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spk02: Hello, and thank you for standing by. Welcome to the C3 AI second quarter fiscal year earnings conference call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 1 on your telephone. It is now my pleasure to introduce Ruben Gallegos.
spk14: Thank you, Andrew, and good afternoon, and welcome to C3AI's earnings call for the second quarter of fiscal year 2023, which ended on October 31st, 2022. My name is Ruben Gallegos, and I'm the Vice President of the Investor Relations. With me on the call today is Tom Siebel, Chairman and Chief Executive Officer, and Juho Parkinen, Chief Financial Officer. After the market closed today, we issued a press release with details regarding our second quarter results, as well as a supplemental to our results, both of which can be accessed through the Investor Relations section of our website at ir.c3.ai. This call is being webcast, and a replay will be available on our IR website following the conclusion of the call. During today's call, we will make statements related to our business that may be considered forward-looking under federal securities laws These statements reflect our views only as of today and should not be considered representative of our views as of any subsequent date. We disclaim any obligation to update any forward-looking statements or our outlook. These statements are subject to a variety of risks and uncertainties that could cause actual results to differ materially from expectations. For a further discussion of the material risks and other important factors that could affect our actual results, please refer to our filings of the SEC. All figures will be discussed on a non-GAAP basis unless otherwise noted. Also, during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release. Finally, at times in our prepared remarks, in response to your questions, we may discuss metrics that are incremental to our usual presentation to give greater insight to the dynamics of our business or quarterly results. Please be advised that we may or may not continue to provide this additional detail in the future. And with that, let me turn the call over to Tom.
spk15: Thank you, Ruben, and hello, everyone. Thank you for joining us. I'm here with Juho Parkinen, our Chief Financial Officer, and we are most pleased to share our results for the second quarter of fiscal year 23. Bottom line, it was a solid quarter in which we delivered our stated objectives and met expectations. despite the rocky economic situation and the generally morose condition of the markets. In the last earnings call, we described two strategic initiatives to spur faster growth. One was to recompose our sales team with an emphasis on technical and domain expertise. The second was to shift our pricing model from a subscription-based pricing model to a consumption-based pricing model. I'm happy to report these initiatives have been successfully completed in the second quarter. I will explain these actions in some detail, but first I'll comment on the financial results and some of the successes that we achieved during the quarter. At large, the quarter was quite solid. Subscription revenue for the quarter was $59.5 million, an increase of 26% year over year. Operating loss improved 15 points year-over-year to 24%. We continue to maintain a healthy growth margin of 77%. Customer count grew 16% year-over-year to 236. Current RPO of $164.5 million was down slightly and consistent with our expectations as we transitioned to a consumption-based pricing model. We ended the quarter with cash reserves of approximately $860 million. The number of completed contracts from the quarter increased to 25, approximately 100% increase year-over-year. Our average contract value in the second quarter was just over $800,000, down from $19 million a year earlier. This reduction in contract value was a direct result of our new pricing model. We believe the new pricing model will result in a substantially increased number of smaller transactions, providing greater forward visibility into both revenue and bookings. Our new consumption-based pricing model was well received by our customers, our prospects, our partners, and by our sales organization. We expect this new model to increase the number of customers with which we engage in any given quarter by an order of magnitude. As these customers continually increase their usage over time, we expect the compound effect on revenue growth to be quite significant. Our customers and prospects find the new consumption-based pricing easier to understand and easier to contract. Our market partners find this new pricing model well aligned with how they price their own services and one that facilitates their successfully selling CTAI products. I'm happy to report that our transition to this new consumption-based pricing model is now complete. Simultaneously, last quarter, we completed a transition of similar magnitude with the re-composition of our global sales team. We are now growing a team of highly qualified, well-trained, technologically expert sales professionals who are engaging with prospective customers and selling pilots, and expanding production usage with existing customers. There is no question that there is pervasive economic uncertainty in the global business community that continues to provide bookings headwinds. This has been especially significant in the tech markets that are experiencing experiencing a bloodbath in equity prices with significant layoffs in companies including Amazon, Meta, Salesforce, Google, Snap, and many others. I believe this is just the start of what will be a significant tech market correction. Layoffs at established companies will accelerate. The many Series A, B, C, and D companies that are hemorrhaging cash will simply not survive. Just like every other tech recession that we've seen, the human capital at the piece parts companies will be redistributed to those companies that survive. We're