Nutanix - Q2 2023
March 6, 2023
Transcript
Operator (participant)
Hello, welcome to Nutanix second quarter 2023 earnings conference call. At this time, all participants are on a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask the question during the session, you will need to press star one one on your telephone. You will hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. I would now like to hand the conference over to your speaker for today, Rich Valera. You may begin, sir.
Rich Valera (VP of Investor Relations)
Good afternoon. Welcome to today's conference call to discuss the results of our fiscal second quarter of 2023. Joining me today are Rajiv Ramaswami, Nutanix's President and CEO, and Rukmini Sivaraman, Nutanix's CFO. After the market closed today, Nutanix issued a press release announcing financial results for the fiscal second quarter of 2023. If you'd like to read the release, please visit the Press Releases section of our IR website. During today's call, management will make forward-looking statements, including statements regarding our business plans, strategies, initiatives, vision, objectives, and outlook, including our financial guidance, as well as our ability to execute thereon successfully and in a timely manner, and the benefits and impact thereof on our business, operations, and financial results.
Our expectations regarding the resolution of the investigation, its impact on our financial statements, including our financial guidance, our financial performance and targets and use of new or different performance metrics in future periods, expectations regarding profitability, our competitive position and market opportunity, the timing and impact of our current and future business model transitions, the factors driving our growth, macroeconomic, geopolitical, and industry trends, including global supply chain challenges, and the current and anticipated impact of the COVID-19 pandemic and its effects. These forward-looking statements about risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially and adversely from those anticipated by these statements.
For a detailed description of these and other risks and uncertainties, please refer to our SEC filings, including our annual report on Form 10-K for the fiscal year ended July 31st, 2022, and our quarterly reports filed on Form 10-Q for the fiscal quarter ended October 31st, 2022, as well as our earnings press release issued today. These forward-looking statements apply as of today. We undertake no obligation to revise these statements after this call. As a result, you should not rely on them as representing our views in the future. Lastly, Nutanix management will be participating in the Morgan Stanley TMT Conference in San Francisco on March 8th. We hope to see you there. With that, I'll turn the call over to Rajiv. Rajiv?
Rajiv Ramaswami (President and CEO)
Thank you, Rich. Good afternoon, everyone. Against an uncertain macro backdrop, we delivered a solid second quarter with results that came in ahead of our guidance and saw continued strong performance in our renewables business. With respect to the macro backdrop, in our second quarter, we continued to see businesses prioritizing their digital transformation and data center modernization initiatives enabled by our platform. However, we have seen some increased inspection of deals by customers, which we believe is likely related to the more uncertain macro backdrop. This is driving a modest elongation in sales cycles. We've considered this dynamic in our outlook for the remainder of the fiscal year. Supply chain constraints with our server partners improved compared with the prior quarter. I'd like to comment on the investigation mentioned in our press release.
We recently discovered that evaluation software from one of our third-party providers was instead being used for interoperability testing, validation, and customer proofs of concept over a multi-year period. Our audit committee commenced an investigation into this matter, which is still ongoing, with the assistance of outside counsel. Rukmini will provide more details on the near-term reporting implications of this matter. I'd like to emphasize that we do not believe it will have a significant impact on the fundamentals of our business and overall prospects. Taking a closer look at the second quarter, we delivered solid top-line growth, including 23% year-over-year ACV billings growth, driven by continued strong performance in our renewables business. We again demonstrated good expense management, which helped us generate $63 million of free cash flow, continuing our strong recent free cash flow performance.
Overall, I am pleased with our financial performance in the second quarter. Our second quarter results reflect the value our customers are seeing in both our core Cloud Platform and in adjacent solutions in our portfolio, with particular strength in Nutanix Cloud Manager. A good example is our largest new customer win in the quarter, which was with a federal agency looking to modernize their infrastructure. They replaced their legacy three-tier environment with Nutanix's Cloud Platform, including Nutanix Cloud Manager to run their business-critical applications, leveraging its simplicity and built-in automation for infrastructure as a service. They also added Nutanix Unified Storage to service their unstructured data needs. We see this as a good example of a customer adopting our full stack offering to modernize and automate their IT infrastructure.
Another notable win in the quarter was with a bank in the APAC region, who had been running a key business-critical application in the public cloud on Red Hat's OpenShift. However, they were having performance issues and were unhappy with the incident response times of their public cloud service provider. Following an evaluation of multiple on-prem and public cloud options, the customer chose to run OpenShift and their critical application on-prem on the Nutanix Cloud Platform, including our AHV hypervisor, concluding that it was the alternative that could deliver the best performance and total cost of ownership. This deal reinforces our view that cloud is an operating model, not a destination, and that our Nutanix Cloud Platform is ideally suited to enabling the hybrid multi-cloud operating model increasingly favored by IT professionals.
Following the general availability of NC2 on Microsoft Azure late in our first quarter, we saw solid momentum with NC2 in the second quarter. A good example is a win we had with an EMEA-headquartered provider of global transportation services looking to accelerate their migration to the public cloud, reduce their data center footprint, and optimize their public cloud spend. Following a rigorous evaluation of alternatives, including native public cloud, this customer chose NC2 on Azure, which they found enabled a roughly 4x faster migration, lower migration costs, and significantly lower operating costs. This win demonstrates how our customers appreciate the ability to rapidly and seamlessly shift their workloads from their private clouds to the largest public cloud providers with the consistent management, governance, and data services provided by the Nutanix Cloud Platform without the time and expense of refactoring their workloads and with lower ongoing operating costs.
On the product front, during the second quarter, we delivered meaningful upgrades to our core platform with the release of AOS 6.6, which offers enhanced data services and a number of networking and security-related features, further strengthening its capabilities to support business-critical applications. In closing, I'd like to provide some thoughts on our priorities and outlook. First, our overarching priority remains delivering sustainable, profitable growth through judicious investment in the business, execution on our growing base of renewals, and diligent expense management. Our strong free cash flow, along with solid top-line growth in the second quarter, reflects the progress we made to date towards this objective.
