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Hello, and welcome to Nutanix Second Quarter 2023 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker for today, Rich Valera. You may begin, sir.

Good afternoon, and welcome to today's conference call to discuss the results of our fiscal second quarter of 2023. Joining me today are Rajiv Ramaswami, Nutanix's President and CEO; and Rukmini Sivaraman, Nutanix's CFO. After the market closed today, Nutanix issued a press release announcing financial results for the fiscal second quarter of 2023. If you'd like to read the release, please visit the Press Releases section of our IR website. During today's call, management will make forward-looking statements, including statements regarding our business plans, strategies, initiatives, vision, objectives and outlook, including our financial guidance as well as our ability to execute thereon successfully and in a timely manner and the benefits and impact thereof on our business, operations and financial results. Our expectations regarding the resolution of the investigation, its impact on our financial statements, including our financial guidance, our financial performance and targets and use of new or different performance metrics in future periods, expectations regarding profitability, our competitive position and market opportunity, the timing and impact of our current and future business model transitions, the factors driving our growth, macroeconomic, geopolitical and industry trends including global supply chain challenges and the current and anticipated impact of the COVID-19 pandemic and its effects. These forward-looking statements involve risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially and adversely from those anticipated by these statements. For a detailed description of these and other risks and uncertainties, please refer to our SEC filings, including our annual report on Form 10-K for the fiscal year ended July 31, 2022, and our quarterly report filed on Form 10-Q for the fiscal quarter ended October 31, 2022, as well as our earnings press release issued today. These forward-looking statements apply as of today, and we undertake no obligation to revise these statements after this call. As a result, you should not rely on them as representing our views in the future. Lastly, Nutanix management will be participating in the Morgan Stanley TMT Conference in San Francisco on March 8, and we hope to see you there. And with that, I'll turn the call over to Rajiv. Rajiv?

Thank you, Rich, and good afternoon, everyone. Against an uncertain macro backdrop, we delivered a solid second quarter with results that came in ahead of our guidance and saw continued strong performance in our renewals business. With respect to the macro backdrop, in our second quarter, we continue to see businesses prioritizing their digital transformation and data center modernization initiative enabled by our platform. However, we have seen some increased inspection of deals by customers, which we believe is likely related to the more uncertain macro backdrop, and this is driving a modest elongation in sales cycles. We consider this dynamic in our outlook for the remainder of the fiscal year. Supply chain constraints with our several partners improved compared with the prior quarter. I'd like to comment on the investigation mentioned in our press release. We recently discovered that evaluation software from one of our third-party providers was instead being used for interoperability testing, validation and customer proof of concept over a multiyear period. Our Audit Committee commenced an investigation into this matter, which is still ongoing with the assistance of outside counsel. Rukmini will provide more details on the near-term reporting implications of this matter, but I'd like to emphasize that we do not believe it will have a significant impact on the fundamentals of our business and overall prospects. Taking a closer look at the second quarter, we delivered solid top-line growth, including 23% year-over-year ACV billings growth, driven by continued strong performance in our renewals business. We again demonstrated good expense management, which helped us generate $63 million of free cash flow, continuing our strong recent free cash flow performance. Overall, I'm pleased with our financial performance in the second quarter. Our second quarter results reflect the value our customers are seeing in both our core cloud platform and in adjacent solutions in our portfolio with particular strength in Nutanix cloud management. A good example is our largest new customer win in the quarter, which was with a Federal agency looking to modernize their infrastructure. They replaced their legacy 3-tier environment with Nutanix's cloud platform, including Nutanix cloud management, to run their business-critical applications, leveraging its simplicity and building automation for Infrastructure as a Service. They also added Nutanix unified storage to service their unstructured data needs. We see this as a good example of a customer adopting our full stack offering to modernize and automate their IT infrastructure. Another notable win in the quarter was with the bank in the APAC region, who had been running a key business-critical applications in the public cloud on Red Hat's OpenShift. However, they were having performance issues and were unhappy with the incident response times of their public cloud service providers. So following an evaluation of multiple on-prem and public cloud options, the customer chose to run OpenShift and their critical applications on-prem on the Nutanix cloud platform, including our AHV hypervisors, concluding that it was the alternative that could deliver the best performance and total cost of ownership. This deal reinforces our view that cloud is an operating model, not a destination and that our Nutanix cloud platform is ideally suited to enabling the hybrid multi-cloud operating model, increasingly favored by IT professionals. Following the general availability of NC2 on Microsoft Azure late in our first quarter, we saw solid momentum with NC2 in the second quarter. A good example is a win we had with an EMEA headquartered provider of global transportation services, looking to accelerate their migration to the public cloud, reduce their data center footprint and optimize their public cloud spend. Following a rigorous evaluation of alternatives, including native public cloud, this customer chose NC2 on Azure, which they found enabled a roughly 4x faster migration, lower migration costs and significantly lower operating costs. This win demonstrates how our customers appreciate the ability to rapidly and seamlessly shift their workloads from their private clouds to the largest public cloud provider with the consistent management, governance and data services provided by the Nutanix cloud platform without the time and expense of refactoring their workloads and with lower ongoing operating costs. On the product front, during the second quarter, we delivered meaningful upgrades to our core platform with the release of AOS 6.6, which offers enhanced data services and a number of networking and security-related features, further strengthening its capabilities to support business-critical applications. In closing, I'd like to provide some thoughts on our priorities and outlook. First, our overarching priority remains delivering sustainable, profitable growth through judicious investment in the business, execution on a growing base of renewals and diligent expense management. Our strong free cash flow, along with solid top-line growth in the second quarter, reflects the progress we made to date towards this objective. While the macro environment remains uncertain, we are encouraged that the strength of our business model underpinned by a growing base of renewals and our ongoing focus on profitability, allow us to raise our fiscal year top-line outlook and reaffirm our free cash flow outlook. I remain confident in our ability to continue to capitalize on the vast opportunity in front of us while continuing to drive sustainable, profitable growth. And with that, I'll hand it over to Rukmini Sivaraman. Rukmini?