confident in our business outlook, especially with the nearly $600 billion addressable market opportunity that we have before us. We continue to invest in our products and in the talent required to meet our goal of building a cash-positive, profitable business that will return to a growth rate of greater than 30% year over year within the next 18 months. Our employee base grew last quarter to over 850, a sequential increase of 83, and we continue to hire key engineers, data scientists, sales professionals, and other key roles across the organization. Turning to some of our customer successes in the quarter, Shell has continued to expand their use of our solutions in new areas and has successfully implemented C3 AI sustainability for manufacturing at two of their key offshore platforms in the Gulf of Mexico. We also have successfully concluded an ESG trial with Shell that focused on leveraging NLP to generate targeted insights on the rapidly evolving ESG priorities of Shell's key stakeholders. Shell has already addressed and communicated that they are realizing massive economic value annually by deploying our C3A applications across the enterprise, upstream, downstream, midstream renewables. We're just getting started. There's a large and growing pipeline of enterprise AI applications that challenge building, testing, and deploying using the C3 AI platform, realizing the strategic value of our partnership and the fulfillment of the digital transformation of one of the largest and most iconic companies in the world. Cargill has continued to expand their use of our solutions, and optimizing food production and distribution to meet the dynamic needs of the market and ensuring sustained food value chains in North America, Latin America, Europe, Africa, and Asia. This is a critical mission that has enormous humanitarian ramifications, and we're proud to participate with Cargill in this important mission. Lastly, we're proud to say that we've continued to expand our relationship with the United States Air Force, working closely with them to improve aircraft availability and efficiency of readiness programs of the entire fleet of over 3,700 aircraft. The AI capabilities that we are putting into operation today offer the potential to improve readiness rates by up to 20% and reduce the cost of maintenance by up to $4 billion per year. Let me address our partner ecosystems. In recent weeks, there's been something of a seismic shift in the enterprise AI software space. Traditionally, the primary competition to purchasing C3A enterprise applications was to license, was for a company to license, so the alternative of purchasing C3 was for a company to license a large number of tools from the hyperscalers, piece parts, from providers like Caldera, Pivotal, Databricks, DataRobot, and the many of the scores of other point solution providers, and then engage in a long and expensive science experiment in an attempt to build a custom enterprise AI platform. No one to our knowledge ever succeeded at that. Now, the market is truly changing due to it changing and demonstrating an increased desire for production, tried, tested, proven enterprise AI solutions. All of the hyperscalers have acknowledged this within the last few months. Thomas Curran at Google Cloud was the leader, announcing the TCP would lead in the market, not with piece parts, but with turnkey production enterprise applications from C3 AI. Then last week, Adam Solitsky, CEO of AWS, announced that their customers were now demanding turnkey applications, not toolkits. This was followed the next day by Scott Cutler, EVP, and Microsoft Azure, all announced that the customers were telling them that they no longer wanted toolkits to build applications. They now want functional turnkey AI applications that accrue immediate value. With a growing family of 42 production enterprise C3 AI applications in the market that serve the needs of financial services, utilities, health, manufacturing, defense, intelligence, and other industries, C3 AI is well positioned to capitalize on this now clearly recognized market requirement. We sell with GCP. We sell with Azure. We sell with AWS. We sell with David Hughes. We sell with Bruce Callen Hamilton. and we are well positioned to help our partners to deliver to their customers the solutions they are demanding. CGAI and Google Cloud are continuing to jointly invest in industry applications with the launch of two new enterprise AI applications last quarter optimized on GCP. Our sales teams are actively co-selling today to over 300 accounts around the world. Last quarter, we closed an expansion with a large transportation company, jointly signed one of the top 50 retailers in the world to license our supply chain applications, and signed several new deals in the financial services and oil and gas industries. Our GCP joint selling activity is quite brisk, and as a result, GCP is our fastest growing install base. That being said, AWS remains C3.AI's largest installed base, constituting about 56% of our customer base. C3.AI and Microsoft continue to close deals, particularly in the energy and manufacturing sectors. Azure remains our second largest installed base, constituting approximately 27% of our customer base. We announced a number of new product enhancements here in the course of the quarter that I'm not going to review in this call, but we continue to invest in technology leadership. We continue to invest in R&D, and we continue to add to our industry-leading portfolio of enterprise AI applications and add greater depth and increase performance to these existing applications. Let me talk for a minute about human capital. C3AI continues to be recognized as a great place to work. In the second quarter, we received over 23,000 job applications. We interviewed over 2,200 of these applicants and we hired 90. One of the secular changes of this tech downturn is the increased availability of highly trained professionals who are willing to come