Varonis Systems, Inc. (NASDAQ:VRNS) Q2 2023 Earnings Conference Call July 31, 2023 4:30 PM ET
Company Participants
Tim Perz – Director of IR
Yaki Faitelson – Chairman and CEO
Guy Melamed – CFO and COO
Conference Call Participants
Matt Hedberg – RBC Capital Markets
Joel Fishbein – Truist Securities
Andrew Nowinski – Wells Fargo
Shaul Eyal – TD Cowen
Rob Owens – Piper Sandler
Roger Boyd – UBS
Jason Ader – William Blair
Saket Kalia – Barclays
Brian Essex – JPMorgan
Rudy Kessinger – D.A. Davidson
Joshua Tilton – Wolfe Research
Chad Bennett – Craig-Hallum Capital Group
Annick Baumann – Jefferies
Shrenik Kothari – Robert W. Baird
Brian Colley – Stephens Inc.
Matt Saltzman – Morgan Stanley
Operator
Greetings, and welcome to the Varonis Systems, Inc. Second Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Tim Perz, Investor Relations. Thank you. You may begin.
Tim Perz
Thank you, operator. Good afternoon. Thank you for joining us today to review Varonis’ second quarter 2023 financial results. With me on the call today are Yaki Faitelson, Chief Executive Officer; and Guy Melamed, Chief Financial Officer and Chief Operating Officer of Varonis.
After preliminary remarks, we will open the call to a question-and-answer session. During this call, we may make statements related to our business that will be considered forward-looking statements under federal securities laws, including projections of future operating results for our third quarter and full year ending December 31, 2023.
Due to a number of factors, actual results may differ materially from those set forth in such statements. These factors are set forth in the earnings press release that we issued today under the section captioned forward-looking statements, and these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. These statements reflect our views only as of today and should not be relied upon as representing power views as of any subsequent date. Varonis expressly disclaims any application or undertaking to release publicly any updates or revisions to any forward-looking statements made herein.
Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures is also available in our second quarter 2023 earnings press release and investor presentation, which can be found at www.varonis.com in the Investor Relations section.
Lastly, please note that a webcast of today’s call is available on our website in the Investor Relations section. With that, I’d like to turn the call over to our Chief Executive Officer, Yaki Faitelson. Yaki?
Yaki Faitelson
Thanks, Tim, and good afternoon, everyone. Thank you for joining us today.
Our second quarter results reflect the strong adoption of Varonis SaaS and provide further validation that our strategy to transition our model to SaaS is working. Customers are adopting SaaS at a rapid pace, which benefits our ARR performance and cash flow generation. I’m proud to announce that our SaaS business now represents approximately 10% of total company ARR. Our second quarter SaaS mix came in at 58%, well ahead of our guidance of 35%, ARR grew 17% year-over-year to $497 million and we have generated $40 million of free cash flow year-to-date, up from $3.9 million through the same period last year. This strong execution and the pipeline we see ahead, is allowing us to raise our full-year SaaS mix, ARR and free cash flow guidance. Guy will review our Q2 results and our updated guidance in more detail.
We continue to see the economy impact customer purchasing patterns with high levels of deal scrutiny and longer sales cycles, but we are encouraged by our second quarter performance against these headwinds. I feel increasingly confident about the trajectory of our SaaS platform and the overall trajectory of our company.
Today I would like to focus my time on why our offering is a must have and why Varonis SaaS continues to resonate with our customers and our internal teams. The recent Pentagon breach, in which Jack Teixeira, a 21-year-old guardsman, allegedly leaked sensitive intelligence on social media sites, is the perfect example of why organizations need Varonis. The incident highlights why insider threats are the most difficult risk to defend against and can do the most damage. It appears that the Pentagon did everything right with its perimeter controls. Teixeira worked in a sensitive isolated information facility that guards against electronic surveillance and suppresses data leakage. That means no USB keys were going in or out, nothing could be uploaded to the internet and no transmissions could take place. Still, none of its perimeter controls could stop this threat. Teixeira was able to transcribe and take photos of classified documents because he had access to information that wasn’t necessary to do his job.
Perimeter controls by themselves do not address the problem that Varonis does, which is to ensure that only the right people have access to the information that they need to do their job. Despite the industry buzz around zero-trust, this incident seems to be a failure in taking a zero-trust approach to the data. In many organizations, the focus is often on safeguarding perimeters rather than protecting the target itself, the data on the inside. You can patch your systems, secure your endpoints and block USBs, and even properly train your employees using phishing simulations, but if your most important data is not locked down and monitored then you open yourself up to massive risks.
In our risk assessments, we find that employees have far too much access to sensitive data all the time, providing visibility during a Varonis risk assessment, which is a crucial step in our sales motion, is helpful for companies, but just begins to scratch the surface of what needs to happen to properly secure data. Varonis helps companies locate sensitive data, visualize who has access to it, and automatically lock it down. The ability to do all three of these is what makes us unique and this allows companies to collaborate safely and get the most value from their data, while at the same time managing risks. Varonis SaaS allows us to do all of this for our customers faster, with less effort and with a drastically reduced overall total cost of ownership, and this is why we are seeing such strong adoption for our new SaaS platform. At the same time, the operational simplicity of Varonis SaaS also allows our internal teams to be more efficient in supporting our customers and introducing new product innovation.
