Varonis Systems - Q2 2024

Transcript

Operator (participant)

Greetings, and welcome to the Varonis Systems Inc. Second Quarter 2024 earnings conference call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Tim Perz, Investor Relations. Thank you, sir. You may begin.

Tim Perz (Head of Investor Relations)

Thank you, Operator. Good afternoon. Thank you for joining us today to review Varonis's second quarter 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 would be considered forward-looking statements under federal securities laws, including projections of future operating results for our third quarter and full year ending December 31st, 2024. Due to a number of factors, actual results may differ materially from those set forth in such statements.

Andrew Nowinski (Senior Equity Research Analyst)

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 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 second quarter 2024 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 (CEO)

Thanks, Tim, and good afternoon, everyone. Thank you for joining us today to discuss our second quarter results, our SaaS transition progress, and the tailwinds impacting our business. First, I would like to remind you why Varonis exists and how we help our customers. Today, the purpose of almost any cyber attack is to steal data, but the purpose of the security solutions most organizations deploy are to protect their endpoints and their perimeters. These technologies are very important, but they aren't enough to protect data. To protect data, you must have a data-first solution and a data-first approach. Varonis's data-first approach helps companies locate their sensitive data, visualize who has access to it, automatically lock it down, and then detect and respond to threats on it.

Andrew Nowinski (Senior Equity Research Analyst)

To use a simple example, credit card companies keep making it harder for bad actors to get your credit card number, but they know credit card numbers will still sometimes be stolen. So they also watch the credit card transactions and compare them to what they know normal usage looks like to detect and stop fraudulent transactions. Varonis uses the same approach for protecting data, making it harder for the wrong people to access it, and monitor the data transactions to spot and stop anything abnormal, like ransomware, insider threats, or AI abuse. With our SaaS platform and recently released MDDR offering, we have a sophisticated and automated solution that enables customers to protect their data with very little time and effort. This allows companies to collaborate safely while also managing risks.

Innovation has always been at the core of Varonis, and in late June, we achieved the FedRAMP In Process designation, which represents an important step towards enabling us to provide the benefit of our SaaS platform to our federal government customers. I would like to take a moment to thank everyone involved in the process. Now, I would like to turn to our second quarter results, which reflect the growing momentum of our SaaS platform and the recently introduced MDDR offering. These offerings are driving strong new customer acquisition and healthy conversion activity from existing customers. ARR grew 18% to $584.2 million, and year to date, we generated $67.3 million of free cash flow versus $40 million generated last year. SaaS ARR now represents approximately 36% of total ARR. I will review our Q2 results and our updated guidance in more detail shortly.

This was another quarter of strong execution by our team that has risen to the challenge of a stable but challenging environment filled with elevated levels of deal scrutiny. The transition to SaaS delivery model is progressing quickly because of the many benefits that our customers realize. Customers can achieve automated outcomes, which means they can ensure that data is protected with very little effort. SaaS is quicker to deploy and operationalize because of significantly lower infrastructure and personnel investments, and SaaS is easier to maintain and upgrade. Additionally, there are three key benefits that we realize. They are shorter sales cycles, larger initial length, and margin benefits over time. I would now like to turn to a couple of tailwinds that we believe will drive momentum in our business. The first is our managed data detection and response offering, which we call MDDR.

This is the first managed service for monitoring and protecting critical data and is only available for our SaaS customers because of the visibility and automation that is built into our SaaS platform. MDDR was only introduced in Q1 and is already becoming a key driver of new business wins and existing customers' conversions to SaaS, and we believe that we are just scratching the surface with this opportunity. We continue to see that CISOs don't have the resources to monitor and investigate alerts fast enough. With MDDR, we handle this for them. If we see a threat, we can stop it and simply notify the customer after the threat has been neutralized. We pioneered the use of machine learning to perform user behavior analysis and build highly accurate threat models.

Our team leverages this significant automation plus our unique telemetry to efficiently detect if data is under attack and to catch threats missed by others. Bottom line, the early proof points that we are seeing leave us excited about what the future holds for MDDR. The second tailwind we see, generative AI. This technology is top of mind for many organizations and is a key theme in nearly all conversations with prospects and customers. The productivity benefits that Gen AI brings are widely understood, but Gen AI also worsens the data access risks companies already face. Take, for example, a bank that was piloting a Gen AI tool with users on their trading floor. They wanted to make trades more productive and earn the bank more money. The traders started to use it for research. They started searching for answers on questions like what stocks do our employees invest in.

The problem is the tool started showing names, Social Security numbers, 401(k) positions, and account numbers. The security team immediately turned it off because they were going to face major fines and sanctions, and it wasn't because those traders were acting maliciously. They were just trying to use the tool and ended up finding extremely sensitive data that was mistakenly open to everybody in the company. We believe that Gen AI adoption within enterprises will serve as a catalyst that exposes the underlying data security risks, and this is the very problem that Varonis was built to solve. As a result, we expect that as companies adopt Gen AI, they will be forced to make addressing those risks a top priority. Without Varonis, right-sizing access control is extremely challenging. We mitigate these risks by automatically ensuring only the right people can access the data necessary for their job function.