While the macro environment remains uncertain, we are encouraged that the strength of our business model, underpinned by our growing base of renewals and our ongoing focus on profitability, allow us to raise our fiscal year top-line outlook and reaffirm our free cash flow outlook. I remain confident in our ability to continue to capitalize on the vast opportunity in front of us while continuing to drive sustainable, profitable growth. With that, I'll hand it over to Rukmini Sivaraman. Rukmini?
Rukmini Sivaraman (CFO)
Thank you, Rajiv. I would first like to note that with respect to the investigation Rajiv mentioned, we are in the process of assessing the financial reporting impact. It is likely that additional costs would be incurred to address the use cases previously noted. As a result, we have not provided financial information regarding expenses in our second quarter preliminary results or our outlook for the third quarter or full fiscal year 2023. While we are working diligently to address this matter and finalize our financials as soon as possible, we do not expect to be able to file our 10-Q on time or following the five-day prescribed extension period allowed under 12b-25. Relatedly, we are rescheduling our Investor Day we had intended to hold on April 4th, 2023, to summer of 2023. We'll provide a specific date once it is confirmed.
With that said, I will now move on to talk through our Q2 results, followed by our outlook for Q3, and then finally provide an update on our fiscal year 2023 outlook. Q2 2023 was a solid quarter with results that came in better than our guidance. ACV billings in Q2 was $268 million, higher than our guidance of $245 million-$250 million, and representing a year-over-year growth of 23%. The significant majority of that growth came from growth in renewals billings. Revenue in Q2 was $486 million, higher than our guidance of $460 million-$470 million, and a year-over-year growth rate of 18%. ARR at the end of Q2 was $1.378 billion, a year-over-year growth of 32%.
New logo additions were about 480 in Q2. Contract durations stayed flat quarter-over-quarter at three years as expected. As described previously, the percentage of orders with future start dates likely due to partner supply chain constraints continue to be a key assumption in our Q2 guidance. This percentage came in lower than it was in Q1 2023 and below our expectations. Q2 revenue also benefited approximately $11 million from the improvement in percentage of future start dates as more licensed revenue was recognized in quarter than deferred. Slightly more than the $10 million estimate we had provided on our last earnings call. Billings linearity was good and DSOs were 28 days in Q2. Free cash flow in Q2 was $63 million, implying record free cash flow margin of 13%. A couple of additional notes on Q2.
One, we retired the remaining principal amount on our January 2023 convertible notes of approximately $146 million with cash from the balance sheet. Two, last month, we reached an agreement to settle the outstanding securities class actions litigation, which is subject to documentation, notice to class members, and court approval. We recorded a net charge of approximately $38 million for the settlement. This is the amount inclusive of legal fees and expenses, net of our expected recovery under our D&O insurance. We expect approximately $33 million to be paid and settled in Q3, while the remainder was already paid for legal defense costs in previous quarters. We ended Q2 with cash equivalents, and short-term investments of $1.311 billion, down slightly from $1.388 billion in Q1 2023. Moving on to Q3 outlook.
The guidance for Q3 2023 is as follows: ACV billings of $220 million-$225 million and revenue of $430 million-$440 million. I'll now provide some more context around our guidance. First, the top-line guidance for Q3 assumes that supply chain dynamics for our server partners would remain more or less the same compared to Q2 2023. It also assumes that contract durations would stay approximately flat to slightly down in Q3 2023 compared to Q2 2023. The revenue guidance includes approximately $5 million of revenue benefit from the decline in percentage of orders with future start dates over the last few months. Said differently, we expect to recognize more license revenue in Q3 than is deferred, similar to the dynamic we saw in Q2.
Over time, as our partners' supply chain constraints resolve and our future start date percentages normalize, we would expect this dynamic to normalize as well. I will now provide an update on our full-year 2023 guidance. We have had a solid first half, and our renewals business continues to provide a strong foundation for growth and efficiency. Those factors, combined with our continued focus on disciplined expense management, allow us to raise our ACV billings and revenue outlook for the year while reaffirming our prior free cash flow outlook.
Our updated guidance for full-year fiscal year 2023 is as follows: ACV billings of $905 million-$915 million, year-over-year growth of 20% at the midpoint, revenue guidance of $1.8 billion-$1.81 billion, year-over-year growth of 14% at the midpoint, and free cash flow of $100 million-$125 million. I'll now provide some additional color on our full-year guidance. First, we are seeing continued new and expansion opportunities for our solutions despite the uncertain macro environment. However, as Rajiv mentioned, we have seen a modest elongation of sales cycles, likely due to increased deal inspection.
We have considered this dynamic in our updated guidance. We continue to expect that the significant majority of our growth in ACV billings for fiscal year 2023 will come from growth in renewals ACV billings, with the uncertainty in the macro environment factored into our expectations for new and expansion ACV billings. A reminder that ACV billings for the full year is not simply the summation of four quarters ACV billings because of deals with less than one year in contract duration. We expect that full-year ACV billings is discounted by approximately 5% relative to the sum of ACV billings from the four quarters. Second, similar to our comments last quarter, the full-year guidance assumes that contract durations would decrease slightly compared to fiscal year 2022.
The fiscal year 2023 revenue guidance also assumes that the percentage of orders with future start dates would ease slightly in the second half of the fiscal year compared to the first half. Third, the reaffirmed free cash flow guidance of $100 million-$125 million includes the impact of approximately $33 million in net cash outflow expected in Q3 from the previously mentioned litigation settlement. It also includes the impact of approximately $12 million of cash usage in Q3 for non-recurring tax obligations related to a portion of our employee RSUs vesting this month and other anticipated cash outflows. These cash outflows were not included in our prior guidance for annual fiscal year 2023 free cash flow.
Finally, I'd like to note that we continue to expect to generate at least $300 million of free cash flow in fiscal year 2025. In closing, we are pleased that our Q2 results reflect our continued execution towards our stated objective of sustainable, profitable growth, and we expect to continue that focus. With that, operator, please open the line for questions.
Operator (participant)
Thank you. Ladies and gentlemen, as a reminder to ask the question, please press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Please stand by while we compile the Q&A roster. Our first question comes from the line of Pinjalim Bora with JPMorgan. Your line is open.