As a reminder, the three key benefits that our customers get from our SaaS platform are: First, customers are much better protected with much less effort with our Automated Remediation and Proactive Incident Response; second, SaaS is easier to deploy and has significantly lower infrastructure costs; and third, SaaS is easier to maintain and upgrade.
Three of the key benefits that we realize are: One, shorter sales cycles; two, larger initial lands; and three, margin benefits over time. We saw further evidence of these benefits this quarter and we are very encouraged by the continued feedback we are receiving from customers. As an example, a large public school district with approximately 4,000 employees became a Varonis SaaS customer this quarter.
Earlier this year, this district was the target of a ransomware attack, which led to the compromise of hundreds of thousands of files that contained sensitive information about students who attended the school. The security team knew they had gaps, but this breach forced the organization to reevaluate its approach to protecting data, which was through manual effort from its internal teams and consultants. Due to the high-profile nature of the breach, they needed a platform that would provide immediate time to value. Within two hours of installation, this organization gained visibility into where their sensitive data was located and who had access to it across their Microsoft and Google deployments.
While visibility was important, our ability to automatically remediate overexposures and quantify the risk reduction over time was critical because of their lack of resources. They purchased Varonis SaaS packages for Windows, Microsoft 365, and DA Cloud for Google. The simplicity of deployment, fast time-to-value and significantly lower infrastructure requirements of our SaaS offering were essential in meeting the organization’s timeline to fix its access issues before teachers would return from summer break.
We also saw an increase in existing customer conversions this quarter. One example is a Fortune 500 healthcare company with 35,000 employees that first became a customer in 2021. They originally purchased 7 on-prem subscription licenses to protect their on-prem Windows deployment. As a large healthcare company, they are subject to significant regulatory scrutiny and needed to ensure that they had security and privacy policies in place. With their Varonis self-hosted deployment, they were already reducing risk by remediating global access and shrinking their blast radius for Windows on-prem. The success that this organization had with Varonis and their on-prem Windows environment drove the request for this same protection on Microsoft 365. Varonis SaaS was a clear fit for this organization. Automatic remediation in Microsoft 365 and the proactive incident response team will drastically reduce time-to-value and the scalability, performance improvements and significant infrastructure savings will meaningfully reduce the resources needed to achieve these outcomes.
On renewal they converted their on-prem Windows licenses into a SaaS equivalent package and purchased an additional SaaS package for Microsoft 365. These customer wins help illustrate the momentum we are currently seeing with Varonis SaaS, and underpin what is giving me increased confidence in our ability to capture our significant market opportunity and deliver value to our stakeholders as we execute on our $1 billion ARR target.
With that, let me turn the call over to Guy. Guy?
Guy Melamed
Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. We are pleased with the team’s execution in the second quarter against a challenging macro backdrop. As compared to 90 days ago, we are increasingly confident as we look to the back-half of the year with the performance we’ve seen so far in transitioning to selling SaaS. Although the macro remains a headwind, when we consider our momentum-to-date and our visibility in the pipeline ahead, we are confident in raising our guidance for full-year SaaS mix, ARR and free cash flow.
It is clear that the transition is gaining momentum and is evidence that we can deliver numerous benefits to our customers while also achieving strong ARR and cash flow benefits. As I have discussed at length since we introduced Varonis SaaS last fall, ARR, free cash flow, and ARR contribution margin are the leading indicators for our business during this transition.
The shift from on-prem subscription licenses where approximately 80% of the deal’s value is recognized upfront, to a SaaS model with fully ratable revenue recognition will cause initial headwinds on the traditional income statement metrics as the SaaS mix and conversions of existing customers to SaaS increases. And this quarter the impact was the largest we have seen to-date, especially as a considerable number of our existing customers showed a desire to convert to SaaS. However, these headwinds are a function of accounting treatment and are not indicative of the health of our business. In fact, the greater these accounting-related headwinds are, the better it is for our business as it means the transition is progressing at a faster pace. As a result of the rapid pace at which our customers are adopting SaaS, we are adjusting our ARR guidance higher and we are adjusting our full-year revenue guidance correspondingly lower.
All three of our north stars, ARR, free cash flow, and ARR contribution margin are trending in a positive direction, which highlights the encouraging progress of our SaaS transition. The momentum seen in Q2 is being driven by Varonis SaaS, which is resonating with our customers and our salesforce.
Our second quarter SaaS mix represented 58% of new business and net new upsell ARR versus our guidance of 35%. After only 2 quarters into the transition, SaaS now represents approximately 10% of the total company’s ARR. The average deal sizes realized in Q2 gives us incremental confidence in the 25% to 30% pricing uplift and margin structure that we previously provided. In the quarter, we once again saw reps introduce Varonis SaaS to customers where an on-prem subscription quote had already been provided, which interrupted the sales cycle for some of these deals. As we look out into remainder of the year, we expect some of the pressure from this dynamic to ease because more of the pipeline expected to close in the second half has started as SaaS rather than as on-prem deployments. This is already factored into our guidance. In the second quarter, a significant amount of SaaS deals were sold to new customers, but we did see an increase in existing customers converting to our SaaS offering. This was in line with the commentary that we provided last quarter on our increased pipeline but was well ahead of the amount that we factored into guidance.
