Q2 2023 Dynatrace Inc Earnings Call
Greetings and welcome to <unk> fiscal second quarter 2023 earnings call.
At this time, all participants are in listen only mode.
A question and answer session will follow the formal presentation.
If anyone should require operator assistance during the conference. Please press star zero from your telephone keypad.
Please note this conference is being recorded.
At this time I'll now turn the conference over to know Welfarist, Vice President of Investor Relations.
You may now begin.
Thanks, operator, good morning, everyone and thank you for joining diner traces second quarter fiscal 2023 earnings Conference call. Joining me on today's call are Rick Mcconnell, Chief Executive Officer, and Kevin Burns Chief Financial Officer.
Before we get started please note that today's comments include forward looking statements such as statements regarding revenue and earnings guidance.
These forward looking statements are subject to risks and uncertainties, depending on a number of factors that could cause actual results to differ materially from those expressed or implied by such statements.
Additional information concerning these uncertainties and risk factors is contained in diner traces filing with the SEC, including our annual report on Form 10-K, and quarterly reports on Form 10-Q.
The forward looking statements included in this call represent the company's view on November 2nd 2022.
<unk> disclaims any obligation to update these statements to reflect future events or circumstances.
As a reminder, we will be referring to some non-GAAP financial measures during today's call E.
A detailed reconciliation of GAAP and non-GAAP measures can be found on the Investor Relations section of our website.
Unless otherwise noted the growth rates, we discussed today are non-GAAP , reflecting constant currency growth.
To see the reconciliation between these non-GAAP and GAAP measures. Please refer to today's earnings press release and financial presentation under the events section of our website and with that let me turn the call over to our Chief Executive Officer, Rick Mcconnell Rick.
Thanks, Noel and good morning, everyone. Thank you for joining us on today's call.
Diamond's races, Q2 results solidly beat expectations on the top and Bottomline and.
In particular adjusted <unk> in the second quarter was 33% year over year.
Subscription revenue came in at $261 million, an increase of 29% year over year in constant currency.
non-GAAP operating income was $73 million or 26% of revenue.
On a trailing 12 month basis free cash flow margin was 29%.
These results once again highlights our ability to run a balanced business that delivers compelling top line growth coupled with strong bottom line performance and they are a testament to the strength of our market the significant value of our platform and the ongoing durability of our business model.
In addition, I'm excited to highlight the launch and released last month of what we believe will prove to be a market changing product innovation with the launch and release of Grail.
Kevin will share more details about our Q2 performance and guidance in a moment.
In the meantime, I'd like to share my view of the current market environment and long term demand trends our platform leadership, including further comments on rail and Theyre intended operational approach for the remainder of the fiscal year.
Beginning with market opportunity digital transformation remains one of the most durable areas of investment for enterprises. This has driven a sustained need for more sophisticated observe ability and application security solutions to successfully navigate the resulting complexity and enormous scale of data.
Our customers tell us that such solutions are mission critical and view them as increasingly mandatory to drive greater operational efficiency improve customer satisfaction and facilitate commerce.
This market evolution has been a key catalyst to our growth in recent years, and we continue to see very healthy demand and resulting pipeline generation across our business.
This is a great indicator of the value our customers place on our solutions and the substantial market opportunity still to come.
We added 164, new logos in Q2, and our net expansion rate was greater than 120% for the 18th straight quarter. We have however, begun to see additional macro impact, particularly in Europe .
Clearly enterprises are working to navigate the rapidly changing economic environment that is leading to increased caution in spending and the resultant lengthening of our average close rate.
Consequently, we are bringing down our our our guidance to reflect increased pressure on new logos and net expansion rates.
As I mentioned demand generation remains very healthy and are competitive positioning plus win rates remain consistent and strong.
Given our pipeline growth market strength and portfolio evolution, we are highly confident in our ability to reaccelerate our growth as economic conditions normalize.
Moreover, our strong enterprise customer base, coupled with our recurring subscription revenue model provide us with excellent P&L resiliency, even in an uncertain economic environment.
As I said last quarter, we are focused on executing well during this period to exit with greater competitive differentiation once the economy improves.
Let me now turn to platform differentiation.
Our approach to observe ability and application security is radically different die.
Diamond trade does not provide a single product or address a single data tech.
Rather we deliver a comprehensive software intelligence platform that combines the industry's deepest and broadest multi and hybrid cloud and end absorbability solution with continuous runtime application security.
It is rapidly becoming impossible for even an army of people and network operation centers to oversee and triage an organization's entire software ecosystem.
By leveraging our AI ops and automation expertise our solution enables customers to successfully navigate this uncontainable increase in complexity.
This is the power of diner trace.
Whereas other approaches deliver dashboards, we deliver precise answers and intelligent automation from data.
It enables our customers to deliver flawless and secure digital interactions by providing broad based situational awareness of their cloud ecosystems at all times.
And it enables them to take action immediately to ensure maximum uptime and performance.
Industry analysts corroborate our leadership position.
Last quarter, we announced our position as a leader in the Gartner Magic quadrant for application performance monitoring and observe ability for the 12th consecutive time.
In October I S. G released their 2022 provider lens for cloud native solutions, which named dining trace a leader with the top overall position in cloud native Absorbability and a leader in cloud Native security.
This recognition reflects both our leading position and absorb ability as well as our strength and its convergence with application security.
Our customers agree of the 164, new logo customers that we landed in Q2, well over half of them are leveraging three plus modules.
