Hello, and thank you for standing by. Welcome to the C3 AI Second Quarter Fiscal Year Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce from [technical difficulty] Investor Relations, Mr. Reuben Gallegos.

Thank you, Andrew, and good afternoon, and welcome to C3 AI's earnings call for the second quarter of fiscal year 2023, which ended on October 31, 2022. My name is Reuben Gallegos, and I'm the Vice President of Investor Relations. With me on the call today is Tom Siebel, Chairman and Chief Executive Officer; and Juho Parkkinen, Chief Financial Officer. After the market closed today, we issued a press release with details regarding our second quarter results as well as a supplemental to our results, both of which can be accessed through the Investor Relations section of our website at ir.c3.ai. This call is being webcast, and a replay will be available on our IR website following the conclusion of the call. During today's call, we will make statements related to our business that may be considered forward-looking under federal securities laws that reflect our views only as of today and should not be considered representative of our views as of any subsequent date. We disclaim any obligation to update any forward-looking statements or our outlook. These statements are subject to a variety of risks and uncertainties that could cause actual results to differ materially from expectations. For a further discussion of the material risks and other important factors that could affect our actual results, please refer to our filings with the SEC. All figures will be discussed on a non-GAAP basis unless otherwise noted. Also during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release. Finally, at times in our prepared remarks, in response to your questions, we may discuss metrics that are incremental to our usual presentation to give greater insight into the dynamics of our business or quarterly results. Please be advised that we may or may not continue to provide this additional detail in the future. And with that, let me turn the call over to Tom.

Thank you, Reuben, and hello, everyone. Thank you for joining us. I'm here with Juho Parkkinen, our Chief Financial Officer, and we are most pleased to share our results for the second quarter for fiscal year '23. Bottom line, it was a solid quarter in which we delivered our stated objectives and met expectations despite the rocky economic situation and the generally morose condition of the markets. In the last earnings call, we described two strategic initiatives to spur faster growth. One was to recompose our sales team with an emphasis on technical and domain expertise. The second was to shift our pricing model from a subscription-based pricing model to a consumption-based pricing model. I'm happy to report these initiatives have been successfully completed in the second quarter. I will explain these actions in some detail, but first, I'll comment on the financial results and some of the successes that we achieved during the quarter. With large, the quarter was quite solid. Subscription revenue for the quarter was $59.5 million, an increase of 26% year-over-year. Operating loss improved 15 points year-over-year to 24%. We continue to maintain a healthy gross margin of 77%. Customer comp grew 16% year-over-year to 236. Current RPO of $164.5 million was down slightly and consistent with our expectations as we transition to a consumption-based pricing model. We ended the quarter with cash reserves of approximately $860 million. The number of completed contracts in the quarter increased to 25, approximately a 100% increase year-over-year. Our average contract value in the second quarter was just over $800,000, down from $19 million a year earlier. This reduction in contract value was a direct result of our new pricing model. We believe the new pricing model will result in a substantially increased number of smaller transactions, providing greater forward…

Thank you, Tom. Now I will provide a recap of our financial results, add some color to the drivers of our financials for the back half of the year and conclude with some additional color related to the consumption-based revenue model we introduced on our last call. As Tom mentioned, we ended the quarter with revenue of $62.4 million, which represents 7% year-over-year growth. Subscription revenue increased by a solid 26% and was 95% of total revenues. Gross profit increased 5% to $47.8 million, and gross margin decreased 122 basis points to 76.6%. The decline is primarily due to a higher mix of trials and pilots, which carry a higher cost required to ensure customer success during this early phase of engagement. Operating loss of $15 million improved $7.6 million year-over-year, and operating loss margin also improved from 39% in the prior year to 24% in Q2. Our customer count increased by 16% year-over-year to 236, and we closed 25 deals during the quarter. It's noteworthy that deals under $1 million grew 167 year-over-year in Q2. Now turning to RPO and bookings. We reported RPO of $417.3 million, which met our expectations as we continue to convert to consumption-based deals. Current RPO was $164.5 million, down 8% from last year. We continue to see positive trends in bookings diversity outside of oil and gas, particularly in the Federal, aero and defense sectors, which grew sequentially and year-over-year. Turning to cash flow. Free cash flow for the quarter was an outflow of $77 million. Breaking this down, $23.7 million was for the build-out of our new headquarters. As I have mentioned previously, this will be amortized over the term of the lease and will not have a meaningful impact on our path to profitability. Normalizing for this payment, our adjusted free…

[Operator Instructions] And our first question comes from the line of Brad Zelnick with Deutsche Bank.