In the second quarter we had approximately $6 million in conversions of existing customers impacting our Q2 revenue. These conversions are being driven by both customers and our salesforce. Customers want the automated protection of Varonis SaaS and our sales reps can earn commission dollars on the incremental dollars sold because SaaS deal sizes are larger. To be clear this positive momentum in converting customers is happening organically as we have not been providing incentives to encourage these conversions. We view this as a clear positive as we plan for the second phase of our transition, which is when we will focus on converting our installed base over to SaaS. As compared to 90 days ago, this is becoming a bigger driver of our top-line growth. As we look to our revenue guidance for the second-half of the year, we are assuming approximately $8 million of conversions in Q3 and approximately $10 million of conversions in Q4. As a reminder, these conversions benefit our north stars metrics, which are ARR, free cash flow and ARR contribution margin. At the same time, this causes an initial headwind to reported revenue and operating margin.
However, despite the headwinds to our traditional income statement metrics, we believe this is a huge positive and should be viewed as such. In the second quarter, ARR grew 17% year-over-year to $497 million. Year-to-date we generated $40 million of free cash flow, which was up from $3.9 million over the same period last year, reflecting the inherent leverage in our model as well as our commitment to balancing topline growth with improving cash flow generation. In Q2 we continued to see a macro environment that was similar to Q1. We are still seeing deal scrutiny and longer sales cycles across the board, which is impacting customer purchasing patterns and is holding back our near-term results. We expect these longer deal cycles to continue along with budgetary scrutiny and our updated guidance already takes this and more into consideration.
Turning now to our second quarter results in more detail. Before I get into the numbers, let me remind you of what we’ve said for a while now, ARR, free cash flow and ARR contribution margin are the leading indicators for this transition. Q2 total revenues were $115.4 million, up 4% year-over-year. During the quarter as compared to the same quarter last year, we had approximately a 15% headwind to our year-over-year revenue growth rate as a result of having increased SaaS sales in our bookings mix, which are recognized ratably versus the upfront recognition of our on-prem subscription products. Subscription revenues were $91.1 million and maintenance and services revenues were $24.3 million as our renewal rates were again over 90%.
Moving down the income statement, I’ll be discussing non-GAAP results going forward. Gross profit for the second quarter was $100.5 million, representing a gross margin of 87.1% compared to 87.2% in the second quarter of 2022. Our gross margins were essentially in line with last year, despite significant revenue headwinds as we are getting greater efficiencies than we initially expected. Operating expenses in the second quarter totaled $99.6 million. As a result, second quarter operating income was $0.9 million or an operating margin of 0.8%. This compares to operating income of $1.7 million or an operating margin of 1.5% in the same period last year.
During the quarter as compared to the same quarter last year, we had approximately a 12% headwind to our operating margin as a result of having increased SaaS sales in our bookings mix, which are recognized fully-ratable versus the upfront recognition of our on-prem subscription products. Second quarter ARR contribution margin was 8.2%, up from 3.7% last year. The significant leverage improvement, even during the early stages of the transition reflects our ability to drive strong incremental margins, while growing ARR and transitioning to SaaS.
During the quarter, we had financial income of approximately $7.6 million driven primarily by interest income on our cash, deposits and short-term investments. Net income for the second quarter of 2023 was $1.1 million or $0.01 per diluted share, compared to a net loss of $0.1 million or a loss of zero cents per basic and diluted share for the second quarter of 2022. This is based on 127.3 million diluted shares outstanding and 109.7 million basic and diluted shares outstanding for Q2 2023 and Q2 2022, respectively. As of June 30, 2023, we had $753.8 million in cash, cash equivalents, marketable securities and short-term deposits. For the six months ended June 30, 2023, we generated $42.6 million of cash from operations, compared to $10.1 million generated in the same period last year and capex was $2.6 million, compared to $6.1 million last year.
During the second quarter, we repurchased 207,278 shares at an average purchase price of $24.51 and we have $36 million remaining on our share repurchase authorization. We ended the quarter with approximately 2,150 employees, roughly flat versus last quarter. As expected, we did see some turnover in our salesforce, but it was at lower levels than our previous transition. Overall, we are pleased with the engagement of the vast majority of our salesforce and their ability to transition to selling SaaS continues to show encouraging progress.
Turning to our guidance in more detail. Our full-year guidance now assumes a SaaS mix of new business and upsell ARR of 50% up from 35% previously, and we expect Q3’s SaaS mix to be 45%. As a reminder federal’s largest quarter is the third quarter and because we are not yet FedRAMP certified we expect to sell on-prem subscription to that market, which will be a headwind to the Q3 SaaS mix. A couple of additional modeling notes on this metric as we look at the back-half of the year. We are continuing to take a prudent approach in building our SaaS mix outlook as the dollar value of deals we expect to close in the fourth quarter is the largest of the year, which is in-line with historical trends.