into the office roll up their sleeves, and get to work. We have never been more confident with the team that we have and with their ability to execute our strategy. Turning to guidance, our Q3 revenue estimate is expected to be between 63 and 65 million, and we are reaffirming our full year, fiscal year 23 revenue guidance of $255 million to $270 million. For non-GAAP operating loss, we expect in Q3 between $25 million and $29 million. And for the full year, we expect operating loss between $85 million and $98 million. We continue to operate at roughly an 80% non-GAAP gross profit margin. We have a clear path to top-line growth, non-GAAP profitability, and cash-positive operations by the end of fiscal year 24. At this time, we do not see our cash balances falling below $700 million before that inflection. Final comments on the big picture. C3 AI is addressing a $600 billion addressable AI software market. If not the largest, we are one of the largest providers of these applications globally. Our business is exactly on track with what we have communicated to you. Our goal remains to establish and maintain the global leadership position in enterprise AI software. In the short one, we believe tech companies and tech equities will continue to face headwinds as long as the Fed keeps its foot on the brake. The collateral damage, I think, is going to be more significant than people think. That being said, when the Fed takes its foot off the brake, be that in 2023 or 2024, C3 AI will be bigger, stronger, cash positive, profitable, a clear market leader, and well positioned to benefit from the inevitable equity market surge that will ensue. Now let me turn the call over to our CFO, Juho Parkuden, for a summary of our financials and additional commentary. Juho.
spk10: Thank you, Tom. Now I will provide a recap of our financial results, add some color to the drivers of our financials for the back half of the year, and conclude with some additional color related to the consumption-based revenue model we introduced on our last call. As Tom mentioned, we ended the quarter with revenue of $62.4 million, which represents 7% year-over-year growth. Subscription revenue increased by a solid 26% and was 95% of total revenues. Gross profit increased 5% to $47.8 million, and gross margin decreased 122 basis points to 76.6%. The decline is primarily due to a higher mix of trials and pilots, which carry a higher cost required to ensure customer success during this early phase of engagement. Operating loss of $15 million improved $7.6 million year-over-year, and operating loss margin also improved from 39% in the prior year to 24% in Q2. Our customer count increased by 16% year-over-year to 236%, and we closed 25 deals during the quarter. It's noteworthy that deals under $1 million grew 157 year-over-year in Q2. Now, turning to RPO and bookings, we reported RPO of $417.3 million, which met our expectations as we continue to convert to consumption-based deals. Current RPO was $164.5 million, down 8% from last year. We continue to see positive trends in bookings diversity outside of oil and gas, particularly in the federal, aero, and defense sectors, which grew sequentially and year over year. Turning to cash flow, free cash flow for the quarter was an outflow of $77 million. Breaking this down, $23.7 million was for the build-out of our new headquarters. As I have mentioned previously, this will be amortized over the term of the lease and will not have a meaningful impact on our path to profitability. Normalizing for this payment, our adjusted free cash flow was an outflow of $54.3 million. Turning to guidance-related assumptions, as Tom mentioned, we have completed our transition from a subscription-based pricing model to a consumption-based pricing model and are now focused on ramping revenue from consumption-based deals. With respect to gross margin, As the number of pilots ramp in the coming quarters and as the proportion of period revenue is more weighted towards pilots, we expect gross margin percentage to decline. However, consistent with the financial model we shared with you as part of the prior quarter earnings call, we expect the gross margin to increase to historical levels by the same time we expect to reach our initial non-GAAP profitability. Operating margin model and guidance includes our expectations for revenue growth and gross margin impact. Looking at our cash reserves, we have sufficient capacity to execute our plan to invest for growth in the coming quarters. We are well capitalized, having approximately $860 million available. With the planned expenditures related to the build-out of our new headquarters and investments in our business, we expect our cash investment balance to bottom out in fiscal 24 before we see improving free cash flow and improving cash balances thereafter. As a reminder, one of our most significant cash usages has been for the build-out of our new headquarters, which unlike many high-tech companies, we actually occupy. We are on track to achieve positive non-GAAP operating margin in the fourth quarter of the next fiscal year, driven by accelerating revenue growth and improving gross margin. Regarding the transition to consumption-based pricing, as a reminder, we do not require existing customers to move to a consumption-based arrangement. our customers have been satisfied and are expected to remain in their current contract terms. As such, we expect RPO to decline as our new deals will not require a significant upfront non-cancellable arrangement, but rather a consumption-based usage arrangement. The assumptions we provided last quarter for modeling the consumption-based business remain unchanged. In summary, We are focused on delivering profitable growth to our shareholders, and we continue to expect achieving non-gap profitability in the fourth quarter of fiscal 24 while growing the top line in excess of 30%. With these remarks, I would like to open the call up for questions. Operator.