Thank you, Rajiv. I would first like to note that with respect to the investigation Rajiv mentioned, we are in the process of assessing the financial reporting impact, and it is likely that additional costs would be incurred to address the use cases previously noted. As a result, we have not provided financial information regarding expenses in our second quarter preliminary results or our outlook for the third quarter or full fiscal year 2023. While we are working diligently to address this matter and finalize our financials as soon as possible, we do not expect to be able to file our 10-Q on time or following the 5-day prescribed extension period allowed under 12b-25. Relatedly, we are rescheduling our Investor Day we had intended to hold on April 4, 2023 to summer of 2023 and will provide a specific date once it is confirmed. With that said, I will now move on to talk through our Q2 results, followed by our outlook for Q3; and then finally, provide an update on our fiscal year '23 outlook. Q2 '23 was a solid quarter with results that came in better than our guidance. ACV billings in Q2 was $268 million, higher than our guidance of $245 million to $250 million and representing a year-over-year growth of 23%. The significant majority of that growth came from growth in renewals billings. Revenue in Q2 was $486 million, higher than our guidance of $460 million to $470 million and a year-over-year growth rate of 18%. ARR at the end of Q2 was $1.378 billion, a year-over-year growth of 32%. New logo additions were about 480 in Q2. Contract duration stayed flat quarter-over-quarter at three years as expected. As described previously, the percentage of orders with future start dates likely due to partner supply chain constraints continue to be a key assumption in our Q2 guidance. This percentage came in lower than it was in Q1 '23 and below our expectations. Q2 revenue also benefited approximately $11 million from the improvement in percentage of future start dates as more license revenue was recognized in quarter than deferred, slightly more than the $10 million estimate we had provided on our last earnings call. Billings linearity was good, and DSOs were 28 days in Q2. Free cash flow in Q2 was $63 million, implying record free cash flow margin of 13%. A couple of additional notes on Q2: One, we retired the remaining principal amount on our January 2023 convertible notes of approximately $146 million with cash from the balance sheet. Two, last month, we reached an agreement to settle the outstanding securities class actions litigation, which is subject to documentation, notice to class members and court approval. We recorded a net charge of approximately $38 million for the settlement. This is the amount, inclusive of legal fees and expenses, net of our expected recovery under our D&O insurance. We expect approximately $33 million to be paid and settled in Q3, while the remainder was already paid for legal defense costs in previous quarters. We ended Q2 with cash, cash equivalents and short-term investments of $1.311 billion, down slightly from $1.388 billion in Q1 '23. Moving on to Q3 outlook. The guidance for Q3 '23 is as follows: ACV billings of $220 million to $225 million and revenue of $430 million to $440 million. I'll now provide some more context around our guidance. First, the top-line guidance for Q3 assumes that supply chain dynamics for our server partners would remain more or less the same compared to Q2 '23. It also assumes that contract durations would stay approximately flat to slightly down in Q3 '23 compared to Q2 '23. Second, the revenue guidance includes approximately $5 million of revenue benefit from the decline in percentage of orders with future start dates over the last few months. Said differently, we expect to recognize more license revenue in Q3 than is deferred, similar to the dynamic we saw in Q2. Over time, as our partner supply chain constraints resolves and our future start date percentages normalize, we would expect this dynamic to normalize as well. I will now provide an update on our full year 2023 guidance. We have had a solid first half and our renewals business continues to provide a strong foundation for growth and efficiency. Those factors, combined with our continued focus on disciplined expense management, allow us to raise our ACV billings and revenue outlook for the year while reaffirming our prior free cash flow outlook. Our updated guidance for full year fiscal year '23 is as follows: ACV billings of $905 million to $915 million, year-over-year growth of 20% at the midpoint; revenue guidance of $1.8 billion to $1.81 billion, year-over-year growth of 14% at the midpoint; and free cash flow of $100 million to $125 million. I'll now provide some additional color on our full year guidance. First, we are seeing continued new and expansion opportunities for our solutions despite the uncertain macro environment. However, as Rajiv mentioned, we have seen a modest elongation of sales cycles likely due to increased deal inspection. We have considered this dynamic in our updated guidance. We continue to expect that the significant majority of our growth in ACV billings for fiscal year '23 will come from growth in renewals ACV billings with the uncertainty in the macro environment factored into our expectations for new and expansion ACV billings. A reminder that ACV billings for the full year is not simply the summation of four quarters ACV billings because of deals with less than one year in contract duration. We expect that full year ACV billings is discounted by approximately 5% relative to the sum of ACV billings from the four quarters. Second, similar to our comments last quarter, the full year guidance assumes that contract durations would decrease slightly compared to fiscal year '22. The fiscal year '23 revenue guidance also assumes that the percentage of orders with future start dates would ease slightly in the second half of the fiscal year compared to the first half. Third, the reaffirmed free cash flow guidance of $100 million to $125 million includes the impact of approximately $33 million in net cash outflow expected in Q3 from the previously mentioned litigation settlement. It also includes the impact of approximately $12 million of cash usage in Q3 for nonrecurring tax obligations related to a portion of our employee RSUs vesting this month and other anticipated cash outflows. These cash outflows were not included in our prior guidance for annual fiscal year '23 free cash flow. Finally, I'd like to note that we continue to expect to generate at least $300 million of free cash flow in fiscal year 2025. In closing, we are pleased that our Q2 results reflect our continued execution towards our stated objective of sustainable, profitable growth, and we expect to continue that focus. With that, operator, please open the line for questions.

