Good day, and welcome to the OneSpan Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Joe Maxa, VP of Investor Relations. Please go ahead.

Thank you, operator. Hello, everyone, and thank you for joining the OneSpan second quarter 2020 earnings conference call. This call is being webcast and can be accessed on the Investor Relations section of OneSpan's Web site at investors.onespan.com. Joining me on the call today is Scott Clements, our CEO and Mark Hoyt, our CFO. This afternoon after market closed, OneSpan issued a press release announcing results for our second quarter 2020. To access a copy of the press release and other investor information, please visit our Web site. Following our prepared comments today, we will open the call for questions. Please note that statements made during this conference call that relate to future plans, events or performance, including the outlook for full year 2020, are forward-looking statements. We have tried to identify these statements by using words such as believes, anticipates, plans, expects, projects and similar words and these statements involve risks and uncertainties and are based on current expectations. Consequently, actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to today's press release and the company's filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties. Please note that certain financial measures that may be discussed on this call are expressed on a non-GAAP basis, and have been adjusted from a related GAAP financial measure. We have provided an explanation and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in the earnings press release. In addition, please note that the date of this conference call is August 11, 2020. Any forward-looking statements and related assumptions are made as of this date. Except as expressly required by the Federal Securities laws, we undertake no obligation to update these statements as a result of new information or future events, or for any other reason. With that, I will turn the call over to Scott.

Joe, thanks for very much. Good afternoon, everyone, and thanks for joining us here today. There are a lot of moving parts in today's earnings release, so I'd like to start off by summarizing some of the key points for you. Number one, our transition from perpetual license to recurring revenue contracts is ahead of schedule. We're seeing strong growth in both subscription and term license categories. Though, this is in near term, partly offset by the expected headwind from lower perpetual license sales. Second, year-to-date, we are ahead of our plan in most measures but there's still some quarter to quarter volatility in our P&L with some of the outperformance in Q1 impacting Q2's top line. Number three, our product investments are paying off with strong growth in OneSpan Sign and good early results from our OneSpan Cloud authentication offering, which was introduced earlier this year. The value of our software sales pipeline is growing over 50% compared to last year, and recurring order growth in Q2 was very strong. Number four, the surge in coronavirus infections and deaths in the U.S. and Latin America and resurgences elsewhere mean that banks now expect a deeper and longer economic downturn that will broadly impact the global economy and that will also pressure bank financial results. Therefore, OneSpan has determined it will withdraw its 2020 financial guidance until there's greater clarity on our customers’ plans. Number five, the strategic outlook for OneSpan remains strong. The need for digital channel security and digitizing the customer experience and financial services are only reinforced by the present new reality. Furthermore, major institutions are in early stages of a generational shift to cloud platforms and infrastructure, which OneSpan began preparing for almost three years ago. Now let me turn to our update on Q2 results.…

Thank you, Scott. Before discussing our second quarter financial details, I do want to comment on the prior period adjustments that we noted when we rescheduled the earnings call to today. During Q2, we identified errors relating to certain contracts with customers involving software licenses that originated in prior periods. We investigated and the errors that we found resulted in overstatements of revenue of $2.2 million from the beginning of 2018 through Q1 2020. This $2.2 million represents less than one half of 1% of the $523 million of revenue we recognized over that same time frame. And while we don't make errors, we do consider these errors to be immaterial and we are adjusting the prior period revenue and related amounts in our earnings release today and in future filings with the SEC. As Scott mentioned, we are externally publishing annual recurring revenue for the first time this quarter. ARR, which we define as the annualized value of all active recurring product contracts greater than or equal to one year in length through 29% to $90 million in the second quarter of 2020. Recurring revenue grew 35% to $23 million in the quarter. We believe that these non-GAAP metrics, in addition to our GAAP results when compared to prior periods, provide additional insight into our transition to becoming a majority recurring revenue company. Total revenue for the second quarter of 2020 declined 2% to $55 million. Product and licence revenue declined 12% to $35 million, and services and other revenue grew 22% to $20 million. Looking in more detail about recurring revenue, our subscription revenue grew 15% to $6 million. This included approximately 30% growth in our e-signature revenue, offset by a lower transaction volume from auto finance customers using our Secure Agreement Automation solution due to the pandemic.…