In addition, we saw an increase in the size of our new logos with our trailing 12 month average land rolling to a $120000.
The reason customers typically choose diner trace is because of our platform strength and I'd like to share just a few examples of Q2, which.
First one of the world's largest multinational energy companies made a significant new investment in dynamics.
With over 4000 applications across multiple cloud providers. This customer recognized that the scale and complexity of their clouds created a need for a unified absorbability platform.
They selected Dino trace across the organization and deployed five of their modules.
This is also a great example of the power of our partner channel, having leverage the AWS marketplace with support from our strategic technology partner D C.
Second once customers experienced the scale and efficiency of automation and AI. They are eager to expand their relationship with diner trace.
One such customer is a large financial organization seeking to enhance customer experience improve operational efficiency and reduce cost by consolidating multiple disparate tools.
As a result, the customer made an eight figure commitment to standardize on diner trace.
They also identified uninterested a crucial player in their strategic initiative to accelerate cloud migration.
A third example highlights the continued traction of our application security offering with one of the largest global cruise lines.
They struggled with prioritizing the hundreds of vulnerabilities they see on any given day.
Dino traits apps that gave the customer the ability to shift through the noise and help them focus on the vulnerabilities that really matter saving them time and resources by speeding up their development processes.
These are just a few examples of the trends that are widespread throughout our customer base.
We continue to maintain our aggressive focus on innovation as a core differentiator of diner Trish.
We delivered 24 major releases per year.
Our innovation engine is constantly humming.
Adding functionality to accelerate product leadership.
In fact, the vast majority of our R&D team is working on growth and strategic initiatives apps.
<unk> and Grail are great examples of this investment and innovation.
To take a moment to thank our founder and CTO burn Grison ader, along with our product and R&D teams for their immense work over the past few years to bring these groundbreaking technologies to market.
With respect to Grail, you should think of it not as a new module that is an additional core technology in the dining Tracy Platt joining.
Joining one agent pure path smart scape and Davis.
It becomes a key element of our comprehensive end to end observe ability solution and will enable us to capture our $50 billion Tam faster.
Rail is a purpose built massively parallel processing data Lake house that changes the game for data ingestion management and real time analytics.
We see it as a quantum leap forward or diner traces competitive differentiation and we are extremely excited about the plethora of opportunities. It enables.
Well there are many salient grail attributes here are three areas that differentiate it in the market.
First Grail enables organizations to cost effectively ingest and retain all of their data while preserving its context across a myriad of data types, including traces metrics logs really user data et cetera.
Second Grail Leverages, the new diner traced query language or D. QL to easily build queries for even the most complex use cases that can be run in near real time.
And third Grail takes advantage of a massive hyperscale or compute resources that can scale to thousands of processors operating in parallel on a single query.
Our first use case for Grail is log management and analytics, which we continue to see a market that is ripe for disruption.
We don't expect rail to have a meaningful impact in FY 'twenty. Three we are delighted to see strong early demand with nearly 100 customers lined up for P. O sees in less than a month of its availability.
One early adopter of Grail is Toyota financial services afford Grail, the team had to decide which log data to cheap and store.
With Grail, they can get cost effective storage for logs, while retaining context, enabling them to deliver more value and better user experience.
This brings me to my final topic, covering our operating approach over the second half of the fiscal year.
I'd like to begin by providing a brief update on partners is a key investment area within our go to market strategy, most notably with global system integrators.
In addition to our formal alliance agreement that we announced with Deloitte last week, we announced a significant expansion of our relationship with the X C. A leading technology services company.
D. C has been a longtime partner of ours and they now plan to embed the diner trace platform as the preferred absorbability solution within its D. C platform access solution, helping their customers optimize and automate their cloud and digital services.
In addition, diner trace in D. C have agreed to launch a joint global strategic go to market program to bring the solution to customers worldwide.
In addition to our commitment to thoughtful and strategic investment in innovation and partnership we are equally committed to protecting margins.
We have adjusted our planned head count increases and Opex through the balance of the year to yield an expected increase in our FY 'twenty three operating margin relative to prior guidance and in alignment with our revised top line model.
Overall, we have proven our discipline in delivering growth in challenging environments, while managing top to bottom line in a balanced way and we plan to continue to execute in this way as we looked at.
Before I turn the call over to Kevin I'd like to take a moment to share my thoughts on the CFO transition.
I am thrilled to have Jim Benson join Dino trace as our CFO .
Jim is a tremendous financial leader with a proven track record of leading and scaling global Finance organization.
Having worked with Jim previously at Akamai I'm confident that he will be a strong partner to me and to the global leadership team.
In addition, I'd like to thank Kevin for his excellent leadership over the past six years and for his dedication to dine at Tres.
Having announced his intention back in may to leave diner traced by the end of this calendar year I very much appreciate his commitment to the company through this rigorous search process and to ensuring a seamless transition to Jim.
I want to thank the finance organization and the rest of the diner trace team for their engagement and supporting this transition I continue.
To be extremely impressed with the strength of this team and I look forward to its next phase of growth.
In closing Dayni trace is a business that delivers high growth with strong profitability and free cash flow.
We delivered a strong second quarter, even amidst macro uncertainty and we remain highly confident in the strength of our market opportunity as well as our platform leadership.
Moreover, we will continue to drive innovation to meet our customers' evolving needs and further differentiate ourselves in the market.
We expect to manage prudently from a financial perspective, and we intend to invest thoughtfully in our strategic priorities near term to emerge from this period in a position of expanded strength.