spk02: Thank you. As a reminder, ladies and gentlemen, to ask a question, you will need to press star 1-1 on your telephone. Please stand by while we compile the Q&A roster. And our first question comes from the line of Brad Zelnick with Deutsche Bank.
spk13: Well, thanks so much, guys. I really appreciate you taking my questions. I guess my first one is either for you, Tom, or for you, Ho. As we think about the plan that you've laid out, and it's nice to see the progress relative to what you told us last quarter, but traditional metrics obviously don't tell the full story. So what's the right metric for us to track the progress quarter to quarter that you're making? What are the milestones that we should be looking for? And maybe can you tell us what metrics do you measure yourselves against internally and hold the sales force accountable to and incentivize them on so we can just get a sense quarter to quarter? In addition to customers, obviously, they eventually translate to dollars, but any insight there is helpful. And then I've got a follow up.
spk07: Thanks. Hi, Brad.
spk15: It's Tom. I mean, I think the bottom line is when we go to this model, we're looking at number of customers, okay? So how many new pilots are closing every quarter? We'd expect in the outer quarters, I mean, this should be an order of magnitude larger than we're doing now. I think we did, what, 13 or 15 last quarter in roughly half a quarter because, I mean, we announced the transition to this model about halfway through the quarter, and we did We did 15 and about a half orders. So it's basically, it's really number, we're really looking at number of customers, Brad, and then we're looking at how far we, you know, how rapidly they grow the use of their products. If in fact we get an order of magnitude more customers and they continue to grow their use as our customers have in the past, and you know we've modeled this very carefully, I mean, we get out there three, four, five quarters, this revenue line should accelerate pretty dramatically.
spk05: Right.
spk10: Brad, just one thing to add to that. So we guided in our original model for the analyst community to expect five pilots for the quarter. We actually closed 13, which was a combination of trials and pilots. So we were quite excited about how this kicked off.
spk13: Thank you for that, Juho. That's helpful. And maybe just one follow-up. Appreciating the accelerated path to profitability and naturally just given what's going on in the world, you guys are in a pretty interesting position for sure. But what would need to happen to get you to positive free cash flow ahead of the fiscal 24 expectation? And maybe can you just clarify for us, is that an exit rate? Is that for the full year, how do we measure that and what circumstances would maybe cause you to accelerate that? Not that you need to, you've got plenty of cash, but this is clearly the discipline that the world wants to see.
spk03: Brad, it's simple.
spk15: We can throw this to be cash positive and profitable, honestly, within 90 days. All I get to do is lay off about 40% of the workforce. Okay. Now, I don't think – I mean, that might make some analysts happy, and it might make some shareholder happy, but it's absolutely not in the best interest of the shareholders, the employees, or the customers. And, but I mean, it's all we have to do is basically stop all marketing expenses and laugh 40% of the people. And it's, you know, I don't know whether it's 40% or 50% or 35, but it's, you know, it's, I mean, hard stop. It's cash positive and profitable like next quarter. And, but I, you know, I don't think that would be responsible and I don't think it's anybody's interest, but you asked the question, we gave it the answer. You all, you have any further light on it? Only thing brought up.
spk10: We've, The way that we've modeled our past profitability, we feel confident on that and we stick to it.
spk13: Got it. So just to clarify the expectation, though, it's for the full year. Is it an exit rate when you say fiscal 24?
spk10: Oh, it's an exit rate at Q4 and F1 24.
spk13: Awesome. Gentlemen, thank you so much. Truly appreciate you taking the questions.
spk15: Thank you, sir.
spk02: Thank you. And our next question comes from the line of Mike Sykos with Needham & Company.
spk06: Hey, guys. Thanks for getting me on here. I did want to circle up on some of the customer count dynamics just because I know that is going to be one of the metrics we're looking at while you guys are going through this transition. I think you guys incited 236 up from 228 last quarter, right? And I just wanted to see what has the customer behavior been like since you guys announced this transition. And what I really would be interested in hearing is, I know you guys are not forcing your customers to migrate down to the consumption model, but curious to hear, have you seen customers trade down to the consumption model since you announced this transition? And then the second question there is, have you seen any changes in customer behavior from a churn perspective?
