Tech Companies Report Mixed Q2 2024 Earnings: Upwork, Fastly, BlackLine, Rapid7, and Certara

Upwork (UPWK) Q2 2024 Earnings Call Transcript

Good day, and thank you for standing by. Welcome to the Upwork second-quarter earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jacob McQuown, vice president to deputy general counsel. Please go ahead. Jacob McQuown -- Vice President to Deputy General Counsel Thank you. Welcome to Upwork's discussion of its second quarter 2024 financial results. Joining me today are Hayden Brown, Upwork's president and chief executive officer; and Erica Gessert, Upwork's chief financial officer. Following management's prepared remarks, they will be happy to take your questions. But first, I'll review the safe harbor statement. During this call, we may make statements related to our business that are forward-looking statements under federal securities laws. Forward-looking statements include all statements other than statements of historical fact. These statements are not guarantees of future performance but rather are subject to a variety of risks, uncertainties, and assumptions. Our actual results could differ materially from expectations reflected in any forward-looking statements. For a discussion of the material risks and other important factors that could affect our actual results, please refer to our SEC filings available on the SEC website and our Investor Relations website as well as the risks and other important factors discussed in today's earnings press release. Additional information will also be set forth in our quarterly report on Form 10-Q for the three months ended September 30, 2024. In addition, reference will be made to certain non-GAAP financial measures. Information regarding non-GAAP financial measures, including reconciliations to their most directly comparable GAAP financial measures, can be found in the press release that was issued this afternoon on our Investor Relations website at investors.upwork.com. Unless otherwise noted, reported figures are rounded in comparison to the second quarter of 2024 or to the second quarter of 2023. Free cash flow is a non-GAAP figure, and all other financial measures are GAAP unless added as non-GAAP. Now, I'll turn the call over to Hayden. Hayden Brown -- President and Chief Executive Officer Welcome, everyone, to Upwork's second quarter 2024 earnings call. Upwork's strong and durable business continues to deliver compelling growth characteristics on both the top and bottom lines. Our second quarter revenue reached $193.1 million, marking a 15% year-over-year increase. Our continued commitment to enhancing profitability was demonstrated by our highest-ever quarter of GAAP net income at $22.2 million, while adjusted EBITDA was $40.8 million, a 21% adjusted EBITDA margin, up from 8.5% in the second quarter of last year. We delivered this revenue growth and outperformed our profitability goals while operating in a dynamic macroeconomic environment that has become more challenging for businesses, large and small. This challenging environment showed through with softer top-of-funnel activity than expected in the second quarter. A leading indicator of the softness that we track internally is client-seeking work, which is a measure of the number of clients engaging in an action that leads to a new contract. In Q1, this number accelerated 11% quarter over quarter, while in Q2, this number decelerated 6% sequentially, with particular impact in May and June, along with a mix shift of active clients toward very small businesses. While we applaud the resiliency of smaller businesses outperforming other cohorts on our platform, small businesses' historical characteristics of lower spend per contract and fewer contracts per client lead us to have more caution about performance expectations for the remainder of the year. We believe it's prudent to assume that the changes in client activity due to macroeconomic conditions that we observed in Q2 will remain for the rest of 2024, and we have factored those changes into lowered 2024 full-year revenue guidance while reiterating our 2024 full-year adjusted EBITDA guidance. Upwork's profitable marketplace model and our continued disciplined execution provide us with a distinct competitive and financial advantage, which we are continuing to leverage. Our advanced technology platform and global two-sided marketplace enable us to serve as the singular online destination to connect highly skilled freelance talent with clients in the full range of ways they want to work. Our numbers also evidence our continued success in winning share from offline, analog, and digital hiring and staffing sources as we outperform broader market trends. Upwork benefits from the ongoing enduring secular shift toward a high-quality, cost-effective, flexible alternative to traditional full-time and contingent staffing approaches. We are in a position of continued strength, both on an absolute and relative basis, with growing profitability and free cash flow dynamics that reflect the fundamental advantages of our business model. Innovation for growth continues to be paramount for Upwork, positioning us for peak performance once the macro rebounds. We continue to invest in multiple revenue and GSV growth levers to maintain our position as an industry leader and translate that leadership position into top and bottom-line growth, supported by continued healthy take rate expansion. These levers include: First, continuing to leverage Upwork's intrinsic ability to shapeshift to wherever the market demand for skills is with the current focus on making Upwork the preeminent destination for AI talent and work; second, improving customer productivity, engagement, and work outcomes in our products by infusing AI-powered features and user experiences built on Uma, Upwork's mindful AI; third, our continued expansion into our enterprise TAM through the right products, partnerships and integrations; fourth, acquiring new clients cost-effectively in that scale by launching new distribution channels through partnerships; and fifth, continuing to drive marketplace quality, efficiency, and adoption of value-added services via our ads and monetization efforts. I'll touch on progress for each of these GSV and revenue-enhancing levers. Based on a long track record of serving clients with access to the talent, it is always most relevant for the skills they need today. Clients are coming to us for professional, skilled, and knowledgeable and transforming their AI dreams into realities. From building and deploying Gen AI chatbots to training and tuning data and prompts for LLMs, to delivering marketing or back-office projects to integrate the latest AI-enabled capabilities, businesses are realizing the need to supplement their internal capabilities and know-how by looking externally to find talent and solutions that deliver on the promise of AI-driven productivity and innovation. This is where Upwork has a tremendous structural advantage. Compared to studies that show only 15% of corporate employees have the AI-related skills and training they need, more than half of freelance professionals on Upwork are already familiar with and using AI tools to deliver high-quality outcomes. It's no surprise then that a recent report from our Upwork Research Institute found that nearly half, 48%, of C-suite executives have already brought in freelancers to get delayed AI-related projects back on track. Upwork is serving a range of businesses, including leading companies like Scale AI, with the expert talent they require for their AI initiatives, and we are evolving our offerings to meet this growing market demand. While GSV from AI-related work was up 67% year over year in Q2, what excites us most is the opportunity ahead for this business and our customers. The tangible benefits for talent on our platform who are leaning into these opportunities are compelling. As just one example, freelance professionals, working on AI-related projects, earned 47% more per hour than those working on non-AI-related projects in Q2. Our second ongoing growth lever is improving customer productivity and enhancing engagement through our own AI-powered product features. During the second quarter, we announced Uma, Upwork's mindful AI, to underpin key steps in the hiring and matching process and serve as an always-on indispensable work companion. Our vision for Uma is to transform the way work is done on Upwork by more seamlessly augmenting the power of people and AI working together. Although this product is still in its early days and has launched only in select use cases, we've seen demand growing with a 23% quarter-over-quarter increase in users interacting with Uma in Q2. Over time, we see Uma changing the game for customers, both making our platform easier to use and improving the quality of work outcomes. We also continue to innovate our offering on behalf of our enterprise clients. The large enterprise market is not a monolith but is comprised of multiple large subsegments, with clients that prioritize their needs differently. So, we have been strategically addressing that diversity of business needs. This quarter, we successfully began testing a new bifurcation of our solutions for enterprise clients in which we have ring-fenced existing functionality and pricing in one offering and winnowed down a more limited set of functionality and alternative pricing to target a subset of enterprise buyers. During testing, this approach yields higher total conversion for our sales team with 46 combined enterprise deals closed in the quarter, 27 for the new offering, and 19 for our traditional enterprise standard and compliance products. This dual-track approach is giving us good insights on how to move forward with modifications to our pricing and packaging to reaccelerate enterprise growth, and we will have further updates in the coming quarters. During the second quarter, Labelbox, Builders FirstSource, and Guidepoint were among the new Enterprise Solutions clients we added. Further advancing our existing enterprise solutions partnerships, this month, we announced a new partnership with Beeline, one of the largest and most familiar BMS providers. We've also built on our MSP partnership with KellyOCG by enabling our first joint clients, including NASDAQ, to incorporate and access the high-quality talent pool we have on Upwork. These steps indicate our agility and further lay the foundation for unlocking this large market opportunity. Historically, Upwork's primary method of acquiring and converting clients has been on our website and mobile apps, attracting them through word of mouth, SEO, and paid acquisition channels. With our broad partnership strategy, we see a new avenue for cost-effectively attracting and converting new clients at scale by embedding Upwork experts and innovative experiences for businesses in the third-party ecosystems wherein those prospective clients encounter the need for expertise in real time. Upwork is already home to huge communities of experts in everything from GoDaddy, WordPress, and website development, to Shopify, e-commerce, and other e-commerce platforms, to social media management, project management, and a massive middle and long tail of knowledge work specialties. Our strategy is to light up these communities of experts inside third-party ecosystems to places where they can enable partners and their customers to succeed. The starting point in engagement does not need to be on Upwork for significant value to be created. In the past quarter, we more than doubled our number of partner deals and May brought the highest monthly revenue derived from partnerships that we've seen to date. Today, partnerships combined contribution to our GSV is small, but it is growing. As we further accelerate this partner program over future quarters, we will reach orders of magnitude more businesses and prime position to leverage Upwork for their work needs. Finally, a critical lever for us as we continue to lean into building more value-added sources for customers that improve the overall quality and efficiency of the marketplace, while also expanding our take rate, are our ads and monetization features, including subscriptions. Q2 was a quarter of record experimentation velocity for us in this area, and we saw a notable success and updates to our pricing and packaging. In the marketplace, we added more connects and our AI-powered Upwork Chat Pro app to the Freelancer Plus subscription, while increasing our price point to one with the additional value we are delivering. These changes contribute to our highest take rate ever. 75% year-over-year revenue growth in asset monetization products and a 68% quarter-over-quarter increase in Upwork Chat Pro daily active users in Q2. Asset monetization products continue to be one of our fastest-growing revenue streams. This is another area where the progress made is significant and yet the runway ahead is even more promising. UpWork is demonstrating our position to capture long-term growth from secular tailwinds, even while navigating a choppy environment in the near term, staying the course and executing unwaveringly on our profitability goals. We are excited to drive this business to tremendous scale, building on our formidable assets and momentum, continuing to invest in growth, and creating meaningful leverage increases every year toward our 35% five-year adjusted EBITDA target. We are thrilled to be in a position to innovate work with and for our customers using our distinct differentiators of talent, technology, and know-how. With that, I will turn it over to Erica to review our financials. Erica Gessert -- Chief Financial Officer Thanks, Hayden. As Hayden outlined, we're excited about the strength of our business model, the opportunities ahead for Upwork, and our ability to generate durable, profitable growth in a tough macro. Our model is highly profitable, with gross margins over 77% in the second quarter, expanding adjusted EBITDA margins, and increasing free cash flow. We are steadfast in our goal to reach 35% adjusted EBITDA margin in the next five years while increasing our operating leverage every year along the way. Now, I'll review a few highlights from our most recent results. Revenue grew 15% year over year to $193.1 million in the second quarter and was driven in part by the flat fee pricing structure we started last year as well as sustained momentum from our ads and monetization products. Marketplace revenue was $166.8 million and grew 17% year over year. In our enterprise business, total enterprise revenue remained flat at $26.3 million in Q2. Within our Enterprise Solutions products, customer spend and behavior remained consistent with Q1 trends, and with the current high interest rate environment, which is impacting corporate spending. Managed services revenue showed strength in the quarter, growing on a year-over-year basis, reflecting increasing demand for work product delivery and the signing of six new managed services MSAs in the past few quarters. While Q1 of this year saw strengthening top-of-funnel activity on Upwork, in Q2, we saw a softening of these trends as well as a mix shift to very small businesses, which affects our average contract size. This activity is a flow-through from broader macroeconomic trends. As a result, Upwork's GSV declined 2.7% and GSV per active client declined 5% year over year. In spite of these temporal macro-related challenges, we're pleased with our ongoing ability to perform better than many traditional staffing, temp services, and job board companies due to our differentiated tech-enabled marketplace business model. Even with these pressures, active clients were up 6% year over year to $868,000, with both new acquisition and retention benefiting us on a year-over-year basis. Our marketplace take rate was at an all-time high of 18% in Q2, up 30 basis points from Q1. We are confident we have additional capacity to grow our take rate, and our approach to this is focused on pricing to value. We continue to test and experiment with a wide variety of monetization strategies on the platform, and these tests are supporting our belief that we have significant opportunities to increase our take rate in the future. As we do this, we will always balance the opportunities we see to monetize the unique platform experiences we enable with marketplace health and growth. In Q2, we saw sustained momentum from our ads and monetization products, with Freelancer Plus subscriptions growing 28% year over year, contributing to what continues to be our highest growth revenue stream. Non-GAAP gross margin continued to improve, both on a year-over-year and sequential basis to 77.6%. Non-GAAP operating expense was $112.2 million in the second quarter, representing 58% of revenue compared to $115.7 million, or 69% of revenue, in the prior year as we continue to successfully reduce operating costs. For the second quarter, non-GAAP R&D expense was $44 million, increasing 21% year over year as we continue to accelerate our pace of innovation and invest in technology. We expect R&D to be higher in absolute dollars year over year but decline as a percentage of revenue throughout 2024. Non-GAAP sales and marketing expense of $43.9 million declined 22% year over year, and we expect to maintain a similar level of spend as a percentage of revenue for the remainder of the year. Our provision for transaction losses, or PFTL, remains low at $1.8 million for Q2, approximately 1% of total revenue. Adjusted EBITDA was $40.8 million in the second quarter, representing adjusted EBITDA margin of 21.1%. Our profitable business model generated our highest quarter of GAAP net income ever and continued to generate GAAP earnings-per-share growth, which includes the impact of stock-based compensation. For the second quarter of 2024, GAAP net income was $22.2 million and fully diluted GAAP earnings per share was $0.17. Free cash flow for the second quarter was $33.5 million, the result of the high free cash flow yield inherent in our business model. We also returned $33.1 million to shareholders through share repurchases, representing nearly 100% of the free cash flow generated during the second quarter. Cash, cash equivalents, and marketable securities were approximately $497.7 million at the end of the second quarter. Turning to guidance. We are providing a more tempered revenue outlook for the remainder of the year based on the data points we have seen since May and no expectations of improvement to the current macro environment. By maintaining our adjusted EBITDA guidance for the year, we are increasing our margin outlook. This is due to the strong focus on cost discipline across our business. Our ability to produce growing margins in this environment gives us confidence in our long-term adjusted EBITDA margin goal. We believe our balanced focus on growth and profitability and growing margins with a high free cash flow yield will produce strong shareholder returns over time. For the third quarter of 2024, we expect to produce revenue in the range of $179 million to $184 million, representing 3% year-over-year growth at the midpoint. For adjusted EBITDA in the third quarter, we are guiding to a range of $36 million to $39 million, which represents an adjusted EBITDA margin of 20% at the midpoint. For the full year 2024, we anticipate revenue between $735 million to $745 million, representing 7% year-over-year growth at the midpoint. Contemplated in our revenue guidance are some near-term headwinds from anti-circumvention initiatives, which we expect will help to improve customer experience and platform quality while stimulating long-term growth of our marketplace. We expect our take rate for the rest of the year to remain stable with what we saw in Q2. As a result of our ongoing cost discipline and the strength of our model, we expect full-year adjusted EBITDA to be within a range of $140 million to $150 million, increasing our adjusted EBITDA margin outlook. As a reminder, GSV and revenue growth, and consequently adjusted EBITDA margins, are affected in the fourth quarter of this year by the fact that there are fewer Sundays in the quarter this year versus last year. Because of the timing each week when our clients are billed, the number of Sundays in any set period affects our revenue and GSV recognition in that period. Excluding the structural impact, our GSV growth rate for the year would be approximately one point higher. We expect full-year 2024 non-GAAP diluted EPS to be between $0.90 and $0.94, up from our guidance last quarter of $0.88 to $0.92. For the full year, weighted average shares outstanding will decline to a range of $139 million to $143 million, down from our previous guidance last quarter of $140 million to $144 million. Our profitable marketplace enables us to achieve durable profitable growth in the near and long term. We can increase profitability and free cash flow while continuing to invest in innovative solutions that will unlock new S-curves of growth for Upwork. Regardless of the macro environment, we will continue innovating and strengthening our position as a market leader, while producing steady and significant operating margin and free cash flow on an ongoing basis. As always, I want to close by thanking our incredible team at Upwork for their contributions this quarter and their unparalleled creativity, focus, and pace of execution. I am proud to be a part of this great team. With that, we would be happy to take your questions. Thank you. [Operator instructions] Please stand by while we compile the Q&A roster. And our first question comes from Andrew Boone of JMP Securities. Your line is open. Andrew Boone -- Analyst Thanks so much for taking my questions. Hayden, in your prepared remarks, you talked about the health of the platform in terms of balancing take-rate initiatives and monetization products. Can you just speak to that in terms of how you are viewing things like Connects and pushing more monetization on to freelancers as well as also making sure that there is plenty of liquidity for the platform as well as supporting more first-time freelancers? Hayden Brown -- President and Chief Executive Officer Thanks, Andrew. I'd say the work we've done so far has been incredibly successful and provides the blueprint for how we want to continue driving in balancing the factors that you're outlining because we are laser-focused on expanding take rate while making these initiatives accretive from a marketplace health and quality perspective. What we look at here is things like Connects and subscriptions and value-added services that we're enhancing the platform with really are ways for us to improve signal quality in the marketplace for us to also give talent and clients more control over when, where, and how they want to engage and to be featured or propose themselves with more priority for work, things like that. And so, really, these are features and functionality in a large part or are in service of our marketplace health goals. And monetization is, in some cases, just a byproduct of how these work most effectively and really can be capitalized on for customers and for us. Stepping back and looking more broadly at the ads and monetization opportunity we have, we know that given where we are today and when we compare our opportunity to other two-sided marketplace businesses, there is a lot of run room here. And we also know specifically about features and functionality, whether it's in value-added services or further enhancements to subscriptions that there's a long road map here that we can execute on. So, we feel great about the opportunity to continue to expand and build on what we've done and really continue to expand take rate in a way that is really valuable and healthy for the marketplace and for customers. Andrew Boone -- Analyst That's helpful. And then I wanted to ask about partner deals. Hayden, as you roll out more of these deals, can you talk about what's been successful and how that paints the picture for where you guys want to pursue additional deals going forward? Thanks so much. Hayden Brown -- President and Chief Executive Officer We view the partnership opportunity as very large, and there's certainly a lot of ways to look at this. OpenAI was our launch partner for this bigger program and really provided the starting point for the momentum that we've been building in that now we have. I'd say what success looks like for us is really using this partnership muscle that we've been building over the last few quarters to build this highly scalable, very cost-effective, new way for us to bring client demand to our talent. And the unlock for us is that we don't need all of these clients to come and know about our brand or register and start with an account on Upwork for them to find success and for them to find our talent. So, we're really turning our model around and bringing our talent out into the ecosystem through these partners and leveraging some of these marquee partnerships like the OpenAI one to generate what has become a very successful and fast-moving funnel here of partners who are coming to us and saying, "Hey, can we get in on some of this action?" Because these partners have ecosystems of clients and customers who themselves have needs that these partners have not always had a good way to service. So, this is what's contributed to May being the highest monthly revenue partnership month we've seen to date and the fact that in the past quarter, we doubled the number of partner deals and are still building from there. So, it is still early in the opportunity, but we do see that this could be a very exciting trajectory around client acquisition and a different model for us to go forward. Thank you. Our next question comes from Bernie McTernan of Needham and Company. Your line is open. Bernard McTernan -- Analyst Great. Thank you very much. Just a couple for me. And maybe we know the answer just based on the guide, but I just wanted to clarify. If the trends that you saw in June continued into July and August on -- at the bookings level, and then the guidance for take rate to be flat sequentially or for the remainder of the year relative to 2Q, is that just thinking about in this kind of top-line bookings environment is not right to be leaning in a monetization, or is there anything else we should be thinking of? And then sorry, one last clarification, just the 100-basis-point impact to GMV growth given the one last Sunday in the fourth quarter, is that for the full year or just the fourth quarter thinking about the year-over-year growth? Erica Gessert -- Chief Financial Officer Yeah. Sure, Bernie. So, in terms of the -- back on the line there. In terms of the trends that we saw on top-of-funnel, first and foremost, we actually saw very strong top-of-funnel demand signals in Q1, and we really saw that that starting to turn in kind of mid-May and then into June and July. We did see those trends get slightly worse in June and July. And so, this is really what we're basing our guidance on. We fully contemplated this impact in our guidance and in fact, are now contemplating no improvement to these trends going forward. So, in that way, I think we feel like we've fully derisked our guidance for the year. On your question in terms of the take rate trends, yes, I mean, I think we're just being prudent, again, kind of anticipating the trends that we're seeing and just looking at top-of-funnel trends, both on kind of the demand side as well as this mix shift and expecting that we'll see a little bit lighter usage in some of the ads products as well. And then on the Sunday effect question, yes, that's -- the one-point impact is for the full year. Thank you. Our next question comes from Maria Ripps of Canaccord. Your line is open. Maria Ripps -- Analyst Great. Thanks so much for taking my questions. First, sort of understanding that you're breathing in a tough macro environment, can you maybe just talk about your ability to sustain your EBITDA guidance? And as we look at your P&L, sort of what are some areas that you can optimize here in the near term without sort of impacting future growth as the environment improves? And then I have a quick follow-up. Erica Gessert -- Chief Financial Officer Yeah. Just in terms of maintaining the adjusted EBITDA guidance, I mean, look, this is an inherently profitable business, and we've made a tremendous amount of progress with the cost discipline muscle that we've implemented as a business. We're obviously continually making progress both on the gross margin line as well as on the opex line. And so, we feel really, really confident that we can continue to do so. We're at 77.5% gross margin now. And we do still have some continued optimization that we can do that we're working on, on rates with hosting costs, other things like that. And then just as a reminder to everyone, we're continuing to invest in growth. Our R&D expense was up 21% year over year in Q2, and we are very, very focused on investing in the growth levers that will grow GSV into the future. So, we think we know we can do both. We can continue to optimize in areas that are kind of lower ROI spend for us, optimized on the G&A line and other places, and produce that growing operating margin while investing in growth. Maria Ripps -- Analyst Got it. That's very helpful. And then secondly, could you maybe talk about any recent developments as it relates to AI tools and functionality? And I know you highlighted a few in the press release. And is there any way to sort of quantify the impact of AI on your overall business? Hayden Brown -- President and Chief Executive Officer Sure, Maria. In terms of the AI tools and functionality, I'd say we're very pleased with how the features and functionality we're launching, including things like our Uma, AI work companion, as well as Upwork Chat Pro, which is an AI-enabled feature for freelancers in particular, to leverage that throughout the work journey on Upwork, these are all getting very strong adoption and continue to be advancing even though they're still in their early stages. We've seen a 23% increase between Q1 and Q2 in users interacting with Uma. We also saw a 68% increase in freelancers using Upwork Chat Pro on a daily basis. So, these are kind of positive signals that this is an effective strategy for us that is going to continue to enhance the experience and our metrics and really is giving us confidence in the road map that we're executing. In terms of AI impact on the overall business, here's one way to think about ring-fencing the negative impact, which I think we get a lot of questions about. As the world is undergoing an AI transition, and inevitably on that journey, some of the old ways of working will get left behind. The segment of jobs in our marketplace that are less complex and hypothetically, most easily disrupted over time by AI, are jobs and Upwork with less than $300 of spend, which comprised just under 5% of our GSV today. To be clear, we are not yet seeing a broad-based AI impact overall in this small job segment. Now, if you look within the small job segment, the current impact from AI is much more limited and is most visible in a couple of categories. Writing and translation is obviously where it's most evident, and that's just as we've expected and seen over multiple quarters now. In writing and translation and elsewhere, we continue to see, at this point, a positive AI-driven mix shift away from simple, very low-effectiveness jobs, to complex, more valuable, higher-paying work. And this transition has started in the past. In the past quarter, we saw hours per contract in writing, we saw spend per contract in translation, all increasing because of the new work that's emerging for editors and translators who are actually working with and supplementing the outputs delivered by AI. So, these factors are really a testament to the AI-related opportunity that we expect to benefit from by offering the human expertise that is so valued across all of our categories in the marketplace as humans are working with AI tools in the ecosystem. And what we see is AI augmenting humans much more so than replacing them. Thank you. Our next question comes from Josh Chan of UBS. Your line is open. Josh Chan -- Analyst Hi. Good afternoon. Thanks for taking my questions. I was wondering if you could talk a little bit more about the trajectory that you saw through Q2. Was it kind of like a one-time step-down in May or June and then kind of flat from there, or was it like a slow easing? And then I guess just to clarify on your guidance, I guess, does that imply a flat-lining from current levels, or does it imply kind of continuing slowing as you talk about maintaining the current trends? Thank you. Erica Gessert -- Chief Financial Officer Yeah. So, maybe to take a step back and talk about kind of the transition from Q1 to Q2, we saw a really promising top-of-funnel demand signals in Q1, our client-seeking work metric, which is a leading indicator for us on overall demand on the platform and growth on the platform was up 11% in Q1. And that trend really started to reverse around mid-May, and then we saw a declining trend into June and July. And again, we saw a couple of factors here. We saw overall demand signals decline. And then we also saw a mix shift to -- we saw strong growth from very small businesses and lower demand from larger customers, which is really understandable given the high interest rate environment that we're operating in. Since smaller businesses tend to have lower spend characteristics overall, this mix shift impacts our GSV per active, which is what's making us more cautious about the outlook for the rest of the year. Josh Chan -- Analyst Thank you. Thanks for the color. And then in terms of your expense management, very impressive in this environment, when demand eventually returns, will you need to undergo like a period of added spend, or how are you thinking about that trajectory as demand eventually bottoms and gets better? Thank you. Erica Gessert -- Chief Financial Officer Yeah, sure. I mean, we're very, very proud of the cost discipline that we've implemented. I think we're doing a great job at it, and I'm really proud of the team here for working so hard. We are very committed to continuing to grow operating leverage as we continue down this path. And even as demand returns, I think we'll be very moderated in the way that we invest. We've built a very, very good, for example, performance marketing engine, with very kind of clear parameters in terms of yield and ROI, and we'll continue to invest that way as we go forward. So, I don't necessarily see the need to ratchet up significantly our spend as demand returns, but we'll assess it as we go. Thank you. Our next question comes from Matt Farrell of Piper Sandler. Your line is open. Matt Farrell -- Analyst Thanks for taking my question. I'd love to understand a little bit more about the bifurcation of the enterprise pricing strategy. What kind of went into that? You obviously hit on some early results, but how should we be thinking about that helping to drive an acceleration in the enterprise business over the next couple of quarters? Hayden Brown -- President and Chief Executive Officer Sure, Matt. Our view on this is the enterprise TAM is so attractive, and we're really positioned well to work aggressively to keep unlocking it. With the pilot we ran in the last quarter, you're right, we saw some promising signals, and we're still in testing and really using the learnings from those signals to inform where we go next from here. I'd say because of where we are with that work, the insights have been really strong, but we're not yet expecting the same level of performance every quarter in terms of the type of new logo conversion that we saw in the last quarter carrying forward. But we do think it's critical in this environment and every environment to remain really agile in unlocking the market opportunity. And that's really what we're focused on doing because we see opportunities both to increase conversion and expand the number of logos in the enterprise space that we have as well as unlock share of wallet. And that's where we're focused. So, I think it's too soon to say more specific than that, but that is actually where we're laser-focused, and the results, I think, are showing that from the agility. Matt Farrell -- Analyst And then kind of following up on some of the questions on the full-year guide. Based on my math, it assumes a pretty significant deceleration in GSV as you move through the rest of the year. I guess, how does the macro, both on the small and the enterprise customers, different? How is it different than previous cycles of slowing? It seems like it's much more intense this time around than it has been in the past, but would love just any more clarity on spending patterns and the assumptions that are embedded in GSV. Thanks. Erica Gessert -- Chief Financial Officer Maybe I'll start, and Hayden, feel free to add on. So, a couple of things here. Like I said, the guidance is based on essentially bringing forward the kind of lower trends that we saw exiting Q2 and even into Q3 for the rest of the year. So, that's what we're basing it on. It's kind of the June and July trends, and we really wanted to make sure that we were not anticipating any improvement to the macro from what we've been seeing in the last couple of months. And so, like I said, to that effect, we do think we've effectively derisked the back half of the year. Just in terms of how macro is impacting kind of spending on the platform, I would say, look, writ large, high interest rates impact demand on the large and medium business customer spend, inflation impacts demand on the small business and consumer side. And these both impact GSV and they have compounding effects, right, over time. And I think we've been able to weather the storm really well for the past few years as we've been going through this, and now we're starting to see some of those compounding effects, I think, really effect on the demand on the platform. But we've been able to grow revenue in this environment due to some of the investments we've made in high-growth categories and our ads and monetization strategy, and we do anticipate that some of those things will also get share with benefits in 2025 and beyond. Operator Thank you. And our next question comes from Marvin Fong of BTIG. Your line is open. Marvin Fong -- Analyst Good evening. Thanks for taking my question. So, I guess just to kind of maybe round out the whole discussion about the state of the world. Anything you could add in terms of categories or even geography areas that might be trending particularly weak or maybe even relatively stronger relative to kind of the overall marketplace? And then I have a follow-up. Hayden Brown -- President and Chief Executive Officer Marvin, what we're seeing is from a category standpoint, the tech industry broadly in the macro at large is being hit harder from a job openings perspective. So, we are seeing that that is flowing through to some extent in terms of demand for tech jobs on our own platform being a bit weaker. And that's consistent with the macro trends. We also know that that impact, however, is not totally uniform. There are some subcategories within our own tech category on our platform that are performing better. So, it's a bit uneven, but that's, I'd say, one theme. The bright spots in terms of categories definitely are the strength in AI-related work. That grew 67% year over year. And we're seeing emerging growth in subcategories even within these AI-impacted slices of the business like rating and translation, whereas even as automation is happening, new growth shoots are popping up. So, that's the category story. To the question of geos or other segments, I'd say we saw U.S., Germany, and U.K. as a bit more impacted than other countries globally in terms of client demand. And again, I think that's indicative of kind of what's going on broadly in those economies. And I did want to also follow up on the bifurcated enterprise. So, I'm just curious exactly what is it about -- or how should we sort of think about the less -- the lower feature version? I mean, what is it that makes it more palatable? Is it some of maybe the upfront cost, or is it a take rate being lower? What exactly is it that's going to draw these more on the fence kind of enterprises? And then just part B of that question, is there any risk in your mind that some of your existing enterprise customers that are on the full-feature version, that they might opt for the less full-feature version? Thanks. Hayden Brown -- President and Chief Executive Officer Yes. I understand the concern. I can tell you there's no risk of cannibalization here. What we are doing is really leveraging the art of getting the packaging, the pricing, the whole structure absolutely right to meet the different subsegments that exist within enterprise. And previously, we had more or less like one offering to target with, and now we have more tools in our toolkit. And again, we're not -- this was one first iteration at this, really aimed at optimizing landing these new customers and expanding their share of wallet, which is something that we want to be absolutely best-in-class at. So, we learned a bunch of things. I would say we're not compromising margins or take rate or kind of the effectiveness of our overall business and its profitability. But we are determined to nail how we get these packages and pricing absolutely right to unlock this market. Thank you. [Operator instructions] And our next question comes from John Byun of Jefferies. Your line is open. John Byun -- Analyst Hi. Thank you. This is John Byun on behalf of Brent Thill. On the macro and GSV growth, I mean, what sort of actions could you take, or what could help resume the growth there? I mean, will it require a low interest rate or some other either external or specific factors to you? And then on the EBITDA margin further expansion, I think in the past, you've mentioned that there was still room to optimizing R&D. Wondering how you still view that. If not, then where are there still big pockets we can optimize more between the different opex lines? Thank you. Hayden Brown -- President and Chief Executive Officer John, we don't have to wait for a better macro to return for our GSV investments to pay off. We expect the levers we're investing in now based on the early stages they're in now to have impact in 2025, even if a challenging macro persists. And certainly, they will perform better when the macro improves. So, our growth will come from enterprise initiatives, including the pricing and packaging work, which unlocks logos and wallet share as well as amplification from the VMS and MSP program. The AI and Uma-powered performance improvements we're making on our platform, from partnership efforts that drive new client acquisition at scale, from the scaling of AI talent and work-related GSV in our marketplace, which is growing at a rapid pace. These efforts are all in their early execution this year, and we never expected them to have a significant 2024 impact. In 2025, they will be beneficial. And they will also be enhanced by the asset monetization work, which will be an additional tailwind, as well as anti-circumvention efforts, which will be favorable next year on GSV and revenue. So, we feel great about our portfolio of opportunities and the ongoing strong execution we have behind every single one of them. Erica Gessert -- Chief Financial Officer And I'll just answer on the adjusted EBITDA margin expansion question. Yes, we absolutely do have more optimization to go in the R&D line. We are continuing to grow that line. And I think you can expect that we are going to continue to invest on -- in innovation on the platform. We think that that ongoing innovation and investment in technology are the ways to grow this business. And so, you will see that line continue to grow some on a year-over-year basis but not nearly to the extent that it has in the past. So, we've been growing over 20% of the year for the past few years in R&D. And we're taking a really surgical approach. We're going kind of project by project and looking through and cutting back where we're not seeing the ROI profile that we want along the time horizons that we want. And again, we also have optimizations that we can take in continuing to improve on our gross margin line. And then I think there's definitely a way to go in G&A as well. That concludes Upwork's second quarter 2024 earnings call. [Operator signoff]