[Operator Instructions] Our first question comes from the line of Pinjalim Bora with JPMorgan.

Congrats. It seems like a pretty good quarter. I just wanted to go back to the investigation that you were talking about. Could you maybe explain it in a little bit of a leaner what happened exactly? And it sounds like it's like an underpayment to a vendor. Am I understanding it right? Or what -- help us understand a little bit in less legal terms.

Yes. Let me start and Rukmini, you can explain the details here, right? But the one thing -- the first thing I want to say is that the fundamentals of our business are unchanged. So this matter doesn't impact our market opportunity or the demand for our solutions. And we are working diligently to resolve it as quickly as possible, and we are very focused on driving sustainable profitable growth. Now with respect to that specific matter, Rukmini, maybe you can just explain the details behind it and what we're doing.

Sure. Yes. Pinjalim. So what we discovered was that certain eval software, evaluation software, from one of our third-party providers, so somebody who provides us software, which is intended for evaluation purposes was instead used for validation, interoperable, testing and proof of concept over a multiyear period. So that is a -- we discovered that, and as we said on the call, that matter is ongoing. And because of that Pinjalim, we weren't able to disclose expense information on the call, and we've announced that we expect to be unable to file our 10-Q in a timely manner, given that we want to make sure this is resolved first. Now I want to also provide a little bit of color that we are -- given this, we still believe that our top-line results, our free cash flow as we reported it, are all unimpacted by this. And when we look forward to guidance, we are pleased to be able to raise our revenue and ACV billings guide, and we're comfortable with the $100 million to $125 million of free cash flow guidance for the year after factoring in the potential impact from this third-party software use that we mentioned on the call. And as I noted in my prepared remarks, the free cash flow guidance also includes the impact of the $33 million approximately from the settlement of the litigation and the impact of this $12 million of cash usage in Q3 for nonrecurring tax obligations related to employee RSUs vesting. And these cash outflows were not included in our prior guidance for the full year free cash flow.

Yes. Understood. And Rajiv, we had -- with some of our discussions with some of your partners seem to suggest that the VMware opportunity is taking shape. But I wanted to ask you, one of the discussions kind of highlighted that just the complexity of some very large VMware customers using tens of thousands of VMs, who might be looking at Nutanix as an alternative. It's just complex to kind of move from one to the other, of course. So I wanted to ask you, what can Nutanix do or what are you doing to kind of make those large companies feel a little bit at you to kind of move those large VMware environments over to Nutanix? And how has those -- some of those discussions have been progressing?

Absolutely. As you can imagine, Pinjalim, we are engaged with many of these customers right now. We have a significantly higher level of engagement. A lot of these are prospective customers that aren't existing ones, and they're all looking to explore their options and manage these potential risks related to the acquisition. What you should keep in mind is, for many, many years, we've been doing these things. We've been doing these migrations. In many cases, when we go out there, we insert our solution on top of a VMware platform, right? Customers are running vSphere, we go in there and we insert AOS, which is our software-defined storage. And over time, customers may choose to use our own hypervisor AHV, instead of the VMware hypervisor. So we have a lot of experience with doing migrations for our customers. Now the large is the environment, the more complex it is and we know that. And typically, we will do this one workload at a time, for example. They will pick us for one use case and then over time, we will expand and other use cases. Historically, it used to be in the computing, but these days, we do databases. We do all mission-critical workloads, all of this. So we have a lot of experience doing these migrations. That said, Pinjalim, I think what you heard -- yes, this is complex, it's going to take time, and this is why we are not factoring in any significant benefit in our fiscal '23 outlook. We expect these cycles to be long, typically nine, 12 months for some of the larger deals.

Our next question comes from the line of Jim Fish with Piper Sandler.

I wanted to build off the last couple of questions, actually. Maybe could you talk about the push-pull effect you're seeing with the demand environment given that ability to consolidate the competitive landscape, especially on the VMware side and maybe even the traditional storage perspective as well as just the HCI market against those traditional storage guys versus the general macro environment. It sounds like, Rajiv, you're talking about an increased lengthening of deal cycles. Is there a way to think about how much longer deals are also taking? So net of my question is, what are you seeing for the push-pull on all these kind of factors on demand? And is there a way to quantify how much longer these deals are taking?