spk03: Hi, Mike. It's Tom.
spk15: No customer, just in customer terms, has requested to convert to the consumption-based pricing model. Understand that these customers are huge. I mean, you get into Shell, you get into Coke, Baker Hughes. I mean, these are very, very large relationships now. And you can imagine their licensing terms are pretty favorable and unique to them. Have we seen any significant change in customer churn? No.
spk06: Appreciate the color there. And then for the follow-up, I did want to, I guess, look back at what we had spoken about last quarter with deals getting pushed out, just given the current environment. So specifically, you guys had called out 66 deals last quarter getting pushed. Have you closed any of those deals in the interim? And do we still see a similar order of magnitude for deals getting pushed? Given that you guys have made this transition, are you helping streamline the adoption process for those customers and accelerating those sales cycles?
spk10: Yeah, so we did close some of those deals that were pushed out of last quarter. And like we expected from our revenue guidance, the macroeconomic climate was tougher for the second quarter. after Q1, but it has stabilized. And in particular, with our new consumption-based pricing, I think our customers and potential new customers are reacting well to that strategy.
spk06: Got it. It makes a ton of sense, especially when I think about that average contract value declining from call it 19 million to less than a million this quarter. So thanks a lot, guys. I'll step back into the queue. Thank you.
spk02: Thank you. And our next question comes from the line of Pendulum Bora with JP Morgan. Pardon me, Pendulum, your line is now open. Please check your mute button.
spk01: Oh, I was talking to myself. Hey, guys, thank you for taking the question. I want to ask about the subscription revenue outperformance. Seems like a big outperformance in the quarter. Was that largely because of the outperformance in the number of pilots that you're doing? Because I Even if you had closed some of the deals that got pushed, I wouldn't have thought that you'd recognize a ton of revenue from those. So help me understand that.
spk03: Well, I think you kind of got it.
spk15: There were some previous transactions that were not based on consumption-based pricing that did close in the quarter that did contribute to that. So I think you called it accurately, Benjamin.
spk01: Okay, so it was because of the deals that closed. Okay. Tom, on a high level, maybe I don't understand what are you hearing from CIOs in terms of IT budgets for next year? Are people – you kind of called out, obviously, the headwinds on macro, but are you hearing people kind of resetting their budgets for next year, next calendar year? What are you hearing?
spk15: I think it's a really good question, and it varies from company to company. I mean, there are a lot of companies that see this and organizations in the federal government. And by the way, I didn't comment on our federal business, but our federal business is really strong, particularly in the defense sector. And if you saw the defense budget that's flying through today, it's increased, I think, almost $200 million. I'm sorry, $200. billion dollars over last year if I'm not mistaken so you know that's a big business you know I think there's kind of two categories there's companies that are like bearing down and using these technologies to figure out how to save money that would include Shell that would include the Air Force okay okay and then there's companies that whose name I will not mention, that are just absolutely going to the mat and slashing expenses on everything. They're going into the bunkers, and they're going into recession mode, and we will see some customer return from that. Okay, hard stop. Okay, they're just cutting to the bone, and so there's kind of two classes of companies out there, those who are investing in savings and those who are just kind of going into a knee-jerk, perfectly rational response to a impending significant recession and then just slashing all costs. And so we see both. And I don't know how long this lasts. You know, you guys are the pros of this, whether it's 12 or 24 months. But, you know, when it's over, we're going to still be here, you know, plug it away at it. But it's, you know, it's, you know... you cannot deny that it's, you know, I mean, it is rocky out there.
spk01: Yep, understood. Thank you so much for the insights.
spk02: Thank you. And our next question comes from the line of Patrick Walravens with JMP Securities.
spk16: Oh, great. Thank you. I want to do a couple sort of financial ones to start with, if that's okay. So, Gross margin, if I'm looking at it right, non-GAAP was 77, down from 81 last quarter. Is there anything worth noting there?
spk10: Hi, Pat. It's Yuho. The only thing to call out there is that when trials and pilots, as Tom mentioned on the opening remarks, there is more higher cost than those in the ongoing subscription. So as we see increase of pilots and trials even in the coming quarters, we are expecting some pressure on gross margin before it climbs back up to historical levels.
spk16: Okay. So as I look forward, should I be around this 77 level?
spk10: I think you should expect a little bit more of a pressure as we increase the pilot as proportion of total deals. And by the time we're back at Q4 FY24, we should be back at these rates and higher. Okay.