Fastly (FSLY) Q2 2024 Earnings Call Transcript | The Motley Fool

Thank you for standing by. At this time, I would like to welcome everyone to today's Fastly second quarter 2024 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator instructions] I would now like to turn the call over to Vern Essi, investor relations at Fastly. Vern, please go ahead. Vern Essi -- Investor Relations Welcome, everyone, to our second quarter 2024 earnings conference call. We have Fastly's CEO, Todd Nightingale; and CFO, Ron Kisling, with us today. The webcast of this call can be accessed through our website, fastly.com, and will be archived for one year. Also, a replay will be available by dialing 800-770-2030 and referencing conference ID number 7543239 shortly after the conclusion of today's call. A copy of today's earnings press release, related financial tables, and investor supplement, all of which are furnished in our 8-K filing today, can be found in the Investor Relations portion of Fastly's website. During this call, we will make forward-looking statements, including statements related to the expected performance of our business, future financial results, product sales, strategy, long-term growth, and overall future prospects. These statements are subject to known and unknown risks, uncertainties, and assumptions that could cause actual results to differ materially from those projected or implied during the call. For further information regarding risk factors for our business, please refer to our filings with the SEC, including our most recent annual report filed on Form 10-K and quarterly reports filed on Form 10-Q filed with the SEC, and our second quarter 2024 earnings release and supplement for a discussion of the factors that could cause our results to differ. Please refer, in particular, to the section entitled Risk Factors. We encourage you to read these documents. Also, note that forward-looking statements on this call are based on information available to us as of today's date. We undertake no obligation to update any forward-looking statements, except as required by law. Also, during this call, we will discuss certain non-GAAP financial measures. Unless otherwise noted, all numbers we discuss today other than revenue will be on an adjusted non-GAAP basis. Reconciliations to the most directly comparable GAAP financial measures are provided in the earnings release and supplement on our Investor Relations website. These non-GAAP measures are not intended to be a substitute for our GAAP results. Before we begin our prepared comments, please note that during the third quarter, we will be attending the Piper Sandler Growth Frontiers Conference in Nashville on September 10. Now, I'll turn the call over to Todd. Todd Nightingale -- Chief Executive Officer Thanks, Vern. Hi, everyone, and thank you so much for joining us. Today, I will cover our results and the dynamics facing our business and then discuss our recent technology developments, go-to-market initiatives, and the path forward. I will then hand the call over to Ron to discuss our second-quarter financial results and our guidance in detail. We reported revenue of $132.4 million for the second quarter, coming in above the midpoint of our guidance. Our operating loss of $12.6 million was also favorable to the guidance midpoint, thanks to strong gross margins and good cost control across the business. While I'm pleased with these results and execution in the second quarter, unfortunately, it does not offset the challenges we currently face with a small set of our largest customers. The industry has been challenged by the largest delivery customers as traffic projections have softened, and focus has shifted to profitability. This has put increased pressure on vendors such as Fastly as our projected growth in those accounts has declined. We've taken initiatives to mitigate this impact. However, these customers constitute a material portion of Fastly's revenue, and we're seeing those effects in our projections for the rest of the year. Our top 10 customers, which is a fair proxy for these large delivery customers, has dropped from 38% of revenue in the first quarter to 34% in the second quarter. Despite this drop in our top 10 customer revenue, we still managed to grow our top-line revenue 8% year over year. This was due to a 13% year-over-year growth in the rest of our customer base as a result of the actions we initiated a year ago in transforming Fastly's business. Specifically, it underscores the changes in our go-to-market strategy as we continue to drive customer acquisition and expand customer wallet share with our platform solution, driving cross-sell and upsell. We've taken steps to bifurcate our business strategy to accommodate these large customers with more bespoke efforts that cater to their multi-vendor strategy. While we've been busy adjusting our sales and customer success teams to this dynamic, we haven't lost focus on driving customer acquisition and growth in the other two-thirds of our business to effectively outgrow this concentration risk over time. The success in this transformation will continue to drive top-line revenue growth and become the foundation of our business. This is truly a moment of transition for Fastly. We must mitigate our legacy dependence on large multi-vendor customers, primarily in the media vertical. By developing our channel and demand gen motions and by expanding our portfolio, we are reaching new verticals and building a more diverse customer base. This will drive more stability and higher growth for Fastly in the years to come. On that note, our customer acquisition efforts showed strong improvement in the second quarter with our enterprise customer count at 601 compared to 577 in the first quarter, an increase of 4% sequentially. And on a year-over-year basis, we grew our enterprise customer count by 50%. Continued innovation is key to durable success in customer acquisition and wallet share growth. The Fastly platform is a software-driven edge network that offers best-in-class delivery, network services, security, compute, and observability. We continue to focus on investing in leading technology and innovation that not only solidifies our platform but also extends its features for the future of web application development. The functionality offer allows our customers to bring their applications to life around the world. And we believe that our unified platform approach will significantly enhance our customer retention and create efficiencies for Fastly in supporting our customer success. Last quarter, we extended our security offering with the general release of our bot mitigation solution. We're excited to share that we have seen a strong response from customers, and its initial ramp has exceeded our expectations. As we shared last year, cross-sell will be a large part of our success in security. Now that we have bot mitigation in addition to WAF and DDoS prevention, we have a complete security portfolio, which will increase cross-sell and revenue growth from existing accounts. One example is a luxury retailer that was already a Fastly delivery and Next-Gen WAF customer. This retailer chose to replace an existing stand-alone bot solution with our technology, truly demonstrating the power of Fastly's platform. Edge compute is the next cornerstone of Fastly's platform, and we are seeing momentum in next-generation applications coming to that platform from existing customers. We've previously discussed how New Relic runs its observability workloads on our compute infrastructure, and there are other customer use cases as well. One great example of this is Yottaa, a SaaS platform designed to optimize enterprise online retail websites. Recently, our partnership expanded to include edge compute technology that is complementary with their core service. This gave Yottaa engineers access to the Fastly API as well as to Fastly's cash management and data capture capabilities. After moving to Fastly, Yottaa saw a noticeable improvement in performance as brands experienced higher conversions and more engaged shoppers. In June, we launched the beta version of our AI Accelerator, an AI proxy capable of delivering performance and cost savings to application builders leveraging large language models. Fastly's AI Accelerator leverages the power of edge computing to deliver unparalleled performance worldwide. And importantly, developers can onboard this technology with a single line of code, allowing rapid adoption and a simple, cost-effective developer experience. We announced the AI Accelerator at our developer event in New York and demoed it at our customer event, Xcelerate, in London. The interest and response here has been great. Beta testers have seen a dramatic speed improvement and cache results, and we plan to make this technology generally available in 2024. This is a key milestone for Fastly, our first truly AI product and the activity here has been amazing. We are incredibly excited about the AI road map ahead. Turning to go-to-market. I'm delighted to share with you that we've brought on Scott Lovett as our new chief revenue officer. Scott is an accomplished technology executive with decades of experience in cybersecurity and network services. His expertise includes all aspects of the go-to-market motion, driving multiproduct line solutions and platform strategies, and delivering reliable growth in evolving markets. He's capable of both operating a global enterprise sales team at scale and driving the transformation and evolution we'll need over the next few years on our path to $1 billion in revenue. Scott joins us from Imperva, a cybersecurity company where he was the chief revenue officer, focusing on new customer acquisition and customer growth. Prior to Imperva, he led successful go-to-market teams at Akamai and Cisco. Scott is the ideal candidate for this role, and I'm thrilled to have him on board. We continue to build upon the strong packaging foundation we launched last year. We recently launched our new self-service model with mix-and-match packages and evolved our free tier offerings. This marks the first time our recent PLG work is reaching the market, and you can expect more to come in future quarters. We also saw a material ramp in our initial observability package, which hit its stride in the second quarter. As a result, our packaging motion is accelerating. And in the second quarter, our customer packaging purchases approximately doubled the first quarter's purchases. Our channel partners continue to have strategic importance in our go-to-market efforts. In the second quarter, our deal registrations grew 33% compared to the first quarter. And our 2024 year-to-date revenue contribution from the channel has more than doubled compared to the second quarter of 2023. We anticipate more opportunities to leverage our channel and help -- and use it to help us drive top-line growth. Now, let me conclude with a discussion of our outlook and the path forward. The large customer headwinds we've seen have continued to impact our business. Unfortunately, our revenue outlook proved more dynamic as the quarter progressed than we expected. And as I discussed previously, this is a moment of transition, and we take this very seriously. We must continue to acquire new customers and grow accounts outside our large media cohort. This will diversify and strengthen our business, and this is exactly the path that we're on. Our third-quarter guidance of 3% year-over-year growth and modified 2024 guidance of 6% year-over-year growth are materially below our budgeted plans. We have to take appropriate action to align our costs with this level of revenue while also position ourselves to invest in future growth. Over the past year, we've controlled expenses effectively through efficiencies in our infrastructure, measured head count management, and trimming overhead. Now, we are intensely focused on growing our business through customer acquisition, portfolio expansion, and innovation at the edge that drives lasting differentiation for application and web development teams. In order to achieve this next level of focus and growth, we will be restructuring the company. This will include a reduction in discretionary spend and a review of our workforce staffing levels. While this is an extremely difficult decision, we believe this step is critical to secure our position in maintaining a path toward operating profit and positive free cash flow. Furthermore, this additional financial rigor enables Fastly to continue to invest in top-line growth and to maintain our differentiation and competitiveness in 2025 and beyond. And now, to discuss the financial details of the quarter and guidance, I will turn the call over to Ron. Ron Kisling -- Chief Financial Officer Thank you, Todd, and thanks, everyone, for joining us today. I'll discuss our financial results and business metrics before turning to our forward guidance. Note that unless otherwise stated, all financial results in my discussion are non-GAAP based. Revenue for the second quarter increased 8% year over year to $132.4 million, coming in slightly ahead of the midpoint of our guidance of $130 million to $134 million. Network services revenue grew 6% year over year to $104.2 million and security revenue grew 13% year over year to $25.4 million. In the second quarter, we continued to see sequential declines in revenue from some of our largest customers that partially offset growth in revenue from other areas, particularly social media, development platforms, and gaming. The sequential declines in revenue from our largest customers were driven by further impacts from the reversal in the consolidation of network services vendors last year that we discussed in Q1 and also a continuation of lower follow-on traffic than we have historically seen following typical customer rerate. As a result, network services revenue per gigabit declined more year over year than the historical trend line we typically experience. We anticipate this dynamic will continue throughout Q3 and then begin to moderate in the fourth quarter. Our top 10 customers comprised 34% of our total revenues in the second quarter of 2024 compared to 38% in Q1 2024, reflecting the impact of the revenue declines from some of our largest customers. Also, no customer accounted for more than 10% of revenue in the second quarter. As Todd discussed, customers outside of our top 10 grew revenue 13% year over year. As we continue to transform our business toward a bifurcated customer strategy, we will continue to focus our customer acquisition strategy and direct more development and go-to-market investment toward the broader market opportunity outside our top 10 customers. Our trailing 12-month net retention rate was 110%, down from 114% in the prior quarter and down from 116% in the year-ago quarter. The decline is primarily due to the revenue declines in some of our largest customers. We anticipate this will continue to be a headwind to our LTM NRR and revenue growth throughout the remainder of 2024. At the end of the second quarter, our RPO was $223 million, down 2% from $227 million in the first quarter of 2024 and down 3% from $231 million in the second quarter of 2023. This decline is primarily due to our largest customers working through their remaining obligations over their contract terms, partially offset by customers increasing their adoption of our packaging products, which are sold on a subscription or SaaS basis and add to our committed RPO. We had 601 enterprise customers at the end of Q2, a net increase of 24 compared to a decrease of one in the first quarter. This represented a 4% sequential increase in enterprise customer growth quarter over quarter. We had 3,295 customers at the end of Q2, a net increase of 5% from the prior quarter. And enterprise customers accounted for 91% of total revenue on an annualized basis in Q2, consistent with Q1. Enterprise customer average spend was $804,000, down 5% from $846,000 in the prior quarter and down 2% from $818,000 in Q2 of last year. I will now turn to the rest of our financial results for the second quarter. Our gross margin was 58.5% compared to 58.8% in the first quarter of 2024 and up 190 basis points from 56.6% in Q2 2023, as we continued to benefit from cost control efforts in bandwidth transit cost and related hosting and managed services costs, which were offset by higher maintenance and support costs. Operating expenses were $90.1 million in the second quarter, slightly better than our expectations. We saw higher commissions and event-related costs for RSA and our Xcelerate customer event impacting sales and marketing. This was offset by lower R&D expenses, driven in part by an increase in capitalized internal use software-related expenses. This was a 17% increase compared to Q2 2023 and up 2% sequentially from the first quarter. Recall, we recorded a $3.4 million sales and use tax benefit that favorably impacted our G&A expense in the second quarter of 2023. Adjusting for this benefit in 2023, operating expenses increased 12% year over year. This modest favorability in our operating expenses, combined with better-than-expected gross profit resulted in an operating loss of $12.7 million in the second quarter, coming in at the lower end of our operating loss guidance range of $16 million to $12 million. In the second quarter, we reported a net loss of $9.3 million or a $0.07 loss per basic and diluted share compared to a net loss of $4.6 million or a $0.04 loss per basic and diluted share in Q2 2023. The one-time $3.4 million sales and use tax benefit in Q2 2023 adversely impacts our year-over-year profit-related comparisons. Our adjusted EBITDA was positive in the second quarter, coming in at $0.8 million compared to $5.2 million in Q2 2023. Turning to the balance sheet. We ended the quarter with approximately $312 million in cash, cash equivalents, marketable securities, and investments, including those classified as long term. Our free cash flow for the second quarter was negative $18.5 million, a $16.4 million sequential decrease from negative $2.2 million in the first quarter. This decrease was primarily driven by a decrease in our cash from operations to negative $4.9 million compared to $11.1 million in the first quarter as first-quarter cash from operations benefited from year-end 2023 receivables that were collected in the first quarter. Our cash capital expenditures were approximately 10% of revenue in the second quarter, coming in above the high end of our guidance of 6% to 8% of revenue we shared on our Q1 call. As a reminder, our cash capital expenditures include capitalized internal-use software. For 2024, we anticipate our cash capex will increase to 9% to 10%. However, we continue to expect our medium- to long-term cash capex to fall closer to our previous 6% to 8% of revenue expectations. I will now discuss our outlook for the third quarter and full year 2024. I'd like to remind everyone again that the following statements are based on current expectations as of today and include forward-looking statements. Actual results may differ materially, and we undertake no obligation to update these forward-looking statements in the future, except as required by law. As Todd shared in his remarks, while we are seeing growth in new customer acquisition, which we believe will lead to further revenue expansion longer term. We are facing a challenging environment of revenue decline from some of our largest customers continuing throughout the course of 2024, which is adversely impacting our revenue growth. Our revenue guidance reflects these dynamics in our business and is based on the visibility that we have today. We expect somewhat flat to modest sequential growth in Q3 revenues compared to Q2 due to lower revenue at some of our largest customers. For the third quarter, we expect revenue in the range of $130 million to $134 million, representing 2% to 5% annual growth. We continue to be very disciplined in our network investment and cost of revenues, which contributed to our second-quarter gross margins being approximately 100 basis points better than we initially expected. For the third quarter, we anticipate our gross margins will decrease approximately 150 basis points relative to the second quarter, plus or minus 50 basis points. As Todd mentioned, we will be taking measures to align our cost structure to the challenging demand environment. This will enable Fastly to focus our investment on go-to-market and product innovation to capitalize on our new customer acquisition momentum while achieving our operating profit and cash flow goals. These measures include a review of discretionary spending, contract renewals, new hire requisitions, and overall staffing. As a result, we expect to generate approximately $14 million in operating expense reductions throughout the second half of 2024. These savings will be spread across R&D, sales, and marketing, and G&A. We expect that roughly one-third of the savings will impact the third quarter with the remainder impacting the fourth quarter. As a result, we anticipate recording a one-time GAAP restructuring charge in the mid-single-digit millions in the third quarter, excluding the impact of stock compensation. Our third quarter operating results will reflect the impact of the decrease in gross margin and the beneficial impact of the operating expense reductions I just mentioned. As a result, for the third quarter, we expect our non-GAAP operating loss to decrease to $12 million to $8 million and a non-GAAP net loss of $0.08 to $0.03 per share. For calendar year 2024, we expect revenue in the range of $530 million to $540 million, reflecting annual growth of 6% at the midpoint. This reflects continued weakness at some of our largest customers, offset by growth outside of our largest existing customers and newer enterprise customers. We expect to continue to see gross margin improvement in 2024 compared to 2023 as we leverage cost on incremental yet lower revenue growth. Our incremental gross margin remains north of 75% on a trailing basis and as a result, we anticipate our 2024 gross margins will improve by approximately 100 basis points, plus or minus 100 basis points relative to 2023. As a result, we expect our non-GAAP operating loss to be in the range of $33 million to $27 million, reflecting an operating margin of negative 5.6% at the midpoint, an improvement of 23% over 2023's operating loss margin of 7.2%. We expect our non-GAAP net loss per share to improve to $0.16 to $0.11, reflecting the improvement in our operating loss expectations. And we expect free cash flow to be in the range of negative $20 million to negative $10 million in 2024 compared to negative $59 million in 2023. As we look to 2025, we believe this cost realignment will enable us to focus investment in go-to-market and product development, to continue to drive new customer acquisition and revenue growth while improving shareholder returns. This brings into focus the goal of achieving operating income and free cash flow breakeven in 2025. Before we open the line for questions, we'd like to thank you for your interest and your support in Fastly. Thank you. [Operator instructions] In the interest of time, we ask that you limit your questions to one primary question and one follow-up. Thank you for understanding. And we'll pause just a moment to compile the Q&A roster. And our first question today comes from the line of Jonathan Ho with William Blair. Jonathan, please go ahead. Jonathan Ho -- Analyst Hi. Good afternoon. I just wanted to start out with a little bit more detail on what happened with regards to these large customers and maybe what caught you off guard with these sort of declines. Are they continuing, or should we expect sort of stabilization at these levels? Todd Nightingale -- Chief Executive Officer Yeah. We mentioned there is definitely softness in the traffic at those large accounts, primarily media, large media accounts. And there's certainly a push to profitability from within those teams, and we're seeing that and trying to react to their needs and the business priorities of those customers. We've really transformed our customer success motion for these large multi-vendor customers. We're focusing on delivering the kind of differentiation and the kind of service that they're looking for in a very bespoke way. So, we have consumed, obviously, some headwinds here in terms of the revenue projection for the back half, which you see in our outlook. But yes, we believe we've stabilized those accounts at this point. Jonathan Ho -- Analyst Got it. Got it. And then just in terms of the guidance, can you maybe help us understand how you sort of came up with these parameters with the revised guidance, how derisked you feel at this point? And are there any other large contract renewals that are coming up in the back half of the year? I think investors really want to understand the downside potential here or whether it's just been completely taken out. Thank you. Todd Nightingale -- Chief Executive Officer Sure. I should mention that the correction or the adjustments we made to our guidance were -- largely weren't due to renewals, but they were due to softness in the traffic projections in the back half. And obviously, it pushes to profitability from those accounts. And look, we're taking a much more high-touch, much more bespoke approach to these accounts, and that's given us more confidence in our projections now. The change is sort of the customer engagement motion and the internal analytics that we're using to make those projections are pretty significant and fundamental to how we're operating. And that's giving us a lot more insight into the dynamics in the top 10 that -- and we believe we've got a pretty good view here for the back half of the year. Ron Kisling -- Chief Financial Officer I mean, the only thing I would add is I think with our overall process, Todd mentioned we've kind of revised our engagement model. We've added regular senior engagement with these largest customers. We believe that's given us a lot better visibility into the dynamics of these customers than we had at the beginning of the year. And we have a much more reliable outlook in terms of what the dynamics are at those customers that -- where patterns really changed a lot earlier this year. Operator All right. Thank you for the question, Jonathan. Our next question comes from the line of Fatima Boolani with Citi. Fatima, please go ahead. Fatima Boolani -- Analyst Good afternoon. Thank you for taking my question. I wanted to ask you about the restructuring efforts that are going to be underway and crystallize in the back half of this year. I wanted to specifically zero in on your comment that, hey, this is going to be more of a broad-based recalibration in terms of resources. But why would sales and marketing be kind of lumped into that, specifically if the aspirations are for driving new customer acquisition? And so, why would it be more of a blanket structure? What kind of give confidence that you're not potentially hollowing out your sales capacity and your sales organization that could prove kind of detrimental potentially to some of those other growth aspirations? And then I have a follow-up, please. Todd Nightingale -- Chief Executive Officer Yeah, absolutely. And I think the question points at the real point for the restructuring. We need to adjust our spend to the top line. And we're always focused on delivering discipline on the bottom line regardless of volatility to the top line. But how we're doing this as a restructuring and very specifically, not a sort of peanut butter across the org is we're restructuring the company in order to allow ourselves to invest in the go-to-market and most importantly, the efficient -- the most efficient parts of our go-to-market to help us drive customer acquisition and wallet share growth in key accounts. And at the same time, in technology innovation that will help us drive revenue growth and sales efficiency in the long run. And specifically, that really means focus on security, on compute, and on AI. And the restructuring is really designed not just to align our spend to our top line to maintain that discipline but also to give us room to continue to invest in customer acquisition and in the -- in these key areas of innovation. Fatima Boolani -- Analyst Got it. And then just a follow-up on Ron's commentary with regards to capex. I think you talked to 9% to 10%, longer-term model 6% to 8%. But you just have come out of a pretty meaningful network rebuild, rearchitect, and up-leveling. So, I'm wondering why that envelope still remains high, particularly in the context of some of your large media delivery customers ratcheting back their traffic level. So, why would that not alleviate some of the incremental capex pressures? Thank you. That's it for me. Ron Kisling -- Chief Financial Officer Yeah. I mean, there's a lot of dynamics beyond it. I think one of the things that we have seen this year has been a positive thing is, on a global basis, more traffic. And so, as we look at traffic levels geographically, a lot of this is the capex needed to support regions where we've seen expanding traffic levels, which ultimately in the long term, play out well. Because as we see higher traffic levels in some of these low -- historically low-volume areas, we're able to drive lower cost on bandwidth and other costs and, ultimately, in the long term will drive efficiency. So, some of it is largely driven by some of the -- just the changes in the geographic traffic mix. And why we believe in the medium to long term that that 6% to 8% of revenue is still the right medium to long term as we really adjust our geographic footprint. Operator All right. Thanks for the questions, Fatima. And our next question comes from the line of Frank Louthan with Raymond James. Frank, please go ahead. Frank Louthan -- Analyst Great. Thank you. Has Scott changed sales metrics, revised any quota guidelines so far? And if not, when will that be completed? And then where do you think quota -- where is quota-bearing head count now? And where does that need to be to reach your goals? Thanks. Todd Nightingale -- Chief Executive Officer Scott's only been on for a couple of months, and it's amazing how much impact he's had already. He's got, I think, a pretty great sort of focus on both the customer acquisition side, but also driving right revenue growth specifically through cross-sell. And he's been looking very carefully at that. And look, I've been incredibly impressed with the way he has come up to speed on our business, which probably shouldn't be surprising given his background and how quickly he's been making changes already, including changes here in order to make that team more efficient and capable of growing and maturing really in the short term. Frank Louthan -- Analyst OK. And can you clarify what percentage of your sales come from the channel today? Todd Nightingale -- Chief Executive Officer We don't disclose the percent from the channel. We've had pretty good success growing that channel, and we'll continue to invest there. But it's not a number we disclose. I will say, I think a part of this future success of this transformation is going to be in optimizing those channel investments, especially around leveraging that channel to drive deal registration and customer acquisition. Operator OK. Thanks for the question, Frank. And our next question comes from the line of Sanjit Singh with Morgan Stanley. Sanjit, please go ahead. Apologies. I was on mute. Thank you for taking the question. I just have a higher-level question in terms of where Fastly is in its growth and sort of profitability curve. With overall top-line growth coming down to the low single digits, the company is still unprofitable and, understanding the restructuring actions that you're taking, still likely to be unprofitable. And with the sort of uncertain macro backdrop, I mean, is there a risk that you start to see weakness on sort of your nonmedia business? And does that sort of -- I mean, I just want to get a sense of like how you guys are thinking about pushing further on the profitability side while the top line may seem still uncertain at least for the next few quarters or maybe for a couple of years, if you go into more of a macro downturn. Todd Nightingale -- Chief Executive Officer No, I think it's an important question. Really, I mean, I think the way we see this is as a moment of transition. You can see the change in our customer concentration happening extremely rapidly here. And what we're doing is really building a foundation in those non-top 10, large media, multi-CDN accounts. And that's the foundation upon which we'll really build the business and especially build that business around a complete edge platform, including not just delivery but security, compute, observability, AI, etc. And we really see this as a period of transition. It's why we're restructuring in order to be able to drive investments into those other areas and drive investments in the go-to-market that's needed to run a true platform play. A true multiproduct-line play to make that revenue base stronger, stickier, and higher growth through cross-sell. We are adjusting that top line. We are adjusting our spend to our top line to maintain bottom-line discipline despite this volatility. We're doing it in a way to really transform the company and take this as an opportunity to drive growth in 2025 as well as profitability. Sanjit Singh -- Analyst Understood. And with the new chief revenue officer being onboarded, how do you see the sort of go-to-market strategy execution in sort of Year 1 of his tenure in terms of the magnitude of change that you expect him to bring to the organization? Todd Nightingale -- Chief Executive Officer Yeah. The restructuring is kind of accelerating that in a lot of ways. A big chunk of the restructuring and the reconfiguration that Scott had begun planning for next year, I think we're able to do now instead. It's like taking this as an opportunity to drive urgency. And pulling that forward, I think, is great. I think it's also helping us prepare to really push hard on the cross-sell motion and upsell motion throughout that long tail of enterprise accounts. Operator All right. Thanks for the question, Sanjit. [Operator instructions] And our next question comes from the line of James Fish with Piper Sandler. James, please go ahead. Quinton Gabrielli -- Analyst Hey, guys. This is Quinton on for Jim Fish. Maybe first for Ron, as we think about the guide change here, when you guided in the prior quarter, it sounded like delivery expectations for these largest customers have been dropped down essentially just to minimum commitment levels. Was this not the case? And so now the updated guide is just embedding minimum commits? Or are you seeing those top 10 customers fall below prior kind of minimum commits and so the downside is just a little bit tougher to gauge? Ron Kisling -- Chief Financial Officer Yeah. So, when you look at our largest customers, not all of them actually have a commit. And in many instances, the commit levels are low or meaningfully below where their expected traffic levels are. So, the commit really isn't, if you will, a good guide. Think of these customers really on the utility basis with variable traffic. And I think that's something we've spoken about in terms of kind of the dynamics of our forecasting process. And I think while historically, we had reliable model around this, I think the break-in patterns that we saw with these largest customers really have a significant impact because they're our largest customers. And this impact was a lot greater and more sustained than we had anticipated last quarter. I do believe with the increased engagement model that we put in place, the senior-level engagement regularly with these customers is that we now have much better visibility into their own internal dynamics around their traffic expectations and traffic allocations. And that visibility translates into a much more reliable view of how their business will play out over the remainder of the year. Quinton Gabrielli -- Analyst Got it. That's helpful. And then sticking with the top 10 customers. Obviously, it sounds like the vast majority of pressure sits on the delivery side rather than security. Are there any sort of impact from the customers taking down traffic that's impacting security that's kind of driving some of this deceleration? Or what do you need to kind of see kind of reacceleration? It sounds like packaging is going well and the incentives across kind of sales and marketing are in place, but we just haven't seen kind of stabilization across that segment. Thanks. Todd Nightingale -- Chief Executive Officer Yeah. Those top 10 accounts tend to be very delivery-heavy, very media-heavy. And so, it does tend to be concentrated on the delivery side and certainly concentrated in the media vertical. And we see the momentum building outside those top 10 accounts and very specifically outside of these large multivendor, primarily media accounts. And it's about putting fuel on that fire. It's about investing in that enterprise motion, while at the same time, building bespoke customer engagement with those top accounts, and returning them to growth and the growth we've been used to there. And it's really -- our focus is really on trying to make sure that we stay on top of both of those initiatives at the same time. Operator All right. Thanks, Quinton. And our next question comes from the line of Will Power from Baird. Will, please go ahead. William Power -- Analyst Great. Thanks. I was hoping just to drill down maybe just a little bit more on the top 10 pressure. I guess I'm just trying to understand. Is this two or three customers? Or is it really kind of broad-based across all the top 10? And anything else you could share just on industry traffic trends versus potential share loss to competitors? Todd Nightingale -- Chief Executive Officer Yeah. It really is a small number of accounts. Not all of the top 10. It's a small handful, less than a handful, I guess. But these are large accounts, and there is a lot of revenue in those accounts, and we take it very, very seriously. It's why we've changed our motion in the way we engage not just in those handful, but across that top tier of media, multi-CDN accounts. There really is strength in that rest of that business. And as we're bringing more technology to market, especially on the security side, we're starting to see some real potential for the rest of the -- for the remainder of the business. And we've also seen a lot of stabilization in the top 10 just at a lower level than we had expected. I mean, I think, you know -- go ahead. William Power -- Analyst Well, no, I was just going to ask if there was any other color on this being more of an industry slowdown in traffic versus some of your top 10 customers just looking to diversify their vendors to reduce costs. Todd Nightingale -- Chief Executive Officer Yeah. I mean, we mentioned this in the call last time. There's certainly softness in the traffic projections that we were expecting. There are people who are, again, like focused on that multi-vendor strategy and maybe adding a vendor here or there. We haven't like been removed from any of those accounts. We continue to have very strong partnerships in each of them. We just have drops in the revenue projection, which is affecting the guidance. Operator All right. Thank you, Will. And our next question comes from the line of Jeff Van Rhee with Craig-Hallum. Jeff, please go ahead. Jeff Van Rhee -- Analyst Great. Just two for me. Just to follow up on Will's question. Can you just break it down roughly proportionately, how much of the revenue reduction was share loss at media customers versus reduced spend expectations at those customers overall? Todd Nightingale -- Chief Executive Officer Yeah. It is a good question. It's just that we don't break down those numbers. We can disclose them. But there's a handful of those. There are areas where both of those motions are happening. We're seeing softness on the traffic side for sure, and we're seeing less revenue due to repricing in a handful of accounts. And both of those things are occurring. We do always expect to see some repricing, not just in our large accounts, but across the board. And with those repricings, we also expect to see increases in traffic as a natural part of our business. We just haven't seen that traffic increase as much as historically we've seen, as Ron mentioned. And because of that, we're just seeing this impact on the revenue guide. Jeff Van Rhee -- Analyst OK. And then if I were to look at the revision to the guide, implicit in there outside of media, how did your outlook change on nonmedia revenue? Todd Nightingale -- Chief Executive Officer Well, we don't disclose it exactly in media and nonmedia, but we do disclose the top 10 and outside the top 10. And the numbers outside the top 10 are -- momentum is building there. We feel pretty strong about it. And again, I really believe that is what's going to drive a more diversified revenue base for Fastly in the long run. It's going to drive a healthier and more accurate projection and broader growth really globally and across all the enterprise verticals, more predictable growth. And growth that will be tied more closely to the portfolio expansion in security and compute, etc. So, we feel pretty good about the projection outside those large top 10 accounts and outside the media accounts, especially in the back half. Operator All right. Thanks, Jeff. And our next question comes from the line of Madeline Brooks with Bank of America. Madeline, please go ahead. Madeline Brooks -- Analyst Hi. Thanks for taking my question. Just one for me. So, if I look at the implied guide for 4Q, that would suggest roughly 1% decline in revenues. If I then take that with the top 10 customer accounts, just projecting out similar growth trends, right, so 13% for not top 10 customers and to continue to climb with your top 10. My rough math would suggest that around 80% of the business by fourth quarter should be those non-top 10 customers. We also -- I just want to point to comments from last quarter's call where you did suggest that we should see healthy momentum from customers that were signed a year ago kick in, in the back half of the year. So, given those two trends, right, where we should see customers outside of top 10 being over 80% of the business, and we should see healthy contribution from customers that were added over the last couple of months, I guess, how do -- can you help me bridge the gap as to why that implied negative 1% guide is the correct guide? Because those two seem to be in contradiction of each other. Ron Kisling -- Chief Financial Officer Yeah. I mean, I think addressing kind of the question of top 10 concentration. While I think -- while we expect to see some continued decline in the concentration in our top 10 customers, we do expect that decline to be slower or decline from what we really saw in the first half, where we saw the -- like 38% to 34%. We'll see some continued decline but not at the rate we saw in the first half. That does sort of imply though as that comes down, that we continue to see strength in the growth rate for the non-top 10, very healthy. And I think to your earlier question, we really haven't seen any real change in our outlook outside of the top 10. Todd Nightingale -- Chief Executive Officer Can I clarify that? Sorry, Madeline, could I clarify what's the negative 1% number? Madeline Brooks -- Analyst If you just take the 3Q guide and then back out first quarter and second quarter and then implied -- or the -- and then your 3Q guide, you would get the implied 4Q of roughly, if I'm rounding, 1%. But I think it's negative 0.6% decline. That's what I'm getting. So, to your -- sorry, Ron, just to reiterate that then. So, the 13% growth trajectory that you saw outside of top 10, you're expecting it to continue at that pace for the remainder of the year? Ron Kisling -- Chief Financial Officer I think implicit in the math, if you see some continued deceleration, although at a slower rate in the top 10, that non-top 10 growth rate, you should see that -- some nominal improvement in gross rates outside of the top 10 in the second half. Todd Nightingale -- Chief Executive Officer And I think that's really what's going to drive the diversification of our revenue. As the customer -- as the effect of customer acquisition that you mentioned become more and more impactful, I expect our customer concentration to continue to come down. That dropped from 38% to 34% in just one quarter. Obviously, I think it's an anomaly. But I do expect, and I think it's healthy for that to slowly continue to decline as the growth of the rest of the accounts become more of a predominant driving force there. Operator All right. Thanks, Madeline. And our next question comes from the line of Rudy Kessinger with D.A. Davidson. Hey, thanks for taking my question. So, your top 10 were about $45 million in revenue in Q2. What's the floor? Are all of those customers pure utility and so they all got off 100% of traffic tomorrow? Or is there any floor? Is it $10 million, $20 million? I guess just how much potential further downside could there be? I know you guys are saying you have -- you feel you have a good handle on it, but you also said that 90 days ago. Ron Kisling -- Chief Financial Officer Yeah. I mean, fair point. I think if you look at the top 10, there is a mix. As I said earlier, not all of the customers do have a commitment. But some of the customers do have a commitment in their traffic levels sort of that point. If they hold to their commitment, there is a meaningful amount of committed revenue across those top 10 in whole. Again, not all of those customers are in streaming where, as Todd mentioned earlier, it's a small handful of these where we've seen the headwind. We've seen some positive momentum and some new customers come into the top 10 this year. So, you've got different dynamics moving there across each of the customers. So, to the point these headwinds are not across all the top 10, there are commitments in there and there are customers where the dynamics are positive. Todd Nightingale -- Chief Executive Officer Just to add one point to that. Part of this new customer engagement motion that we have implemented in the last few months is about driving additional commitments into that space. Traditionally, that part of the market has relatively small commitments and a huge utility upside. And we've been working hard at improving that balance and getting a larger commitment in exchange for more traffic and rate changes. Rudy Kessinger -- Analyst OK. And then security, it slowed to 13% year over year, which is the lowest on record. What's the expectation for growth in security implicit in your second-half guide? Do you expect any acceleration with the bot product out there? Todd Nightingale -- Chief Executive Officer Yeah. We don't disclose projections by product line. But I can tell you, we're deeply focused on security. I'm certainly not that excited with the 13% number there, and that represents some softness on that -- in that product line that is regrettable. We're going to be deeply focused on bringing that security growth rate back into the high 20s, if not higher. Operator All right. Thanks, Rudy. [Operator instructions] And our next question comes from the line of Tom Blakey with KeyBanc Capital Markets. Tom, please go ahead. Thomas Blakey -- Analyst Hey, guys, thanks for taking my question. I think what I'm trying to just understand what's kind of baked into 2025, I guess, a little bit with regard to these large media customers. I think you've given a lot of color there. Maybe just shifting to pricing. I think pricing commentary in prior quarters was OK. There was no kind of like alarm there. But I think some of Ron's comments was maybe degrading from a quarter-on-quarter perspective. If you could just give an update on pricing? And if you could, if you wanted to help us focus on the pricing dynamics of the nonmedia, what's going on just and the general health there? And I have a follow-up. Todd Nightingale -- Chief Executive Officer I think the point in Ron's statement was right on the money. We have seen pricing pressure in those large media accounts. There's definitely a trend that those accounts are deeply focused on profitability. We're seeing that in their disclosures as well, and I'm sure your teams are tracking it. Outside of those media accounts, the pricing model has been pretty successful. We're seeing good momentum in packaging, I think, because that SaaS-style model and the pricing environment is pretty healthy. And that's not just on the delivery side but across security and the surge we saw in the launch of the observability packages. The pricing has been pretty good across that space. It's helping us keep our gross margins on target, which is great despite less top-line revenue. And I feel pretty good, to be honest about pricing outside of media for sure. Thomas Blakey -- Analyst Great. Thanks, Todd. Yeah, that was a segue for the second question to Ron about the gross margin. Outperformed on the second quarter, seems to be taking a step down in the third quarter. Just walk us through maybe the dynamics there and helping us kind of like understand where we could exit in heading into '25 around 50% kind of like targets that we were talking about in prior quarters. That would be helpful. Thanks, guys. Ron Kisling -- Chief Financial Officer Certainly, yeah. I think one of the dynamics on the gross margin decline you saw sequentially, although it was a fairly small decline, is we're seeing a little bit higher pricing adjustments than we've seen in the past. Those tend to fluctuate a little bit. If you recall, we saw higher pricing declines in the first half of '23, that sort of moderated in the second half. I think we're going to see the same dynamic this year where we saw higher pricing discounts in the first half as some of these largest customers focused on profitability, and we didn't see traffic. We saw rerates that didn't bring additional traffic. We expect that to soften a little bit in the second half over the course of the year. And with this transition that Todd spoke about, as these largest customers become a smaller percentage, and we see increasing growth in the non-top 10, that's going to drive some favorability in our gross margins moving forward as some of this pricing pressure starts to mitigate in the second half. And those largest customers, where we're seeing this, are a smaller concentration. Operator All right. Thanks, Tom. And that concludes our Q&A session today. So, I will now turn the call back over to Todd Nightingale for closing remarks. Thanks. This time marks a moment of transition for Fastly, and I want to thank the team for their commitment and continued focus on our customers and on Fastly's growth. Restructuring the company is a necessary step, but this decision was not taken lightly as we care deeply for all of our employees and all of our teams. To everyone on the call today, I want to thank you for joining us and for your interest and support.