With that let me turn the call over to Kevin.
Thank you for the kind words, Rick and good morning, everyone.
Before I jump into the business I want to share that it has been a true pleasure to be part of the team that has helped build <unk> over the last six years I'd like to thank our board John and Rick for providing me the opportunity to be part of this talented team and it's been a truly rewarding experience and highlight it.
Korea.
Equally important I'd like to thank all of the diner tracers that a bit that's so much passion and commitment. It is so rewarding to see such a vibrant community together.
Together, we have all built dying trees into one of the most successful software businesses the.
The market opportunity is immense you are in great hands, with Rick and Jim and I remain confident that Dino trace will continue to be highly successful.
And now onto our second quarter performance.
As Rick mentioned, we delivered a strong second quarter in a fluid environment, we over achieved our internal forecast and guidance across all of our key operating metrics, even as we saw many of the macro trends from last quarter continued to weaken in Q2.
Overall, the resiliency of our subscription model the strength of our enterprise customer base and solid execution are reflected in our performance. We have a strong business and expect to continue to deliver a balanced performance of growth profitability and cash flow.
As with previous quarters, I will focus on adjusted are our growth as it normalizes for currency fluctuations and the wind down of perpetual a R. R. Please.
Please note that all growth rates will be year over year and in constant currency unless otherwise stated.
Finally, Tres delivered 33% adjusted are our growth in the second quarter.
There are for the second quarter was $1.065 billion.
Please note that our reported error or would have been $12 million higher or $1.077 billion. When you consider the incremental FX headwinds in the quarter.
Moving on to the building blocks of growth for the business. We added 164, new logos in the second quarter in line with our expectations, but certainly an area of our business that continues to be impacted by economic headwinds.
As Rick mentioned the average a R. R for new logo lands was $120000 on a trailing 12 month basis compared to $114000 last quarter.
In the second quarter, and once again, well over half of our new logos landed with three or more modules, representing the movement to the observer ability platform.
The value of the dangerous platform continues to resonate with prospects as they look to deliver rapid operational efficiencies and a tight budget environment downtick traces ability to rapidly drive greater automation and efficiency that deliver strong all our ROI and places us near the top of the strategic investments.
Yes.
Our net expansion rate for the second quarter was once again above 120% gross retention rates have been consistently trending up for the last two years.
From an existing customer standpoint, we continued to see strength in multi module adoptions with 55% of our customers now using three plus modules at an average <unk> of nearly $500000 per customer or.
Overall, we are pleased with the resiliency of our enterprise customers that deliberate a strong second quarter performance, even in a challenging environment.
Our existing customers view us as an essential part of their ecosystem, given the proven value operating inefficiencies and insights that we deliver.
Moving on to revenue total revenue for the second quarter was $279 million up 30% year over year and subscription revenue for the second quarter was $261 million up 29%.
With respect to margins non-GAAP gross margin for the second quarter was 83% down two percentage points from Q2 of last year.
This reduction was primarily driven by investments in our partner strategy that showed up as services cost of goods and customer success initiatives as we expand broader coverage.
As we've said before we have a very healthy margin profile, reflecting the value and efficiency of the <unk> platform and I do anticipate gross margins stepping up in the back half of 'twenty three.
Investments in innovation and so like go to market initiatives remain top priorities for us for the second quarter, we invested $41 million in R&D or 15% of revenue. We continue to drive successful product innovation and as Rick noted our recent launch of Grail is a great example of our.
Fast commitment to ongoing market leadership.
On the go to market side, we invested $90 million in sales and marketing this quarter or 32% of revenue prioritizing investments in direct sales and our expanding partner strategy.
We grew our sales rep head count by about 25% year over year, which will be down from our original goal of 30% growth as we've pulled back slightly as we have sufficient capacity given today's environment.
Our non-GAAP operating income for the second quarter was $73 million, resulting in a non-GAAP operating margin of 26%.
Exceeding the top end of the guidance range by 250 basis points due to the revenue upside combined with a disciplined investment strategy.
On the bottom line non-GAAP net income was $64 million or 22 cents per share three cents above the high end of our guidance range.
Looking at the balance sheet as of September 30th we had $563 million of cash an increase of $193 million compared to the same period last year.
And inclusive of $120 million of debt repayments on a trailing 12 month basis.
Our free cash flow was $25 million compared to $14 million in the same period last year.
Due to seasonality in billings, we believe it is best to be free cash flow over a 12 month period on a trailing 12 month basis, our free cash flow was $300 million or 29% of revenue. We are extremely pleased with our continued healthy cash generation and.
And we have not yet needed to modify customer payment terms due to macro issues.
The last financial measure that I would like to discuss this morning is our remaining performance obligation.
R. P O was approximately $1.53 billion at the end of the quarter, an increase of 29% over Q2 of last year. The current portion of our P O, which we expect to recognize as revenue over the next four quarters was $878 million, an increase of 29% year over year.
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We are very pleased with the R. R. P of growth and it's important to remember that seasonality associated with bookings and contract modifications will cause variability in the RPM growth rates.
When combined these strong Q2 results demonstrate the durability of our business model that supports our strong balance of growth and profitability.
Now, let me turn to guidance.
Our pipeline and demand generation remains very healthy and our competitive positioning in win rates remain strong. However, the macro conditions continue to generally weekend and we think this is even more prevalent in Europe .
As a result, we now expect close rates in the back half to be lower than what we experienced in the first half of fiscal 'twenty three.