Pinjalim Bora (Software Analyst)
Great day, guys. Thanks for taking the questions and congrats. Seems like a pretty good quarter. I just wanted to go back to the investigation that you were talking about. Could you maybe explain it in a little bit of a layman's term, what happened exactly? It sounds like it's like an underpayment to a vendor. Am I understanding it right? Or what? Help us understand a little bit in less legal terms.
Rajiv Ramaswami (President and CEO)
Let me start and Rukmini, you can explain the details here, right? The one thing, the first thing I want to say is that the fundamentals of our business are unchanged. This matter doesn't impact our market opportunity or the demand for our solutions. We are working diligently to resolve it as quickly as possible, and we are very focused on driving sustainable, profitable growth. With respect to that specific matter, Rukmini, maybe you can just explain the details behind it and what we're doing.
Rukmini Sivaraman (CFO)
Sure, yes. Hi, Pinjalim. What we discovered was that certain, you know, eval software, evaluation software from one of our third-party providers, somebody who provides us software, which is intended for evaluation purposes, was instead used for, you know, validation, interoperability testing and proof of concepts over a multi-year period. That is, was, you know, we discovered that. As we said on the call, that matter is ongoing. Because of that, Pinjalim, we weren't able to disclose, you know, expense information on the call. We've announced that we expect to be unable to file our Form 10-Q in a timely manner, given that we wanna make sure this is resolved first.
Now, I wanna also provide a little bit of color that we are, you know, given this, we still believe that our top line results, our free cash flow, as we reported, are all, you know, unimpacted by this. When we look forward to guidance, we are pleased to be able to raise our revenue and ACV billings guide. We're comfortable with the $100 million-$125 million of free cash flow guidance for the year after factoring in the potential impact from this third-party software use that we mentioned on the call.
As I noted in my prepared remarks, the free cash flow guidance also includes the impact of the $33 million approximately from the settlement of the litigation and the impact of this $12 million of cash usage in Q3 for non-recurring tax obligations related to employee RSU vesting. These cash outflows were not included in our prior guidance for the full-year free cash flow.
Pinjalim Bora (Software Analyst)
Yep, understood. Thank you for the color. Rajiv, Some of our discussions with some of your partners seems to suggest that the VMware opportunity is taking shape. But I wanted to ask you, one of the discussions kind of highlighted that the you know, just the complexity of some very large VMware customers using tens of thousands of VMs. Who might be looking at Nutanix as an alternative. It's just complex to kind of move from one to the other, of course. I wanted to ask you, what can Nutanix do or what are you doing to kind of make those large companies feel a little bit at ease to kind of move those large VMware environments over to Nutanix?
How have some of those discussions been progressing?
Rajiv Ramaswami (President and CEO)
Absolutely. As you can imagine, Pinjalim, we are engaged with many of these customers right now. We have a significantly higher level of engagement. A lot of these are prospective customers that aren't existing ones, and they're all looking to explore their options and manage these potential risks related to the acquisition. What you should keep in mind is for many, many years, we've been doing these things. We've been doing these migrations. In many cases, you know, when we go out there, we insert our solution on top of a VMware platform, right? Customers are running vSphere, we go in there and we insert AOS, which is our software-defined storage. And over time, customers may choose to use our own hypervisor, AHV, instead of the VMware hypervisor. So we have a lot of experience with doing migrations for our customers.
The larger the environment, the more complex it is, and we know that. Typically we will do this one workload at a time, for example. They will pick us for one use case, and then over time, we will expand and do other use cases. Historically, it used to be end user computing, but these days we do databases, we do all mission-critical workloads, all of this. So we have a lot of experience doing these migrations. That said, Pinjalim, I think what you heard, yes, this is complex. It's going to take time, and this is why we are not factoring in some, you know, any significant benefit in our fiscal 2023 outlook. We expect these cycles to be long. You know, typically nine, 12 months for some of the larger deals.
Pinjalim Bora (Software Analyst)
Yep, got it. Okay, getting back in the queue. Thanks.
Operator (participant)
Thank you.
Rukmini Sivaraman (CFO)
Thank you.
Operator (participant)
Please stand by for our next question. Our next question comes from the line of James Fish with Piper Sandler. Your line is open.
James Fish (Senior Research Analyst)
Hey, guys. Wanted to build off of the last couple questions, actually. Maybe could you talk about the push-pull effect you're seeing with the demand environment, given that ability to consolidate the competitive landscape, especially on the VMware side and maybe even the traditional storage perspective, as well as just, you know, the HCI market against those traditional storage guys versus the general macro environment. As it sounds like, Rajiv, you're talking about, you know, an increased lengthening of deal cycles. Is there a way to think about how much longer deals are also taking? Net, net of my question is, you know, what are you seeing for the push-pull on all these kind of factors on demand? You know, is there a way to quantify how much longer these deals are taking?
Rajiv Ramaswami (President and CEO)
Jim, indeed, you know, there is a push and pull on this, as you say. First on the macro. We see strong performance from our renewals, and that's been continuing. Of course, that helps reduce the risk in our business model and the guide that we put out there. We have taken into account the uncertain macro environment, as you say, right? In terms of the impact that we're seeing, we have been seeing this greater inspection. What I would say is what that means is a very... I would say so far it's been a modest increase in the average sales cycle, right? The time it takes to close a deal goes up a bit. We've seen this across both new logos or new customers and existing customers looking to expand, right?
They're just being a little bit more careful, taking some more time to review the economics of everything and looking at the TCO benefits. That said, we do have strong TCO benefits, right? Typically compared to legacy infrastructure. When you look at the dynamics vis-a-vis the second piece of it, which is compared to third-party or legacy three-tier storage, I think those dynamics are largely the same. When there is, for example, time for a refresh or any kind of modernization effort, the customers compare, you know, HCI versus three-tier, and we are generally able to show a better TCO, a much more modern ability for them to go build a cloud platform. That dynamic hasn't really changed. Clearly, the VMware dynamic, certainly, you know, will help in the long term, but not in the short term.