BlackLine, Inc. (BL) Q2 2024 Earnings Call Transcript

BlackLine, Inc. (NASDAQ:BL) Q2 2024 Earnings Conference Call August 6, 2024 5:00 PM ET Company Participants Matt Humphries - Vice President of Investor Relations Owen Ryan - Co-Chief Executive Officer Therese Tucker - Co-Chief Executive Officers Mark Partin - Chief Financial Officer Conference Call Participants Steve Enders - Citi Rob Oliver - Baird Chris Quintero - Morgan Stanley Matt VanVliet - BTIG Pat Walravens - Citizens JMP Alex Sklar - Raymond James Pinjalim Bora - JPMorgan Adam Hotchkiss - Goldman Sachs Brent Bracelin - Piper Sandler Koji Ikeda - Bank of America Merrill Lynch Daniel Jester - BMO Capital Markets Jake Roberge - William Blair Operator Good day, and thank you for standing by. Welcome to the Q2 2024 BlackLine Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Matt Humphries, Vice President of Investor Relations. Please go ahead. Matt Humphries Good afternoon, and thank you for joining us today. With me on the call are Owen Ryan and Therese Tucker, Co-Chief Executive Officers of BlackLine; as well as Mark Partin, Chief Financial Officer. Before we get started, I'd like to note that certain statements made during this conference call that are not historical facts including those regarding our future plans, objectives and expected performance, in particular, our guidance for Q3 and full year 2024 are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements represent our outlook only as of the date of this call. While we believe forward-looking statements made during the call are reasonable, actual results could differ materially as these statements are based on our current expectations as of today, and are subject to risks and uncertainties, including those stated in our periodic reports filed with the Securities and Exchange Commission, in particular, our Form 10-K and Form 10-Q. We do not undertake and expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law. All comparisons we make on the call today relate to the corresponding period of last year, unless otherwise noted. Finally, unless otherwise stated, our financial measures disclosed on this call will be non-GAAP. A discussion of these non-GAAP financial measures and information regarding reconciliations of our historical GAAP versus non-GAAP results is available in our earnings release, which may be found on our Investor Relations website at investors.blackline.com or in our Form 8-K filed with the SEC today. Now I will turn the call over to BlackLine's Co-Chief Executive Officer, Owen Ryan. Owen? Owen Ryan Thank you, Matt, and good afternoon, everyone. Thank you all for joining us today. BlackLine's results this quarter were driven by improved execution as progress against our operating model continues at a steady pace. Specifically, we delivered $161 million in total revenue, non-GAAP operating margin of 20% and $43 million in non-GAAP net income. Our strategic products portfolio had a solid quarter and we also saw the number of customers with $1 million or more in annual recurring revenue increased to 68. Our go-to-market teams executed well this quarter and we believe that the additional focus, rigor and discipline across the business is supporting our results. We also have several strong and proven leaders that recently joined BlackLine, and their early efforts are beginning to drive the types of outcomes we expect longer term. While there is even more work to do going forward, we believe early results are validating our efforts while further enhancing our differentiation in this large and growing market opportunity. Going deeper into execution this quarter, we saw improved close rates, larger deal sizes and solid competitive win rates. Also, our enterprise business was a highlight this quarter with notable performance in Europe and APAC. While total deal volume remains subdued and new business sales cycles remain extended, these results give us confidence that our efforts are driving improvements. We also saw solid results from our strategic product portfolio and note that our consolidation and financial analytics pillar saw some great wins and expansions. We recently began packaging our financial close and consolidation solutions together as a unified end-to-end offering for customers and prospects. While this initiative is still in its early stages, initial results are promising, and we look forward to expanding this offering more broadly in the months ahead. We also saw some improvement in pipeline creation, especially as we exited the quarter. One area supporting this improved pipeline is in our invoice to cash pillar, which has seen building interest from customers and prospects interested in electronic invoicing, presentment and [indiscernible] or EIPP. We acquired this capability last year as part of our data interconnect acquisition. And after a successful integration process have started to position our offering in the market as a complete end-to-end invoice-to-cash solution. Further, this additional capability helps support our recent inclusion in the Gartner Magic Quadrant for invoice to cash. Next, we are making progress enhancing our marketing message and brand, thanks to our refocused marketing efforts. We have become more disciplined in our customer targeting while driving more comprehensive end-to-end message. We have also become more intentional on meeting customers where they are in their life cycle, both pre and post purchase to not only land new customers but also enable quicker, more efficient expansion within existing accounts. While early, these efforts help support our strategic goal of elevating the conversation with our customers in the office of the CFO. One area where I am pleased to see progress is in our continuing effort to ensure that the value of the BlackLine promise remains steadfast than absolute. We focus on delivering a strong value proposition to our customers. emphasizing not only time to value, but also the ROI on their precious spend. This value-centric approach has become especially important in today's environment and has strengthened our position against competitors will often rely more on price as a differentiator. We believe our improving competitive win rates indicate that our focus on value is resonating well in a market increasingly attuned to value over cost. As many of you know, I regularly meet with customers and prospects to understand their needs and how BlackLine can better help transform their accounting and finance organizations. This quarter, I've seen a clear trend reinforced and that is digital finance transformation is still very much in focus. Customers still see this as a multiyear journey, and it is a core component of their long-term strategies. The key takeaway here is that while we may encounter short-term challenges related to budgets and the pace of transformation, the long-term opportunities and secular trends within the office of the CFO remains strong and highly relevant. In addition to meeting with customers, I spent considerable time with our partners, aligning our goals and exploring joint opportunities to support our customers. We find that partner-led implementations, especially in the enterprise and upper end of the middle market, enhance our value proposition and supports our strategy of improving customer outcomes. Building on this, in quarter 2, we made progress on enhancing our distribution efforts through our partner network. We've achieved better partner alignment, particularly in enterprise, resulting in a higher percentage of partner influence pipeline and an increased sharing of services and implementation work. Additionally, we are integrating our partners more deeply into all 4 of our pillars to drive further global opportunities. We have also seen notable increases in partner participation at our customer events reinforcing and validating our progress. Our partnership with SAP showed solid performance this quarter from our SolEx business, driven primarily by new customer wins. And we recently announced that SAP has included our financial reporting and analytics solution as part of the SolEx partnership. We are optimistic about this joint offering with SAP given recent success with this solution. Our renewal rate this quarter was in line with expectations, but below where we expect to be over the longer term. So how are we continuing to address this? First, we have been prioritizing and enhanced customer onboarding experience to ensure consistency and adoption. This approach directly supports our value proposition and accelerates time to value for customers. It also has the potential to accelerate expansion and renewal activity within our customer base. Next, we are quickly driving more digital self-service options for customers based on continued customer feedback. This shift aims to increase customer satisfaction while reducing our cost to serve. We have also begun building customer groups within key industries where users are sharing their experiences and success leveraging BlackLine. Finally, our recent efforts to drive process optimization with customers has led to improved levels of customer satisfaction, better customer engagement and increased usage. While we are pleased with these initiatives, we anticipate that it will take a few more quarters to fully realize these benefits and drive our renewal rate to our traditionally high level. As mentioned earlier, we saw terrific new customer wins this quarter. with notable outperformance in Europe and APAC. Specifically, we won a competitive replacement with one of the top 2 U.K.-based pharmaceutical companies as part of our SolEx partnership. The customer was looking for a partner to automate and transform their finance and accounting processes while also consolidating on a single trusted vendor from a collection of manual tools. This multi-solution deal, including financial close, automated journals, intercompany and Smart Close positions the customer to drive real transformation across their accounting and finance organization. Next, in North America, we signed a well-known fast food chain to a multi-solution deal as part of a competitive replacement. The customer was initially looking to replace their financial close solutions with a more modern and end-to-end solution. They were also considering moving away from their current vendor to their native ERP partner. However, our efforts to position and sell both financial close and consolidation together, providing an end-to-end solution exceeded their expectations and with the logical choice for their finance and accounting teams. In the mid-market, we signed a leading global law firm to a multi-solution deal as part of their digital finance transformation efforts. Their existing financial close and consolidation processes are manual, time-consuming and lack appropriate visibility and automation. Our sales team working hand-in-hand with our pillar leaders were able to speak to the value of a modern end-to-end solution for their financial close and consolidation process to support their longer-term strategic goals. We also saw some large expansions with customers this quarter, with notable cross-selling of our strategic products. We signed our largest deal ever in Canada with an existing global insurance customer that needed a partner to help them consolidate their complex financial systems landscape enhance their compliance and controls and drive automation as they continue to grow. Leveraging a partner, we were able to deliver compelling value proposition that supports their multiyear digital finance transformation journey. In APAC, we expanded with Australia Post, an existing customer in one of Australia's largest government-owned entities. They were seeking a solution to improve and automate their invoice to cash processes, working with their finance team, we demonstrated how our invoice-to-cash solution and partnership could serve to drive real automation, unlock working capital and give them additional visibility and control as they look to reshape their business. With that, I'll hand it off to Therese to discuss how we're continuing to accelerate innovation for our customers. Therese Tucker Thank you, Owen. This was a solid execution quarter at BlackLine, and I am proud to highlight several key achievements from the quarter that underscores our commitment to innovation and customer success while delivering a more complete solution for our customers. First, our R&D teams are delivering cutting-edge solutions and capabilities that are now or will be soon available to our customers. These new solutions and capabilities are designed to meet and exceed our customers' evolving needs and help them stay ahead. As you know, the complexities within the company's financial systems landscape are growing due to increased demands placed on accounting and finance teams the need for high-quality data and insights that drive decision-making. As an example, we are progressing through the early adopter phase of our studio solution with a growing matter of customers transitioning into production and increasing their usage, while still in the early stages of rollout, we are seeing encouraging levels of engagement and strong satisfaction from our customers. This positive feedback is an indicator of the solution's longer to potential and impact. Looking ahead, we are poised to expand the rollout of Studio more broadly in the latter half of this year, bringing its innovative capabilities to a wider audience and offering additional value for our customers. We also recently entered the early adopter phase with our Gen AI-powered Journal Risk Analyzer solution. Customers, especially those seeking better insights and intelligence into their journal processes continue to show interest in this unique and powerful solution. It can reduce the level of risk through an analysis and visibility, while also enhancing compliance and audit readiness through its automated capabilities. We believe AI-powered solutions like the Journal Risk Analyzer offer a low-risk way to build trust and confidence with customers who want to leverage AI responsibly in their most sensitive and critical accounting and finance processes. Our methodical approach to innovation involves not just creating new solutions, but also seamlessly integrating them into customers' existing workflows and processes. This past quarter, we rolled out several new AI-powered capabilities that we expect to enhance the customer experience, driving greater levels of productivity, automation and delivering value wherever customers are at in their digital finance transformation journeys. We are introducing and embedding these AI-powered capabilities thoughtfully, educating customers on low-risk use cases to enhance adoption and instilling confidence and trust over time. Building an AI foundation with customers and leveraging this to expand usage and adoption is core our strategy, recognizing that AI is not a one-size-fits-all approach. To go a bit further in our financial close pillar, we are starting to integrate natural language processing into our core financial close solutions, beginning with account reconciliations. This unique and powerful enhancement is just the start. Looking ahead, we envision extending and embedding these advanced capabilities broadly across our suite of financial close solutions, setting a new standard for efficiency, intelligence and risk reduction in finance and accounting operations. Additionally, within both our financial close and consolidation and financial analytics pillars, we went live with our document description summarizer in May for early adopters. We've seen customers begin to use these additional capabilities. And while early, we are pleased with the initial results. As Owen mentioned, our invoice-to-cash solution was recently included in the Gartner Magic Quadrant for the first time. which we believe should enhance our competitive positioning and support our long-term growth objectives. Core to be an additive quadrant was the addition of EIPP capabilities from our acquisition of Data Interconnect last year and, of course, our successful integration efforts. We are already seeing early opportunities with prospects and customers seeking a comprehensive end-to-end invoice-to-cash solution to solve their most challenging business problems. In addition, we have made significant strides in advancing our platform strategy, driven by the expansion of our global cloud and infrastructure capabilities. These efforts not only address today's complex mission-critical customer processes, but also anticipate future needs. By strengthening our platform's foundation, we believe that we can ensure that our services remain reliable, secure and accessible worldwide. This supports our goal of delivering unparalleled service quality regardless of customers' price or location. As part of these efforts, we recently stood up our APAC data center in partnership with our public provider to enhance localized cloud operations. We're also advancing our data strategy and data platform build-out to support the integration and management of high-volume customer data and reporting. This not only supports our customers directly, but also supports our own AI development work. Lastly, we are adding additional connectors and APIs to further support the real-time ingestion and bidirectional movement of high-volume data required by a modern platform. Looking ahead, our product road map and platform build-out are filled with exciting developments. We are poised to introduce further customer-centric innovation, supporting our market leadership and differentiation. Each step we take is guided by a clear vision and strategy reinforced by our ongoing commitment to our customers' success. To close, our company's performance this quarter is beginning to reflect the changes we have made over the past year. While there is much to do, we feel we are well positioned for long-term success and remain committed to delivering value to our customers, partners and stakeholders. And of course, we thank all black liners for making this happen. With that, I'd like to turn it over to Mark Partin, who will review our updated financial guidance. Mark? Mark Partin Thank you, Therese. Our overall performance in the second quarter improved compared to Q1. Some of these improvements were anticipated as we continue to execute on our operating model, while others are being driven by our recently strengthened leadership team. We've also seen some early signals that top of funnel demand is improving, but acknowledge that it is early, and we are still below levels that we would consider normal or healthy. Despite this, we remain focused on our financial results, especially our progress on margin expansion and free cash flow generation and that such results support our ability to meet demand where it is and invest strategically. With that in mind, let's review our financial performance in more detail. Total revenue grew to $161 million, up 11% with subscription revenue growth of 12%. Services revenue growth was flat and continues to weigh on our overall top line performance. We expect that services will remain a headwind to our full year revenue growth. Calculated billings growth was 12% with trailing 12-month billings growth of 11%. Remaining performance obligations, or RPO, was up 9% with current RPO growth of 10%. We closed the quarter with total annual recurring revenue, or ARR, of $620 million, up 10%. Net new customers increased by 24% in the quarter, bringing our total customer count to 4,435. Gross customer adds were healthy this quarter, but were offset with expected lower middle market customer churn. Our revenue renewal rate in the second quarter was 93%, in line with expectations as we continue to see instances of vendor consolidation occurring. Net retention rate, or NRR, was 104% this quarter primarily driven by a lower velocity of account growth and slightly higher customer churn. Strategic product performance was a highlight this quarter, and it represented 28% of sales, coming in towards the higher end of our target range. Performance this quarter was primarily driven by strength in financial reporting and analytics, Smart Close and transaction matching. Partners were involved in 85% of large deals this quarter. with consistency across both new and existing opportunities. SolEx performance was in line with our expectations, driven by a higher mix of new business. In Q2, SAP partnership revenue represented 25% of total revenue. Turning to margins. Our non-GAAP gross margin was 79% was non-GAAP subscription gross margin of 82%. Gross margin performance remains in line with our expectations as we focus on optimizing cloud spend and progress with our GCP migration efforts. Non-GAAP operating margin was 20% above our expectations, largely driven by productivity gains across our sales team is across our R&D teams. Non-GAAP net income attributable to BlackLine was $43 million, up 40% and represented a 27% non-GAAP net income margin due primarily to operating income outperformance. We generated $41 million in operating cash flow and $34 million in free cash flow in the quarter with a free cash flow margin of 21%. Our free cash flow generation remains a key strength for BlackLine. Turning to our balance sheet. In May, we took action to repurchase 80% of existing 2026 convertible notes from the proceeds of a new $675 million convertible note along with cash on hand. After these concurrent transactions, we ended the quarter with over $1 billion in cash, cash equivalents and marketable securities. Last week, we also retired our existing $250 million face value 2024 convertible notes using cash from the balance sheet. Following this recent transaction, we have approximately $800 million in cash, cash equivalents and marketable securities. Our updated share count guidance reflects these transactions. Now on guidance. We are raising our full year revenue and non-GAAP operating margin guidance ranges. Our execution in the second quarter, while improved, is balanced against our view that the demand environment remains muted, but stable as we move through the end of the year. Further, we still expect that services revenue growth will be a headwind to our full year total revenue growth rate. Now for the third quarter of 2024, we expect total GAAP revenue to be in the range of $162 million to $164 million, representing approximately 8% to 9% growth. We expect non-GAAP operating margin to be in the range of 19% to 20%. And we expect non-GAAP net income attributable to BlackLine to be in the range of $38 million to $40 million or $0.49 to $0.52 on a per share basis. Our share count is expected to be approximately 77 million diluted weighted average shares. And for the full year 2024, our updated guidance is as follows: we expect total GAAP revenue to be in the range of $647 million to $651 million, representing 10% growth; we expect non-GAAP operating margin to be in the range of 18% to 19%; and finally, we expect non-GAAP net income attributable to BlackLine to be in the range of $158 million to $168 million or $2.08 to $2.21 on a per share basis. Our share count is expected to be approximately 76.1 million diluted weighted average shares. With that, I'll now ask the operator to open the discussion to take your questions. Question-and-Answer Session Operator [Operator Instructions] Our first question comes from Steve Enders with Citi. Steve Enders Okay. Great. I guess I'm just going to get a better sense for the -- what you're seeing out there in the deal environment. I guess how much do you feel like is just a bit of a change in the go-to-market that you've made over the past year or so and those investments beginning to have an impact versus some improvement in the deal environment or some other competitive dynamics potentially changing here? Owen Ryan So thanks, Steve, for the question. And I think the thing that we're seeing is our deliberate focus and our execution and spending more time with our customers is beginning to have a very positive impact I can't tell you that the demand is increasing just because it's increasing. It feels to us like we're driving through our execution and performance and having those kind of real conversations with our customers that show the value that we can bring the impact that we can make is beginning to resonate with our customers. But it doesn't certainly feel like we have a tailwind. It feels like we're working very hard for every opportunity to bring it to fruition. Steve Enders Okay. No, it's great to hear. I guess, as we think a little bit about like the revenue mix this quarter, it looks like the net new users came in pretty solid here and definitely improvement from last quarter. I guess, was there kind of any change in terms of maybe module adoption or anything to call out sort of kind of what drove the solid sequential improvement in new users on the platform this quarter? Owen Ryan I think it ties to when we said we had good success in the enterprise space. What you're beginning to see is the efforts that we have, again, focused on the right kind of customers that can really take advantage of the BlackLine platform. And so that's what drove that number. Operator Our next question comes from Rob Oliver with Baird. Rob Oliver The first is just on the -- congratulations on the FRA product being included now with SolEx. Can you talk a little bit about the potential pipeline for that product? Or the timing on that, was that included in the basket for Solex as part of this quarter? Or is that new? And then I guess, maybe for Mark Partin, on the 25% contribution from SAP, should we expect that, that number could grow as some of the initiatives around SAP and their move towards S4 HANA conversions and stuff could start to pick up? Is that your expectation? Therese Tucker Rob, it's Therese, and I'll begin. We are super pleased that SAP recognizes the value that FRA is bringing to their enterprise group reporting. And the intent is it does get sold together, which, again, is a very, very powerful combination. We had -- we did not have any deals this quarter. under that partnership. However, we are putting together quite a nice little pipeline. Now I can't promise anything in Q3 because it is SAP, it's typically larger enterprise deals and time lines on those, I don't want to be predictive on that. But I am pleased with that development, and I'm pleased with what I'm seeing. Owen Ryan Yes. I think what -- just to add to that, so we got a lot of good publicity at the Sapphire [ph] conference, where we got on the main stage to shop showcase that solution did receive a lot of positive reaction. And we think that there's a real good ability for us working very closely with SAP to drive very positive outcomes for our customers. So still very early days. But we like what we're seeing so far. But as we all know, it takes a little bit longer to sometimes get things done. Operator Our next question comes from the line of Chris Quintero with Morgan Stanley. Chris Quintero Congrats on the solid execution. Really great to hear about the strong momentum in Europe and APAC. Curious where you think those areas are showing better growth? Is it the lower penetration rate there? Or is there something else going on that's driving that performance versus U.S.? Owen Ryan Well, obviously, we're a little bit smaller in Europe and APAC than we are in North America. But again, I would be remiss if I did not give our BlackLine, there's a lot of credit for executing and they really since the beginning of the year, just understood what we're trying to do, how we're going to go about doing it, and they're doing what we've asked them to do and more. And that's just terrific. And I think that's just going to continue around the globe. So very, very confident in our ability to execute right now. Chris Quintero Got it. That's helpful. And then the free cash flow margin being above 20%, again, is quite impressive. So would be great to hear how you're thinking about the growth versus margin equation? Are you thinking about it differently today, especially kind of given the fact that you're approaching the high end of your medium-term margin targets here? Mark Partin Yes. We've been super pleased with the performance of the business, both the accounting team that's generating the extra cash and just the business model from a profitability were high-margin business, which generates free cash flow. And I think we've been proving that sort of quarter after quarter and expect to keep putting the pressure on and driving free cash flow. Operator Our next question comes from Matt VanVliet with BTIG. Matt VanVliet Yes. I guess first on the AI front. Therese, you mentioned continuing to embed more functionality, sort of gaining the trust and confidence of customers but curious on how you're thinking of that longer term. How do you monetize the AI development you have? Are you anticipating sort of stand-alone modules that you use there? Or is this really just driving the value over the cost component that I had mentioned. Therese Tucker Both, Matt. So first off, I think that embedded AI is going to become table stakes. And I think if you implement it properly, then your customers get a lot more value. And that creates a stickiness that I really, really want to see with our customers and our products. Secondly, I think the ability to create new products that are very specifically gen AI-driven that can do some amazing things. Those things are very easily monetizable. Okay. So they are -- so I think both embedded increases stickiness and not really so much looking to monetize and nickel and dime our customers to that on those. I think there'll be table stakes. And absolutely, products like our new Journals Risk Analyzer are going to be super important to leverage and monetize AI in a way that our customers are delighted in. Matt VanVliet All right. Very helpful. And then I wanted to just maybe dig a little bit deeper on some of the increased partner participation, both at your events and obviously on the deal flow with 85% of your deals, including that. Curious, is this just sort of a steady improvement of the relationship with those partners? Is there something very specific that has been implemented over the last few months that you're seeing definitive upside from? Just maybe help us understand how that's progressing today and what we should expect maybe for the back half of the year. Owen Ryan Yes. Remember, I think we shared a while back that we created, if you will, a contract between our partners and ourselves and what they could expect from us and what we expected in return. As you know, we also reduce the number of partners we've worked dramatically with because we're really trying to focus and deepen those relationships on the very top of the firms that we're dealing with all around the globe across all of our portfolio and in the markets that we're trying to serve. And that is just beginning to show up day after day after day. in how we're working through new opportunities, how to try to improve optimization, how they're helping reason the team think about product enhancements. There's just a real good momentum that is building, and we expect it's going to continue to build as we move forward with these partners. I think they're excited about the fact that they're in the tent with us, and we're really trying to make them to partners in a way that maybe we see with software firms and their system integrators. Operator Our next question comes from Pat Walravens with Citizens JMP. Pat Walravens Great congratulations. So Owen, I was intrigued by the part of your script where you talked about bundling consolidation and close -- and so I was wondering if you could just sort of remind us and maybe Therese will pitch in here, the history of the consolidation capability and then tell us sort of in the go-to-market, why you're calling that out now? Owen Ryan I'll take the short version and Therese will definitely add to this. And good to hear from you, Pat. Hope we had a good vacation when you're away a little bit. Look, I think obviously, financial close is at the heart of what we've been doing. Our customers have been asking us for a while now to help them with consolidation, Therese and the team went out and built our financial reporting and analytics tool, which also had a consolidation capability. One of the things that we started to really experience was in the middle market, specifically as our customers taking the FRA tool and using it for consolidation and then encouraging us to continue to invest in it. That's where, again, the voice of our partners and our customers become so important in how we innovate and trying to meet them where they are. And so that's sort of been the evolution. And I think just in this -- last year, we have a dedicated pillar leader around our CFA team. He's working really well with our financial close team going out to talk to our customers about a more holistic journey and our customers deciding not only do they want financial close, but they want consolidation as part of that. So as we continue to evolve and build out our platform, I think you're going to see more and more of that as we draw our success. But I'm not the platform expert. I'm going to turn it over to Therese to add a lot more to that. Therese Tucker Pat, thanks for the great question. One of the reasons that this combination is so powerful is because the information that comes into BlackLine comes way upstream. So we have some very, very granular information. So when you flow that into consolidation and reporting, you get this end-to-end transparency that customers absolutely love. So you can drill into any line on your balance sheet and see precisely how that number calculated. You can look at the underlying reps or various analyses that are tied to some general ledger account in some other business units and learn precisely why things were flux in a certain way. So it's that end-to-end ability starting with some very granular data that makes us a very powerful combination. Operator Our next question comes from Alex Sklar with Raymond James. Alex Sklar Just in terms of the strategic product bookings, really nice results in terms of mix this quarter. I just wanted to get an update, what you have seen in terms of the results of having the 4 pillar heads in place. A big step up in the 1 million-plus customers, I assume that's kind of all tied in. But what changed there with strategic products versus recent quarters? And then just a follow-up. Any way to think about the mix of strategic product opportunities in your pipeline relative to that bookings mix? Could this be kind of a new normal level? Owen Ryan So I think probably the most important thing that's changed is we have dedicated pillar leaders across each of what we're trying to do, and that has had a profound impact not only in what we're trying to do in the marketplace, but also around the product, how we promote that, how we go at our pipeline. And that is just resonating its way up and across the whole organization in a very, very positive way. And what's really critical about that is the 4 pillar leaders work super well together. They understand their success and we've aligned their goals to make sure not only they successfully individually, but as a team, and that's having a really good positive impact. So then what does that mean for us as we move forward? I think it would suggest that our strategic products should continue to do well. We're starting to see some growth in the pipeline that was highlighted in the prepared remarks. And and we're excited about what the possibility is. That's why we're -- we've built out these strategic products and -- and so I don't want to commit to that's going to be the new norm. But that said, we're bullish on the fact that we're starting to really get some good traction with these products in the marketplace. Alex Sklar Okay. Great color there, Owen. Mark, maybe one follow-up for you. If we look at kind of the implied fourth quarter operating margin, it's a bit below second quarter and third quarter. Is that just timing of beyond the black this year? Or anything in terms of increasing level of investments planned for exiting the year? Mark Partin You got it. It's our large customer event that's going to take place in the fourth quarter this year, BTB. And so that actually creates some variability in quarter-to-quarter operating margin. Operator Our next question comes from Pinjalim Bora with JPMorgan. Pinjalim Bora Two questions for Mark Partin. It seems like the dollar churn has been stable, but you called out logo churn. I want to know if that's basically in the low end of the spectrum and any change in the dollar churn across mid-market and enterprise? And how should we think about the net retention through the rest of the year? Mark Partin Pinjalim, yes, on the renewal rate, interesting Q2 was a pickup in the enterprise that actually improved to 95%. So enterprise got better, which was something we were looking for. The mid-market ticked down high 80s from what it had been in the low 90s. And this was intentional choice as we've talked about in terms of sharpening our are targeting and focus in the mid-market to go after the higher range. And so burning through some of that on the low end, created a bit of noise in the renewal rate. On the retention rate, that's a function, of course, of the lower renewal rate. But also, it is a macro driven number, our ability to expand and grow within the accounts, our ability to maintain the positive attrition in the accounts can be impacted by macro. Fortunately, in Q2, we saw some real improvements in the customers that did renew. We were able to extend their lifetime. We have one of the largest average duration of contracts that we renewed in the quarter. And we strengthened our relationships and are resolved in the customers that renewed in Q2 to step around. So from that standpoint, it was a positive. Driving that retention rate higher in the future isn't just a macro. It's our ability to upsell and cross-sell strategic products in these accounts. And we're demonstrating that the pillar operating model as well as our focus in product innovation is making a difference. We just haven't seen that show up in that number yet, and that will take a little bit of time. Operator Our next question comes from Adam Hotchkiss with Goldman Sachs. Adam Hotchkiss Great. I just wanted to follow up on the consolidation and platform discussion. Now that you've cleaned up some of the near-term converts and have liquidity through 2029, I guess how are you thinking about with the most natural platform adjacencies you could potentially dig into from an M&A perspective? Just any color around capital allocation would be useful. Owen Ryan Yes. Adam, look, I think since Therese and I both came into the role, one of the things we thought about is how we continue to both deepen and broaden the platform with natural extensions of what the office I would expect and what our partners are seeing also in the marketplace. So we continue to look. We've been looking since the beginning about where best to put our capital. We're very diligent. I think 1 of things you probably could pick up in the way the operating model, operating margin is improving, is that neither Mark, myself or Therese, want to waste any money. So we'll keep looking. And if the right thing is there, then we'll pounce on it, but we're not going to do anything that doesn't make economic sense for our shareholders. Operator Our next question comes from Brent Bracelin with Piper Sandler. Brent Bracelin I wanted to go back to SAP. SAP is clearly an important partner for you. They reported here a couple of weeks ago, we're starting to see finally an acceleration in their business and enterprise spend around the ERP modernization with that end of support coming here in 2027. Walk us through what are you seeing relative to that partnership and opportunity as customers move from ECC to S/4HANA. Is that -- are those opportunities that are percolating now? Or do you kind of have to wait until the end of the migration before you try to upsell them additional back line functionality? Owen Ryan Yes. A couple of points to that. So one is the relationship with SAP continues, gets stronger. Therese and I were exchanging messages with their CEO today trying to continue to get together and make sure that we keep the momentum that we have built. Obviously, we've talked about the fact that the relationships, you can have them at the top of the organization, but most important is in the field and out of the accounts. And I think that's where we're seeing maybe the most progress in the most critical markets with those relationships are, in fact, building. I think one of the interesting things that the SIs would tell us what we're seeing with SAP and with backline is that many of our customers are looking for early wins in their SAP migration and going with BlackLine first, actually shows to the organization that they can have success in their digital transformation. And so there's been many situations now since the beginning of the year. where there's going to be an S4 implementation, but BlackLine has been on the front end of that versus on the back end of it. And so we're seeing some positive signs in that regard. I think it's still very early innings for the SAP for migration, but we're well connected to it and are optimistic that it will show bear fruit in the months and years ahead. Brent Bracelin Helpful color there. And then maybe, Mark, for you, just following up on a strategic product. category. I think that 28% mix was the highest we've seen in 2.5 years. It did come in below your plan last quarter, kind of above expectation range here towards the high end of this quarter. Do you think that's just timing of when some of those strategic deals closed, and we shouldn't read into it? Or are there early signs that suggest maybe you are seeing an inflection on the strategic product adoption front? Mark Partin Yes. I think that's a really good question. I would say Q1 an anomaly on the low side. And I would say in Q2, what we saw was a very strong average deal size. We saw very strategic deals getting done. We didn't see the same slip deals that we saw in Q1. We brought things over the line. We meant to that had strategic products. In fact, every strategic pillar performed and performed well. and perform globally in the enterprise and the mid-market. So it was, from my standpoint, from the CFO's view that kind of diversity and breadth in strategic products looks very good, and it's in the pipeline that way. And I think this operating model is contributing to being able to bring these in and just as importantly, close them out at the end of the day. So it is early. It can be variable from quarter-to-quarter. We thought this year we could operate in the 25% to 30% range. That was sort of our intended target for the strategic portfolio. And it looks like in Q2, we were on the high end of that. So super pleased with it. Operator Our next question comes from Terry Tillman with Truist. Unidentified Analyst This is [indiscernible] on for Terry. Could you just elaborate on how you're collaborating with partners to develop enhance the accounting video? I'm also just curious if there are any specific regions or markets where we expect to see higher partner engagement? Therese Tucker We have had quite a bit of input from our partners. And if you think about it, our partners are really experts around the reengineering of processes to get some great efficiencies out of operations. And so the ability to take that expertise and actually visually represented in a work stream that can then be automated is a really powerful capability that studio brings Therefore, we have been getting quite a bit of feedback from our partners on the types of capabilities, the types of APIs types of things that they would want to see visually represented inside of studio. With that, over the longer term, totally losing my voice, one second -- over the longer term, we want this to become a repository where our partners can really put their very specific intellectual property around process engineering. So I think it's going to be a really nice way to showcase all the expertise that our partners bring, and they have been very helpful in developing the capabilities that we currently have. Owen Ryan I think on the geographic split of what are we seeing, it's pretty strong around the world. I think one thing I would just observe though because we haven't really given it credit, which is the teaming with BlackLine and with our partners, yes, it's on the sales force, but it's also with BlackLine's professional services team. And what we're seeing is tighter linkage there of working together to bring the best of both to our customers and driving more success. So we're very pleased with how it's evolving around the globe. Like I said, for our largest ones, in particular, they really have stepped up their efforts to make sure they have resources in the critical geographies that BlackLine is trying to drive, where there are people that are certified to serve, if you will, on implementing BlackLine. Operator Our next question comes from Koji Ikeda with Bank of America Merrill Lynch. Koji Ikeda So I wanted to ask a follow-up on the medium-term targets and specifically about free cash flow and kind of the growth in free cash flow generation algorithm. With free cash flow, on the margin side, already above the medium-term targets. And we're getting close to being in the window for medium-term target. How do you think about maybe the potential for flexing free cash flow upside down or investing it back a little bit further to press on the gas a little bit for revenue growth? And I guess where I'm going with this is, could we come into a period where we're bringing down free cash flow margin a bit to drive that higher revenue growth? Mark Partin Yes. Thanks, Koji. It's a great question. And obviously, the management team here is spending a lot of time looking at the opportunities. It's a large market. It's a new leadership team. We are constantly reviewing places where we can invest and put money to work to drive greater growth, to bring more capabilities to our customers. At the moment, the beginning of our sort of planning process with management, I don't want to get out in front of that. And so we'll come back at some point after evaluating and making some choices. But our guidance for this year we have high confidence that we can deliver the growth and the investment and the innovation that we talked about in our discussions with you with these ranges. We've always had a very elegant business model that can drive cash can drive margins, and we've turned it on this year. But also been very careful to invest in the go-to-market where today we have more capacity and capability than we've had maybe ever. We have the highest ramped group of salespeople tenured sales leaders around the company. We have a lean, efficient operating R&D model that has not just gone around the globe to find talent and to be more efficient but is also putting real money around new product innovation. So I'm optimistic that free cash flow can be a great asset for us in the coming years. But I'm also keen to drive growth, put money or wood behind the arrow and really drive greater growth towards our model. So let me kind of end it there, and we can come back to you guys another time. Koji Ikeda Mark, that's super helpful. And just a follow-up here on kind of the demand environment, maybe a question for Therese or Owen. Just broadly within the office of the CFO, are you beginning to notice that wallets are beginning to open up a little bit more for technologies in the office of the CFO? Are you noticing any difference in sales cycles or maybe the number of acquired signatures or maybe some pent-up demand for the office of the CFO digital transformations is beginning to pick up right now? Owen Ryan Yes. So I spend a lot of my time talking to customers and prospects and now with our partners. I would say the additional sign-offs have not gone away. If anything, I would say, CFO is more often now seem to be refereeing between the CIO and the CIO as to what the decisions are going to be made I wouldn't say that there's an opening of the checkbook, but I think there's been more willingness if you can fully show demonstrate the value you're going to bring to that customer and that they're going to get an ROI in a pretty reasonable time period, then that has the opportunity to open the door. I think that's where we have gotten better as a team. is really demonstrating the value we can deliver to our customers and making sure it's going to get implemented the right way, and that's the combination of our partners and our BlackLine professionals to make sure the value of the BlackLine software delivers on the promise that we make to our customers. And so that's what we see is helping us to win, and we're going to keep driving that as we move forward. I wish the wallets were open, we're easily. But I would say we're still trying to pry open a little bit more than just people throwing out of them at this point in time. Operator Our next question comes from Daniel Jester with BMO Capital Markets. Daniel Jester Yes. Great. So in the prepared remarks, digital self-service was mentioned a few times. I guess, maybe can we expand on sort of what this means for BlackLine in particular? And how does -- you think you could influence your go-to-market from this? And then secondly, Mark, I apologize if I missed this earlier, but it does look like on the revenue guidance, the fourth quarter picks up a little bit. I think the comp is easier year-over-year, but is there anything else you'd call out about the seasonality of revenue this year? Owen Ryan On the self-service, what we're seeing is so many of the questions that our customers have sort of repeat. And so what we've been able to do is now really try to provide place or repository where they can have their questions easily responded to. And we think we're just going to continue to be able to build that kind of database. So it makes it easier for our customers and quite frankly, for our partners who are helping drive implementation. So that idea of self-service is something we've been asked more and more by our customers, and we're responding to that request. And I think we're just really even scratching the surface on that at this particular point in time. So let's stay tuned for a little bit more, and I'll turn it over to Mark. Mark Partin Yes. Thanks, Dan. Our rest of year guide does pick up for the remainder of the year. However, it balances against some conservatism. So while there might be some minor uptick in Q4, that could be related to timing, it could be related to seasonality. And but there's not a material difference from here to the end of the year and what we think in Q3 and Q4 from a revenue. So the guide, it's just for us to continue sort of moving at this pace with an appropriate pragmatism in it. Operator Our final question comes from Jake Roberge with William Blair. Jake Roberge Great to hear about the improvement in close rates and pipeline during the quarter. If you had to stack rank what's driving that performance, is that more on the go-to-market verticalization in those new product leaders? Or is it really more on the recent kind of product and partner changes? If you could just parse out what's driving that improved execution, it would be helpful. Owen Ryan Can I give you answers on A, B and C? Because I don't know that they're 1 through 10. I think it's a combination of how the whole organization is really starting to gel together. And I think we've got a lot of new leaders who really seem to know how to work well together. They meet each other more than halfway to get things done. And so we're seeing that showing up in what our -- starting with the BDRs, reaching out into the marketplace and following up. Those are our account managers, are our net new reps being supported by marketing, the go-to-market team behind the scenes are working much more cooperatively. So that's all driving what we believe is really better execution. And again, we're still early in driving it. It's fantastic to have these pillar leaders. And like I said, they're working together very well. They're out there in the market, helping our teams close deals, take customers through the journey. We're doing a better job of articulating the platform and where BlackLine is going. So it's not just a big point solution, but it's a vision of what we think we can help you do. And then, of course, it's exciting when you can talk about your road map. And our customers can see not only the breadth of what we offer today, but how we're going to deepen that and then what Theresa is doing with the team to add adjacencies, the other things that our customers and our partners are asking for. And I think that it's a combination of all of it. We're -- again, it's still early. No one should leave this call thinking that BlackLine has done and we're finished. We got a lot of work still as an organization, but we are super proud of what the team is doing, the way they're collaborating and their understanding that our success is based upon the success of our customers' postal. Operator I'm showing no further questions at this time. I would now like to turn it back to Owen Ryan for closing remarks. Owen Ryan Thank you, and thank you, everyone, for listening today and for your questions. We certainly appreciate you spending time with us. We're excited about the future and look forward to talking with all of you later today and tomorrow. So thanks, everyone. Have a good night. Operator Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Rapid7, Inc. (RPD) Q2 2024 Earnings Call Transcript

