Varonis Systems Inc

NASDAQ:VRNS

Earnings Call Analysis

Varonis Reports Steady SaaS Transition

Varonis is well into its SaaS transition amidst macro headwinds and the war in Israel, with a third of employees in Israel but no expected material impact on global operations. Q3 SaaS represented 59% of new and upsell business, exceeding the 45% guidance. The conversion to SaaS is driving a 16% year-over-year growth in ARR to $517.5 million, with a significant increase in free cash flow from $0.8 million to $46 million. Q4 revenue outlook anticipates $12 million of conversions to SaaS, creating a headwind but not affecting ARR or cash flow. Full-year guidance raises SaaS mix expectation to 55% and ARR to $535-$539 million, with revenues projected to grow by 5% to $495-$499 million.

Transitioning to a Software-as-a-Service Giant

The company is on a steadfast journey toward achieving its $1 billion annual recurring revenue (ARR) target, propelled by a robust transition to a SaaS business model and a quicker pace of innovation. Their confidence in reaching this milestone is evidenced by the SaaS segment now representing about 15% of the company's total ARR.

Company Resilience Amidst Geopolitical Tensions

Despite the war in Israel, the company has managed minimal impact on its global operations, with Israel accounting for less than 1% of its business and a low single-digit percentage of team members called up to active duty. Their proactive execution of contingency plans underscores a commitment to employee safety without disrupting the business flow.

Robust SaaS Adoption and Financial Performance

The company is pleased with the robust uptake of its SaaS offerings and the momentum of its transition, contributing to strong ARR of $517.5 million, up 16% year over year. They have generated remarkable year-to-date free cash flow of $46 million, a massive leap from $0.8 million in the previous year. These financial metrics have led to improving cash flow generation despite initial headwinds from the transition in their traditional income statement.

Navigating the Headwinds of a Macro Environment

The company continues to battle macroeconomic challenges that manifest as longer sales cycles and increased deal scrutiny, impacting near-term results. Despite this, they stay the course, with updated guidance reflecting these headwinds and expectations for continued pressure on their income statement metrics as they deepen their SaaS foothold.

Income Statement Under Transition

Total revenues dipped slightly to $122.3 million, down 1% year-over-year. A revenue growth headwind of about 12% is attributed to the increased SaaS sales, which are recognized ratably as opposed to the upfront recognition of on-premises products. However, strong gross margins of 87.3% display resilience, and SaaS platform efficiencies that somewhat counterbalance the revenue headwinds.

Increased Margins Signaling Efficient Growth

The ARR contribution margin for the third quarter marked a sizable increase to 11.1% from 3.6% the previous year. This margin enhancement during the early transition period highlights the company's adept ability to boost margins while growing ARR and making the strategic pivot to SaaS.

Raised Outlook for SaaS and Guidance for the Next Quarter

Riding the tailwinds of successful SaaS adoption, the company has raised its full-year SaaS mix guidance to 55%, up from 50%. Furthermore, they anticipate a SaaS mix of 60% in Q4. In this quarter, they foresee $12 million in renewals transitioning to SaaS, inferring revenue headwinds. For Q4, they project total revenues between $115 million to $154 million, with a growth rate of 5% to 8%, and non-GAAP operating income of $25 million to $27 million. Moreover, for the full year, they expect ARR between $535 million to $539 million with free cash flow of $40 million to $45 million, and total revenues pegged at $495 million to $499 million, implying a 5% growth. Lastly, non-GAAP operating income is predicted to be between $26.5 million to $28.5 million.

Earnings Call Transcript 2023-Q3

[Operator]

Greetings, and welcome to Varonis Systems, Inc. Third Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Tim Perz, Investor Relations. Thank you. You may begin.

[Tim Perz, executive]

Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis' third quarter 2023 financial results. With me on the call today are Yakov 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 fourth 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 third 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, Yakov Faitelson, Yakov?

[Yakov Faitelson, executive]

Thanks, Tim, and good afternoon, everyone. Thank you for joining us today. Let me start by saying our thoughts are with our employees, customers, partners and all of those impacted by the recent events in Ed. We will continue to do whatever it takes to support our employees Today, I would like to review our Q3 results and discuss how AI can serve as a meaningful tailwind to our business in the years to come. But first, I would like to remind you why Varonis and the problems we solve. Data is the prime target for bad actors because of its important to a business. Data is also out of control. The explosion of the cloud and remote work has improved collaboration, but has also made securing data more difficult. Varonis helps companies locate sensitive data visualize who has access to it and automatically lock it down. This allows companies to collaborate safely and get value from their data while managing risk and AI will only make this an even greater priority. Our third quarter results reflect the continued healthy adoption of Varonis SaaS.

