Q2 2023 Varonis Systems Inc Earnings Call
Participants
Guy Melamed; CFO & COO; Varonis Systems, Inc.
Tim Perz; Director of IR; Varonis Systems, Inc.
Yakov Faitelson; Co-Founder, Chairman, CEO & President; Varonis Systems, Inc.
Andrew James Nowinski; Senior Equity Analyst; Wells Fargo Securities, LLC, Research Division
Annick Jana Baumann; Equity Associate; Jefferies LLC, Research Division
Brian Lee Colley; Security Software Research Analyst; Stephens Inc., Research Division
Brian Lee Essex; Research Analyst; JPMorgan Chase & Co, Research Division
Chad Michael Bennett; Senior Research Analyst; Craig-Hallum Capital Group LLC, Research Division
Jason Noah Ader; Partner & Co-Group Head of Technology, Media and Communications; William Blair & Company L.L.C., Research Division
Joel P. Fishbein; Research Analyst; Truist Securities, Inc., Research Division
Joshua Alexander Tilton; Research Analyst; Wolfe Research, LLC
Matthew George Hedberg; Analyst; RBC Capital Markets, Research Division
Matthew Louis Saltzman; Research Associate; Morgan Stanley, Research Division
Robbie David Owens; MD and Senior Research Analyst; Piper Sandler & Co., Research Division
Roger Foley Boyd; Associate Analyst; UBS Investment Bank, Research Division
Rudy Grayson Kessinger; Senior VP & Senior Research Analyst; D.A. Davidson & Co., Research Division
Saket Kalia; Senior Analyst; Barclays Bank PLC, Research Division
Shaul Eyal; MD & Senior Analyst; TD Cowen, Research Division
Shrenik Kothari; Senior Associate; Robert W. Baird & Co. Incorporated, Research Division
Presentation
Operator
Greetings, and welcome to the Varonis Systems, Inc. Second Quarter 2023 Earnings Conference Call. (Operator Instructions)
As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Tim Perz, Investor Relations. Thank you. You may begin.
Tim Perz
Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis' second quarter 2023 financial results.
With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer of Varonis. After preliminary remarks, we will open the call to a question-and-answer session.
During this call, we may make statements related to our business that will be considered forward-looking statements under federal securities laws, including projections of future operating results for our third quarter and full year ending December 31, 2023. Due to a number of factors, actual results may differ materially from those set forth in such statements. These factors are set forth 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 obligation 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 second quarter 2023 earnings press release and investor presentation, which can be found at www.varonis.com in the Investor Relations section.
Lastly, please note that a webcast of today's call is 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?
Yakov Faitelson
Thanks, Tim, and good afternoon, everyone. Thank you for joining us today.
Our second quarter results reflect the strong adoption of Varonis SaaS and provides further validation that our strategy to transition our model to SaaS is working. Customers are adopting SaaS at the rapid pace, which benefits our ARR performance and cash flow generation. I'm proud to announce that our SaaS business now represents approximately 10% of total company ARR. Our second quarter SaaS mix came in at 58%, well ahead our guidance of 35%. ARR grew 17% year-over-year to $497 million and we have generated $40 million of free cash flow year-to-date, up from $3.9 million for the same period last year.
The strong execution and the pipeline we see ahead is allowing us to raise our full year SaaS mix, ARR and free cash flow guidance. Guy will review our Q2 results and our updated guidance in more detail.
We continue to see the economy impact customer purchasing patterns with high level of deal scrutiny and longer sales cycles, but we are encouraged by our second quarter performance against these headwinds. I feel increasingly confident about the trajectory of our SaaS platforms and the overall trajectory of our company.
Today, I would like to focus my time on why our offering is a must-have and why Varonis SaaS continues to resonate with our customers and our internal teams. The recent Pentagon bridge in which Jack Teixeira, a 21-year-old guardsman allegedly leaked sensitive intelligence on social media sites is a perfect example of why organizations need Varonis. The incident highlights where insider threats are the most difficult risk to defend against and can do the most damage.
It appears that the Pentagon did everything right with its perimeter control, to share a word in a sensitive isolated information facility to the guards against electronic surveillance and suppress data leakage. That means no USB keys were going in or out. Nothing could be uploaded to the Internet and no transmissions could take place. Still, none of its perimeter controls could stop this threat. Teixeira was able to transcribe and take photos of classified documents because he had access to information that wasn't necessary to do his job. Perimeter controls by themselves do not address the problem that Varonis does, which is to ensure that only the right people have access to the information that they need to do their job.
Despite the industry buzz around zero trust, this incident seems to be a failure in taking a zero trust approach to the data. In many organizations, the focus is often on safeguarding perimeters rather than protecting the target itself, the data on the inside. You can patch your systems, secure your endpoints and lock USBs and even properly train your employees using phishing simulations, but if your most important data is not locked down and monitored, then you open yourself up to massive risk.