Yes. Jim, indeed, there is a push and pull on this, as you say. So first on the macro. We see strong performance from our renewals and that's been continuing. And of course, that helps reduce the risk in our business model and the guide that we put out there. Now we have taken into account the current macro environment. As you say, right, in terms of the impact that we are seeing, we have been seeing greater inspection. Now what I would say is, what that means is, very -- I would say, so far, it has been a modest increase in the average sales cycle, right? The time it takes to close the deal goes up a bit, and we're seeing this across both in new logos or new customers and existing customers looking to expand, right? They're just being a little bit more careful, taking some more time to review the economics of everything and looking at the TCO benefits. Now that said, we do have strong TCO benefits that typically compared to legacy infrastructure. So when you look at the dynamics vis-a-vis the second piece of it, which is compared to third party or legacy 3-tier storage, I think those dynamics are largely the same. When there is, for example, time for a refresh or any kind of modernization effort, the customers compare HCI versus 3-tier, and then able to show a better TCO, a much more modern ability for them to go build a cloud platform. And that dynamic hasn't really changed. Clearly, the VMware dynamics certainly will help in the long term, but not in the short term. But in the short term, what I would say, is increase the level of engagement. So there's clearly a push and pull. We have the -- to summarize, we've got the renewals business that provides a foundation. On the new business, small elongation and deal cycles. On the other side, we're seeing more engagement from a VMware basis. And so we've tried to do our best to factor in all of these dynamics into the guide that we gave you.

That's helpful. Impressive on the free cash flow beat this quarter. Just trying to make sure here, how much of this was driven by essentially the operations versus working capital numbers and really underneath, we're trying to understand where OpEx would have kind of come in, barring any of these added expense issues and Rukmini, sorry to layer on here, but you just had mentioned the free cash flow outlook included the potential impact of this investigation. Does that also assume the catch-up potential?

Thank you, Jim. All good questions. So let me try to parse that. So as I said in my remarks, Jim, we are not commenting on expense -- expenses either for Q2 or on a forward-looking basis. So I'll stop there. But in terms of free cash flow, right, for Q2, as you said, we're happy with the free cash flow performance in Q2. And I will just say that I think we talked about DSOs on the call, right, which was 28 days. It was unusually low in Q1, and we saw it kind of come back to, I would say, within the range, right, in Q2 because typically, our payment terms for DSOs are 30 to 45 days. And so I would expect it to be sort of in that area. Now to your second question, so yes, we are comfortable with our full year $100 million to $125 million free cash flow guidance, Jim, including the potential impact from -- arising from this matter, right, related to the third-party software use that we mentioned on the call and the other sort of items around the $33 million for the settlement and the onetime $12 million tax obligations we discussed.

Our next question comes from the line of Mike Cikos with Needham & Company.

I did have a couple of questions. Just to circle back to the Audit Committee, and I want to make sure that everyone had this right. So this investigation that we have right now is totally independent of the -- I'm not sure I'm getting the numbers right now, the anticipated expense in 3Q that you had cited regarding a $33 million for the litigation settlement, correct?

That's correct, Mike.

And so if I look at the audit investigation specifically, can you provide us like when was the issue discovered? When did the Audit Committee commenced its investigation? When did Nutanix engaged outside counsel? I'd just like to see if we can get a time line for how these events are playing out under the hood? Again, just because we have this limited guidance that we're being provided today.

Yes. Thank you, Mike, for the question. If I understand that there's limited guidance here, Mike, and we -- what I can say is that given this review is ongoing, what we can say is that we are working diligently, right, with the Audit Committee and our outside counsel to resolve this as quickly as possible so we can be in a position to share more with you. At this point, we're not able to kind of provide very specific timelines to your question, but we are working diligently to make sure we are resolving this appropriately and in a timely manner.

And I just wanted to see -- like one of the things I'm struggling with on my side, and again, it's probably just a misunderstanding on all of the legal comportment that are involved here. But I know that you guys are saying that this third-party provider was using software for evaluate. I don't want to butcher it, but I think it was supposed to be…

Yes, let me try…

Yes, and I'm trying to see, is there an impact on revenue as a result of this? Or is it entirely expense base? Because again, I'm trying to get it like, is there potential for this in any way to impact your top-line results? Like you're giving us the revenue and ACV billings guide, is that untouched by this investigation at this point? And then the follow-up is like, how is it we don't have the expenses here, but you guys are able to refer the free cash flow. I think that's what I'm wrestling on my side. And I apologize for the long-winded question, but I just want to make sure I'm being clear.

Yes. Thank you, Mike. So let me try and clarify some of those pieces. So you are correct that we do not believe that this matter has any impact on our topline metrics, specifically revenue, ACV billings, which as you point out, we've disclosed and we're guiding to. So that's one part of it. And in terms of just -- sorry, what was the second part of your question? Mike, I think there was one more question after that.

Yes. Yes. So...

On free cash flow, I think, right? Yes.