It's in the short term, what I would say is increase the level of engagement. There's clearly push and pull. To summarize, we've got the renewals business that provides a foundation. On the new business, small elongation in deal cycles. On the other side, we're seeing more engagement from a VMware basis. We've tried to do our best to factor in all of these dynamics into the guide that we gave you.
James Fish (Senior Research Analyst)
That's helpful. You know, impressive on the free cash flow beat this quarter. Just trying to make sure here, how much of this was driven by essentially the operations versus, you know, working capital numbers? Really underneath where we're trying to understand where OpEx would have kind of come in barring any of these, you know, added expense issues. Rukmini, sorry to layer on here, but you just had mentioned the free cash flow outlook included the potential impact of this investigation. Does that also assume the catch-up potential?
Rukmini Sivaraman (CFO)
Thank you, Jim. All good questions. Let me try to parse that. You know, as I said in my remarks, Jim, we are not commenting on expenses either for Q2 or on a forward-looking basis. I'll start there.
In terms of free cash flow, right, for Q2, as you said, with, you know, we're happy with the free cash flow performance in Q2. And I will just say that I think, you know, we talked about DSOs on the call, right, which was 28 days. It was unusually low in Q1. And we saw it kind of come back to, I would say, within the range, right, in Q2. Because typically our payment terms for DSOs are 30-45 days, and so I would expect it to be sort of in that area
Now to your second question. Yes, we are comfortable with our full-year $100 million-$125 million free cash flow guidance, Jim, including the potential impact from arising from this matter, right, related to the third-party software use that we mentioned on the call, and the other sort of items around the $33 million for the settlement and the one-time, $12 million tax obligations we discussed.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of Mike Cikos with Needham & Company. Your line is open.
Mike Cikos (Senior Analyst)
Hey, guys. Thanks for getting me on here. I did have a couple of questions. Just to circle back to the audit committee, and I wanna make sure that everyone has this right. This investigation that we have right now is totally independent of the... I wanna make sure I'm getting my numbers right now. The anticipated expense in 3Q that you had cited regarding the $33 million for the litigation settlement, correct?
Rukmini Sivaraman (CFO)
That's correct, Mike.
Mike Cikos (Senior Analyst)
If I look at the audit investigation specifically, can you provide us like when was the issue discovered? When did the audit committee commence its investigation? When did the Nutanix engage outside counsel? I'd just like to see if we can get a timeline for how these events are playing out under the hood. Again, just because we have this limited guidance that we're being provided today.
Rukmini Sivaraman (CFO)
Yes. Thank you Mike for the question. Yes, I understand that, you know, there's limited guidance here, Mike, You know what I can say is that given this review is ongoing, what we can say is that we are working diligently, right, with our committee and our outside counsel to resolve this as quickly as possible, so we can be in a position to share more with you. At this point, we're not able to kinda provide the very specific timelines to your question, but we are working diligently to make sure we are resolving this appropriately and in a timely manner.
Mike Cikos (Senior Analyst)
Well, I appreciate that. I just wanted to see like, one of the things I'm struggling with on my side, and again, it's probably just a misunderstanding on all of the legal comportments that are involved here. I know that you guys are saying that this third-party provider was using software for evaluate. I don't wanna butcher it, but I think it was supposed to be.
Rukmini Sivaraman (CFO)
Got it. Yeah. I let me try.
Mike Cikos (Senior Analyst)
interoperability. Yeah. Yeah. I'm trying to see, is there an impact on revenue as a result of this? Is it entirely expense based? 'Cause again, I'm trying to get at like, is there potential for this in any way to impact your top line results? Like you're giving us the revenue and ACV billings guide. Is that untouched by this investigation at this point? The follow-up is like, how is it we don't have the expenses here, but you guys are able to reaffirm the free cash flow? I think that's what I'm wrestling on my side. I apologize for the long-winded question, but I just wanna make sure I'm being clear.
Rukmini Sivaraman (CFO)
Yeah. Thank you. Thank you, Mike. Let me try and clarify some of those pieces. You are correct that we do not believe that this matter has any impact on our top line metrics, specifically revenue, ACV billings, which as you point out, we've disclosed and we're guiding to. That's one part of it. In terms of just. Sorry, what was the second part of your question? Am I getting there was one more question?
Mike Cikos (Senior Analyst)
Yeah. Yeah.
Rukmini Sivaraman (CFO)
On free cash flow, I think.
Mike Cikos (Senior Analyst)
Yes, exactly. Exactly.
Rukmini Sivaraman (CFO)
Correct. Yeah. Sorry about that. I think on free cash flow, we reported Q2 free cash flow, right? Like that's the $63 million that we reported out. For the full year, I think this is important, so I'm glad you asked the question, Mike. We are comfortable with the $100 million-$125 million free cash flow for the year after factoring in a potential impact from this third-party software use that we mentioned on the call, and the two other items, right? $33 million, which as you said, is separate matter from a previously outstanding litigation settlement. That's $33 million that was not factored in before. This $12 million of cash usage in Q3 for non-recurring tax obligations related to a portion of our employee RSUs vesting this month.
Mike Cikos (Senior Analyst)
Okay. Okay. Maybe, again, this is just me being naive here or phrase it how you will, but again, I just wanna make sure with the third-party provider, like how were they supposed to be using the software versus what we're seeing today as far as its interoperability testing? Again, I just wanna make sure I'm aware of like the different nuances here for what's causing this investigation in the first place.
Rukmini Sivaraman (CFO)
Yes. Understood, Mike. This is a software that we were using from a third-party software provider. It was evaluation software intended to be used for evaluation purposes, and instead it was being used by us for interoperability testing, validation and proof of concept. That is the matter that's being reviewed right now.
Mike Cikos (Senior Analyst)
I see. Because you it was intended for evaluation, but instead you guys were using it for interoperability testing and validation. Because of the different usage of that software, there's potentially a different cost for what you had been paying.
Provider. Is that a very simple way of putting that? I know I'm probably mischaracterizing a lot.
Rukmini Sivaraman (CFO)
Yes.