We saw further evidence that our transition to a SaaS business model is working in SaaS ARR now represents approximately 15% of total company area. Third quarter SaaS mix came in at 59%, comfortably ahead of our guidance of 45%. ARR grew 15% year-over-year to $57.5 million and we have generated $46 million of free cash flow year-to-date, up from 800,000 to the same period last year. Guy will review our Q3 results and our updated guidance in more detail. From a macro standpoint, we continue to see high level of directory and longer sales cycle this quarter but remain encouraged by the progress of our fast position against these headwinds.

Now I would like to spend some time on how AI presents a meaningful opportunity for Vero. In my conversation with customers in prospect, AI comes up more and more. and my key takeaway for Vos is that the growth of AI is the potential to generate significantly more data, significantly more risk and significantly increase the need for data security. Stepping back, Gener presents both opportunity and risk for companies. It has an opportunity to boost productivity and efficiency, but in order to safely realize these benefits -- there are security risk that businesses must mitigate first. This represents opportunities for companies like Veloce. The first risk is related to a I call self-inflict risk, which happens when businesses start using AI to suggest content to employees. And as data is locked down, that is little to prevent AI from analyzing the company's entire data estate and revealing critical business assets, the customer list, payroll files or bank account information to their own people. Microsoft recommends mitigating this risk by securing sensitive data before deploying core pilot, which is the company's AIS system and specifically the comment having the right information, access controls and policies in place, which is precisely what Varonis done. Without Varonis, rightsizing access control is very challenging. Managing access compose only gets harder over time, with dataport and AI will surely contribute further to this problem without the right control in place, AI doesn't know who should see what surface everything for everyone. This becomes a huge risk for organizations and bad actors won't even mean to search for content, they want to still -- I will help them to find it automatically.

AI will also increase the risk that companies face for external takes. A few examples of this include helping then actors create and translate fishing image so they can use them in many languages, creating fake data sets in order to treat companies into paintline and spend creating made Unfortunately, the use of AI will continue to lower the barriers to entry for hacking or ice organizations mitigate this risk by ensuring that only the people have access to information that they need to do their job. Varonis can help organizations ensure that employees only see content suggestions that are relevant to their job function. It's a bad actor bypass perimeter controller Varonis can lock out the compromise machine preventing damage from happening, although that we see arising from security risk related to the , we are also leveraging this technology in new ways to improve our customer experience. Varonis has been using machine learning and AI for many years in our analysis engine and threat model, for example.

And today, we are announcing 2 exciting generated AI capabilities in our SaaS data security platform. AI system security operations center or what we call SOC and natural language search. Although we do not plan to say as a separate skew our AIS system SoC will provide security analysts with an intelligent DIS system specialized in performing investigation, remediating threats and proactively hardening environment. Our SaaS platform can analyze all and provide context and next steps to help Irish more efficiently resolve security incident. With natural and research AI mix. Even is user power is. Anyone from the help desk to CISO can use natural language to get fast and accurate answers to questions such as do we have any file containing passwords that are exposed to even on the Internet? Or what user has been accessing or pay refine. Today, we introduced general features build upon the Bonistas that we have discussed with you over the past year and will further reduce the time to value for our customers and improve their experience.

with that I would like to spend a moment to remind you of the 3 key benefits of SaaS platform provides our customers. First, customers are much better protected with much less effort with automated remediation in proactive incident response Second, chassis quicker to deploy and a significantly lower infrastructure costs and third, stasis easier to maintain and upgrade. 3 of the key benefits that we realize out one, shorter sales cycles, to larger initial lands and the margin benefits over time. This quarter, we continue to see additional proof points of these benefits. -- large state government organization became the only SaaS customer this quarter. We first gained a department of this state as a customer in 2022. Over the past year, we had a very successful deployment in the department that allowed us to build curability and ultimately win the broader state government mandate. -- for this organization, SaaS as a master because the security team is trait thing. Now they will benefit from quicker time to value faster deployment and most importantly, they will be better protected with our proactive incident response team and automated remediation for Windows on prem and Microsoft 365.

We also continue to see healthy interest from existing self-hosted customers who converted to SaaS this quarter. One example was a multinational financial institution that first became a customer in 2020 given the large volume of sensitive customer data committed to make sure that information was locked down. They originally purchased 4 on-prem subscription licenses to protect their on-plan Windows environment. This organization success protecting all-prime window drove a desire to consume all of the platform by going both wider and deeper. Varonis as well now help them shrink the blast radius in the cloud just as they did on plan. Proactive incident response will supplement the starting capabilities and Varonis the need for this customer to manage their own hardware, which will improve the scalability -- we converted their one-window licenses into a SaaS equivalent package and they purchased an additional staff package for Microsoft 365 widening their coverage. The sustainment that we saw from our SaaS transition this quarter, coupled with a faster pace of innovation gets us closer to achieving a $1 billion ARR target and delivering meaningful stakeholder value. With that, let me turn the call over to Guy Melamed.