Elizabeth Chwalk - Director of Investor Relations Corey Thomas - Chairman & Chief Executive Officer Tim Adams - Chief Financial Officer Thank you for standing by. I'd like to welcome everyone to the Rapid7 Second Quarter 2024 Earnings Call. [ Operator Instructions] I would now like to turn the call over to Elizabeth Chwalk, Director of Investor Relations at Rapid7. Please go ahead. Elizabeth Chwalk Thank you, operator, and good afternoon, everyone. We appreciate you joining us today to discuss Rapid7 second quarter 2024 financial and operating results in addition to our financial outlook for the third quarter and full fiscal year 2024. With me on the call today are Corey Thomas, our CEO; and Tim Adams, our CFO. We have distributed our earnings press release over the wire, and it is now posted on our website at investors.rapid7.com, along with the updated company presentation and financial metrics file. This call is being broadcast live via webcast, and following the call, an audio replay will be available at investors.rapid7.com. During this call, we may make statements related to our business that are considered forward-looking under federal securities laws. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include statements related to the company's positioning, strategy business plans and financial guidance for the third quarter and full year 2024 and the assumptions underlying such goals and guidance. These forward-looking statements are based on our current expectations and beliefs and on information currently available to us. Actual outcomes and results may differ materially from the future results expressed or implied in these statements due to a number of risks and uncertainties, including those contained in our most recent quarterly report on Form 10-Q filed on May 8, 2024, our most recent annual report on Form 10-K on February 26, 2024, and in the subsequent reports that we filed with the SEC. The information provided on this conference call should be considered in light of such risks. Actual results and the timing of certain events may differ materially from the results or timing predicted or implied by such forward-looking statements and reported results should not be considered as an indication of future performance. Rapid7 does not assume any obligation to update the information presented on this conference call, except to the extent required by applicable law. Our commentary today will primarily be in non-GAAP terms and reconciliations between our historical GAAP and non-GAAP results can be found in today's earnings press release and on our website at investors.rapid7.com. At times, in our prepared comments or in responses to your questions, we may offer incremental metrics to provide greater insight into the dynamics of our business or our quarterly results. Please be advised that this additional detail may be onetime in nature, and we may or may not update these metrics in the future. With that, I'd like to turn the call over to our CEO, Corey Thomas. Corey? Corey Thomas Hello, and welcome to everyone joining us on our second quarter 2024 earnings call. As previously few weeks ago, Rapid7 ended the second quarter with $816 million of ARR which is in line with our expectations and represents 9% growth over the prior year. Growth was led by our direct detection response business as customers continue to prioritize their ability to efficiently monitor security data across their full environment while extending their teams with our deep security expertise. The strongest demand was for our consolidated threat complete offerings which drove over 40% of new ARR in the quarter. As we progress through the second quarter, the underlying market dynamics we've highlighted as tailwinds to our business continue to support our broad strategic plans. Security practitioners are increasingly struggling in managing visibility into their complete IT environments. Current market offerings don't tackle these challenges effectively or economically which the latter factor being particularly difficult for mainstream enterprises. As we continue to advance key investments around innovation this year, these are the core customer challenges, we remain focused on solving. Rapid7 is investing to build a strong security operational ecosystem for mainstream enterprises, supported by a leading data platform for contextualizing risk across fragmented complex environments. Over the past year, we've been strategically reorienting our company towards an integrated data platform, focusing on the highest value workloads in cloud and detection response and building out a more efficient go-to-market motion. We firmly believe that providing visibility across the customers' risk environment by integrating traditional vulnerability management with a broad set of cloud security solutions and pairing that with a world-class D&R SOC efficacy in one place gives customers a more effective solution and overall better security outcomes at the price value they are seeking. Our strategic plan is to capture this opportunity while optimizing our business for better long-term growth. In order to meet these strategic objectives, we start this year by sharing our intentional and targeted efforts around 3 key areas: detection response innovation, our partner ecosystem and mainstream cloud security adoption. We've spoken to these critical areas on the last few earnings calls. And today, I'm pleased to update you on the progress we made in each and every last one of them. Our first area of focus is innovation to deliver world-class detection response experience to our customers. Rapid7 has taken a deliberate approach in this market over the last few years, and we continue to invest in extending our capabilities with a committed focus on delivering the integrations, features and usability that resonates most with mainstream enterprise customers. This overarching approach supports the steady growth we are seeing today in the following ways. The escalated frequency of ransomware attacks is driving security teams to favor solutions that monitor their full IT environments. We continue to focus investments towards expanding the breadth of alert coverage on our platform, which improves our ability to monitor and manage more third-party security data on our platform and sets Rapid7 apart from our peers in sales and the SDR space. Rapid7 also stands out against point vendors that lack broad expertise and capabilities across security operations. Our ability to offer integrated platform to solve adjacent security concerns like full visibility into hybrid attack service delivers better security outcomes and more compelling economic value. And lastly, we are one of the few detection response platforms that gives customers a seamless extension of their own security teams by using our managed services and the extensive expertise that comes along with it. We continue to invest in the efficiency and scale of our SOC including leveraging AI and analytics to make these teams more effective. Our second area of focus this year is our partner ecosystem, which continues to increase in importance as we scale and prioritize efficient demand generation. Investing in our grower services and partner ecosystem to increase our capacity for service delivery as well as provide a strong source of efficient demand generation will help us deliver more sustainable and profitable growth. Sales pipeline generated across our strategic partners grew 15% year-over-year in the second quarter, which was an accelerate from Q1. Our team is seeing traction broadly as we continue to implement our MSSP partnerships, key channel relationships and increasingly engaged with customers in marketplaces like AWS. Our Comcast business partnership is progressing nicely and will serve as a steady driver of scale for our detection response business. Customer buying behavior continues to shift towards the hyperscaler marketplaces, and our ability to support this has doubled the volume of deals that we have closed year-to-date on AWS marketplace. Furthermore, we're gaining mind share and momentum with our top channel partners, which is helping to support stronger pipeline growth remains a growth opportunity for Rapid7. Our last area and the one that I'm most excited about today is our focus on leading mainstream cloud security adoption. To give some context to the unique challenges and opportunities in this space, it's helpful to remember that many security teams don't exactly know what their IT environments look like. While this knowledge is foundational to protecting those environments mass suite of the customer attack surface is limited by data collection, which tends to be expensive and challenging, especially as it relates to securing cloud security environments. Because there are multiple sources of data to emulate. We are lowering the barrier of visibility by allowing customers to secure their attack service by integrating diverse set of security data, including network, identity and cloud telemetry together on the Rapid7 demand platform. This leads me to the announcement you may have heard and seen yesterday, we introduced our new Command Platform at Black Hat. This fully integrated platform extends our traditional insight capabilities by allowing customers to integrate more of their critical security data in one place, whether that data comes from Rapid7 or other providers, given security operations teams greater visibility that they can trust. Our flagship exposure command offering aims to provide integrated risk visibility across the full attack surface and optimal cost effectiveness. This single unified view can help customers understand what does my complete environment look like and what are my biggest exposures is the core of our new Exposure Command offering. The hybrid attack surface clarity offered by Exposure Command across both traditional and cloud environments is now built into our vulnerability management and improved suite of robust CNAPP capabilities for an integrated threat-based approach to risk reduction. Exposure Command is voiced by our recent acquisition of Noetic, which provides an integrated high-confidence view of assets across the attackers. We believe that the Noetic technology and the top-notch team will be crucial pieces of Rapid7 broader offering, and we're thrilled to have them on board. Starting officially this week, the Rapid7 team will be executing on the following opportunities for our company and our customers related to Exposure Command. First, the opportunity to drive meaningful expansion from our existing InsightVM base to Exposure Command with frictionless upsell offers for customers looking to unlock better attack service visibility and expand into the cloud. Second, we expect this new platform offering can enhance retention not only through Exposure Command, but by offering additional attack surface management functionality as part of the existing VM offering and a minimal uplift. Third, Exposure Command acts as a second flagship land offering with disruptive market pricing to position us strongly in competitive deals and to help us expand the market to new mainstream customers. We believe there are many underserved mainstream customers that lack visibility into their broader environments, in part due to the complexity and cost structure for existing CNAPP offers. And finally, we believe accelerating cloud security adoption, via Exposure Command will further support D&R growth. As customers know well, you can't effectively monitor and respond to risk without visibility into your attack surface and having visibility into your full environment is a driver for greater urgency around [indiscernible] and responding to threats. As we look ahead, we believe that the long-term investments we are prioritizing this year is the 3 critical areas I just described, reporting the [indiscernible], looking at our partner ecosystem and accelerating mainstream cloud adoption, will ultimately deliver the best security outcomes and the strongest economic value for our customers. We remain steadfast in our commitment to enhancing value for our shareholders, and we are working to capture upside and opportunity through our focus strategic plan. We're currently in the market with our 2 flagship offerings, Exposure Command and detection response, to address the highest priority areas of steady with their security operations. We continue to innovate on our underlying product capabilities and improve our land and expand motions to meet customers' needs in the existing markets. We are confident that our recently streamlined leadership organization focused on profitability and efficient growth and a clear strategy to provide leading security operations platform to mainstream enterprise customers will support long-term growth for Rapid7. Thank you for joining us on the call today. I will now like to turn the call over to our CFO, Tim Adams, to share additional detail on our financial results and outlook. Tim? Tim Adams Thank you, Corey, and good afternoon to everyone on today's call. Thank you for taking the time to join us today. Before I turn to our results, a quick reminder that except for revenue, all financial results we will discuss today are non-GAAP financial measures, unless otherwise stated. Additionally, reconciliations between our GAAP and non-GAAP results can be found in our earnings press release. Rapid7 ended the second quarter of 2024 and with $816 million in ARR, consistent with our expectations and growing 9% over the prior year. Our Q2 ending ARR result reflects continued strength in our detection and response business, particularly for our threat complete offerings. As Corey shared, this consolidated offering drove over 40% of new ARR in the quarter and underscores the customer demand we are seeing for broad, effective well-integrated solutions at compelling price points. Trends in the rest of the business during the second quarter were in line with our expectations as we work towards the launch of our Exposure Command, our new integrated risk management offering. ARR growth in the second quarter was weighted towards our sales expansion as ARR per customer grew 7% over the prior year to $71,000. While our total customer base grew 2% year-over-year to end the quarter with nearly 11,500 customers. We continue to see growth in our higher-value platform customers that is partially offset by a decline in lower value non-platform customers. Second quarter revenue of $208 million grew 9% over the prior year and exceeded our guided range. Recurring product subscription revenue grew 10% over the prior year to $200 million which was better than expected on favorable linearity in the quarter. Professional services revenue declined sequentially as we continue to actively deemphasize certain lower-value services. Our revenue mix continues to shift towards international, which grew 19% year-over-year and now represents 23% of total revenue. I'll turn now to our operating and profitability measures for the second quarter. Profit gross margin was 76% in the quarter and total gross margin was 74%, and both of which are in line sequentially and with the prior year. Sales and marketing and R&D expenses were 33% and 15% of revenue, respectively, compared to 39% and 21% in the prior year. G&A expense was in line with the prior year at 7% of revenue. Operating income of $39 million was above our guided range and represented a roughly 19% operating margin, approximately 12% higher than the second quarter of last year. Adjusted EBITDA was $45 million in the quarter and net income per diluted share was $0.58. Moving to our balance sheet and cash flow. We ended the second quarter with cash, cash equivalents and investments of $494 million compared to $464 million at the end of the first quarter. We generated $29 million of free cash flow in the quarter, up from the $28 million we reported last quarter. This brings us to our guidance for the remainder of the year. We continue to expect full year ending ARR to be in the range of $850 million to $860 million, which represents growth of 6% to 7% over the prior year. Our second quarter was broadly in line with our expectations. And as we look out at the rest of the year, our assumptions for the second half have not meaningfully changed since we updated guidance in May. While the demand environment continues to be chunky, we expect relative stability in customer spending trends to continue. And while we expect improving pipeline momentum exiting the year, only a modest contribution from Exposure Command is assumed in the fourth quarter. And lastly, we continue to expect that our detection and response business will remain healthy. Similar to the comments we made last quarter, given the ramp of ARR in the second half of the year and the timing of our recent Exposure Command launch, I would like to share some directional commentary on our ARR expectations for the third quarter. We expect a high single-digit sequential increase in millions of net new ARR dollars similar to the increase in the second quarter. We are raising and narrowing our full year revenue range to $833 million to $837 million representing growth of 7% to 8%, up from the $830 million to $836 million. On profitability, we are maintaining the midpoint and narrowing our full year operating income range to $152 million to $156 million. Our updated operating income range is the result of better expense control in the second quarter that is offset by new incremental costs in the second half of the year related to the Noetic acquisition as well as higher advisory and legal fees. We expect full year net income per share in the range of $2.15 to $2.20 based on an estimated 74.7 million diluted weighted average shares outstanding. Our full year expectation for free cash flow is now $150 million to $160 million. While we remain strongly committed to expanding profitability and continue to see a reasonable path to our original target of $160 million. Our updated range reflects the new incremental costs in the second half of the year related to Noetic and higher advisory and legal fees. Moving to quarterly guidance. For the third quarter of 2024, we expect total revenue in the range of $209 million to $211 million, representing growth of 5% to 6% over the prior year. We expect non-GAAP operating income in the second quarter in the range of $36 million to $38 million and non-GAAP net income per share of $0.50 to $0.53 which is based on 74.9 million diluted weighted average shares outstanding. Thank you for taking the time to join us on the call today. And with that, we will open the call for questions. Operator? [Operator Instructions] Your first question comes from the line of Matt Hedberg from RBC. Matt Hedberg Corey, nice to see the stability in the results. I guess I wanted to drill down a little bit on some of the go-to-market changes that you talked about a month or so ago. Maybe just a little bit more of the rationale there? And how do you think about that potentially impacting second half performance? Corey Thomas Yes. No, it's a great question, Matt. So the primary drivers, we're gearing up for the evolution of our go-to-market motion as we really focus on both the Command and Exposure Command launches. A big part of that is upgrading our VM customers to our new Command Platform, which we think is going to be more relevant to the future, the traditional vulnerability management, and we had a higher urgency around that. We had 3 established leaders who have a strong track record, strong tenure with the company that we're ready to actually take over sort of like integrated roles across each of the regions. The second part of it is, I've been spending the last several years, really focused on our product and R&D. And I really wanted to actually sort of like spend more direct time with our sales leaders as we were actually making this -- as we were making this transition, and as we were looking to accelerate the business going forward. Matt Hedberg Got it. That makes a lot of sense. And then I guess somewhat related to the second question. In your prepared remarks, you called out sales pipeline from partners grew nicely. And I think you called out sort of MSP and AWS and maybe a couple of others. How does that -- as you think about the evolving go-to-market motion, how important are partners going to be especially with new product rollouts and just broader distribution from that sense? Corey Thomas Look, I think it's critical. If you just take a step back, remember, we have like 2 big things that we're really focusing on is, one, making sure and making the transition to make sure that our products and our services are relevant for the next 5 years, not the past 5 years. We've had a lot of focus on the product strategy around detection and response, managed detection and response and now sort of like integrated Exposure Command with our new attack service management offering. And so we've been highly focused there overall. But the second part is how do we actually set ourselves up for efficient growth as we actually go forward. And as you know, we have to make some sort of like hard but important decisions to actually look and say, like, how do we become the growth-oriented security operations company over the next 5 years, and we saw partners is critical to that. We think we're making good traction there. We're still in the middle of the transition there. But we're seeing the things point in the right way. Partners like our offering. We're increasing our investment. We're increasing our service around it. We think it's good for partners, it's good for our customers. But we think that these 2 big things that we've been actually doing, ensure our product strategy is right for the next 5 years which is really a long-term orientation and ensuring that our go-to-market strategy has the most leverage for both our customers and the company are 2 big things we're doing and partner's a key to that. Operator? Your next question comes from the line of Fatima Boolani from Citi. Unidentified Analyst This is Joel on for Fatima. So maybe just first one to follow up on the GTM conversation. So in relation to some of the GTM and sales org changes from earlier this year, could you just talk about how sales productivity and attrition levels have trended relative to your internal expectations? And then also from that perspective, what's embedded in your guidance for the year? Corey Thomas Yes. So on the -- I assume you're talking about the sales people themselves. We've seen very healthy retention of the sales force. It's in line with our expectations overall and where we're expecting the sales force maturity. I can tell you that our sales team is extraordinarily excited by the new Command launch and the new products that we actually have coming into the market. I haven't seen this much momentum in a long time. We think that that's bolstering some of the retention in an overall, I would to say challenging high-level macro environment, we're seeing lots of excitement and momentum as we enter the second half of the year from our sales team. Unidentified Analyst Got it. And then maybe just a follow-up for you, Corey. On the CRC D2 any shareable anecdotes from customers and maybe how early momentum is tracking relative to your expectations? Corey Thomas Yes. So the biggest difference between -- so we launched our new Command Platform. And you can think about the Insight Platform was a Rapid7 platform that actually offered a common set of products on a common platform. The Command Platform is in all security data platforms. It includes both Rapid7 data. But critically, customers want to actually see all of their security data about their attack surface and they don't want that to be the system integrator on that. The problem that we actually solve with the Command Platform and with the Exposure Command is we provide the lowest cost, highest efficacy view of the overall attack surface while actually integrating all the security telemetry across the ecosystem overall. And so that's the primary drive and purpose of the Command Platform overall. And with that, I would just say that we're actually seeing a lot of early interest. That's too early to tell, but I'll tell you, we saw prelaunch, the pipeline build - we saw our sales has been the highest of any launch that I've seen in Rapid7's history. We've already got the first set of deals in that was sort of like -- because it was addressing a real customer need. That said, is that we're pretty pragmatic about the expectations for this year. Our primary goal this year is to build pipe so that we're set up for sort of right reacceleration next year. But if sales cycles come in, that's great, but it's not something we're factoring into our overall plans. The next question comes from the line of Jonathan Ho from William Blair. Just wanted to get a sense for how you're thinking about this Command Platform upsell, and perhaps how you're seeing the market change, whether there's any shift in terms of customer spending behaviors that are maybe moving more towards the CTEM or attack surface management value proposition? Corey Thomas Yes. It's a great question. Look, we've been worried about this for a while. We started investing, as you know, several years ago. We've been accelerating the investment. That was a big part of the restructuring that we did last year. because what we really want to position ourselves up was to position ourselves for future customer needs and that customer needs to [indiscernible]. Right now, our customers' biggest challenge is that you asked almost any customer, they do not have a clear understanding of the overall attack surface. And vulnerability management has done a decent job, but it's still sort of providing a silo of data about parts of the attack surface space provides it with a lack of context. What we heard from lots of customers is they wanted to actually have a high confidence view of their overall attack service. They wanted to actually integrate the data from all of their security telemetry not just from one vendor. That supply many asset inventory systems. And they actually want to lower the cost of actually the ability to get an understanding to the overall attack surface, which is one of the challenges that you have on the cloud side. And so we are seeing a shift to CTEM, or I think Gartner calls the exposure management space. It's not just sort of packaging vulnerability management together and cloud together. It's the ability to make sure you have end-to-end visibility across the environment. but just important where we put lots of investment, where we actually combine our innovations with Noetic's innovation is the ability to integrate all that data in to actually have the highest confidence view of the state of the overall attack surface at any moment in time and then to be able to integrate all that different data in and be able to drive in, investigate, respond, prioritize across all the data, across all the attack surface. So far in early discussions, that's providing real value to customers in ways that traditional vulnerability management didn't, which was just another data source that customers didn't have to spend a lot of time and people to actually go figure out like how do I relate that data to other data in the environment. The next question comes from the line of Joel Fishbein from Truist Securities. Joel Fishbein Congrats on the Command Platform launch. Corey, for you, I just would love a little bit more color on -- and I know it's early days, pricing, packaging and go-to-market for the Command Platform. And what will it actually include and not include that would be really helpful. Corey Thomas Yes. So the -- while it's early days, what I would just say is that, look, similar to what we did in D&R, our goal is to actually make the ability to have 100% visibility with confidence into customers' environments, affordable and achievable. So it will be an uplift, but it's a relatively, I think, reasonable uplift for existing vulnerability management with customers. We think that if we actually do that, it will not just improve sort of like NRR expansion growth, it will also lock customers in for longer, and make them stickier because we're solving a bigger, better problem. The second thing that we've actually -- gives us by taking that approach is when the customers better understand what their attack surface is, it turns out that there's more to monitor, and we can actually monetize it with our detection and response offering. So you can expect it to be a small uplift from the incremental vulnerability management perspective, but we really are pricing this to actually have customers complete visibility into their overall attack surface. From there, we actually have several different offerings on top of that, that we can actually monetize, but it all starts on the basis of every customer has a 100% confidence in understanding of their attack surface. Your next question comes from the line of Alex Henderson from Needham. Alex Henderson Yes, before I throw a question at, I just wanted to clarify something. Did you say your pipeline was up 15% for the company as a whole? Or was that just the bar channel [indiscernible] question? Corey Thomas Yes. So that was our overall partner ecosystem, was up 15%. The commentary on the company is just that we have seen pipeline stabilize and improving, but we want to see that improvement continue as we build our momentum for next year. Alex Henderson Okay. So if I were to look at the 2 major products that you've got now, what you're calling your 2 foundational platforms, if I was a new customer, say, in the June quarter of next year, and I acquired these 2 product lines simultaneously for a reasonable sized company. What would be the relative sizing of the 2 acquired properties? Would one be larger than the other? Is the exposure of Command product larger or smaller than the detection and response platform? Corey Thomas Yes. You're just talking about raw pricing. Is that correct? Just so I'm sure I understand the question. Alex Henderson Yes. If a new customer, say, 1,000 employees which is larger? Corey Thomas Yes. So the way to think about it is that Surface Command is designed to sort of be very low cost and give you complete coverage of the environment, and so people can actually integrate the data across the environment. Exposure Command combines the integration capabilities of Surface Command with all of the raw sort of capabilities. So think about it, it will be disruptive against traditional cloud pricing but it's meant to actually really drive adoption. So it's meant to be affordable and drive overall coverage in the environment. And then there's lots of -- the way to think about it is detection and response is going to be at a premium price point. And frankly, it's going to be more customizable the customer's needs, and we really get our monetization in the detection and response space because that's critical, and we have a wide range of price points from technology only, demand services partners, demand service with us, to customer learning. But we have a wider range of price points with detection and response, and that's also a super strategic for customers. And part of why we take the disruptive approach on Surface Command and Exposure Command is because the more people understand their attack surface, the easier it is for us to monitor and secure the attack surface with the customers. Alex Henderson So should we be thinking about this as somewhat of a loss leader entry product that then allows you to upsell the detection and response platform and therefore, is a much smaller contribution to revenues but does drive the overall business proposition over time. Is that the right way to think about... Corey Thomas Yes. The way that I would think about it is it will actually be a contributor - we expect it to be a contributor to growth. But I would say it's probably a smaller contributor to growth in detection and response, but it's still a net positive contributor to growth, just to be clear. And I think that is disruptive sort of like packaging and pricing doesn't interrupt that, it does set up for higher expansion in growth in the detection and response business. That's true. But we're not pricing in where it's a negative to growth. It is accretive to growth. We expect it to be accretive to growth, but we expect detection and response to be a larger growth driver. That's true. Next question comes from the line of Joshua Tilton from Wolfe Research. Look, I just have one for me. And I guess I heard the prepared remarks, especially around the guidance. But just maybe help us get a little confidence around your confidence interval on the applied second half net new ARR. I understand you guys talk to like strength in consolidated offerings, which was 40% of net new ARR this quarter. But we're talking about pretty small numbers for net new ARR in the first half versus what's implied in the second half. And kind of feels like the rest of the business needs to pick up to kind of hit the numbers you're talking to. So just maybe help us gain a little bit more confidence around your [guys'] decision to leave the full year -- to reiterate the full year ARR outlook today. Corey Thomas That's great. If you really look at it, I think while you're right on the first-year half of guidance, it's really Q1 was just like sort of like really poor in terms of it. Our big question that we actually had was really stabilized in Q2 and having a stable outlook for Q3. We feel very good about that. In addition, in Q4, we have just more longer-term deals in there. So we have a little bit more in the bank going into Q4. But really, what you're talking about is getting back up to a little bit above a flat year-over-year net ARR from last year. We feel good about that trend line. I mean frankly, from the Q1 spot to the Q2, just even though it was a small number, getting that momentum back and having that outlook be stable for Q3, was the trend that we're actually looking to actually get on. And that puts us, I think, in the guidance range. And actually, we feel comfortable about landing in the guidance range right now. Tim Adams Yes. Corey, in your prepared comments, you talked about the strength in the partner pipeline build up 15%, which year-over-year, which was up from Q1. So we are seeing the momentum on that side. And we know that Q4 has historically always been a strong quarter for us, and we anticipate that again this year. Corey Thomas But even that, we expect it to be relatively like stable from last year, and we're seeing enough momentum and build for that. Joshua Tilton Just a very quick follow-up on my end. Can you guys, maybe broadly speaking, actually not broadly speaking, just in general, I don't know if you give an update. I don't remember exactly when you give - but can you just help us understand like the strength you're seeing or like what the run rate is, or is there an update on the IDR business. Has that kind of been a shining light for you guys over the last 2 quarters? Corey Thomas Yes. IDR is much higher in the preference stack, and it's been the biggest contributor of overall growth this year. And we see the demand there. And in fact, we are working to expand our IDR services. Because we see customers looking for us to actually do more from a detection response perspective. So we see that as something that's high in the value stack. Customers are looking at health both on the technology side and on the managed service side from us and our partners. And so we see that as a big opportunity, frankly, not just now, but over the next several years. Tim Adams Yes, Corey, we didn't break it out this quarter and maybe we have in the past. But we both said in our prepared comments, it's really been an acre for us, a very strong positive anchor and it grew very nicely in the quarter. Your next question comes from the line of Brian Essex from JPMorgan. Unidentified Analyst This is Charlotte [indiscernible] on for Brian Essex. I know you gave some color in the prepared remarks, but could you expand a little bit about the platform customer count versus your total customer count and how that's trending? And if there -- if you're seeing better traction in the enterprise has been -- different aspects like that, that would be really helpful. Corey Thomas Yes. I think in the past, we've broken it out platform versus traditional. Look, we continue to see fall off of our small dollar transactional customers. Our platform customers grew faster than that. And so you can think about like mid-single digits in terms of that, which was -- I would just say in line with expectations and healthy. We always want to grow customers. But we're happy that the growth is coming on the platform side. We think that sets up for better long-term growth. Tim Adams Yes. Corey, it was up sequentially and year-over-year on the platform side, and it's the lion's share of the customer base, and it's performing well. Your next question comes from the line of Rob Owens of Piper Sandler. Unidentified Analyst Great. This is Ethan on for Rob. Corey, I just wanted to ask on the VM space as a whole. Do you see some of the headwinds in growth that you're seeing here, you and other -- your peers are seeing as kind of cyclical or more secular longer term? Corey Thomas Yes. So look, I think the biggest thing is we've been worried and focused on building our platform for a little while because we've seen the pressure that - and the strategic value that vulnerability management was going to have. And so we really have to have an intentional approach to actually shift our value stack up. First, with detection response. And now with our CTEM or overall Exposure Command offering to make - to solve more strategic problem for customers because at the end of day, it's about the customer. And vulnerability management solves a problem, but that problem is becoming less and less strategic for customers. I think that's the pressure that you're staying in the market. It's one that we've been sort of like worried about and focused on for a little while. So while I think that's true, I think vulnerability management is still critical, and that's why we see it as an important capability of our solution, but it's a capability of the solution. It's not a stand-alone solution as we see it, and we think stand-alone solutions will continue to see pressure, but we do think that if you're solving the broader visibility risk, understanding of the attack surface problem, then we actually think that's something that customers are going to find valuable. We're seeing good early momentum, but it's sort of the tail -- the pace of that, but we're seeing very good on traction there. The next question comes from the line of an anonymous caller from Morgan Stanley. Oscar Saavedra This is Oscar Saavedra on for Hamza Fodderwala from Morgan Stanley. I want to dig in a little on your commentary on pipeline generation by partners. Nice to see that it was up 15%. Last quarter, I know you mentioned - you indicated that the contribution from the new focus was not yet making up the contribution loss from you deemphasized, I was just wondering if you can comment on how that trended this quarter to what extent that gap was closed compared to last quarter. And as we look ahead, how should we think about maybe the time line for that to sort of breakeven? Corey Thomas Yes. As part of the - some of the changes that we actually made it is something that I'm paying a lot of attention to. What I'll say is that we saw it stabilize and grow better than it has in a while in the quarter. But we do are looking to actually manage it to grow faster. Now the partner stuff takes time. And I would just say that, that's a core sort of like part of the transition period but we feel that we're on the right trajectory enough so that we're actually increasing our investment allocation to the partner ecosystem because we're seeing the yield and the results there. And really, what we're focusing on is how do we, of course, make sure that we actually are executing against this year's targets, but also how do we actually build that momentum as we actually go into next year. And so I'll just say it's trending the right way. Of course, like everybody else, we want to see more sooner. And we're managing our investments staff off on that path, but we're seeing the right direction. We're just looking to actually get more out of it faster. The next question comes from the line of Mark Cash of Raymond James. Mark Cash This is Mark on for Adam. So Corey, if I could start with you. Some exciting changes in the product front happening, while those just move to regional go-to-market structure are not reflecting to your overall -- so are those changes related? Or was the move to regional sales structure something that's already being worked on? And why move to that structure? Corey Thomas Yes. The changes to actually -- the regional sales structure array is being worked on. We have been looking at how to within the region align the land, expand, retain businesses, drive not just efficiency but especially since we have more partnership business, to make sure that we actually had more alignment there. So that work was already underway and our previous Chief Commercial Officer actually did lots of their homework working with the regional sales leaders to actually help bring that plan forward and to make it a reality there. So -- but the reason for it was not just an efficiency thing, it was also execution about how do we actually make sure that we're actually upgrading our installed base to the new Command Platform in a timely fashion while working with and expanding our partner ecosystem. Mark Cash Okay. And Corey, if I could ask - I'm sorry, maybe actually for Tim, if you don't mind. I guess you generate $150 million to $160 million of free cash flow this year, substantial margin improvement year-over-year. So how are you now thinking about rank ordering the uses of cash that you have this more durable statement of cash coming to the business? Tim Adams Yes. In terms of more of a capital structure use of cash. So first priority is to make sure we always have enough cash to run the business, which has never been a problem, I would call that a couple of hundred million that you would leave on the balance sheet. Corey and I have talked very publicly of one acquisition per year to at least have the room to do that similar to the acquisition, we welcome the Noetic team to Rapid7, and that is a tech and team, a smaller-sized deal. So I would call all of that priority number 1. And then priority number 2 is we're very mindful of the debt stack that we have, and we have plenty of time to manage that accordingly but ultimately, to repay the debt. So I'd put it in that order of priority. Our next question comes from the line of Michael Romanelli from Mizuho. Michael Romanelli Yes. This is Mike on for Greg. Maybe 2 for me. I guess, just firstly, from your perspective, have you seen any change in customer behavior since the CrowdStrike IT outage very recently? And then just on average discounting rates. So what do they look like in 2Q? Were there any changes sequentially? Corey Thomas Look, the CrowdStrike was a big deal for our customers and for the security industry in general. It took a lot of time. Lots of people put heroic efforts in to get their businesses back online while they were staying secure. We have overlapping customers and we were trying to make sure that we supported our customers. And so I think people are sort of like, while systems are back online, I think that took a lot out of security teams. And so I think that was probably the bigger pressure point. I think it's too early to know anything else. But I just know security teams and IT teams put in a herculean effort and I think it really matters, and they should be appreciated. Relative discount. I don't think we saw anything material on the relative discounting... Our next question comes from the line of Kingsley Crane. Kingsley Crane So in light of some of your peers focusing on profitability, I wanted to double click on product gross margins. How much room do you feel you have to expand product gross margins over time? Is 80% a reasonable goal? Or you expect most future margin improvements to be from sales and marketing for example? Corey Thomas It's a really good question. I would say the one -- look, I think customers get a vote here. And I will say that customers are also looking for more existence and enablement. So I think right now, we have confidence that we can grow margins overall. We have the flexibility to actually grow it at the gross margin line from operating expenses. But customers are looking for more help and assistance. Now I think part of the reason that we actually have room on the gross margin line is really 2 things is one, we are gearing up more partners and managed services partners, which actually help with that. And our team is investing in AI, which actually has the benefit of helping our customers get more coverage and support, while also allow us to expand our margin profile. And so we haven't sort of like fixed the model. We don't want to sacrifice our ability to support customers engage with customers. But right now, we have very high confidence that we can expand our overall margin as a company while accelerating growth but it's going to actually -- sorry, the overall demand level of customer service, which has been going up hugely where customers want to have Rapid7 and its partners help them more -- their security programs that's going to be offset by AI and the ability for us to continue to ramp partners. Great question. Thank you. Kingsley Crane Both of that's really helpful. And just one more. So one of thing through geodynamics, we've seen some challenges in the states for a lot of security companies. You've added almost as much net new revenue last year in international as you did in the state. So I just want to talk more about what you're seeing in the U.S. market in particular, and what you're hearing from the customers? Corey Thomas So I would -- so there's 2 things. One, customers are still under lots of budget crushers. And so I just want to be clear that, that has not gone away. Customers are trying to figure out how to address security, and frankly, how to do it in a tighter budget envelope overall. But we see most customers trying to really address security, and they're trying to address the budget envelope overall. That hasn't changed. What they're focusing on is the most critical security problems, and that's why we've had this urgency to really drive and make sure the problems that we solve are the most meaningful problems that we can possibly solve in the security stack. That's what you've seen us aggress so heavily in long-term product service and technology. Because that's the moment to do it, so that we're actually doing a more important job for customers overall. But most customers are struggling with this, how do I actually make sure that I'm adjusting my business' budget needs while also making sure obviously ensuring our business and that's not going away. And we see that in North America, too, just like most security companies. Our next question comes from the line of Brad Reback from Stifel. Brad Reback Great. Corey, as we look out to next year, can you envision a scenario where total customer count is actually down? Corey Thomas Look, look, in this world, you can never say never. I'll just say that our strategy right now is to focus on quality of customers. And I think that like if you look at our strategic platform customers, if you look at what we're doing with the Command Platform, I have high confidence in the Command Platform customers will be up. I have high confidence that the strategic customers will be up. I would just say we're less concerned about some of the historical transactional business, and that creates noise. And so on the overall customer count, who knows. But I'll just say on the things that actually matter, we have very high confidence that, that will continue to improve. And we're expecting to see a healthy transition and help the adoption of our overall Command Platform. Tim Adams Yes, and the platform customers, Corey, as we mentioned earlier, continue to grow sequentially in the year-over-year... Corey Thomas Yes, absolutely. Yes. But that's also -- on the total customer count, there are some things that we are managing and some that we are not I think one thing also talking about just how to provide over time, more consistent transparency to the things that matter. But I would just say about the things that matter, we feel very good about our ability to grow that customer segment. Brad Reback That's great. Just one follow-up on that. Any reason you wouldn't start providing the absolute platform customer count going forward? Corey Thomas Yes. So right now, our team is looking -- every year, we go through the cycle of looking at like what's the right thing to provide. I know that amongst a bunch of other things are in consideration about what we actually share and provide going forward. Look, our goal is to provide the most meaningful insight to our investors. And I know that Elizabeth and the team are working through that right now. So I can't make any commitments now, but they work through that every year. I know they're looking to it again now as we are at the end next year. Our next question comes from the line of Schneider Rod from Baird. Zach Schneider This is Zach Schneider on for [indiscernible] at Baird. I just wanted to ask about upselling to existing customers and specifically how you plan sustaining its momentum in the face of budget constraints and elongated sales cycles? If you could talk to any specific initiatives that are being implemented to enhance customer engagement and drive higher upsells? And additionally, how you're addressing customer concerns regarding pricing and ROI? Corey Thomas Yes. So absolutely. Look, we have what I think is a very high ROI story. We saw a big problem for our - to say, relatively modest and reasonable incremental spending cost. And we think that, that formulation has the impact of making it easier for customers to say, yes, make it easier to actually secure existing renewals because we're prioritizing a lot of incremental value to customers for what's a relatively modest incremental price point. And so we're taking that out to all of our customers. Again, the initial feedback has been good, but we're in the early stages of taking that strategy out to customers. We're doing it across all of our sales teams. And I think we're set up well for success there. But again, we want to make it really, really compelling. And that's why we did not pick like others, a purely monetization strategy, which is about the company. We make how we solve the biggest possible customer problem at the most reasonable economics. And we think that's a [indiscernible] that's going to be attractive. Our next question comes from the line of Trevor Rambo of BTIG. Trevor Rambo This is Trevor on for Gray Powell. Congrats on some nice results. Maybe dovetailing off a question before, but what needs to happen for ARR growth to improve back to double digits over the next year or so in terms of growth, what levers do you guys have to -- at your disposal to get there? Is that something more of an exposure command gaining traction? And when should we think about that becoming a possibility at this point? Corey Thomas Yes. So look, we're clearly your -- while it's too early to comment specific to next year, I will comment on the levers because that's a very reasonable question there. Look, the levers we have is one, we have latent demand in detection response that we just have to actually -- our team took on work to expand the offering in the coverage. So customers are asking us for stuff. And we just have to explain our offerings. It's not rocket science there. but our team is working through that, and we think that allows us to address more of the overall detection response market as we actually go forward. The one that we've actually talked about is the Command Platform, Exposure Command. We actually think that allows us to actually really participate in the higher value set similar to the cloud, similar to the attack surface management, where customers actually spend their money versus traditional vulnerability management, which just isn't as big a budget priority. So now we're actually playing in the area where customers actually have priority and they're looking to spend money, and we're providing a good overall value proposition. And then in addition to that, we actually have a couple of add-ons that we're introducing in the installed base. Now all of that has to tee up with the continued investments that we're actually making in the partner ecosystem to actually drive scale and the rationalization that we're actually doing around the alignment across the business. But if you look at that right product strategy around detection response, which we expanded that business, you're going to hear more about that later. The Exposure Command, which allows us to be more strategic in the risk and visibility space. We're executing that. We have good momentum there. Partner, continue to make investments. And frankly, we're going to be accelerating those investments over time. We're seeing good traction there. And then we're really focused on equipment to enable our team. We have a good nor team there, and I think that they're set up well. Those are the things that can actually drive traction as we actually go into next year. It's early, but we're actually seeing this set up good -- but we have to actually, first and foremost, we have to start by continuing to actually leverage the healthy pipeline trends that we actually saw where it stabilized and upticked in Q2. And we have to actually really accelerate that and build that. But those are the things that actually drive as we go forward. Our last question comes from the line of Rudy Kessinger of D.A. Davidson. Rudy Kessinger I want to come back to just some slides net new ARR in the second half. I mean it's 4x as much net new ARR basically implied in the second half versus the first half, at the midpoint of the ARR outlook. And I know you've given a few comments, Marketplace pipeline, up 15%. They get 4x the net new ARR. So just can you give some commentary on the overall pipeline for the second half relative to the first half? Is there any other assumptions in the outlook such as maybe improved gross retention that might be helping drive some of the sequential improvements here? Or just any other color you could provide would be very helpful. Corey Thomas Yes, 2 quick things. One, it's a primarily a Q1 dynamic not the linearity exiting Q2. I would just point out that you talk about 4x in the second half, it was 7x in Q2. And so when you have the Q1 that we actually had the numbers don't make any sense. You could have actually said 7x in Q2 was going to make it -- or 8x in Q2, it's going to make any sense either. And so really, it's the traction and the -- it's the rate of improvement, and we're back on a healthy rate of improvement. So yes, Q1 was bad, but I think we actually normalized and stabilized things in Q2 and we said, well -- and then to get to your quarter question, which is actually really good is that we didn't leave the guidance range the same, just to leave it the same. We actually took a very detailed look at our pipeline. And we believe that from the pipeline and the data and everything that we actually see today that we're going to be in the guidance range that we actually indicated. But those are the 2 considerations that are just shared. Thanks for the question. Rudy Kessinger Yes. Okay. And then just as a quick follow-up, if I could, just... Just on the new logo side. Yes, on the new logo side, I saw it looked back to positive quarter-over-quarter. I guess, just any comments on new logo bookings in Q2 relative to expectations? Corey Thomas So I would just say with any expectation, look, Q2 was a quarter that we expected to normalize. We saw normalization. I would not say it was a whole [loan] quarter. I would just say that Q1 was a bad quarter. Q2, we expect it to actually get back to business and normalize it, it normalize. We saw very healthy traction and normalized traction on the platform side. We gave the number about mid-single digits. We saw the - us getting back to positive net overall customer growth. And that's kind of where we expect it to be in a healthy normalized environment and the setup. So we actually - it was what we expected, and what we needed to do to actually set up for us to be where we want to be as we actually exit the year. The primary thing that I'm focused on right now is, of course, the introducing the product to our customers, the new products to our customers and building pipeline not just for the back half of the year, but as we go forward. Thank you very much. And operator, are there any other questions? All right. With that, I want to thank everyone. I know that there's lots of stuff going on, but I really appreciate the questions and the support. I think we're in an exciting time. We've been executing our product strategy. We're taking that out to our customers. And we've been intentionally focused on investments that are going to set us up for the next several years, not the past 3 years. So I appreciate everyone's time and attention. Thank you all. Ladies and gentlemen, that concludes today's conference call. Thank you all for joining. You may now disconnect.

Certara, Inc. (CERT) Q2 2024 Earnings Call Transcript

David Deuchler - Investor Relations, Gilmartin Group LLC William Feehery - Chief Executive Officer John Gallagher - Chief Financial Officer Good day and thank you for standing by. Welcome to the Certara Second Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, David Deuchler, Head of Investor Relations. Go ahead. David Deuchler Good afternoon, everyone. Thank you all for participating in today's conference call. On the call from Certara, we have William Feehery, Chief Executive Officer; John Gallagher, Chief Financial Officer. Earlier today, Certara released financial results for the quarter ended June 30, 2024. A copy of the press release is available on the company's website. Before we begin, I would like to remind you that management will make statements during this call that include forward-looking statements and actual results may differ materially from those expressed or implied in the forward-looking statements. Please refer to slide 2 in the accompanying materials for additional information, which you can find on the company's Investor Relations website. In their remarks or responses to questions, management may mention some non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures are available on the recent earnings press release available on the company's website. Please refer to the reconciliation tables in the company materials for additional information. This conference call contains time-sensitive information and is accurate only as of the live broadcast today, August 6, 2024.Certara disclaims any obligation, except as required by law, to update or revise any financial projections or forward-looking statements, whether because of new information, future events or otherwise. Thank you, David, and good afternoon, everyone. Thank you for joining Certara's second quarter earnings call. John and I will begin with prepared remarks, and then we will take your questions. Certara's second quarter performance reflects continued strength in software and made a more challenging environment in services. We have found that the pace of recovery in the market demand has been relatively mixed. There are positive signs among some biotechs, especially those in the clinical stage, but we see continued caution in the spending patterns of some Tier 1 clients. This has affected our business segments in different ways. Our software business is growing with new products, new seats and new clients as customers see the potential for our products to reduce cost and improve development outcomes. However, our services business is more dependent upon the overall progress of projects in the global development pipeline where there has been reduced spending across the industry and which has impacted our near-term commercial opportunities. That said, our conversations with customers indicate high interest in biosimulation over the long term and specifically in Certara's software and services. Second quarter total revenue grew 3% to $93.3 million which was slightly below our internal expectations. Underlying this was 13% growth in our Software segment and negative 3% growth in our Services. During the quarter, Certara made efforts to optimize the allocation of resources across the business, including cost reduction actions to better position ourselves for balance of 2024 and beyond. As we look to the future, we were encouraged to see our total bookings in the second quarter were $98.9 million, which grew 15% year-over-year. Throughout the quarter, the pace of commercial activity in our services business progressed towards the lower end of our expectations with Tier 3 customers outperforming and Tier 1 customers underperforming. We have not yet seen an inflection point at the market level in services demand, but we have seen some green shoots in the Tier 3 customer base and are encouraged by that customer group heading into the second half of the year. We believe that our Tier 1 customers have continued to evaluate spending priorities and pipeline development initiatives throughout the first half of the year. This has resulted in slower spending and elongated decision-making, impacting our services businesses. We are encouraged by 14% growth in services bookings for the second quarter. As we continued our continue strength in software, reemerging strength in biotech customers and the normal seasonality of our business, we continue to have confidence in our full year outlook, which we are reiterating today. The environment we have seen year-to-date falls within the range of outcomes we anticipated when we initiated 2024 guidance earlier this year. As we assess the remainder of the year, we believe disciplined commercial strategy, new product releases and a stable end market keeps the revenue guidance range achievable with the upper end of the guidance range possible with an improving end market outlook, but we are tracking to the lower half of revenue guidance range, given what we've seen during Q2 with our Tier 1 services customers. We will continue to focus on commercial execution as we progress through the second half of the year. Next, let's touch on some recent highlights at Certara. In the rapidly changing biopharma landscape, we're engaging with key players across the sector. During our inaugural client summit called Certainty, we brought together biosimulation experts to discuss our offerings in an interactive environment. Over 250 clients joined various tracks tailored to specific applications, networking and engaging with the Certara team. This may even include hands-on workshops for Simcyp, Phoenix and Pinnacle 21 plus a preview of the CoAuthor AI regulatory writing software. The summit proved to be an excellent platform for solidifying customer relationships and promoting model-informed drug development. We have also continued to focus on investments that support the long-term adoption of biosimulation. Last month, we announced an agreement to acquire Chemaxon, a leading provider of cheminformatics software used in the discovery phase of drug development. This acquisition is expected to close in the fourth quarter, subject to customary closing conditions. Used by 18 of the top 20 pharma companies, Chemaxon's tools span the design, make, test and analyze framework, which is used to make lead optimization and pipeline development prioritization decisions. By integrating these tools with Certara's biosimulation products and artificial intelligence technology, we can enhance the use of model-informed drug development in the discovery and lead optimization phases. Chemaxon is expected to generate 2024 software revenues of over $20 million with our team of over 200 employees, including more than 75 software developers. Their 2024 adjusted EBITDA margin is below Certara's corporate average, but we have a road map to achieve margins approaching Certara's corporate average adjusted EBITDA margin by the end of 2025. In the second quarter, we continue to make progress in developing new software products and product features and integrating AI across our portfolio. In early June, we released the 23rd version of Simcyp, which included new features such as advanced biomarker modeling to predict drug-drug interaction risks and expanded biopharmaceutics capabilities. Additionally, the new version of Simcyp aligns with recent FDA guidelines, covering pH-dependent drug-drug interactions and therapeutic proteins that should help ensure smoother regulatory processes. We also announced the highly anticipated full commercial launch of our CoAuthor regulatory writing software at DIA 2024. CoAuthor leverages generative AI to accelerate the drafting of regulatory submissions and as it demonstrated, improved efficiency to first track by greater than 30%. CoAuthor is another example of how Certara is using AI technology acquired in the Vyasa transaction to develop impactful products that can ultimately drive further market penetration. Early customer feedback has been very positive. And we expect the product will generate notable commercial interest as the year progresses. Wrapping up, we are working diligently to improve growth and profitability of the businesses in the second half year. There have been several exciting developments related to our software products this year. And we announced a strategic acquisition that will help accelerate industry adoption of model-informed drug development, particularly in the discovery phase with strong synergistic growth opportunities. We continue to attract new customers and attract and add new products features that impact drug development timelines and efficiencies. As I look forward to the rest of the year and beyond, I am confident in the investments we are making in our business and that they will translate to long-term growth. With that, I will now hand things over to John, to discuss our financial results in more detail. John Gallagher Thank you, William. Hello, everyone. Total revenue for the three months ended June 30, 2024, was $93.3 million, representing year-over-year growth of 3% on a reported basis and 3% on a constant currency basis. Software revenue was $38.2 million in the second quarter, which increased 13% over the prior year period on a reported basis and on a constant currency basis. The growth in the quarter was driven by biosimulation software and Pinnacle 21. Ratable and subscription revenue accounted for 65% of second quarter software revenues, up from 57% in the prior year period. Software bookings were $41.8 million in the second quarter, which increased 17% from the prior year period. Trailing 12-month software bookings were $145.5 million, up 11% year-over-year. The software net retention rate was 108%, which is consistent with our long-term growth profile. Looking at our software bookings performance by tier, we saw very strong performance in both Tier 1 and Tier 3 customer segments, driven by continued adoption of our software. Now, turning to services revenue, which was $55.1 million in the second quarter down 3% versus the prior year period and on both a reported basis and a constant currency basis. Our services business continues to recover following a period of cautious spending among our customers. We were pleased to see improving performance in the Tier 3 customer base, which we anticipate will continue, while Tier 1 customers underperformed our internal expectations on cautious spending, as Bill mentioned earlier. Technology-driven services bookings in the second quarter were $57.1 million, which increased 14% from the prior year period. TTM services bookings were $262.9 million, down 2% as compared to the prior year. Total cost of revenue for the second quarter of 2024 was $39.8 million, an increase from $36.2 million in the second quarter of 2023, primarily due to a $2.8 million increase in employee-related expenses, a $0.5 million increase in stock-based compensation and $0.8 million increase in software amortization. Total operating expenses for the second quarter of 2024 were $62.5 million, an increase from $41.2 million in the second quarter of 2023. Drivers of increased operating expenses included higher employee-related expenses due to recent acquisitions and planned investments in sales and marketing, and research and development, along with higher stock-based compensation transaction expenses related to the debt refinancing. Adjusted EBITDA for the second quarter of 2024 was $26.3 million, a decrease from $32.4 million in the second quarter of 2023. Adjusted EBITDA margin was 28.2%. We expect sequential improvement in adjusted EBITDA margin in the third quarter due to the realigned resources and cost reductions mentioned earlier. And so we remain confident in our full year adjusted EBITDA margin guidance of 31% to 33%. As Bill said in his remarks, after evaluating investments and cost allocation in the first half of the year, we have realigned resources to be more consistent with where we see the largest growth opportunities. Our focus remains on investing for growth, particularly in software and AI, while ensuring underperforming areas of the business are appropriately structured. Wrapping up the income statement. Net loss for the second quarter of 2024 was $12.6 million compared to net income of $4.7 million in the second quarter of 2023. Reported adjusted net income for the second quarter of 2024 was $11.4 million compared to $18.4 million for the second quarter of 2023. Diluted loss per share for the second quarter of 2024 was $0.08 compared to earnings per share of $0.03 in the second quarter of 2023. Adjusted diluted earnings per share for the second quarter of 2024 was $0.07 compared to $0.12 for the second quarter of last year. Moving to the balance sheet. We finished the quarter with $224.6 million in cash and cash equivalents. As of June 30th, 2024, we had $296.7 million of outstanding borrowings on our term loan and full availability under our revolving credit facility. During the quarter, we took action to refinance our revolving credit facility and term loan in an effort to reduce our interest expense and push out maturities five to seven years, respectively. These actions taken are expected to be accretive to fiscal 2025 EPS by $0.01 and by $0.02 from fiscal '26 through '31. We are reiterating our guidance for the full year 2024, excluding any impact from Chemaxon as follows; we expect total revenue in the range of $385 million to $400 million, representing growth of 9% to 13% compared with 2023. Through the first half of 2024, we are tracking toward the lower half of the revenue range. We expect to grow adjusted EBITDA on a dollar figure basis in 2024 and expect an adjusted EBITDA margin in the range of 31% to 33%. Upon the closing of the Chemaxon transaction, we do expect to maintain our adjusted EBITDA margin guidance of 31% to 33%. We expect adjusted EPS in the range of $0.41 to $0.46 per share, fully diluted shares in the range of $160 million to $162 million and a tax rate in the range of 25% to 30%. I will now turn the call back over to our CEO, William Feehery for closing remarks. William Feehery Thank you, John. To summarize our message today, we are pleased with the many exciting developments at Certara in the second quarter and we remain focused on executing our growth and profitability goals in 2024. There's a lot to be excited about at Certara as we advance biosimulation with our innovative technology. Operator, can you please open the line for questions. [Operator Instructions] Our first question comes from Jeff Garro from Stephens. Your line is now open. Jeff Garro Yes, good afternoon. Thanks for taking the questions. Maybe start on the guidance and I appreciate the direction there that you're tracking towards lower half of the range on revenue. But maybe you could give some more comments on what gives you confidence that won't slip below the bottom end of that range. John Gallagher Yes, hi Jeff, this is John, I can take that one. So, as you pointed out, and we said in the remarks, we're tracking towards the lower half of the guidance range given the current environment, and that's primarily due to the performance that we've seen in Q2 on the Tier 1 services customers. So they are tracking below what our expectations were. But that being said, we do expect software to continue to do well. As we mentioned, we're seeing good signs in Tier 3 customers, both in software and in services. And then if you take those together with typical seasonality that we've seen, including last year. So last year was a tough end market environment, and we saw typical seasonality in Q4, then that's what gives us the confidence on maintaining the range. Jeff Garro Excellent. That hslps. And then maybe to hit the profitability side a little bit, I was hoping you could speak a little bit more to the cost reductions. Maybe help us by calling out which line items will see more of an impact? And then how we should think about the run rate those actions on annualized basis versus the impact we'll see in Q3? And then more strategically, why any cost reductions taken in recent weeks or months, what would impact the long-term growth opportunity for the company. Thanks. John Gallagher Yes, right. So what we -- as we said, we were reallocating resources based on where we're seeing the biggest growth opportunity. So we're focusing the investment dollars on software and integrating AI and then we're taking some cost actions as it related to areas that were underutilized or underperforming parts of the business. As far as how you see that showing up. So that's what gives us confidence in the guide on EBITDA margin because those actions have already been taken and are showing up in the P&L net. So those will continue to flow through, not only in Q3, but also in Q4. And the way to think about it is you should think about it as about a 500 basis point benefit or impact on percent revenue costs. And you'd see about 300 of that come on the cost of sales line and about 200 coming on OpEx. Jeff Garro Maybe Will can take the last part around why the cost actions will impact the growth opportunity from here? William Feehery Yeah. Thanks, Jeff. Appreciate it. So I think we've just adjusted based on what we've seen as the current situation in market. We haven't cut our investments in new products or in the long-term vision and health of Certara. We've maintained our investments, as John said, in AI. We trimmed a little bit here and there based on what we saw in the market -- just market demand in the short run that I think were prudent to do, and some of it was just -- we just decided not to hire positions that we intended to hire and we're committed to get into our EBITDA margin guidance, and that's one of the actions we took to get there. Our next question comes from David Windley from Jefferies. Your line is now open. David Windley Hi. Thanks. Good afternoon. Thanks for taking my questions. I wanted to pick up on where Jeff left off. On I guess, on the magnitude, 500 basis points is pretty substantial. And guess if I zoomed out, you entered this year with your bookings trajectory having been a little bit challenging and making the decision to actually spend a little bit more and invest in some growth, I think, targeted at R&D and sales and marketing. I see in your deck, on your 2024 business update slide, you do talk about reduced spending in sales and marketing. And so I guess wanted to understand a little bit the bigger picture about -- Bill, I appreciate your comments on current environment, but maybe what's changed in the six months since decision to kind of double down on some investments as you entered 2024? William Feehery Yeah. Thanks, David. I'll start, and then John can chime in some of the numbers here. But I think what we saw as we went into 2024 is there's a tremendous opportunity for us to continue to invest in software and particularly in the AI investments that we started to make when we bought out the asset and into last year. We continue to do them, and they're starting to pay off. We've launched a product recently, which is just getting out there, but it's been very well received by customers. So we see those investments as worth continuing and paying off. What we saw during the first half of the year, was we've had some -- I think in the beginning part of the year, we had some softness in Tier 3 as they've picked up as we went through the year. There's still a little bit of softness in Tier 1s as we go through. So that's particularly in the services side. And so it's relatively easier for us to adjust our cost position and services relative to the longer-term investments in software. And so we took some necessary actions there. So John, if you want to chime in on that? John Gallagher Yeah, yeah, Bill. Hi, David. I think what we did there is we were slowing some head count growth. So that's a piece of it. And we were really targeting, as Bill was just saying, we're targeting the underutilized areas of the business to take some costs out where it wasn't efficient. And so at the time that we did the guide on the fourth quarter call, we said that we had put together investments, and we had expected the plan to play out in a certain way. And some of the plan isn't playing out in the way that we expected at the time that we did that guide. And we said if that was the case, we would need to take actions to maintain the EBITDA and we've done that, and we've done that as you would expect us to, basically because of what we saw happening with Tier 1 services customers. David Windley Okay. And if I could follow-up on that, good segue there. In thinking about Services, my intuition is that Services with your big customers would maybe lean a little bit more toward regulatory end market access and smaller customers would lean a little bit more toward biosim services, is that right such that like the services weakness that you're seeing in Tier 1 is in a different area than the weakness you maybe had seen in small and that's improving now in small? Or is it really in the same area, all in kind of biosim? John Gallagher It's really both. So, it's -- the services weakness that we're seeing is both in regulatory and it's in Biosim services. David Windley Okay. Great. Thanks. I'll follow-up offline. Thank you. Thank you. Our next question comes from Michael Cherny from Leerink Partners. Your line is now open. Q -Dan Clark Great. Thank you. This is Dan Clark on for Mike. First from us, how are you guys thinking about pricing on the services side just with these elongated customer conversations on the Tier 1 side, like how do you kind of balance discipline in pricing or price increases and getting deals done? Thanks. John Gallagher Yes, I'd say that the price increases are more modest, given the environment that we're in and the cautious spend and the slower decision-making, we are still increasing price, but we're increasing more modestly. Q -Dan Clark And then just a quick modeling question. The customer summit you guys held in 2Q, how should we think about the expense in the sales and marketing lines as so you can kind of model the rest of the year there? Thank you. John Gallagher Yes. So as we were just saying, the first half and the 2Q sales and marketing expenses is increasing based on the investment that we made and to some degree because of the M&A transactions that we brought in. We have taken actions as were just discussing that are going to slow head count growth and would slow the head count growth that we have on our line item also. Thank you. Our next question comes from Michael Ryskin from BofA. Your line is now open. Q - Unidentified Analyst Hi. It's Wolf on for Mike. Thanks for taking question, guys. I kind of want to pick back up on the guidance theme, but perhaps just take a step back to end markets overall. I think we all kind of saw Smith Biotech funding take a sequential step down in 2Q and thought that CRO or larger pharma spend with CROs and the like seemed fairly stable. Obviously, you're kind of pointing to an opposite dynamic from that. So I'm just wondering if you can talk to how the tenor of your conversations with those two customers evolved over the course of the quarter. William Feehery Yes. Thanks for your question. I think what we saw was there was a pickup in the small biotech funding the first quarter. And then I think we believe that we saw that start to flow through in the second quarter. So there's some lag between what happens in funding and obviously, when it reaches us. But the pickup was welcome because we had seen weakness in that segment for really quite some quarters now. So it was good to see them come back. I think on the larger customers, we saw just more caution around spending. It's certainly true in past years, we've seen pickups in the second half and particularly as you go into the very end of the year as customers want to spend their budget. So we're sort of cautiously watching what happens to that market. And obviously, we factored that into the guidance that we gave. Unidentified Analyst Got it. Thank you. And then just one more kind of strategic one. Could you talk to the rationale behind the Chemaxon deal? Just interested in your kind of intent in expanding more into the preclinical space and what opportunities that you see there? William Feehery Yes. Thanks for the question. So Chemaxon is an important acquisition for us. I think a lot of people have asked me for a while, what are some areas that we're interested in expanding in? And we've always talked about preclinical and the discovery space as being areas that are ripe for biosimulation to make a bigger impact. Most of the biosimulation help that we provide our clients in Certara has been sort of preclinical and then especially in the clinical phase, and we do really well there. But it's important to be able to help our clients make informed decisions on which drugs to take forward and which leads to optimize. We see an opportunity there to make a bigger impact on the overall success of drug development and Chemaxon has quite a number of tools that we believe that we can integrate into a wider suite of biosimulation tools going forward to enable that. Thank you. Our next question comes from Luke Sergott from Barclays. Your line is now open. Unidentified Analyst This is [indiscernible] on for Luke. Thanks for the question. Piggybacking off of Wolf's question on biotech and biotech funding, what's the expectation for the rest of the year? I know you're suspecting that you're seeing sort of the 1Q pickup flowing through this quarter. But what's kind of embedded in the guide for the rest of year on how those biotechs are going to perform? William Feehery Yes. Thanks for the question, John, do you want to take that one? John Gallagher Yes, I got it, Bill. The way to think through the customer tiering on the biotech for the remainder of the year is we are not planning an uplift on Tier 3. We were pleased to see a bit of an uptick in Q2, but we have the guide really contemplates a continuation of just sort of stability on the Tier 3 customer base. But that being said, I mentioned earlier, we do anticipate typical seasonality. So turning to Tier 1 customers, the guide does contemplate a pickup in Tier 1 customer activity Q4, which is what we've seen historically. And importantly, we saw last year during that time also that had a difficult end market environment. So that's the only piece of seasonality or uptick that we really have planned into the guidance. Q - Unidentified Analyst Got you. That's really helpful. And then a follow-up on just software bookings. You mentioned maybe some strength was driven by expansion of biosimulation to new customers. Is this mostly driven by new offerings? And I'm kind of curious if CoAuthor was a significant portion bookings due to the new unveil or is this more of a side effect of the commercial reorg? And could you just give us an update on the progress there and how it's trending versus your expectations on synergies? Thanks. William Feehery Yes. Thanks. And maybe I'll start with that one, John. So we saw a nice growth in our core software products, and particularly Simcyp and Pinnacle 21 so that was good to see. CoAuthor was just sort of fully launched at the end of June so it's a bit too early for that to be a significant impact on our bookings. But we did have a pretty big launch, and we've received quite a bit of interest for that product. So let's watch as we go forward, but it didn't play a significant effect to the numbers that we reported for the quarter. I'd say across the board, we saw a lot of interest in AI. There's been basically steady stream of feature launches and product extensions in our Simcyp family, which has contributed a lot to the growth. So those are the kind of -- I would say it's kind of in the core software areas that we saw the best growth. Thank you. Our next question comes from Joe Vruwink from Baird. Your line is now open. Joe Vruwink Great. Hi, everyone. If the smaller customers are buying biosimulation software and starting to become more visible in the services pipeline, is there any history for you to say that your large customers tend to follow the small customers within a matter of some quarters or is just current regulatory environment, the large customers are dealing with so different that it kind of muddies any historical comparisons you might make? William Feehery Yes. Thanks, Joe. It's a good question. I think we see them as the market is operating a little bit differently. We think that what we've seen was the large customers have gone through a period of a number of them of rethinking their large portfolios of drugs, which ones they're going to continue to take forward and which ones they're not. Obviously, that's not really the question for the smaller ones who are trying to -- most of them are trying to get funded for one drug or one platform. So I'm not sure that we tend to see, what do you want to call it, a causal link like you're talking about. Now obviously, biotechs often go through M&A with larger customers at some point. So maybe somewhere down the line, that will be an effect, but it's not kind of -- it's not really in our thinking for the rest of year. Joe Vruwink Okay. Thank you. And then just a tougher backdrop specifically for regulatory services, any risk that that carries over to your regulatory focused software offerings or you mentioned at the start of the call, just large customers very focused on cost reductions and efficiencies. Is a tougher environment you're seeing on the services side actually beneficial in bringing up things like Pinnacle or maybe it creates an even more favorable launch environment or something like CoAuthor? William Feehery Well, CoAuthor is a pretty interesting tool. We've -- in our internal testing, we've seen pretty substantial reductions in the amount of hours it takes to create regulatory documents. And so I think in any type of environment, a significant cost savings like that are a good pitch. And so that's why we're getting -- I think we're being well received there. I think it helps that we have a regulatory business, and so we've used that experience to inform the creation of that product. So it's kind of think of that as we have this product as almost designed by the users of the software. And so that's given us a pretty good sense on how to design something that's truly useful in that market. I would say, we still see continued spending across the board by customers on software, most of whom look at the software as once you're in there, they tend to look at it as continued investment in their infrastructure. So as long as they're going to continue to do R&D, they're going to need most of our software. And so the discussion is around how much renewal and what are we doing with new features and new extensions and things like that. So I think that's one reason why we've seen that as a stronger market right now, whereas the services have tended to be more project-based as people adjust their portfolios and they stop some drugs they start others, there's some disruption to the flow of projects that come through to us, and so that's going to factor this year. [Operator Instructions] Our next question comes from Max Raines [ph] from William Blair. Your line is now open. Unidentified Analyst Hi. Good afternoon. Thanks for taking our questions. I wanted to ask you a question along the same line as Wolf's [ph] question earlier. So on the services side, given we've seen clinical CROs flowed out pretty well, is it fair to assume that at least a chunk of these programs in large pharma moving forward, but they're electing to do so maybe without your consulting services? Or do you really think it's more a function of the fact that you're missing now and on bidding and working on these clinical programs that are actually being paused and reevaluated. And therefore, maybe there's a potential for you all to still recognize revenue from these programs in the back half of the year or 2025 as it potentially move forward? : Yes. We do believe that, and in addition, we point to the fact that we did see an uptick in services bookings in the second quarter. So I would say too early to call a huge recovery in the market, but we are seeing improvement as -- in the overall environment as we move forward to the second half of the year. I don't know, John, if you want to comment on that? John Gallagher Yes. I think we anticipate having when we did the guide, it said it would be a first half, second half story particularly on services. And we're seeing that in the way that this year is playing out, we'd anticipate to have 49% first half, 51%, 52% second half. And so we typically do see services pick up in the latter part of the year and namely in Q4. And so that's the typical seasonality that we've been referring to and that we saw last year. So we do think that, that will be a component of how this year plays out also. Unidentified Analyst Yes. That's helpful. Thank you. And then maybe sticking on the services bookings side. I guess it sounds like, based on your commentary, they were relatively in line with your expectations, but any comment around what you're looking for in the quarter and then how services bookings in particular stacked up? I know when we talked last quarter you kind of pointed us to 2021 and 2022 from a seasonality perspective. It looks like the average step-down in those years was about 10% sequentially, and they were down about 20% sequentially here in the second quarter of this year. So any comment around just how services bookings kind of stacked up to your expectations here in the second quarter? William Feehery Yes. So the -- I mean, the services bookings did come in later than we had expected, given the Tier 1 performance of what we had seen. But that being said, services bookings did grow 14% year-on-year. And as we look forward to the second half then -- as I mentioned, I think probably the key component in the second half is the seasonality that we've seen, and we saw last year importantly. So we're not anticipating anything outsized in that seasonality compared to what we saw last year. Thank you. Our next question comes from Steve Dechert from KeyBanc. Your line is now open. Q - Steve Dechert Hi, guys. Just wondering if you think the launch of Certara Cloud had an impact on your second quarter bookings. Thanks. William Feehery It's still early days, Steve, for Certara Cloud to have a material impact on the bookings. So the answer to that. Although, as we said, our software bookings and our software revenue continues to be strong. We don't see any reason for that to change. And Certara Cloud is a key component of our strategy going forward, and we think that that's going to enable not just that product, but all of the products in our portfolio. But for Q2, that wouldn't have been a meaningful part of our booking. Thank you. This concludes our question-and-answer session. Thank you for your participation in today's conference. This does conclude our program. You may now disconnect.