Exactly. Exactly.

Correct. Yes. Sorry about that. So I think on free cash flow, we reported Q2 free cash flow, right? Like that's the $63 million that we reported out. Now for the full year, I think this is important. So I'm glad you asked the question, Mike, that we are comfortable with the $100 million to $125 million free cash flow for the year after factoring in a potential impact from this third-party software use that we mentioned on the call and the two other items, right? So $33 million, which as you said, a separate matter from a previously outstanding litigation settlement. So that's $33 million that was not factored in before, and this $12 million of cash usage in Q3 for nonrecurring tax obligations related to a portion of our employee RSUs vesting this month.

Okay. Okay. And then maybe, again, this is just me being naive here. There was phrase it how you will, but again, I just want to make sure, with the third-party provider, like how were they supposed to be using the software versus what we're seeing today as far as its interoperability testing? Again, I just want to make sure I'm aware of like the different nuances here for what's causing this investigation in the first place.

Yes. Understood, Mike. So let me -- so what -- this is the software that we were using from a third-party software provider. It was evaluation software intended to be used for evaluation purposes, and instead, it was being used by us for interoperability testing, validation and proofs of concept. So that is the matter that's being reviewed right now.

I see. And so because you -- it was intended for evaluation, but instead you guys were using it for interoperability testing and validation because of the different usage of that software, there's potentially a different cost for what you had been paying that provider. Is that a very simple way of putting that? I know I'm probably mischaracterizing a lot of that.

Yes.

Okay. Okay.

Yes, that's right, Mike. So yes, it's intended to be used for evaluation software, and we discovered that was instead being used for these other inoperability, validation and proof of concept, and so that's what's under review right now.

Yes. And I'd just say one thing there, Rukmini, and what this means, therefore, there might be some additional expense, right, in terms of using usage of that.

That's correct.

So that's why we are -- until we have -- this is done, we can't really specifically give you expenses.

Our next question comes from the line of Meta Marshall with Morgan Stanley.

Maybe one question for me or first question for me just on kind of the beat and better outlook. I'm just trying to get a sense of the blend of how much of that is from earlier renewals? And then how much of that is from the future less future start dates kind of moving in? So just trying to get a sense of kind of what the various contributors to the upside were? And then maybe just a second question, not to belabor the point, but just is there a way to contextualize like in fiscal year '22 just how much payments were to this vendor just to kind of get a sense of why you have confidence that even with an increase in those payments, you would still be able to kind of meet the free cash flow target that you laid out.

Thank you for the question, Meta. So let me take that one by one. So I think your first question was around just the raise for the full year, right, and what contributed to that. So I mean, clearly, in Q2, we beat both on ACV billings and on revenue, right? And so I think that certainly makes us feel more comfortable raising the guide for the full year. On the revenue piece, we did try to provide some color for you in the prepared remarks around the percentage of future start dates. So that does have an impact. So you saw it had about $11 million impact in Q2. And for Q3, we expect that to be about $5 million more of license revenue that gets recognized in quarter versus deferred. And so there was some of that effect factored in, Meta, to your question on the full year. And I think on renewals, as Rajiv has said and I emphasize this too that our renewal business is doing well, and so that, again, continues to underpin the significant majority of our growth and lowers the risk somewhat given all of that is based on deals that we've already done that are coming up for renewal. Now I think the second part of your question was whether we'd be able to quantify some of these payments, and we are not able to provide any specific quantification on that at this point, Meta, given the review is ongoing. But as I said before, we are continuing to work diligently to try and get this dissolved.

Okay. Got it. I mean just maybe following up on the renewal piece. Clearly, those are doing well, but just maybe in the past quarters, early renewals have been a greater contributor to upside. So just -- I'm just trying to get a sense if there's no early renewal component that we should be thinking of here as well.

Yes. I would say, it's not outside the norm, Meta. So anything we've discussed before, we typically do go to our customers as a lot of other vendors do as well, about even 6 months advance of the renewal date to begin those discussions. So there will be some timing movements here and there. We do some co-terming like most subscription vendors do. So -- but nothing outside of the normal or what we would expect that contributed to renewals.

Our next question comes from the line of Ben Bollin with Cleveland Research.

I wanted to circle back a little bit on the renewals. Could you speak to how much of the footprint was up for renewal or is up for renewal in fiscal '23? And how that develops into fiscal '24? And then I had a follow-up.

Hi, Ben, thanks for the question. Yes. So we haven't quite provided kind of a percentage almost of ARR, right, that's up for renewal, I think, is your question. So we haven't quite quantified that, Ben, but I will say that overall, given where we are in our journey, right, really all we sell now is subscription software, term licensing software other than professional services, which is a small portion of the overall business. So -- and our renewals are starting to flow in, right? So we do expect to see kind of continued growth in that base of renewals as we layer on kind of the additional trims that we -- urgent software that we have sold over time, right? So I would say that is a growing base of renewals, but we haven't provided a specific number or a percentage of ARR that's up in this year.

Okay. And then the other item. When I look at the billings targets into 3Q and the fiscal year, it implies a pretty notable acceleration into 4Q. What are you seeing that drives that acceleration following what you're guiding to in 3Q and then what you're expecting in 4Q? That’s it. Thank you.