spk16: And then the subscription fee, but services missed at least my number by a lot and went down sequentially by a lot. What's to note there?
spk10: Only thing is that the services is a direct result of our transition to these pilots in our new consumption-based pricing model. There are minimal upfront big professional services deals associated with these. So as we... As the pilots convert to ongoing license arrangements, we do expect the services component to increase as well. And in the second half of this fiscal year, we actually are expecting services to return back to the 10% to 20% of our total revenues. Oh, for Q3, it would be 10% to 20% of total revenue? I'm saying the full back half of the year, so it could be somewhere in the range for Q3 and higher or lower in Q4. Okay. Okay.
spk16: And then if you look at the subscription revenue of $59 million and change, the footnote says 32% of that is from related parties. Do you mind just explaining that for people? Because I do get that question quite a bit.
spk10: It's just the related parties relating to Baker Hughes. So Baker Hughes is, of course, still a significant shareholder of C3AI, and any revenues that we interact with Baker Hughes' direct purchases, we call them out in the financials.
spk16: Yeah, and so, Tom, the bear case would be that in some way is a lower quality revenue. What would your response be to that?
spk03: Oh, boy.
spk15: Yeah, I'm sure you have one, but... I don't know how to respond to that. I mean... we're going to be doing a lot more deals with a lot more customers. We're going to convert a lot more of them into production, and they're going to grow just like Shell, Baker Hughes, Coke, and everybody else has grown. And, you know, there's, you know, so right now things are looking pretty promising. I think we're right on track.
spk16: Okay, great. Last one, and this one is probably for you, Tom. So you signed – it's been a year since you signed that $500 million production other transaction agreement with the Department of Defense. How would you say it's going so far versus your original expectations?
spk15: DOD is really big. So I think that year over year, DOD grew by what percent? A hundred percent. A hundred percent. Roughly 100%. 100% in terms of bookings. DOD is a real bright point, Pat. You're talking specifically on MDA. The MDA agreement applies to all of DOD, by the way. And then we have another $100 million agreement with RSO. And we'll announce in this release, but tomorrow morning there should be an announcement about a big partnership that we're doing with with Booz Allen Hamilton in all of the federal government, particularly DOD, but that business is looking strong.
spk07: All right, great. Thank you very much.
spk02: Thank you. Thank you. And our next question, Pete Singh with Morgan Stanley.
spk00: Excellent. Thank you. This is DO2, known as Sanjit. I really just want to touch on sort of the consumption growth that you're seeing, especially with the Ex Machina product. Just if you can sort of provide any color on, one, how you see consumption trending with those customers, and then how you expect that going forward and maybe sort of related to this environment, how are customers using it maybe differently than they have before? Sure.
spk15: Okay, great. This is Tom. And I would say of the various products that we have in the marketplace today, of which we have, I think, 42 production products, Ex Machina being one of them, we are underperforming on the execution of Ex Machina sales. It is a dramatically superior product to other products that are out there in the marketplace. That being said, it's kind of order of $1,000 thing, okay, in terms of a unit, okay? And we really haven't put the sales motion together to do that at scale. Now, we've taken the objectives to get after it, but I cannot look you in the eye and say that we're hitting that ball over the left field fast because we're not, okay, in terms It's a great product. Our customers love it. We have somebody, we have three customers that have much greater consumption. Baker Hughes and Conair. Baker Hughes and Conair. Almost 900% increase. 300% increase there. But can I look you in the eye and tell you that we're realizing the potential of that product? That product could be an entire separate company. Our CRM product could be an entire separate company. Our ESG product could be an entire separate company, standalone company. And in all three of those, I think we really need to get focused and get going, and we haven't done that yet.
spk00: Okay, that's helpful. That's helpful. I mean, your commentary sounds worse than the 270% consumption increase that you're seeing there. Any colors on what's enabling that increase in consumption? And then to... How are you, in your other products, trying to enable similar consumption rates? Is there anything to highlight that you're doing differently there to get to those kind of trends that you're seeing in this product, although you're not highlighting it specifically?
spk15: Do you want to focus on Ex Machina? Is this about Ex Machina or is this about our raw products?
spk00: This is more broadly. Okay.
