SecureWorks Corp

NASDAQ:SCWX

Earnings Call Transcript 2024-Q2

[Operator]

Good morning. My name is Prika and I will be your conference operator today. At this time, I would like to welcome everyone to the SecureWorks' Second Quarter Fiscal 2024 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. A supplemental slide presentation to accompany the prepared remarks can be found on the company's website. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.

At this time, I would like to turn the call over to Kevin Toomey, SecureWorks' Vice President of Investor Relations. So, Mr. Toomey, you may begin your conference.

[Kevin Toomey, VP, IR]

Thank you, operator. Good morning and welcome to SecureWorks' second quarter fiscal 2024 earnings call. Joining me today are Wendy Thomas, our Chief Executive Officer; and Alpana Wegner, our Chief Financial Officer.

During this call, unless otherwise indicated, we will reference non-GAAP financial measures. You will find the reconciliations between these GAAP and non-GAAP financial measures in the press release and presentation posted on the website earlier today. Finally, I'd like to remind you that all statements made during this call that relate to future results and events are forward-looking statements based on current expectations. Actual results and events could differ materially from those projected due to a number of risks and uncertainties, which are discussed in our press release, web deck, and SEC filings, which you can also find on the Investor Relations website at investors.secureworks.com. We assume no obligation to update our forward-looking statements.

With that, I'll turn the call over to SecureWorks CEO, Wendy Thomas.

[Wendy Thomas, CEO]

Thank you, Kevin, and welcome, everyone

I'm pleased to share that we delivered on our financial commitments in the second quarter and executed on several key strategic milestones. We also took actions to align our cost structure to our go-forward SaaS business, laying the foundations for profitability in fiscal '25.

Taegis annual recurring revenue or ARR was $276 million at the end of the second quarter. And Taegis revenue grew 55% year-over-year to $66 million in the quarter. To put those numbers into context, that puts us in the top three in terms of global market share for managed detection and response, out of more than 50 tracked companies as published by Gartner.

The majority of organizations find it challenging to outpace growing cyber risk without the technology and expertise SecureWorks and its partners bring to managing detection and response operations. Our platform design and productization strategy positions us to leverage MDR as the leading edge to drive adoption of our Taegis XDR platform, differentiating our managed XDR approach from others in the market.

This, with our multiple partner-led go-to-market path, that broaden our region's coverage enable us to capitalize on a large and expanding market opportunity. The Taegis platform was uniquely designed to address the security challenges of our customers and partners in several ways. First, Taegis is open without compromise. This means Taegis provides customers real choice around security controls such as endpoint, cloud, identity, and network, and more importantly, pivots with customer technology choices over time. And as market recognition of our XDR platform grows, I'm pleased to share we were named a leader in the recent 2023 Frost & Sullivan XDR Radar report, earning the top innovations product in the open XDR category.

Second, Taegis provides superior detection, separating the signal from the noise, and with our fixed per ends pricing, we incent customers to share the full breadth of their security telemetry with us. This translates into enhanced detection performance for our customers and alleviates the need for them to compromise security for their purpose of minimizing the volume-based pricing that many XDR vendors charge. And as our partner ecosystem expands, the depth and breadth of the telemetry we ingest makes Taegis even more powerful.

Third, Taegis provides unmatched response with integrated proprietary orchestration and automation capabilities, a growing set of response playbooks, and access to unlimited incident response. What this means for our customers is an industry-leading return on investment with superior security outcomes.

I'll turn now to a couple of market observations and then provide an update on our go-to-market results. First, consistent with the reports of others in the industry, we continued to experience longer sales cycles than a year ago. These are largely driven by longer customer decision-making cycle times, primarily a result of increased layers of deal review. In this environment of heightened fiscal responsibility, technology budget decisions more often reach the highest levels of the organization. We do not see indicators of this changing in the near term.

Second, we're encouraged to see more prospects actively planning for XDR adoption because market awareness grows, and customers, who have already adopted Taegis XDR laying out roadmaps for security vendor consolidation with native security controls, embedded orchestration, and a minimum of one-year storage included. Taegis XDR makes it possible for customers to realize better security for less money with fewer vendors.