In our risk assessment, we find that employees have far too much access to sensitive data all the time. Providing visibility during the Varonis risk assessment, which is a crucial step in our sales motion, is helpful for companies but just begins to scratch the surface of what needs to happen to properly secure data. Varonis helps companies locate sensitive data, visualize who has access to it and automatically lock it down. The ability to do all 3 of these is what makes us unique, and this allows companies to collaborate safely and get the most value from their data while at the same time, managing risks. Varonis SaaS allows us to do all of this for our customers faster with less effort and with a drastically reduced overall total cost of ownership. And this is why we are seeing such strong adoption for our new SaaS platform.
At the same time, the operational simplicity of Varonis SaaS also allows our internal teams to be more efficient in supporting our customers and introducing new product innovation. As a reminder, the 3 key benefits that our customers get from our SaaS platforms are: first, customers are much better protected with much less effort with our automated remediation and proactive incident response. Second, SaaS is easier to deploy and has significantly lower infrastructure costs. And third, SaaS is easier to maintain and upgrade. Three of the key benefits that we realized are: one, shorter sales cycles, two, larger initial lands and three, the margin benefits over time. We saw further evidence that these benefits this quarter are very encouraged by the continued feedback we are receiving from customers.
As an example, a large public school district with approximately 4,000 employees became a Varonis SaaS customer this quarter. Earlier this year, this district was the target of a ransomware attack, which led to a compromise of hundreds of thousands of files that contain sensitive information about students who attended the school. The security team knew they had gaps, but the bridge forced the organization to reevaluate its approach to protecting data, which was through manual effort from its internal teams and consultants.
Due to the high-profile nature of the breach, they needed a platform that will provide immediate time to value. Within 2 hours of installation, this organization gained visibility into where their sensitive data was located and who had access to it across their Microsoft and Google deployments. While visibility was important, our ability to automatically remediate overexposures and quantify the risk reduction over time was critical because of the lack of resources. They purchased Varonis SaaS package for Windows, Microsoft 365 and the AI cloud for Google. The simplicity of deployment, fast time to value and significantly lower infrastructure requirements of our SaaS offering were essential in meeting their organization's timeline to fix this access issues before teachers would return from summer break.
We also saw an increase of existing customer conversion this quarter. One example is a Fortune 500 health care company with 35,000 employees that first became a customer in 2021. They originally purchased 7 on-prem subscription licenses to protect their on-prem window deployment. As a large health care company, they are subject to significant regulatory scrutiny and needed to ensure that they have security and privacy policies in place. With the Varonis self-hosted deployment, they were already reducing risk by remediating global access and shrinking in the blast radius for Windows on-prem.
The success that this organization had with Varonis and the on-premise Windows environment drove the request for the same protections on Microsoft 365. Varonis SaaS was a clear fit for this organization, Automatic remediation in Microsoft 365 and proactive incident response team, we drastically reduced time to value and the scalability, performance improvements and significant infrastructure savings will meaningfully reduce the resources needed to achieve these outcomes.
On renewal, they converted their on-prem Windows licenses into SaaS equivalent package and purchased an additional SaaS package for Microsoft 365. These customer wins illustrate the momentum we are currently seeing with Varonis SaaS and underpin what is giving me increased confidence in our ability to capture our significant market opportunity, and deliver value to our stakeholders as we execute on our $1 billion ARR target.
With that, let me turn the call over to Guy. Guy?
Guy Melamed
Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today.
We are pleased with the team's execution in the second quarter against the challenging macro backdrop. As compared to 90 days ago, we are increasingly confident as we look to the back half of the year with the performance we've seen so far in transitioning to selling SaaS. Although the macro remains a headwind, when we consider our momentum to date and our visibility in the pipeline ahead, we're confident in raising our guidance for full year SaaS mix, ARR and free cash flow. It is clear that the transition is gaining momentum and is evidence that we can deliver numerous benefits to our customers while also achieving strong ARR and cash flow benefits.
As I've discussed at length, since we introduced Varonis SaaS last fall, ARR, free cash flow and ARR contribution margin are the leading indicators for our business during this transition. The shift from our on-prem subscription licenses where approximately 80% of the deal's value is recognized upfront to a SaaS model with fully ratable revenue recognition will cause initial headwinds on the traditional income statement metrics as the SaaS mix and conversions of existing customers to SaaS increases.
In this quarter, the impact was the largest we've seen to date, especially as a considerable number of our existing customers showed a desire to convert to SaaS. However, these headwinds are a function of accounting treatment and are not indicative of the health of the business. In fact, the greater these accounting-related headwinds are, the better it is for our business as it means the transition is progressing at a faster pace.
As a result of the rapid pace at which our customers are adopting SaaS, we are adjusting our ARR guidance higher and we are adjusting our full year revenue guidance correspondingly lower. All 3 of our North Stars, ARR, free cash flow and ARR contribution margins are trending in a positive direction which highlights the encouraging progress of our SaaS transition.
The momentum seen in Q2 is being driven by Varonis SaaS, which is resonating with our customers and our sales force. Our second quarter SaaS mix represented 58% of new business and net new upsell ARR versus our guidance of 35%. After only 2 quarters into the transition, SaaS now represents approximately 10% of the total company's ARR.