spk10: Rob, go ahead. Let me just kind of add on to that. So for Ex Machina, just what Tom said, like he was We're still very early stages on that. So, yes, we see those key customers that started early with us, massive increase in consumption. Yes, we're excited about that. But that entire product is completely in its infancy, and we have high expectations on it. With the other point on other consumption, so remember, again, we start these pilots, The consumption deal starts with a six-month pilot, and then it moves into consumption. We started this quarter, so we're not really seeing any consumption until the initial six-month phases are complete. So that question, and as we start talking about consumption under all the other deals that we do, we'll start reporting and discussing that more detailed probably in Q1 next year.
spk00: Okay, got it.
spk10: Thank you.
spk02: Thank you. Thank you. And our next question comes from the line of Kingsley Crane with Canaccord Genuity.
spk04: Hi, thanks for fitting me in. So for Tom, looks like there's strong traction in Department of Defense, new and expanded deals with numerous agencies. Imagine the AI Defense Forum was a helpful touchpoint to close these. So how would you characterize momentum in this sector? And then are these companies embracing the new consumption model or are they preferring to commit more upfront in the legacy model?
spk02: I'm showing our next question comes from the line of Kingsley Crane. Please go ahead.
spk15: Yeah, this is Kingsley. Kingsley, hi.
spk04: Yeah, could you hear me?
spk15: No. One more time, please.
spk04: Oh. Okay, right. So for Tom, looks like there was really strong traction in the Department of Defense, expanded deals with numerous agencies. How would you characterize momentum in this sector compared to a few years ago? And then are these companies looking at the consumption model? Are they – primarily sticking to the current model?
spk15: Great question. You know, it takes some time to really get traction in DOD, okay? And we've been working on that since, you know, 2014, okay? You know, at the level of the Secretary of the Army and the Secretary of the Air Force and the Joint Chiefs and And, you know, we've really been working hard. I think we have 12 projects all delivered on time on budget to spec. And really what we're finding is the consumption model there is really, really well received. They like it. Okay. And, you know, they're kind of used to seeing these, you know, multi-billion dollar juggernaut projects from the Lockheed Martins of the world or these, or, you know, other providers. And we're coming in where, hey, we'll bring the project live for half a million bucks. And after that, 55 cents per CPU hour. So it's like, where do I sign? So there, you know, it's been very well received in that market.
spk04: Okay, thank you. That's really great to hear. And then for you, Ho, just want to touch again on the services revenue. You know, understandable that it would be lower given some of the trial activity. So, since we expect trials to continue in the new consumption model, just trying to get a better handle on how quickly services should ramp back up to that 10 to 20%.
spk10: Well, again, there's a component of the ongoing relations with our existing customers and potential services engagements with them, and then our expectation of services engagements as these pilot deals convert to consumption deals. So what I was alluding to earlier to Pat's question, we are expecting services activity in the second half of this year, and then separately in the long-term models, you should expect that as the pilots convert to consumption, there are services deals associated with those as well.
spk04: Okay, thanks, very helpful.
spk02: Thank you. And our next question comes from the line of Arsenij Matovic with Wolf Research.
spk05: Hi, this is Arsenij on for Gal, and I think on the call you said there were 13 consumption pilot wins in the quarter, and maybe that was maybe better than you initially expected. Is that a run rate you're comfortable with going into the end of the fiscal year? the back half, and any particular call-outs for sectors where the consumption model is maybe getting better traction than you initially expected? Thank you.
spk10: So, sorry, the second half of your question, it was a little unclear, but let me address the first one. Yes, well, we're excited on the beginning of this. So we did 13 pilots and trials, so there's still a combination of some of the trials in there, but we do expect them to convert to a consumption-based arrangement at the end of the trial period. I do not... we would not want to increase any of our assumptions in the model we shared with you last quarter. So even though we said five this quarter and we came in at 13, I want to keep the model as it was that we provided last quarter.
spk05: Great. And then just a brief follow-up. In terms of stock-based compensation, I think it's the second consecutive quarter where stock-based compensation as a percentage of sales is above 85%. I think one we talked about, maybe that was a lot to do with share refreshes, and I wanted to see what dynamic was that happened in Q2 and what level of stock-based compensation should investors become comfortable with moving forward. Thank you.
spk10: Yeah, I think broadly speaking, you see this across the industry, but stock-based compensation under GAAP is stuck with the grant-based fair value of the underlying equity instrument. And as you obviously know, the history of the entire tech sector and C3 AI in the last year and a half, we are carrying significant stock-based compensation costs for awards that were granted when the share price was much higher than it is today. So unfortunately, there's nothing we can do about that unless the underlying employee decides to seek for other opportunities. So for now, until the end of these vesting terms for these awards, we are going to be carrying these pretty high stock-based compensation costs.