I guess my first one is either for you, Tom, or for Juho. Just as we think about the plan that you've laid out, and it's nice to see the progress relative to what you told us last quarter, but traditional metrics obviously don't tell the full story. So what's the right metric for us to track the progress quarter-to-quarter that you're making? What are the milestones that we should be looking for? And maybe can you tell us what metrics do you measure yourselves against internally and hold the sales force accountable to and incentivize them on so we can just get a sense quarter-to-quarter? In addition to customers, obviously, they eventually translate to dollars, but any insight there is helpful. And then I've got a follow-up.

Brad, it's Tom. I mean, I think the bottom line is when we go to this model, we're looking at a number of customers, okay? So how many new pilots are or closing every quarter? We'd expect in the other quarters, I mean, this should be in order of magnitude larger than we're doing now. I think we did, what, 13 or 15 last quarter in roughly half a quarter, because we announced the transition to this model about halfway through the quarter, and we did 15 in about half a quarter. So basically, it's really number -- we're really looking at a number of customers, Brad, and then we're looking at how far we -- how rapidly they grow the use of the products. If in fact, we get in order of magnitude more customers, and they continue to grow their use as our customers have in the past, and you know we've modeled this very carefully, I mean, we get out there three, four, five quarters. This revenue line should accelerate pretty dramatically.

Right. Brad, just one thing to add to that. So we guided in our original model for the analyst community to expect five pilots for the quarter. We actually closed 13, which was a combination of trials and pilots. So we're quite excited about how this started, this kicked off.

That's helpful. And maybe just one follow-up. Appreciating the accelerated path to profitability and naturally, just given what's going on in the world, you guys are in in a pretty interesting position for sure. But what would need to happen to get you to positive free cash flow ahead of the fiscal '24 expectation? And maybe can you just clarify for us, is that an exit rate? Is that for the full year? How do we measure that? And what circumstances would maybe cause you to accelerate that? Not that you need to, you've got plenty of cash, but I mean, this is clearly the discipline that the world wants to see.

Brad, it's simple. We can turn this to be cash positive and profitable honestly within 90 days. All I got to do is layoff about 40% of the workforce, okay? I don't think -- I mean, that might make some analysts happy and it might make some shareholder happy, but it's absolutely not in the best interest of the shareholders, employees or the customers. But I mean, it's all we have to do is basically stop our marketing expenses and lost 40% of the people and I don't know whether it's 40% or 50% or 35%. But, I mean, hard stop, it's cash positive and profitable like this quarter. But I don't think that would be responsible, and I don't think it's anybody's interest, but you asked the question we gave you the answer. Juho, do you have any further light on that?

Only thing, Brad, that we -- the way that we've modeled our path to profitability, we feel confident on that and we stick to that.

Got it. So just to clarify the expectation though, it's for the full year? Is it an exit rate when you say fiscal '24...

It’s an exit rate of Q4 FY '24.

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

I did want to circle up on some of the customer count dynamics just because I know that is going to be 1 of the metrics we're looking at while you guys are going through this transition. I think you guys had cited 236 up from 228 last quarter, right? And I just wanted to see what has the customer behavior been like since you guys announced this transition? And what I really would be interested in hearing I know you guys are not forcing your customers to migrate down to the consumption model. But curious to hear, have you seen customers trade down to the consumption model since you announced this transition? And then the second question there is, have you seen any changes in customer behavior from a churn perspective?