Companies are thoughtfully considering these risks before expanding from pilots into broad rollouts. The feedback we are hearing from customers continues to strengthen the conviction we have in our ability to benefit from enormous circular tailwinds, and we are seeing a healthy pipeline build with respect to this opportunity. With that, I would like to briefly discuss a couple of key customer wins from Q2. A large Midwest hospital system became a Varonis customer this quarter. This organization was concerned about where sensitive data was located, who had access to it, and how they would respond to a ransomware attack. During the risk assessment, we detected attacks already in progress, including an attack on their CEO account coming from outside the organization. The company was able to prevent it and ensure that the account was secured.

The second attack that occurred was a business email compromise that began when an employee clicked on a phishing link that came from a malicious email, and the account started accessing files from an unusual geolocation. Luckily, our team was able to confirm they would detect and stop this compromise before any sensitive data was accessed. Because we have a conclusive record of the data transaction and prevent any damage from being done, they purchased Varonis SaaS for their hybrid environment with MDDR protection and were able to avoid material breaches that could require them to publicly file any data breach disclosures. We continue to see healthy demand from existing customers converting from our self-hosted platforms to Varonis SaaS. One example of this is a multinational commercial real estate firm that has been a Varonis customer since 2014.

They wanted to decrease their infrastructure spend and reduce the time spent maintaining and upgrading their software. Moving to Varonis SaaS allowed them to immediately cut their server footprint and reduce their ongoing maintenance requirements. In addition to these operational savings, they will automatically remediate overexposure in Microsoft 365. They also purchased the Varonis SaaS hybrid package through the Azure Marketplace, which simplified their procurement process. In summary, the adoption of our SaaS platforms and MDDR offering are driving positive business momentum, and we are just scratching the surface of our long-term opportunity. We are excited to enter the second half of 2024 from a strong position to capitalize on the tailwind of MDDR, Gen AI, and increasing data-centric compliance regulation. With that, let me turn over to Guy.

Guy Melamed (CFO and COO)

Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today.

Andrew Nowinski (Senior Equity Research Analyst)

Our second quarter performance gives us increased confidence in our full-year trajectory driven by our SaaS platform and MDDR offering. At the end of Q2, SaaS ARR increased to approximately $210 million, or 36% of our total company ARR, driven by strong contribution from new logos and existing customer conversions. This momentum, coupled with the tailwinds Yaki mentioned, allows us to raise our full-year ARR and free cash flow guidance and also to increase our SaaS ARR expectations. The key drivers of our business this quarter were SaaS and MDDR. With each passing quarter, our story becomes more strategic and simpler for customers. SaaS eliminates the two biggest prospects of not wanting hardware or having the headcount to manage the platform. SaaS obviously requires less hardware and meaningfully simplifies maintenance and upgrades, and MDDR removes the need for people to review alerts since we do it all for them.

We're seeing that the value proposition of our platform, together with the simplicity of our story, is shortening deal cycles when compared to on-prem subscription deals. Generative AI remains a theme in nearly every customer conversation we are having and reinforces our view that this will become a secular tailwind. Our pipeline continues to be healthy as a result, and as we discussed in the past, we are still not seeing material contribution to our reported metrics derived from it. Consistent with our prior comments, we have not included the impact of material Gen AI adoption in our guidance. As we enter the second half of the year, we look forward to converting more of the installed base of on-prem subscription customers to our SaaS platform.

Pricing continues to be in line with our price list increase of 25%-30%, and in some cases, we see deal sizes increase in excess of that as customers consume more of the platform upon conversion to our SaaS platform. We expect that the ramp-up of this phase will not be linear, and momentum should grow in each quarter with further acceleration in dollar terms in 2025 and 2026. In the second quarter, ARR grew 18% year over year to $584.2 million, and year to date, we generated $67.3 million of free cash flow, which was up from $40 million generated over the same period last year. These metrics demonstrate our commitment to balancing top-line growth with improving cash flow generation during the transition. Turning now to our second quarter results in more detail.

As a reminder, the leading indicators of our transition are ARR, free cash flow, and ARR contribution margin. As we have said many times, the faster we progress through the transition, the more headwinds we will experience to our traditional income statement metrics, but we view this in a positive light. As compared to three months ago, we feel increasingly confident in the trajectory of the business following our second quarter results. While the macro environment remains challenging, it is also stable, and SaaS and MDDR are resonating well in this market to drive positive business momentum. Q2 total revenues were $130.3 million, up 13% year-over-year.

During the quarter, as compared to the same quarter last year, we had approximately a 6% 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 products. In the second quarter, SaaS revenues were $44.8 million. Term license subscription revenues were $62.7 million, and maintenance and services revenues were $22.8 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 $109.6 million, representing a gross margin of 84.1% compared to 87.1% in the second quarter of 2023. Gross margin continued to be strong, and the year-over-year change is due to the revenue headwind associated with a higher mix of SaaS sales, increased headcount to support the transition, and increased hosting costs.