In Q3 we are assuming $8 million of existing customer conversions that will serve as a headwind to revenue and $10 million in Q4, which is higher than Q2 but consistent with the pipeline we have. We are again raising our ARR guidance to reflect strong adoption trends of Varonis SaaS from our customers. Coupled with our improved efficiency, this also results in greater ARR contribution margin, which reflects our ability to focus on operating leverage during the transition. We are meaningfully raising our free cash flow guidance to reflect the strong cash generation trends we saw in the first half of the year. The higher SaaS mix drives corresponding adjustments to revenue and operating income guidance because of the ratable accounting treatment of SaaS versus the upfront accounting treatment of on-prem subscription. Ultimately, we view the improved guidance as a clear sign that the transition is progressing in a positive direction and continue to view ARR, free cash flow, and ARR contribution margin as our north stars during this transition.
Lastly as a reminder, our guidance continues to factor in macro headwinds that we’ve discussed at length in the past.
Now turning to our guidance. For the third quarter of 2023, we expect total revenues of $123.5 million to $127 million, representing growth of 0% to 3%; non-GAAP operating income of $1 million to $2 million; and non-GAAP net income per diluted share in the range of $0.02 to $0.03. This assumes 127.1 million diluted shares outstanding.
For the full year 2023, we now expect ARR of $529 million to $535 million, representing growth of 14% to 15%; free cash flow of $40 million to $45 million, which includes an incremental $2 million of headwind related to the TCJA capitalization of R&D provisions for a total of $8 million to $10 million; total revenues of $497 million to $503 million, representing growth of 5% to 6%; non-GAAP operating income of $19 million to $22 million; and non-GAAP net income per diluted share in the range of $0.21 to $0.23. This assumes 126.8 million diluted shares outstanding.
In summary, the acceptance of SaaS is progressing at a rapid pace with only two quarters into the transition, approximately 10% of our total ARR is now coming from SaaS. Our second quarter SaaS mix of 58% versus our guidance of 35% as well as the significant increase in existing customer conversions, generated meaningful improvements to our three north stars during this transition, which are ARR, free cash flow and ARR contribution margin. That gives us the confidence to raise our guidance as we enter the second half of the year.
With that, we would be happy to take questions. Operator?
Question-and-Answer Session
Operator
Thank you. Ladies and gentlemen, at this time, we’ll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Matt Hedberg from RBC Capital Markets.
Matt Hedberg
Congrats on the faster transition here. I’m curious for other — Yaki or Guy. Of the $6 million of SaaS conversion that you saw this quarter, do you have a sense for what the incremental spending was on those conversions versus had they been sort of on-premise subscriptions and maybe the inverse of that is do you know what the headwind to revenue was on that sort of that incremental conversion that you saw this quarter?
Guy Melamed
Absolutely. So first of all, when we look at the price list, the price list of SaaS is 25%, 30% higher. And when we compare the actual sales, apples-to-apples, the same number of licenses and the same number of users we’re actually seeing that. So the pricing is working very well for us. What is important to remember is that when you see existing customers move from on-prem to SaaS with our SaaS offering, where we’re selling the actual platform, they’re actually consuming more licenses, and they don’t have the ability to buy licenses individually.
So we’re seeing customers consuming more of the product, and that’s working very well. When you look at the headwind, the actual headwind to revenue was approximately 15%. And on the operating margin, we saw that headwind at 12%.
Operator
Our next question comes from the line of Joel Fishbein with Truist.
Joel Fishbein
Thanks for taking the question and also great execution on the SaaS transition. I just wanted you to talk a little bit about any — the changes in go-to-market? And any color you can give us on the adoption of the bundled Silver, Gold, Platinum? That would be really helpful.
Yaki Faitelson
Overall, there is no fundamental change. We’re trying to do everything in a risk assessment. This is our customer buying. But fundamentally, the changes that with our SaaS offering with 10% of the effort, you can get orders of magnitude more valued. So the reality is that we are the first and last ones here. The damage happened in breaches and cyberattacks from the data level. And if you can protect your data, really, nothing will help you.
So what we see is that our customer is almost doing nothing, are able to find critical data for immediate excessive access control, which is the holy grail of data protection, and reliably alert on any abnormal behavior and get to the root cause of every problem. So it’s just the overall what customers are experiencing, it’s something that is completely different. And because of the fact that it has so much such tremendous automation, it’s much easier for them to get value. They want more licenses. It’s much easier for us to expand. And this is most innovative year we ever had and there is so much meat on the bone in terms of the overall content in this data protection platform, and it’s easier for us to expand.
Guy Melamed
Joel, I just want to touch on the question about bundles. In 2022, we offered bundles on our on-prem subscription offering. And that was an attempt to try and simplify the conversation with the customer. We also know that the more licenses the customer consumes, the higher the customer satisfaction, and that was very clear in 2022. So we doubled down on that.