Okay, thanks very much Mark. As I already noted, our software and services sales opportunity pipeline grew substantially in the first half of 2020, demonstrating that we're offering solutions our customers need. However, there is increased uncertainty about the timing of customer projects as we enter the second half of 2020. The surge of coronavirus infections and deaths beginning in early June in U.S. and Latin America and continued flare ups in Europe make it clear the virus will not be quickly contained. Most banks are now expecting a deeper, more extended economic downturn and it increased their loan loss reserves and expectation of more bankruptcies in small and medium businesses in the quarters ahead. Late in Q2 and into early Q3, we saw some lengthening of sales cycles as banks evaluate impacts to their operations from the pandemic. Nevertheless, many banks are anticipating increased fraud losses and the need for continued digital channel expansion. Based on our discussions with both customers and industry analysts, we believe that banks will be more cautious about technology investments but the projects that facilitate a better and more secure digital experience will continue to be a priority. As I've noted before, it's important to understand that a majority of our revenue is driven by additional sales to existing customers, and that we generally have significantly net positive retention rates with those customers. Given the global economic uncertainty, we believe it's prudent to take the following two steps. First is to withdraw our full year 2020 guidance as have many of our technology and cybersecurity company peers. Our present outlook is for 2020 full year recurring software and services revenue growth to be consistent with the three year outlook we gave at the end of last year, offset by perpetual license revenue declines as…

Thank you. We will now begin the question and answer session [Operator Instructions] Our first question comes from Gray Powell with BTIG. Please go ahead.

Yes, so I guess I had a couple. So it sounds like there was a lower than expected mix of perpetual license revenue in Q2. Was that more a function of deal delays that you talked about related to the macro environment, or is that something that you see potentially recovering over the next six to 12 months? So maybe I'll start there.

I'll take a crack at that, Mark, and you can certainly add in. I think one of the things that's been pretty clear through the second quarter is that the transition towards recurring revenue contracts has gone faster than we assumed it would at this point in time. So I think that transition is happening faster. That means more recurring opportunities and fewer perpetual license contracts. I think there was the slowness that I mentioned in my comments, I think was not limited to perpetual contract types. It was I think over a more general effect. So I'm not sure that had a lot to do with this shift towards more recurring. Mark, I don't know if you have anything to add to that?

I think just adding on Scott. We have seen the faster transition to term license has been a perk, so I think that's a big driver of the quarter’s results.

And so on the subscription line. So I thought the commentary on 30% e-signature growth was good. And I guess I'm a little bit new to the story. I thought that your business was the bulk of the subscription line. So I was confused by the difference between that 30% growth rate and the headline growth, which I think was more like in the mid-teens. So can you maybe just talk about the subscription line, or I guess, first of all, the difference in those two numbers? And then just your confidence level in getting growth in the subscription line back above that 25% pace? It sounds like you had pretty good bookings on that business.

Yes, let me take the last part of that and Mark can talk about the composition of the subscription line. I think the answer to the question is yes. We had triple digit bookings growth in the subscription category and in the second quarter. So we also had, I know, I don't remember in total, but I know with OneSpan Sign, we also saw triple digit bookings growth in the first quarter. So, we do expect that to continue and to come through in the P&L over the coming quarters. So Mark, you want to talk about the composition. Go ahead.

Gray, in that subscription line, I tried to allude to this in my comments. It's not just the subscriptions but also one-time overage charges that we see. So from quarter-to-quarter, it can be a bit lumpy. And one of the transaction-based book of business we have from our secure agreement automation with auto financing, we saw some of those one-time overages decline quarter-over-quarter in Q2.

So essentially, that's a transaction-based business on the auto sector and that automotive asset finances the biggest component of the Secure Agreement Automation business. So I think as we all know, there have been fewer automobiles sold over recent few months and that shows up in that number.

Our next question comes from [Andrew King] with Colliers Securities. Please go ahead.

Just looking at the ARR growth of 29%. I just want to get an idea of how sustainable that is through the year? And then also if you could talk about what e-signature was, if you talk about expanded used cases that you're seeing in the quarter that will be great. Thanks.

I'll let Mark go into some of the detail on the numbers, but the outlook is we have it right now is that we will see continued solid ARR growth for the full years. So we have said that over the period through 2022, we would see sort of 25% to 30% annual compound average ARR growth. I think we are going to see that this year. So I think that's the headline. And then in terms of e-signature, there were a couple of areas that were perhaps interesting. I mentioned in my comments earlier the USDA project. We are seeing and have seen a significant interest in other parts of the government for increased use of e-signature. And we talked a little bit I think in the first quarter release about the small business administration as another example. And then we're also seeing elevated interest and saw some books and business around healthcare. There is a real demand and a real need around various elements of healthcare telehealth, as well as other healthcare use cases for e-signature type products. So I think the interesting thing is that we're seeing these trends in e-signature really on a global basis. We have a real solid growth of bookings and opportunities for e-signature really in almost every region of the world. So we feel very good about the direction of that business. I don’t know Mark if you want to add any comments about the ARR outlook?