[Guy Melamed, executive]

Thanks, Yakov. Good afternoon, everyone. Thank you for joining us today. It goes without saying that the health and safety of our employees is a permanent importance to us, and we will continue to do whatever it takes to support them. Before I discuss results, I want to briefly comment on the impact of the war in Israel on our operations. From a top line perspective, Israel has historically represented less than 1% of our business. We have approximately 1/3 of our employees located in Israel, principal research and development facility as well as a portion of our support and general and administrative team. At this time, a low sing-digit of our global team members has been called up to Active Beauty.

We have executed business contingency plans to minimize the impact on our business. And at this time, we don't expect a material impact on our global operations. With that, I'd like to turn to Q3 results. We are pleased with the continued strong adoption of Verona SaaS against continued macro headwinds. Our SaaS transition continues to gain momentum, and this quarter provided additional proof of the numerous benefits to our customers as well as the tailwind to our ARR and cash flow performance. As a reminder, ARR, free cash flow and ARR contribution margin are the leading indicators for our business during this transition. The shift from on-prem subscription licenses where approximately 80% of the deal 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 increased. And this quarter's impact was meaningful as the number of existing customers converting to SaaS again increased. However, these headwinds are a function of accounting treatment and are not indicative of the health of our 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. Our third quarter SaaS mix represented 59% of new business and net new upsell ARR versus our guidance of 45%. And after only 3 quarters into the transition, SaaS now represents approximately 15% of the company's total ARR. The average deal sizes realized in Q3 continue to provide us with confidence in the 25% to 30% pricing uplift and margin structure that we previously provided. In the third quarter, a significant amount of SaaS deals were sold to new customers, but we again saw an increase in existing customers converting to our SaaS offering. In the third quarter, we had approximately $10 million in conversions of existing customers, impacting our Q3 revenue. To be clear, this is the renewal amount that was previously booked as an on-prem subscription that is now SaaS, which causes a headwind to our reported revenue and operating margin, but does not impact ARR or free cash flow. The $10 million from this quarter does not include the uplift that we realized from these conversions, which is accretive to ARR and free cash flow.

As we look to our revenue guidance for the fourth quarter, we're now assuming that approximately $12 million of existing customer renewals will convert to SaaS in Q4, which is up from $10 million previously. In the third quarter, ARR grew 16% year-over-year to $517.5 million. Year-to-date, we generated $46 million of free cash flow, which was up from $0.8 million over the same period last year, reflecting the inherent leverage in our model as well as our commitment to balancing top line growth with improving cash flow generation.

In Q3, we continued to see a macro environment that was similar to the first half of the year. We're still seeing deal scrutiny and longer sales cycles across the board, which is impacting customer purchasing patterns and is constraining our near-term results. We expect these longer deal cycles to continue along with the associated budgetary scrutiny, and our updated guidance takes this into consideration.

Turning now to our third 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 ARPU margins are the leading indicators for this transition. We take our commitments to the Street since it's based on a combination of our expected SaaS mix and existing customer conversion. As we said previously, the faster we progress throughout the experience our traditional income statement metrics. We view these headwinds in a positive light as they show our customers are adopting our SaaS solution more rapidly. Q3 total revenues were $122.3 million, down 1% year-over-year.

During the quarter, as compared to the same quarter last year, we had approximately a 12% 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 $97.7 million, and maintenance and services revenues were $24.6 million as our renewal rates were again over 90%. cost profit for the third quarter was $106.7 million, representing a gross margin of 87.3%. As a result, third quarter operating income was $4.9 million or an operating margin of 4%. This compares to operating income of $9.8 million or an operating margin of 7.9% in the same period last year. During the quarter, as compared to the same quarter last year, we had approximately an 11% 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.

Third quarter ARR contribution margin was 11.1%, up from 3.6% last year. The significant leverage improvement even during the early stages of the transition reflects our ability to drive strong incremental margin while growing ARR and transitioning to SaaS. During the quarter, we had financial income of approximately $8 million, driven primarily by interest income on our cash deposits and investments in marketable securities. Net income for the third quarter of 2023 was $10.4 million or $0.08 per diluted share compared to a net income of $6.7 million or net income of $0.05 per diluted share for the third quarter of 2022. This is based on 126.7 million diluted shares outstanding and $126.9 million diluted shares outstanding for Q3 2023 and Q3 2022, respectively. As of September 30, 2023, we had $731.5 million in cash, cash equivalents, short-term deposits and marketable securities.

For the 9 months ended September 30, 2023, we generated $49 million of cash from operations compared to $8.4 million generated in the same period last year. CapEx was $2.9 million compared to $7.6 million last year. During the third quarter, we repurchased 1.2 million shares at an average purchase price of $30.10 and which completed our intended repurchase. Over the course of the program, we repurchased approximately 4.4 million shares at an average purchase price of $22.64 for a total consideration of approximately $100 million.