Therefore, we will be reducing air our constant currency guidance by $30 million and we believe this will primarily impact air or towards the end of the fiscal year.
In light of this increased pressure on a R. R. We are moderating some investments in order to increase operating margin and to continue to drive a balanced business. So.
So let me walk you through some of the key assumptions and insights into what is included in our updated guidance.
First as I mentioned.
New logos continues to be an area of the business that is most impacted by the weakening of the economy given that we now expect new logo additions in fiscal 'twenty three to be down roughly 5% over last year, reflecting tighter budget scrutiny and elongated sales cycles.
From a head count standpoint, we had a strong first half for hiring and have a talented team in place to execute against our strategic goals.
This provides us flexibility to moderate the pace of hiring in the back half of the year, while still maintaining healthy growth in head count on a year over year basis.
Third with more than 40% of our business denominated in foreign currency.
Continued strength of the USD creates a sizable headwind.
We now expect full year constant currency impact to be approximately $60 million on a R. R in revenue.
This represents an incremental headwind of approximately $20 million to a R and $12 million to revenue for the full year compared to our prior guidance.
And finally consistent with prior guidance the perpetual license wind down for fiscal 'twenty three is expected to be approximately $8 million or 80 basis points. The headwind in Q3 will be approximately one percentage point.
With that in mind, let's start with our guidance for the full year again with growth rates in constant currency.
We expect <unk> to be between $1.164 billion and $1 billion $172 million, representing an adjusted air growth of 24%.
From a constant currency standpoint, this represents a $30 million or 300 basis point decline from prior guidance driven by the factors I outlined above.
In terms of the error of seasonality, we expect that net new air or is going to be $120 million in the back half of twenty-three split roughly evenly between Q3 and Q4 to reflect further conservatism in guidance.
Given some strength in Q2 revenue and the fact that we think the error reduction is backend loaded we are raising the midpoint of our prior revenue guidance by 50 basis points.
We expect total revenue to be between $1.119 billion and $1.126 billion and subscription revenue to be between $1.047 billion to $1.052 billion, both of which result in 27% year over year.
Growth.
From a profit standpoint, we remain committed to offsetting incremental headwinds with operational efficiencies and appropriate investment management.
With that in mind, we are raising our non-GAAP operating margin guidance to 24, 5%.
Representing a 175 basis point increase from the midpoint of our prior guidance.
We believe this will still enable us to support additional investments in R&D and sales and marketing.
We are raising non-GAAP EPS by seven cents to <unk> 81 to 83 per share based on 292 to 293 million diluted shares and a non-GAAP effective cash tax rate of 11%.
And finally, we are maintaining our free cash flow margin guidance of 27, five to 28, 5% of revenue in terms of dollars, we expect free cash flow to be between 308 and $321 million.
Looking at Q3, we expect total revenue to be between 283, and $286 million or 24% to 25% growth subscription.
<unk> revenue is expected to be between $266, five and $268 $5 million.
Up 24% to 25% year over year.
From a profit standpoint, non-GAAP operating income is expected to be between $71, five and $73 $5 million 25, 5% of revenue and non-GAAP EPS of 21 to 22 cents per share.
In summary, our second quarter fiscal 'twenty three results demonstrated strong performance amidst increasing macro headwinds, it's a challenging environment and the durability of our business model is purpose built to navigate these transitory market conditions.
We are being mindful of our investments and we'll continue to prioritize strategically and innovation and go to market.
Our strong financials subscription business model and healthy enterprise customer base combined with a world class people organization continue to position us for resilient and predictable growth and profitability as we move forward.
And with that we will open the line for questions operator.
Thank you.
This time, we'll be conducting a question and answer session.
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One moment. Please so we poll for questions. Thank you.
Thank you and our first question is from the line of Matt Hedberg with RBC capital markets. Please proceed with your question.
Great guys. Thanks for taking my questions.
I guess either for Rick or Kevin.
Q2 was it was a really nice quarter in a really tough tape and kind of looking at Kevin Your your new air our assumptions I think per my math it looks like it's down about 27% in the second half that's where it was up about 13% in the first half.
And I guess a question that we're getting from a lot of folks that are sort of your level of confidence that this will be the last cut.
So maybe I know you gave some of the underlying assumptions, but maybe maybe enter our assumptions or anything else that can kind of get us helpful with what looks like a quick.
A significant level of conservatism.
Sure. Thanks, Matt.
We were served as you mentioned, we were certainly pleased with the performance in the quarter and it came in ahead of expectations internally and obviously externally as well. So we're pleased with that performance.
You know when we thought about the back half, though as you I'm sure you can imagine we went back and looked at pipeline coverage and how the geographies were performing and also the economic conditions in the region and we just continue to see additional pressure.
And we are expecting additional pressure coming out of the European area. So generally the reduction is primarily focused in the European part of the world.
That will be a little bit of new logos new.
Those will be down 5% year over year against a generally most of that will be coming out of Europe , and there will be some pressure obviously on the net expansion rate and reduce booking bye bye.
By $30 million.
And obviously that will have some pressure on the net expansion rate. We do believe though Matt that was as we said in the call it.
But this is a back end loaded adjustment and I think that's indicative of what you saw US guide from a revenue standpoint, a world, where we actually slightly slightly increased our revenue guidance. So backend loaded trying to be very.
Trying to be cautious we did we reset once unfortunately, we had to do it again. Unfortunately, we want to be very conservative going into Q3 and Q4, we're very bullish on the business now where were optimistic but we need to balance it with.