Mike, it's Tom. No customer just in customer has requested to convert to the conversion base price -- the consumption-based pricing model. I understand that these customers are huge. I mean, you get in the Shell and you get into Koch, Baker Hughes, I mean, these are very, very large relationships now. And you can imagine their licensing terms are pretty favorable and unique to them. Have we seen any significant change in customer churn? No.

I appreciate the color there. And then for the follow-up, I did want to -- I guess looking back at what we had spoken about last quarter with deals getting pushed out, just given the current environment. So specifically, you guys had called out 66 deals last quarter getting pushed. Have you closed any of those deals in the interim? And do we still see a similar order of magnitude for deals getting pushed given that you guys have made this transition? Are you helping streamline the adoption process for those customers and accelerating those sales cycles?

Mike, this is Juho. Yes, so we did close some of those deals that were pushed out of last quarter. And like we expected from our revenue guidance, the macroeconomic climate, was tougher for the second -- after Q1, but it has stabilized and in particular, with our new consumption-based pricing, I think our customers and potential new customers are reacting well to that strategy.

Got it. It makes a ton of sense, especially when I think about that average contract value declining from, call it, $19 million to less than $1 million this quarter.

And our next question comes from the line of Pinjalim Bora with JPMorgan.

I was talking to myself, I want to ask about the subscription revenue outperformance seems like a big outperformance in the quarter. Was that largely because of the outperformance in the number of pilots that you're doing? Because even if you have closed some of the deals that got pushed, I wouldn't have thought that you would recognize a ton of revenue from those. So help me understand that.

Well, I think you kind of got it. There were some previous transactions that were not based on consumption-based pricing but did close in the quarter. That did contribute to that. So I think you called it accurately, Pinjalim.

Okay. So it was because of the deals that closed. Okay. Tom, on a high level, maybe help us understand what are you hearing from CIOs in terms of IT budgets for next year. Are people -- you kind have called out, obviously, the headwinds on macro, but are you hearing people kind of resetting their budgets for next year, next calendar year? What are you hearing?

I think it's a really good question, and it varies from company to company. I mean, there are a lot of companies that see this as -- and organizations in the Federal government -- and by the way, I didn't comment on our Federal business, but our Federal business is really strong, okay? Particularly in the defense sector. And if you saw the defense budget, when he's flying through today, he increased, I think, almost over -- I'm sorry, $200 billion over last year, if I'm not mistaken. So that's a big business. I think there's kind of two categories. There's companies that are like bearing down and using these technologies to figure out how to save money. That would include Shell. That would include the Air Force, okay? And then there's companies that whose name I will not mention, that are just absolutely going to the mat and slashing expenses on everything. They're going train the bunkers and they're going into recession mode, and we will see some customer churn from that, okay? Hard stop. Okay. And they're just cutting to the bone. And so these two classes of companies out there, those who are investing in savings and those who are just kind of going into a knee jerk, perfectly rational response to an impending significant recession and then just slashing all costs. And so we see both. And I don't know how long this lasts. You guys are the pros of this, whether it's 12 or 24 months. But when it's over, we're going to still be here if you don't plug it away at it. And -- but it's -- you cannot deny it. I mean, it is rocky out there.

And our next question comes from the line of Patrick Walravens with JMP Securities.

I want to do a couple of sort of financial ones to start with, if that's okay. So gross margin, if I'm looking at it right, non-GAAP was 77%, down from 81% last quarter. Is there anything worth noting there?

Pat, it's Juho. The only thing to call out there is the trials and tickets, as Tom mentioned in the opening remarks, there is more higher cost than those than the ongoing subscriptions. So as we see increase of pilots and trials even in the coming quarters, we are expecting some pressure on gross margin before it climbs back up to historical levels.

Okay. So as I look forward, should I be around this 77 level?

I think you should expect a little bit more of a pressure as we increase the pilot as a proportion of total deals. And by the time we are back at Q4 FY '24, we should be back at these rates and higher.