Upstart Holdings, Inc. (UPST) Q2 2024 Earnings Call Transcript

Dave Girouard - Co-Founder, Chief Executive Officer Sanjay Datta - Chief Financial Officer Cindy Moon - Lead Corporate & Securities Counsel Good day everyone! And welcome to the Upstart Second Quarter 2024 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Cindy Moon, Lead Corporate and Securities Counsel. Please go ahead. Cindy Moon Good afternoon, and thank you for joining us on today's conference call to discuss Upstart's second quarter 2024 financial results. With us on today's call are Dave Girouard, Upstart's Chief Executive Officer; and Sanjay Datta, our Chief Financial Officer. Before we begin, I want to remind you that shortly after the market closed today, Upstart issued a press release announcing its second quarter 2024 financial results and published an Investor Relations presentation. Both are available on our Investor Relations website, ir.upstart.com. During the call, we will make forward-looking statements, such as guidance for the third quarter of 2024 and the second half of 2024 relating to our business and our plans to expand our platform in the future. These statements are based on our current expectations and information available as of today and are subject to a variety of risks, uncertainties and assumptions. Actual results may differ materially as a result of various risk factors that have been described in our filings with the SEC. As a result, we caution you against placing undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements as a result of new information or future events, except as required by law. In addition, during today's call, unless otherwise stated, references to our results are provided as non-GAAP financial measure and are reconciled to our GAAP results, which can be found in the earnings release and supplemental tables. To ensure that we can address as many analyst questions as possible during the call, we request that you please limit yourself to one initial question and one follow-up. Next week, on August 15th, Upstart will be participating in the Needham FinTech & Digital Transformation Conference. On September 12th, Upstart will participate in B. Riley's Securities Consumer and TMT Conference. Now we'd like to turn it over to Dave Girouard, CEO of Upstart. Dave Girouard Good afternoon, everyone. I'm Dave Girouard, Co-Founder and CEO of Upstart. Thanks for joining us on our earnings call, covering our second-quarter 2024 results. I've said many times over the last couple of years that I've never lost an ounce of faith or optimism in the future of Upstart, and today, you can begin to see why. I'm proud and thankful for the incredible work done by Upstarters in the last 2 years to build a stronger and better company on so many dimensions. The numbers and guidance we released today demonstrate that we're turning a corner. We've made real progress toward returning to sequential growth and EBITDA profitability and, I believe, toward resuming our role once again as the Fintech known for high growth and healthy margins. We've also rebuilt our funding supply by locking in important long-term funding partnerships and significantly reducing the use of our balance sheet to fund loans. We expect this trend of reduced loan funding from our balance sheet will continue through the remainder of 2024. But this progress is not due to any dramatic improvements in macroeconomic factors or risk. Any such macro wins remain in our future. Rather, our progress is the result of the dedicated efforts of more than 1,200 Upstarters. The improvements that are evident in our business today are coming from inside the house: First, significant and even dramatic AI model wins; second, a revamped and revitalized funding supply; and third, increased operating efficiency. These wins and more are providing the foundation for the Upstart comeback story that I expect we'll share with you in the quarters and years to come. Today I'll provide some insight to these major initiatives and how they're building on the progress we've made in recent months. We continue to focus the majority of our efforts on our core personal loan product, where the opportunity for leadership in a fast-growing category is clear. Our product today is far superior to what we offered two years ago in all the dimensions that matter. Model accuracy, fraud detection, automation, funding resiliency, acquisition costs, and revenue optimization are leaps and bounds better than they were in 2022. Most importantly, I'm thrilled to share that we very recently launched one of the largest and most impactful improvements to our core credit pricing model in our history. In fact, with this launch, 18% of all accuracy gains in this model since our inception have been delivered by our ML team in the last 12 months. To dive a bit further, Model 18, or M18 as we call it internally, is the first to incorporate APR as a feature, or as an input to the model. It's, of course, common to think of APR as an output of a risk model at least indirectly, but we know empirically that the APR also affects the repayment risk of a loan. All else being equal, a higher APR will select for a riskier borrower, a notion known as adverse selection. Conversely, a lower APR will select for a less risky borrower. If you have a background in computer science or math, you quickly realize that having APR as both an input and output to the same model presents some challenges. Solving this problem requires running our risk models many times in parallel to arrive at the appropriate answer. In fact, M18 generates approximately 1 million predictions for each applicant in order to converge to the correct APR, which is six times the number of predictions of the prior model. We believe the improvement in accuracy is well worth it. Additionally, I'm very happy to report that we expect M18 to substantially improve our funnel conversion rate. From a competitive standpoint, I believe that significant technical obstacles such as the one I've described here are themselves a clear sign of progress. We're pushing the boundaries of computing and AI to build more accurate models, and we have seen few signs that peers in the lending space are far enough along the path of AI-based modeling to even encounter these technical challenges. We also reached another all-time high on automation of our core unsecured loan product, with 91% of loans in Q2 fully automated. As a reminder, this means no documents, no phone calls, no waiting, and no human involvement whatsoever. Two years ago, this number was 73% and we weren't sure reaching 90% was even possible. Driving automated approvals up, while keeping fraud to minimal levels is an obvious fit for AI, so we would expect Upstart to continue to lead on this front. And automation isn't just a win for cost and efficiency it also provides the foundation of a fundamentally better product for the consumer. Ultimately our strategy is to offer the best rates and best process to all for every credit product that matters. This means continuing to expand our platform to auto loans, small-dollar relief loans, and home equity lines of credit, and we're making great strides in each of these products. In Q2, our auto team released new underwriting models for both our auto retail and refinance products as well as a new fraud model for auto retail. We've now seen multiple months of calibrated loan performance and are growing confident that our loans are performant and increasingly competitive in the market. In the interest of continuing to move our auto business to profitability, we increased the monthly fee we charge each dealership for the use of our software. Despite this, we believe we're still quite inexpensive relative to competitive offerings. We're also investing heavily in servicing and recovery for auto and saw a 33% improvement in roll rates and a 44% increase in recovery rates in the second quarter alone. And our small dollar "relief" product continues to grow rapidly, with 57% sequential growth in the number of loans in the second quarter. Our intention with this product is to expand access to bank quality credit rather than to generate enormous profits. Nonetheless, I'm thrilled to say that in Q2, SDL became our second product to reach break-even economics. We also signed our first warehouse for SDL this past quarter. For the current quarter, we've identified opportunities to reduce the variable cost of these loans by more than 40% which would represent another incredible win and opportunity to increase approval rates further. Overall, this team continues to execute like pros and is helping Upstart expand its impact on the American consumer rapidly and responsibly. As of today, our Home Equity Line of Credit is available in 30 states, covering 51% of the U.S. population. We exited Q2 with an instant approval rate for HELOC applicants of 42%, up from 36% in Q1. This means we're able to instantly verify applicants' income and identity without the need for tedious document uploads. Consistent with our experience in personal loans, instantly approved applicants convert almost twice as often as other applicants. With respect to credit performance of our HELOCs, things couldn't be better. With more than 300 HELOCs originated, we have zero defaults to date. Finally, we've seen significant interest from Upstart's bank and credit union partners in our HELOC product and hope to launch our first lending partnership before the end of the year. We continue to invest enormously in servicing and collections. To give you a sense of this, in the last two years we've tripled the number of Upstarters on our servicing product and engineering teams, and this investment is paying off. We've made it radically easier for borrowers to make payments in whatever way works for them. We've implemented new channels for reaching borrowers who are delinquent. These efforts and more have helped drive delinquency rates down by 16% year-over-year and have helped reduce support costs per current loan by 30%. We've also now increased the number of borrowers enrolled in auto pay for 36 consecutive weeks. Much of our team's efforts to-date have prepared our servicing infrastructure for the deployment of AI models that we believe will enable us to build a significantly differentiated loan-servicing capability. Two years ago, we told you that we would upgrade the funding supply on the Upstart platform. We aimed to move a significant portion of our funding from at-will monthly agreements to longer term committed partnerships. Given the importance and complexity of these relationships, we cautioned that this would take some time. I'm pleased to share that we've now accomplished this goal. We ended Q2 with well over half of the institutional funding on our platform coming from committed capital and other co-investment partnerships. We began with the announcement of our first partnership with Castlelake 15 months ago. This partnership has since been renewed. We've since added significant partnerships with Ares and Centerbridge. Other institutional investors that have been with us for much longer have also returned to the platform. We continue to pursue additional opportunities to broaden and deepen our funding supply as Upstart returns to growth mode. We also said back then that we'd use our own balance sheet as a transitional bridge to this better state. You can see from the numbers we released today that we've begun to reduce the use of our balance sheet to fund loans. We're hopeful this will continue through the rest of the year, though I'd like to always reserve the option to use our balance sheet to do the right thing for our business. I'm also pleased to report that banks and credit unions continue to return to the Upstart platform. We've signed eight new lenders since Q1. Performance and lender demand on the platform are creating a competitive environment which is beginning to reduce prices for Upstart borrowers. In fact, lenders representing about half of the monthly available funding on Upstart from lenders have reduced their target returns recently as their liquidity has improved and their demand for loans has increased. This is the first time in two years that we've seen loan prices drop on Upstart. For many reasons, transforming credit with AI is complex and challenging. Tackling the world's most entrenched problems with AI is difficult and it doesn't happen overnight. But to those who ultimately solve these problems, there comes a tremendous reward. Today we're tackling problems that we weren't even aware of a couple years ago. My perspective is that, top to bottom, we've gone through a significant reinvention of the company, both from a technology and business model perspective. We're confident we're on the right track and making rapid progress. And this is just beginning to show in our financials. Despite the fact that many trillions of dollars in credit are originated each year, our competition in AI is scarce. In Generative AI, you have a significant number of well-funded and talented competitors, such as OpenAI, Google, Anthropic, and Meta, at the cutting edge of model building. In AI for lending, you have Upstart. Thanks. And now I'd like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q2, 2024 financial results and guidance. Sanjay. Sanjay Datta Thanks, Dave. Good afternoon to all. And thank you for joining us. A notable topic for us over the past few quarters has been the macro climate and its impact on both consumer spend and credit loss. The stimuli of 2020 and early 2021 left consumers flush with cash, and in retrospect, unleashed a two-year plus surge of consumption as consumers clung to new elevated spending habits well beyond the duration of the stimulus, and in our view, also beyond our collective means. These trends were, of course, exacerbated by punishing price inflation. This inflation, which also had its roots in the post-COVID monetary expansion, appears to have mostly run its course as we had anticipated for much of the past year. We now also see signs that the venerable American consumer is reluctantly waving the white flag, acting to moderate outlays and rebalance budgets. Consumption of goods, both durable and non-durable, has actually been falling in real terms over the course of this year. Spending on services has continued to rise, but half this increase over the past year is attributable to skyrocketing healthcare expenditures. Many other subcategories of services consumption growth in our economy have also started to abate. To be unambiguous, we believe this is a welcome development for the American economy, which has been on an unsustainable tear over this broader period of time. One product of improving fiscal health is that we are seeing credit default trends finally turn a corner, having peaked in aggregate sometime earlier this year, and now inflecting back down towards prior lower levels. This dynamic is reflected in our declining upstart macro index, which has now unambiguously fallen for three consecutive months and has reached its lowest level since January of 2023. This downward-traveling UMI is now a consistent pattern across all borrower segments that we can observe. While the more U.S. borrower continues their rehabilitation, we also note ongoing improvement in the funding markets, both on the institutional side as well as in the banking and credit union sectors. For the second consecutive quarter, we've increased the number of lenders who are active on our platform and have observed reductions in required rates of return. On the institutional side, we have now renewed all of our committed capital deals from last year and are currently in the process of adding new partners to the program in anticipation of future borrower growth. One such recent example is the new agreement we've completed with Centerbridge, a leading global alternative investment firm, by which they acquired $400 million of our personal loans. We are seeing early signs of funding progress in some of our newer products as well. We have secured financing to continue scaling up our auto and small-dollar loan offerings and expect to complete our first forward-flow sale of HELOC loans in the coming days. These collective funding efforts have allowed us to reduce the overall size of our balance sheet and store up some dry powder in support of any future growth and new product development needs. With this macro environment as backdrop, here are some financial highlights from the second quarter of 2024. Revenue from fees was $131 million in Q2, down 9% from the prior year, as higher pricing for prime loans created downward pressure on origination volumes. Net interest income was negative $3 million an improvement both year-on-year and sequentially, as the larger than typical core loan balance sheet we were carrying until late in the quarter produced income which helped to offset excess loss in our R&D portfolio. Taken together, net revenue for Q2 came in at $128 million, $3 million above our guidance, but down 6% year-on-year. The volume of loan transactions across our platform in Q2 was approximately 144,000 loans, up 31% from the prior year and up 21% sequentially, and representing over 89,000 new borrowers. Average loan size of $7,700 was down from $9,500 in the prior quarter, driven lower by continuing robust growth in small-dollar loans, as well as by pressure from higher pricing on prime loans, which tend to run larger than average. Our contribution margin, a non-GAAP metric which we define as revenue from fees, minus variable costs for borrower acquisition, verification, and servicing, as a percentage of revenue from fees, came in at 58% in Q2, flat sequentially and 2 percentage points above our guidance for the quarter. We continue to benefit from very high levels of loan processing automation, with our 8th consecutive quarterly improvement in percentage of loans fully automated, resulting in a new high of 91%. Operating expenses were $183 million in Q2, down 6% sequentially from Q1, as the workforce restructuring underwent yielded lower payroll costs across all of our functions. These savings were somewhat offset by the impact that higher loan volumes and smaller loan sizes are having on our loan processing costs. Altogether, Q2 GAAP net loss was $54 million, and adjusted EBITDA was negative $9 million, both comfortably ahead of guidance, and encouraging proof points on our path back to profitability. Adjusted earnings per share was negative $0.17, based on a diluted weighted average share count of $88 million. We ended the second quarter with loans on our balance sheet of $686 million before the consolidation of securitized loans, down from $924 million in the prior quarter. Of that balance, loans made for the purposes of R&D, principally auto loans, stood at $396 million. In addition to loans held directly, we have consolidated $135 million of loans from an ABS transaction completed in 2023, from which we retain a total net equity exposure of $21 million. We ended the quarter with $375 million of unrestricted cash on the balance sheet, and approximately $449 million in net loan equity at fair value. We have long maintained that once the macro environment ceases to be a headwind, we will have the opportunity to generate conversion growth through improvements to our models and acquisition campaigns. With loss rates that have now collectively appeared to plateau, this is precisely what we are expecting for the duration of this year. Last quarter, this nascent trend gave us the foundation to provide guidance for the back half of the year, which was based on an assumption that our model gains would deliver their historical pace of growth. Our model launches since that time have, in fact, produced enough uplift to put us ahead of schedule. Note that despite our relative optimism on the macro climate as it relates to credit performance, our guidance for the rest of the year in no way relies on either further improvements to the macro environment, nor on falling interest rates. Either of those eventualities, should they occur, would likely show up as tailwinds to our forecast. With that in mind, for Q3 of 2024, we are currently expecting total revenues of approximately $150 million, consisting of revenue from fees of $155 million, and net interest income of approximately negative $5 million, contribution margin of approximately 57%, net income of approximately negative $49 million, adjusted net income of approximately negative $14 million, adjusted EBITDA of approximately negative $5 million, and a diluted weighted average share count of approximately 90 million shares. For the second half of 2024, we expect revenue from fees of approximately $320 million and positive adjusted EBITDA in Q4. Overall, we would like to say that we feel good about how we've managed financially through this challenging period. We emerged with expanded margins and a reduced cost base underpinning the tangible progress we've made on the road back to profitability. And successfully reimagining our funding model has created a more resilient capital base and a shrinking balance sheet. More importantly, we are optimistic about the strength and direction of the business as we look ahead. While we are wary of prematurely sounding the all clear, the macro no longer appears to be a direct impediment to our business. An improving macro climate is not contemplated in our forward numbers and is not something we need in order to thrive. But if and when that does materialize, it should be wind in our sails. I would like to conclude by acknowledging the entire Upstart team for persevering together through this long metaphorical winter and also to all of our departed teammates who have been a part of the cause even if they are no longer able to. I'm looking forward to a time in the near future when we all will have to refasten our seat belts. With that, Dave and I are happy to open the call up to any questions. Operator. [Operator Instructions]. We'll pause for just a moment to assemble the queue. We will take our first question from Mihir Bhatia with Bank of America. Please go ahead. Mihir Bhatia Hi. Thank you for taking my questions. I wanted to start by just asking if you could comment a little bit more about just the inter-quarter trends and what you saw in July. It sounds like you're quite positive on the back half of the year and maybe if you could just comment a little bit on what you saw, both in terms of loan demand and also just credit performance as you went through the months in the quarter and to the extent you are willing to about July. Sanjay Datta Yeah, hey Mihir. Great to hear from you. So, you're asking about credit trends and loan trends in July? Mihir Bhatia And through the quarter, month-by-month in the quarter, like, did loan demand accelerate? Did you see more demand in June than April? Sanjay Datta I see. I mean, at a high level, I guess to the extent you can hear optimism both in our guide and in our comments, it's probably reflective of a quarter that obviously is leading into Q3 on a good footing and a positive trajectory, and to the extent that we are guiding Q3 on an upward trajectory, I would say that July is representative of that as well. Mihir Bhatia Okay. And then maybe just switching a little bit to the expense structure a little bit more. What I'm really trying to understand is the fixed versus variable cost of the model. So, as top line expands, what kind of impact will that have on profitability and how much should we expect to drop to the bottom line versus maybe you reinvest in growth or product expansion or additional growth? How should we be thinking about that equation? Thanks. Sanjay Datta Sure. Thanks Mihir. In rough terms, as the business expands, I would expect our contribution margins, which really capture our variable cost base, to shrink somewhat, mainly due to reductions in take rates. As the business becomes more profitable, we will probably invest more in volume and in lifetime value. I think the cost components of our contribution margin should be fairly consistent because we essentially attempt to originate up to the point of marginal cost breakeven. I don't think those points will dramatically change as we scale. As for the fixed cost base, I think, well, the intention is that it will grow slower than the top line of this business, meaning we should achieve operating leverage as the business scales. So between those two, I think that scale should drop pretty efficiently to the bottom line as we rescale. We will take our next question from Ramsey El-Assal with Barclays. Please go ahead. Ramsey El-Assal Hi. Thanks so much for taking my question. The conversion rate increased quarter-over-quarter and obviously a lot more year-over-year. I know you mentioned some pretty exciting model improvements. I guess, what should we expect on conversion rate for the next couple of quarters? Are your model improvements driving maybe further conversion rate improvements or should it plateau at a certain point? What should we be looking for? Sanjay Datta Hey Ramsey, great to hear from you. I would say that to the extent our guidance is indicating upward trajectory, almost all of that is coming from conversion gain, and the underlying model accuracy driving funnel improvement over time. I would say for the foreseeable future, that will be the growth model. There is potentially a rate at which those conversion rates plateau, but I don't think we're close to those rates at this time. So there's still a lot of runway to improve those conversion rates and drive the growth of the top line. Ramsey El-Assal Okay, a follow-up from me. On the smaller dollar relief loans, can you talk about these loans in the context of being like an acquisition channel for larger, longer duration borrowers or loans? In other words, are you seeing any of these small dollar customers come back and apply for larger loans that you can now kind of underwrite sort of like a training wheels type of a scenario in terms of being a channel into your core business? Dave Girouard Hey Ramsey, this is Dave. I think that's a pretty good description of how that product works and why we have it. It's really to push deeper with small amounts of dollars at risk, to be able to approve somebody on a shorter term loan, is just an opportunity for the models to learn faster and go faster and to acquire customers that are then eligible for other Upstart products later. So it is doing a super nice job of pushing the boundaries of our models, both in terms of the automation as well as in the selection and pricing, so that's gone extremely well. We have seen quite a bit of return for other loans, so that's also proving well. As we said on the call, it's become economically strong for us. It's not a drain on us in any way. So it's been just frankly all around a great win for us and we would expect it to continue to be. We will take our next question from Kyle Peterson with Needham. Please go ahead. Kyle Peterson Great. Good afternoon guys. Thanks for taking the questions. I wanted to start off on the size of the balance sheet. Here it was great to see some nice runoff there, especially on the core personal side. I guess how should we think about the pace of runoff over the next few quarters, especially now that you guys seem to continue to bolster your funding? Sanjay Datta Hey Kyle, great to hear from you. The answer to that question is a bit - about the outcome of how fast the borrower side of the platform is scaling up due to model improvements and how quickly we're signing up new capital agreements. Obviously the intention continues to be delivering those borrowers and that yields to our lending partners and to the institutional markets. But there's always going to be a bit of mismatch in timing. We may get a model win and not have the capital available or we may sign the capital up and the model win may come afterwards. And so I think in the give and take between those two sides of our platform, that's where we've historically used our balance sheet to step in. So all that to say, I do believe that the medium term direction here will continue to be a reduction in our balance sheet, at least as far as core loans are concerned. But there may be some timing mismatch along the way such that there may be some sort of swings up and down as we do that. So it's a bit hard to really calculate a very accurate pacing, if you will, given the volatility of those two sides of the business. Kyle Peterson Okay, that's helpful. And then I guess just to follow-up on expenses, particularly with the fixed cost base, I think you guys have said kind of in the past that in the fixed cost base you guys have today can support a lot more volume than you guys have been doing, call it in the past four to six quarters here. How much, if we do get a better environment for originations, I guess how much more volume can you guys support with the fixed cost structure that you guys have today? The contribution margin probably you guys gave was helpful earlier. Just trying to think about the fixed cost leverage. Sanjay Datta Well, I guess I'll say that through the end of this year and with the growth plans we have, we feel pretty good at where our cost base is. If the business were to start to really take off beyond that, I think there's some areas on the margin that we would like to reinforce, but nothing on the level of what we anticipate the growth of the business itself could be. So, I guess the main takeaway is there will be improving operating leverage as the top line grows. We'll take our next question from Peter Christiansen with Citigroup. Please go ahead. Peter Christiansen Good evening, Dave, Sanjay. Thanks for the question. I want to dig into your comment about some of the at-will supplies of funding coming back. Just wondering if you could give us a barometer where we are perhaps compared to maybe, I don't know, '21 part of 2022 in terms of some of those levels or at least indication of funding level that we saw back then. Then I guess, well, back then we also had 40% of your funding volume was through the ABS market. Would you expect that to returning to the ABS market for issuance in the near future? Thank you. Sanjay Datta Hey Pete, thanks for the question. I would say that the recovery of what we think of as the at-will funding markets, writ large, that's the world of credit funds and hedge funds that predominantly depend on ABS as a liquidity channel. It's early days for the recovery. I don't think we're near the scale that we were at a couple of years ago. That's of course reflective of the fact that the ABS markets are certainly not at the level of volume and liquidity that they were back then. But I do think that those markets are rapidly improving and we have plans to be back in the ABS market certainly before the end of the year. So, I think those things continue to be on a good trajectory. Peter Christiansen That's good to hear. And I recognize that period is not a fair comparison with the unique era. But secondly, in terms of the co-investment, how should we think about that level progressing over the next, I don't know, one or two quarters? Is that still, do you think, going to be a portion or tied to your funded principle? Dave Girouard Hey Pete, this is Dave. I think the co-investment partnerships are definitely key to our future. I mean, that's what we've been working on for some time, to go from almost entirely at-will funding a couple of years ago to having longer term committed partnerships. So that is very important to us. We view, the at-will funding can be useful in a lot of ways, but over dependence on ABS, particularly when those markets can ebb and flow quite a bit, isn't healthy for us. So as we said, we have well over half our funding at the end of Q2 in these longer term partnerships, and we think these are, we would like to maintain that percentage. So I think we're where we want to be with more long-term committed capital, less reliance on ABS and that sort of structure. As we grow back, we would like to sort of keep things as they are now. We will take our next question from James Faucette with Morgan Stanley. Please go ahead. James Faucette Thanks so much. I wanted to follow-up there on the committed capital. How should we be thinking about what that looks like in terms of a unit economics or accounting treatment in those partnerships versus kind of at-will generally? Sanjay Datta Yeah, hey James. In terms of unit economics, the loans that are being funded through that channel look very similar to the broader institutional loans. They differ from the lending partner channel. In that the risk aperture is a little broader and the returns are a little commensurately higher. But in terms of our unit economics, there's really very little difference between that channel and maybe what you might think of as more of the at-will institutional channel. In terms of the accounting, like these deals I would say are still becoming more and more standardized or templatized as we do more of them. I think historically they've shown up in a couple of different places on our balance sheet. But increasingly we're going to love to sort of standardize the structure of the deal, of the deals that we do. And we do pull the holistic view of it together on our investor earnings deck, which gives you a glimpse of the total exposure. James Faucette Got it. And then quickly, last quarter you alluded to the fact that you were seeing some, you had indexed more to prime than you historically had and given some of the prior actions you took. Just wondering if you can give us an update in terms of what you are seeing in prime versus subprime this quarter and what you anticipate going, getting back to more normalized mix? Good, thank you. Our mix has swung toward prime, and I think generally that we would see, as we regrow, we would like to be very balanced across the credit spectrum, and we think that's best for our brand, it's best for stability of the business, etcetera. So one thing we would anticipate in the coming quarters is a stronger position at the primer end over the credit spectrum than we've had traditionally, where we really have not had funding appropriate to compete in that part of the market, but we think that's changing. So I think you'll see us be more balanced in the future than we've been in the past with regard to the credit spectrum. We will take our next question from Dan Dolev with Mizuho. Please go ahead. Dan Dolev Hey you guys, thanks for taking my question. Great quarter, great results, very happy to see that. I want to know, what's going to happen assuming interest rates cut. How much torque do you think there is in the business, that you can actually expand growth, expand loans, as the environment gets more easier for you to do that? That's pretty much my only question. It's like, what the - how much upside can we dream, to dream at this point? Thank you. Sanjay Datta Hey Dan, great to hear from you as always. Look, reducing rates, benchmark rates and market rates are unambiguously good for the business. They haven't obviously been the main headwind to our business. Default rates have been much more punitive in how they've evolved over the last two years or so, but definitely having the benchmark rates go up from zero to 5%-ish has been a headwind as well. And if that reverses, it'll be a - it would presumably be a tailwind. It's a bit hard to quantify the exact nature of the tailwind as rates reduce and it obviously depends on how far back down they go. But each quarter point will result in lower financing costs for the institutional investors, and if that creates lower hurdle rates, those will result in lower rates to our borrowers. And I guess I'll just say that I think each cut would be a noticeable benefit in terms of its impact on our conversion rates. Dan Dolev Got it. Well, definitely looks like you're up-starting a new cycle, so congrats again. We will take our next question from Giuliano Bologna with Compass Point. Please go ahead. Giuliano Bologna Hello! Good afternoon, and congrats on the results and some of your funding announcements. One thing I'd be curious about digging into a little bit is your marketing expenses. It looks like you got some improvement in your marketing efficiencies this quarter. And in the past, what you've kind of said is that there were some challenges with some loans being priced about 36% that you couldn't necessarily convert. And I'm curious, when you think about the improvement in your marketing efficiency this quarter, how much of it was driven by being able to approve or underwrite more loans under 36%. And I'm curious, kind of how that could evolve over the next few quarters and how that's kind of factored into your outlook at this point. Dave Girouard Sure. So the marketing efficiency is a function of our funnel conversion, most generally. So when the funnel converts better, our marketing tends to get more efficient, etc. So that's a dynamic that's always in play. The 36% kind of rate cap on Upstart means that, as base rates go up and as risk goes up, more and more, fewer and fewer people are approved, and we've seen that in spades in the last couple of years. We went through a two-year period where rates almost constantly were going in an upward trajectory. And every time that happened, a bunch more people would not be approved, because effectively the rate in the system requires of them, it goes over 36%. So that's a little bit unwinding going the other way now, which is a good thing. Partially, or most of it actually is due to model accuracy in the newest versions of the models, who are able to sort of identify more people who fit under that envelope of 36%, and the result of that is that you see marketing efficiency improving. So that's a dynamic we would expect to continue in the coming months and quarters. Giuliano Bologna Yeah, and maybe taking away at that point, I'm curious in a sense of where things are, in a sense of when we think about funnel conversions and kind of the improvement, where do you think we are? Have we kind of improved 10%, 20% of normalization or is there a lot more to go with 100 basis point or 200 basis point decrease in interest rates? Dave Girouard Hey Giuliano! I would think of this as just an ongoing journey. I think that model accuracy has systematically improved since the beginning of our company and each improvement has a commensurate improvement on our conversion rates. Those can obviously be temporary set back by the macro, but as the macro normalizes, so will our conversion rates. And the question to how much better they can get, is sort of the same answer to the question of how much more accurate can your models get at approving good borrowers and avoiding bad ones. And we've talked about the fact that we think we've really just kind of scratched the surface in terms of our model's ability to improve explainability in credit default. And so we believe that the longer term roadmap for this company continues to be improving models and improving conversion rates over the years. So we don't think of it as sort of normalizing right now. We think we're back on the journey of improving models and improving conversion rates, now that the macro is no longer a direct headwind. Giuliano Bologna Alright, maybe one very quick question. You're obviously going on 50% or rolled off 50%, forward committed capital as kind of a percentage of your funding. I think in the past you've kind of referred to that as kind of where you'd want it to be closer to a higher end of the range. I'm curious, would you look to kind of overshoot that and then grow kind of the spot or uncommitted business to catch up with that? Is there kind of any structural limitation in the near term to what percentage of volume or funding you'd want to have come from forward committed capital sources at this point? Dave Girouard Yeah, I think that given that we are feeling increasingly optimistic about the roadmap of model improvements and the lack of macro headwind, I think it's in our interest to put in some more capital deals in place now. And in your words, to try and overshoot a little bit in anticipation of that growth materializing over the coming quarters, just given that these deals are relatively heavily negotiated and they take some time to put in place. So I think we want to err on the side of having those partnerships in place, in anticipation of where we see the borrower side of the platform growing. Giuliano Bologna That's very helpful. I appreciate it and I will jump back in the queue. We will take our next question from Rob Wildhack with Autonomous Research. Please go ahead. Rob Wildhack Hey guys, a question on the outlook. Updated guidance suggests better trend on origination. You guys sound pretty positive overall. Could you maybe break down how much of the improved outlook is coming from maybe mechanically from lower interest rates versus a better model versus maybe better funding? How would you quantify each of those or any additional drivers into the better outlook? Dave Girouard Hey Rob, this is Dave. I think that there is no assumption of approving interest rates or a reduction and kind of macro risk built into that. So the guidance is based on really what we're seeing based on improvements we've made internally. And maybe the way to think of that is better models means better conversion rate. The other important input is we have to, of course, have sufficient funding supply to keep up with that growth. But the gating item in terms of like what's really gating where our guidance sits today, it really is just about economic funnel conversion. And it's improved a lot really through model improvements primarily. And at this point we feel comfortable that we on the funding side can make things match well. So, that's a long-winded way of saying it's really through things we've done ourselves. It is not based on any assumptions about improvement in rates or risk in the environment. Rob Wildhack Okay, thanks. And then a question on the small dollar loans. I mean, could you give some color on how much the growth in small dollar loans may or may not have impacted the conversion rate quarter-over-quarter? And the same question going forward, as you grow in small dollar loans, does that drive the conversion rate a lot higher? Sanjay Datta Yeah, hey Rob. The STL product is having an impact on the overall conversion rates. I think it's on the order of maybe 2% or 3% impact at the scale that it's at. So it's not insignificant, but it's also relatively minor. We will take our next question from Simon Clinch with Redburn Atlantic. Please go ahead. Simon Clinch Hi everyone, thanks for taking my question. I was wondering if you could talk about what it takes or what factors you, or what levers you can pull and what macro tailwinds you might need to see the sort of gross inquiries that come into the upslot network before conversion. How do you drive that higher over time, because that is down quite materially from where it's been in the past. And I'm just wondering if that was just overstated previously and whether there's actual quite a lot of upside still in this coming cycle for that. Sanjay Datta Hey Simon, just with the top of the funnel inquiries, such as the visits to the site. I don't - we've not published sort of traffic or conversion to the site. So that's not something that we've discussed publicly or tried to track in that means. Is there something different you mean by that? Simon Clinch So I just take your volumes and then kind of back out from the conversion rates to what it was before you've converted and I'll just use that as a means to sort of track approximately what the volumes would be. Yeah, it's not exactly the same thing, but it's directionally correct. Generally speaking, a lot of times we are controlling that by how much we're spending in various marketing channels and also just generally how competitive our rates are. So that's part of it, whether we're doing direct mail or some sort of digital acquisition or whether we're kind of remarketing to our own customer base or through partner channels that are responsive and can vary how much traffic they send us based on the quality of our rates, etc. So that's, those are things that are a function of the market in some sense, or how strong our product is, how much we're actively marketing. So hope that fills in some of the blanks for you. Simon Clinch Okay, thanks. And maybe you could talk a bit more about the Model 18, M18. And just, I guess, can you give us a sense, for those of us who aren't educated in machine learning and stuff like that, but just really how unique something like that is and ultimately how quickly a model like that really starts to have an impact on your business? Dave Girouard Well, we're in a sort of never-ending quest to accurately price each and every loan offer that's made on our system. And one of the things we've known, and I think most lenders of some sort know, is that the quality of the offer you make to the market, meaning the level of the APR, has an impact on who accepts it and therefore how that loan performs. So the APR, which is, most people would think of it as the output of the model, actually affects the performance of the loan. So this is something, again, most people would tell you they have an intuitive sense of, but mechanically answering it and having models that are sophisticated enough to handle that is very important, particularly in the modern world where consumers have lots of choices, they compare rates all over the place. You know, this is something that even 10, 15 years ago, hardly existed. But today consumers have a lot of it, ways they can compare and find the best rates. So having a lot of savvy around that notion of adverse selection and positive selection is really important. And solving it from a technical perspective really comes down to trying to converge to the appropriate APR. And what that amounts to technically for us is running our risk models many, many times in parallel, in order to converge to the right number. It's a significant challenge that we've gotten over and I think we're just beginning to reap the benefits of it. The guidance that you are seeing for the second half of the year, a significant fraction of what you are seeing in terms of our optimism for the second half of the year, it comes directly through the improvements in that model, and also we see a lot of continued opportunity in that domain, in that area to improve the models. And that's what, again, that's what we're in business to do. It's generally where all the advantages of Upstart are, is when we can build better risk models and we're having some really good success in that area right now. We will take our next question from Vincent Caintic with BTIG. Please go ahead. Vincent Caintic Hey, good afternoon. Thanks for taking my question. First, just wanted to follow-up on the funding partnership discussion. It's good to see that the credit investor demand is increasing. Just if you could maybe talk about some of the discussions you are having. What are those credit investors focused on? What's changed where you are now getting more signups? How is - if you can give a sense for how pricing has changed or improved and maybe how much of your annual origination volume is now covered by all these new signups? Thank you. Sanjay Datta Hey Vincent, welcome back. On the funding partnerships that we are engaging in, I mean, there's sort of two general vectors. One is increasing comfort or confidence with credit trends in general and maybe sort of macro risk. And then second, we're sort of being innovative in some of the financial structures that we're coming up with and discussing with some of these partners and prospective partners. And it's sort of a learning, I would say a learning curve for all of us, in terms of how to get these partnerships implemented and put in place and managed. And so a lot of the journey with a prospective partner is just about understanding the model and the structure and how it all works. And then the recognition that there's definitely ways of creating win-win partnerships here for us as the issuer and for these counterparties who are interested in the yield. And so, I wouldn't say beyond that there's been dramatic changes in preferences over rates, and sort of supply and demand dynamics. It's mostly been just an ongoing education for all of us around how these structures work, and I think it's going in a very good direction. In terms of capacity, as Dave said, we're sort of a bit north of 50% of all the institutional money that's going to fund the loans on our platform and the past quarter came from these types of arrangements. And we'll aim to maintain that kind of coverage or that kind of capacity over the long-term and the medium-term. We'll maybe overbuild a little bit in anticipation of some growth that may happen in the coming quarters. Vincent Caintic Okay, that's great color. Thank you. And my second question, just if you could talk about the competitive environment for consumer financing. It seems like others in this environment might be pulling back when you hear about from the traditional banks on their earnings calls for talking about, some stress on the low end and the middle consumer. So it seems like a lot of competition is pulling back, but I just wanted to get that sense from you, what you are seeing with that competitive environment. Thank you. Dave Girouard Well, I think our position on the consumer, I like to think we've been ahead of the crowd a bit, in the sense that it was clear there was deterioration of credit at the sort of less affluent part last year, and then later last year into the more affluent part. But as Sanjay said in his remarks earlier, we're seeing sort of uniform improvement now across the board. So we sort of feel like we've been kind of signaling this for some time, that we're nearing the end of the cycle. And I think we just have clear indications that credit is actually in a normalization period, not in a deterioration period. Now, what others are seeing or saying and where their data is coming from, I obviously can't speak to, but I think we feel pretty good about that. With regard to, banks and lenders can either be a partner of ours or they can be a competitor of ours. But I know the ones that are partners of ours are tending to see increasing liquidity and have sort of swung to the place where they are needing more assets, they are needing more loans and we talked a bit about that. So they are coming in a little bit more competitively, lowering their return targets and really wanting to sort of swing the dial a little bit. So I don't think there's any sort of caution to the wind like environment, but I do think the sort of lack of liquidity that was really serious a year ago and probably carried on through the end of 2023 has really improved a lot. And for us, that means the lending partners, the banks and the credit unions have definitely returned and that's been very helpful for us. We will take our next question from Reggie Smith with JP Morgan. Please go ahead. Reggie Smith Hey, good evening. Thanks for taking the question. I've got two quick ones. So I guess you guys called out model improvements and a better UMI, which is great to hear and see. My question is, how should we think about those two things in the context of the returns in your core investment portfolio? And I guess specifically I'm trying to figure out, I mean, should that manifest in better performance there? If not, like where do these gains and model efficiency accrue? Obviously consumers are getting approved for more loans, but how do we think about how that flows through to your business? And I've got a follow-up. Thank you. Sanjay Datta Yeah, hey Reggie. This is a great question. In general, model gains or model accuracy improvements such as the one that we highlighted, generally improve our ability to accurately separate risk. And that generally shows up mainly in our improved conversion funnel. So it would create business expansion. It wouldn't necessarily improve the calibration of the model in how it assesses an average pool of loans. So it wouldn't necessarily be expected to have a huge impact on the performance of the co-investment positions we have. The UMI, to the extent it continues to fall, would have a direct impact on the performance of loan pools such as the ones that our co-investment partnerships have invested in, because it essentially means that credit trends are improving in real time. And as they do the performance of those loans, any loans that are outstanding would be expected to improve and potentially over perform, and that would result in higher returns to our investment positions. So I think that would have a pretty direct impact. Reggie Smith Right, understood. And then I guess to follow-up on the unit economics. I'm not sure how much you guys can share here. But curious, with some of these committed structures, I assume you are selling these loans maybe at a slight discount to fall or maybe part of - where are you in that? Where are you in terms of that? And is the thinking that over time you could get to a place where you do sell a better premium default or is kind of part the aspirational goal there? Or am I completely off and maybe selling them at a gain right now? I'm not sure. Sanjay Datta Yeah, the committed partnerships we are in, as with all of the at-will capital, the traffic and the institutional markets, all of those loans are trafficked at par, and I think that's our goal. We're not necessarily looking to create a business model from gain from sale. I think our goal is to traffic loans at par that are correctly priced to the borrowers. And to the extent we're co-invested, we'll participate in the yield. That would be... Reggie Smith Understood. One-last-one. [Multiple Speakers] Okay, if I could sneak one last question, I want to give you guys flowers for returning to EBITDA positivity in the fourth quarter. Was curious how you are thinking about stock compensation expense longer term. I noticed that it's been up and it's well above where it was when you guys were much more profitable. So just curious, like, what's your thinking there? Thank you. Sanjay Datta Well, we happy to take our flowers for the return to profitability. I appreciate that. How we're thinking about stock compensation, I don't think it's dramatically different than how we thought of it in the past. As a tech company that's headquartered in the Valley, it's important to us for our employees to have a stake in the mission and the outcomes of the business, and I think we're at a pretty comfortable balance between cash compensation and equity compensation, depending on role and level. So I don't necessarily see a dramatic departure from how we've managed it to-date. We will take our next question from Arvind Ramnani with Piper Sandler. Please go ahead. Arvind Ramnani Thanks for taking my question. I want to ask, on this call and in the prior calls, you'll have talked about some of the big investments you have made in improving your model and capabilities. And as we get into a better kind of operating environment or lending environment, not that you have a better model. I mean, how do you expect the business to perform in a more conducive environment, just given the backdrop of a better model, a better offering? Well, I think, as I kind of said in my remarks, I think we've gone through a pretty significant transformation of the business over the last couple of years, both from a technology perspective and from a business model perspective. On the technology side, we feel much, much better at the quality of the models, how quickly they can react to changes in the environment, the amount of separation we're getting. So, it's the normal trajectory of an AI model where it's getting more and more data, more and more variables. We're putting more sophisticated software in as we talked about Model 18. So, higher degrees of automation, as we talked, we have a record high on that front. So, the technology side has just really improved a lot and just made us more efficient. And I think, on the business model side, one of the things we clearly identified is we needed to have funding structure that had permanence to it, so that when we grow, and even if there's bumps in the road along the way, which there inevitably will be, we can grow through them. And that's kind of what we've done on the business model side, has really changed the nature of funding from completely at-will to dedicated partnerships, and we have some skin in the game in these partnerships as co-investors, which we think given our role and our aims in the market, is a structure if that makes sense. So, of course, in the good times when rates are dropping and the consumer's getting financially healthier, that's all very easy, and we're hopeful that's what we're headed into. But of course, the test is when the market is not so easy, but that's what we're designing for. We're designing for a future with less volatility and more ability to thrive through whatever economic climate we find ourselves in. Arvind Ramnani Yeah, that's really helpful. And I know, like I mean, I'm willing to give you the benefit of doubt that our models are better, but I wanted to ask, have they been validated by some client feedback, some banking partner feedback? What is your sort of comfort level in saying that, 'hey, we have a better model,' right? I mean, are you looking at internal data and coming to a conclusion, or are you getting that from external validation? What really gives you sort of comfort that you have proof that you have a better model? Dave Girouard Yeah, I mean, there's very, very well-understood statistical techniques to actually describe and quantify accuracy of a model, and there are several different ones, and we use generally all of them. So it's not hard for us to assess ourselves whether our model is getting more accurate or not relative to prior versions of our model. So that's not - it's not hypothetical in any sense. It's something very straightforward in terms of building more accuracy into a model. Certainly, every lending partner and credit investor on our platform sees all the data that is coming out in terms of all month-by-month performance data, etc. They have their own means of evaluating whether they think the credit's performing well or not, or what have you, but they are not looking at the software if you will, trying to assess our model, but they care about the results, of course. But there's no - I don't think there's any reason to question that we can accurately identify the level of improvement and accuracy that we see in each subsequent version of our model. It's kind of the nature of the system to do so. Arvind Ramnani All right, yeah. That's really helpful. Thank you very much. And I'm looking forward to circling up with you soon. There are no further questions at this time. Mr. Girouard, I will turn the conference back to you for any additional or closing remarks, sir. Dave Girouard Alrighty, thanks to everybody for joining us today. As we discussed, the actions we've taken over the last few years are beginning to pay off, and we believe we're well set up for the remainder 2024 and into next year. So hope you all enjoy the rest of your summer. We look forward to speaking with you all in the fall. This concludes today's call. Thank you for your participation. You may now disconnect.