Turning to our guidance in more detail. We're raising our full year SaaS mix of new business and upsell ARR guidance to 55% and up from 50% previously, and we expect Q4's SaaS mix to be 60%. We continue 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 Q4, we're assuming that $12 million of renewal will convert to SaaS, which will serve as a headwind to revenue. conversions to SaaS before considering any uplift to deal sizes do not impact ARR -- our guidance continues to factor in the same level of macro headwinds that we've discussed at length in the past.

Now turning to our guidance. For the fourth quarter of 2023, we expect total revenues of $150 million to $154 million, representing growth of 5% to 8%. Non-GAAP operating income of $25 million to $27 million, and non-GAAP net income per diluted share in the range of $0.22 to $0.24. This assumes 126.1 million diluted shares outstanding. For the full year 2023, we now expect ARR of $535 million to $539 million, representing growth of 15% to 16%. The Free cash flow of $40 million to $45 million, which includes $8 million to $10 million of headwind related to the TCJA capitalization of R&D provisions. Total revenues of $495 million to $499 million, representing growth of 5%.

Non-GAAP operating income of $26.5 million to $28.5 million, non-GAAP net income per diluted share in the range of $0.31 to $0.33. This assumes $126.6 million diluted shares outstanding. In summary, we continue to see solid demand for both new and existing customers who wish to consume your owners through our SaaS platform. As a result, our transition continues to move quickly and approximately 15% of our total ARR is now coming from SaaS. This is benefiting our ARR performance and cash flow generation, which positions us for a strong fourth quarter.

With that, we would be happy to take questions. Operator?

[Operator]

[Operator Instructions] Our first question comes from the line of Saket Kalia with Barclays.

[Saket Kalia, analyst]

Okay. Great. I just want to send our thoughts to the Varonis team and their families in Israel.

[Guy Melamed, executive]

Thank you .

[Saket Kalia, analyst]

Absolutely. If I stick to 1 question, maybe I'll make it for you here, Yaki, it just seems like great traction on SaaS. For those customers that are moving to your SaaS tools, what are you seeing on usage of the different modules? Are you seeing any change in usage now that the tools are arguably easier to deploy and use?

[Yakov Faitelson, executive]

Well, we see just a dramatic change. We see what we call robotic value proposition. And it's -- the North Star was always what we call 10% of the effort, order of magnitude, more value this works according to plan. we can measure everything from installation to update to remediation, our ability to do pressing the other thing, we also build the ability of our people by our professional services to support the customer is much more in we can provide a lot of the value of the platform with the customer almost doing nothing, just very, very little in helping in terms of configuration. So just completely different value proposition, literally an missing robots.

[Operator]

Our next question comes from the line of Hamza Fodderwala with Morgan Stanley.

[Hamza Fodderwala, analyst]

Yaki, I wanted to dig in a little bit more about your commentary around generative AI. I think a lot of the CIOs and CISOs that we're talking to more recently are talking about our data security and governance is a big hurdle to deploying these lower language models. And I'm curious to what extent are you starting to have conversations with customers on how they can deploy these generative AI models in a way that can prevent things like data leakage or poisoning from occurring?

[Yakov Faitelson, executive]

I think that it's going to be a complete game changer. The reality is that we still haven't seen it completely, but just the initial release of staple copilots for business, I think essentially what it does. It's mining all the data that people can access and this is not me saying Microsofts are saying that 90% of the access controls are excessive. You don't need them. So you have this tools that leveraging large language models that going in mining massive amounts of data creating in tremendous rate high-value information products that are completely out of policy. So now thinking about it, if I take your credentials and 90% of the data you can access is not relevant for you. And you have these AI tools that are extremely sophisticated that's creating this highly valuable data. I just think that very soon what you will see is that organizations understand that they need to make sure that they have access control data auditing and classification in place in order to make sure they can realize productivity gains and avoid these assets. So this is something that we're starting to see that customers are talking about it, that all the customers are talking about it. And I really believe that Varonis is the foundation to make sure that you can -- that you would be able to use this AI-based product.

[Operator]

Our next question comes from the line of Matt Hedberg with RBC Capital.

[Matthew Hedberg, analyst]

Congrats on the results, and we send our thoughts and prayers to all the VAronis employees around the globe and in Israel. Yaki, maybe as a follow-up to Hans' question, I think in the prepared remarks, you said you don't expect to sell a separate Gen AI SKU at this point. I'm curious if could that change in the future? And then maybe secondarily, as you're having these initial conversations with customers, how do you think it could impact deal sizes longer term?