Okay. And then the subscription fee, but services missed at least my number by a lot and went down sequentially by a lot. What's to note there?

Only thing to say, it's -- the services is a direct result of our transition to these pilots in our new consumption-based pricing model. There are minimal upfront big professional services deals associated with these. So as we -- as the pilots convert to ongoing license arrangements, we do expect the services component to increase as well. And in the second half of this fiscal year, we actually are expecting services to return back to the 10% to 20% of our total revenues.

So for Q3, it would be 10% to 20% of total revenue?

I'm saying the full back half of the year. So it could be somewhere in the range for Q3 and higher or lower in Q4.

Okay. And then if you look at the subscription revenue of $59 million and change, the footnote says 32% of that is from related parties. Do you mind just explaining that for people, because I do get that question quite a bit?

It's just the related party is relating to Baker Hughes. So Baker Hughes is our, of course, still a significant shareholder of C3 AI, and any revenues that we interact with Baker Hughes is direct purchases. We call them out in the financials.

Yes. And so Tom, the bear case would be that in some way is a lower quality revenue, what would your response be to that?

Oh, boy...

I'm not sure you have one, but...

I don't know how to respond, Pat. We're going to be doing a lot more deals, a lot more customers. We're going to convert a lot more of them into production, and they're going to grow just like Shell, Baker Hughes, Koch and everybody else has grown. And there's -- so right now, things are looking pretty promising. I think we're right on track.

Okay. Great. Last one, and this one is probably for you, Tom. So you signed -- it's been a year since you signed that $500 million production, other transaction agreement with the Department of Defense. How would you say it's going so far versus your original expectations?

DoD is really big. So I think that year-over-year, DoD grew by what percent?

100%.

Roughly 100%. 100% in terms of bookings. DoD is a real bright point, Pat, and you're talking specifically on MDA, the MDA agreement applies to all of DoD, by the way, okay? And then we have $100 million agreement with RSO, and you will announce not in this release, but tomorrow morning as the announcement about a big partnership that we're doing with Booz Allen Hamilton, okay, in all of the Federal, particularly DoD. But that business is looking strong.

And our next question, Sanjit Singh with Morgan Stanley.

Excellent. This is [Seaton] for Sanjit. I really just want to touch on sort of the consumption growth that you're seeing, especially with the Ex Machina product. Just if you can sort of provide any color on, one, how you see consumption trending with those customers? And then how you expect that going forward? And maybe sort of related to this environment, how are customers using it maybe differently than they have before?

Okay. Great. This is Tom. And I would say, of the various products that we have in the marketplace today, okay, of which we have, I think, 42 production products, Ex Machina being one of them, okay? We are underperforming on the execution of Ex Machina sales. It is a dramatically superior product to other products that are out there in the marketplace. That big set, it's kind of order of $1,000 thing, okay, in terms of the unit, okay? And we really haven't put the sales motion together to do that at scale. Now we've taken the objectives to get after it, but I cannot look you in the eye and say, that we're hitting that ball over the left field fast, because we're not, okay? And it's a great product. Our customers love it. We have somebody -- we have three customers that have much greater consumption whether...

Baker Hughes and Con Edison almost 300% increase.

300% increase there. But can I look you in and tell you that we're killing, that we're realizing the potential of that product, that product could be an entire separate company, okay? Our CRM product could be an entire separate company, our ESG product could be an entire separate company, stand-alone company. And in all three of those, I think we really need to get full it going, and we haven't done that yet.

Okay. That's helpful. I mean, your commentary sounds worse than the 270% consumption increase that you're seeing there. Any color sort of on what's enabling that increase in consumption? And then two, how are you -- in your other products, like trying to enable similar consumption rates, is there anything sort of to highlight that you're doing differently there to get to those kind of trends that you're seeing in this product, although you're not highlighting it specifically?

Do you want to focus on Ex Machina -- or is it about Ex Machina or is this about overall products?

This is more broadly.

More broadly. Go ahead, Juho.