The average deal sizes realized in Q2 gives us incremental confidence in the 25% to 30% pricing uplift and margin structure that we previously provided. In the quarter, we once again saw reps introduce Varonis SaaS to customers where an on-prem subscription quote had already been provided, which interrupted the sales cycles for some of these deals. As we look out into the remainder of the year, we expect some of the pressure from this dynamics to ease because more of the pipeline expected to close in the second half has started as SaaS rather than an on-prem deployment. This is already factored into our guidance.
In the second quarter, a significant amount of SaaS deals were sold to new customers, but we did see an increase in existing customers converting to our SaaS offering. This was in line with the commentary that we provided last quarter on our increased pipeline but was well ahead of the amount that we factored into guidance.
In the second quarter, we had approximately $6 million in conversions of existing customers, impacting our Q2 revenue. These conversions are being driven by both customers and our sales force. Customers want the automated protection of Varonis SaaS and our sales reps can earn commission dollars on the incremental dollars sold because SaaS deals are larger.
To be clear, this positive momentum in converting customers is happening organically as we have not been providing incentives to encourage these conversions. We view this as a clear positive as we plan for the second phase of our transition, which is when we will focus on converting our installed base over to SaaS. As compared to 90 days ago, this is becoming a bigger driver of our topline growth. As we look to our revenue guidance for the second half of the year, we're assuming approximately $8 million of conversions in Q3 and approximately $10 million of conversions in Q4.
As a reminder, these conversions benefit our North Star's metrics, which are ARR, free cash flow and ARR contribution margin. At the same time, this causes an initial headwind to reported revenue and operating margin. However, despite the headwinds to our traditional income statement metrics, we believe this is a huge positive and should be viewed as such.
In the second quarter, ARR grew 17% year-over-year to $497 million. Year-to-date, we generated $40 million of free cash flow which was up from $3.9 million over the same period last year, reflecting the inherent leverage in our model as well as our commitment to balancing topline growth with improving cash flow generation. In Q2, we continued to see macro environment that was similar to Q1. We're still seeing deal scrutiny and longer sales cycles across the board, which is impacting customer purchasing patterns and is holding back our near-term results. We expect these longer deal cycles to continue along with budgetary scrutiny, and our updated guidance already takes this and more into consideration.
Turning now to our second quarter results in more detail. Before I get into the numbers, let me remind you of what we've said for a while now. ARR, free cash flow and ARR contribution margin are the leading indicators for this transition. Q2 total revenues were $115.4 million, up 4% year-over-year. During the quarter, as compared to the same quarter last year, we had approximately a 15% headwind to our year-over-year revenue growth rate as a result of having increased SaaS sales in our booking mix which are recognized ratably versus the upfront recognition of our on-prem subscription product. Subscription revenues were $91.1 million, and maintenance and services revenues were $24.3 million as our renewal rates were again over 90%.
Moving down the income statement. I'll be discussing non-GAAP results going forward. Gross profit for the second quarter was $100.5 million, representing a gross margin of 87.1% compared to 87.2% in the second quarter of 2022. Our gross margins were essentially in line with last year despite significant revenue headwinds as we're getting greater efficiencies than we initially expected. Operating expenses in the second quarter totaled $99.6 million. As a result, second quarter operating income was $0.9 million or an operating margin of 0.8%. This compares to an operating income of $1.7 million or an operating margin of 1.5% in the same period last year.
During the quarter, as compared to the same quarter last year, we had approximately a 12% headwind to our operating margin as a result of having increased SaaS sales in our booking mix, which are recognized fully ratable versus the upfront recognition of our on-prem subscription products.
Second quarter ARR contribution margin was 8.2%, up from 3.7% last year. The significant leverage improvement even during the early stages of the transition reflects our ability to drive strong incremental margins while growing ARR and transitioning to SaaS.
During the quarter, we had financial income of approximately $7.6 million, driven primarily by interest income on our cash, deposits and short-term investments. Net income for the second quarter of 2023 was $1.1 million or $0.01 per diluted share compared to a net loss of $0.1 million or a loss of $0.00 per basic and diluted shares for the second quarter of 2022. This is based on 127.3 million diluted shares outstanding and 109.7 million basic and diluted shares outstanding for Q2 2023 and Q2 2022, respectively.
As of June 30, 2023, we had $753.8 million in cash, cash equivalents, marketable securities and short-term deposits. For the 6 months ended June 30, 2023, we generated $42.6 million of cash from operations, compared to $10.1 million generated in the same period last year and CapEx was $2.6 million compared to $6.1 million last year.
During the second quarter, we repurchased 207,278 shares at an average purchase price of $24.51 and we have $36 million remaining on our share repurchase authorization. We ended the quarter with approximately 2,150 employees, roughly flat versus last quarter. As expected, we did see some turnover in the sales force, but it was at lower levels than our previous transition. Overall, we're pleased with the engagement of the vast majority of our sales force and their ability to transition to selling SaaS continues to show encouraging progress.