Operating expenses in the second quarter totaled $107.5 million. As a result, second quarter operating income was $2.1 million, or an operating margin of 1.6%. This compares to operating income of $0.9 million, or an operating margin of 0.8% in the same period last year. During the second quarter, as compared to the same quarter last year, we had approximately a 5% headwind to our operating margin 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 products. Second quarter ARR contribution margin was 14.9%, up from 8.2% 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 a financial income of approximately $8.1 million, driven primarily by interest income on our cash deposits and investments in marketable securities. Net income for the second quarter of 2024 was $6.8 million, or $0.05 per diluted share, compared to net income of $1.1 million, or net income of $0.01 per diluted share for the second quarter of 2023. This is based on 128 million and 127.3 million diluted shares outstanding for Q2 2024 and Q2 2023, respectively. As of June 30, 2024, we had $790.3 million in cash, cash equivalents, short-term deposits, and marketable securities. For the six months ended June 30, 2024, we generated $68.4 million of cash from operations compared to $42.6 million generated in the same period last year, and CapEx was $1.1 million compared to $2.6 million last year.

Turning now to our updated 2024 guidance in more detail, it is important to note that our guidance now assumes 48% of total company ARR will come from our SaaS platform by year-end. As it relates to our quarterly revenue guidance, there are more conversions embedded in our Q4 guidance versus our Q3 guidance because we have more renewals in Q4 from a seasonal perspective, and the third quarter is federal's largest quarter, and we still expect to sell on-prem subscription in that vertical. For the third quarter of 2024, we expect total revenues of $140 million-$143 million, representing growth of 14%-17%, non-GAAP operating income of $7 million-$8 million, and non-GAAP net income per diluted share in the range of $0.07-$0.08. This assumes 128.2 million diluted shares outstanding.

For the full year 2024, we now expect ARR of $629 million-$635 million, representing growth of 16%-17%, free cash flow of $80 million-$85 million, total revenues of $544 million-$552 million, representing growth of 9%-11%, non-GAAP operating income of $18 million-$21 million, non-GAAP net income per diluted share in the range of $0.22-$0.24. This assumes 128.1 million diluted shares outstanding. In summary, our second quarter performance, coupled with the many tailwinds in our business, gives us confidence to raise our full-year ARR and free cash flow guidance and also to increase our SaaS ARR expectations. We look forward to driving continued momentum as we move through the second phase of our SaaS transition and unlocking meaningful value for our customers, our company, and our shareholders. With that, we would be happy to take questions. Operator?

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press Star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press Star 2 if you would like to remove your question from the queue. We ask that you limit yourself to one question so that others may have an opportunity to ask questions. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the Star keys. One moment, please, while we pull for questions. Our first question comes from Saket Kalia with Barclays. Please proceed with your question.

Okay. Great. Hey, guys. Thanks for taking my question here and nicely done this quarter.

Tim Perz (Head of Investor Relations)

Thank you.

Yakov Faitelson (CEO)

Thank you.

Saket Kalia (Equity Research Analyst)

So I'll keep it to one here. Yaki, can you maybe just talk about the success that you're having in converting your on-prem customers to SaaS? And Guy, maybe as part of that discussion, I mean, you talked about, I think, sort of an inline uplift that, as you've talked about in the past, but it sounds like maybe it's doing a little bit better. Maybe you could just talk us through, just anecdotally, how the economics are looking on some of those conversions.

Yakov Faitelson (CEO)

Thanks. Hi, Saket. The SaaS conversions are working very well because of the offering. We're talking about completely automated outcomes. If you have us, most probably you will not have a data breach and a data loss, and we are taking a lot of the operations on us. This is on top of just the regular SaaS benefits. So it's literally 10% of the effort for the customer and 10 times more value. This works extremely well, and it's very easy for us to demonstrate the immediate value and the ongoing value. The customers are benefiting tremendously while moving to SaaS. So this is a fairly easy proposition for them to move to a SaaS platform.

Guy Melamed (CFO and COO)

And from a pricing perspective, there's a 25%-30% price uplift on a like-for-like basis. So when you assume kind of the same features and functionality. But when we look at the data, the discount rates have held firm, so we really are recognizing pricing in line with that uplift. And what's very interesting to see is that when we kind of built the packaging for SaaS, our desire really was to have customers consuming more of the platform. And what we're seeing is that they're actually doing that. We're seeing deal sizes increase in excess of that uplift. So that's working really well for us.

Andrew Nowinski (Senior Equity Research Analyst)

When you look at the conversions in Q2, that really helped us get to approximately 36% of total ARR coming from SaaS, or really $210 million. And what we actually saw is an increase in the conversions. A lot of them came from perpetual maintenance customers, which was really a positive sign for us. So when we look at kind of the pace of the transition, the focus is on SaaS ARR as kind of the leading metric to measure the progress, and we're really happy with the progress we've done so far.