Mike Cikos (Senior Analyst)
I just wanna stress that. Okay. Okay.
Rukmini Sivaraman (CFO)
Yes, that's right, Mike. Yeah, it was intended to be used for evaluation software, and we discovered it was instead being used for these other, you know, interoperability validation and proof of concept. That's what's under review right now.
Rajiv Ramaswami (President and CEO)
Maybe I'll just say one thing there, Rukmini. I mean, what this means is therefore there might be some additional expense, right, in terms of usage of that software.
Rukmini Sivaraman (CFO)
That's correct.
Rajiv Ramaswami (President and CEO)
That's why we are, until we have, you know, this is done, we can't really specifically give you expenses.
Mike Cikos (Senior Analyst)
Got it. No, that's clear right now. I apologize. It must have been the way I was misreading or reading the press release, but that wasn't apparent to me initially. I don't wanna take up too much time, so I'll turn it over to my colleague here. Thank you for explaining that.
Rukmini Sivaraman (CFO)
Thank you, Mike.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of Meta Marshall with Morgan Stanley. Your line is open.
Meta Marshall (Managing Director)
Great. Thanks. Maybe one question for me or first question from me just on kind of the beat and better outlook. Just trying to get a sense of the blend of how much of that is from earlier renewals, and then how much of that is from the future, you know, less future start dates kind of moving in. Just trying to get a sense of kind of what the various contributors to the upside were.
Maybe just a second question, not to belabor the point, but just is there a way to contextualize, like in fiscal year 2022, just how much payments were to this vendor, just to kind of get a sense of, you know, why you have confidence that even with an increase in those payments, you would still be able to kind of meet the free cash flow targets that you laid out. Thanks.
Rukmini Sivaraman (CFO)
Thank you for the questions, Meta. Let me take that one by one. I think your first question was around just the raise for the full year, right? What contributed to that? I mean, clearly in Q2, we beat both on ACV billings and on revenue, right? I think that certainly makes us feel more comfortable raising the guide for the full year. On the revenue piece, we did try to provide some color for you in the prepared remarks around the percentage of future start dates. That does have, you know, an impact. You saw it had about $11 million impact in Q2. For Q3, we expect that to be about $5 million more of licensed revenue that gets recognized in quarter versus deferred.
There was some of that effect factored in, Meta, to your question on the full year. I think on renewals, you know, as Rajiv has said, and I emphasize this too, that our renewals business is doing well. That, you know, again, continues to underpin the significant majority of our growth, and lowers the risk somewhat given all of that is based on deals that we've already done that are coming up for renewal. Now, I think the second part of your question was, whether we'd be able to quantify, some of these payments, and we're not able to provide any, specific quantification on that at this point, Meta, given the review is ongoing.
As I said before, no, we are continuing to work diligently to try and get this resolved.
Meta Marshall (Managing Director)
Okay, got it. I mean, just maybe following up on the renewals piece, like clearly those are doing well, but just maybe in the past quarters, early renewals have been a greater contributor to upside. You know, just trying to get a sense if there's no early renewal component that we should be thinking of here as well.
Rukmini Sivaraman (CFO)
Yeah, I would say it's not outside the norm, Meta. I think we've discussed before, right? We typically do go to our customers as a lot of other vendors do as well, about, you know, even six months advance of the renewal date to begin those discussions. There will be some timing movements here and there. We do some quote arming like most subscription vendors do. But nothing outside of the normal or what we would expect that contributed to the renewal.
Meta Marshall (Managing Director)
All right, great. Thanks. Thanks so much.
Rukmini Sivaraman (CFO)
Thank you.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of Ben Bollin with Cleveland Research. Your line is open.
Ben Bollin (Analyst/Partner)
Good afternoon. Thanks for taking the question. I wanted to circle back a little bit on the renewals. Could you speak to how much of the footprint was up for renewal or is up for renewal in fiscal 2023 and how that develops into fiscal 2024? Then I had a follow-up.
Rukmini Sivaraman (CFO)
Hi, Ben. Thanks for the question. Yeah, we haven't quite provided kind of a percentage or most of ARR, right? That's up for renewal, I think is your question. We haven't quite quantified that, Ben, but I will say that, you know, overall, given where we are in our journey, right? You know, really all we sell now is subscription software, term license software other than, you know, professional services, which is a, you know, a small portion of the overall business. And our renewals are starting to flow in, right? We do expect to see kinda continued growth in that base of renewals as we layer on kind of the additional terms that we or just software that we have sold over time, right?
I would say that is a growing base of renewals, but we haven't provided a specific number or a percentage of ARR that's up in this year.
Ben Bollin (Analyst/Partner)
Okay. Excuse me. Then the other item, when I look at, the billings targets into, 3Q and then fiscal year
It implies a pretty notable acceleration into 4Q. What are you seeing that drives that acceleration following, you know, what you're guiding to in 3Q, and then what you're expecting in 4Q? That's it. Thank you.
Rukmini Sivaraman (CFO)
I think a few things. When you acceleration, if you mean growth, I think a couple of things I would say, Ben. Right? Typically our Q4 seasonally is a better quarter for us than Q3 is. And that's because it's the end of the, you know, fiscal year for us. And so that is expected. We also have, you know, last year, our Q4 ACV billings provides a bit of a, somewhat of an easier comp, given some of the dynamics that were happening in Q4 of last year. I think from when you look at the guidance for the Q3 ACV billings and quarter-over-quarter, what's implied for Q4, it's, I would say, within the range of what we would expect from Q3 to Q4.
Ben Bollin (Analyst/Partner)
Thank you.
Operator (participant)
Thank you.
Rukmini Sivaraman (CFO)
Thank you, Ben.
Operator (participant)
Please stand by for our next question. Our next question comes from the line of Matt Hedberg with RBC. Your line is open.
Matt Hedberg (Managing Director and Software Research Analyst)
Great, guys. Thanks for taking my question. You guys are coming up, I believe about on the one-year anniversary from when you had some sales attrition issues last year. It feels like a long time ago now. I'm wondering though if you could talk about just how general attrition levels stand today and maybe sort of kind of overall hiring plans for the remainder of the year.