Turning to our guidance in more detail. Our full year guidance now assumes a SaaS mix of new business and upsell ARR of 50% up from 35% previously, and we expect Q3's SaaS mix to be 45%. As a reminder, Federal's largest quarter is the third quarter. And because we are not yet FedRAMP certified, we expect to sell on-prem subscription to that market, which will be a headwind to the Q3 SaaS mix.
A couple of additional modeling notes on this metric as we look at the back half of the year. We are continuing to take a prudent approach in building our SaaS mix outlook as the dollar value of deals we expect to close in the fourth quarter is the largest of the year, which is in line with historical trends. In Q3, we're assuming $8 million of existing customer conversions that will serve as a headwind to revenue and $10 million in Q4, which is higher than Q2, but consistent with the pipeline we have. We're again raising our ARR guidance to reflect strong adoption trends of Varonis SaaS from our customers. Coupled with our improved efficiency, this also results in greater ARR contribution margin which reflects our ability to focus on operating leverage during the transition.
We are meaningfully raising our free cash flow guidance to reflect the strong cash generation trends we saw in the first half of the year. The higher SaaS mix drives corresponding adjustments to revenue and operating income guidance because of the ratable accounting treatment of SaaS versus the upfront accounting treatment of on-prem subscription. Ultimately, we view the improved guidance as a clear sign that the transition is progressing in a positive direction and continue to view ARR, free cash flow and ARR contribution margin as our North Stars during this transition.
Lastly, as a reminder, our guidance continues to factor in macro headwinds that we've discussed at length in the past.
Now turning to our guidance. For the third quarter of 2023, we expect total revenues of $123.5 million to $127 million, representing growth of 0% to 3%, non-GAAP operating income of $1 million to $2 million and non-GAAP net income per diluted share in the range of $0.02 to $0.03. This assumes 127.1 million diluted shares outstanding. For the full year 2023, we now expect ARR of $529 million to $535 million representing growth of 14% to 15%. Free cash flow of $40 million to $45 million, which, includes an incremental $2 million of headwind, related to the TCJA capitalization of R&D provisions for a total of $8 million to $10 million. Total revenues of $497 million to $503 million, representing growth of 5% to 6%. Non-GAAP operating income of $19 million to $22 million and non-GAAP net income per diluted share in the range of $0.21 to $0.23. This assumes 126.8 million diluted shares outstanding.
In summary, the acceptance of SaaS is progressing at a rapid pace. With only 2 quarters into the transition, approximately 10% of our total ARR is now coming from SaaS. Our second quarter SaaS mix of 58% versus our guidance of 35% as well as a significant increase in existing customer conversions generated meaningful improvement to our 3 North Stars during this transition, which are ARR, free cash flow and ARR contribution margin. That gives us the confidence to raise our guidance as we enter the second half of the year.
With that, we will be happy to take questions. Operator?
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from the line of Matt Hedberg from RBC Capital Markets.
Matthew George Hedberg
Congrats on the faster transition here. I'm curious for other -- Guy, of the $6 million of SaaS conversion that you saw this quarter, do you have a sense for what the incremental spending was on those conversions versus had they been sort of on-premise subscriptions and maybe the inverse of that is do you know what the headwind to revenue was on that sort of that incremental conversion that you saw this quarter?
Guy Melamed
Absolutely. So first of all, when we look at the price list, the price list of SaaS is 25%, 30% higher. And when we compare the actual sales, apples-to-apples, the same number of licenses and the same number of users, we're actually seeing that. So the pricing is working very well for us. What is important to remember is that when you see existing customers move from on-prem to SaaS with our SaaS offering where we're selling the actual platform, they're actually consuming more licenses, and they don't have the ability to buy licenses individually. So we're seeing customers consuming more of the product, and that's working very well. When you look at the headwind, the actual headwind to revenue was approximately 15%. And on the operating margin, we saw that headwind at 12%.
Operator
Our next question comes from the line of Joel Fishbein with Truist.
Joel P. Fishbein
Great execution on the SaaS transition. I just wanted you to talk a little bit about any -- the changes in go-to-market? And any color you can give us on the adoption of the bundled silver, gold, platinum. That would be really helpful.
Yakov Faitelson
Overall, there is no fundamental change. We're trying to do everything in a risk assessment. This is our customer buying. But fundamentally, the changes that with our SaaS offering with 10% of the effort, you can get oodles of money fees, more value. So the reality is that we are the first and last one deal. Damage happened in breaches and cyber attacks from the data level. And if you can protect your data, really, nothing will help you.
So what we see is that our customers is almost doing nothing are able to find critical data for immediate excessive access control, which is the holy grail of data protection, and reliably alert on any abnormal behavior and get to the root cause of every problem. So it's just the overall what customers are experiencing, it's something that is completely different. And because of the fact that it has so much -- such tremendous automation, it's much easier for them to get value. They want more licenses. It's much easier for us to expand, and this is the most innovative year we ever had and there is so much meat on the bone in terms of the overall content in this data protection platform, and it's easier for us to expand.
