Earnings Call Transcript - AI Q2 2024

Operator, Operator

Good day, and thank you for standing by. Welcome to the C3 AI Second Quarter Fiscal Year ‘24 Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentations, there will be a question-and-answer session. Please be advised that today’s call is being recorded. I would now like to turn the conference over to your host, Mr. Amit Berry. Please begin.

Amit Berry, Head of Investor Relations

Good afternoon, and welcome to C3 AI’s earnings call for the second quarter of fiscal year 2024, which ended on October 31, 2023. My name is Amit Berry, and I lead Investor Relations at C3 AI. 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. These statements reflect our views only as of today and should not be considered representative of our views as of any subsequent date. We disclaim any obligation to update any forward-looking statements or 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 our 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.

Tom Siebel, Chairman and CEO

Thank you, Amit. Good afternoon, everyone, and thank you for joining our call today. Results: Bottom line, we continue to accelerate our revenue growth and our customer engagement count and continue to gain traction with C3 Generative AI and our Enterprise AI applications in the second quarter. Total revenue for the second quarter was $73.2 million, an increase of 17% compared to $62.4 million one year ago, and accelerating from an 11% increase in the first quarter. The total number of customer engagements was 404, an increase of 81% compared to 223 last quarter. North American revenue of $61.2 million increased 28% year-over-year, while EMEA revenue of $10.6 million decreased 11% year-over-year, and federal revenue increased 100% year-over-year. Subscription revenue for the quarter was $66.4 million, constituting 91% of total revenue and increasing 12% from a year ago. GAAP gross profit for the quarter was $41.1 million, representing a 56% gross margin. Our non-GAAP gross profit for the quarter was $50.4 million, representing a 69% non-GAAP gross margin. Our GAAP net loss per share was $0.59, and non-GAAP net loss per share was $0.13. We ended the quarter with $762.3 million in cash, cash equivalents and investments. C3 AI’s partner ecosystem continues to drive significant growth. In Q2, the company closed 40 agreements through our partner network, including AWS, Booz Allen, Baker Hughes, Google Cloud, and Microsoft. The qualified opportunity pipeline with partners has increased by 75% in the past year. We’ve signed new and expanded agreements with Nucor Corporation, Roche, Con Edison, Hewlett Packard Enterprise, GSK, formerly SmithKline, the United States Navy, the Administration for Children & Families, a division of Health & Human Services, Indorama and First Bank among others. Over the past several months, C3 AI has helped Nucor, the largest steel producer in the United States to better optimize caster production schedules specifically to improve production levels and reduce cost levels in the steel casting process. C3 AI is now helping Nucor scale this across several additional mills. In Q2, C3 AI also kicked off two new use cases at Nucor, tackling process optimization and demand forecasting, and we also completed a C3 Generative AI pilot targeting operational health and safety. GSK, formerly GlaxoSmithKline, is now using C3 AI's supply chain suite to increase efficiency in its supply chain, using AI to optimize yield and improve demand forecasting processes. Con Edison, a C3 customer since 2017, continues to expand its use of the C3 AI applications, most recently by adding C3 Generative AI. Con Edison is using C3 Generative AI to help workers quickly find answers to questions and analyses related to smart meters, service levels and infrastructure data. In the second quarter, Con Edison completed two pilots of C3 Generative AI, which have now converted to production. We also continue to expand our footprint in state and local governments with particular interest in C3 AI law enforcement from San Mateo County, California, and C3 AI Residential Property Appraisal from Stark County, Ohio, and Charlotte County, Florida. Our federal business continues to show significant strength with bookings up 187% year-over-year. We closed new and expanded deals with the United States Navy, the Intelligence Community, Joint Staff J8, the Defense Logistics Agency, and the Administration for Children & Families. We’ve talked many times about our successes in helping them modernize the Department of Defense, and we’re proud now to say that our products are helping civilian government agencies as well. This quarter, we began work with the Administration for Children & Families, a division of the U.S. Department of Health & Human Services. The agreement with C3 AI was part of their first order under a $90 million blanket purchase agreement. This part of ACF’s work involves helping unaccompanied children who cross the U.S. border find temporary shelter and permanent homes. Our platform will be used in complex modeling and predictive analytics at ACF to help them keep track of the number of unaccompanied children in the ACF’s care, staffing needs and determine how long these children are with their case managers among other tasks. C3 AI continues to leverage its extensive commercial supply chain experience in the federal government and is now applying this experience in the defense sector with the C3 AI contested logistics application for Transcom and for DLA. During the quarter, C3 AI converted two Defense Logistics Agency pilots into follow-on projects for the Department of Defense. The first project delivers a common operating picture of the supply chain for DoD and enables leaders at multiple echelons to see in near real-time their global Class 9 supply posture. The application unifies disparate supply data and provides the Defense Logistics Agency the ability to identify supply chain inefficiencies, forecast parts consumption and parts shortage, conduct impact assessments, and put into place mitigation plans. The second project supports DLA’s energy directorate, leveraging C3 AI’s commercial expertise in the oil and gas sector. The C3 AI’s contested logistics application modernizes and streamlines global fuel distribution for the Department of Defense. Users can see global fuel inventories, anticipate fuel consumption, identify supply network risks and create distribution and transportation plans to prevent disruption and assure supply. These applications promise to significantly impact the efficiency of the Department of Defense logistics enterprise and improve readiness. Our partnership with AWS deepened with an expanded strategic collaboration agreement in the quarter. The availability of our new no-code self-service generative AI application, C3 Generative AI, is now available on the AWS