Fortinet, Inc. (FTNT) Q2 2024 Earnings Call Transcript

Aaron Ovadia - Director of Investor Relations Ken Xie - Founder, Chairman & Chief Executive Officer Keith Jensen - Chief Financial Officer John Whittle - Chief Operating Officer Good day and thank you for standing by. Welcome to the Fortinet Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Aaron Ovadia, from -- the Director of Investor Relations. Aaron? Aaron Ovadia Thank you and good afternoon, everyone. This is Aaron Ovadia, Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Keith Jensen, our CFO; and John Whittle, our COO. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results Second quarter of 2024, before providing guidance for the third quarter of 2024 and updating the full year. We will then open the call for questions. During the Q&A session, we ask that you please limit yourself to one question and before we begin, I'd like to remind everyone that is on today's call that we will be making forward-looking statements and these forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those projected. Please refer to our SEC filings and in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in our earnings press release and the presentation accompanying today's remarks, both of which are posted on our Investor Relations website. The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations with immediately following today's call. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise. Okay. Thank you Aaron and thank you to everyone for joining our call. We are pleased with our strong execution in the second quarter as we successfully balanced growth and profitability. We achieved record operation margin which increased 820 basis points to 35% and managed to building revenue in the high end of the guidance range, reached our full year 2024 revenue and operation margin guidance and we continue to invest for growth. Gaining market share and secure networking and investing in fast-growing Unified SASE and Secure Operation market. Secure networking customers are increasingly recognized our FortiOS and FortiASIC technology offering 5 to 10x better performance than our competitors while improving security effectiveness and providing a low total cost of ownership. For over 20 years, we have been leading the shift to networking and security convergence and the industry projection now indicate secure networking will surpass to traditional network by 2026, 4 years earlier than previously anticipated. In the second quarter, Unified SASE accounted for 23% of total building, up 1 point. We expect our differentiated Unified SASE offering to become a leader in the SASE market. We believe we are the only company that has built all the SASE functions organically in a single operation system. We have a converged networking and security stack, including our market-leading SD-WAN, ZTNA, Secure Web Gateway, CASB, Firewall and many other innovations. Our SASE offering provides flexible enforcement delivering a better user experience while securing access to application on-premise and in the cloud. Furthermore, we continue to build our own SASE delivery infrastructure, including leverage of FortiGate technologies, providing us with a competitive long-term cost advantage. As announced earlier today, we acquired Next DLP, a next-generation cloud-native SaaS data protection platform, extending from endpoint to cloud. This will allow us to enter the stand-alone enterprise DLP market as well as immigrate market for the SASE solution. We also recently improved our position in the Gartner Magic Quadrant for single-vendor SASE and are the only vendor included in all 5 of major network security Magic Quadrant single-vendor SASE, network firewall, SD-WAN, secure service edge and enterprise wide and wireless in infrastructure. Each of the solutions run on our single unified operating system for the OS with AI-powered FortiGuard secure service and unified management. AI-driven Secure Ops accounted for 10% of total building in the second quarter, up 1 point. Our comprehensive Secure Ops portfolio backed by over a decade of AI experience offers the broadest range of sensors and advanced analytics to continuous access activity to identify sign of cyber strides. For AI harness generative AI to table chart our platform and help secure the operation team make better informed decision and respond to threats faster by simplifying the most complex task. Fortinet is available in FortiAnalyzer for the SIM and for store and will soon be available in other Fortinet product. In addition, we are pleased to further expand our secured portfolio with acquisition of Lacework and we believe that together, our solution form one of the most comprehensive full-stack cloud security solution available from a single vendor. Lacework organically developed AI-driven cloud native application protection platform will be combined with the power of Fortinet security platform, ensuring broad protection across network, cloud and endpoint. This acquisition increases our total addressable market by $10 billion and add a team of talented engineers dedicated to cloud-native security while also expanding our sales force that can sell the entire Fortinet portfolio of solutions. Yesterday, we announced several enhancements to Fortinet security platform which are already stand as the most comprehensive OT security platform on the market, enhancements include new recited plans [ph], advanced secure networking and secure operation capability and expanded partnership with leading OT vendors, reflecting Fortinet's commitment to security for the growing cyber physical system market. As further evidence of our innovation and commitment to excellence in OT, we recently earned a prestigious Red Dot product design work for a FortiGate Rugged 70G with Dual 5G model. Fortinet was the only secured company who will see this recognition in the industry next-generation firewall. Before turning the call over to Keith, I wish to present our employees, customers partners and suppliers worldwide for their continued support and hard work. Keith? Keith Jensen Thank you, Ken and thank you, Aaron and good afternoon, everyone. Let's start with the key highlights from the second quarter. Overall, we are very pleased with our execution in the quarter. We achieved record growth in operating margins at 81.5% and 35.1%, respectively, while delivering top line numbers at the high end of our guidance range. Revenue grew 11% as product revenue exceeded our expectations, driven by robust software revenue growth and sequential hardware growth that more closely aligned with historical norms. We also added 6,300 new logos as we continue to invest in our channel partners. As you'll hear in a moment, we believe we are on a pace for another rule of 40 year. At the same time, we accelerated our investments in the fast-growing Unified SASE and security operation markets with the acquisitions of Lacework and Next DLP. Lacework strengthens our position in the high-growth CGNAT market and expands our total addressable market by $10 billion, while Next DLP improves our position in the stand-alone enterprise data loss prevention market. Combined, Fortinet will gain over 900 customers and talented sales and engineering teams. And I'll just pause here to offer a very warm welcome to team members from both companies. Continuing with our Q2 highlights, we've taken the lead in partnering with the U.S. Cybersecurity and Infrastructure Security Agency, or CISA through a secure by design pledge and are leading with our responsible transparency practices. We want to emphasize, we understand customer trust is paramount to our business. Our continued success across all customer segments in each of our 3 pillars, represents hundreds of thousands of end customers testing and buying for net security solutions. Simply stated, this is a significant scale advantage and a responsibility a few others have and also offers customers validation at a very robust level. We are committed to responsible updates and deployment processes supply chain controls, product security measures and transparency. To understand more about the proactive measures we take to safeguard our customers and our reputation, please visit our trust website at fortinet.com/trust. Looking at billings in more detail. Total billings were consistent year-over-year at $1.54 billion, overcoming the headwind from the drawdown in backlog in the comparable quarter. At the same time, total bookings increased year-over-year and more importantly, the sequential growth rate approached pre-COVID, pre-supply chain norms. Unified SASE and SecOps delivered strong growth along with software while product sales recovered more than expected. We continue to see significant progress from our investments in both pillars and saw strong pipeline growth of 45% for Unified SASE and 18% for SecOps. Both pillars are gaining significant momentum within our installed base is over 90% of Unified SASE and SecOps billings are coming from existing customers. Larger enterprises continue to be our largest customer segment. with large and mid-enterprises combining to represent 86% and 82% of Unified SASE and SecOp solutions, respectively. Within Unified SASE, 40 SASE buildings continue to grow at triple-digit rates as existing customers can seamlessly integrate our solution within minutes to secure their hybrid workforce. While 40 client customers are able to use a single agent to secure Internet, private and SaaS applications. We've also integrated 40 AP with 40 SASE for securing thin edges and unmanaged devices. Our Unified SASE solution continues to gain market recognition. For the second consecutive year, we've been recognized as a challenger in the Gartner Magic Quadrant for single vendor SASE with the third highest placement in the ability to execute access. And as mentioned earlier, we are further improving our FortiSASE solution by adding powerful data loss prevention capabilities from Next DLP. Rounding out the billings commentary, the SMB was again the top performing customer segment, while international emerging was again our best-performing geography. On an industry vertical basis, technology and transportation grew at double-digit rates, while service provider and manufacturing were more challenged. Turning to revenue and margins. Total revenue grew 11% and to $1.434 billion, driven by service revenue growth and software licenses. Service revenue of $982 million grew 20%, accounting for 68.5% of total revenue. Service revenue growth was led by 36% growth in SecOps and 27% growth in Unified SASE. As noted on Slide 5, Unified SASE includes SASE and related technologies together with SD-WAN. Product revenue decreased 4% but better than expected to $452 million. Excluding the impact of backlog, product sales growth improved 14 points quarter-over-quarter and a similar amount year-over-year. Software license revenue growth continued to accelerate at 26% and represented a high teens percentage of product revenue, a nearly 5-point increase in the software mix year-over-year. Combined revenue from software licenses and software services such as cloud and SaaS security solutions, increased 32%, accelerating from 23% a year ago and providing an annual revenue run rate of over $800 million. Total gross margin increased 360 basis points to a quarterly record of 81.5% and exceeded the high end of our guidance range by 400 basis points, benefiting from higher product and services gross margin as well as a 5-point mix shift to higher-margin service revenues. Product gross margin of 66% increased 250 basis points year-over-year, mainly due to increased software mix and lower indirect costs. On a quarter-over-quarter basis, product gross margin increased from 56% to 66% as hardware demand increased and inventory levels and related inventory charges moved closer to historical norms. Service gross margin of 88.6%, increased 240 basis points as service revenue growth outpaced labor cost increases and benefited from the mix shift towards higher-margin FortiGuard Security subscription services. Operating margin increased 820 basis points to a quarterly record of 35.1% and was 840 basis points above the high end of our guidance range, reflecting the record gross margin as well as cost efficiencies within the business. Looking at the statement of cash flows summarized on Slides 16 and 17. Free cash flow was $319 million for the quarter and $927 million for the first half of 2024, or $1.1 billion after adjusting for real estate and infrastructure investments. Cash taxes in the quarter were $252 million. As a reminder, last year's second quarter benefited from the deferral of approximately $190 million in cash tax payments which were ultimately paid in the fourth quarter of 2023. Infrastructure investments totaled $23 million. Average contract term in the second quarter was 28 months, flat year-over-year and up 1 month quarter-over-quarter. DSO decreased 7 days year-over-year and increased 2 days quarter-over-quarter to 68 days. While we did not repurchase shares in Q2, share buybacks have totaled $5.3 billion over the last 4 plus years and the remaining buyback authorization is $1 billion. Now, I'd like to share a few significant wins from the second quarter. In a 7-figure deal, an international government agency purchased 12 solutions across all 3 pillars, including 8 SecOp solutions. This new customer selected Fortinet because of our operating system's ability to consolidate over 30 networking and security functions into a single unified platform, covering SecOps, SASE and Secure Networking. The customer was impressed with the integrated security, end-to-end visibility and automated response features of our FortiOS operating system. Next, in a 7-figure win, a large utility company, expanded our partnership by signing their first enterprise agreement with us to safeguard their OT environment. This deal displaces 5 legacy vendors and includes ruggedized equipment deployed to the customers' power plants, control centers and substations. Keys to this expansion win were our proven expertise in securing critical infrastructure and our price for performance advantage. And lastly, in a competitive displacement win, our retail store chain purchased our FortiSASE solution in a 7-figure deal. This customer chose Fortinet because of our integrated FortiOS platform, as they were able to seamlessly integrate FortiSASE with their existing Fortinet security solutions. Now I'd like to offer some comments on customer inventory digestion and the firewall refresh cycle. Last quarter, we pointed to a 25% improvement in the number of days of registered FortiGuard contracts from its peak and view this as an early but soft indicator of that "inventory digestion" at end users appear to be normalizing and the firewall market could start to show signs of recovery. To provide an update on this indicator and other signs of possible improvement in the firewall market, we can share that as shown on Slide 19, in the second quarter. The days of registered security service contracts improved another 12 days and has now returned to 2020 pre-supply chain, pre-COVID crisis levels. Inventory commitments and levels are normalizing at our contract manufacturers and in the channel. And as noted earlier, the sequential increase in hardware sales in the second quarter aligned more closely with historical norms. While these indicators are positive, we believe customers are currently managing a tough macro environment and a key election year in the U.S. and we believe this is having an impact on our customers' purchasing decisions. As a result, we believe a full refresh cycle is unlikely to occur in 2024 but more likely in 2025. Moving on to guidance. As a reminder, our third quarter and full year outlook which are summarized on Slides 21 and 22, it's subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call. Before reviewing the outlook, I'd like to offer a few modeling notes in light of our Lacework and Next DLP acquisitions, covering estimates included in our Q3 and full year guidance. For billings, the acquisitions increased Q3 by approximately 0.5 point and the full year by approximately 1/3 point. Total revenue increased Q3 and full year growth by 1 point and 1.5 points, respectively. For gross margin, they decreased Q3 and full year margins by less than 0.5 point for each period. For operating margin, they decreased Q3 and full year margins by 3 points and 1.5 points, respectively. Inclusive of these acquisition-related estimates, for the third quarter, we expect billings in the range of $1.530 billion to $1.600 billion which at the midpoint represents growth of 5%, revenue in the range of $1.445 billion to $1.505 billion which at the midpoint represents growth of 10.5%. Non-GAAP gross margin of 79% to 80%. Non-GAAP operating margin of 30.5% to 31.5%. Non-GAAP earnings per share of $0.56 to $0.58 which assumes a share count of between $767 million and $777 million. Capital expenditures of $40 million to $60 million. A non-GAAP tax rate of 17%. And cash taxes of $125 million to $145 million. And again, for the full year, inclusive of the numbers we gave a moment ago, we expect billings in the range of $6.400 billion to $6.600 billion; revenue in the range of $5.800 billion to $5.900 billion which at the midpoint represents growth of 10%. Service revenue remained of $3.975 billion to $4.025 billion which at the midpoint represents growth of 18%. Non-GAAP gross margin of 79% to 80%, Non-GAAP operating margin of 30% to 31.5%. Non-GAAP earnings per share of $2.13 to $2.19 which assumes a share count of between 767 million and 777 million. Capital expenditures of $320 million to $360 million. Non-GAAP tax rate of 17% and cash taxes of between $525 million and $575 million. I look forward to updating you on our progress in coming quarters. Before we begin the Q&A session, it is with deep sadness that we recognize the passing of our friend, Peter Salkowski, our SVP of Finance and Investor Relations. Peter was an integral part of the Fortinet team for over 6 years and was renowned for is passion for mentoring and developing the next generation of leaders. We'll miss Peter and fondly remember his commitment to fostering talent and nurturing potential within our company. I know that Peter worked closely with many of you on this call and the outlining of condolences and heartfelt memories you've shared since his passing clearly shows the positive impact he had on so many people's lives. Peter took great pride in his contribution to Fortinet and rightly so. having contributed to increasing shareholder value from $8 billion to $46 billion during his tenure Fortinet. We'll miss Peter. Thank you, Keith. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. [Operator Instructions] Our first question comes from the line of Brian Essex of JPMorgan. Brian Essex Sorry for your loss. Keith, if I could maybe touch on the margins. I think it's incredible margin results for the quarter. Could you help me understand or maybe unpack outside of the obviously, the gross margin benefit that you saw in the quarter. Maybe help me understand where you saw better cost efficiencies, how sustainable are they particularly in light of the effort to incentivize the channel and the sales force to focus more on selling SecOps and SASE with maybe some incremental effort? Keith Jensen Yes. I think the gross margin is the largest driver of what you saw in the operating margin, particularly when you look at it on a quarter-over-quarter basis and in that, we talked about or made reference to a more normalized environment for us in terms of inventory levels, turns and what we're seeing with channel inventory but also commitments to our contract manufacturers. So I think that we've been working through that for probably the last 3 quarters, maybe 4 quarters. And with that, I would say, I think we've returned to a more normal state and so I would expect that to continue on. I think we're getting a little more contribution from sales and marketing than maybe I'd like at the moment and I would expect us to make a little bit more investments there as we go through the second half of the year. Keep in mind, we're getting a very large group of salespeople as Ken made reference to from both the Lacework and the Next DLP acquisitions. But I think we feel certainly comfortable with the guidance that we've given for both Q3 and for the full year on the margin line. Brian Essex Great. Maybe just a quick follow-up. How should we anticipate the impact of the operating margin to reflect on free cash flow as we look through the rest of the year? Should we look at historical spread between margin and cash flow margin and maybe estimate kind of ballpark the same kind of spread? Or are there going to be more puts and takes like timing of tax payments that are going to mess with that free cash flow margin as we fine-tune our models? Keith Jensen Yes. I don't -- I mean, I think it's a good starting point is to look at the improvement in operating margin flowing through to free cash flow. Some of the changes that we monitor would be things like contract duration but you've seen now that industries and companies have been talking about contract duration for several quarters and you really haven't seen that come through to us yet. I should say, yes, habits going to come through to us. And so I'm not I think we have opportunity to leverage our balance sheet more with our customers and prospects that we have. But I don't see over the next 90 days or 180 days, a dramatic shift in that area. One moment for our next question. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Hamza Fodderwala I'll echo my condolences for Peter and his family, we'll definitely miss them. Keith, I wanted to follow up on the margin question because obviously, it was a very strong beat, I think a lot more than any of us were expecting historically, Fortinet has kind of managed the business towards the 25%-plus type operating margin run rate. I'm curious, is this the new base that we should sort of think Fortinet goes off of longer term? Or is it sort of a onetime margin outperformance given what you saw on the gross margin side coming out of the inventory digestion headwinds? Keith Jensen Yes. Again, I think the inventory part of that is I think we've worked our way back to a more normalized state. So I think that is our business model going forward for it that way. There can always be something that changes but I don't see us anticipating something in the gross margin line and that is by far and away the biggest opportunity there. I think it also says that we clearly have the opportunity to more -- invest more in go-to-market than we did in the first half of this year. And I think we've factored in some of that investment ideas or those ideas in our forecast and our guidance. In terms of whether or not I make Ken Cry, when I increase the margin the way I did, that's a different topic and I'll let him respond to that. Ken Xie Also, we'll benefit from the service revenue which has a much higher margin compared to the product revenue. So once the product starts growing, because product has a lower gross margin, that probably will impact the margin but the product is also the leading indicator of future service. So that's where we kind of also were happy to see the product also starting growing now which I think going forward with the product has a higher percentage, that probably also will impact the margin. Our next question comes from the line of Fatima Boolani of Citi. Fatima Boolani I wanted to share my condolences for Peter, he was just a fantastic person and he will absolutely be missed. Keith, I wanted to zero-in on your comments regarding software license growth. You talked about that accelerating 26% year-on-year, I believe and now it constitutes a high-teens percentage of your product revenue, I wanted to understand what are the drivers behind that massive mix shift and how we should think about the trajectory of this mix shift in the context of your guidance for the remainder of the year and bringing into consideration some of the hardware digestion, potential prolonging comments that you shared as well, if you can help us square that away? Keith Jensen Yes. I think the software license, if you kind of step back and look at what the business model is not to make it only simplistic, we want to -- it's so compelling to start with the firewall and it's very compelling to start with the ASIC. So a physical part of it, we don't always do that but we almost always start with a firewall, whether it's physical or virtual. Really, what you want to do is get the operating system in the hands of the customer. And what form factor that takes is we're fairly agnostic about that. So once that happens, then you start to see the knock-on effect of either selling more firewall use cases and other form factors into organizations or you're seeing that full portfolio, the SecOps product line take hold as continuous to expand throughout organization. So I would expect that we're going to continue to see tailwinds and growth, no doubt about it from the software part of the business. Will there be a mix shift that slows a little bit when firewall and FortiGate starts to return? Sure, absolutely. But this has been a trend that we talked about a little bit, I think, last quarter and probably some earlier quarters about the software mix and the mix shift that we've been seeing. So I would expect that, that's going to continue on given the success we're seeing in the other 2 pillars. Ken Xie In the FortiSASE and FortiOS, we see customers setting turn around more and more function which also enable more service for us. At the same time, the FortiSASE Secure Ops has also fully pretty much our service base and plus a lot of secure a high percentage in software compared to the hardware on the secure networking part. So that's both helping drive the additional software and licensing growth. Our next question comes from the line of Gabriela Borges of Goldman Sachs. Gabriela Borges Either for Ken or for Keith. On the firewall refresh cycle, I can appreciate your comments on not expecting to see a recovery in 2024. Share us a little bit more detail on why you think we'll see it in 2025. And -- to what extent are customers giving you an indication that they will be refreshing in 2025, perhaps as we get through the election and some of the macro or perhaps because of their updated depreciation plans? Any color on why you think the timing will be 2025 would be helpful. Ken Xie I think it's probably more Keith. I think the rest of the year probably still pretty tough to make an environment where the election or some interest rate is still pretty high. The money cost is pretty high that's where some companies may not really want to spend some long-term investment which is drive the product revenue and building infrastructure, so that's what we view. Also, if you look at it historically, every 4 years -- 4 to 5 years, the network here or another network in our security they need to be refreshed for faster, more function layer. So that's where we feel when we're starting this supply chain issue, they artificially put up the since lag started in 2001 [ph], maybe next year will be pretty much full year cycle now. So some company may start looking to refresh the product they purchased 4, 5 years ago, especially in certain vertical like retail, some other we see pretty strong growth in early days of a supply chain issue and we feel probably in the next 1 to 2 years, they may starting to return to see some investment on the infrastructure. On the other side, we see the big trend we always believe, always a hybrid mode, even there's -- like we have a very advanced SASE infrastructure side but also to secure OT/IoT area, to secure a lot of infrastructure, work for home and we do need an appliance in the field. And also even for SASE, we do offer both cloud-based SASE and also on premise-based private SASE. So that also needs some hardware to support in local for the customer. Our next question comes from the line of Tal Liani of Bank of America. Tal Liani The fact that -- can you go back to the fact that billings, you made 2 acquisitions this quarter, you didn't change the billing guidance for the year but you did beat the numbers for this quarter by $20 million, so in effect, you reduced the billing for the next 2 quarters. What are the drivers in billings? I know we spoke about it in the past but what are the drivers for billings and what's the outlook for billings going forward? Second question is your -- you grew revenues by 11%. But when you look at OpEx, they're flat. And you don't do buybacks now what's the outlook for buybacks? And what's the outlook for OpEx? Will it start growing now that you started executing on revenue growth. Keith Jensen Tal, I think I kind of missed -- very, very faint on your questions there. Maybe if you can give us maybe a little later recap of the 2 questions you had. Ken Xie I think that get some part about the 2 acquisitions impact on billing. I believe the post-acquisition, I think, Lacework maybe this year will contribute or maybe... Keith Jensen Yes. I think that -- I mean if you kind of look at the recap of the year, there's not a lot of variability in it, if you will. We are a little bit light in the first quarter, we came back and recovered the first quarter shortage in the second quarter. Now you see us looking at the third quarter and maybe taking that just a little bit off of some of the Street numbers and looking to see a little bit of that back in the fourth quarter. But we're kind of taking the third quarter correction to the Street numbers and putting it into the full year number. But yes, offsetting a very, very similar amount in terms of what we expect to get from the acquisitions and that leaves the full year range very much intact. And I understand that tick up is quick, I understand part of that is I'm taking -- I'm getting inorganic benefit in that number of the 0.5 point that we talked about at the -- and really taking down the organic part of the business. But again, I think we're talking about small numbers here. Tal Liani Got it. My second question can hear me okay now. But my second question was about OpEx that was flat and no buybacks. What's the outlook on those items? Keith Jensen Yes. I think the OpEx is probably a little lighter on the sales and marketing line than maybe we would like to see, particularly as we start looking at more opportunities as we get into the second half of the year and into 2025. So hopefully, we'll find some opportunities there to make investments. Obviously, you're going to get a fairly significant movement there from the 2 acquisitions that we just did and we gave the number about what the OpEx impact is going to be, that will largely be in sales and marketing. Buyback, I think that we still remain being opportunistic and that opportunistic number changes every 90 days as we reset our plans. Ken Xie Yes. And also, in the market, whether the private company, public company, we see the multiple probably more friendly for [indiscernible] compared to the last 2, 3 years. So we should go back to more reasonable so that we see some opportunity there. Our next question comes from the line of Rob Owens of Piper Sandler. Rob Owens Curious relative to the macro and obviously a lot of cross currents out there, maybe what you're seeing via your different customer sizes and different theaters? Keith Jensen Yes. I think because we are so diversified, as you kind of alluded to, 70% of the business is international and a little bit less than 30% in the U.S. And yes, there's been a lot of elections around the world this year but it's certainly the U.S. election, maybe weighing on people and every kind of taking a position of waiting to see. As you move -- pull back from that, the international emerging part of the business has been strong, very strong for several quarters and continues on to be. A lot of those are oil-producing countries and similar. So I think they've done well in this economic cycle. There are a little more risk there perhaps with geopolitical events in some of those countries. But to this point, it really hasn't had an impact there. We are much more likely to be the number 1 market share when you move outside the U.S. and parts of Europe and the Middle East and Latin America and parts of APAC. And I think having an incumbency advantage, if you will, helps you in those more challenging times because you're there, you're on site and you have that opportunity to cross-sell and upsell your installed base. Ken Xie In the U.S., last next growing area which also needs more direct marketing, direct sales. That's also need more investment. So that's where we do plan to invest more into sales and marketing to keep gaining market share in the U.S. Rob Owens And Keith, if you contemplate these acquisitions and a little bit of mix shift to software and I realize hardware is weak right now with the potential recovery next year. But how are you thinking about billings duration? You shave some off the back half and I think some of that's probably the mix shift towards software as we kind of look overall at the model and the increase in revenue but as we contemplate 2025, how should we think about billings duration and potential compression with more cloud-based or software deals that are likely shorter in nature? Keith Jensen Well, I look forward to seeing you in November at the Analyst Day and we'll talk more about 2025 and midterm numbers. But in the interim, I would probably say that if it's a white space account in some of these places like Lacework would be, for example, I think it's going to be much more prone to having a shorter duration contract. If it's part of that 90% of be selling SecOps or SASE solutions to my installed base. What I'm seeing to this point is my installed base continues to purchase in terms of contract duration, the way they have historically. So they haven't -- if I sell something from the SecOp portfolio into one of my firewall customers, they tend to sign up for a longer duration contract than you may see from a point solution vendor. Our next question comes from the line of Shaul Eyal of TD Cowen. Shaul Eyal Keith or Ken, so listening to Keith's commentary about the potential refresh cycle not taking place in the second half of this year but most likely during 2025. And again, not trying to front run the November Analyst Day but should we be thinking about 2025 accelerating over 2024? And again, I know you don't have the current visibility to guide to '25 but just conceptually, is it fair to assume another year of double-digit growth? Ken Xie We do believe next year, there's -- I think first, overall, we see the long-term convergence -- networking convergence to network security, we're still keeping going. That's why we do give the CAGR in secure networking area is about 15% year-over-year growth. If you look in the investor presentation slide for about which page. But on the other side, we also see a lot of new opportunity, whether in the OT area in the Unified SASE and also upsell, cross-sell which are all helping driving, I would say, probably like a 90% customer initially moved by a FortiGate getting the firewall and network security market first which we have a huge advantage over competitors. But after that one, they're keeping expanding beyond the network security, go to the other area. So that's what's happening for the Unified SASE for the Secure Op. And now the product, especially on the FortiGate firewall side we're starting to see kind of go back to normal or starting growing with the market now. So, we do feel probably next year will be whether the refresh cycle which after -- that's where the existing customer, if they have the product for 4, 5 years, that's probably the average turn starting to refresh. And so we do see probably next year, we're starting that process. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Brad Zelnick Keith, I think you called out the service provider segment is more challenged this quarter after being a strong performer last quarter. And I know it's lumpy and remains a top vertical as it always has been for Fortinet. But can you share an update on what's happening in that segment? And in particular, how your value prop and unified -- and focus on Unified SASE and SecOps applies in this important vertical? Ken Xie Yes. I don't feel the service provider telecom slowdown, it's really kind of lumpy and on the other side, we're also starting to see the telecom service provider more interest in offer their own SASE using our product solution or kind of helping customers do the private SASE, localized SASE which also will helping drive our long-term growth. But I do believe long-term wise, the service provider will be if not the biggest, probably one of the biggest part of the whole cybersecurity business because they have the infrastructure, they have the customer relation, so we still want to keep a focus on the service provider area. But for them, it's really the sales cycle resting is long and the deal pretty big, like 8-figure deal. That's where the lumpiness probably impacted the quarterly. But if you look at more long-term multi-quarter annually, I don't believe it's still keeping growing. Keith Jensen Yes, Ken is spot on, right? It's a lumpy industry. Financial services can be to at times as well. But I think more importantly, I think the conversations around their own independent SASE solution that they can bring to market is something that's getting a lot more conversation from the service providers. I think we saw it first internationally and we're starting to see a little bit more of it here domestically. But that's going to -- that's a pretty exciting opportunity if it continues to move forward. Brad Zelnick Just a quick follow-up on the very impressive operating leverage that you've shown us particularly on the sales and marketing line, where I know, Keith, you said that it's more than you'd like to see at this point. But just structurally, like to see it down, albeit very slightly sequentially on a dollar basis, especially as you outperformed on the top line and billings this quarter. I'm just trying to understand like where it comes from? And is there anything structurally that change that we should be thinking about, whether it's commission deferral rates, channel rebates or anything else other than headcount? Keith Jensen Yes. I think there's a few things going on there. I think probably 9 months ago, we looked at the cost structure pretty closely. And across a number of areas. And the first place that people kind of look at and when you're in that vote is marketing programs and they get hit pretty hard early on. And I think you're trying to see that roll through you do make changes to your compensation programs, whether it's for direct salespeople or for channel people or what have you. And I think maybe as we're coming out of that environment now, it's important for us to kind of revisit some of those decisions and making sure I kind of talk about the investment opportunities that we have in the sales and marketing line. And I think I would include the channel net as well. It is why I would say that to your point or you're repeating me, probably a little bit lower than we would have liked it to have been in the second quarter. And I think we'll continue to make go-to-market investments here in the second half of the year. Ken Xie Yes, I agree with Keith. We're starting tracking more carefully for the ROI for each investment in marketing sales and also try to improve the efficiency with the marketing sales. On the other side, we are a little bit behind on hiring in the sales and marketing side which we intend to accelerate. So that's actually what will drive the future growth. Our next question comes from the line of Adam Tindle of Raymond James. Adam Tindle I just wanted to continue the margin discussion. Obviously, you had great product gross margin performance this quarter on top of those tight cost controls. And the question really is around pricing dynamics in the core firewall business from here. The supply chain sounds like it's clearly normalized. You've had multiple years of price increases during this period of time. What are your expectations of the pricing dynamic in core firewall from here? What would it take to maybe even consider reducing price back to historical at some point? And any comments that you want to make on the competitive environment in light of this? Ken Xie I think we have not increased the price in the last few quarters. I think that because we still believe we have a huge advantage with FortiASIC, FortiOS technology has a more function better performance, lower total cost of ownership and also energy cost. So we feel we're keeping that advantage over our competitors. On the other side, we don't see any pressure to also decrease price all kind of discount more. So that's where we feel we're keeping pretty stable for the price. And at the same time, that the customers see the benefit of our product solution and with better performance, more function which also will drive the future service. I think the bigger environment also, we don't feel changed much. Definitely, we see that the inventory all go back to normal weather on kind of inventory and also the channel inventory. That's also more helping driving the healthy behavior in the business also in the supply chain area. Maybe Keith has something to add. Keith Jensen Just to repeat what Ken said, maybe a little more granularity. I think the price increases that you referred to, we're really probably a late '21, 2022 impact. And I don't think we're really raising prices at '23. We did take some prices down at the end of '23 and in the very beginning of 2024. But that's really been the only pricing actions we've taken in the last 6 months. And then to Ken's point, I think we're at a moment where we think it's probably -- the value for the solution is very, very strong. I think the energy costs that Ken mentioned is starting to get -- it's gotten a lot of traction internationally in Europe but you're starting to see more conversation around that in the U.S. and that could be people concerned about energy consumption and issues with AI and EV and government actions on manufacturing. So I do think the energy cost advantage is coming into play more. And then last one on that discounting was, I think, very much in line. I think we actually improved discounting meaning higher prices by about 1 point quarter-over-quarter and kind of a similar number one way or the other for the full year. So we obviously have room given the margins to use discounting and pricing as a lever. But I think there's other things that we'd like to push on first. Our next question comes from the line of Adam Borg of Stifel. Adam Borg Also condolences on Peter's passing. He's certainly missed by all of us. We'd love to talk about the Next DLP acquisition. Maybe talk a little bit more about what's attracting you to the stand-alone enterprise data protection market overall and Next DLP in particular? John Whittle This is John Whittle. There's a lot of positivity around that. We obviously just announced it today, we closed it yesterday. We did a lot of diligence on the company, The tech is great. And not only will we plan to offer it stand-alone but also integrated with our FortiSASE solution. And so I think it's another step in steadily bolstering our FortiSASE solution, We feel very, very confident in our strategy there. For the most part, as you know, I mean, we've done some tech and talent tuck-ins. Most of our technology is organic I think to some of the earlier questions, you think about the firewall market coming back next year. And we really just started kind of organizing our solutions into these 3 pillars less than a year ago and the amount of progress we've made and the execution we've made in kind of developing very, very competitive solutions in SASE and SecOps in addition to secure networking is pretty impressive. And I think this is an important step along the way to continue to develop the best SASE solution out there to protect our customers. Adam Borg That's great. And maybe just as a quick follow-up there, John. Maybe just could you comment on current level of sales force productivity for SASE and SecOps and the opportunities for improvement from here? Just general sales force productivity as you've gone through many months at this point of training and just ramping of the ability to sell that across your company globally. John Whittle Yes. No, it's a really good question. I think what we're seeing is it does take time. We are very focused on that broad sales enablement I always say, I mean, the opportunity just abounds from our solution set and we're always with a customer-first focus. So in terms of protecting and serving our customers the opportunity to bounce I think our sales force -- the good news is they have a ton of opportunity. I always say they're going to suffer more from indigestion than starvation. But we've got really a big focus in the company to really train up that sales force, enable that sales force, make sure we have the incentives in the right place and make sure we have the support. So when they do qualify different opportunities in different solution sets, the support to support them in that sale. So I think, like Keith had alluded to, we often land with the firewall and then expand and get that support to our sales force with SASE and SecOps solutions and we're seeing a lot of success there. Our next question comes from the line of Saket Kalia of Barclays. Saket Kalia Tip my cap to Peter as well. We're going to miss him. Ken, maybe just to start with you. I wanted to get into just the firewall refresh for next year a little bit. I mean you've seen so many refresh cycles over the years. How would you sort of compare this upcoming cycle versus others in the past? And maybe touch on how SASE and sort of -- maybe what sounds like a higher mix of virtual might sort of play into that? Ken Xie Yes, agree. There's the infrastructure probably different than the last refresh cycle. You see more hybrid working environment, whether working remotely and also more supporting broad connection, including connect all this OT/IoT device level. For the SASE, we always believe also should be a hybrid SASE environment, not just cloud only. You do need to have a private SASE, some other local SASE offer by service provider. And also some time, the SASE also need secure some device which cannot install a software agent like using a FortiAP, FortiSwitch to secure this agent is device. So that's where we feel this also will always kind of the unified SASE will be the long-term future. We believe we also combine both the hardware and the software and infrastructure and appliance together. So that's where the refresh. On the other side, network security is always probably the biggest market -- I mean it has been the biggest market in cybersecurity for probably 30 years now, 20, 30 years and keep expanding because more people devices get connect and more application to access or even as cloud, you do need to secure on the network side. So that's what we see when you try to access the network side and also the long-term convergence of network in network security, that's also what drives the refresh. That's also you can see the Gartner research we pointed out, the convergence of network in the network security also starting or accelerating. So originally, I think last year, they say by 2030, the secure networking will be larger than traditional networking. Now they say, 2026, 4 years ahead, the secure networking will be larger than the traditional networking. So that's where we really invest long term on this trend. And with all this FortiOS, FortiASIC and making the best both appliance and infrastructure, the ASIC technology and at the same time, also try to investment more in the sales and marketing area to really catch the trend and also keep gaining market share. So that's the strategy to be ahead. Saket Kalia That makes a lot of sense. Keith, if I could fit in one quick follow-up. Just on the software mix in product, I think you said, call it, roughly $800 million run rate. Can we just touch on, even anecdotally, roughly how much of that is sort of virtual firewall versus SecOps? And I realize they're coming in at software gross margins. But can you put a finer point on that and sort of what that aggregate business might be coming in at from a gross margin perspective as we think about that gross margin shift long term? Keith Jensen Well, I think whether it's a virtual firewall or any other software product or the software licenses are all coming in at very, very attractive margins. I think that when you look at some of the SaaS solutions that are sitting in the services line for SecOps and so forth, you get a very wide range of margins there but it's only because of the relative size or maturity of the solution. Obviously, something that's very new and absorbing a lot of the hosting cost is a little harder. But those aren't as big numbers. As you see those SecOps solutions get greater and greater traction and more critical mass, the margins start to normalize. I think kind of what's really been exciting is the ability to absorb those data center POP, colo, everybody's got their hand in the products and on these things, cloud provider fees and developing the SaaS solutions and still bring up the services gross margin. And by the same token, being able to absorb the charge for Lacework on the operating margin line because we've managed the business in terms of cost of goods sold for the product side, I think we're really, really pleased with how those 2 things will work hand in hand. Our next question comes from the line of Joseph Gallo from Jefferies. Joseph Gallo I also want to echo my condolence to the team and Peter. Sadly, big shoes to fill. I just wanted to double click on what drove the better performance in product in 2Q? Was there some large deals or region, segment or vertical that stood out, especially since you don't expect the refresh benefit until calendar '25? Keith Jensen No, great question. I mean we've talked about 8-figure deals and our size 8-figure deals can kind of still will around, as you saw in the fourth quarter last year, we did 6 of them. We had one 8-figure deal, Q1. We had 2 in Q2. So I would wouldn't attribute to that. I think what we saw the last month of the quarter and particularly as we got into the last week of the quarter, what you see in a strong market is a lot of deals started to fall in place and we're getting across the finish line. I think we saw a lot more positiveness if you will, at the end of Q2 than maybe we saw say at the end of Q3 or something like that last year. Joseph Gallo Okay. And then just on a follow-up to that. And I think it was a follow-up to Fatima's question. Given that mix shift, you now expect in the second half, given the delayed refresh, what is your confidence or visibility into the billings re-acceleration in the second half? Do you, in theory, have more visibility now, given that it's less hardware based? Or how are you thinking about that? Keith Jensen Yes. I don't think that the form factor really impacts the visibility in terms of what's in the pipeline or how we work with the sales teams in terms of forecasting. I've not noticed a difference, if you will, in close rates between a virtual machine and a physical machine. Ken Xie Yes, we probably would do some more deep study to maybe on Analyst Day, we'll give some color next year and also some midterm model on November 18 which also the 15 anniversary of IPO. This concludes the question-and-answer session. I would now like to turn it back to Aaron Ovadia, Director of Investor Relations. Aaron Ovadia Thank you. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs and Oppenheimer during the third quarter. We will also be holding an Analyst Day on November 18 where we expect to update our medium-term financial model. The webcast link will be posted on the events in the Presentations section of Fortinet's Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Porch Group, Inc. (PRCH) Q2 2024 Earnings Call Transcript