Setting the expectations that we will deliver on.
Yeah, Let me, let me just add quickly Matt and thanks for the question first of all we are very confident overall in this business pipeline is growing that is a great sign and the challenge is some purchasing decisions are getting deferred as Kevin said, particularly in Europe , and Etsy law and gaining some sales cycles.
We wanted to de risk the model as we looked at the second half and that's what we tried to do overall health of the business very strong so great about the overall product leadership and evolution, which I talked about and that's how we're going to manage the business in the second half.
Got it Super helpful guys, and then maybe just one for you on Grail, obviously, a lot of exciting things to think about there for the future 100 customers plc.
You know what you know eventually when that first to hit your or how do you expect that to sort of benefit as it is it is it just even more.
Maybe just the monetization of I guess is the question eventually when it comes out I know, it's still early here, but how should we think about that eventually maybe its fiscal 'twenty four driver.
Well as I said, Matt we believe that the log management and analytics market is very ripe for disruption. We believe we have a very very unique opportunity to take advantage of that given the technology technological framework that we've constructed and we are thrilled with the early demand and interest from customers. We saw this in our.
Our customer innovate sessions, which we executed globally in Singapore, Sao Paulo in London, or the prior month or six weeks getting firsthand feedback from customers here. So we feel very good about it we still believe what we said a quarter ago, which is that as with infrastructure, we think that log management and analytics can add.
Add $100 million or so they are are over an eight quarter span or thereabouts and so that's what we're still expecting a following launch.
Okay.
Thank you.
Next question comes from the line of Sterling Auty with Moffat Nathanson. Please proceed with your question.
Yeah. Thanks.
First Kevin Congratulations thank you for all the hard work and good luck with all the future endeavors.
And then in terms of question I wanted to drill in on the existing customers. We saw a notable slowdown out of the hyper scaler.
How did you factor that into your <unk> and what gives you the confidence that that's the right level in terms of the full year guide. Thank you.
So.
Thank you Sterling, it's been great working with you. So you know I always appreciate the great covering and great questions and insights that you have in the business as well. So I appreciate that thank you.
With respect to our guide and how we thought about the hyperscale or it was absolutely part of the equation.
I will say that our hyperscale or component of our business continues to grow nicely. So we didn't see as dramatic of a slow down as they did you know some of them are printed publicly. So we're pleased about that and I'd say the other thing that we're super excited about again more over the next couple of quarters as opposed to the near term, but it is the <unk>.
GSI partnerships that we're developing right. The one that we have with the likely one that we just announced with DXP.
The other ones in process that we will talk about it in the near future as well. So yeah. We definitely took some adjustments from a hyperscale or slow down.
Pleased with the performance internally, we do also think theres another tailwind on the juice side, So I'm not trying to walk up our guidance didn't get too excited about it but definitely some tailwind there that we.
We adjusted down, but we think there's some tailwind.
Yeah. The only thing I would add Sterling is that we obviously have a huge market opportunity with the installed base of the Hyperscale there's already.
It is a it is obviously well well over $100 billion in revenue and we believe that as observe ability becomes more commonplace becomes more standard in cloud deployments, especially for enterprise customers that there is a lot of opportunity to penetrate that installed base and and obviously the growth rate continues to be strong, even though down over the prior quarter.
And Hyperscale.
Understood. Thank you guys.
Thanks, Tim.
Our next question is from the line of Camille Messick with William Blair. Please proceed with your question.
Hi, Thanks for taking my question.
I just wanted to better understand the linearity of the man.
Progress when did you see the largest deterioration in sales and how did that change in the first few weeks of the third quarter.
So in Q2, Camille our business performed as expected if not to let you know as we mentioned it it performed slightly better so we definitely reset our expectations a little bit in terms of linearity and linearity came in line performance came in line with expectations or for the for the quarter.
So pleased about that when we look into Q3, when we look into Q4.
Our approach is just to be more cautious right at it.
The economy seems to be getting tougher yields cycles.
We believe we'll continue to elongate as Rick said, we have great pipeline coverage are our win rates are great, but the close rates. When you just expect them to slow down in Q3, Q4, and that's really what's driving so those are the and you know it's really a quote close rate assumption is sort of how we're thinking about adjusting our guidance.
Top of funnel the all those metrics when rates are doing great, but we just wanted to be a little bit more cautious as we go into the back half of it.
That's helpful and if I could just follow up Kevin and Kevin called out a slight slowdown in the pace of sales rep hiring can you update us on your hiring targets for fiscal 'twenty three for the business as a whole and what has hiring looks like today.
So ballpark I work, where 25% for total company midpoint through the year, which is great I'd say, we're definitely a little slightly.
Bit higher on the innovation R&D and in sales and marketing side and our sales head count growth as I mentioned, we did about 25% growth. There. So we did a great job in the first half of getting great talent on the board our retention is very high as well.
I think that can also help our pass sales capacity as we go we will have better and more mature reps. So that's where we are camille midpoint of the year we'll.
We will continue to grow R&D in 'twenty.
20, plus percent in that range.
The quarters play out here over the next over the next six months.
And then will slow some other things down generally so I think that's the punch line is I think fiscal year, ending head count will probably be around 20% growth with it a little bit higher in the innovation and go to market.
Got it I appreciate the color. Thanks again.
Our next question is from Atlanta from Raimo <unk> with Barclays. Please proceed with your question.
Hey, Thank you.
Kevin If you look at.
B B.