And when we offer the SaaS platform, we no longer have bundles. We’re selling it as one SKU. So you can have eight licenses that appear as one SKU. We don’t have the option to buy that individually. That’s actually working very well in conversations, simplifying the discussion with customers providing more value because we’re selling outcomes. We’re selling the actual platform itself and that’s been working very well with the SaaS transition.
Operator
Our next question comes from the line of Andrew Nowinski with Wells Fargo. Please proceed with your question.
Andrew Nowinski
I wanted to ask maybe a higher-level question. I guess I’m kind of surprised you aren’t talking about AI yet because I would think as organizations start training their LMs with their corporate data. It would seem like the need for data protection increases and the need for visibility into where that data resides, also increases. So I guess, are you seeing any customers come to Varonis as part of their AI initiatives and looking at your SaaS platform?
Yaki Faitelson
You’re 100% right. So it’s what you said, it’s very, very accurate. There are really two dimensions. One is that when you look at these large language models, primarily what they are doing, they are mining massive amount of data and now that customers have their own open AI instances and will start to see adoption of these — all these copilots. What will happen is that we take all your unstructured data and will make it succinctly a very valuable information product that they can be run out completely outside of the regular policies or using your current active control permissions which are broken and you don’t know that there exist a whole package. So this is super critical.
And we definitely in the last few weeks are starting to see a lot of interest. And I think that once people will understand how they can — how end users will use it in their organization, this can be a massive, massive driver for us. The other thing is it’s very easy for layman with these new AI technologies to build malware and APTs and for sophisticated actors to up their game and inflict tremendous damage in organization.
So what will happen is that it’s becoming much easier to buy a perimeter security and do a lot, a lot of damage on the data layer, and this is the main objective of CSO. So this is definitely a driver. And there is a third driver is the ability of our platform to integrate these kinds of solutions to provide value — it’s also something that we believe that potentially can be a game changer. So yes, the AI is a massive driver primarily because of the nature of the lion’s share of the data we are protecting and the exposure that it’s bringing.
Operator
Our next question comes from the line of Shaul Eyal with Cowen.
Shaul Eyal
Congrats on the ongoing successful transition. So this transition, Yaki or Guy, is accelerating better than expected. How should we be thinking about your 2027 ARR metrics and guidance that you shared with us back in March, wouldn’t that target will be achieved sooner? And maybe I’m front-running myself here.
Guy Melamed
So there’s two aspects to this. There’s the ARR and there’s kind of the transition itself. We’ve made a lot of progress in the past two quarters, which really likely requires us to revisit our guidance for the time line at year-end.
Just to remind you, we assumed completing the transition for us would mean SaaS reaching anywhere between 70% to 90% of our total ARR. The transition has moved fast. We’re very happy to have 10% of our total ARR coming from SaaS, and that’s only in really just two quarters. It’s moving fast because the reception from our customers and our salesforce has been really positive.
So we look forward to providing more color at year-end on that time line. And in terms of the ARR, we are seeing significant benefits with the move to SaaS, you can see that with the ARR this quarter. We’re also seeing benefits on the free cash flow and also leverage in the model.
Operator
Our next question comes from the line of Rob Owens with Piper Sandler.
Rob Owens
Curious if you could comment on kind of top of the funnel activity given your SaaS approach is more frictionless than just what you’re seeing in terms of customer interest and how that might compare with, say, where you were a year ago?
Yaki Faitelson
We definitely see that customers understanding that they need to protect data. We also see that customers understand that they invested massively in security solutions that are not protecting the data and are very hard to manage. So it’s just — it’s — on one hand, it’s a hard economy. But on the other hand, we definitely see that organizations are thinking what will be the biggest bank for their back and what they need to do. And would just gradually because they’re realizing the benefits of the overall platform and what we can do and things that we can repair and mainly the automated outcome. Like when they see the outcome, it’s solid, it’s classifying automatically, remediate automatically, you can roll back. You have any indicator of abnormal behavior, we can do it with a proactive IR from the cloud. It’s a game changer. So we definitely see a lot of interest across the board. There’s a lot of — you also have scrutiny in deals, and we’re just in the beginning of the transition, but there are a lot of positive signs and definitely transitioning so far growing significantly faster than we anticipated.
Operator
Our next question comes from the line of Roger Boyd with UBS.
Roger Boyd
Great. Thanks for the question and congrats on another nice quarter of execution. Just wondering on the possibility of pent-up demand. You now have $50 million in SaaS ARR, which is up pretty significantly over the last two quarters. Can you just talk about how you’re thinking about the pipeline for the rest of the year? And as you think about 3Q in particular, the 45% mix, any considerations there around SaaS other than just the Federal fiscal year-end.
Yaki Faitelson
No. The overall SaaS, it’s going very well. One is the team really built a very, very good SaaS product. And all the regular benefits of SaaS, the total cost of ownership, ease of operations and upgrades. But the beauty is that we really rebuild the company in a sense of these automated outcomes, which is night and day from the salesforces solutions. So — and if you think about it, I think what happened now, we MOVEit or OPSH era, everything that happens, happens on the data level, you can’t unbreach data. When data is in the wrong hands, it’s a huge problem.