Guy Melamed
Joel, I just want to touch on the question about bundles. In 2022, we offered bundles on our on-prem subscription offering and that was an attempt to try and simplify the conversation with the customer. We also know that the more licenses the customer consumes, the higher the customer satisfaction, and that was very clear in 2022. So we doubled down on that. And when we offer the SaaS platform, we no longer have bundles. We're selling it as 1 SKU. So you can have 7, 8 licenses that appear as 1 SKU. We don't have the option to buy that individually. That's actually working very well in conversations, simplifying the discussion with customers, providing more value because we're selling outcomes. We're selling the actual platform itself and that's been working very well with the SaaS transition.
Operator
Our next question comes from the line of Andrew Nowinski with Wells Fargo.
Andrew James Nowinski
I wanted to ask maybe a higher-level question. I guess I'm kind of surprised you aren't talking about AI yet because I would think as organizations start training their LMs with their corporate data, it would seem like the need for data protection increases and the need for visibility into where that data resides also increases. So I guess, are you seeing any customers come to Varonis as part of their AI initiatives and looking at your SaaS platform?
Yakov Faitelson
You're 100% right. So it's what you said, it's very, very accurate. There are really 2 dimensions. One is that when you look at these large language models, primarily what they are doing, they're mining massive amount of data and now that customers have their own OpenAI instances and will start to see adoption of these -- all these co-pilots, what will happen is that they'll take all your unstructured data and will make it succinctly a very valuable information product that they can be run out completely outside of the regular policies or using your current active control permissions which are broken and you don't know that they exist and who tasked it. So this is super critical. And we definitely in the last few weeks, starting to see a lot of interest. And I think that once people will understand how they can -- how end users will use it in their organization, this can be a massive, massive driver for us.
The other thing is it's very easy for layman with these new AI technologies to build malware and APTs and for sophisticated actors to up their game and inflict tremendous damage to an organization. So what will happen is that it's becoming much easier to bypass perimeter security and do a lot, a lot of damage on the data layer, and this is the main objective of CECL. So this is definitely a driver and there is a third driver, which is the ability of our platform to integrate these kinds of solutions to provide value. It's also something that we believe that potentially can be a game changer. So yes, AI is a massive driver primarily because of the nature of the lion's share of the data we are protecting and the exposure that it's bringing.
Operator
Our next question comes from the line of Shaul Eyal with Cowen.
Shaul Eyal
Congrats on the ongoing successful transition. So this transition Yakov, Guy, is accelerating better than expected. How should we be thinking about your 2027 ARR metrics and guidance that you shared with us back in March? Wouldn't that target will be achieved sooner? And maybe I'm front-running myself here.
Guy Melamed
So there's 2 aspects to this. There's the ARR and there's kind of the transition itself. We've made a lot of progress in the past 2 quarters, which really likely requires us to revisit our guidance for the timeline at year-end.
Just to remind you, we assumed completing the transition for us would mean SaaS reaching anywhere between 70% to 90% of our total ARR. The transition has moved fast. We're very happy to have 10% of our total ARR coming from SaaS, and that's only in really just 2 quarters. It's moving fast because the reception from our customers and our sales force has been really positive. So we look forward to providing more color at year-end on that timeline.
And in terms of the ARR, we are seeing significant benefits with the move to SaaS. You can see that with the ARR this quarter. We're also seeing benefits on the free cash flow and also leverage in the model.
Operator
Our next question comes from the line of Rob Owens with Piper Sandler.
Robbie David Owens
Curious if you could comment on kind of top-of-the-funnel activity given your SaaS approach is more frictionless than just what you're seeing in terms of customer interest and how that might compare with, say, where you were a year ago?
Yakov Faitelson
We definitely see the customers and they're saying that they need to protect data. We also see that customers understand that they invested massively in security solutions that are not protecting the data and are very hard to manage. So it's just it's -- on one hand, it's a hard economy, but on the other hand, we definitely see that organizations are thinking what will be the biggest bang for their buck and what they need to do.
And I would just gradually because they're realizing the benefits of the overall platform and what we can do and things that we can retire and mainly the automated outcome -- like when they see the outcome install it, it's classifying automatically, remediate automatically, you can roll back, you have any indicator of abnormal behavior. We can do it with a proactive IR from the cloud, it's a game changer. So we definitely see a lot of interest across the board. There's a lot of -- you also have scrutiny in deals, and we're just in the beginning of the transition, but there are a lot of positive signs and definitely, this transition so far growing significantly faster than we anticipated.
Operator
Our next question comes from the line of Roger Boyd with UBS.
Roger Foley Boyd
Congrats on another nice quarter of execution. Just wondering on the possibility of pent-up demand. You now have $50 million in SaaS ARR, which is up pretty significantly over the last 2 quarters. Can you just talk about how you're thinking about the pipeline for the rest of the year? And as you think about 3Q in particular, the 45% mix, any considerations there around SaaS other than just the federal fiscal year-end.