Daniel Kurnos - The Benchmark Company Jonathan Bass - Stephens Steven Hromin - Oppenheimer Ryan Tomasello - KBW Jason Kreyer - Craig-Hallum Capital Group Good afternoon, everyone, and thank you for participating in Porch Group's Second Quarter 2024 Conference Call. Today, we issued our earnings release and filed our related Form 8-K with the SEC. The press release can be found on our Investor Relations website at ir.porchgroup.com. Joining me here today are Matt Ehrlichman, Porch Group's CEO and Chairman and Founder; Shawn Tabak, Porch Group's CFO; Matthew Neagle, Porch Group's COO; and Michelle Taves, GM Porch Group Media, Data and Marketing. Before we go further, I'd like to take a moment to review the company's safe harbor statement within the meaning of the Private Securities Litigation Reform Act of 1995, which provides important cautions regarding forward-looking statements. Today's discussion, including responses to your questions, reflects management's views as of today, August 6, 2024. We do not undertake any obligation to update or revise this information. Additionally, we will make forward-looking statements about our expected future financial or business performance or conditions, business strategy and plans, including the application and formation for the reciprocal exchange based on its current expectations and assumptions. These statements are subject to risks and uncertainties, which could cause our actual results to differ materially from these forward-looking statements. We disclaim any obligation to update publicly any forward-looking statements whether in response to new information, future events or otherwise, except as required by applicable law. We encourage you to consider the risk factors and other risks and uncertainties described in our SEC filings as well as a risk factor information in these slides for additional information, including factors that could cause our results to differ materially from current expectations. We will reference both GAAP and non-GAAP financial measures on today's call. Please refer to today's press release for reconciliations of non-GAAP measures to the most comparable GAAP measures discussed during this earnings call, which are available on our website. The financial information provided today is preliminary, unaudited and subject to revision upon completion of the closing and audit processes. As a reminder, this webcast will be available for replay, along with the presentation shortly after this call on the company's website at ir.porchgroup.com. I'll now turn the call over to Matt Ehrlichman, CEO, Chairman and Founder of Porch Group. Over to you, Matt. Matt Ehrlichman Thanks, Lois. Good afternoon, everybody. Thanks for joining us today. We have some great progress that I'm excited to share. First, our insurance profitability actions, including utilizing our unique data, continues to result in attritional losses being significantly better than planned, and substantial year-over-year improvements in our insurance gross combined ratio. Second, we have refiled the reciprocal exchange application. This gets us a step closer to what we believe is the optimal structure for scaling with reduced exposure to unusual weather events. And as we'll share more today, we are excited to announce that we've launched our home factors data products to help third parties improve the risk assessment and marketing. We have home factors for virtually every home in the U.S. to identify important information about the property, all uniquely known by Porch. Our results in the second quarter were solid despite continued macro headwinds while we budget and plan for catastrophic weather based on our historical experiences, trends and buffer for volatility. In the past three months, there have been two uncommon weather events, both so rare that they are classified as more than one in 10-year occurrences. In May, Houston experienced a hurricane-like event with a 100-mile an hour sustained winds, which impacted our second quarter by $23 million net of reinsurance. More recently in July, Hurricane Beryl was a Category 1 hurricane as it progressed through Houston and is expected to impact our third quarter by $30 million net of reinsurance. We want to highlight these rare events as our execution related to what we control was very strong. Overall, in the second quarter, revenue grew 12% to $111 million. Revenue, less cost of revenue, grew 10% to $19 million. Adjusted EBITDA loss was $35 million, an $8 million improvement over the prior year and right about on track with our plan. Again, the May Houston cat event lowered revenue less cost of revenue and adjusted EBITDA by $23 million. We saw continued strong underwriting execution in our insurance business leading to lower claims versus our expectations, price increases leading to higher profitability in our software businesses and overall strong cost control. Shawn will take you through those details shortly. Unexpected weather will happen periodically in the homeowners insurance industry. And while disruptive for policyholders and near-term results for the impacted period, it creates long-term opportunity for the industry at large. It means we and the industry will continue to raise prices and will fuel significant expansion in the size of the homeowners insurance market. Operating as a reciprocal exchange can help mitigate weather and claims volatility while still being able to participate in the growth of this industry. This, in our mind, is a very exciting place to play. And as I mentioned, we're very pleased today to announce the key milestone of filing our new and updated application to create the Porch Insurance Reciprocal Exchange with the Texas Department of Insurance, and we are working closely with the TDI targeting approval later this year. As a reminder, as proposed, at launch, the HOA carrier will be sold to the reciprocal for a surplus note back to Porch Group, with all parties, with all policies, premium, losses and certain costs such as reinsurance, will move into the reciprocal entity, which will be owned by its policyholders similar to a mutual company. The reciprocal will pay claims directly from its balance sheet. We at Porch Group will handle the day-to-day operations, receiving fees as a percentage of gross written premium. Importantly, our expenses will be less volatile than they are today and will include mostly fixed costs, such as employee salaries. We're excited about what this will mean for our customers and our future, transition to a more predictable, higher margin and lower volatility at Porch. Along with the reciprocal application, we also announced today that Porch Group has contributed 18.3 million Porch shares to HOA to support this critical planned transition. This contribution helps to bolster HOA's balance sheet strength and rating after Q2 weather impacted surplus. And in addition, the contribution strengthens HOA's long-term surplus position, which better positions HOA for any future third-party surplus note capital raising efforts and importantly, is expected to support premium growth in 2025 and beyond. HOA will hold the shares on its balance sheet, and we currently do not expect the shares to be sold. The value is then included in HOA's surplus, which had a healthy buffer as compared to regulatory requirements at the end of Q2. To the extent that Porch stock increases then, this would grow HOA surplus. If and as we execute and increase the value of Porch Group, this can create an important and long-term opportunity in a flywheel. Additional surplus translates into supporting more premium for HOA and the reciprocal. We believe more premium would drive more fee-based income and profit for Porch Group post reciprocal. We would expect more profit at Porch Group to increase our valuation over time, in turn, increasing surplus reciprocal and HOA. We believe we're set up for a very exciting future ahead. A last few quick notes before I turn the call over to Shawn. Our software businesses remain resilient and delivered growth despite a sluggish housing market, which declined 3% year-over-year in Q2. Our warranty business launched a new product called Surge Protection. And although early days, we are seeing strong conversion through our moving concierge channel. Michelle Taves, who joins us today and leads our data division for Porch, who's going to share more about the progress with Home Factors, including new clients and case studies. We see a great deal of promise here given both the uniqueness and demonstrated value of our data. We mentioned previously that we are vigorously pursuing parties concerning the Vesttoo fraud, which was discovered in 2023. In Q2 of this year, our legal firm hired on a contingent fee basis filed suit against two parties. These things take time, so we'll look to update you as further as it progresses. And last, finally, we've been recertified as a great place to work again this year with year-over-year improvements in key metrics that we track. My goal from the outset of founding Porch was to build a truly great and enduring company and ensuring we're a great place to work with a set of values that are real, is critical and core to making this happen. Before we get into the detail, I'll provide some high-level thoughts on our financial performance in the second quarter. Overall, we're pleased with the second quarter being broadly in line with our expectations. Attritional claims outperformed our expectations and the related loss ratio improved over the prior year. This is a testament to the insurance profitability actions we discussed previously around the three Ps: product, price, and portfolio. As Matt noted, these are the things we can control, and the team executed well against these. This was offset by the May Houston cat event which drove volatility in the quarter. I'll give more details on that shortly. In our software business, we saw improvements in our profitability driven by price increases as we execute our strategy to roll out new functionality for our customers while increasing price. And importantly, we remain diligent with strong cost control. Now let's take a closer look. Revenue was $110.8 million in the second quarter of 2024, a 12% increase over the prior year, driven by our Insurance segment, which grew 22%. Revenue, less cost of revenue, was $19.2 million with a margin of 17% of revenue, consistent with the prior year. Overall, the vertical software revenue less cost of revenue margin increased approximately 800 basis points to 83%, offsetting growth in the lower-margin insurance segment. Adjusted EBITDA loss was $34.8 million, an $8.4 million improvement over the prior year, with all segments contributing to the improvement. As a reminder, on the seasonality of our business, Q2 is typically when we see the lowest adjusted EBITDA for the year given weather-related insurance claims. We continue to focus on controlling and reducing operating expenses such as audit fees and contractor costs. In the second quarter, sales and marketing expenses, as a percent of revenue, decreased by 400 basis points over the prior year. Similarly, product and technology and G&A also decreased as a percent of revenue. Gross written premium was $117 million, a decrease from the prior year as we focus on profitability and nonrenewal of higher risk policies. The nonrenewals were completed this quarter, impacting our insurance KPIs, which Matthew will discuss shortly. The insurance segment was 71% of total revenue in the second quarter, an increase from 65% in the second quarter of 2023. Revenue from our Insurance segment was $78.3 million, a 22% increase over the prior year. This was driven by 28% increase in premium per policy and lower reinsurance seating, which more than offset the decrease in policies in force due to the nonrenewals and the Q1 sale of our legacy in-house insurance agency, EIG. Vertical Software segment revenue was $32.6 million, a decrease of 5% over the prior year. Within that, the software and services subscription businesses increased 4% over the prior year, driven by price increases in Rynoh and inspection and overall, was offset by the moving business. Shifting to claims costs in our insurance segment. Here, we break down the cost of revenue between attritional and other costs and catastrophic weather claims. In the second quarter, attritional claims performed $17 million better than anticipated. Additionally, our typical seasonal catastrophic weather claims also performed better than we anticipated. In the second quarter, the May Houston cat event drove approximately $23 million in cost of revenue, net of reinsurance to the point of it being categorized as a one in 10-year event. In HOA's 15-year history, it had never experienced something like this. So while this was unfortunately one of the years where this wind event occurred, this was largely offset with strong execution against the areas within our control. Moving to adjusted EBITDA by segment. Overall adjusted EBITDA loss was $34.8 million in the second quarter of 2024. The insurance segment adjusted EBITDA loss was $27.3 million, an improvement of $3.9 million over the prior year. The vertical software adjusted EBITDA was $4.8 million, a $3 million improvement over the prior year, driven by price increases in our software and services subscription businesses and cost control. The vertical software adjusted EBITDA margin increased to 15% in the quarter. Client retention remained strong at 98% in Rynoh in the second quarter. Corporate expenses were $12.2 million or 11% of total revenue, a 300 basis point improvement over the prior year with strong cost control. Stepping back from the quarter, let's take a look at our performance in the first half of 2024. Year-to-date, we've delivered revenue of $226 million, a 22% increase over the prior year, driven by the insurance segment. Adjusted EBITDA loss in the first half of 2024 was $52 million, a $13 million improvement over the prior year. Our Insurance segment adjusted EBITDA loss was $30 million, an $8 million improvement over the prior year. Our Vertical Software segment adjusted EBITDA was $6 million, a $4 million improvement over the prior year driven by price increases and cost control. Corporate and other expenses also decreased year-over-year. Operating cash outflow was $26 million in the second quarter of 2024, and $18 million for the first half of 2024. As of June 30, we had $410 million in cash, cash equivalents and investments. And excluding the $293 million of HOA, Porch held $117 million, broadly in line with the prior quarter. Additionally, Porch Group held $11 million of restricted cash and cash equivalents, primarily for our captive and warranty businesses, and a $49 million surplus note from HOA. HOA surplus at June 30 was approximately $40 million. This number includes approximately 18 million Porch Group shares, contributed into the HOA to which a discount is applied per our insurance accounting rules. Since the shares are held by HOA, a wholly owned subsidiary of Porch Group, and are not owned by a third party, the shares are eliminated in our consolidated financial statements. They are accounted for as treasury shares. And therefore, these shares are excluded from our weighted average shares outstanding when calculating earnings per share. Moving on to guidance. Today, we are updating our full year 2024 outlook for our profit metrics. Our updated profit guidance is primarily driven by three items. First, as I mentioned, in Q2, we saw a strong performance against the things we can control, including underwriting performance and related attritional losses in our Insurance business, price increases in our Software business and strong cost control. This has been offset by two catastrophic weather events, which fall outside the range of our typical expectations for catastrophic weather included in our original guidance. The first was the $23 million May Houston cat event in Q2. The second is another weather event, Hurricane Beryl, which made landfall in Houston in the first week of July, that we expect to have $30 million in claims costs through revenue, net of reinsurance in Q3. We are reiterating full year 2024 revenue of $450 million to $470 million, with growth of 5% to 9%. As I noted last quarter, we expect growth to be front-end weighted with a tough comp in Q3. And as a reminder there, in Q3 of 2023, we had lower reinsurance seating in those higher revenue immediately post the Vesttoo reinsurance fraud discovery. Last year, we called out the revenue impact of this as $30 million in Q3 of 2023. We expect revenue less cost of revenue of $190 million to $200 million, which incorporates the items I've mentioned. Again, any incremental cat events exceeding historic trends are not included in our guidance and would negatively affect the range. Overall, we expect adjusted EBITDA loss of $20 million to $10 million, which incorporates the items I've mentioned. At the midpoint, this is a decline of $22.5 million from our previous adjusted EBITDA guidance. Given this now includes $53 million of additional costs related to the two weather events, this highlights the degree of our business has outperformed that which we control and what our normalized results would have been expected to produce. This guidance indicates that our second half of 2024 is still expected to be more profitable than the $21 million of positive adjusted EBITDA we produced in the second half of 2023, despite Hurricane Beryl. Although we are guiding to what is most probable, I will note, we have not lost sight of our full year profitable target and are working towards that, maximizing efforts on what we can control. And finally, we expect gross written premiums of $460 million to $480 million. Thank you all for your time today. And I'll now hand over to Matthew to cover our KPIs. Let's look at our KPIs. The average number of companies was 29,000 in Q2, slightly lower due to the mortgage title and inspection industries continuing to feel pressure from the housing and refinance markets and fewer companies operating for the time being. There are signs of possible changes to interest rates and home sales growth beginning in 2025, which we clearly would welcome. Average revenue per company per month increased 17% to $1,253 over the prior year, driven by lower seating and premium increases. We had 231,000 monetized services in the quarter, 5% lower than the prior year. Average revenue per monetized service was $395, up 19% from last year due to continued growth in insurance. Looking now at our insurance segment KPIs which, as a reminder, included EIG Insurance Agency in 2023, which we have since divested. In the second quarter, gross written premium was $117 million from 232,000 policies in force. As Shawn mentioned, these KPIs were impacted by nonrenewals completed this quarter, and this process is now complete. Annualized revenue per policy was $1,348, an increase of 161% from the prior year, driven by premium increases and lower seating. Focusing now on HOA, our insurance carrier, annualized premium per policy increased 28% to $2,059. Premium retention was 88%, lower than the prior year, driven by the nonrenewal actions. Our gross loss ratio was 117% in Q2. On Slide 21, we present the gross loss ratio split by cat and attritional losses. As Shawn said, our attritional losses outperformed. Our attritional gross loss ratio was 21%, 14 percentage points better than prior year. As you can see in the chart, this was offset by catastrophic weather claims with the cat loss ratio increasing 11 percentage points year-over-year to 96%, of which 22 percentage points were from the May Houston event. The overall current year gross loss ratio was 117%, an improvement from 120% last year. Our gross combined ratio in Q2 was 124%, an improvement from 180% last year, which again goes to highlight that even in Q2, which is a quarter in our year with the most losses, the amount of improvement we have made to the insurance business. Last quarter, we discussed the three Ps driving our strong underwriting performance. Today, we'll also outline our expectations for premium growth. First, product we'll continue leveraging our unique data, which is crucial for our insurance profitability. Michelle will elaborate on this shortly. We're also revising deductibles and policy terms like introducing a roof schedule that adjusts replacement value based on the roof's age, thereby reducing our risk and mitigating customer price increases. Second, on price. The slide shows a 28% increase in earned premium per policy over the prior year, reflecting adjustments for a high frequency, high severity environment. In part due to the recent weather events, we anticipated continuing to raise prices meaningfully. Third, portfolio. We completed nonrenewals of unprofitable policies and are now starting to work through reopening certain ZIP codes and geographies that we had closed in order to manage the premium levels of our business to current levels. Given the progress we have made overall, we are ready for growth, and we expect premium to increase nicely in 2025 and beyond, both adding policies and step up in rate. Thank you, everyone. I'll now turn over to Michelle for our quarterly deep dive. I am Michelle Taves, GM of Porch Group Media, Porch's Data and Marketing Solutions Division. I've been with the business for nine years with my 30-year career being spent focused on creating data products for many types of use cases and customers. I am super excited about where our business is and the opportunities that lie ahead. Porch Group Media, formerly V12, was acquired by Porch in January 2021, and we've rapidly evolved into a leader in mover marketing and data products. We've upgraded our data platform and now leverage unique data on properties and consumers. Through our solutions, we help brands to reach consumers who have important and time-sensitive needs for home improvement projects and when purchasing a new home. Recently, we launched Home Factors, which offers detailed property and homeowner insights, allowing companies to reach the right consumer at the right time, and helps them better assess risk and pricing for their services. Today, I'm going to explain the use of our unique property and consumer data and how we can gain an underwriting and pricing advantage for our homeowners insurance business. Additionally, I'm going to highlight some new data products we're launching to assist other companies that we're targeting in noncompetitive markets. Porch's extensive property and mover data is structured into intelligence and combined with other sources to form a vast data platform with billions of data points. This enables us to generate predictive insights, including Home Factors for nearly every property in the U.S. We long utilized machine learning and recently, we're incorporating new AI technologies to rapidly structure and extract insights from our data. Our data platform team is innovating at an impressive pace, now producing a new Home Factor every few weeks, allowing us to continually bring impactful products to market. Our insights cover both interior and exterior property details such as type of pipe, roof condition and water heater location, providing valuable information on property condition and risk that would be impossible together any other way. One of our Home Factors is the presence of water intrusion. Imagine knowing which properties are likely to have a water stain on the wall, rust around the water heater or corrosion near washing machine pipes. Historical claims data shows a strong correlation between these signs and future water claims. By identifying homes with these risks, we can accurately assess and price them. Our data suggests that about 65% of HOA's policyholders should face an 8% to 10% surcharge, while around 30% could receive a 20% discount on premiums. This allows carriers to set pricing more accurately for lower or higher risk customers or avoid underwriting higher-risk customers likely to generate a claim. It also rewards and encourages homeowners to take care of their home. We are really excited to announce that we are currently in market monetizing Home Factors, and we're encouraged by the early testing we're seeing. After two years of quietly developing unique valuable products, we've proven their advantage with our insurance carrier, HOA, who uses the data, delivering top-tier loss ratio performance. Today, I'm excited to share three use cases, demonstrating how we are monetizing the data while maintaining our competitive edge. First, we're targeting third-party insurance carriers in noncompetitive states to use Home Factors. Early results match our findings with HOA showing significant correlation between our insights and claims frequency and severity, provide proving value for pricing and decision making. Second, a large retailer is using our data to market to their customers more effectively. Instead of broad-based ads, they're using Home Factors like window repair needed or roof replacement required to pinpoint the right consumer at the right time within their database, leading to a 30% increase in purchase intent signals. Third, a home security company improved customer retention by 8% and reduced cancellations by 9% using our Mover Match program. Mover Match identifies customers in the process of moving, allowing businesses to connect with them early in the decision-making process. This is particularly valuable for mover solutions as the first to contact the consumer often wins the business. Overall, we're still early in our journey, but we are thrilled at the progress we're making, and we are eager to release additional Home Factors in Q3 of this year, and we have a robust road map ahead of us that will remain unique to what Porch can provide. Thanks, everyone. I'll hand it over to Matt to wrap up. It's a big deal for us. I'm very excited to want you continue to progress. I'll say that there are several significant high-margin opportunities ahead for Porch. And certainly, the opportunity to monetize impactful data products is one of those. To wrap up, one of the other high-margin opportunities is, of course, our homeowners insurance opportunity and business and how it scales, particularly following the reciprocal launch. As we mentioned, we'll keep the market informed on progress and updates as we continue forward in 2024. Once approved, we would expect to host an Investor Day. And at that point, we'll drive more details on the higher-margin economic model and forward-looking guidance. We're committed to continuing to write profitable homeowners insurance business and expect to grow premium nicely in 2025 and beyond. While we revised our adjusted EBITDA guidance range to include the known July hurricane event, we are still focused on this full year positive adjusted EBITDA objective. We aim to continue our track record of strong execution on what we control, and we'll be maximizing all efforts to achieve that goal. We aim to execute vastly over the remaining five months of the year, and again, do expect to have a very high profitability second half. We have a number of catalysts ahead and are excited to deliver for you all. With that, we'll wrap the prepared remarks and pass the call to the operator. Rob, if you can go ahead and open up the call for Q&A. [Operator Instructions] Your first question comes from the line of Dan Kurnos from The Benchmark Company. Your line is open. Daniel Kurnos Thanks. Good afternoon. Just two quick ones for me. I guess, Matt, it's always tricky walking the fine line between opening up the aperture and preparing the scale. And then obviously, you get these cat events that hit cash flow. So I'm just kind of curious on your sort of willingness now to invest in growth near term or more thoughts on derisking the portfolio until you get the TDI approval. And then on Home Factors, I just -- I mean, any more color on how we should think about the data opportunity V12 had retail exposure, which we heard about today. And so it's kind of a broad brush. So I just love to think about either the TAM or how we should think about that impacting the P&L. Matt Ehrlichman Yes. Happy to. Maybe I'll take the first. And Michelle, why don't you take the second. The -- so I mean, in terms of growth, Dan, kind of what we're talking about today is we don't think these events really change our plan. Obviously, you could see in our P&L this year, we just -- our business is just core outperformance could have absorbed one of these one in 10-year events, not two of those one in 10-year events. And -- but the reality is, is that we see what's happening in terms of attritional losses. We see how the business -- the core business is performing on a run rate basis. And we're not that far away in terms of our expectations from being able to get the business, in our view, again, optimally structured through the reciprocal. So like Matthew and I both mentioned, we are through that period of nonrenewals and it is time to start unlocking ZIP codes will get closed and really starting to position and open up growth, which we do expect to be able to again grow premiums nicely in 2025. Sure. Sure. I guess a few points. I would say that we're at the very beginning of our journey. We are very optimistic for the opportunity. There's tons of valuable predictive insights that are growing across the industry. So we know that for sure. We have proven case studies, and we're seeing some positive results with HOA and validation across other businesses. So we're feeling really confident. We've already started monetizing the product, and we're having a great deal of conversations across different industries. And I think the final point I would say is I've had the opportunity to create many data products over my career, and I've never had so much excitement from clients as I've seen with home Factors in such a really short period of time. Matt Ehrlichman And maybe I'll just layer on two quick thoughts. I think it's all perfectly said. One, is it's fun to start unpacking this, Dan, I think, just for the market. Obviously, this has been our strategy and our plan for some time. It's been a bit since we had acquired V12 and there's been a lot of, I would just say, core fundamental work to be able to get to this time, where we're able to kind of share that we are now out monetizing some of these really cool, very unique data products with third-party partners. Again, it's not like it's a big surprise to me, I suppose, that there's strong interest in the market because, one, we have data about properties that no one else has. And we have Home Factors now for virtually every home in the U.S. And two, we know definitively with all the work we've done with Homeowners of America over the last set of years with that data, that it creates real and substantial value and being able to predict risk. And so the market is going to, I believe, be really excited about it, which means it should become a really meaningful business for us. It should be very high margin. And it's really accretive to everything you see today. So again, we're at the beginning of the journey, but it should be a fun time. And if we really pull it off, Michelle nails it and knocks it out of the park, once you get those first set of third-party partners using the data, well, you start to create momentum in the market where now everybody really needs to use the data to be able to be competitive. And that's happened in a variety of times across multiple different data companies. And so we think that we're positioned really well there. Your next question comes from the line of John Campbell from Stephens. Your line is open. Jonathan Bass Hi, guys. This is Jonathan on for John. Thanks for taking my questions. So drilling down on your vertical software revenue, particularly the portion that's transactional, would you expect that rev to outpace the national market when a housing recovery begins? Or would you say that rev is more closely tied to the national relocation or corporate moves market? I was going to say the vertical software segment. I just peel back the onion there. We've seen the overall housing market continue to be soft and struggle this year. And really, we have two types of businesses there. We have our more traditional software and services businesses. Those we saw growth this quarter of around 4%. And to your point, Jonathan, we had the moving businesses where we saw a decline more consistent with the overall housing market decline. I think our opportunity there as the housing market recovers is as there's more folks that are moving, I think we have a good opportunity to beat the market there and grow our revenue in those businesses really nicely. The another thing I'll point out also on -- from a profitability perspective, those businesses have improved profitability quite substantially over the last couple of years, even in this down housing market. So I think as the market recovers, we will get additional leverage there from the more profitable structure -- cost structure we have for those businesses in the years to come. Matthew Neagle I would just add two small points. One, to build on Shawn's profitability. These businesses are very scalable, and so we can handle many more transactions with little to no variable cost. And so you're going to see whatever impact you see on the revenue, there's going to be significant flow-through to the bottom line. The other thing that you mind is some of those businesses monetize refinances. And so there's kind of two markets we can monetize. One is the moves in the real estate transactions, and we will certainly benefit as the market recovers, but then also as interest rates decline and the refinancing market comes back, that will also be a tailwind for us. Matt Ehrlichman Last thing to add, just to make sure it wasn't missed. Just -- I'm not sure if people understand that there's two ways that we feel pressure right now in the market. Matthew hit the transaction volume with both home sales and refinance. But the other is, if you just think about these companies that are operating in these markets, it's just harder to run a business. So there's fewer companies that are out there. So as the market turns around, not only will there just be more transactions, which falls straight into our systems and into revenue, but you'll also just have more companies that are joining and entering into these markets, which gives us more businesses to be able to sell to and partner with. Jonathan Bass Got it. Thank you. Thank you for the color there. And then as a follow-up. Looking at insurance, in recent quarters, you guys have exited certain states where you felt like you couldn't be profitable. Would you ever consider exiting a market like Houston where these wet cat weather events are occurring and seem to be occurring on a consistent basis, it almost seems like? Matt Ehrlichman Yes. I would say we would, of course, consider whatever creates the most shareholder value in the long term. Certainly, we are pragmatic and that is our focus, to go build a great long-term business. We do not think that means exiting Houston to be quite -- Houston has actually been over time for HOA, an attractive and highly performing market. Now obviously, there's going to be a recency bias because just in the last three months, there were two of those events. But we do think that overall, that market is well suited for us and to be effective and profitable going forward. The only other thing I would add is, again, just to stress the point, when these events happen, yes, it is unfortunate for those near-term results, but it creates a lot of opportunity in the market. And so we do think there -- it means that there will be meaningful price increases because at the end of the day, carriers, insurance carriers are going to make sure they're priced to be able to generate profit. And so we will certainly follow along with what the market would do there. Your next question comes from the line of Jason Helfstein from Oppenheimer. Your line is open. Steven Hromin This is Steve Hromin on for Jason. So just two questions from us. One is, why did you guys decide to update the reciprocal application? I'm just wondering what kind of information changed versus once you initially applied whenever that was, let's say, it was like nine months ago or so. And then secondly, does your updated full year guide assume any improvement in the housing market within either of your segments? Matt Ehrlichman I'll take the first, and Shawn or -- if you'd like to take the second. When we say update the reciprocal application, really, we're talking about just getting the reciprocal application back on file. So if you recall, more than a year ago, we were on file. We had to pull that back when there was that -- the Vesttoo fraud reinsurance partner that we had worked with. We worked with the TDI to be able to wait the appropriate amount of time, make sure the business was just performing really well, healthy. We certainly crossed the key milestones that we needed to. And now we've refiled the application. In terms of updates, you're really just updating for actuals that have happened over this period of time. But the core strategy and what we're implementing certainly remains the same. Shawn Tabak Yes. With respect to the housing market, we continue to expect a fairly stagnant housing market. And so that's what we've considered in our guidance for now. Certainly, any positive momentum there would have an impact. But we've continued to be, I think, more on the conservative side of what we would expect there. Your next question comes from the line of Ryan Tomasello from KBW. Your line is open. Ryan Tomasello Hi, everyone. Thanks for taking the questions. On the reciprocal exchange regarding the $18 million -- 18 million share, excuse me, contribution to HOA, was that figure determined with the consultation of TDI? And then the $40 million statutory surplus figure that you cited, is that a pro forma figure that's fully burdened for 2Q cat and the 3Q cat from Hurricane Beryl? Or is there something timing dynamic there that has yet to flow through to fully bake in that impact for the $40 million? Shawn Tabak I can take that. Maybe I'll just start with the second one real quick. So that's our June 30 surplus number for HOA. We said approximately $40 million. So that's burdened by the cat that we saw in May for the Houston event. As we look forward here, one thing I would just point to is second half of the year is typically when we generate the most surplus at HOA. And in particular, with the increases in profitability that we saw this year, one data point we look at is, last year, in the second half of the year, our insurance segment did -- generated about $50 million in adjusted EBITDA. And not all of that goes to HOA, but I think it can just give you a sense as to the scale even without the additional work that we've done this year and we saw in our results in the first half, as to the general seasonality of our business and how we generate more profits in the second half of the year. The first question was about the share contribution. We, of course, contributed $18 million -- 18 million shares, excuse me, into HOA. A couple of things on that. It bolsters the balance sheet. The company independently -- to answer your specific question, the company -- we decided to do it because it has the strategic benefits that we talked about. I think Matt showed the flywheel where you can -- adding the shares in strengthens the long-term surplus. That supports future premium growth, additional premium growth in 2025 and beyond. And then we can also benefit from future appreciation of Porch shares there by adding additional -- creating additional surplus, which again, creates the opportunity for more premium. And under the reciprocal model, as we noted, that generates fees for Porch Group. I think it's also a strategic benefit. So as we launch the reciprocal, I think we can create strategic alignment with the reciprocal after launch and importantly, as we bring in external capital sources there to further generate surplus or increase surplus there. So I think the net from all of that is it supports HOA's transition to the reciprocal. And so those are really the reasons that we thought it was the right thing to do. One technical point I think that we called out, just so folks understand, the shares, they're not traded currently. They're not included in weighted average shares outstanding when we calculate our earnings per share. They're effectively treated like treasury shares. So there's -- they're not voting shares at the moment. Matt Ehrlichman One last point on the HOA's surplus. Ryan, I think I know where you're going and just one thing that Shawn didn't note, just to make sure it's clear. The $30 million net impact side of Beryl is not just all HOA. We have a captive reinsurer as well that sits behind it. And so if you're thinking about -- your question might have been thinking about, okay, what happens to HOA surplus. We actually -- we expect HOA surplus to remain consistent and actually grow here as it goes throughout the year and remain in a strong position. So that's kind of what you were thinking about. We're well set up to make sure HOA continues to be healthy, and we do not expect additional contributions into HOA, including given Beryl. Ryan Tomasello Okay. Great. Thanks for clarifying that, Matt and Shawn. And then on the accounting treatment, Shawn, you already kind of touched on it, but I guess, a bit of an interesting kind of dynamic you're trying to understand if there's any triggering event for that accounting treatment to change once you hopefully get the reciprocal off the ground if, ultimately, those shares would be included in the consolidated share count after you deconsolidate HOA. Just trying to understand the accounting there on the math because clearly, this is real capital that was issued to backfill HOA's balance sheet. So if you can just walk us through how that accounting may or may not change going forward. Shawn Tabak Yes. Yes. I think one thing that's important to note is, in addition to the flywheel that we talked about and supporting more capital HOA, when we do the reciprocal exchange and effectively transfer HOA to the reciprocal, we'll get a surplus note back equal to effectively the net assets of HOA, plus or minus, some adjustments there. And so that would include the -- whatever the share value is at that point in time. And I guess, on the consolidated VIE accounting, we'll probably cover that at a future date. But for now, those are the additional sources of value and how we would operate there as the reciprocal is launched. Your next question comes from the line of Jason Kreyer from Craig-Hallum Capital Group. Your line is open. Jason Kreyer Great. Thank you, guys. So Matt, earlier this year, you talked about the addition of some hail and wind coverage you put in place. Just curious if that helped you at all in this quarter, if that's in a position to help you as we get into the back half of the year? Shawn Tabak Yes. I could take that one. Yes. So as a reminder for folks, I think what Jason was referring to, this year, we secured an additional kind of reinsurance product for severe convective storm parametric coverage. I think what we had articulated earlier this year, as we purchased $30 million of aggregate severe convective storm and that includes hail. And the coverage there was really geared towards a series of smaller storms or hail-related losses, which is really what we saw in the first half of 2023. And the approximate cost there for this coverage was about $5 million for the year. So a couple of things to note there. And that's just a reminder on what the product is. So a couple of things to know. It's an aggregate cover, so it's evaluated over the course of the full year. So we'll have more information on the cover received there later this year. Additionally, the other thing I'd note is that the May Houston event was primarily a large wind. It really was a hurricane-like event with wind speeds up to 100 miles per hour on the straight line and sustained basis. So as of now, we've not included any assumptions in our financials or guidance for that as of June. Jason Kreyer Okay. Thank you for that. And then just any early perspective on exposure to [indiscernible]. And I know that kind of just hit or is just happening. But just as we think through where you've got more density of policies, if you feel like you've got exposure there. Shawn Tabak Yes. So first and foremost, I think as Matt mentioned, our thoughts are with the customers and -- community rather, of those that are impacted by the hurricane. A couple of things to note. We don't write policies in Florida. We talked about a couple of quarters ago how we've moved out of Georgia. In South Carolina, we don't rank within 50 miles of the coast. And overall, I would say, in South Carolina, we've also reduced our exposure as part of the portfolio profitability actions that we talked about. So far, this looks to be mostly rain event. And as a reminder, we don't cover flood. So the event is obviously happening as we speak, but I think that can give some context as to our exposure in the region there. There are no further phone questions. Lois, do we have any written questions? Lois Perkins Thanks, Rob. We have one here. Shawn, you mentioned the full year adjusted EBITDA from profitable target. What are you doing to drive this? Shawn Tabak Yes, I could take that one. So I wanted to first make sure we are -- it's clear some of the things we talked today -- about today in terms of the improvements and the performance of the business. What we've guided to today is essentially a $30 million improvement year-over-year based on the midpoint of our full year adjusted EBITDA guidance. And that's even with $53 million of additional costs from these two one in 10-year events. And as we mentioned, I think today, a couple of times driven by the profitability actions, the price increases in software and strong cost control. Now we typically buffer for -- we have enough buffer for one, one in 10-year event. This year, it looks like we're having two, Beryl, obviously, in addition to the May event. So overall, if I just step back from that, I think what it highlights is the improvement in the business and also that what we have been presented this year is two, one in 10-year events. I'd say there are other things we're working on that are outside the scope of what we typically would include in our guidance to try and offset the impact of these items. And overall, we remain very focused on our profitability goals at the company. That concludes our question-and-answer session. I will now turn the call back over to Matt for closing remarks. Matt Ehrlichman Thank you. Thanks, all, for the questions. I appreciate it. As we talked about, it's a pretty exciting time and pretty new time for the company. Obviously, we're working hard to get the reciprocal on file and get the business structure in the ideal way that we would like to. And we're excited to share more when it's the right time around some of the details there. Per the question, we're excited and focused on growing premium while still executing on the profitability that Shawn just talked about. And hopefully, at some point in the not too distant future, some of the -- what has been headwinds like the housing market will start to turn to tailwinds. We know that will happen. It's just a matter of how far off in the future, and we will be able to benefit meaningfully as that does happen. And then lastly, maybe I'll just close with fun to be able to announce kind of the launch of a new key product, Home Factors, that has, we believe, again, a tremendous amount of potential and very high margins. With that, I appreciate everybody's time and the continued support, certainly. We will talk to you guys again at our Q3 earnings in November, until then. This concludes today's conference call. Thank you for your participation. You may now disconnect.