marketplace. This new application allows users of all technical levels to begin using generative AI within minutes of signing up. I encourage you to take a look at it, for those of you who are interested. Under the expanded collaboration agreement with AWS, we’re focusing on offering advanced generative AI solutions, combined with what they’re doing in Bedrock and other initiatives for enterprises and AI applications for customers in multiple verticals, including manufacturing, power and utilities, consumer packaged goods, state and local government, and the federal government. C3 AI and AWS’s joint qualified pipeline has more than doubled year-over-year with heightened interest in the C3 Generative AI suite. In Q2, C3 AI has been recognized multiple times for its innovation in the AI space. We’ve been named to the Fortune 50 AI Innovators list. In Q2, we closed 62 agreements, including 36 pilots and trials. Our new pilot count is up 270% from a year ago. Notably, 20 of these were generative AI pilots, a 150% increase from Q1. With the lower entry price points of our pilots, we are more easily able to land new accounts. Our pilots came from manufacturing, federal, defense, aerospace, pharmaceuticals, and other industries. Now, we did see sales headwinds in the quarter. While the interest in AI applications and especially generative AI is growing substantially, we’re also seeing, in many cases, lengthening decision cycles. Virtually every company in the last 3 to 6 months has created a new AI governance function as part of its decision-making process. These AI governance functions assess and approve those AI applications that will be allowed to be installed in the enterprise. This has added a step to the decision process in AI. Take it to the bank. It has simply added a step to the process and it is lengthening the normal sales cycle. So this provided a sales headwind in the quarter. And while the increased scrutiny lengthens the sales process, we believe that this is a healthy process to ensure that companies are adopting safe and appropriate AI solutions. And did it impact revenue? Yes, it did. But get over it. The world is a better place; people are making very careful well-informed decisions and we will all be happier for this in the long run. However, this dynamic did provide an unexpected headwind to our Q2 sales revenue performance. In addition, our sales execution in Europe was frankly unacceptable. Since then, we’ve been through our planning meetings and have taken appropriate organizational steps to immediately improve sales execution in Europe. Now let’s take a look at the top-line. The transition from subscription-based pricing to consumption-based pricing has been a key story for the last 6 to 7 quarters. Prior to the transition, the company was growing at a rapid growth rate of 38% year-over-year. The downside of the subscription model was lumpiness in bookings, lengthy sales cycles, and low levels of revenue predictability. We believe the transition to a consumption-based pricing model brought us in line with today's industry standards, making it easier for new customers to acquire our solutions and subsequently increase their spending as their usage and adoption increases. While we are still in the process of completely transitioning to the new pricing model, preliminary empirical results indicate that our predictions are coming true. Since the transition, revenue growth initially decreased, then flattened, and now it is increasing as the consumption-based pricing model takes effect. Average selling prices decreased, RPO has decreased, and customer engagement has increased substantially. If we look back over the last 4 quarters, our revenue growth was -4%, 0%, 11%, now 17%. Bookings growth has been 71% year-over-year. New contract growth at 148% year-over-year. Pilot growth is 50% quarter-over-quarter, 170% year-over-year. This is the beginning, middle, and end of this story. We announced a transition to consumption-based pricing and we are seeing the revenue increase as predicted. Now let’s talk about generative AI. Generative AI changes everything. I believe it more than doubles our addressable market overnight. We’ve seen the predictions from Bloomberg predicting this to be over a $1.3 trillion market by 2032. Goldman Sachs predicts that this could increase corporate profits by 30% in the next decade. By combining our substantial investment in the C3 AI platform with developments in large language models and retrieval augmented generation, C3 AI is in a unique position to address the fundamental problems preventing the adoption of generative AI in government, defense, intelligence, and the private sector. We have taken 14 years and $2 billion of software engineering to solve significant issues like hallucination, cybersecurity risks, and industry-wide LLM dependency. Our LLM agnostic solution uniquely positions us to overcome these challenges. This has allowed us to be at the forefront of generative AI implementations. We handle text, telemetry, images, signals, and enterprise data, both structured and unstructured. This is unique in the market, and the results are exciting. We have many customers and a robust team in place, allowing us to deliver these solutions rapidly. Our strategic decision to invest in generative AI is aimed at addressing our significant market opportunity. Our suite of generative AI products wins on reliability, flexibility, adaptability, accuracy, and security, just as our Enterprise AI platform does. Our plan is to greatly expand our customer base, aiming for exponential growth of users in the C3 Generative AI application. The surge of interest has led to a 55% sequential increase in new opportunities in the second quarter, representing the most rapid acceleration across our product offerings. We expect this momentum to grow as we continue to innovate and develop increasingly exciting products. Our announcement of the self-service C3 Generative AI on the AWS Marketplace plays a crucial role in expanding our addressable customer pool and user base exponentially. This product makes generative AI accessible to users of all technical levels. We are making a sizeable and timely investment in application development, model engineering, lead generation, branding, and market awareness to capture market share in generative AI. While this will exert short-term pressure on free cash flow and profitability, we believe it's essential. We expect positive cash flow in Q4 and remain committed to producing positive cash flow for the full fiscal year 2025. C3 AI remains focused. We are one of the few AI software pure plays with established relationships and a proven technology platform aimed at capitalizing on the generative AI market opportunity. Now I'll turn the call over to Juho Parkkinen, our Chief Financial Officer, to discuss our financial performance and provide guidance.