How other companies or how would you kind of need to think about the scenario like coal freight is usually the one that the C of O is driving in terms of the like everything.
Everything is kind of keeps seems to be working but like compute is kind of where I kind of put the final scope. One if you look about your.
Pipeline and you said the pipeline coverage is 45, if you think about like.
Deal sizes in the pipeline and also how they track through the pipeline have you seen a change there or is that all sort of like what you've seen before but like the final stepping up the colter I, just where you kind of want to be more conservative and then I have one follow up correct.
Yes.
It it it really raimo it really is it's close rates. That's what we've you know we've looked at and of course, there's some moving parts here and there, but the fundamental change in the business is elongated cycles, which means our close rate there just aren't what they were historically so that's that's what we see and again as we mentioned it's more pronounced.
So we're in the European region.
The only other thing I would add to that is that a is that while that's true on close rates. It is important to understand that we expect close rates to re normalized there's nothing that we have seen suggest that as the macro environment improves although we're not predicting exactly when that is but as the macro environment improves we expect.
Those close rates three normalized and the good news is with ongoing growth in pipeline and no change in win rates, we think that that's a very productive long range scenario.
Okay. It makes sense and then one question I'm really if you think about you've mentioned earlier that it's not just the number of tool it's like slightly more fundamental like how do we think about your positioning of Grail and you know when you offer a product in a market like it is.
Real becoming like the platform and then everything builds out is that the unbilled.
On the Olympics, but something like how how do you have to think about like what do you think about Dana trees and held their positioning.
Are you guys positioning a product like in a year or two like how does it all fit together could you speak to that a little bit. Thank you.
Sure Grail as I mentioned Raimo is a core technology, just like one agent pure paths smart scape et cetera for us. It is a as I said massively parallel processing and data Lake House.
Gives us incredible performance at exceptional scale and also an ability to do that at a in a very cost effective way. So that's how we sort of look at Grail. The first instantiation of that is log management and analytics and that's our that's how we will initially deploy rail so that's.
That's sort of our overall perspective on how we take advantage of this market opportunity and leverage Grambling forward. It is a solution that doesn't do re indexing doesn't give me hydration and uses wrapping technology to provide very complex analytics on logs in near real time and that is a very very good.
Positioning.
Hmm Okay. Thank you.
Thank you. The next question is from the line of Mike CECO with Needham <unk> Company. Please proceed with your question.
Hey, guys. Thanks for taking the questions here. The first question I wanted to ask about was around the you just today or guide I know that we have this.
You're calling out from Europe , and you have cited I guess pressures, we're expecting in the second half of the year on both new logos and new expansions.
So first happy to have the color regarding that 5% year to year decline, we expect them to be logos for fiscal 'twenty three.
Regarding the net expansions.
<unk>.
We should be thinking about that playing out over the remainder of the year is there potential for that to actually get below that 120% plus you guys have.
<unk> been posting on a consistent basis.
Got it.
So yes, unfortunately based on our guidance there.
Mathematically that net expansion rate in the fourth quarter would fall below 120%.
Again, that's based on what we have currently guided we also highlighted in our in the prepared remarks that our net expansion rate remains very healthy certainly in the second quarter with very healthy our third quarter is always always a very big quarter from its going back to our customer base and expansion in our customer base. So we're off.
Michigan about that and you know it's still early on Q4, but so again, we wanted to Derisk. The number in Q4 mathematically that expansion rate could drop below Q4 period for a period of time as Rick said, though you know we think these are just transitory.
Adams and the business in long term net expansion rate will certainly rebound well north of 120%, assuming we come in around where the guidance, but you know I don't I don't want to walk numbers up again, but you know we're very bullish about the ability to continue to sell in our customer base average they are still around 300000 insignificant opera.
Tell me what rail coming on board that will be another good in FY 'twenty four as well. So again, we definitely believe there's a lot of tailwind to that number and if it does drop below 120, <unk>, we think that will be shortly.
Thank you that's that's very helpful with the color there and if I could just tack on one more follow up it's really around the sales cycle.
Elongation that we're calling out today and I just wanted to make sure I was clear can you give us a rough order of magnitude for the Delta that we're seeing like or are these push outs.
Weeks or more in the neighborhood of months and then the follow up question. Just just given how you guys are describing Europe , but I think it's probably fair to characterize.
The euro pressures being more pervasive in nature. So first is.
Volume of pressure in Europe , a fair characterization and then second.
Is any of that weakness spilling over to other geographic regions that you guys participate in.
Well, the Mike Lee the weakness in macro environment as he's clearly global but more pronounced in Europe , which is what we're calling out. So that's a that's point number one and with regard to the overall sales cycles, we look at it mostly in terms of quarters.
But but the vast vast majority of any deals that pushed out due to lengthening close cycle last quarter, we expect to close this quarter and as I said no change in win loss ratio. So we feel good about the prospects as we look into the quarter associated with those close rates.
Thank you very much guys.
Our next question comes from the line of Andrew Nowinski with Wells Fargo. Please proceed with your question.
Okay. Thank you I want to start with a question on the.
Close rates and the operating margin expansion. So I appreciate your focus on profitability and expanding that margin, but do you think maybe the slowdown in hiring do you think that could possibly extend this period of lower close rates or are those close rates really independent of the sales capacity that you have.
Yes, I think that's right I think they are independent Andrew and I think they are independent for two reasons. One is as I mentioned, we grew sales organization, 25%. The other thing that's happening.