Let me share some customer examples of how Taegis is resonating in the market. Last quarter, we won a leading utility infrastructure company with the teams that invested in a variety of security controls in recent years in response to a security posture assessment. But the results weren't what they were hoping for. Their team was overwhelmed with low fidelity alerts from a variety of costly and unconnected security controls, and in the face of rising cyber risk to their business. This customer was seeking valid detection and a streamlined approach to investigations and remediation, and they had a mandate to scale their existing investment in their SOC team.

They saw the power of Taegis XDR to work across their existing investments with a path to streamline those investments as contracts come up for renewal. And importantly, they immediately benefited from fewer, higher fidelity detections with full threat context and response recommendations.

They have shared with us yet another prospect how powerful and reassuring it has been to have rapid access to security experts via chat in 90 seconds or less, a unique feature for subscribers to our XDR software.

Another great win this quarter was an expansion with the current customer, a $6 billion multinational consumer goods manufacturing company that saw the power of Taegis in improving their security operations in Europe and decided to extend Taegis to the rest of their organization.

Taegis enabled them to implement a global governance model across their corporate headquarters and regional security teams across all major continents of the world. The ease of deployment and the ability to seamlessly manage operations across the follow-the-fund SOC model as well as predictable pricing were the key drivers for this customer to expand their relationship with SecureWorks as their global security platform partner.

I'd like to share a few highlights on how we are expanding our partner ecosystem through our multiple go-to-market channels, including MSSPs that sell and deliver Taegis-powered security services under their brands; solution providers that sell Taegis with SecureWorks delivered services in targeted markets; cyber risk partners who can reduce breach exposure for their customers by leveraging our portfolio of solutions; and technology alliance partners to create seamless protection for our joint customers.

We're doing great progress in our MSSP partner program this quarter, a large and growing market opportunity for us. Partners are choosing to build our MDR business on Taegis based upon the compelling return on investment opportunity and positive Taegis customer feedback. While these relationships have a long sales cycle, we're seeing the beginning stages of pipeline conversion with our MSSP partners as indicated by our new partnership with EY.

EY recently announced their intelligence extended detection and response service powered by SecureWorks Taegis XDR. Taegis as uniquely positioned to be the platform of choice for MSSPs to run their security operations with maximum effectiveness and efficiency, creating better outcomes for their customers and grow their business profitably.

Turning to solution providers. We've expanded our partner first motion since our launch in North America last December, having executed on our plan to extend the program to the Middle East, the United Kingdom and for Europe. We remain confident that these partners are an important path to market as customers value the advisory role that solution providers play in recommending trusted solutions and easing the procurement process. With any new sales motion, instead of relationships like this, it takes time to ramp.

Under the leadership of our new CRO, who started this past quarter, we are deepening our relationships with the partner community globally and refining the sales motions to capitalize on the partner-led opportunity.

Year-to-date, more than 60% of global Taegis new acquisition business was closed with the partner. We're also expanding our technology alliance relationships. We remain committed to cementing new partnerships with market-leading technologies to create seamless security visibility and superior security outcomes for our customers enabled by the open XDR approach of Taegis.

For example, we recently announced a partnership with Akamai, a global cloud services leader, integrating their leading zero-trust network access solutions into Taegis. Embedding the data and intelligence to scale secure access is fundamental in an era of work anywhere which is driving identity to become the new perimeter.

Moving to an update on product development. This quarter, we expanded our platform capabilities to improve alert triage with an automated role-based process for creating and updating investigations, directly benefiting our customers by minimizing the time between detection and executing a response. This also drives scale by reducing the workload for MDR analysts. This is just one example of our investments in automation this year that have yielded a significant reduction in the time to complete investigations, supporting more rapid response and driving our highest customer satisfaction ratings in this area to date.

If you recall in the first quarter, we discussed two new offerings to unify the way companies prevent, detect, and respond to threats across both IT and OT or operational technology environments. During the second quarter, we launched Taegis integrations with two leaders in OT monitoring, Claroty and [indiscernible] which can be managed to the Taegis in the context of a customer's entire attack surface. These new partnerships provide more visibility, threat detection and response for traditionally siloed IT and OT environments, while improving the search, event analysis and response experience in Taegis. We are seeing strong interest in our OT offering as we are well-positioned to address the rising risk of breach from converged OT and IT environments in the industrial space.