The other thing we saw, we are not trying to simply convert the base. But once they see it, mainly because of these benefits, these outcomes in the SaaS, customers wants to move. So we feel very good with the fast transition and….
Guy Melamed
And just to add to that, when we look at kind of the SaaS mix we’re raising it to 50% from 35%. Just remember, we started the year with a 15% expectation. And if you kind of break down Q3, the answer is really simple. You kind of asked about it. It’s — we’re not yet FedRAMP certified, which means that we plan to sell on-prem subscription to that market, and that will be a headwind to the mix in Q3. And then kind of the other factor to keep in mind is that Q4 is our largest quarter, and it’s on a much larger denominator.
But overall, we’re really happy with the momentum that we’re seeing with our SaaS business. And we take our commitments to the Street very seriously. So we wanted to put numbers out there that we feel good about.
Operator
Our next question comes from the line of Jason Ader with William Blair.
Jason Ader
Guy, I wanted to ask you about gross margins. You mentioned greater efficiencies than expected. Can you just elaborate on that?
Guy Melamed
Yes. We’re — when you look at kind of the fact that we’re only very early in the transition, we’re seeing a lot of benefits, and we think we can see more benefits going forward. The benefits could be with kind of the way handling the customer when we kind of do the risk assessment. But also it allows us to be more efficient with dealing with any questions that the customer has.
So overall, when you look at kind of the margins, we’re very happy to kind of have the margins we have as we just started, and we feel very good about our ability to generate leverage in the model going forward.
Operator
Our next question comes from the line of Saket Kalia with Barclays.
Saket Kalia
Okay. Great. Hey, Yaki. Hey, Guy. Thanks for taking my questions here. Yaki, maybe for you. I was wondering if you could just go one level deeper into just some of the details on the bundles. What differentiates Silver from Gold from Platinum? And what are sort of the rough differences in pricing across those three bundles, again, high level?
Guy Melamed
Saket. A similar question was asked before, so I’ll just try and kind of emphasize. In 2022, we actually had an offering which was Gold, Silver and Platinum but that was for the on-prem subscription offering. And because we saw that, that was working very well. When we announced the SaaS transition, we’re not offering those bundles anymore. We’re just selling the platform. So you see a situation where a customer in the on-prem subscription would buy seven licenses.
This today appears as one SKU under the SaaS offering. So it allows us to sell more of the platform and we’ve talked a lot over the last couple of years about the fact that Varonis more is more. The more licenses a customer has, the higher the customer satisfaction, the more automated results they receive. And because of that, we’re seeing in that SaaS transition, how customers are embracing it. It simplifies the conversation for the rep and the customers, and that’s something that is working very well for us.
Operator
Our next question comes from the line of Brian Essex with JPMorgan.
Brian Essex
Yaki, I was wondering if I could follow up to Rob’s question actually. If we think about the sales cycle and the pipeline process, could you maybe comment on where you’re seeing better performance versus where you might be seeing friction. And what I mean is if you kind of carve it in the buckets, I’m thinking about this in terms of starting off with lead generation from channel and marketing going to assessment, going to tech win and then approval, then the closing and deployment, where are things maybe better than they were last quarter? And where might you have the friction say, for example, with what you’ve highlighted in the salesforce where a deal might get delayed slightly because of the shifting from maybe a term license to a SaaS deal.
Yaki Faitelson
I think we need to distinguish between doing a transition to be very committed to do the transition very effectively to the overall salesforces. In the overall salesforces, everything is easier with SaaS. And primarily, it’s much easier for the customers to get value. As I said, it’s 10% of the effort, 10x more value. Like this north star is working very well and our mantra is, you just need to pay it, we are protecting your data. It is starting to work very well.
So if you really want to break it down, the all sales motion and the salesforces, it just works very well. The challenge, if you will, in a hard economy, everything is scrutinized and there is just the friction of this nature. We need to make sure that people understand what we do every time we are doing something that is such a profound change. You need to make sure that all the customers see it and there is a big difference between during the sales pitch seeing the demo and test it. So we need to make sure that the marketplace understands what we do. But overall, upwards in the sales motion, everything is much, much easier with SaaS and the customers, just night and day, in the way that they realize value and the value is ongoing value.
Guy Melamed
And 1 thing we talked a lot about is kind of the first six months of the transition. And when you look at where we are today, that we’re past that part, which really was the riskiest part, the Varonis SaaS is working the adoption of our customers and the excitement of our salesforce are really at levels we’ve never seen before even more compared to the previous transition and I just want to add in terms of the macro, Q2 was very similar to Q1 in terms of the macro, but our guidance assumes continued worsening of economic conditions across the board. And just to point that out.
Operator
Our next question comes from the line of Rudy Kessinger with D.A. Davidson.