Rajiv Ramaswami (President and CEO)
Yeah. I can take that, Matt. In general, by the way, the environment has gotten a lot better over the last year from a hiring perspective as well as a retention, given what's happening out there in the markets, both with respect to other large tech companies as well as a lot of the startups that our people were potentially going to, right? From that situation, I think things have gotten a lot better. Now to your question on the sales front specifically, we are doing, again, every quarter we've been seeing rep attrition, retention improve actually quarter-over-quarter. Our rep headcount has been roughly flat. We do expect in FY 2023 to grow our rep count modestly from where we're at.
At the same time, of course, we are very focused on continuing to drive higher rep productivity.
Matt Hedberg (Managing Director and Software Research Analyst)
Got it. Thanks. That's helpful. Then, congrats on that large federal agency win. Maybe just, you know, go kind of expand the aperture a bit and just talk about sort of like public sector spend in general. You know, how much of a driver, you know, has that been for you and how do you expect that to continue from here?
Rajiv Ramaswami (President and CEO)
First of all, I'll just say in the U.S., by the way, we only have two verticals. One is public sector and the other is healthcare. Public sector clearly very important for us. We are well penetrated into public sector across both civilian, defense, government agencies across the board, as well as state local education. It's a very important market. That's why we have a vertical presence in it targeted at that market. I would say it continues to be a very solid source of business for us. We continue to drive their modernization efforts. We are fairly broadly deployed, but we see continued opportunities there as well. It's a good and very important sector for us with continued spending.
Of course, they have their budget cycles, as you know, every year, right? I mean, depending on certain quarters where, towards the year end, and we tend to see a bump in the public sector sales during that quarter. That's again, it's all as usual, I would say.
Matt Hedberg (Managing Director and Software Research Analyst)
Got it. Thanks a lot.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of Aaron Rakers with Wells Fargo. Your line is open.
Aaron Rakers (Managing Director and Technology Analyst)
Thanks for taking the questions. I've got two as well if I can. I just wanted to maybe first ask about the ACV piece of the guidance. I know that you talked about the macro dynamics, but, you know, looking at the high end of the guidance range, it's still down about, you know, 15% or 16% sequential. I know you also talked about, you know, possibly a slight decline in, you know, duration. I'm curious, you know, that's definitely below what seasonality has looked like over the last couple of years. Is that all just macro? Is there something else that you're factoring in, or maybe quantify kind of that slight possible decline in duration? Just trying to unpack that guidance for ACV this quarter.
Rukmini Sivaraman (CFO)
Sure. Thank you. Thank you, Aaron. Yeah, we were happy to be able to raise both revenue and ACV billings guidance. You're right, Aaron, that sort of half over half, I guess it does imply a decline in ACV billings, like for second half over or first half. I would say, you know, one is what you've already pointed out and which we talked about, which is this modest elongation in sales cycles that we, there was anecdotal in Q1. We saw it. We saw a modest elongation in Q2, we have factored in, as I mentioned in my remarks too, right, some conservatism as it relates specifically to the new and expansion portion, ACV billings portion, right, of the, of the overall guide. There's definitely that.
If you look at a year-over-year growth rate, I think there's still a meaningful growth rate, you know, year-over-year for the, for the second half. That's, that's kinda how we are thinking about the ACV guidance for the, for the full year and implied second half.
Aaron Rakers (Managing Director and Technology Analyst)
Very, very helpful. On the free cash flow, I apologize for going back to this, but, you know, if you look at the first half of the year, you did about $109 million of free cash flow. If I take the adjustments that you've quantified, you know, factoring into let's just call it the midpoint of that $100 million-$125 million, you know, factor back in the $33 million and the $12 million that you talked about, it's still a particularly large decline relative to the first half. I understand that there's an unquantified element to this investigation dynamic. I guess the question is there anything changing within the free cash flow dynamic, be it working capital, that's changed in the back half of your guidance relative to what you saw in the first half?
I'm just trying to understand why free cash flow second half was first half down, aside from just those factors that you outlined?
Rukmini Sivaraman (CFO)
Good question, Aaron, thank you for asking a clarification question. Right. First is, I think as we sort of You just pointed out, actually, we do expect to see lower billings and revenue in the second half, which, you know, it does have an impact. As you can imagine, billings does have a direct impact on free cash flow. You know, I think you've done the math right around just the some of the items that we pointed out. As we said, it does factor in the potential impact from the use of this third-party software as well, which we are not quantifying at this point. That's how to think about the full year free cash flow guide.
We don't anticipate sort of any, you know, any significant material changes to working capital, or anything like that for the rest of the year.
Aaron Rakers (Managing Director and Technology Analyst)
Yeah. Thank you very much.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of Jason Ader with William Blair. Your line is open.
Jason Ader (Equity Research Analyst and Co-Head Technology Group)
Thank you. Good afternoon, guys. I wanted to ask just I think it may be confusing for folks on this third-party evaluation software. I think that, people may be wondering, evaluation of what? What are you guys evaluating with that software?
Rajiv Ramaswami (President and CEO)
Yeah, maybe I'll give you some color. Right. Eval software is meant for eval use, right? You go try it. You go try it out for whatever you're using it for, you try it out, and then at some point you purchase it. What we found was, in some cases, we were using the eval software for doing interoperability testing or customer proof of concepts, validating. That goes beyond the scope of what the eval software was being used for.
Jason Ader (Equity Research Analyst and Co-Head Technology Group)
The eval software, were you paying a very small amount because it was just eval software and therefore now you're gonna have to pay a lot more because you were using it for things that it wasn't meant for? Is that the idea?
Rajiv Ramaswami (President and CEO)
Yeah. We haven't quantified how much, right? We can't get into that kind of a detail here. Yeah. You're right? I mean, therefore, there's some additional expense required likely to for the usage and use cases that we were looking at.
Jason Ader (Equity Research Analyst and Co-Head Technology Group)
Okay, great. Another question for you, Rajiv, just on this whole cloud versus on-prem debate.
Rajiv Ramaswami (President and CEO)
Mm-hmm.