You asked if the 29% ARR growth is really sustainable. We published a table in our investor presentation that just went out to show the growth of the quarterly ARR since the beginning of 2019. And we've seen pretty consistent growth in that figure that is driven by subscriptions, term licenses and then maintenance on both term licenses and maintenance on our perpetual contracts. The fourth component that really drives that number up is our strong retention rate, our lack of churn. So I think the combination of those four items will continue to push ARR forward. And that's one of the metrics we want to get out to the investors. The other item I want to note Andrew is that our term based license revenue line is still relatively lumpy because of the 606 rev rec and driven by the term length of those licenses. So that's why we're publishing ARR, because we think that that gives a better representation of the growth of our recurring revenue streams.

[Operator Instructions] Our next question comes from Roger Boyd with Needham and Company. Please go ahead.

Just wondering if we could dig into the comments on deal push outs. I'm wondering if we can get any more info on the conversation kind of with your customers. Is this mostly budget related or there's some architecture driven decisions where customers are rethinking their longer term regional strategies and maybe pushing deals out from that perspective?

As far as we can tell, this is purely related to economics and the uncertainty that banks are now seeing. I mentioned my call, we've seen many banks really make significant changes to their loan loss reserves over the last quarter. And that has an impact on their capital ratios and things like that. And so they want to make sure that they can operate their business well in the coming quarters to replenish those capital ratios as they go forward. So I have not heard anywhere that this is really a technology issue in any sense. It really is just purely I think, first of all, and we saw in the June time frame, it’s actually a little bit interesting. We saw going through May that the quarter is proceeding pretty typically. Then in June, you will recall at the end of the first week of June, we started to see a spike in coronavirus infections in the three largest states in the U.S., in California, Texas and Florida. And by the second week of June, the national infection rate was starting to rise pretty rapidly. And I think this was right after that period in April, May, when some states and locations started to open up again after flattening the curve. And so it became clear, I think at that point that this was going to, the challenge for the pandemic was going to be sustained. And banks realized I think that that was going to ultimately have some impact on certainly small and medium size businesses and that they needed to put up additional reserves. We're seeing sort of similar behavior, albeit a little more slowly in Europe. And then I think banks in some of the emerging markets, particularly Latin America, are certainly a little challenged…

And then maybe on that hardware comment and the lower guidance there. As you think about the hardware refresh cycle, is this -- do you think it's more of an opportunity now to sell software and subscriptions to the customers that were using hardware previously?

Well, I think that's possible. Certainly, there is a secular trend that's going on over time where there is a technology substitution of mobile security rather than hardware tokens. And that's obviously not a new issue. That's been, I think generally been happening for some time. I think it is likely that that will probably be a little more pronounced. And certainly in the in the near term, we saw some real strength in that area, certainly in the early part of this year. And so we'll see. I think the hardware business is being -- I think there was some inventory buildup last year in advanced PSD2. Banks probably not really being sure how much they were going to need. And now we have this period where I think all of their -- the large majority of their new account opening is probably happening online and mobile. And that lends itself a little bit more, of course, to mobile security and our mobile security offerings as opposed to hardware. So there are some big projects for hardware updates and refreshes that are on the horizon. So we'll see how those proceed. I think that's probably more of a late this year next year phenomenon, but we'll certainly have easier compares for next year.

Our next question comes from Anja Soderstrom with Sidoti. Please go ahead.

A lot of good questions asked already, but you were talking about the sales and marketing, expect that to increase in the second half. Are you still hiring and what are you intended to do in marketing that you haven't done in the first half? And you also mentioned that you are seeing more opportunity now in the adjacent markets. You've been mentioning that before but it hasn't really been a big driver. Are you going to make a bigger push there perhaps now and banking is sort of slowing down?

So I think on the marketing spend that we talked about, we're running I think about $8 million. Mark, I think we're about $8 million under what our expectation has been on operating expense year-to-date [Multiple Speakers] correct me if that’s wrong, Mark.

Yes. That’s Right.