spk15: Or I'll never be realized by the person who was granted the stock option. Yeah. I don't know that never, but no time soon.
spk07: Yeah. Thank you. Thank you.
spk02: Thank you. One moment, please, for our next question. And our next question comes from the line of Adam. Make of America.
spk11: Hey, great. This is Adam. Thanks for taking our question. Can you talk a bit about the shape of the revenue curve for next year? I guess naturally we expect it to kind of increase sequentially every quarter given the new consumption model. But is there a chance there's still some lumpiness in that as certain larger customers may renew on kind of like the non-consumption license?
spk10: Yeah. Yes, I think the short answer to that is yes. And what we guided last quarter, we beat it for this quarter. Our guidance for next quarter, you see sequential increase, and it does have the Q4 as an increase to that with respect to the implied guidance. The revenue curve is flattening as a result of the consumption-based pricing increase. business model, but as we enter into the short term and as we enter into FY24 and especially the second half of FY24, you should start seeing the graph to get steeper and steeper in line with the presentation we shared last quarter.
spk11: Okay, that's helpful. And then again, just like the gross margin, did you kind of call out when that might trough out and what kind of like the level of that might be? I think it was at like 77% for this quarter. So is it fair to assume that that's kind of like the trough level for that? Thanks.
spk10: Well, thank you for the question. I think the more important thing is that we assume there would be a pressure in the gross margin when we provided the operating margin and operating profit guide and our passive profitability. So we are expecting pressure on it, but it doesn't change our passive profitability one bit. So I cannot tell you exactly where I think it will dip down to, but I think in your models as you prepare the business, back when we hit FY24Q4, we should be back at 77 plus gross margin. So it may go down in the interim, and then it climbs back up as we enter profitability.
spk11: Okay. That's super helpful. Thank you.
spk02: Thank you. Thank you. And our next question comes from the line of Arvind Ramnani with Piper Sandler.
spk09: Hi. Thanks for taking my question. I had a question on some of your partnerships or alliances to help drive sales. Are you able to kind of dimension how much of your new sales or bookings come from your you know, in-house sales teams versus your partners. I'm sure it's probably pretty difficult to kind of bifurcate the two, but if you're able to do that, that'd be great. And on the same topic of partnerships, you know, are the margins higher or lower on sales that are brought in by some of your partners?
spk15: Hi, Ranga. Hi, it's Tom. Virtually... All of our sales today, we're selling with a partner, not through a partner, okay? And so that would be 100% where we're selling with them. Now, they may introduce us to the account. They may bring the executive team over here, as Google has, as Bruce Allen, I'm sorry, as Baker Hughes has, as Microsoft has in the past, like many, many times. but we're actively engaged in the sales process. Now, we are just now putting our products on the marketplaces of the various hyperscalers, and so that dynamic might change going forward. But there's no margin difference because there's virtually no case where they're selling independently of us.
spk07: Terrific. Thank you.
spk02: Thank you. And our next question, and our last question, comes from the line of Michael Turitzis with KeyBank.
spk12: Hi, this is Michael Vidovic. I'm from Michael Turitzis, and thanks for taking my question. Could you just talk about linearity in the quarter and then trends you're seeing to start out November for Fiscal 3Q?
spk10: So linearity, are you talking about that deal velocity in the quarter, or what are you asking about?
spk12: Yeah, and just was it, you know, month to month, you know, how did deals trend? Was it a constant uptick throughout the quarter, or was it stronger, you know, back end of the quarter or the beginning of the quarter?
spk10: Well, we see activity all throughout the quarter, but it's not unusual in this business where as you approach quarter ends, you have slightly more activity.
spk12: Okay, and then just a quick thought on a vertical standpoint, particularly energy, have you seen like an uptick in deals in that area? Which areas besides federal are you seeing particular strength in at this time? Thanks.
spk10: So if your question is relating to the diversification of industries, we see continued diversification, which we're very excited about. Yes, there's deals in energy, but defense, as we discussed, is really exciting for us as many other industries as well. And we continue to expect more diversification with the consumption-based pricing and scores of new customers.
spk15: Okay, I guess that was our last question, and gentlemen, thank you for your thoughtful questions, and we appreciate the courtesy of your participating in our call, and we thank you all very much for your time.
spk02: Ladies and gentlemen, this concludes today's conference call. Thank you for participating and you may now
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