Operator (participant)

Our next question comes from Hamza Fodderwala. Please proceed with your question.

Hamza Fodderwala (Executive Director of Cybersecurity Equity Research)

Great. Thank you for taking my question, and congrats on the continued SaaS momentum. Yaki, I wanted to ask this question to you on what you talked about with generative AI. Not expecting contribution this year, which I think is prudent. I just wanted to get a sense of your timing as to when you think these Gen AI deployments will be more mainstream at the enterprises that you serve. And when do you think Varonis could start to benefit from some of these deployments? You're already talking about seeing more interest in pipelines. So I was wondering if you could maybe flesh out the timing of this opportunity for us.

Yakov Faitelson (CEO)

Thanks for the question. Before the timing of the opportunity, I'll tell you what I see from customers that we are seeing this tool, this Copilot and LLMs, that immediately is exposing the problem of excessive permissions and identity. So you use it, and it's like a Pac-Man from hell that goes and mines all the available data.

Andrew Nowinski (Senior Equity Research Analyst)

By that, if you don't have a platform like ours, you get a lot of data that you don't need to get. And once you get it, it just keeps digging, and people are starting to do a lot of things that can harm organizations badly. And this is even before it's in the wrong hands. God forbid you have an attack or something like that. I think that eventually it's inevitable that it will be in the hands of every business user. I don't know. It's hard to predict, but I believe it eventually will be something like Word or Excel, that it will be in the hands of every end user. And if you will not solve the data protection problem and you understand behavior, you're going to have just a lot of risk.

We definitely start to see that in a measured way organizations are starting to use it, but we're also starting to see just a slowly material impact on the pipeline. I think that people understand that this is inevitable to use these tools because of the productivity gains, and you can't do it. If you will do it as is without fixing permissions, understanding abnormal behavior, the ability to classify your data, it's a losing proposition for the organization. So we believe that over time we will benefit from it, and we believe that slowly but surely this is something that will be in the hands in one way or the other. We believe that it will be in the hands of every knowledge worker.

Guy Melamed (CFO and COO)

Hamza, just to add from a numbers perspective, and to add to what Yaki just said, when you kind of look at the results of the quarter, they were really strong. That's without Copilot being a material contributor yet. When we look at kind of the guidance and the assumptions there, we don't bake in any optimistic assumptions in our guidance before we see enough data to support the trend. We haven't yet baked in any contribution related to Copilot. We're seeing that healthy pipeline that Yaki talked about. Similar to what we have done in the past, we'll be happy to update you on any changes when the time is right. Bottom line, it's not part of the current guidance, but we think it should serve as a tailwind to the business.

Operator (participant)

Our next question comes from Brian Essex with JPMorgan. Please proceed with your question.

Brian Essex (Executive Director of US Software Equity Research)

Hi, good afternoon, and thank you for taking the question, and congrats from me as well. Nice to see the acceleration or slight acceleration in ARR along with better profitability and cash flow, particularly so early on in your transition process. And I guess that leads me into the question. Maybe for Guy, sustainability of profitability and cash flow here on out, how should we think about it, both in terms of the sustainability and level of potential margin expansion that we might expect?

Guy Melamed (CFO and COO)

When you look at kind of our philosophy in terms of the investments and growing top-line growth, we've always been very focused on not increasing the top line, but making sure that some of it's coming to the bottom line and making sure that we're generating more meaningful cash generation. I think we've done that very well.

Andrew Nowinski (Senior Equity Research Analyst)

As you mentioned, it's not easy to do that at the beginning of a transition. I think we manage that very well. But when you kind of look at the quarter, there were a couple of things that really contributed kind of the strength of the quarter and I think can help us drive top-line growth and free cash flow going forward. We're definitely seeing shorter sales cycles on SaaS and also seeing healthy and much better new logo activity. That's being driven by SaaS value proposition and the fact that we're eliminating the two biggest pushbacks of customers. One, not wanting to buy hardware, and the second one is that they don't have enough people to support the solution. So kind of when you look at the momentum in the quarter, really the factors that drove that outperformance in the quarter were those two. Overall, we're really happy with the progress and want to make sure that we grow top line and generate more meaningful free cash flow in the years ahead.

Operator (participant)

Our next question comes from Joel Fishbein with Truist Securities. Please proceed with your question.

Joel Fishbein (Managing Director and Senior Software Equity Research Analyst)

Thanks for taking the question, and congrats on the great execution. Yaki, for you, you mentioned the hospital system that deployed Varonis during the quarter, and I would love to understand the competitive landscape around that deal or competitive dynamics. And also, Guy, if you could share maybe the size of the deal, any parameters around that would be really helpful as well. Thank you.