Shoals Technologies Group, Inc. (SHLS) Q2 2024 Earnings Call Transcript

Brian Lee - Goldman Sachs Mark Strouse - JPMorgan Chase and Co. Mo Chen - Truist Jon Windham - UBS Colin Rusch - Oppenheimer Philip Shen - ROTH Capital Partners Maheep Mandloi - Mizuho Securities Kashy Harrison - Piper Sandler Donovan Schafer - Northland Capital Markets Good afternoon, and welcome to the Shoals Technologies Group Second Quarter 2024 Earnings Conference call. Today's call is being recorded and we have allocated one hour for prepared remarks and Q&A. At this time, I would like to turn the conference over to Matt Tractenberg, Vice President of Finance and Investor Relations for Shoals Technologies Group. Thank you. You may begin. Matthew Tractenberg Thank you, operator. And thank you everyone for joining us today. Hosting the call with me is our CEO, Brandon Moss; and our CFO, Dominic Bardos. On this call, management will be making projections or other forward-looking statements based on current expectations and assumptions which are subject to risks and uncertainties which should not be considered guarantees of performance or results. Actual results could differ materially from our forward-looking statements. Risk factors include, among other things, those described in our filings with the Securities and Exchange Commission, including economic, market and industry conditions, project delays, defects or performance problems in our products or their parts, including those related to the wire insulation shrinkback matter, failure to accurately estimate the potential losses related to such matter and failure to recover those losses from the manufacturer, decreased demand for our products, policy and regulatory changes, supply chain disruptions and availability and price of our components and materials. Today's presentation also includes references to non-GAAP financial measures. You should refer to the information contained in the company's second quarter press release for definitional information and reconciliations of historical non-GAAP measures to the comparable GAAP financial measures. Please note, that the slides you see here are available for download from the Investor Relations section of our website at investors.shoals.com. Before we begin, I want to remind our audience that Shoals will be hosting its first Analyst Day for research analysts and institutional investors on September 5 in Nashville, Tennessee. Our extended management team will present our strategy, growth drivers and investment thesis. Formal presentations will be followed by a factory tour and evening reception. If you're interested in joining us in person, please reach out to me directly at [email protected]. A live webcast will also be made available for those wishing to join virtually. I'll begin with second quarter highlights, followed by an overview of market trends, and then discuss our updated outlook. I'll then cover the team's progress at Intersolar and provide an update on warranty remediation and our ongoing ITC intellectual property litigation. Finally, I'll wrap up with some customer highlights before handing the call over to Dominic, who will review our financial results for the quarter and the 2024 outlook. I'm pleased to report second quarter results exceeded expectations both on revenue and adjusted EBITDA. Q2 revenue of $99.2 million declined 16.7% from the prior year period but increased 9.3% sequentially. The year-over-year decline was largely a result of broader market disruptions we and others have been discussing this year and which I'll review in a moment. Gross margins of 40.3% declined by 210 basis points from the prior year period, driven by lower sales volumes and higher labor costs, but expanded 10 basis points sequentially. Adjusted EBITDA was $27.7 million for the period, down $20.5 million from the prior year period as a result of lower revenue and adjusted gross margin. We added $126 million of backlog and awarded orders to end at a record $642.3 million for the second quarter. While we're increasingly positive on long term outlook, we are not immune to near-term challenges many are experiencing within the U.S. utility scale solar market. To provide some context, 56% of planned installations in gigawatts are experiencing delays of six months or more. Almost 70% of installations are experiencing delays of any duration. Total gigawatts experiencing any delay now totals %41, up 15% from prior year period. And as of June 2024, U.S. Energy and Information Administration Form 860M on time installs and gigawatts are at their lowest level in 18 months. As a result of these delays, we continue to experience incremental pushouts during the second quarter, resulting in approximately $40 million of additional revenue moving from the current year into 2025. No cancellations occurred in the period. The reasons for delay remain consistent and include permitting lengthy interconnection queues, the inability to obtain transformers and switchgear in a timely manner, labor shortages and persistently high financing costs. We have no indication that these delays are unique to Shoals as customers have been candid in their feedback and share market expectations with us in real time. In fact, as you'll hear today, we believe that many of the strategic initiatives and focus are beginning to show signs of promise. As you would expect in a period of continued uncertainty around timing of rate cuts, ADCVD, a presidential election cycle, and supply chain disruptions, our book and term business was challenged as well, impacting our second half expectations. We take our commitments very seriously and believe setting realistic and achievable goals is critical to retaining the trust of shareholders. That said, while the underlying fundamentals of the U.S. utility scale solar market remains strong and compelling, project timing volatility persists. To account for this ongoing risk many are experiencing, we believe it's prudent to further reduce our full year 2024 outlook. Our revised outlook accounts for continued project delays and assumes minimal book-and-bill business for the remainder of the year. While we expect current challenges will resolve in time, strong tailwinds for low growth are expected to strengthen, driven by the growth of AI, the U.S. manufacturing renaissance and the electrification of transportation modes. We remain confident in solar's vital role and new power generation capacity for two key reasons. Utility scale solar remains quicker and more economical to deploy than conventional energy sources, and the major tech companies driving AI and data center growth have committed to powering these facilities with sustainable energy. These factors support our positive long-term outlook despite near-term uncertainty. While short term volatility is challenging for all of us, we remain focused on what we are building for the long term, a more resilient, consistent and diversified business. The impact of today's efforts will be realized in time, and we continue to believe that we are uniquely positioned to win in the marketplace. We will continue to focus on increasing our wallet share of domestic EPCs, expanding into previously unserved market segments, adding new products to our portfolio and moving into attractive geographies outside of North America. Moving to international. In addition to more than 130 customer meetings, we met with many of you at Intersolar in Germany in June. There, we unveiled our most comprehensive international product suite to date, launching new solutions for unobstructed rows, agri solar and north south configurations complementing our east west offerings. Our new prefabricated plug-and-play solutions eliminate the need for insulation piercing connectors, helping ensure durability in extreme conditions and protecting the long-term investment of developers. The lineup features globally certified versions of our U.S. products and innovations like SuperJumper, Trenched BLA, Mini BLA and Smart Combiner. These solutions are designed to simplify project design, reduce risk, accelerate timelines and cut costs while helping customers meet sustainability goals. These products significantly expand Shoal's international capabilities with our portfolio, which, based on conversations with customers, now address approximately 90% of their unique product needs. We continue to target Latin America, Australia, Southern Europe, Africa and the Middle East with an estimated collective opportunity of 63 gigawatts in 2025, more than double the U.S. market expectations. We look forward to updating you on our progress. Turning to our remediation efforts related to shrinkback on wire purchased from Prysmian, a former vendor, our potential range of exposure has not changed this quarter. Since our last update, we have become aware of two additional sites potentially displaying shrinkback. We continue to work with our customers to remediate known issues and further our understanding of remediation challenges and opportunities. In terms of the legal proceedings against Prysmian, we are working the process and expect written discovery and depositions to be completed by early next year. With regards to our ITC intellectual property litigation, the court's initial ruling was originally expected on July 12, but was delayed to August 16 based on the court's need for additional time. We continue to believe we presented a strong case in the protection of our intellectual property and await the initial ruling. Moving now to some exciting developments on the customer front. First, I'm pleased to see orders begin to appear from the EPC we signed a new agreement with in the first quarter. The relationship is off to a great start and I'm encouraged by the early traction. I'm also very proud to announce an expansion of our master supply agreement with Blattner, one of the largest EPCs in the market today. This agreement will add an additional 12 gigawatts through June of 2027 and is on top of the amount remaining on the existing MSA. We believe this expansion is a testament of the strong relationship we've built with this industry leader. We look forward to a long and productive partnership. Wins with existing partners are the most visible examples of the traction we see, but when we look deeper into our customer list, I'm even more encouraged. Through the first half of 2024, we've seen significant traction with customers who we previously saw wallet shares decline from. In fact, more than $130 million of our backlog and awarded orders as of June 30 is now from this subset of customers. Over the last six months, I've met with many of these customers myself and we've had very candid conversations about what they want and need from us. We believe we're turning the corner with many of them. We are gaining wallet share with these customers and appreciate their trust and support, and we intend on exceeding their expectations. Quoting activity continues to be at record levels as our value proposition remains compelling, particularly in an environment of rising labor and material cost. Notably, the amount of projects Shoals is quoting across all customers has increased by more than 50% within the U.S. utility scale solar market compared to just a year ago. In the first half of the year, a significant portion of our quote volume is with accounts beyond our top 20 customers. We are very positive about the opportunity ahead. In summary, while I'm pleased with our book-to-bill of approximately 1.3 in the period, I'm more encouraged by the quality and diversification of the order book. Our customer mix is improving and is a direct result of many of the things we've put in place over the last year, including expanding our outreach to underserved customers and enabling a deeper level of engagement within each account. Last quarter, we raised the subject of our revenue recognition as it pertains to industry capacity. While we provide this in the spirit of transparency and ongoing education for our analysts and shareholders, we believe it paints a valuable picture. I also think it's worth reminding you about our sales cycle. Because there is, in some cases, a significant lag in which we recognize revenue and when you may have visibility into that project. We believe we've done a great job growing our market share over the years and there are opportunities to expand it going forward. What is clear from the analysis, is that our sales cycle from first outreach through multiple engineering iterations to production to delivery and installation to COD is often in excess of two years. For example, some projects that went live in 2023 were recognized as revenue at Shoals as early as 2021. Approximately 10% of the 2023 COD was recognized as revenue in 2021, 70% in 2022 and 20% in 2023. Looking at the data from another angle, in revenue terms, not COD, 21% of projects associated with our 2022 reported revenues and 81% of those associated with our 2023 reported revenues have not gone live as of today. The average lead time from revenue recognition to COD is 13 months, consistent with what we've shared with you in the past but in some cases, it's more than two years and some projects go live in a short time after installing our solutions. What we glean from this analysis is the sales cycle has been lengthening, also consistent with past observations. Said another way, much of the commercial activity you see occurring today in 2024, from customer engagement to quoting to engineering will not be seen this year, but in years to come. That is a function of the size of the projects, the permitting and interconnection complexity which we all navigate, but also a function of the foundational changes we are implementing here at Shoals. Changes that are being put in place to prepare us for the market growth we see ahead and the expansion we tend on driving. Shoals brought the EBOS category to market first in 2008, so it shouldn't be surprising that we have leading market share. What might surprise you is that we've achieved that while addressing only a subset of the market, approximately 70% in fact. That 30% belonged to customers we either did not do business with or to projects that were smaller in size. That opportunity, that expansion of our served addressable market could be in excess of 30 gigawatts of capacity in the next three years alone according to industry estimates. Our goal going forward is to ensure all customers have the products and service they need to be successful in the marketplace. The changes we've made to our sales structure, product offering and marketing efforts are designed to do just that. In the last year, we built a formal product development function staffed with experienced electrical engineers who have already launched more new products than in the previous three years. We've improved and refined a marketing function that is capturing the customer voice, ensuring we meet their needs and is aligned with future market opportunities. Our new sales go-to-market pod strategy leverages a proven playbook to scale our business while improving touch points. Each of these critical functions are led by new, passionate business leaders who bring a wealth of experience, process and strategy to Shoals. Early indication is that these commercial initiatives we're executing on today are already making a difference. We can see it in the MSA expansion like Blattner's and other new commercial agreements with new customers we've signed this year and the composition of our awarded order book and the conversations with our customers I've been having this year. We are improving our customer service to existing accounts while expanding our offering into new market segments like CCNI, data centers and battery storage, and entering new geographies with new EPCs. We believe that what we are doing today will set us up for success in the years to come, but we like what we're seeing already and so do customers. With that, I'll turn it over to Dominic who will discuss our second quarter financial results and our outlook for the remainder of the year. Dominic? Dominic Bardos Thanks, Brandon. And good afternoon to everyone on the call. Turning to our financial results. Second quarter net revenue declined 16.7% to $99.2 million year-over-year, but increased 9.3% sequentially. The year-over-year decline in net revenue was driven by project pushouts, which resulted in lower demand for our products in domestic utility scale solar projects. Gross profit decreased to $40.0 million compared to $50.5 million in the prior year period. Gross profit as a percentage of net revenue was 40.3% compared to 42.4% in the prior year period, primarily due to higher labor costs and lower fixed cost absorption. General and administrative expenses were $19.2 million compared to $16.7 million during the same period in the prior year. The year-over-year increase in general and administrative expenses was primarily related to legal fees for the patent infringement and wire insulation shrinkback matters and planned increases in payroll expense. Approximately $1.4 million of G&A expense was specifically related to the wire insulation shrinkback litigation. Net income was $11.8 million compared to $18.9 million during the same period in the prior year. Adjusted EBITDA was $27.7 million compared to $48.2 million in the prior year period. Adjusted EBITDA margin was 27.9% compared to 40.4% a year ago, driven largely by lower sales and adjusted gross margin. Adjusted net income was $17.8 million compared to $31.2 million in the prior year period. Cash flow from operations was $37.8 million, while capital expenditures were $2.0 million. The strength in cash flow from operations was driven by an improvement in working capital, more specifically, a reduction in receivables. As you likely read our announcement in June, our board approved our first share repurchase program up to $150 million, with authorization to repurchase through December 31 of 2025. This included a $25 million of an accelerated share repurchase, which was launched in June and completed just last week in the third quarter. In total, we retired approximately 3.9 million shares at an average price of just under $6.40 per share. We funded the initial ASR using cash on hand in June, which allowed us to quickly allocate capital towards an opportunity that we believe provides an attractive long-term return for shareholders. As we said on last quarter's earnings call, we do not believe the current share price reflects the long-term value we are creating, and so we expect this authorization may be used opportunistically over time. We will continue to evaluate investment opportunities to deploy the strong free cash flow we see ahead, which first and foremost includes growing our core business, but may also include M&A. We will prioritize those opportunities with the most attractive return profile that aligns with our strategy. Moving to wire insulation shrinkback, as Brandon mentioned, based on our current knowledge and assumptions, the remediation range remains at $59.7 million on the low-end and $184.9 million at the high-end. During the second quarter, we spent $5.3 million in cash for remediation efforts and had a remaining warranty liability on our balance sheet of $46.0 million related to the shrinkback matter as of June 30. The current portion of the remaining liability is now $29.8 million. As a reminder, this represents the amount of cash we estimate we will consume during the next four quarters as we continue remediation efforts and does not reflect any potential recovery from Prysmian or increased reserves if our assumptions or knowledge of facts change. This figure is more than covered by our expected free cash flow over the same period. Our balance sheet remains very strong and we ended the quarter with net debt to adjusted EBITDA of 1.1 times, which is down from 1.5 times a year ago and a significant improvement from 4.4 times as of Q1 2022. Optimizing our balance sheet is crucial to maximizing financial flexibility and long-term growth. By carefully managing our assets and liabilities, we can ensure efficient use of capital, reduce costs and position the company to seize new opportunities as they arise. Turning to backlog and awarded orders as of June 30, 2024, we had $642.3 million in backlog and awarded orders, an increase of 18% year-over-year as the company added $126 million to backlog and awarded orders during the period. As we have previously discussed, some of our international orders have longer lead times than domestic orders and we are also winning domestic jobs that extend or have been delayed beyond our historical revenue cycle of nine to 13 months to realize revenue from awarded orders. As of June 30, approximately $465 million of our backlog and awarded order projects have planned delivery dates in the coming four quarters with the remaining $177 million beyond that. We are halfway through 2024 and are comfortable where we currently sit for next year. Our sales team is encouraged by the level of customer engagement and projects continue to come into our awarded orders for 2025 at a reasonable pace. As you would expect in a period of market uncertainty, there will be gives and takes as we make our way through the second half of the year, but our intention is to give you more clarity in the coming quarter. Turning now to the outlook. As a result of the current macroeconomic and industry uncertainty, we will continue to provide quarterly guidance for the remainder of the year. Based on current business conditions, business trends and other factors, the company now expects third-quarter revenue to be in the range of $95 million to $105 million, third-quarter adjusted EBITDA to be in the range of $25 million to $30 million. And fourth-quarter revenue to be in the range of $85 million to $105 million and fourth-quarter adjusted EBITDA to be in the range of $22 million to $31 million. These figures imply that for the full year 2024, the company now expects revenue to be in the range of $370 million to $400 million. This incremental change is reflective of the industry delays we're experiencing. I want to stress that we believe these changes reflect the timing of revenues, not lost projects. Adjusted EBITDA is expected to be in the range of $96 million to $110 million. Adjusted net income to be in the range of $62 million to $76 million. Cash flow from operations to be in the range of $62 million to $82 million. Capital expenditures to be in the range of $15 million to $20 million and interest expense to be in the range of $15 million to $20 million. With that, I'll turn it back over to Brandon for closing remarks. I would like to close by providing some additional color on why we remain so positive on the markets in which we operate and the transformation you're seeing at Shoals. Energy production is not meeting demand, that much is clear. What is not clear yet is what is going to be done to solve that problem. AI requires an enormous amount of power, and we believe the data center operators who are in an AI arms race are struggling to meet their net zero goals. And it's not just the data center operators, you might be among the 2.6 million people in Texas without power for days following Hurricane Beryl last month. A more robust grid is critical. It's getting worse, not better. All of us see more electric vehicles on the road today, and while we can argue the rate of adoption, we haven't seen anyone arguing that it's up and to the right. We believe the electrification of transportation is inevitable and it will strain the grid. No matter where you look, the trends we are embracing require more power, not less. We also know that solar power provides the most compelling economics. It's clean, accessible, and often the fastest to bring online, certainly as compared to nuclear, which estimates say could take a decade or more to stand up, and certainly more than coal, given the regulatory hurdles you need to navigate. We know Shoals brought to market the EBOS category for U.S. utility scale solar. We have an exceptional history of high quality, custom engineered solutions for our EPC customers. The rest of the world is navigating many of the same issues we are here, and while cheap labor is readily available, experienced electricians and engineers are not. Those EPCs are in need of many of the same solutions we provide today, and those discussions have already begun. We know that there are large portions of the U.S. utility and distributed generation market that have not been served by Shoals. We also know how meaningful the international market opportunity is for us and we know that operational excellence, including productivity and efficiency optimization is now top of mind. These market opportunities, when paired with the strong foundation we have and the new capabilities, talent and products we are introducing, set us up well for a successful future. We look forward to introducing those team members, discussing those capabilities, and letting you hear directly from our customers at our Investor Day, why Shoals is the partner they have chosen to do business with. I want to thank our customers and shareholders for their trust and our employees for their hard work. [Operator Instructions] The first question is from Brian Lee from Goldman Sachs. Please go ahead. Brian Lee Hi guys, good afternoon. Thanks for taking the questions. I guess, the first one I had was just on, you know, over the past three months, I guess, what has been the biggest incremental change here, you know, that's underscoring the revised outlook again downward for the second straight quarter. I guess, you know, we understand there's delays out there and your peers have been talking about how the environment's fluid, but it seems like the magnitude is maybe a bit more pronounced for you guys in terms of what it means to numbers versus others. So, just trying to reconcile why that might be the case? What's changed over the past three months for you specifically? And then, you know, maybe any comments you can share also on just the competitive landscape, because I know there's, especially with this revised outlook going to be incremental concerns around, you know, that potentially being an idiosyncratic factor in what's causing this update? And I had a follow up. Brandon Moss Brian, thanks. Good questions. A lot to unpack there. I guess, to tackle the first one first, really the big picture for us, quarter-to-quarter is it's more of the same. We talked about $50 million of project pushouts in the first quarter. We had about $40 million this quarter. So, the short term volatility, I know it's frustrating. It's frustrating for us. Again, I'd remind everybody, these are not lost projects. These are projects that are pushed out to the right. As it relates to, you know, the discussion around or the question around the competitive landscape, I feel better than ever about our commercial execution. We showed backlog and awarded order growth to record levels this quarter of $642 million, adding $126 million of backlog and awarded orders and a strong book-to-bill ratio of 1.3. So, I like how we're executing. I think our customers like how we're executing, as evidenced by our new extension to the Blattner agreement of 12 gigawatts, which is unbelievably exciting for this organization. What is also extremely exciting about our commercial execution is the quality and diversity of our order book. If you think about our order book last year this time, prior period Q2, about 77% of our backlog and awarded orders was made up of our top ten customers. That number is now 61%. I talked about in previous calls, you know, we had a handful of customers where we've lost wallet share and we needed to improve, $130 million of our backlog and awarded orders is now related to that customer subset. So, really happy with commercial execution. I think, you know, the challenges that we face are not unique to Shoals, are market driven challenges. And again, I couldn't be happier with how we're executing on the customer side. I think you have a follow up. Brian Lee Yes. No, that was super helpful color. I guess, you know, given your comments between Q1 and Q2, it's almost $100 million of, you know, pushouts, not lost projects. Do you have indications from your customers that that's going to, you know, progress in '25? You will actually be asked to deploy and ship that product in 2025? Or what's sort of the visibility into the recapture of that, you know, close to $100 million of pushouts you've seen through the first part of this year? Thanks, guys. Brandon Moss Yes. The project pushouts, look, as I've talked about in the past, myriad of reasons, you know, what we hear probably most commonly is site permitting and interconnection challenges. So, you know, these project -- we look at everything on a project by project basis. We have our customers and construction schedules in many cases, and we see these projects pushing out into 2025. Now, you know, I think I've been asked this question in the past, you know, is one plus one going to equal two for 2025? We see these challenges, you know, still persisting into the back half of the year. There are project delays and those are a challenge for us. So, you know, we will continue to monitor those projects on a project by project basis as we always do, Brian. The next question is from Mark Strouse from JPMorgan Chase & Co. Please go ahead. Mark Strouse Yes, good afternoon. Thank you very much for taking our questions. Curious if you can discuss the ASP trends for these new orders that you're booking and whether we should think of your gross margins kind of remaining in that low to mid-40s range that you've talked about previously? Just kind of trying to feel out if any of these headwinds, be it industry or company specific, if those headwinds are impacting your pricing power? And then I've got a follow up as well. Thank you. Brandon Moss Yes. Thanks, Mark. Thanks for the question. Good to hear from you. Yes, no changes to our guided margin of 40% to 45%. So, we still feel good about those numbers moving forward in this environment and environments in the future. Mark Strouse Okay. And then, just a quick follow up to clarify the 2Q bookings, does that include anything from this new Blattner agreement? And then, if you're able to, are you able to say how much of the original 10 gigawatt MSA with Blattner is outstanding? Brandon Moss Yes. So, just for point of clarity on how we calculate backlog and awarded orders because I do think it varies from company to company amongst our peer set. Backlog -- awarded orders are calculated when we've got a verbal commitment from the customer, the EPC, that they have won the project, and we have a substantial amount of engineering design work done. So, in the case of Blattner and this new agreement, none of the new 12 gigawatts would be included in our backlog and awarded orders because these are projects out into the future in which they haven't yet won, nor we have started designing. So, although we've got, you know, an agreement in place, it is not included in our backlog and awarded orders. As far as the original agreement, we'll provide, you know, specifics but you can think of that as maybe at the halfway point. The next question is from Jordan Levy from Truist. Please go ahead. Mo Chen Hi, thanks. It's Mo on for Jordan. I have two questions here. First one, in the press release you mentioned there are change being made in the planning process for this year and next. I know it's still too early to give guidance for 2025, but how are you thinking about activity levels based on your current commercial activity? Thanks. And I have a follow up. Brandon Moss Sure. Yes, as I mentioned, you know, during Brian's question, we're very pleased with our commercial execution. Quoting still remains at an all-time high. We're excited that our backlog and awarded orders have reached record levels. And we love a 1.3 book-to-bill ratio. So, you know, we feel very strongly about how we're executing our new, you know, we've got some new commercial strategies, new teammates, and I think we're doing quite well in that area. As far as 2025 goes, given the level of volatility with these projects and the relative uncertainty around delays, it's just too early to call the ball on 2025. So, I'm not going to do that. You have a follow up? Mo Chen Sorry. Yes, I was on mute. Yes. I mean, it's great to see international attempting to ramp and increase as a percentage to backlog. So, what dynamics are you seeing in those market, I mean, Africa, Latin America, Middle East, like you just mentioned? And how does that differ from what you're seeing in the U.S. in terms of project slowdowns? Thanks. Brandon Moss Yes. For the international business that we've got booked today, I would say, you know, large projects, longer sales cycles, as you can imagine, where these projects are just, you know, construction at its core is not as easy as it might be in a state here in the U.S. So, you know, longer project cycles is probably, you know, the biggest thing to point out. Look, we're excited about our international market opportunity. As I mentioned in the prepared remarks, 63 gigawatts of opportunities. We've got a new leader for that business. We have launched, you know, the largest suite of products we've ever launched one time just at Intersolar here in June, and the feedback we've gotten from customers has been fantastic. So, I like our chances in developing organic growth and our focus local markets. So, more to come on international, but great progress being made. The next question is from Jon Windham from UBS. Please go ahead. Jon Windham Hi, great. Thanks for taking the questions. I was hoping you could just help bridge the gap on. I think you had mentioned $40 million pushed out of 2024 to 2025. However, I think the total revenue cut was more like $790 million. Is that just go get business? That's not going to happen now? Just if you could help bridge that. Really appreciate it. Thanks. Brandon Moss Yes. Thanks, Jon. Yes. So, exactly $40 million pushed out into 2025. And look, this volatility in the marketplace has made it difficult for us to close typical book, and turn business within the year. So, I mean, you hit the nail on the head and that's what gets you to the numbers that you mentioned, just a challenging, volatile market. But again, pointing out on the project business that have pushed out, those are still good projects for us. Just to reiterate, no projects canceled in the quarter, just pushed out to the right. The next question is from Colin Rusch of Oppenheimer. Please go ahead Colin Rusch Thanks so much. You know, can you talk about, you know, what your win rate was versus quotation activity during the quarter and how that compares to where you've been historically? Brandon Moss Yes. Colin, we have not -- good to hear from you. One we've not disclosed our win rate in the past. Not going to do that today. What I will say, though, we talked about is we have identified that approximately 30% of the total available market of U.S. utility scale solar was going basically, you know, underserved by Shoals in the past. That was either due to us not being aligned with one specific customer, whom we are now aligned with, and a group of customers that have just gone underserved. So, look, I think Shoals has had historically a strong win rate on jobs. You know, my focus now is maintaining that win rate and hopefully applying it to this new segment of the market, approximately 30% that over, you know, a period of three years will represent 30 gigawatts of opportunity for us. So, you know, I look for the batting average to stay strong, but also the plate appearances to increase for those baseball fans out there. So again, we're excited about our commercial execution. Colin Rusch Appreciate it. And then, in Europe, obviously, it's a nice start out of the gate with the new products. Can you talk about, you know, whether you're adding incremental customers here? Are these existing customers where you're just actually finally getting over the hump with them on new products or new products because of the product configurations? Brandon Moss Yes. The goal for us, Colin, is to add new customers, right? That's the point of localizing this product offering and really the aggressive push to develop new products in the marketplace. Historically, you know, we have been attacking our international sales with, just call it for lack of better terms, a U.S. based product portfolio, which didn't allow for much opportunity in many markets. So, we're trying to localize our product assortment and I think we've done that with our new product launch, and then in some cases localized production. So, you know, making good headway there. And again, the opportunity for us is to continue to serve our export customers, which we've had great success with, but also drive new organic growth in our focus countries or focus regions, rather. The next question is from Philip Shen from ROTH Capital Partners. Please go ahead. Philip Shen Hi guys. Thanks for taking my questions. I wanted to follow up on the price topic. You know, some of our channel checks with some of your customers suggest you may have lowered price recently to the tune of maybe 5% to 10%. I was just wondering if you can affirm or, you know, confirm that in any way? And then, is this something that might be one off or is it across the board? And then, if you're able to maintain margin, as you mentioned earlier, is it because you have, you know, cost outs that are helping you with that? I know you've had some copper, you know, increases here, but you're contracting in such a way that it's all passed through. So, axing out the raw material increases, if you can talk through the pricing, that would be fantastic. Make sense? Brandon Moss Yes. Phil, I'll answer that pretty simply is, look, we feel that our pricing has remained fairly consistent. No huge changes in our pricing strategy in the marketplace. And you hit it on the head where we're, you know, basically flowing commodities through our products and, you know, don't have exposure to commodities with inventory as projects -- or I'm sorry, inventory raw materials are procured as the project is booked. So, yes, I appreciate your channel checks. I'm happy to say -- and it sounds like you're hearing we're winning some projects in the marketplace, but no change to our pricing strategy dynamics. Philip Shen Got it. Thanks, Brandon. And yes, we have identified, you know, you guys continue to do well with bookings. You showed that to us today. And it seems like bookings could have a seller in the back half and you could win shares. We got 325. Wanted to just check in -- so that's the kind of the bookings kind of front end element. You talked about earlier with the guide down that there wasn't a specific reason, it was kind of an amalgamation of everything that's been happening. But the main change that we've noticed in the market since your Q1 call has been the Southeast Asia ADCVD. And when we polled, you know, 25 asset owners, customers of yours, you know, I think 40% of them cited that they pushed out 25 CODs. And of the 40%, most of them cited Southeast Asia as one of the reasons why. So, maybe that's coming back to you in terms of module availability. Maybe they're not saying Southeast Asia specifically. Just curious if you can give us a little more color as to the guide down. You know, is module availability a reason? And perhaps, as a result, Southeast Asia ADCVDs could actually be one of the key drivers? Brandon Moss Thanks. Yes, Phil, I think that ADCVD is a driver. It is not a main driver for us. So, as we get projects push out, we understand the reasons why those are being pushed out. And you know, a swap to modules also incorporates really a redesign of our product, sometimes a minor redesign and sometimes a significant redesign. Say, if you were moving from bifacial to thin film, right? So, it is a reason, it is not the top reason. From the customer feedback that I get and also the design team that is interacting with our customers every day and working on these projects, you know, the prevailing reasons that we've heard more recently is site permitting and interconnection. I mean, those are the big ones with probably site permitting being the top of the list. So, it is a factor, but it is not the factor of the guide now. Philip Shen Got it. Thanks, Brandon. One last quick one. Do you have a sense for when peak pain on site permitting and interconnection could be? I mean, is it around the corner or do you think this can persist for, you know, some time? Thanks. Brandon Moss Thanks. Yes, Phil, I wish I knew. Hopefully, it ends soon, right? I mean, I think with the backlog of permitting and interconnections. You know, I think we're in for turbulent times here for the foreseeable future. So, you know, it's a challenge for our customers. It's a challenge for us. The next question is from Maheep Mandloi from Mizuho Securities. Please go ahead. Maheep Mandloi Hi, thanks for taking the questions here. And I apologize if this was addressed earlier, but just wanted to understand the gross sort of the EBITDA margin or gross margin decline in the guidance for the second half over here. Is this a function of revenue or volumes here or any more design work required as customers push out some projects here? Brandon Moss Yes. Thanks, Maheep, for the question. I mean, you know, it's mostly just the leverage on the operations side and leverage on our SG&A expenses guide. Maybe, Dominic, I'll kick it over to you to maybe give some color to that if you'd like? Dominic Bardos Yes. The only thing I would add is that, you know, with some of the projects being delayed, it's kind of difficult on the labor force as we're ramping to have some of the production capacity ready to deliver for the customers. And when the projects push, we're left with less efficient workforce than we desire. We called that out in second quarter. We're trying to be careful about how we ramp. We don't want to whipsaw our workforce. But fundamentally, it's between those two factors as we're ramping for production, but these are lowered numbers, and so we are losing a little bit of leverage. Maheep Mandloi Got it. Understood. Just on the buybacks here, any thoughts or algorithm on how you would kind of exercise those going forward or what prices? Sure. So, yes, the -- fundamentally, as you recall, the Board authorized up to $150 million, but we just want to start with some cash on hand. We did a $25 million ASR that's been completed. We believe that we have much better value for the long-term for our shareholders in a number of ways. And we want to be very open to looking at things like our organic growth, international markets and expansions and perhaps M&A. So, I don't want to use up all the dry powder necessarily on a share repurchase. Clearly, you know, with the stock price trading where it is, we believe it's a long-term disconnect from the value that we believe is happening long-term that we can continue to drive. So, I don't think if we announce something else with the, you know, available $125 million of share repurchase, we would announce that publicly, but at this point, nothing has been announced. Maheep Mandloi Got it. Appreciate that. I'll take the rest offline. Thank you. The next question is from Kashy Harrison from Piper Sandler. Please go ahead. Kashy Harrison Good afternoon. And thanks for taking my questions. So, my first one, just given the, you know, recent guidance revision, all the market commentary, you know, it's clear that predictability here is deteriorating. And so, I was wondering if you'd just give us the market some color on maybe some initiatives that are underway internally to improve your forecast? I'm just trying to understand, you know, what you're doing internally to avoid another, you know, guidance revision, you know, when we're back here on this call in November. Brandon Moss Kashy, yes, thanks for the question. And fair question, right? Again, we're experiencing a volatile market. I know that's extremely frustrating. It's frustrating for us. It's a challenge to plan labor, you know, as Dominic pointed out. Look, we're touching these projects, touching the EPCs. We've got a process. We're looking at this stuff on a weekly basis and summary review on a monthly basis. And we're collecting as much information from the EPCs as we can, including, you know, what panels they're using, what trackers they're using, permitting notice to proceed. So, that data is collected in our CRM and, you know, it's reviewed, as I said, on a weekly basis. So, we're trying to call this thing as accurately as we can. I think, look, it's not a challenge that is unique to Shoals right now. You know, on time installs are the lowest we've seen in 18 months, and it's a challenge for us to predict our customers delays. So, yes, again, I know it's a frustration. It's frustrating for us. We feel good about our revised guidance, you know, for the back half of the year and it's the best estimate we can give right now. Kashy Harrison Okay. Got it. Fair enough. And just for my follow up question, I think you indicated that quotes or quoted value was up, I think maybe, like 50% year-over-year. You know, how do you explain the gap between, you know, quotes being up year-over-year, but orders being down year-over-year? Is that just a time lag? Is there some other explanation, you know, the elections, or you know, what's going on there? What's the story there? Brandon Moss Yes. Look, it's just the elongation of these project cycles, right? You know, that much has been consistent here the last couple of quarters. We've talked about it. You know, when we think about when we have a project identified to the time it takes to get to an awarded order status and then awarded order to actual purchase order or backlog in our terms, there is an elongation to that. You know, it is a change to the environment. I think, long-term, it's not necessarily a terrible thing because we've got, you know, better visibility, longer visibility, although it is somewhat volatile right now, we at least have the visibility to these projects. So, quote volumes are up. And then, also -- again, our backlog and awarded orders, if you think about from a year-over-year, period-to-period standpoint, are up 18%. Again, it's just that conversion from awarded order to revenue. The next question is from Donovan Schafer from Northland Capital Markets. Please go ahead. Donovan Schafer Hi guys, thanks for taking the questions. So, first, with the 12% in the international backlog, I know that that, you know, there's a longer conversion time there, but just kind of trying to anticipate what that could look like. And I think you've provided some commentary on this before, but can you remind us, is it tending towards combiner boxes or more towards BLA type? And I know like even with combiner boxes, you know, you guys can have that via system sale. So, is it like a design system sale or more component sale? And is it more of the combiner box variety or more of the BLA? If you can just unpack that, that'd be great. Brandon Moss Yes. Hi, Donovan. I would classify our backlog and awarded orders internationally is more of a solution sale than less. You know, we're not going to give project to project specifics, but they are, for the most part, solution sales. Donovan Schafer And are the solution sales primarily combiner box? Brandon Moss No, when we talk about a solution sale, those for the most part would include BLA in this case. Yes, I mean, you know, they're not a, you know, a component sale. They are, you know, custom engineered sites and, I would say, a full solution is probably a good way to characterize this. Donovan Schafer Fantastic. That's good to hear. And then, as a follow up, you talked about, you know, regaining customers where you had lost some wallet share. And I'm curious if you could clarify when you say that, you know, sometimes we talk about wallet share, it's about how much of the, you know, for a given project, say, like a gigawatt project, you know, you could say, well, geez, we lost wallet share because we still won the project, but we didn't get, you know, maybe the wire management solution included or something? Or is it a case where you actually were not winning as many projects with a particular customer, and so it's sort of almost had a market share component to it? And if you can describe what you did to win that back? Brandon Moss Yes. Great question. Your characterization of wallet share, I would say both of what you described are the case. You know, you asked about the international projects, our goal, our sales team's goal is to sell the total solution, right? So, anytime we're not selling the total solution, we want to move the customer up the value continuum and sell that total solution. So, that is one part of it. The other part is the, you know, the amount of spend we're getting from our EPC customers. Whether that's, you know, 10% or 20%, 30%, 50%, we want to grow with them to make sure that we are doing more and more projects each year. So, it is absolutely the case in, you know, both situations. As it relates to what have we done, I think I've mentioned in previous calls about us adopting this sales pod structure. I don't think that that's probably a new terminology to anybody out there. It is us having a distinct team of folks that are cross functional here at Shoals to serve our EPC customers. So, we've got broader touch points within the customer base. We're freeing up our account executives so they can have more frequent touch points and also grow with new customers. You know, cold calling on new customers and growing our business and attacking that 30% of the total available market that we may not have been serving in the past. And I think that fundamental change is what is driving the $130 million of backlog and awarded orders, you know, with customers where we saw wallet share decline. So, I like what I'm seeing. I like the fact that we're seeing orders with the new EPC that we announced in the first quarter, and we signed another supply agreement with an EPC in the second quarter, which was great. So, you know, good progress being made on the commercial side, there's no doubt. This concludes the question and answer session. I would like to turn the floor back over to Matt Tractenberg for closing comments. Matthew Tractenberg Thank you, Sachi. And thank you to our audience today for joining us today. If you have any additional questions, reach out to [email protected]. We're happy to help you. And finally, everyone is always welcome to join our live webcast of our Investor Day on September 5, that can be accessed on our IR website at investors.shoals.com. Have a great day, everyone. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.