Before I hand the call over to Alpana to walk through our financial results, let me shift gears and talk about our path to profitable growth. Our competitive advantages are resonating in the market and demand for our solutions is increasing. The depth and breadth of our partnership ecosystem provides diverse vectors for growth well into the future. I'm pleased with the progress our team has made, since the launch of our partner first go-to-market motion, but with broader sales cycle elongation, the conversion to the top-line is taking longer than we initially projected.

In addition, our other MSS business lines are sunsetting faster, which is a positive for the business in the long term. However, it is creating a near-term headwind on our total revenue this year. As such, we are revising our full-year revenue and our ARR guidance to reflect these shifts in timing. We are delivering and remain committed to improving adjusted EBITDA while investing in the highest-quality solutions and security outcomes for our customers and partners to retain our market leadership position.

I want to thank our customers and partners for joining forces with us, and my thanks to our teammates for their hard work and commitment to the SecureWorks mission of securing human progress. I also want to welcome Alpana Wegner for her first SecureWorks earnings call since joining us in June. I look forward to working closely with her as we drive growth and scale into our business.

With that, I'll turn the call over to Alpana to walk through our financial results and guidance.

[Alpana Wegner, CFO]

Thanks, Wendy. Good morning everyone.

I'm excited to join SecureWorks, a time where the business is pivoting to financial model that has highly recurring revenue and support scalability and profitability. I'll start with the highlights of our Q2 financial results and then I will provide expectations for Q3 in the remainder of the year.

Total revenue for the quarter was $93 million, above the high end of our guidance of $90 million to $92 million, driven primarily by higher professional services revenue. Our Taegis business performed in line with our expectations in the quarter. Taegis subscription revenue was $66 million, up 6% sequentially and 55% year-over-year. Taegis ARR increased 37% year-over-year to $276 million, now representing more than 90% of our total ARR.

Average revenue per Taegis customer health at $135,000 and remains a premium to both the industry average and to our historical other MSS average, underscoring the value that Taegis provides our customers. Total gross margin expanded 70 basis points sequentially to 70.7% this quarter and showed an improvement of 520 basis points versus second quarter a year ago, demonstrating the scalable opportunity within the Taegis business.

Adjusted EBITDA loss was $10.3 million compared to a $14.3 million loss in the prior year period, reflecting our actions to lower operating costs and to expand the gross margin of our Taegis business.

Turning to the balance sheet and capital allocation. We ended the second quarter with a strong balance sheet with $65 million of cash, no debt and an undrawn credit facility. We used $28 million of cash from operations compared with $17 million used in the prior year period, which primarily reflects the timing of cash receipts and the timing of net transactions with Dell. We recently expanded and extended our existing revolving line of credit to a $50 million facility with a maturity and repayment period of March 2026, providing us with longer-term additional liquidity.

Before moving to guidance, I would like to provide additional details on the restructuring activity we announced last month, which further aligned our cost structure to our highly scalable Taegis centric business model. The annualized impact of the cost reductions in total are expected to be $50 million. As we previously shared, the other MSS and nonstrategic services business are rolling off at a faster pace than originally projected. And accordingly, we have been actively managing the related costs out.

After taking into effect the reductions we announced last month, we estimate approximately $10 million on an annualized basis of duplicative fixed and transition-related costs remaining in the business with a split of 80/20 across cost of revenue and operating expenses. We expect these costs to roll off as we complete the end of life in the first half of fiscal '25.

The remainder of the cost reductions were in operating expenses, we identified opportunities across G&A, R&D and sales and marketing to streamline, simplify and align to our SaaS model, including efficiencies from our partner first go-to-market. We recognized $14 million of restructuring costs in Q2, $11 million of which will be paid in cash outflows, with the majority being in second half of fiscal '24.

Now turning to our guidance. Our revenue and our ARR outlook for the remainder of the year is shaped by two primary factors. The first is we expect to continue to wind down our other MSS business at a faster pace than previously anticipated. And the second, as Wendy mentioned earlier, while we are building strong solution provider relationships and growing pipeline, the ramp time for our ARR and professional services has elongated.