Jason Ader (Equity Research Analyst and Co-Head Technology Group)
Specifically, are you seeing any slowdown in the migration of workloads to the cloud because of recent customer cost sensitivity just in this environment that we've been in over the last six months or so?
Rajiv Ramaswami (President and CEO)
Yeah. You know, in fact, we gave you an example of a repatriation in our, you know, in our prepared remarks here. Definitely we are seeing, especially, you know, in many areas of the world now, customers are much, much more cost sensitive, in terms of looking at the cloud, the public cloud in particular, and saying, "When should I go to the public cloud and for what?" They're starting to look at the whole cloud economics as a very important part. In the example that we showed, for example, this customer was actually running a production workload in the public cloud. It was a mission-critical workload, and they decided to migrate it on-prem because they could get a better TCO. They could also get better support experience and response times from vendors by doing so.
We are seeing that definitely being much more nuanced now. It's not taking everything you have and going to the public cloud. It's being much more nuanced about what you put where and what is it gonna cost you.
Jason Ader (Equity Research Analyst and Co-Head Technology Group)
Great. Thank you.
Operator (participant)
Thank you. Please stand by for our next question.
Rukmini Sivaraman (CFO)
Thank you.
Operator (participant)
Our next question comes from the line of Simon Leopold with Raymond James. Your line is open.
Simon Leopold (Managing Director)
Thanks for taking the question. I wanted to see if you could maybe address the elongation of decision process, whether or not there's variation in this behavior between existing customers and new customers, or whether you're seeing any kind of patterns by customer types, verticals or something discernible like that. Then I've got a very quick follow-up.
Rajiv Ramaswami (President and CEO)
Yeah, Simon, that's a good question. I don't think we have that level of visibility because a lot of this is somewhat anecdotal, and we've seen it for both new and for existing customers. Right. Clearly for us, typically in the past, you know, expansion in existing customers is generally easier and quicker compared to new, right? Net new prospects. We are seeing an elongation in deals for both. I will also say it's a very modest elongation at this point. It's just that, for example, just anecdotally, well, you know, something that a VP may have budget for at a VP level and say, "Yeah, I'm gonna go ahead and do it," now is being scrutinized at the CFO level to say, "Okay, do you really have to go spend this money now? Can you wait?
Is there a TCO benefit that you can quantify for me quickly? That's the kind of, I think, dynamic that we are seeing. It's hard to parse out specifically. It varies a lot, by customers, but we're seeing this with both new and for expansion.
Simon Leopold (Managing Director)
Thanks. Just a quick one is on this third-party software issue, do you have insight into whether or not this affects your cost of goods sold or the R&D line, or you just don't know that yet? I guess I'm sort of trying to figure out where these charges would show up.
Rajiv Ramaswami (President and CEO)
Yeah. Rukmini?
Rukmini Sivaraman (CFO)
Thank you, Simon. Yeah. At this point, given this is ongoing, Simon, we're not able to get more specific, on the types of expenses or where the P&L it might fall.
Simon Leopold (Managing Director)
Thank you.
Rukmini Sivaraman (CFO)
Thank you.
Operator (participant)
Thank you.
Please stand by for our next question. Our next question comes from the line of Ruplu Bhattacharya with Bank of America. Your line is open.
Ruplu Bhattacharya (Director)
Hi. Thank you for taking my questions. I'm filling in for Wamsi Mohan today. Rukmini, one question for you real quick, just to clarify on the third-party software issue. Do you think that this impacts the historical, you know, last couple of years financials, and will you be restating your financials and maybe, you know, does this impact margins lower and earnings lower? Will you be restating that when you file your statements?
Rukmini Sivaraman (CFO)
Thank you for the question, Ruplu. You know, again, this review is ongoing, we really, you know, can't comment on any of that, Ruplu. We are, you know, working quickly and diligently to make sure we're able to, you know, provide more clarity on all of this. At this point, you know, there's really nothing more I can add on the specifics.
Ruplu Bhattacharya (Director)
Okay. Okay, maybe one for Rajiv. You talked about customers inspecting deals more and a slight modest increase in the sales cycle. You know, when I look at the new customer adds, right? This quarter, it was like 490, which really is the lowest quarter for new adds going back to 2017. Can you talk about like, you know, any thoughts on that? I mean, on that, you know, on the lower number of net adds this quarter. Any competitive dynamics you're seeing, or could this also, you know, any thoughts on FX? Because you price in dollars and, you know, with the dollar strengthening recently, how is the pricing environment and are you having to price lower?
Just your thoughts on the number of new adds and the competitive dynamics that you're seeing and then pricing.
Rajiv Ramaswami (President and CEO)
Yeah. I'll talk about two of those, and I'll let Rukmini comment on FX. First of all, we are focusing on higher quality, higher ASP new logos, more so than new logo count. We wanna make sure that when we get when we put our efforts to go winning a new logo, we make that count, right? Much more so, and provides us a bigger deal, drives up our sales productivity and also provides more expansion opportunities. That's been our focus more so than the new logo count. The new logo count shows up in terms of what it is. It's more of a result rather than a number that we're trying to focus on in terms of trying to hit a new logo target.
The second thing I would say is our, we are very much holding up our prices, right? Unit prices have remained very stable, and they're not going down in any way. The third part of it in terms of FX, Rukmini, perhaps you can comment.
Rukmini Sivaraman (CFO)
Yes. You know, Ruplu, your question, I think, was that given that we denominate all of our transaction in U.S. dollars, is it effectively a price increase, which it is in some parts of the world, right, where the dollar has strengthened. What we're seeing is this is anecdotal, right? In some cases, we've seen it sort of put some pressure on the timing of some transactions, especially in the emerging markets. Overall, I think to Rajiv's point, our unit economics and our overall pricing is in a good place. We haven't seen a sort of significant or systematic impact on that from any of these drivers.
Ruplu Bhattacharya (Director)
Okay. If I can sneak, one quick one in. Backlog was very high coming into this fiscal year. Did you also reuse backlog in the quarter, and what's the expectation for backlog for the rest of the year? Thank you so much.