No, I think, let me just kind of add on to that. So for Ex Machina, just what Tom said, we're still very early stages on that. So yes, we see those key customers that started early with us massive increase in consumption. Yes, we're excited about that. But that entire product is completely in its infancy, and we have high expectations on it. The other point on other consumption. So remember, again, we start these targets, the consumption deals start with a six-month pilot and then it moves into consumption. We started this quarter. So we're not really seeing any consumption until the initial six-month phases are complete. That question, and as we start talking about consumption under all the other deals that we do, we'll start reporting and discussing that more detail probably in Q1 next year.

And our next question comes from the line of Kingsley Crane with Canaccord Genuity.

So for Tom, it looks like there's strong traction in Department of Defense, new and expanded deals with numerous agencies. Imagine the AI Defense Forum with a helpful touch point to close these through. So how would you characterize momentum in this sector? And then are these companies embracing the new consumption model? Or are they preferring to commit more upfront in the legacy model? [technical difficulty]

I'm showing our next question comes from the line of Kingsley Crane.

Yes. Could you hear me?

No. One more time, please.

Okay. Right. So for Tom, looks like there was really strong traction in Department of Defense, expanded deals with numerous agencies. How would you characterize momentum in this sector compared to a few years ago? And then are these companies looking at the consumption model? Or are they primarily sticking to the current model?

Great question. It takes some time to really get traction in DoD, okay? And we've been working on that since 2014, okay, at the level of the Secretary of the Army and the Secretary of the Air Force and the joint chiefs and the -- and I mean, we've really been working it hard. I think we have 12 projects, all delivered on time, on budget to spec. And really, what we're finding is the consumption model there is really, really well received. They like it, okay? And they're kind of used to seeing these multibillion dollar juggernaut projects from the Lockheed Martins of the world or other providers, and we're coming in where, hey, we bring the project live for $0.5 million, and after that, $0.55 per CPU hour. It's like where do I sign?" So there it's been very well received in that market.

Okay. That's really great to hear. And then for you Juho, I just want to touch again on the services revenue, understandable that it would be lower given some of the trial like activity. So since we expect trials to continue in the new consumption model. Just trying to get a better handle on how quickly services should ramp back up to that 10% to 20%?

Well, again, there's a component of the ongoing gradations with our existing customers and potential services engagements with them. And then our expectation of services engagements as these pilot deals convert to consumption deals. So what I was alluding to earlier to Pat's question, we are expecting services activity in the second half of this year. And then separately, in the long-term models, you should expect that as the pilots convert to consumption, there are services deals associated with those as well.

And our next question comes from the line of Arsenije Matovic with Wolfe Research.

This is Arsenije on for Gal. And I think on the call, you said there were 13 consumption pilot wins in the quarter, and maybe that was maybe better than you initially expected. Is that a run rate you're comfortable with going into the end of the fiscal year? The back half? And any particular call-outs for sectors where the consumption model is maybe getting better traction than you initially expected?

So sorry, the second half of your question, it was a bit unclear, but let me address the first one. Yes, while we're excited on the beginning of this, so we did 13 pilot plant trials. So there's still a combination of some of the trials in there, but we do expect them to convert to a consumption-based arrangement at the end of the trial period. I do not -- we would not want to increase any of our assumptions in the model we shared with you last quarter. So even though we said 5 this quarter and we came in at 13, I want to keep the model as it was that we provided last quarter.

Great. And then just a brief follow-up. In terms of stock-based compensation, I think it's the second consecutive quarter where stock-based compensation as a percentage of sales is above 85%. I think in Q1, we talked about maybe that was a lot to do with share refreshers. And I wanted to see what dynamic was that happened in Q2. And what level of stock-based compensation should investors become comfortable with moving forward?

Yes. I think broadly speaking, you see this across the industry. But stock-based compensation under GAAP is stuck with the grant date fair value of the underlying equity instrument. And as you obviously know, the history of the entire tech sector on C3 AI in the last 1.5 years, we are carrying significant stock-based compensation cost for awards that were granted when the share price was much higher than it is today. So unfortunately, there's nothing we can do about that unless the underlying employee decides to seek for other opportunities. So for now, until the end of these vesting terms for these awards, we are going to be carrying these pretty high stock-based compensation costs.