For the third quarter of fiscal '24, we expect total revenue of between $88 million to $90 million and non-GAAP net loss per share of $0.05 and $0.07. For the full year, we now expect Taegis ARR to end between $285 million and $300 million, which at the midpoint is a 12% year-over-year growth. We continue to expect other MSS ARR to represent 5% or less of total ARR. Taegis revenue between $264 million to $268 million and total revenue of between $360 million to $368 million.

Our outlook on profitability takes into consideration the recent restructuring activities. We continue to expect Taegis gross margins to be 70% or better, adjusted EBITDA to be between negative $31 million to $37 million and adjusted EBITDA in the fourth quarter near breakeven and EBITDA profitability in fiscal '25. We expect full year non-GAAP EPS loss to be between $0.36 and $0.41 and we expect net cash used in operating activities to be between $70 million and $80 million. This change reflects the timing of the cash outlay related to restructuring costs I just covered, as well as a reduction of $5 million in tax benefit realization and $8 million related to a state sales tax settlement. We also expect CapEx of $6 million to $8 million.

In closing, I'm pleased we delivered against our financial commitments in the second quarter. We believe our differentiated platform stages, our extensive security expertise, the multiple go-to-market paths we have underway and our actions in fiscal '24 will drive our business to sustainable profitable growth next year.

Thank you for joining us on the call today. Wendy will now rejoin us as we begin Q&A. Operator, can you please introduce the first question.

[Operator]

Thank you. The first question comes from Mike Cikos with Needham.

[Mike Cikos, Needham]

Thanks team, for getting me on here. I'm really looking forward to working with you upon - I think this is our first time having you on for a company call now. I guess my first question would be for Wendy. And one of the things I'm trying to figure out when I look at Slide 4, for example, it shows that the Taegis customer count has been at 2,000 now. I think this is the third consecutive quarter. So my question is, I guess, what is SecureWorks doing to help drive net new logos to the Taegis platform? And when can we expect to start seeing that show through on the customer count.

[Wendy Thomas, CEO]

Good morning. What we have in our Taegis logo count is a rounded number. So you don't see some of the movement in that necessarily each quarter. But we - customer count this quarter was fairly consistent with what you see in the ARR line. As our business model is shifting in terms of a couple of things. One, our platform was designed for a target market that is both a little more upmarket, and you see that in our average revenue per customer of 134,000 versus some of our - the rest of the competitors in the market in terms of that average, as well as to target managed services providers who, in our customer count, the end customer count doesn't show up there. It's one MSP partner. So we tend to focus in on the ARPC as much as anything in terms of that revenue opportunity.

And then clearly, as we're making the partner shift as well, and you saw the announcement we've expanded into Europe and the Middle East this quarter and having signed those partners to launch in those markets. We see growing demand and pipeline from the partners that we've launched in North America and expect to see that same ramp with those partners as well. So it's just go-to-market shift and expansion opportunity that will drive that growth going forward.

[Mike Cikos, Needham]

Great. Thanks for that Wendy. And I guess just a follow-up. I know we're talking about the sales cycles here. I guess my question is, did we actually see sales cycles elongate for looking at this most recent quarter versus quarter - versus the previous quarter. I know that we've seen extension on a year-to-year basis, but just wanted to see if there was any incremental elongation on a sequential basis. And I guess just a follow-up for Alpana as well. Just given, call it, $65 million in cash on the sheet exiting the quarter and the expectation for continued usage over the remainder of the year with updated guidance. Can you give us a sense for, I guess, your cushion, what you're comfortable with on the sheet before maybe you start tapping into the revolver you have just anything there would be beneficial. Thank you, guys.

[Wendy Thomas, CEO]

Okay. I'll take the first part and hand off to Alpana. So the good news is, security is clearly still a high priority for customers. What we don't see is customers saying, no. The demand is there. Our pipeline is increasing and it's growing in terms of the mix with partners as we expand that partner ecosystem. So what we do see is that there is just this era right now and every organization is looking to operate at a heightened level of fiscal management. And so we do see more layers of deal review, additional layers, if you will. And we did see that elongate in 2Q versus first quarter as well as year-over-year.