Right. Okay. So we're under running about $8 million on operating expense, a lot of that comes from less travel, obviously, and some other related expenses that we have been under running. So as we now look into the second half of the year and I think the uncertain or the challenging outlook related to the economy, we are really looking at what are the things that we can do to maximize our opportunity in the second half of the year. And so there are a few things that -- well, there's actually quite a number of things that we're doing, but one of those is to invest to invest more in marketing. We saw in the first half of the year some elevated return and significant progress from our lead generation activities. Our CMO, John Gunn and his team have done a really fantastic job elevating the lead generation productivity. And that's part of what's driving the increases in our opportunity pipeline that I mentioned a couple of times on the call already. And so we've made a lot of effort to really improve and strengthen that lead generation program. And given what we saw in the first half, the underrun in spend that we had in the first half, we think there's an opportunity to take some of that savings and reinvest it in more marketing certainly in the third and the fourth quarter. So that we can certainly benefit not only 2020 but really benefit 2021. So we're seeing good return on that investment we believe. And so we're going to do more of that lead gen activity. Then we also are adding, I would say on a targeted basis, additional salespeople. We added salespeople in the first half of the year. We're going to continue to do that. So that is, again, as we get into the latter part of this year and into the early part of 2021, we will have a larger sales force with better coverage, ready to roll as we get into the back part of this year and into next year. So those are -- we think that we are absolutely on the right track with our products and solutions, and a lot of indicators of that, some which I've mentioned here. And so we think there is growth opportunity out there and we're going to be aggressive at going and getting up. What was your -- you had second part to your question…

Yes, about the adjacent market mainly focusing on financial industry, but are you maybe pushing more for that now or…

I would say we're in the early stages of that, Anja. We have -- I've said, I think many times over the last two, three years that our first focus was to make sure that we with our new products and our new strategy that we could sustain our relevance to our core financial services customer base. So that was really the number one imperative for us. We are feeling I think pretty good about that at this point in time. Certainly more to do. We continue to invest in our products and in our research and development. But we feel good that we have made a lot of progress in that direction. And so now, it is an appropriate time for us to begin looking more earnestly at adjacent spaces. So we already touched a number of adjacencies, particularly in the e-signature business. But with our new -- some of our new cloud authentication products or capabilities in mobile security and things like that, the importance of digital communication in healthcare is becoming a much bigger issue now that we're seeing a lot of activity in government, as I mentioned. So we think we have both the right products to begin to look at some of these adjacencies and the right timing to begin doing that. So we are making significant -- not significant but I would say initial efforts in terms of marketing into some of those spaces and selling into some of those spaces. This will take time for sure. We are going to -- if we're going to commit to additional verticals, we want to make sure that we do it correctly that we make the right investments and we don't waste our time. We're going to go after these verticals. We're going to do it in a disciplined way. And we're, I would say, at the early stages of that.

The next question comes from Matthew Furnas with Mandias Capital. Please go ahead.

I guess I'd like you guys to address the term immaterial in the context of your revenue misstatement. And I guess, I look back and I see you guys have been revenue estimates by $2.4 million over the last nine quarters and your Chairman sold $23 million of stock subsequent to the end of the quarter, at the end of Q1. And your stock is down 30% after hours. So for longtime shareholder, maybe you could define the term immaterial.

Mark, I’ll let you take that from an accounting point of view?

Matthew, on the -- as I mentioned in the investor deck. We show the quarterly -- actually no, it's in the earnings press release. We have a table that shows the quarterly impact of the revenue. And as you look back over each quarter, we went back and analyze this to make sure there was not a single quarter where there was a beat or a miss that was impacted by these changes in revenue over those nine quarters. That's how we determine the fact that was immaterial over the $525 million in revenue over that same time frame.

I guess, if you're sure enough about those numbers, you would be able to file your 10-Q on time. and I guess you've lost a certain amount of trust here. And again, I guess I'd like you to address the $23 million of stock sold by your former chairman since the end of March.

So I'll take that one. I think -- well, first of all, you corrected that. He's not -- he is no longer our chairman. He remains a member of the board. He was the founder of the company. And he is 75 or 76 years old roughly. And so he has a long term plan, a state plan. I'm not knowledgeable necessary, but all the particulars of it, but I think he has been executing his state plan over, really over a couple year period now. So I don't think [Multiple Speakers]…

Since the end of March. That's clear.

I would assume -- I think that probably is the case that he has sold more in that time frame but that's obviously his right to do that. And we obviously work very closely with our board and all of our executives to ensure that trading takes place only when it's appropriate. And I believe that that is the way Ken has handled it. And I think that -- and I'm not sure what he'll say about it. These are his personal decisions around his state planning that we don't have a whole lot to do with.

All right. Well, thank you for answering my question. And I'm obviously a disappointed shareholder. So thank you.

I totally understand. Absolutely.

This concludes our question-and-answer session. I would like to turn the conference back over to Scott Clements for any closing remarks.

Thank you. Thank you, operator. Thank you all for joining us on our call here today. We are making I think tremendous progress in terms of transitioning our companies to recurring revenue and a more stable, higher value mix of revenue. We're going to continue to do that in the quarters ahead. And we are, I think confident and excited about the future of OneSpan. So thank you all for listening in today.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.