Rudy Kessinger
Thanks for taking my question and congrats again on the phenomenal execution on the fast transition. Guy, certainly, a number of callouts on this call on existing customer migrations. You gave some figures about migrations or conversions you expect in the second half a number of your customers, existing customers that I’ve spoken with have messages and interest in converting to your SaaS product at some point in near term. So I guess you’re not incentivizing the sales support yet for conversions. But I guess given the natural kind of interest that you’re seeing, you envision incentivizing the salesforce at some point maybe sooner than you previously expected to convert existing customers at renewal to SaaS.
Guy Melamed
Great question. Phase 2, which we defined is converting our installed base to SaaS really hasn’t started yet. And when you look at kind of H2 assumptions we took into consideration $8 million and $10 million of conversions in Q3 and Q4, respectively, which is really higher than the Q2 number, but still a very small percentage of our existing customer base. .
So although we’re seeing existing customers convert this asset, it really hasn’t been our main priority yet. We expect that to be more of a focus next year, and then we’ll take everything into consideration and decide what’s the best thing. But as of now, it’s happening in a natural way.
Operator
Our next question comes from the line of Joshua Tilton with Wolfe Research.
Joshua Tilton
And congrats on a solid quarter. Lots of good questions have been asked so far. I’m going to ask kind of an easy one. 10% of ARR coming from SaaS seems awesome. Could you maybe just help us understand directionally from last quarter, like how that’s progressing? Was that a double on a percentage basis from last quarter? Just kind of help us understand maybe the rate of change you’re seeing in the business from a quarter ago outside of just SaaS as a percentage of the new business mix.
Guy Melamed
So we really provided a lot of the data points when you look at kind of the actual conversions. The conversions in Q2 were significantly higher than the conversions that we had in Q1. If you remember, we actually called out in our prepared remarks last quarter, the fact that we’re seeing an increased pipeline, but we didn’t assume those would convert. We’ve actually — in Q2, we saw that happen.
And the other thing that has increased is actually the percentage of the SaaS mix, which went from 37% to 58% and that’s obviously from a much larger denominator. So overall, the progression of the SaaS offering and the conversations has been much better in Q2. You also need to remember that, that’s kind of a natural evolution when you have quotes that are provided to customers and they’re provided initially as on-prem subscription, every time you introduce a new concept during a sales conversation with a customer, you’re adding turbulence.
And that’s why we talked a lot about kind of the six months. Obviously, there’s some of that, that would be in the second part of the year, but the majority happened in the first six months, and we did see SaaS progressing and improving both on the new customer side and the existing customer side, significantly improving from Q1 to Q2.
Yaki Faitelson
We are still very early in the journey for SaaS. But so far, the overall adoption, given the reaction from current customers and the ability of the salesforce to adapt to the transition, we have some experience with transition, is well ahead of our initial expectations.
Operator
Our next question comes from the line of Chad Bennett with Craig Hallum.
Chad Bennett
So just on the ARR side, I know you guys didn’t anticipate much in terms of conversions when you started the year, but they seem to be accelerating in a big way. Just if you kind of look at net new ARR in the quarter, with $6 million of conversion, obviously, in the conversion assumption you have for the second half I’m just curious to kind of get your insight into what the non-conversion SaaS business and how that performed in the quarter and the expectation for the second half of the year. Because if you back out the six versions, net new ARR was kind of flattish sequentially. And if you kind of do the same exercise in the second half, there’s not a lot of net new ARR growth.
Guy Melamed
No problem. I think it’s a great question. And I think you need to kind of split between what we feel about the business and the way we’ve guided. We feel very good about the business going into the second half. I think that when you look at kind of the way we treat our commitments to the Street, we take them very seriously. So we wanted to put numbers out there that we feel good about. When you look at the progression of the business, which Phase 1 is what we’re focusing on right now, we’re trying to sell SaaS to our new customers, which is working very well with the SaaS mix that we’re in. But the on-prem subscription is working just as good.
When you look at kind of the evolution, we want to convert our existing customers when we get to Phase 2. We’re seeing some of that happening now. But overall, you should look at the guidance in kind of the same way we’ve guided in the past, we feel very good going into the second part of the year.
Operator
Our next question comes from the line of Joseph Gallo with Jefferies.
Annick Baumann
This is Annick Baumann on for Joe Gallo. Maybe just taking a high level again, when you kicked off the SaaS transition, you spoke of learnings from your subscription transition and using that knowledge here, what have been some of the biggest surprises to the upside this time around and your expectations? And then maybe what’s the biggest difference versus last time that you’ve seen so far in this transition?
Yaki Faitelson
I think that there are many. One is that it’s — when you are doing this thing and you’re committing, just many times a little of friction with the salesforce costs that are out there, people that want to convert and a lot of delays. We saw that but less than we expected. I think the difference is that it’s completely in a different business, the value that customers are getting and how fast we are getting the value, the ease that we can bring them to value and how relatively little support we need to provide to the system relatively to the on-prem, how the benefits of the metadata that we have in the cloud is just working for us and we can really transform in P2, clear customer value and the speed at the engineering is working. As Guy said, it’s still early stages, but overall, the gross margin and all the moving parts that we see that we can really get a lot of leverage from the model. So this is overall what we see. So it’s — as I said, still early, but way ahead of expectation.