Yakov Faitelson
No. The overall SaaS, it's going very well. One is the team really built a very, very good SaaS product, and all the regular benefits of SaaS, the total cost of ownership, our operations and upgrades. But the beauty is that we really rebuild the company in a sense of these automated outcomes, which is night and day from the self-hosted solutions. So -- and if you think about it, I think what happen now, we move it or share, everything that happened, it happens on the data level. Can't un-breach data when data is in the wrong hands, it's a huge problem.
The other thing we saw, we are not trying to sell to convert the base. But once they see it, mainly because of these benefits, these outcomes in the SaaS, customers wants to move. So we feel very good with the fast transition. And...
Guy Melamed
And just to add to that, when we look at kind of the SaaS mix, we're raising it to 50% from 35%. Just remember, we started the year with a 15% expectation. And if you kind of break down Q3, the answer is really simple. You kind of asked about it. It's -- we're not yet FedRAMP certified, which means that we plan to sell on-prem subscription to that market, and that will be a headwind to the mix in Q3. And then kind of the other factor to keep in mind is that Q4 is our largest quarter, and it's on a much larger denominator. But overall, we're really happy with the momentum that we're seeing with our SaaS business. And we take our -- we take our commitments to the Street very seriously. So we wanted to put numbers out there that we feel good about.
Operator
Our next question comes from the line of Jason Ader with William Blair.
Jason Noah Ader
Guy, I wanted to ask you about gross margins. You mentioned greater efficiencies than expected. Can you just elaborate on that?
Guy Melamed
Yes. We're -- when you look at kind of the fact that we're only very early in the transition, we're seeing a lot of benefits, and we think we can see more benefits going forward. The benefits could be with kind of the way handling the customer when we kind of do the risk assessment. But also it allows us to be more efficient with dealing with any questions that the customer has.
So overall, when you look at kind of the margins, we're very happy to kind of have the margins we have as we just started, and we feel very good about our ability to generate leverage in the model going forward.
Operator
Our next question comes from the line of Saket Kalia with Barclays.
Saket Kalia
Okay. Great. Yaki, maybe for you. I was wondering if you could just go one level deeper into just some of the details on the bundles. What differentiates silver from gold from platinum? And what are sort of the rough differences in pricing across those 3 bundles, again, high level.
Guy Melamed
Saket. A similar question was asked before, so I'll just try and kind of emphasize. In 2022, we actually had an offering which was gold, silver and platinum but that was for the on-prem subscription offering. And because we saw that that was working very well, when we announced the SaaS transition, we're not offering those bundles anymore. We're just selling the platform. So you see a situation where a customer in the on-prem subscription would buy 7 licenses, this today appears as 1 SKU under the SaaS offering. So it allows us to sell more of the platform, and we've talked a lot over the last couple of years about the fact that at Varonis, more is more. The more licenses a customer has, the higher the customer satisfaction, the more automated results they receive, and because of that, we're seeing in that SaaS transition, how customers are embracing it. It simplifies the conversation for the reps and the customers, and that's something that is working very well for us.
Operator
Our next question comes from the line of Brian Essex with JPMorgan.
Brian Lee Essex
Yaki, I was wondering if I could follow up to Rob's question actually. If we think about the sales cycle and the pipeline process -- could you maybe comment on where you're seeing better performance versus where you might be seeing friction. And what I mean is if you kind of carve it in the buckets, I'm thinking about this in terms of starting off with lead generation from channel and marketing going to assessment, going to tech win and then approval, then the closing and deployment, where are things maybe better than they were last quarter? And where might you have the friction say, for example, with what you've highlighted in the sales force where a deal might get delayed slightly because of the shifting from maybe a term license to a SaaS deal.
Yakov Faitelson
I think we need to distinguish between doing a transition to be very committed to do the transition very effectively to the overall sales process. In the overall sales process, everything is easier with SaaS. And primarily, it's much easier for the customers to get value. As I said, it's 10% of the effort, 10x more time value like this North Star is working very well. And our mantra is, you just need to pay, we are protecting your data. This is starting to work very well. So if you really want to break it down, the all sales motion and the sales process, it just works very well.
The challenge, if you will, in a hard economy everything is scrutinized and there is just the friction of this nature. We need to make sure that people understand what we do. Every time we are doing something that is such a profound change, you need to make sure that all the customers see it and there is a big difference between during the sales pitch seeing the demo and test it. So we need to make sure that the marketplace understands what we do. But overall, apples-to-apples in the sales motion, everything is much, much easier with SaaS and the customer, which is night and day in the way that they realize value, and the value is ongoing value.
Guy Melamed
And one thing we talked a lot about is kind of the first 6 months of the transition. And when you look at where we are today, that we're past that part, which really was the riskiest part. The Varonis SaaS is working. The adoption of our customers and the excitement of our sales force are really at levels we've never seen before even more compared to the previous transition. And I just want to add in terms of the macro, Q2 was very similar to Q1 in terms of the macro, but our guidance assumes continued worsening of economic conditions across the board. And -- just to point that out.
Operator
Our next question comes from the line of Rudy Kessinger with D.A. Davidson.