[Yakov Faitelson, executive]

So it's definitely, it can change. If you think what we are doing with REI, One thing is that you can use the product with just natural language means that you don't need to learn fintech, which is tremendous. The second thing, really, if you look at the method data we are collecting, we are the only company in the world that has this meta data, what we call data oriented tradition and response, and you can take a regular IT person. And we now have the assistant to be world-class detection person. But with time, maybe we will monetize it, but it's for us the best way to monetize it is to sell the platform. And this is really answering your -- the other part of your question. initial deal is great, but I really think that the way that we can grow ARR is in our customer base, I think that it's significant and what we are seeing now is just the tip of the ice bread. We're starting to have stability in the overall transition to a completely different usage, able to leverage the unique data that we have to have been the foundation for really the digital world to make sure that it can be prepared and benefit in a secure way, and then we'll decide if we are going to monetize this model. But at this point, we want to make sure that we have so much to sell to our customers, but it will be very easy for them to use it and to gain value..

[Operator]

Our next question comes from the line of Brian Essex with JPMorgan.

[Brian Essex, analyst]

Our thoughts are with you and your families in Israel as well. Just wanted to dig in a little bit towards -- maybe for Yaki, what you're seeing in the pipeline, particularly with regard to previous commentary reflecting elongated sales cycles and the impact of deals in flight as you or as those customers assess moving to SaaS instead of term. Maybe if you can help us understand the impact in the quarter and then how much visibility into the pipeline? What was growth like? And how much confidence that gives you into your ability to execute in the last quarter of the year here?

[Yakov Faitelson, executive]

We see very healthy pipeline across the board. And the other thing that we're starting to see is that organizations understand that data protection is inevitable. It's actually our first frontier in your last resort. If you don't protect data, whatever, it will never be protected. And if everything else that you are doing will fail. It's the only thing that we save you. And I also think that many organizations didn't attack its head on because it was hard to do. And with the robotic value proposition that we are building, they understand that they can do it. And if you look at really enterprise projects, we can gain immediate time to value and ongoing value in a completely automated way. So I just think that I'm spending a lot, a lot of time with customers these days, and I definitely see that people understand that they need a sophisticated data security platforms and the only way that they can do it with automation, and we are very well positioned to take this budget.

[Operator]

Our next question comes from the line of Joel Fishbein with Truist.

[Joel Fishbein, analyst]

I'm also thoughts in Paris with all of you. I wanted to just follow up on the new SEC reporting rules. And if you are seeing it your customers starting to ask questions about them and also is that as a potential driver to your pipeline and new business?

[Yakov Faitelson, executive]

It's definitely a potential driver. What we see all around is that people understand that they need to protect data. I think that in the last few years, organizations spent a fortune on security. And a lot of them get not such great return on investment. You have a lot, a lot of security around the perimeter and at the end of the day, if you will detect the most breaches or they are happening from an insider that is a user or someone stall a credential and acting like a user and really inflicting the damage on the data stores. tax can come from anywhere on any device, not only going in 1 direction. And it's the data that essentially the most valuable assets that most organizations have and the most vulnerable one. So the SEC regulation is just another one, just inevitable. You want to have cyrosecurity, you need to protect data. So this is really where we are and what we see. And definitely, every regulation is.

[Operator]

Our next question comes from the line of Roger Boyd with UBS.

[Roger Boyd, analyst]

Great. Congrats on another very strong quarter of SaaS adoption. I don't think investors should be too surprised to see Varonis outperforming on a transition time line. But just given the success you're seeing with SaaS and meaningful outperformance on mix expectations and conversions. Any update to how you're thinking about the timing of Phase 2 of the transition? And why not lean further into a more active plan to convert existing customers?

[Guy Melamed, executive]

I think that question can be broken into 2. One is the overall time line and the second part is Phase 2. When we think about kind of the overall time line, I think with a 5% SaaS increase versus last quarter. When you think about that math and kind of the way it extrapolates going forward, it definitely makes sense to reconsider our time line, and that's something that we talked about last quarter that we would revisit our guidance for that at year-end, and we plan to do that. I think overall, when you think about the transition, it's moving very fast. We're very happy to have 15% of our ARR coming from SaaS in just 3 quarters. That's -- it's happening fast because our customers and our sales force are adopting it very, very positively. So we definitely look forward to providing more color on that part in our next earnings call. In terms of Phase I -- when you think about kind of the conversion of the installed base, and that's how we define Phase 2, it hasn't begun yet. But we are increasing the number that we expect in terms of conversion in Q4 to $12 million. and that's gone up from $10 million that we guided last quarter. And when you think about the Q3 number, we actually came in at $10 million, which is a really high number as you think about it. And it's very positive but still a very small percentage of our existing customer base. So as much as we're seeing very strong adoption that's happening in a natural way, we haven't prioritized it yet, but we plan to do that next year. So I think overall, as we look at the progression of the transition, it's been really positive, and we hope to continue to move in that pace going forward.

[Operator]

Our next question comes from the line of Andrew Nowinski with Wells Fargo.