Yakov Faitelson (CEO)

Yes, thanks. Overall, we don't see more competition in the pipeline. For different use cases, we see different companies, but essentially, regarding this deal and others, what I think that it's very important to understand: I saw hundreds of big breaches in the last few years. And they all usually have modern security stuff, world-class EDR and modern firewall and SIEM. But once you have an identity, there is no perimeter anymore. And you need a data-first solution in order to solve this problem. You can invest a lot without getting the benefits. With our SaaS solution, it's really we are, in order to protect your data, we are the first thing you need to do and the last thing that is going to save you.

Andrew Nowinski (Senior Equity Research Analyst)

And you get the world-class security people that looking at it 24/7 to make sure you don't have a data breach or a data loss. This is just a common thing throughout all the deals. With more automation and more coverage, we have more use cases and more ways to get into enterprises. Just the whole sales motion with the value proposition is working very well.

Guy Melamed (CFO and COO)

In terms of the deal itself, what was very interesting about the deal is that they bought the full package, including the MDDR. They wanted to make sure that we helped them in protecting against any breaches that take place. Obviously, what we can do with them, we can do with many other customers. This was $several hundred thousand in deal size. They bought the full package. They had about just over 6,000 users. A very healthy deal in what they consumed from a platform perspective and the ASP that we were able to get there.

Operator (participant)

Our next question comes from Matt Hedberg with RBC. Please proceed with your question.

Great. Thanks for taking my question, guys. Congrats as well. There were some questions earlier on about Gen AI and Copilot, but I wanted to focus on Office 365. I think you had an analyst, I believe it was in March of 2023, and you talked about maybe 1% penetrated in the Office 365 base. I think you said the time of that equated to maybe $125 million of cloud or SaaS ARR. I'm curious, could you give us an update about how that's progressing? It just seems like that's such a huge opportunity. Just sort of wondering if there's an update on how you think about penetration within that opportunity.

Guy Melamed (CFO and COO)

So you're absolutely right. When we laid out kind of the penetration, it was about 1%.

Andrew Nowinski (Senior Equity Research Analyst)

When you look at kind of the Office 365 in terms of how that's contributing to total ARR, we've seen a steady increase as a percentage of total ARR that's coming from the Office 365. What's actually very interesting to see is that customers are now consuming more of the platform together with the MDDR, which is making this extremely more appealing for them and helps in kind of the whole conversation with the customer. I wouldn't say that we're even close to scratching the surface. It's obviously improved slightly, but in terms of the opportunity, we're so far from kind of even getting to a point where it gets to the mid-single-digit percentages. We're far away from that. That just shows kind of the essence of how we can take advantage of the opportunity going forward.

Yakov Faitelson (CEO)

Our next question comes from Fatima Boolani with Citi. Please proceed with your question.

Fatima Boolani (Managing Director and Co-Head US Software Equity Research)

Hi, good afternoon. Thank you for taking my questions. Guy, I wanted to ask you about MDDR and if you can help put some numerical contours around some of the comments you made around the solution driving new customer velocity, better transaction velocity, influencing deal sizes. Just wondering if you can add a little bit more quantitative color around that. And the reason I ask is this time last year, you were in very early innings of your SaaS transition, and you didn't really have a formalized monetization model for MDDR, whereas this year you do. So I'm wondering if you can compare and contrast how much MDDR has positively influenced the SaaS momentum and the broader metrics. Thank you.

Guy Melamed (CFO and COO)

Absolutely. I think that's a great question. Just to remind everyone, we actually introduced MDDR at the beginning of this year. So it's not even been full two quarters, but the way we're seeing both the salesforce and our customers adopt it has been phenomenal. They've really embraced the simplicity of us doing things for them. So that's been very well received. In terms of exactly quantifying how much it's increasing in terms of ASP, we're seeing the ASP go up. But if you remember, we talked a lot about the fact that the way we price MDDR is that either you buy additional licenses and then you get the MDDR at a reduced price, or if you want to buy kind of MDDR as a standalone with kind of, I'd say, the package plus, then you would pay a higher price.

Andrew Nowinski (Senior Equity Research Analyst)

What we've actually seen from a behavioral perspective is that the customers actually are going towards buying the extended package, which is helping us in terms of the ASP. I don't want to quantify it because it's so early, less than two quarters in, but I can tell you that in terms of adoption, it's been one of the fastest adopted. I call it platform because we're selling the platform with MDDR, so it's been one of the fastest adopting platforms. And not only that, we truly believe that this offering should be part of every customer. It's obviously going to take time, but that's kind of the journey that we believe every customer should go through.

Yakov Faitelson (CEO)

We are also surprised with how effectively this offering of saving customers, like main customers on a weekly basis from a catastrophe, from attacks that people bypass the perimeter, they have an identity, and they can do massive amount of damage in the way that our user behavior analytics is working with all the telemetry that we are taking from Active Directory, Azure AD, stuff like Okta, DNS, and proxy, make sure that most of the time they even don't get to the data. If they get to the data, we see immediately the abnormal behavior, stop them, and doing very effective forensics also on the data layer, and they know exactly what happened. So it's just amazing to see how effective it is and how much value it brings to customers.

