2023-09-11 21:18:14 ET
Summary
- VRNS is a data security software company that offers data management systems to organize and protect business data.
- The company is undergoing a transition to a SaaS model, which is expected to drive growth and improve earnings quality.
- While near-term challenges exist, such as economic uncertainties, the potential benefits of SaaS adoption are substantial, and the company has a historical precedent of robust growth.
Summary
Varonis Systems ( VRNS ) designs and develops data security software solutions. The company offers data management systems to organize, manage, and protect unstructured and semi-structured data such as documents, spreadsheets, presentations, media files, and other business data. This post is to provide my thoughts on the business and stock. I recommend a buy rating for VRNS, as I expect the SaaS transition to aid in growth acceleration, which will lead to a closing of the valuation gap vs. faster-growing peers.
Investment thesis
My thesis for VRNS focuses on the ongoing transition of the business towards its SaaS model, which I believe will enhance the earnings quality and therefore receive a premium in valuation multiple. SaaS accounted for 58% of new and upsell business for VRNS in 2Q23, marking another quarter of progress in the company's transition to SaaS. This number has doubled over the previous quarter, and it is well above the target of 35% of net-new annual recurring revenue. Since VRNS' SaaS solution has achieved 80% feature parity with its on-premise solution, I anticipate a smooth and continuing transition. Furthermore, management anticipates parity to be achieved in the coming quarters. The improved earnings quality is just one of many advantages of this shift. For instance, now that VRNS hosts for customers, SaaS provides superior remediation at a lower IT cost. Customers won't have to spend a lot of money or wait a long time to put this into action, which should make it easier for them to adopt.
Therefore, I anticipate that SaaS cross-sell will propel robust license adoption in the long run. Just to give you some perspective, VRNS has thousands of on-premise customers they could easily convert with the help of discounts (in my opinion). Remember that these clients are easy to get in touch with due to the established rapport, so the time required to convert is way less than finding new prospects. Even though VRNS's primary business strategy remains the sale of SaaS to new customers, positive results from the conversion have been visible in the most recent quarter. Upon renewal in 1Q23, the company saw a couple hundred thousand on-premises customers switch to the SaaS model. My positive view on SaaS becoming a larger part of the business is also supported by management's view that the introduction of SaaS bundles has made it more likely that they will achieve double-digit license penetration.
However, I remain cautious about the near-term performance, as management commentary regarding the macroeconomy suggests that it is still challenging. Despite progress in the SaaS migration, VRNS experienced a slowdown in ARR for another consecutive quarter. Specifically, ARR slowed to 16.6% y/y, a trend that continued throughout 2022. The good news is that it hasn't gotten worse since last quarter, and management's guidance is cautious because it takes into account worsening macro conditions, such as tighter budgets, longer sales cycles, higher unemployment, and other negative economic trends. In light of the positive tone of the initial SaaS adoption commentary and the fact that SaaS has the potential to improve attach rates, pricing, and margins by as much as 25–30%, I think VRNS has a shot at exceeding guidance, which is a positive catalyst for the share price.
So first of all, when we look at the price list, the price list of SaaS is 25%, 30% higher, and when we compare the actual sales apples to apples, the same number of licenses and the same number of users, we're actually seeing that, so the pricing is working very well for us. - 2Q23 earnings results call
Valuation
I believe the fair value for VRNS based on my model is $39. My model assumptions are that growth will accelerate over the next 2 years as the SaaS transition gains further traction and VRNS benefits from the increase in pricing. This should naturally drive a higher multiple, closing the gap between itself and peers that are growing much faster.
Peers include Zscaler, Qualys, Palo Alto Network, Fortinet, SentinelOne, etc. The median forward revenue multiple peers are trading at is 7.5x forward revenue, and the expected 1Y growth rate is mid-teens to 20+%. When compared to peers, VRNS is still growing much slower as it undergoes the SaaS transition, but growth should inflect higher once this transition ends. Remember that VRNS was growing at 25–30%+ before 2019, so there is precedent for a higher growth rate.
Risk
The risk in investing in VRNS is that the SaaS transition might take longer than expected, which may disappoint the market when growth expectations are not met. With slower growth, it would also impact the EBIT margin expansion as revenue growth is needed to drive operating leverage.
Conclusion
VRNS is on a promising trajectory with its SaaS transition, marking steady progress and enhancing its earnings quality. While near-term challenges persist due to economic uncertainties, the potential benefits of SaaS adoption are substantial, including improved attach rates, pricing, and margins. My fair value estimate for VRNS stands at $39, driven by the anticipation of accelerated growth as the SaaS shift matures, closing the valuation gap with faster-growing peers. Although risks exist, such as potential delays in the transition impacting growth expectations, VRNS has a historical precedent of robust growth, which bodes well for its future. Overall, I recommend a buy rating for VRNS, emphasizing its potential for long-term growth and improved market positioning through its successful SaaS transformation.
For further details see:
Varonis Systems: SaaS Transition Is On Track