[Andrew Nowinski, analyst]

Okay. I think last quarter, your guidance was for SaaS to account for about 45% of that new and upsell business because of the expected contribution from the U.S. federal deals. So I guess, given how much higher SaaS was relative to your guidance this quarter, is it fair to assume that the Fed demand was not as strong as you expected? And if so, what happened to those deals?

[Guy Melamed, executive]

So the growth driver this quarter was overall the enterprise business. And when you look at the 59%, it was driven by the Enterprise business. It's a strong reflection of how customers in the enterprise business are adopting SaaS. When you look at the federal industry as a whole, we definitely see the opportunity there, but it's still small mid-single-digit percentages out of ARR -- but when we look at the opportunity, we feel very confident about our ability to grow there.

[Operator]

Our next question comes from the line of Fatima Boolani with Citi.

[Fatima Boolani, analyst]

Our par with you in the entire employee base in the complex zone. Yea question for you, a bigger picture one, actually, we've been hearing a lot about data protection, data security posture management and sort of all these new monitors that are coming up as well as more traditional backup and recovery vendors on the infrastructure side, talk a lot about the importance of data protection and data recovery. I wanted to get your perspective on how you are interfacing with buyers as buying psychology changes around data protection. I wanted to get your sense of how those conversations are changing for you, if at all? And if these sort of changes in the competitive landscape, are benefiting you in a way in providing a spotlight to what you've been saying all along with respect to the importance of data protection.

[Yakov Faitelson, executive]

I think that we just don't see the backup and business continuity in data protection, we are much more on data security. And -- but it's just -- people understand that they need to protect valuable data. Regarding posture management and all of this stuff, I think that organization understand very well that this is the first time that we are benefiting from other people doing marketing -- and in order to solve the program, you really need these 3 use cases and you need a metadata and something that is very hard to do. and everything really eventually in order to solve the problem, you need to be under 1 umbrella of the data security platform. You think it's most breaches, people are doing this lateral movementbetween data stores, and we need to enrich the data. So we definitely see that the marketplace understands and they need 1 big platform, you need to be able to classify in 1 place and then a repository to do it. scale to have the profile of our people and identities are using data and to be able to do remediation in a very reliable automated way. So we definitely see that everything that is happening in the ecosystem benefiting us, and we are very excited to have tailwind from the marketing that other vendors.

[Operator]

Our next question comes from the line of Chad Bennett with Craig-Hallum.

[Chad Bennett, analyst]

So just on -- I know it's early, but just in terms of kind of the type of customer converting from on-prem subscription to to SaaS. I think you've talked before about that 25% to 30% uplift. But -- and I think you gave a couple of examples on the call already. But is there any commonality in terms of where the on-prem subscription customer is in their license journey when they're converting. And is there -- are you seeing significant cross-sell upsell on that conversion from a license standpoint? Or is the hope obviously like a lot of conversion stories that once you get them to SaaS like-for-like product, that whole cross-sell upsell just becomes easier and kind of accelerated.

[Guy Melamed, executive]

I think that's a very good question. And when you -- well, I'll start by saying that the SaaS offering is so much better for our customers. but it's a no-brainer for them. And we're seeing that with the amount of conversions that are happening in a natural way. When conversions happen, we can get an uplift in the number of licenses that they buy because we're selling the platform. They don't have the opportunity to buy individual licenses. We can get an uplift in the fact that the number of users goes up. and we can get an uplift in their ability to consume more of the product. It really depends on the situation of the customer, where they are in terms of the renewal, whether they want to speed it up or wait for the actual renewal date to come to place. So it's very individual. But at the end of the day, once we get them to the SaaS offering, their ability to see value and the simplicity of the usage of the product gives us a tremendous opportunity to continue to sell them more and more licenses. So I would say there's no 1 straight answer on how it happens. But at the end of the day, it just works in our favor to get them to SaaS with good confidence in our pricing methodology as we see it so far.

[Operator]

Our next question comes from the line of Rob Owens with Piper Sandler.

[Robbie Owens, analyst]

I was curious if you could comment on just what the channel response has been regarding the move to SaaS and are you getting the breadth of channel participation that you would hope in new transactions?

[Yakov Faitelson, executive]

Yes. It's the channel reaction is usually just saying direct correlation to the customer reaction. So definitely, they understand it's it's much easier to sell and it requires significantly less professional services, and this is something that they will need to adapt to. We just -- it's the whole thing of this platform is tremendous automation but we're definitely getting a lot of help with the channel to take this last 1 model.

[Operator]

Our next question comes from the line of Jason Ader with William Blair.

[Jason Ader, analyst]

I wanted to ask you on first a clarification. You said a 12% headwind to revenue growth in Q3, I believe. That's 12 percentage points, correct?

[Guy Melamed, executive]

Correct.

[Jason Ader, analyst]

Okay. And then just on the kind of following up on the channel question, can you remind us how you go to market, how much is direct? How much is indirect? And then where are you seeing the most success right now? -- in terms of finding new customers?