So I think a few things. So when you say acceleration, did you mean growth? I think a couple of things, I would say, Ben, right? So typically, our Q4 seasonally is a better quarter for us than Q3 is, and that's because it's the end of the fiscal year for us and so that is expected. We also have -- last year, our Q4 ACV billings provides a bit of a -- somewhat of an easier comp given some of the dynamics that were happening in Q4 of last year. But I think from -- when you look at the guidance for the Q3 ACV billings and quarter-over-quarter, what's implied for Q4, it's, I would say, within the range of what we would expect from Q3 to Q4.

Our next question comes from the line of Matt Hedberg with RBC.

You guys are coming up, I believe, about on the one-year anniversary from when you had some sales attrition issues last year. It feels like a long time ago now. I'm wondering, though, if you could talk about just how general attrition levels stand today? And maybe sort of kind of overall hiring plans for the remainder of the year?

Yes. I can take that, Matt. So in general, by the way, the environment has gotten a lot better over the last year from a hiring perspective as well as the retention given what's happening out there in the markets, both with respect to other large tech companies as well as a lot of the start-ups that our people were potentially going to, right? So from that situation, I think things have gotten a lot better. Now to your question on the sales front specifically, we are doing -- again, every quarter, we've been seeing repatriation -- retention improve actually quarter-over-quarter. And our rep headcount has been roughly flat. We do expect in FY '23 to grow our rep count modestly from where we're at. And at the same time, of course, we are very focused on continuing to drive higher rep productivity.

Got it. Thanks. That's helpful. And then congrats on the -- on that large Federal agency win. Maybe just kind of expand the aperture a bit and just talk about sort of like public sector spend in general, how much of a driver has that been for you? And how do you expect that can continue from here?

Yes. So first of all, I'll just say, in the U.S. -- by the way, we only have two verticals. One is public sector and the other is healthcare. So public sector is clearly very important for us. We are well penetrated into public sector across both civilian, defense, government agencies across the board as well as state, local education. So it's a very important market. That's why we have a vertical presence in it targeted at that market. And I would say, it continues to be a very solid source of business for us. We continue to drive their modernization efforts. We are fairly broadly deployed, but we see continued opportunities there as well. So it's a good and very important sector for us with continued spending. Now of course, they have their budget cycles, as you know, every year, right? I mean depending on certain quarters where for the year-end, we tend to see a bump in the public sector sales during that quarter. But that's -- again, it's all as usual, I would say.

Our next question comes from the line of Aaron Rakers with Wells Fargo.

I have got two as well, if I can. I just wanted to maybe first ask about the ACV piece of the guidance. I know that you talked about the macro dynamics, but looking at the high end of the guidance range, it's still down about 15% or 16% sequential. I know you also talked about possibly a slight decline in duration. So I'm curious, that's definitely below what seasonalities look like over the last couple of years. Is that all just macro? Is there something else that you're factoring in or maybe quantify kind of that slight possible decline in duration? Just trying to unpack that guidance for ACV this quarter.

Sure. Thank you, Aaron. So yes, we were happy to be able to raise both revenue and ACV billings guidance. And you're right, Aaron, that sort of half over half, I guess, it does imply a decline in ACV billings like second half over first half. And I would say, one is what you've already pointed out and which we talked about, which is this modest elongation in sales cycles that we -- there was anecdotal in Q1. We saw it. We saw a modest elongation in Q2. And so we have factored in, as I mentioned in my remarks, to write some conservatism as it relates specifically to the new and expansion portion about the ACV, but ACV billings portion, right, of the overall guide. So there's definitely that. And if you look at a year-over-year growth rate, I think there's still a meaningful growth rate year-over-year for the second half. So that's kind of how we are thinking about the ACV guidance for the full year and implied second half.

Yes, very, very helpful. And then on the free cash flow -- and I apologize for going back to this, but if you look at the first half of the year, you did about $109 million of free cash flow. If I take the adjustments that you've quantified factoring into, let's just call it, the midpoint of that $100 million to $125 million, factor back in the $33 million and the $12 million that you talked about is still a particularly large decline relative to the first half. So I understand that there's an unquantified element to this investigation dynamic. So I guess the question is, is there anything changing within the free cash flow dynamics, be it working capital that's changed in the back half of your guidance relative to what you saw in the first half? I'm just trying to understand why free cash flow second half versus first half down aside from just those factors that you outlined.

Good question, Aaron, and thank you for asking a clarification question, right? So first is, I think as we sort of you just pointed out, actually, we do expect to see lower billings and revenue in the second half which does have an impact, as you can imagine, billings does have a direct impact on free cash flow. And then I think you've done the math right around just the items that we pointed out, and as we said, it does factor in the potential impact from the use of this third-party software as well, which we are not quantifying at this point. So that's how to think about the full year free cash flow guide. We don't anticipate sort of any significant material changes to working capital or anything like that for the rest of the year.

Our next question comes from the line of Jason Ader with William Blair.

I wanted to ask just, I think, it may be confusing for folks on this third-party evaluation software. I think that -- I think people may be wondering, evaluation of what? What are you guys evaluating with that software?