That organization is the 10 year's increase right and I think we've talked about this fairly before as you have more mature reps their productivity is much higher as well. So we do believe a 25% head count growth and sales organization with increasing maturity low attrition rates.
That's up to Reaccelerate when macroeconomic condition.
Rebound and then the other piece that that can be additive over time, which I think you know Rick in the organization have done a great job is at is the partner channel right. I think we're doing well with the Hyperscale is I think we're doing and the opportunity is perhaps even larger with the GSI is then.
You've talked about that in the prepared remarks in terms of what we've done are equivalent.
But the way partnership and more to come there as well. So overall I think that gives us a lot of capacity.
Celebrate the business as we move forward.
They should rebound.
Okay. That's great. Thank you and then I wanted to ask a follow up question on Grill, you noted that it's it's more than just a new module. So I'm wondering.
Is this is grill targeted at new customers to replace their legacy data warehouse solutions and their data lakes or will this be more of an add on sale you know initially targeted at existing customers.
Just wondering where do you think you'll see that initial traction with Grail.
Well the no most hanging fruit is in clearly our installed base where are customers Trust 90 trades already they have strong and healthy net expansion. They are used to adding modules, we have a more than 50% of our customers now on three plus modules and in fact, new logos or closing with more.
And then more than three plus modules at a greater than 50% as well. So it is a cross platform salad cross platform play and Grail fits nicely into that but having said that we also have a experienced and seen interesting and significant demand even out to shoot from new customers that are interested.
And candidly moving away from their existing log management and analytics solution.
Got it thank you.
Our next question comes from the line of Kochi Takeda with Bank of America. Please proceed with your question.
Hey, guys. Thanks for taking the question I had a question on sales capacity. You know you had comments on investing for the future potential growth reacceleration lots of commentary on the pipeline and how it continues to build a really balanced against the current environment. If that is the close rates. So the question here is really you know.
What are you looking for around the end markets, maybe signal a pick up again in sales hiring. So the capacity is ramping ahead of a demand curve versus potentially trying to catch up to demand.
I think I told you I think the leading indicators that we'll continue to monitor will be top of funnel right and then we're going to be looking at close rates and win rates and conversion rates as well. So once we start to see those move in.
That's when that's when I think we would probably we step into a little bit more.
Sales capacity investments, but again, please keep in mind you know based on what I. Just said, we think we have a lot of capacity in the organization. Obviously you know there is a productivity given the environment. So we think this organization that we have and we're gonna be in six six months six months 12 months.
We will give a lot of capacity to reaccelerate the business and we think we generally think how'd you that we're in a good spot with the sales organization and the partner organization and we will we will add to head count.
Even demand.
Got it thanks, and then maybe just a quick follow up for Kevin in your prepared remarks, you did mention that you aren't seeing any are any payment term changes right now, but you know thinking about the guide is it are there any assumptions for more flexible payment terms incorporated within the guidance. Thanks guys.
There are not.
We I added that day, and we added that Dan just to get.
Or would that be enterprise customer base that we are working with you know when they decided to move forward on projects generally you know, they're not negotiating payment terms at.
They always seem to tend to focus on the discount.
So so we're good there we have pretty good visibility into the cash flow over the next six months as well. So we didn't bake anything and we don't we don't see it meaningful even during COVID-19. The impact was de Minimis. So I don't I don't expect that would move the needle on the fiscal year.
Got it thanks, so much guys. Thank you.
Okay.
Our next question is from the line of Adam Tindle with Raymond James. Please proceed with your question.
Okay. Thanks, Good morning, Rick I, just wanted to start with kind of the story for the stock previously considered this fiscal year fiscal 'twenty three to be more of an investment year, where margins would be in the low 20% range and then they would re accrue to the mid 20% range in fiscal 'twenty four alongside new product releases. So we thought growth would potentially accelerate and spend a lot.
A lot to think about for fiscal 'twenty four today, obviously the environment has changed you're increasing your profitability outlook and now in the mid 20% range here today I'm wondering you know how we can think about this story from here I'm wondering if this means fiscal 'twenty four becomes more of an investment year as some of these investments are now spread over multiple.
Years of some of those initiatives are understandably pushed out and how you would kind of reset telling the growth and margin story from here if that makes sense.
Yes, Hi, Hi, Adam So a few things few quarters ago, we did want to make some incremental investments in certain areas. We've made those investments in Grail and partners and Str's. For example, and those are those have enabled us to expand the business through this period of time and set ourselves up for the long term.
Traditionally operated in the mid twenties operating margin and that are that's what we expect to do going forward. So that's where we're resetting the boundary to an operating margin at this stage.
It up by 175 basis points at the midpoint, and that's where we expect to be able to operate as we look at that.
Okay got it and then maybe I can just follow up on the question why is this the last cut as I think about potential risk factors from here and please add any that you're thinking about but M. P is the region that you're seeing a lot of the challenges I'm wondering how currency impacts demand in that region. Thank you.
You do have some U S dollar pricing and I'm wondering as I think about a potential pressure from here.
The need to reduce pricing in that region to match the purchasing power of the customer, particularly relevant as I'm sure you have a bunch of renewals coming up this coming quarter, just wondering how you're thinking about pricing and currency as it relates to that and any potential deflation.
To happen in the model. Thank you.
Well to clarify that was a question for you on Europe , I'm, sorry, I missed that.
Jim.
Right.
FX impact and whether you'll you'll potentially need to reduce pricing, which would potentially be a headwind got growth right.
So we operate in Europe , I would say, 95% of our business is done in local currency or over in Europe .