So it's just an opportunity for organizations to make sure that when they make this investment, they are - they're doing so with a full understanding of the opportunity, the road map for future savings and that they have a partner that they trust to be in this with them as more than a vendor but truly someone who is engaged in evolving with their business. And I think that's one of the unique things given our reputation and brand and how we operate with our existing customers who provide tremendous references for us, that is the strength of turning that pipeline into ARR.

[Alpana Wegner, CFO]

And good morning, Mike, this is Alpana. It's nice to speak to you this morning and look forward to talking further with you. As it relates to the question on cash, yes, as you noted, we ended the quarter with $65 million on the balance sheet. From my perspective, I think of our use of cash, tracking pretty closely from a trend perspective with what we're looking from an outlook perspective on the shift in trajectory with EBITDA. And so as we see EBITDA improving with the guide of a breakeven in Q4 of this year, I would say that you should expect to see our cash flow trending in the same direction with cash flow generation coming next year.

And so from your question on the revolver, it's nice to have. We're very happy with where that's at, having it at $50 million in a three-year term now with the most recent amendment, but I don't see a need in the near term from an operating cash flow perspective, needing to tap into it any time in the near term.

[Mike Cikos, Needham]

Terrific. Thank you for all the color guys. I'll turn it over to my colleagues. I appreciate it.

[Wendy Thomas, CEO]

Thank you.

[Alpana Wegner, CFO]

Thank you.

[Operator]

Thank you. [Operator Instructions] Your next question comes from the line of Hamza Fodderwala of Morgan Stanley.

[Hamza Fodderwala, Morgan Stanley]

Hi, good morning. Thank you so much for taking my question. Wendy, just maybe first one for you to follow up on the last question. Just on the overall demand environment, would you say that you're starting to see some stability? Are things getting maybe slightly worse? Any sort of green shoots that you see in terms of broader security demand trends on your end?

[Wendy Thomas, CEO]

Sure. Good morning. From our end, we do see, as I mentioned, demand and pipeline increasing, so we do see good shoots there and not the kind of - not spending at all on security that we saw probably 1.5 years ago, where people really took a pause. So that part is positive, absolutely.

The second part for us is that XDR and MDR are still markets that are in ramping adoption, if you will. And I would say that the market awareness of and understanding of MDR for certain and now XDR is growing, so that it's kind of become an area of why aren't you making a plan for this kind of transition of a legacy SIM or really a people-led security operation. And so we view that as another positive trend for our business versus obviously very mature security product markets that are in a different space now.

[Hamza Fodderwala, Morgan Stanley]

Got it. And maybe just one quick follow-up for Alpana. I'm sorry if I missed it, but was there any color or indication on when we would see a return to sort of revenue growth again?

[Alpana Wegner, CFO]

We are not currently guiding to fiscal '25. But what we are providing is the outlook from a profitability and cash flow perspective for '25 is there. What I would say is our continued focus on growth is front and center. There's no deceleration in terms of our focus on it. And we're continuing to strategically look at taking the demand that we're seeing in the pipeline and how we look to convert that faster. And I would say the end of life that we've announced on our other MSS lines, we still see that progressing on track. If not, as we've mentioned, it's accelerating. And so as we come to a close and kind of get that top line overhang behind us in the first half of next year, we would certainly expect the top line to return to growth.

If you look at the pages line on its own, it is growing. And so that would be an indicator as well as to where we see the future.

[Hamza Fodderwala, Morgan Stanley]

Thank you so much.

[Alpana Wegner, CFO]

Thank you.

[Operator]

Thank you. [Operator Instructions] There are no further questions at this time. Mr. Toomey I turn the call back over to you.

[Kevin Toomey, VP, IR]

Okay. Thank you. That wraps the Q&A and today's call. A replay of this webcast will be available on our Investor Relations page at secureworks.com, along with our supplemental web deck and additional financial tables. Thank you, everyone, for joining us today.

[Wendy Thomas, CEO]

Thank you.

[Operator]

Thank you all for joining today's call. I can confirm today's call has now concluded. You may now disconnect, and enjoy the rest of your day.