Yes. Maybe I'll give you some color, right? So eval software has meant for eval view, right? So you go try it. You go try it out for whatever you're using it for you try out, and then at some point, we purchase it. What we found was, in some cases, we were using the reval software for doing interoperability testing or customer proof of concepts, validating. So that goes beyond the scope of what the eval software was being used for.

So the eval software, were you paying a very small amount because it was just eval software, and therefore, now you're going to have to pay a lot more because you were using it for things that it wasn't meant for. Is that the idea?

Yes. So we haven't quantified how much, right? But we can't get into that kind of detail here, but yes, you're right, right? I mean, therefore, there is some additional expense required likely to -- for the usage and use cases that we were looking at.

Okay. Great. And then another question for you, Rajiv, just on this whole cloud versus on-prem debate. Specifically, are you seeing any slowdown in the migration of workloads to the cloud because of recent customer cost sensitivity just in this environment that we've been in over the last 6 months or so?

Yes. In fact, we gave you an example of a repatriation in our prepared remarks here. Definitely, we are seeing -- especially in many areas of the world now, customers are much, much more cost sensitive in terms of looking at the cloud, the public cloud in particular and saying, when should I go to the public cloud and for what? And they're starting to look at -- this whole cloud economics is a very important part. So in the example that we showed, for example, this customer is actually running a production workload in the public cloud because of mission-critical workload, and they decided to migrate it on-prem because they could get a better TCO. They could also get better support experience and response sense from vendors by doing so. So we're seeing that definitely being much more nuanced now. It's not going -- not taking everything you have in going to the public cloud. It's being much more nuanced about what you put where and what is it going to cost you.

Our next question comes from the line of Simon Leopold with Raymond James.

I wanted to see if you could maybe address the elongation of decision process, whether or not there's variation in this behavior between existing customers and new customers? Or whether you're seeing any kind of patterns by customer types, verticals or something discernible like that? And then I've got a very quick follow-up.

Yes, Simon, that's a good question. I don't think we have that level of visibility because a lot of this is somewhat anecdotal, and we've seen it for both new and for existing customers, right? Clearly, for us, typically in the past, expansion in existing customers is generally easier and quicker compared to new, right, net new prospects. But we are seeing an elongation in deal for both, and it's -- but I will also say, it's a very modest elongation at this point. So it's just that, for example, just anecdotally, well, something that a VP may have budget for at a VP level and say, yes, I'm going to go ahead and do it. Now with being scrutinized at the CFO level, say, okay, do you really have to go spend this money now? Can you wait? Is there a TCO benefit that you can quantify for me quickly? So that's the kind of, I think, dynamics that we are seeing. It's hard to parse out specifically as it varies a lot by customers, but we're seeing this as both new and for expansion.

And then just a quick one is, on this third-party software issue, do you have insight into whether or not this affects your cost of goods sold or the R&D line? Or you just don't know that yet? I guess I'm sort of trying to figure out where these charges would show up.

Yes. Rukmini?

Thank you, Simon. Yes, at this point, given this is ongoing, Simon, we're not able to get more specific on the types of expenses or where the P&L, it might fall.

Our next question comes from Ruplu Bhattacharya with Bank of America.

I'm filling in for Wamsi Mohan today. Rukmini, one question for you real quick. Just to clarify on the third-party software issue, do you think that this impacts the historical last couple of years' financials? And will you be restating your financials? And maybe does this impact margins lower and earnings lower? And will you be restating that when you file your statements?

Thank you for the question, Ruplu. Again, this is -- this review is ongoing, and so we really can't comment on any of that, Ruplu, but we are working quickly and diligently to make sure we're able to provide more clarity on all of this. But at this point, there's really nothing more I can add on the specifics.

Okay. Okay. Maybe one for Rajiv. You talked about customers inspecting deals more and a slight modest increase in the sales cycle. When I look at the new customer adds, right, this quarter, it was like 490, which really is the lowest quarter for new adds going back to 2017. So can you talk about like any thoughts on that? I mean on that -- on the lower number of net adds this quarter, any competitive dynamics you're seeing? Or could this also -- any thoughts on FX because you price in dollars and with the dollar strengthening recently, how is the pricing environment? And are you having to price lower? So just your thoughts on the number of new ads and the competitive dynamics that you're seeing and then pricing.

Yes. I'll talk about two of those, and I'll let Rukmini comment on FX. But first of all, we are focusing on higher quality, higher ASP new logos, more so than new logo comp. So we want to make sure that when we get -- when we put our efforts to go winning a new logo, we make the count, right, much more so and provides us a bigger deal, drives up our sales productivity and also provides more expansion opportunities. So that's been our focus more so than the new logo count. The new logo count shows up in terms of what it is. It's more of a result rather than a number that we are trying to focus on in terms of trying to hit a new logo target. The second thing I would say is, our -- we are very much holding up our prices, right? Unit prices have remained very stable, and they're not going down in any way. And then the third part of it, in terms of FX, Rukmini, perhaps you can comment.