Rudy Grayson Kessinger
Congrats again on the phenomenal execution on the fast transition. Guy, certainly, a number of callouts on this call on existing customer migrations. You gave some figures about migrations or conversions you expect in the second half. A number of your customers, existing customers that I've spoken with have messages, made sure are converting to your SaaS product at some point in near term. So I guess you're not incentivizing the sales support yet for conversions. But I guess given the natural kind of interest that you're seeing, you envision incentivizing the sales force at some point maybe sooner than you previously expected to convert existing customers at renewal to SaaS?
Guy Melamed
Great question. Phase 2, which we defined is converting our installed base to SaaS really hasn't started yet. And when you look at kind of H2 assumptions, we took into consideration $8 million and $10 million of conversions in Q3 and Q4, respectively, which is really higher than the Q2 number, but still a very small percentage of our existing customer base.
So although we're seeing existing customers convert to SaaS, it really hasn't been our main priority yet. We expect that to be more of a focus next year, and then we'll take everything into consideration and decide what's the best thing. But as of now, it's happening in a natural way.
Operator
Our next question comes from the line of Joshua Tilton with Wolfe Research.
Joshua Alexander Tilton
Congrats on a solid quarter. Lots of good questions have been asked so far. I'm going to ask kind of an easy one. 10% of ARR coming from SaaS seems awesome. Could you maybe just help us understand directionally from last quarter, like how that's progressing? Was that a double on a percentage basis from last quarter? Just kind of help us understand maybe the rate of change you're seeing in the business from a quarter ago outside of just SaaS as a percentage of the new business mix.
Guy Melamed
So we really provided a lot of the data points when you look at kind of the actual conversions. The conversions in Q2 were significantly higher than the conversions that we had in Q1. If you remember, we actually called out in our prepared remarks last quarter the fact that we're seeing an increased pipeline, but we didn't assume those would convert. We've actually -- in Q2, we saw that happen.
And the other thing that has increased is actually the percentage of the SaaS mix, which went from 37% to 58% and that's obviously from a much larger denominator. So overall, the progression of the SaaS offering and the conversations has been much better in Q2.
You also need to remember that that's kind of a natural evolution when you have quotes that are provided to customers and they're provided initially as on-prem subscription, every time you introduce a new concept during a sales conversation with a customer, you're adding turbulence. And that's why we talked a lot about kind of the 6 months. Obviously, there's some of that that would be in the second part of the year, but the majority happened in the first 6 months, and we did see SaaS progressing and improving both on the new customer side and the existing customer side, significantly improving from Q1 to Q2.
Yakov Faitelson
We are still very early in the journey for SaaS, but so far, the overall adoption, given the reaction from current customers and the ability of the sales force to adapt to the transition. We have some experience with transition is well ahead of our initial expectations.
Operator
Our next question comes from the line of Chad Bennett with Craig Hallum.
Chad Michael Bennett
So just on the ARR side, I know you guys didn't anticipate much in terms of conversions when you started the year, but they seem to be accelerating in a big way. Just if you kind of look at net new ARR in the quarter, with $6 million of conversion, obviously, and the conversion assumption you have for the second half, I'm just curious to kind of get your insight into what the non-conversion SaaS business is and how that performed in the quarter and the expectation for the second half of the year. Because if you back out the $6 million of conversions, net new ARR was kind of flattish sequentially. And if you kind of do the same exercise in the second half, there's not a lot of net new ARR growth.
Guy Melamed
No problem. I think it's a great question. And I think you need to kind of split between what we feel about the business and the way we've guided. We feel very good about the business going into the second half. I think that when you look at kind of the way we treat our commitments to the Street, we take them very seriously. So we wanted to put numbers out there that we feel good about. When you look at the progression of the business, which Phase 1 is what we're focusing on right now, we're trying to sell SaaS to our new customers, which is working very well with the SaaS mix that we're in. But the on-prem subscription is working just as good. When you look at kind of the evolution, we want to convert our existing customers when we get to Phase 2. We're seeing some of that happening now, but overall, you should look at the guidance in kind of the same way we've guided in the past. We feel very good going into the second part of the year.
Operator
Our next question comes from the line of Joseph Gallo with Jefferies.
Annick Jana Baumann
This is Annick Baumann on for Joe Gallo. Maybe just taking a high level again, when you kicked off the SaaS transition, you spoke of learnings from your subscription transition and using that knowledge here. What have been some of the biggest surprises to the upside this time around and your expectations? And then maybe what's the biggest difference versus last time that you've seen so far in this transition?
Yakov Faitelson
I think that there are many. One is that it's -- when you are doing this thing and you're committing just many times a little of friction with the sales force costs that are out there people that want to convert and a lot of delays. We saw that but less than we expected. I think the difference is that it's completely a different business. The value that customers are getting and how fast we are getting the value, the ease that we can bring them to value and how relatively little support we need to provide to the system relatively to the on-prem. How the benefits of the metadata that we have in the cloud is just working for us and we can really transform into clear customer value, the speed that the engineering is working. As Guy said, it's still early stages but overall, the gross margin and all the moving parts that we see that we can really get a lot of leverage from the model. So this is overall what we see. So it's -- as I said, still early, but way ahead of expectation.