[Guy Melamed, executive]

So we sell 100% through channel, but our outside sales force really does all the heavy lifting of doing the risk assessment, talking to the customers, explaining where the risks are. So the channel helps us in getting the meeting and they help us in closing the deal, but all the hard work in between is done by our outside sales force. When we look at the opportunity with our SaaS offering, it opens up new markets -- it opens up new territories, it opens up new industries to basically new customer opportunities that we didn't have before. And all of the reception that we have to date received on the SaaS offering has been positive, and we expect that to continue as we kind of really went through the toughest part of the transition kind of clearing through the pipeline and now introducing every new customer with a quote that is SaaS only and not really on-prem subscription as we had in the past. So I think overall, we're very well positioned to take advantage of that opportunity going forward.

[Operator]

Our next question comes from the line of Joseph Gallo with Jefferies.

[Joseph Gallo, analyst]

And appreciate the AI commentary. You guys have a large M365 footprint. Can you just give us an updated size and growth profile of that business? And then maybe just to be clear, given the rollout of CoPilot this week, does your existing solution capture that opportunity now? Or is it more just that you guys are perfectly positioned to capture that opportunity long term?

[Yakov Faitelson, executive]

Regarding the product in terms of preparing an organization for AI, it's already here. So it's just the basic Varonis value proposition, understand what data is critical, make sure that only the right people can access the right data, alert and stop any abnormal behavior, it is the basic without it, you can't use it in a secure way. And this is 100% us.

[Guy Melamed, executive]

And just to touch on the first part of the question. When we look at the Office 365 contribution, it's definitely become a significant tailwind for us going forward. But if you go back to our Investor Day in March, we actually showed in 1 of the slides there that our penetration within the overall 365 opportunity, was at the time in March, it was 1%, hasn't grown too much since then. So when you think about the opportunity going forward, there's so much for us to capitalize on and we see the reception of our customers very positive when we sell that life.

[Operator]

Our next question comes from the line of Rudy Kessinger with D.A. Davidson.

[Rudy Kessinger, analyst]

SGuy, what was SaaS as a percentage of the mix if you exclude federal in Q3? And then just how much higher is federal as a percentage of new and upsell ARR in Q3 relative to Q4 in the other quarters?

[Guy Melamed, executive]

So like I said before, the actual driver this quarter was the Enterprise business. And that's really what drove the 59%. To remind you, we're not FedRAMP certified yet. So we didn't have a SaaS sales that were sold under the federal business, but we do expect to have FedRAMP for next year's cycle, which can become a significant opportunity for us. And when you think at the overall opportunity from a new business and an upsell in that market, we fit like a glove to that type of use case. The amount of malicious actors that have happened only in the last couple of months has been tremendous, and our product sits there very, very nicely. And we feel that we can capitalize on that opportunity and grow our ARR coming from that industry going forward.

[Operator]

Our next question comes from the line of Joshua Tilton with Wolfe Research.

[Joshua Tilton, analyst]

Kind I'll just save my thoughts and prayers with your employees and just all the people of Israel I'm actually going to sneak in 2.5 questions really quickly. My first question is just -- how should we think about the implied Q4 net new ARR seasonality? And are the macro impacts baked into 4Q worse than they were a quarter ago? And on the AI front, which is my second question, why won't Microsoft offer these capabilities? And if so, do you expect this to bring you into more competition with them going forward?

[Yakov Faitelson, executive]

So in terms of Microsoft, we are the only truly company in the world today that taking 3 streams of metadata, the permissions, the content and the activity to build these robust for right-size access -- so we just -- we need to build completely different type of solutions in order to do that. So I just think that we can for a long time leverage or more and maintain tremendous competitive advantage in the.

[Guy Melamed, executive]

And when we kind of think about the guidance, our philosophy hasn't changed. So we're definitely thinking about the guidance in the same way that we've talked about it throughout the year. I think in terms of where we are in Q3, we definitely saw things stabilize compared to previous quarters, and that's a good sign for us. But our assumptions in terms of guidance have stayed the same. And we think that we are set up well for having our large Q4 in terms of seasonality, we don't see any change compared to the on-prem subscription. So SaaS should be the largest quarter. Q4 should continue to be the largest quarter of the year. as it has been in previous years. Obviously, from a revenue recognition perspective, it does change because it's ratable, but you've heard me talk millions of times about the fact that free cash flow and ARR contribution margins are the right metrics for this transition. And especially in Q4, they should be viewed as the leading indicators of the business.

[Operator]

Our next question comes from the line of Shelby Seyrafi with FBN Securities.