Yes. So Ruplu, your question, I think, was that given that we denominate all of our transaction in U.S. dollars, is it effectively a price increase? Which it is in some parts of the world, right, where the dollar has strengthened. And so what we're seeing is, this is anecdotal, right? In some cases, we've seen it sort of put some pressure on the timing of some transactions, especially in the emerging markets. But overall, I think to Rajiv's point, our unit economics and our overall pricing is in a good place. And so we haven't seen a sort of significant or systematic impact on that from any of these drivers.

Okay. If I can sneak one quick one in backlog was very high coming into this fiscal year. Did you also reduce backlog in the quarter? And what's the expectation for backlog for the rest of the year?

Thank you for the question, Ruplu. So on backlog, yes, you're right. When we entered this fiscal year at the end of July, we did say that we had record levels of backlog, and we expect during the course of the year to use that backlog over time to get to a more normalized level by the end of the year. We did use some backlog in Q2 in line with our expectations, and again, we expect that we will continue to consume that over the course of the rest of this year.

Our next question comes from the line of George Wang with Barclays.

Congrats on the quarter. Just maybe you can, Rajiv, kind of unpack kind of service provider channel, any kind of update you have. Last quarter, you talked about the SP channel as a new sort of area to kind of land new customers. So just curious if you have any kind of updates on this?

Yes, I think, George, we are certainly very excited about that route to market because we are relatively new in terms of our using this route to market for us. So it's a growing business opportunity for us. Last quarter, we said, the largest deal in the quarter was done through that SP channel. And it's still -- we're still in the very early stages in that innings there, and we continue to build up our service provider partners. We're trying to enhance the product capabilities to provide a very as broad an offering as possible. So we have -- so it's a continued -- it's a journey, and it's going to take us multiple quarters for it to start becoming a significant chunk of our business. Right now, it's still a small portion of our overall business.

Okay. I have to create a follow-up. Just in terms of the AHV kind of your own hypervisor this quarter is 63% mix, up 2 points sequentially. Can you give some color just on the traction of your own sort of hypervisor? And how are you seeing in terms of the migration kind of customer reception?

Absolutely. And I would say, it's becoming more and more important now in the context of the whole VMware-Broadcom acquisition as well. Now for us, it's always been a blend. We would like to see, of course, more customers using AHV, okay? On the one side, which, of course, will mean that our AHV as a percentage of our workload keeps going up. But at the same time, we see there's a huge opportunity in terms of us inserting into other hypervisor footprints. And in fact, that's the default. It used to be -- if you go back many years ago, that was our default. We would insert it into somebody else's hypervisor environment, like a hypervisor. So we want to continue that because there's still a huge opportunity there. So the model with customers has been, in some cases, we will go and start on top of a third-party hypervisor with the rest of our solution stack. So our software-defined storage, for example. And then over time, they will choose to migrate some of that to AHV. We also have a dynamic where in many new customers, they go all in with AHV from day one as well. So we have both those dynamics, and we want to maintain a balance of both because we do want to, of course, have customers on our own hypervisor and sell them the full stack solution. But at the same time, we want to be able to go after those customers that have other hypervisors and be able to insert into their environment as well. So I'd say -- so that's the blend that we're trying to get comfortable with, but overall, it continues to mature. More and more customers using it. Ecosystem is being becoming broader and broader. We have third-party certifications like Red Hat and others on it now. So it's becoming, let's call it, ready for all mission-critical workloads at this point.

Due to the interest of time, our final question comes from the line of Thomas Blakey with KeyBanc.

Nice quarter. I just wanted to maybe just simplify a lot of the questions that were asked about renewal trends. I mean it's very important for hitting some longer-term free cash flow targets. Could you just speak to the trend? No numbers in fiscal '22, fiscal '23. What you're seeing from a renewal opportunity in fiscal '24 to fiscal '25 to hit those targets? Is the trend moving in the right direction? And just start there.

Tom, thanks for the question. So look, I think we've emphasized a few times and I'm happy to, I think, clarify I think for you, Tom. It's a good question on just the overall renewals work stream. We've talked about how it's a driver both of our growth and efficiency, and it continues to perform well. And yes, we do believe it's going in the right direction, not just for fiscal year '23, as we talked about in majority of growth coming in, in '23, but also more generally, right? And that's why we did mention that we reiterate our sort of $300 million-plus free cash flow number for '25, and so we continue to believe that, that thesis still holds.

And given the commentary around the macro, maybe a downtick in my opinion from what I'm hearing from the last couple of quarter calls here and combined with the solid results. Can we get some feedback in terms of what maybe the higher kind of net dollar retention rate was on some of these renewals? What are -- where are those numbers up? And what was driving that?

Right. So I think if your question on NRR, our net dollar-based retention rate metric, Tom? Is that the question?

Yes. From the renewals, yes.

Yes. So thank you for that. So I think I want to first clarify that when we talk about renewals billings, we're purely talking only about renewals, right? It does not factor in any of the expansion that is factored into our new and expansion portion, right? That's sort of incremental ACV. NRR, to your point on, we don't actually disclose on a quarterly basis. So what I will say, though, is if we look back to our last Investor Day, we had given some ranges in that 120 to 125-ish percent sort of range, and it is still in that in that range in terms of the NRR number. And so yes, and as we've also talked about how for new and expansion is where we are baking in some caution as it relates to the full year guide, given what we're seeing in the business.