Guy Melamed
I think that one important takeaway when we look at this transition versus the previous transition and kind of what we've learned and what we're trying to implement is that the transition as a whole is standing on 3 pillars. That's the technology, the commission and our commitment to actually making the change. And when you look at the technology, we're very happy with where we are today and the fact that it's working so well, as Yaki mentioned, and that's the first pillar. And without it, nothing else matters.
The second pillar is coming of the comp plan, making sure that the team and the sales force understands what's the right way to make money. And I think from our previous transition and in this transition, we set a comp plan that works very well hand-in-hand with our desire to make the change.
And the third pillar is really the management commitment of making that change. If you kind of make an announcement that you want to move, but you're not fully committed, then the first and second pillar don't really help. So when you look at kind of where we are today, I think those 3 pillars are standing very strong.
Yakov Faitelson
Definitely, our experience from the first transition is helping us a lot. It's very different in terms of the value proposition and tremendous asset -- technological assets that we have but understanding how transitions are working, how you need to be committed to it to understand how this usually plays out. But in the near term, you are paying but in the long term, you really get a lot of great reward. This help us a lot, and it's the leadership team already experienced that. So it's much easier to get everybody committed to the transition.
Operator
Our next question comes from the line of Shrenik Kothari with Robert W. Baird.
Shrenik Kothari
So Yaki, Guy, I mean, you mentioned about the second phase of transition, which is, of course, converting your installed base over to SaaS, and it's becoming a bigger driver and you have provided some numbers. But you also mentioned, of course, it's still not a priority this year from the 2 pillars that you just highlighted, management commitment, comp plans.
So just since you guys highlighted the longer deal cycles to continue along with budget with scrutiny. I'm just curious, like in terms of the impact from these longer cycles, like -- is it more upsized on the newer logos versus the conversion mix? Like typically, of course, the newer logos are tougher, but in your case, of course, it's -- I'm just trying to understand like the impact of these longer sales cycles and more budget scrutiny, how does it kind of affect both the new logos as well as your conversions right now?
Yakov Faitelson
I think that regarding the overall scrutiny, the scrutiny is there. But when people really think about what they need to do and how they need to protect data and what -- getting for their money and what they can do with limited security professionals, the ROI works very well for us. .
So when people are scrutinizing our value proposition, it works well for us. It can take sometimes more time. You need to explain it, to justify it. But the whole process of where you are going to put, how you're going to allocate your resources, what you need to do and what you need to protect, this is something that works well for us. It's not fun, this scrutiny, but it works very well for us.
Operator
Our next question comes from the line of Brian Colley with Stephens.
Brian Lee Colley
Could you provide an update on where you stand in terms of bringing the SaaS platform to feature parity with the on-prem platform. I'm just curious if you think getting to that feature parity level will be an additional catalyst to spur more SaaS conversions?
Yakov Faitelson
We are moving very fast with the parity. For new customers, it's a no-brainer. And just there are so many features in the SaaS that are -- it's just completely different universe than the self-hosted on-prem platform. For most of our customers for 80% of them, we are already in parity. And for the 20% -- and for the 20% we move fast. But the right time we'll discuss the migration as Guy told you that it's in phases. We want to make sure that it's frictionless, it's automated. This is not a priority -- top priority for us now. We have just a very detailed plan how to go after new business, customers and there are customers that want a part of the solution in SaaS, part on prem and then they will convert. There are many options here.
Operator
Our last question comes from the line of Matt Saltzman with Morgan Stanley.
Matthew Louis Saltzman
Very much appreciate the level of disclosure you guys have given on the transition. Makes it lot easier on our side. You've spoken a lot about the operating leverage that you should drive through the transition. I'm just curious with everything progressing faster than expected, when should we expect to see some of that operating leverage come through via the P&L? I mean I'd imagine that this should probably precede the ARR and revenue conversions, just especially with more existing customers converting and the inherent leverage there. But I'm curious if there's kind of any guidepost that you guys can give us in terms of when we should expect at least some offset to the upfront headwinds associated with the SaaS transition?
Guy Melamed
I think that's a great question. And if you kind of go back to the 3 North Stars, we talked about ARR and free cash flow, but we also talked about the ARR contribution margin. Because the operating margin is really impacted by the revenue headwinds. So when you look at kind of the ARR contribution margin, you're already seeing some of the leverage in the model. We ended the quarter with 8.2%. That's 450 basis points of improvement year-over-year. And when you kind of look at the expectation going forward, we feel very good about our ability to generate leverage through the SaaS offering, but you're already seeing it now. So I think overall, we're very happy with the fact that even in the early stages of our transition, not only are we keeping kind of the cost structure as a whole intact, but we're actually showing pretty significant leverage year-over-year.
Operator
That is all the time we have for questions. I'd like to hand it back to management for closing remarks.
Guy Melamed
Thanks for your interest in Varonis. Have a nice day.
Operator
Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines and have a wonderful day.