Rukmini Sivaraman (CFO)
Yeah. Thank you for the questions, Ruplu. On backlog, yes, you're right. When we entered this fiscal year, at the end of July, we did say that we had record levels of backlog. We expect during the course of the year to use that backlog over time to get to a more normalized level by the end of the year. We did use some backlog in Q2, in line with our expectations. Again, we expect that we will continue to consume that over the course of the rest of this year.
Operator (participant)
Thank you. Please stand by for our next question. Our next question comes from the line of George Wang with Barclays. Your line is open.
George Wang (VP Senior Analyst)
Hey guys, congrats on the quarter. Just maybe you can Rajiv kind of unpack kind of service provider channel, you know, any kind of updates you have? Last quarter, you talked about, you know, the SP channel as a new sort of, you know, area to kind of lend new customers. Just curious if you have any kind of updates on this?
Rajiv Ramaswami (President and CEO)
I think, George, we are certainly very excited about that route to market because we are relatively new, you know, in terms of our using this route to market for us. It's a growing business opportunity for us. Last quarter, we said, you know, the largest deal in the quarter was done through that SP channel. We're still at the very early stages in that in that innings there. We continue to build up our service provider partners. We're trying to enhance the product capabilities to provide a very as broad an offering as possible. We have. It's a journey, and it's gonna take us multiple quarters for it to start becoming a significant chunk of our business.
Right now, it's still a small portion of our overall business.
George Wang (VP Senior Analyst)
Oh, okay. Thanks. I have a quick follow-up. Just in terms of AHV, kind of your own hypervisor, this quarter is 63% mix, up two points, sequentially. Can you give some color just on the traction of your own sort of hypervisor and how are you seeing in terms of the, you know, migration kind of customer reception?
Rajiv Ramaswami (President and CEO)
Absolutely. I would say it's becoming more and more important now in the context of the whole VMware Broadcom acquisition as well. For us, it's always been a blend. We would like to see, of course, more customers using AHV, okay, on the one side, which of course will mean that our AHV as a percentage of our workload keeps going up. At the same time, we see there's a huge opportunity in terms of us inserting into other hypervisor footprints. In fact, that's the default. It used to be, you know, if you go back many years ago, that was our default. We would insert into somebody else's hypervisor environment, like a VMware hypervisor. We wanna continue that because there's still a huge opportunity there.
The model, you know, with customers has been, in some cases, you know, we will go insert on top of a third-party hypervisor with the rest of our solution stack, so our software-defined storage, for example. Over time, they will choose to migrate some of that to AHV. We also have a dynamic where in many new customers, they go all in with AHV from day one as well. We have both those dynamics, and we wanna maintain a balance of both because we do want to, of course, have customers on our own hypervisor and sell them the full stack solution. At the same time, we wanna be able to go after those customers that have other hypervisors and be able to insert into their environments as well.
I'd say, so that's the blend that we're trying to get comfortable with. AHV overall continues to mature. More and more customers using it. Ecosystem is becoming broader and broader. We have third-party certifications like Red Hat and others on it now. it's becoming, let's call it, ready for all mission-critical workloads at this point.
George Wang (VP Senior Analyst)
Okay, great. Thanks.
Rukmini Sivaraman (CFO)
Thank you George.
Operator (participant)
Thank you. Due to the interest of time, our final question comes from the line of Thomas Blakey with KeyBanc. Your line is open, sir.
Thomas Blakey (Senior Research Analyst)
Hi. Great. thanks for sneaking me in, guys, and a nice quarter. I just wanted to maybe just simplify a lot of the questions that were asked about renewal trends. I mean, it's very important for hitting longer-term free cash flow targets. Could you maybe just speak to the trend, you know, no numbers, in fiscal 2022, fiscal 2023, what you're seeing from a renewal opportunity in fiscal 2024 to fiscal 2025 to hit those targets? Is the trend moving in the right direction? I'll just start there.
Rukmini Sivaraman (CFO)
Hi, Tom. Thanks for the question. Look, I think we've emphasized a few times, and I'm happy to I think clarify for you, Tom, it's a good question on just the overall, you know, renewals work stream. We've talked about how it's a driver both of our growth and efficiency. It continues to perform well. Yes, we do believe it's going the right direction, not just for, you know, fiscal year 2023, as we talked about the majority of growth coming in in 2023, but also more generally, right? That's why we did mention that we reiterate our sort of $300 million plus free cash flow number for 2025. We continue to believe that that thesis still holds.
Thomas Blakey (Senior Research Analyst)
Thanks. Thanks for that. You know, given the commentary around the macro, maybe a downtick in my opinion from what I'm hearing from the last couple quarter calls here. Combined with the solid results, can we get some feedback in terms of what maybe the higher kind of net dollar retention rate was on some of these renewals? You know, were those numbers up, and what was driving that?
Rukmini Sivaraman (CFO)
Right. I think is your question more on NRR or net dollar-based retention rate metric, Tom?
Thomas Blakey (Senior Research Analyst)
Yeah.
Rukmini Sivaraman (CFO)
Is that the question?
Thomas Blakey (Senior Research Analyst)
Yeah.
Rukmini Sivaraman (CFO)
Okay.
Thomas Blakey (Senior Research Analyst)
From the renewals, yeah.
Rukmini Sivaraman (CFO)
Thank you for that. I think I want to first clarify that when we talk about renewals billings, we're purely talking only about renewals, right? It does not factor in any of the expansion. That is factored into our new and expansion portion, right, that sort of incremental ACV. NRR, to your point, Tom, we don't actually disclose on a quarterly basis. What I will say, though, is, you know, if we look back to our last Investor Day, we had given some ranges, you know, that 120%-125-ish% sort of range. And it is still in that range, in terms of the NRR number.
As we've also talked about how for new and expansion is where we're baking in some caution as it relates to the, you know, the full-year guide given what we're seeing in the business.
Thomas Blakey (Senior Research Analyst)
All right. Okay, thank you very much.
Rukmini Sivaraman (CFO)
Thank you, Tom.
Operator (participant)
Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.