SaaS Shift And On Prem Churn Will Challenge Margins Yet Support A Stronger Long Term Profile

Catalysts

About Varonis Systems

Varonis Systems provides a data security platform focused on protecting sensitive information across on-premises and cloud environments through automation and threat detection.

What are the underlying business or industry changes driving this perspective?

• Although SaaS ARR of approximately US$545 million now represents 76% of total ARR and management plans to reach an 83% SaaS mix, the end of life for self-hosted solutions by December 31, 2026 could prompt some remaining on-prem customers to reduce spend or leave altogether, which would pressure total ARR growth and limit the uplift from conversions on revenue.
• While demand for securing cloud data and AI related use cases such as Copilot, databases and email is helping Varonis sell broader SaaS and MDDR bundles, weaker on-prem renewal rates in the final weeks of Q3 highlight execution risks in account management that could temper upsell momentum and slow expansion of ARR from existing customers.
• Although partnerships and integrations with large ecosystems like Microsoft, including Copilot related security, position Varonis to participate in data security spend around AI, dependence on a few key partners could compress pricing power or delay larger rollouts, which would affect incremental revenue and limit improvement in operating margins.
• While acquisitions such as Cyral and SlashNext broaden coverage to database activity monitoring and AI native email security, integration complexity and the need to educate customers on new use cases may extend sales cycles and increase go to market costs, which would weigh on operating income and near term earnings.
• Although year to date free cash flow of US$111.6 million and over US$1.1 billion in liquidity support continued investment in SaaS and automation, reallocating resources after a 5% headcount reduction and resizing the federal team could disrupt sales execution in underperforming segments, slowing ARR contribution and delaying any improvement in contribution margins.

Assumptions

This narrative explores a more pessimistic perspective on Varonis Systems compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Varonis Systems's revenue will grow by 17.2% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -18.8% today to 3.3% in 3 years time.
• The bearish analysts expect earnings to reach $32.3 million (and earnings per share of $0.29) by about January 2029, up from $-114.5 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 216.3x on those 2029 earnings, up from -36.3x today. This future PE is greater than the current PE for the US Software industry at 32.6x.
• The bearish analysts expect the number of shares outstanding to grow by 4.75% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.78%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The end of life for self hosted solutions by December 31, 2026 creates uncertainty for the remaining on prem customer base, and management is already assuming lower renewal rates for this segment. This could weigh on ARR and total revenue if a portion of customers reduce spend or churn instead of migrating to SaaS, pressuring earnings.
• Weaker than expected renewals in the federal and non federal on prem subscription business in the final weeks of Q3, combined with management’s comment that they do not yet know if this is a one off or a new trend, suggest that churn in the remaining 24% of ARR that is not SaaS could persist or worsen. This would hit ARR growth and limit any improvement in net margins.
• The company is cutting 5% of headcount and resizing the federal team while still trying to push more upsell, cross sell and SaaS conversions. Any disruption in account management or sales execution during this resource reallocation could slow SaaS ARR growth and delay the path from a non GAAP operating loss of US$8.2 million to US$5.2 million toward sustained profitability.
• Varonis is increasing its reliance on large partners such as Microsoft and on new offerings from acquisitions like Cyral and SlashNext. If integration takes longer than expected, customers are slow to adopt newer database and email security use cases, or partner related opportunities do not scale as hoped, the uplift from these investments could fall short of expectations, weighing on revenue growth and operating margin.
• The bullish long term narrative depends heavily on strong SaaS net revenue retention and higher average selling prices from conversions and bundles. Management acknowledged sales process issues, budget scrutiny at customers and uncertainty over how the remaining on prem cohort will behave, which together introduce a risk that upsell and expansion trends moderate over time, limiting ARR growth and constraining net income.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Varonis Systems is $40.0, which represents up to two standard deviations below the consensus price target of $50.15. This valuation is based on what can be assumed as the expectations of Varonis Systems's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $62.0, and the most bearish reporting a price target of just $40.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $978.9 million, earnings will come to $32.3 million, and it would be trading on a PE ratio of 216.3x, assuming you use a discount rate of 8.8%.
  
• Given the current share price of $35.25, the analyst price target of $40.0 is 11.9% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.