Operator (participant)

Our next question comes from Shaul Eyal with TD Cowen. Please proceed with your question.

Shaul Eyal (Managing Director of Equity Research)

Thank you. Good afternoon. Congrats on the outperformance and improved guidance. Yaki or Guy, it's been about 10 days since the global CrowdStrike IT outage. Just curious, Yaki, maybe for your views, have you seen any increased interest, heightened interest over the course of this past very, very short period?

Yakov Faitelson (CEO)

Not really. Software updates can have sometimes go wrong in what happened here. CrowdStrike is a great company. They're taking care of it. But in general, what we see are completely unrelated to CrowdStrike is that organizations understand that they need a data security platform. I think that in general, they understand that perimeter security is very important, but it's not enough. And you can be 99.9% okay, but then bad actors are managed to bypass it in any way. And if you don't have something like us, it will end up with a horrible breach. So this is what we see in the market. That's just organizations understand that they need a data-first solution, and this is the way to protect the valuable information.

Operator (participant)

Our next question comes from Andrew Nowinski with Wells Fargo. Please proceed with your question.

Andrew Nowinski (Senior Equity Research Analyst)

Okay. Thank you. So you talked about now expecting more conversions in Q4, which obviously creates a revenue headwind. But I'm wondering what prompted this change in assumptions this quarter and what you saw in the results in Q2 that may have prompted that because the guidance for the year suggests a fairly steep deceleration in Q4 revenue growth. Just wondering maybe what changed or what prompted the change. Thanks.

Guy Melamed (CFO and COO)

I don't think there's any change in the way we're looking kind of at Q2 and definitely not putting anything in different light in Q4.

Andrew Nowinski (Senior Equity Research Analyst)

I think there's a couple of things to note about the conversions. First of all, Q4 is the largest quarter. So we're taking advantage of any renewal as an attempt and desire to convert them into SaaS. And I think if you look at Q2, there was a large revenue beat, and that revenue beat had a couple of mechanics behind it that had to do with it. First of all, I think it's important to note that ARR is kind of the leading indicator and was really strong this quarter with good momentum in the business. I think that's very clear. During the transition, I think revenue is not really the indicator that would indicate on the health of our company. And I think we've been very clear on that as well.

When we look at what we said in the past, the more conversions we see from on-prem subscription to SaaS, the greater the headwind for our traditional income statement metrics. This quarter, we actually had really strong conversions, and there were two positive factors that took place that didn't cause revenue headwind. The first one was that we saw perpetual maintenance customers choose to convert to our SaaS platform. Since perpetual maintenance revenue is recognized rapidly, just like SaaS is, there is a tailwind when those customers convert to SaaS because of the uplift. As you remember, when we laid out the transition plan during the Investor Day last year, we didn't initially plan for those customers to convert to our SaaS offering. The fact that we're seeing this happen in a natural way is a huge positive for the business.

And kind of the second factor that impacted Q2 is that we saw an increase in customers choosing to convert ahead of the actual renewal date, which doesn't serve as a headwind to revenue this quarter, but will have an impact on our revenue in future quarters. So really, to summarize, when you look at kind of the momentum of the business, it's really strong. And although revenue should not be the measure for the health of the business, the reason it was stronger this quarter is because of the perpetual maintenance customer conversion and the early on-prem customer conversions that will impact revenue in Q3 and Q4.

Operator (participant)

Our next question comes from Roger Boyd with UBS. Please proceed with your question.

Roger Boyd (Software Equity Research)

Hey, everyone. Thanks for taking the questions. And again, congrats on the good results. You launched a number of database SKUs at the beginning of the year, including for Snowflake. Can you just talk about the momentum you're seeing with those products, and particularly with the Snowflake SKU, have the data security concerns stemming out of the incident there benefited the uptake or pipeline of that product? Thanks.

Yakov Faitelson (CEO)

I think that we're starting to see a lot of concerns from every data repository that is being complicated in the permission model, and the use is a lot of collaboration, and Snowflake is one of them. We're definitely starting to see a lot of momentum for these products, and we also see that the very unique intellectual property that we have, the deep technology that we have, is very much needed there. The other thing that we see is that exactly what I said about the perimeter is if you want to protect data, you need to protect data. You need a data-first solution. Because if you don't have it, as I said, once you have an identity, that's it. You are in the data. And I just think that once you have the right product, organizations are starting to take data security very seriously.

Operator (participant)

Our next question comes from Joe Gallo with Jefferies. Please proceed with your question.

Joseph Gallo (Software Equity Research)

Hey, guys. Thanks for the question. Just wanted to double-click on the new logo business. How was it this quarter? Any quantitative metrics, whether it's total customers or growth that you can share? And should we expect that side of the business to accelerate now that you have Copilot and MDDR in addition to the sales comp changes? Thanks.