[Shebly Seyrafi, analyst]

So your headcount really was flattish in terms of growth in Q1 and Q2. And it looks like it grew around 50, which is a decent pace for the first time in like a year. So my question is, is this a sign that the environment is better for you. You talked about deal scrutiny, et cetera. But at least is it better and therefore, you're hiring more? And related to this, talk about your headcount growth expectations going forward.

[Yakov Faitelson, executive]

It's -- we know how to do this transition and it was very important for us when we did it just to be focused on just the right moving parts to make sure that it will work. We definitely see just more stability in the transition and despite the economic headwinds, we definitely see that there is just inevitable demand for data security. This is something that the organization need and we have a lot of pipeline in what we can do in terms of an enrollment of features and products, a massive total available market. So we need to cover it with sales force and make sure that our customers succeed and we keep building the organization. So the business is performing, and we are investing against massive opportunity.

[Guy Melamed, executive]

And if you go back to our last quarter's earnings call, you could hear in the commentary that we talked about the fact that we're hiring. So obviously, the fact that we grew the headcount was part of our planning. We want to continue to increase the head count, but we obviously want to do it in the right way, and we want to make sure that we generate increased productivity, and I think we can do that going forward. So it's a balancing act of increasing headcount at the right pace in the right positions, in the right locations, but also improving our leverage as we have done when you look at kind of the fact that the ARR contribution margin is now 11.1%, an increase of 750 basis points year-over-year, which is pretty significant.

[Operator]

Our next question comes from the line of Shrenik Kothari with Robert W. Baird.

[Shrenik Kothari, analyst]

Again, thoughts and prayers to your entire team out there. Just a follow-up to the previous Microsoft question. Yaki, you mentioned about the tailwinds and the growth runway in implementing the access controls and governing policies. And there was a previous question on the competitive advantage versus Microsoft as well. Just trying to understand, of course, as the significance of data security rises, as we just pointed out and especially in the realm of generative which -- where you're anticipating kind of more traction, particularly for data access, governance, this the right way to think that Heron is kind of focusing on a comprehensive data protection platform including data security, access control, governance versus what Microsoft is offering, just kind of more narrow kind of DLP and this urgency around data security and of course, with respect to the data protection tailwinds, like is this the competitive advantage that you guys have? And is that the right way to think about the competitive dynamic from your perspective. I have a quick follow-up there as well.

[Yakov Faitelson, executive]

Yes, it's essentially completely different. What we're just giving you automated outcomes regarding the access control classification and fall detection. We have very little pictures that overlap and a lot of very good synergy to work with the way that they can label for VLP. As you mentioned and other stuff and -- but it's different. We actually work very well with them, and we have a very good partnership regarding the generated VI, which is the foundation, the building blocks, if you want to use generative AI in the right 2-way and not to introduce a lot of risk and can end up in disaster, you need to use our solution to make sure that you already. So this is -- except of all the AI features that we can deliver using technologies in cloud engage models. We are the foundation to make sure that businesses can use it in order to extract value from the.

[Operator]

Our next question comes from the line of Hugh Cunningham with JD Cowen.

[Hugh Cunningham, analyst]

And I'll echo that everyone here on our team, our thoughts and prayers are with you and your families, your friends and your coworkers there of Varonis. I do have 2 quick ones. First 1 is the 25% to 30% uplift that we're talking about, that's just on pricing of subscription versus SaaS. That doesn't include any assumptions that you mentioned before. more licenses, users go up, anything like that?

[Guy Melamed, executive]

Apples to apples only. So yes, .

[Hugh Cunningham, analyst]

Okay. And then these conversions of existing customers, are these taking place at the end of their existing contracts? What I'm trying to figure out here is if when you quote a number, $10 million or $12 million, that number includes a sort of accelerated recognition for the initial period in that subscription. Is that right?

[Guy Melamed, executive]

No. that relates only to the deals within the quarter.

[Operator]

Our next question comes from the line of Brian Colley with Stephens.

[Brian Colley, analyst]

Can you talk about how the SaaS platform has impacted the pipeline for new logos as well as sales cycles for those new customers. I'm just curious if you're seeing an acceleration in new logo adds or sales cycles.

[Guy Melamed, executive]

So I can tell you, when we look at the new customer adds, we've definitely seen positive signs this quarter. And I think that as we look at our ability to sell SaaS to new customers, as I said in 1 of my previous answers before, it opens up opportunities that we didn't have before with the on-prem subscription. So I think overall, definitely gives us the ability to to show value. I said before, we're kind of past this challenging part of the transition, where we had to clean -- clean through the pipeline where some of the quotes were introduced to customers in the past as on-prem subscription. Now we're just starting with the SaaS as part of the quote. It's been very well received by customers because the value of the SaaS product is much greater than the on-prem subscription .

[Operator]

That's the end of our Q&A session. I'd like to hand it back to management for closing remarks.

[Guy Melamed, executive]

Thanks for your interest in Varonis. Look forward to meeting you all at our conferences this quarter.

[Operator]

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.