Guy Melamed
I think that one important takeaway when we look at this transition versus the previous transition and kind of what we’ve learned and what we’re trying to implement is that the transition as a whole is standing on three pillars. That’s the technology, the commission and our commitment to actually making the change. And when you look at the technology, — we’re very happy with where we are today and the fact that it’s working so well, as Yaki mentioned, and that’s the first pillar. And without it, nothing else matters.
The second pillar is coming of the comp plan, making sure that the team and the salesforce understands what’s the right way to make money. And I think from our previous transition and in this transition, we set a comp plan that works very well hand-in-hand with our desire to make the change.
And the third pillar is really the management commitment of making that change. If you kind of make an announcement that you want to move, but you’re not fully committed, then the first and second pillar don’t really help. So when you look at kind of where we are today, I think those three pillars are standing very strong.
Yaki Faitelson
Definitely, our experience from the first transition is helping us further. It’s very different in terms of the value proposition and tremendous asset and technological assets that we have. But understanding how transitions are working, how you need to be committed to it, to understand how this usually plays out. But in the near term, you are staying. But in the long term, you really get a lot of great reward. This help us a lot, and it’s the leadership team already experienced that. So it’s much easier to get everybody committed to the transition.
Operator
Our next question comes from the line of Shrenik Kothari with Robert W. Baird.
Shrenik Kothari
So Yaki, Guy, I mean, you mentioned about the second phase of transition, which is, of course, converting your installed base over to SaaS, and it’s becoming a bigger driver and you have provided some numbers. But you also mentioned, of course, it’s still not a priority this year from the two pillars that you just highlighted, management commitment comp plans.
So just since you guys highlighted the longer deal cycles to continue along with budget with scrutiny. I’m just curious, like in terms of the impact from these longer cycles, like is it more upsized on the newer logos versus the conversion mix? Like typically, of course, the newer logos are tougher, but in your case, of course, it’s — I’m just trying to understand like the impact of these longer sales cycles and more budget scrutiny, how does it kind of affect both the new logos as well as your conversions right now?
Yaki Faitelson
I think that regarding the overall scrutiny, the scrutiny is there. But when people really think about what they need to do and how they need to protect data and what they are getting for their money and what they can do with limited security professionals, the ROI works very well for us.
So when people are scrutinizing our value proposition, it works well for us. It can take sometimes more time. You need to expand it to justify it. But the whole process of where you are going to put — how you’re going to allocate your resources, what you need to do and what you need to protect, this is something that works well for us. It’s not fun, the scrutiny but it works very well for us.
Operator
Our next question comes from the line of Brian Colley with Stephens.
Brian Colley
Could you provide an update on where you stand in terms of bringing the SaaS platform to feature parity with the on-prem platform? I’m just curious if you think getting to that feature parity level will be an additional catalyst to spur more SaaS conversions?
Yaki Faitelson
We are moving very fast with the parties. For new customers, it’s a no-brainer. And just there are so many features in the SaaS that are — it’s just completely different universe than the self-hosted on-prem platform for most of our customers, for 80% of them, we are already in party. And for the 20%, we move fast. But at the right time we’ll discuss the migration as Guy told you that it’s in phases. We want to make sure that it’s frictionless, it’s automated. This is not a priority — a top priority for us now. We have which is a very detailed plan how to go after new business, customers and there are customers that want a part of the solution in SaaS, part on-prem and then they will convert. There are many options here.
Operator
Our last question comes from the line of Matt Saltzman with Morgan Stanley.
Matt Saltzman
Thanks for taking the question and very much appreciate the level of disclosure you guys have given on the transition makes it lot easier on our side. You’ve spoken a lot about the operating leverage that you should drive through the transition. I’m just curious with everything progressing faster than expected, when should we expect to see some of that operating leverage come through via the P&L. I mean I’d imagine that this should probably precede the ARR and revenue convergence, just especially with more existing customers converting and the inherent leverage there.
But I’m curious if there’s kind of any guidepost that you guys can give us in terms of when we should expect at least some offset to the upfront headwinds associated with the SaaS transition.
Guy Melamed
I think that’s a great question. And if you kind of go back to the three north stars, we talked about ARR and free cash flow, but we also talked about the ARR contribution margin. Because the operating margin is really impacted by the revenue headwinds. So when you look at kind of the ARR contribution margin, you’re already seeing some of the leverage in the model.
We ended the quarter with 8.2%. That’s 450 basis points of improvement year-over-year. And when you kind of look at the expectation going forward, we feel very good about our ability to generate leverage through the SaaS offering, but you’re already seeing it now. So I think overall, we’re very happy with the fact that even in the early stages of our transition not only are we keeping kind of the cost structure as a whole intact, but we’re actually showing pretty significant leverage year-over-year.
Operator
That is all the time we have for questions. I’d like to hand it back to management for closing remarks.
Guy Melamed
Thanks for your interest in Varonis. Have a nice night.
Operator
Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines and have a wonderful day.