Never realized by the person who was granted the stock option. Never, but no time soon.

[Operator Instructions] And our next question comes from the line of Adam Bergere, Bank of America.

Great. This is Adam on for Brad. Juho for you, can you talk a bit about the shape of the revenue curve for next year? I guess, naturally, we expect it to kind of increase sequentially every quarter given the new sequential given the new consumption model. But is there a chance there's still some lumpiness in that, as you know, certain larger customers may renew on kind of like the non-consumption license?

Yes, I think the short answer to that is yes. And what we guided last quarter, we beat it for this quarter. Our guidance for next quarter, you see sequential increase and it does have the Q4 as an increase to that with respect to the implied guidance. The revenue curve is flattening as a result of the consumption-based pricing business model. But as we enter into it, in the short term, and as we enter into FY '24 and especially the second half of FY '24, you should start seeing the graph to get steeper and steeper in line with the presentation we shared last quarter.

That's helpful. And then, again, just like the gross margin, could you kind of call out when that might trough out and what kind of like the level of that might be? I think it was at like 77% for this quarter. So is it fair to assume that that's kind of like a trough level for that?

Well, thank you for the question. I think the more important thing is that we assume there would be a pressure in the gross margin when we provided the operating margin and operating profit guide and our path to profitability. So we are expecting pressure on it, but it doesn't change our path to profitability in 1 bit. So I cannot tell you exactly where I think it will dip down to, but I think in your models as you prepare the business back in FY '20 -- sorry, back when we hit FY '24, Q4, we should be back at 77-plus gross margin. So it may go down in the interim and then it comes back up as we enter profitability.

And our next question comes from the line of Arvind Ramnani with Piper Sandler.

I had a question on some of your kind of partnerships or alliances to help drive sales. Are you able to kind of dimension how much of your new sales or bookings come from in-house sales teams versus your partners? I'm sure it's probably pretty difficult to kind of bifurcate the 2. But if you're able to do that, that would be great. And on the same topic of partnerships, are the margins higher or lower on sales that are brought in by some of your partners?

Arvind, it's Tom. Virtually all of our sales today, we're selling with a partner, not through a partner, okay? And so that would be 100%, where we're selling with them. Now they may introduce us to the account. They may bring the executive team over here as Google has, as Booz Allen -- I'm sorry, as Baker Hughes has, as Microsoft has in the past like many, many times. But we're actively engaged, okay, in the sales process. Now we are just now putting our products on the marketplaces of the various hyperscalers. And so that dynamic might change going forward. But there's no margin difference because there is virtually no case where they're selling independently of us.

Our next question and our last question comes from the line of Michael Turits with Keybanc.

This is Michael Vidovic on for Michael Turits. Could you just talk about linearity in the quarter and then trends you're seeing to start out November for fiscal 3Q?

So are you talking about that deal velocity in the quarter? Or what are you asking about?

Yes. And just was it month-to-month, how do deals trend? Was it a constant uptick to reach throughout the quarter? Or was it stronger back end of the quarter or the beginning of the quarter?

We see activity all throughout the quarter, but it's not unusual in this business where as you approach currently, you have slightly more activity.

Okay. And then just a quick follow-up on the vertical standpoint, particularly energy, have you seen like an uptick in deals in that area? And I guess, which areas besides Federal are you seeing particular strength in this time?

So if your question is relating to the diversification of industries, we see continued diversification, which we're very excited about. Yes, there's deals in energy, but defense, as we discussed, is really exciting for us as many other industries as well. And we continue to expect more diversification with the consumption-based pricing and scores of new customers.

Okay. I guess that was our last question. And gentlemen, thank you for your thoughtful questions. And we appreciate the courtesy of you participating in our call. And we thank you all very much for your time.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.