Guy Melamed (CFO and COO)

The majority of the new ACV in Q2 was driven by new logos. We're definitely seeing shorter sales cycles on the SaaS fields. SaaS is really opening up new markets for us because it eliminates, as I said before, the two biggest pushbacks we used to get. One is that they don't have the people or don't want the hardware. So when you look at kind of the opportunity of growing the new business, and we talked a lot about kind of SaaS and MDDR combined, simplifying the conversation, making it easier for our sales team to talk to customers and kind of talk about the value proposition in a simplistic way. I obviously hope, and I think we have good indicators that the new customer would continue going forward.

Andrew Nowinski (Senior Equity Research Analyst)

But I can tell you that when you look at the results in Q2, the Q2 new business was very strong.

Operator (participant)

Our next question comes from Jason Ader with William Blair. Please proceed with your question.

Jason Ader (Co-Group Head of Technology, Media, and Communications)

Yeah. Good afternoon, guys. Wanted to ask about gross margin. I guess a little surprised at how strong it was in the quarter, just given the growing mix of SaaS. Can you just talk about what your expectations are for the second half of the year and into next year for gross margin? And are there any kind of specific idiosyncrasies around the gross margin beyond just the rising SaaS mix, which obviously has a negative impact?

Guy Melamed (CFO and COO)

Yep. You're 100% right. We were very happy with kind of the gross margins. They were really strong.

Andrew Nowinski (Senior Equity Research Analyst)

I think that when you look at kind of the ARR contribution margin and do it based on cost, you'll see that we were really at the same percentage that we had last year, which is 12%. So we were extremely happy with that. If you look ahead, the one thing that we want to make sure is convert our customers to SaaS. So the quicker we convert them, the more headwind we'll get from a revenue perspective. And on top of that, we have to make some investments in support to transition, really to support the transition. So you should see gross margins somewhat having kind of declining slightly, but I can say to you that when we look at the gross margins in the bigger picture, we're really happy with where we are, especially with the initial investments that we need to make to support this transition.

We expect to see the leverage even further kind of in the years ahead.

Jason Ader (Co-Group Head of Technology, Media, and Communications)

So Guy, just to be clear, the gross margin for Q3 and Q4, you expect to be below where Q2 was?

Guy Melamed (CFO and COO)

So we don't really guide on the gross margins on a quarterly basis. I'll talk conceptually about the fact that overall, when you look at kind of gross margins this quarter versus last year on the ARR contribution margin, you didn't see much of a change. You might see a bit of a change because of the investments that we're making. But overall, in the big picture, the gross margins are really healthy, and we're really happy with what we're seeing from kind of the margins on the SaaS product. And on top of that, there's leverage that you see in the different departments. You get the leverage in the sales and marketing.

Andrew Nowinski (Senior Equity Research Analyst)

There's leverage down the road on the R&D when you stop supporting two types of code. So the fact that we're making those investments in kind of the support team and the customer success team to support the transition doesn't really impact the overall bottom line. And we're very committed on showing operating margin improvements. And when you look at the ARR contribution margin, we saw a really nice increase versus last year.

Operator (participant)

Next question comes from Rob Owens with Piper Sandler. Please proceed with your question.

Rob Owens (Managing Director and Senior Research Analyst)

Great. Thank you for taking my question. I was hoping maybe you could elaborate a little bit around compressing sales cycles on the SaaS front. And if you could quantify that versus maybe where your traditional sales cycles are. And I guess secondarily, what you're seeing from a renewal standpoint. Thank you.

Guy Melamed (CFO and COO)

So I can definitely dig into this. I think what we're seeing in the sales cycles are really that they're shorter on the SaaS versus the on-prem subscription. I think it comes to the fact that the value proposition of our platform, together with the simplicity of the story, is causing that shortening deal cycles when you compare them to the on-prem subscription deals. We said from day one that we expect sales cycles to be shorter on SaaS versus the on-prem subscription because of the simplicity. How much it came down shouldn't be really a focus point. Whether it's 25%, 33%, or even 50% shorter, the point is really that we're seeing a significant enough reduction for us to talk about it and call it out today.

Andrew Nowinski (Senior Equity Research Analyst)

So really, it gives us a lot of momentum, and I think it's a critical benefit that we talked a lot about the fact that we transitioned to SaaS and the benefits that that generates. In terms of renewal rates, we're seeing very healthy renewal rates. We're very happy with them. And we've also said that we expect over time to have renewal rates increase with the SaaS offering.

Operator (participant)

Our next question comes from Joshua Tilton with Wolfe Research. Please proceed with your question.

Joshua Tilton (SVP of Equity Research)

Hey, guys. Thanks for taking my question. First of all, congrats on a great quarter. I guess what I'm trying to understand is just, I think if I look back, this is probably one of your best beats on ARR, total ARR in quite some time.