So the 99% so our guidance is assuming that the euro remains where it is for the balance of the year. So we don't expect to see any additional constant currency adjusted eight our guidance, assuming flat with respect to pricing and what's happening there from an end user standpoint.
You know when we do renewals with our customers, we are actually looking to drive higher pricing.
Alright I appreciate the you know the economy is tough right now, but the cost of everything is going up and we are trying to pass some of that on to our end.
End users as well so you know historically we've done.
Low single digit price increases, we're trying to realize a higher percent price increase as we move the business forward. We're certainly seeing that from our vendors that we work with and we think that's the right thing to do for the business. So no no specific additional price pressures over in Europe , and we are certainly trying to make sure that we.
Increased prices appropriately to maintain margins.
Thank you.
Our next question is from the line of Fatima.
Bill I mean, it with Citi. Please proceed with your question.
Good morning. Thank you for taking my question I'm like one for you and one for Kevin Rick I'll start with you just the commentary on budgetary caution.
You know I can appreciate that's contributing to the sales cycle conversation being contracted but I'm wondering if you can share some nuances as to what these customers are doing in lieu of a launching.
Launching onto the <unk> platform is it more.
Sticking to a D. I Y lower cost you know open source environment or you know are they sticking with incumbents and what are some of the granularity and the discussion in terms of the reasons customers are pushing.
Pushing out the conversation.
Hi, Panama. It it is absolutely just sticking with what you currently have typically DIY, we always say that DIY is our biggest competitor and it is companies that just think I can get by for another quarter or another two quarters doing doing what they have been doing with DIY deployment and trying to manage through.
Do that without taking advantage of sophisticated AI ops and performing capabilities such as those that tiny tiny sliver. So.
That's what's happening currently.
Got it and Kevin just for you are with the cost of moderation measures that are now clearly in place and you can see it in your comments around them moderating hiring when should we see some of that dovetail into free cash flow conversion I'm. Just curious because you didn't change the range is on your free cash flow margins.
So how should we think about you know a delayed impact or you know seasonal factors that maybe aren't obvious to us.
On the free cash flow margin side versus the operating margin upside. Thank you.
Sure.
So generally as we mentioned we took a are down by about $30 million, which you you would think would generally flow through to free cash flow depending on when you build that however that was offset by our slower investment rates of operating income operating margins went up to offset generally the decline in air which is why we were able to maintain.
That's free cash flow the free cash flow conversion rate of margin of 28%. So we you know we don't nothing's going to happen in FY 'twenty for that is going to change. The trajectory. You know we're not you know, we're not pulling things and to drive higher cash flow here in 'twenty three that's just a normalized run.
Based on operating at a 24, 5% operating margin.
Okay.
Operator. Thank you. Our final question is coming from the line of will power with Baird. Please proceed with your question.
Great. Thanks for taking the question, maybe just to start with a follow up I know it was as it pertains to the full year outlook, you're now expecting weaker customer expansion as well.
You know on top of some of the new logo pressures.
I Wonder did you just to be clear is that something you're already seeing I guess as you kind of walk through the months of October and if it is something youre seeing.
And expect those are particular workload or use cases, where you're expecting some of that customer.
Expansion pressure relative to perhaps prior expectations.
It's it's not something that we're seeing now, but you know what we what we've seen as we've mentioned during the call here is that it's it's a close rate item at this point right and obviously close rate means that whether it's an expansion deal or a new logo deals all of those things are are getting pushed out which implies that obviously.
New logo number is going to come down and net expansion rate is going to come down we have seen over the over the last two quarters, a slight change just given that adjusted air came down by a percentage point.
A very slight change in net expansion rate in Q2.
We're we're we're optimistic I don't want to walk up numbers, we're optimistic that the business continues to perform and remain resilient, but.
Trying to be cautious and conservative we wanted to bring down that backend numbers. So I. There's no trends, we're seeing the only trend. We see right. Now is just close rates are extended in Europe in particular, and the implied as new logos and that expansion will come down as a result of that but I just tried to communicate that.
Hopefully short term temporary.
And we do believe every customer can continue to accelerate.
Okay.
Okay, and then maybe just sneak one in for.
Kevin nice to see that.
The higher margin assumptions for the year and I know you referenced.
Iterating hiring I know, that's that's probably a big piece of that and anything else on the higher operating margins.
Call out there.
We should be aware of.
No as eat as Rick mentioned, we did make some of the strategic targeted investments in the first half rates are those are those will be reduced in Q3 and Q4, so that drives higher op margins and then yeah. I think generally as you can see from our P&L, we've been operating at a 25% op income margin. So it really is generally at this point head.
Count and those targeted investments we've made in Q1 and Q2 are coming to conclusion here as well. So those are sort of the two things that we that we needed to adjust generally.
Great. Thank you.
Okay.
Okay. Thank you.
This time, if we shouldn't have a question and answer session and I'll turn the call over to Rick Macdonald for closing remarks.
Well. Thank you all for joining this morning's call we really do appreciate it Diana Tres <unk>.
Very strong business Q2 was very solid delivering high growth profitability and free cash flow I'm extremely bullish on diner traces market opportunity and our growing product differentiation with solutions such as Grail as we discussed and absolutely believe in very strong view to the future we are participating.
Fading at several conferences this quarter and look forward to speaking with you in the coming weeks and we thank you again for your continued support.
This concludes today's conference you may disconnect your lines at this time. Thank you for your participation.
Yeah.