the most shareholder value? And we -- when we look at the space that we are in, as you know from the massive amount of investment that's going into the cybersecurity space from private equity and venture capital, the growth rate that a lot of companies are seeing, there is a substantial opportunity to grow and expand our business and deliver real value to our customers, and through that, of course, grow the business and return value to our shareholders. We do not feel constrained in terms of the opportunity set that is before us, and we don't have to go far afield to get that.

I'm talking about the things that we really know how to do. And so I think as we continue to look at that, we see these real opportunities for growth and investment, and the opportunity to generate significant accelerated growth and significant return, and that is our capital allocation -- No. 1 capital-allocation priority. I will tell you that at such time as we feel that either those growth opportunities are diminished or our ability to access them is impaired, then we obviously will consider other alternative uses of cash to do the best that we can to create shareholder value.

We do have an active M&A practice, I would call it here. We are constantly reviewing the landscape around us, understanding the gaps in our strategy, or maybe not the gaps in the strategy, but the gaps that we have in the ability to secure a strategy. And so our -- those acquisition priorities and partnership priorities really result from the strategy itself, it really starts there. And based on that, we identify where we can accelerate our growth, our ability to capture opportunity and value and really target those things.

When we find the right opportunity, we do this, I think, with a good level of discipline and thought about return on investment. We want to be thoughtful and prudent in the way that we do those. That we don't -- if don't see them or we don't find them, then of course we'll consider other alternatives. So I think that's maybe the way that I would describe not only our prioritization but the reason for the prioritization.

And we are -- we consider all of the alternatives in terms of investment organic growth investment, M&A and at the right time, using -- delivering cash back to shareholders when that seems like it makes the most sense.

Dan Drawbaugh -- B. Riley FBR -- Analyst

Understood. Thanks very much for the color.

Scott Clements -- Chief Executive Officer

Yep. Thanks, Dan.

Operator

I'm showing no further questions at this time. I would now like to turn the call back over to Scott Clements for closing remarks.

Scott Clements -- Chief Executive Officer

Well, thanks very much for joining us on our call today. I think we had a solid quarter here. It is on track of what we intend to do for this year and we're excited about the third quarter and the second half of 2019. So we appreciate you joining us.

We do appreciate the feedback that we get from many of you with respect to our strategy and the direction of our company and the choices that we make. We remain open to input and thought from our investors, and certainly from the analysts who cover our company. So I want to thank you for that feedback and look forward to getting more. Thanks, again.

I hope you all have a good rest of your day.

Operator

[Operator signoff]

Duration: 36 minutes

Call participants:

Joe Maxa -- Director of Investor Relations

Scott Clements -- Chief Executive Officer

Mark Hoyt -- Chief Financial Officer

Dan Drawbaugh -- B. Riley FBR -- Analyst

Anja Soderstrom -- Sidoti and Company -- Analyst

Matthew Galinko -- National Securities -- Analyst

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