Andrew Nowinski (Senior Equity Research Analyst)

I'm just trying to understand what exactly changed this quarter that drove that rate of change to the positive, and how durable is that going forward? I know you mentioned that GenAI is not contributing to the model yet, but did you just do way more conversions this quarter? Did MDDR just start showing up in the numbers? Or is it just a function of maybe maintenance to SaaS uplift is just much higher than what you've seen on your prior conversion rates? So just help us understand exactly what drove this rate of change and how durable you think this outperformance that you delivered today is going forward.

Guy Melamed (CFO and COO)

First of all, thank you. We're really happy with kind of the results of the quarter. As you mentioned, the strong quarter is really without the Copilot being a material contributor yet.

Andrew Nowinski (Senior Equity Research Analyst)

I think when you look at kind of the underlying factors that helped drive this quarter, one of them was the shorter sales cycles on SaaS, and the other one was much better new logo activity. Those were kind of two of the elements that drove that. I think it kind of ties to the fact that MDDR, together with our SaaS offering, is making things much easier for our customers to consume. So when you look at kind of the overall health of the business, we're really happy with where we are. Obviously, we're very focused on continuing on that execution, but I wouldn't say that the conversions is what drove the business. What drove the business in Q2 was the new logo activity and the shorter sales cycles that we saw in SaaS.

Operator (participant)

Our next question comes from Rudy Kessinger with D.A. Davidson. Please proceed with your question.

Rudy Kessinger (Managing Director and Senior Equity Research Analyst)

Hey, guys. Thanks for taking my questions, and congrats on the numbers. Looks like a great quarter. I guess I'm curious, on Copilot, you've talked about it becoming a healthier material contributor to pipeline. If we combine that with what you've said about some of these faster sales cycles on SaaS and obviously those deals being SaaS deals, I guess that would imply we should start to see some material benefit to your new business from Copilot, probably several quarters out from now. Is that the right way we should be thinking about it? Or with some of these deals around Copilot, are you seeing them progress slower, faster than your typical deal, just given the pace of how those companies are rolling out Copilot? Thank you.

Guy Melamed (CFO and COO)

So one thing we try to do is only comment on kind of data that gives us enough confidence to call it out.

Andrew Nowinski (Senior Equity Research Analyst)

You've heard us talk about the expectation that sales cycles on SaaS would be much shorter from day one of announcing the transition. But this is kind of the first quarter that we feel confident in calling it out because 18 months have gone by since we announced the transition, and we have that data to support it. I don't know how Copilot kind of changes the data. I can promise you that from a transparency perspective, we've tried to be very clear in providing color when we see data that materializes. But I think if you look at kind of Copilot starting to contribute, we really don't know. It can contribute later this year or in 2025. What I promise you is that once we see data that supports that, we'll call it out and provide you that color.

Yakov Faitelson (CEO)

The way to think about it, we believe, is to understand that if these Copilot tools are going to be in the hands of knowledge users, the need for security will be almost inevitable. And without a doubt, at this point, we believe that we have the best product in the market. So if these tools will be in the hands of users, and we believe that there is real AI evolution based on LLMs, you will need a solution like Varonis in order to protect it.

Operator (participant)

Our next question comes from Shrenik Kothari with Robert W. Baird. Please proceed with your question.

Shrenik Kothari (Senior Research Analyst)

Hey, thanks for taking my question, and great job this quarter. Yaki, so you highlighted, of course, the shorter sales cycles and the pricing uplift continues to be strong.

Andrew Nowinski (Senior Equity Research Analyst)

In some cases, you're seeing deal sizes increase in excess of what customers, as a result of customers consuming more of the platform upon conversion, and highlighted the real estate firm was immediately able to reduce the footprint and the maintenance by moving to SaaS. Just, that's all great. But I'm just curious if you still have a long tail of the on-prem base, which might be a bit more price-sensitive and a bit more averse to transition that we kind of have been hearing. So you have sales incentives you touched upon. But just can you elaborate a bit on how do you plan on working with these customers to demonstrate the value proposition and justify this price uplift of the SaaS platform for this existing cohort of on-prem and have a quick follow-up for Guy?

Yakov Faitelson (CEO)

Yeah. I think that with the vast majority of our customers, it's just very compelling to move to SaaS because of the automated outcomes. So you want to make sure that you can avoid a breach without almost any effort, and it works very well. But these transitions are hard work. You need great attention to details, a lot of execution. You need to go to the customers that use one product, and you need to make sure that they understand that this is something completely different and demonstrate it. But we know how to do it. We know how to do transitions, but I can tell you that every day is just a lot of work, and you need to do it diligently and effectively. But this is exactly what we are doing, and you can see the results.

Shrenik Kothari (Senior Research Analyst)

Yeah, yeah.

Operator (participant)

It appears we have no further questions at this time. We would now like to turn the floor back over to Tim Perz for closing comments.

Tim Perz (Head of Investor Relations)

Thanks for the interest in Varonis. We look forward to speaking with you all at conferences this quarter.

Yakov Faitelson (CEO)

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