Juho Parkkinen, CFO

Thank you, Tom. I will now provide a recap of our Q2 financial results and some additional color on our consumption-based revenue model, which we introduced five quarters ago. Total revenue for the second quarter increased 17.3% year-over-year to $73.2 million. Subscription revenue increased to 11.7% year-over-year to $66.4 million and represented 90.7% of total revenue. Professional services revenue was $6.8 million and represented 9.3% of total revenue. Gross profit for the second quarter was $50.4 million, and gross margin was 68.8%. As a reminder, we continue to expect short-term pressure on our gross margins due to a higher mix of pilots, which carry a greater cost of revenue during the pilot phase of the customer life cycle. Operating loss for the quarter was negative $25 million compared to our guidance range of negative $27 million to negative $40 million. The improvement in operating loss versus guidance was driven by the timing and amounts of the generative AI-related investments we made to capture market share as well as our team’s ongoing focus on disciplined expense management. At the end of Q2, our accounts receivable was $143.2 million, including unbilled receivables of $104.8 million. The general health of our accounts receivable remains strong. Now turning to RPO and bookings. Reflecting our transition to consumption-based contracts, we reported second quarter GAAP RPO of $303.6 million, which is down 27.3% from last year and current GAAP RPO of $170.2 million, which is up 3.5% from last year. We continue to see positive trends in the diversity of our pilot bookings with 10 industry segments represented in Q2 pilots as compared to 8 in Q1. Free cash flow for the quarter was negative $55.1 million. We continue to be very well-capitalized and closed the quarter with $762.3 million in cash, cash equivalents and marketable securities. During the quarter, we started 36 pilots, a 50% increase from last quarter. The actual vCPU consumption data we see from pilot activity has validated our assumptions made when we transitioned to the consumption-based pricing model five quarters ago. Our pilot conversion rates are trending upwards and are close to our target of 70%. At quarter-end, we had cumulatively signed 109 pilots, of which 103 are still active. Turning to guidance, as Tom mentioned, we expect Q3 revenue to range from $74 million to $78 million, and non-GAAP loss from operations to range from negative $40 million to negative $46 million. We remain committed to delivering positive cash flow in Q4 FY24 and for the full year of fiscal year ‘25, and non-GAAP profitability in the second half of fiscal ‘25. For the full fiscal year ‘24, we are maintaining our previous revenue guidance in the range of $295 million to $320 million. We are increasing our non-GAAP loss from operations guidance to a range of negative $115 million to negative $135 million.

Operator, Operator

Our first question comes from the line of Timothy Horan of Oppenheimer.

Timothy Horan, Analyst

Thanks a lot, guys. Really appreciate the time. Can you give us a sense of what you’re seeing with AI in terms of productivity improvements? And what is the major bottleneck that you think customers need to overcome to really start implementing services?

Tom Siebel, Chairman and CEO

The major bottleneck as it relates to generative AI involves the problems inherent in large language models. The answers that come from these models tend to be unreliable or random, and issues of cybersecurity are significant. We need to address these concerns, or companies will hesitate to implement AI solutions. Additionally, many solutions are dependent on specific language models, which can be problematic as we are seeing rapid advancements in the industry.

Timothy Horan, Analyst

So specific to your customers, what do you think the bottleneck is for adoption? If you have resolved all these problems, what do you think they require at this point to really start adopting?

Tom Siebel, Chairman and CEO

We have a fast sales cycle. Many of them are existing C3 customers, but we have to address their concerns first. After that, we launch the application, and generally, within 4 to 8 weeks, it goes live. We're seeing significant growth in our pilots.

Operator, Operator

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

Mike Cikos, Analyst

I wanted to ask about the subscription gross margins. It was good to see gross margins increased sequentially despite the increased pilot count. Can you help us understand what went better than expected?

Juho Parkkinen, CFO

In the big picture, we expect gross margin degradation for our subscriptions to continue. However, in this quarter, we saw an improvement on a sequential basis. Looking ahead, we expect flattening or a decrease in the next quarter as the pilot count increases.

Mike Cikos, Analyst

There was an article claiming there were headcount cuts. Is there any validity to that? It seems people are trying to figure out how you are investing more while also potentially cutting staff.

Tom Siebel, Chairman and CEO

We have performance-related layoffs quarterly. We also hired about 100 new employees recently. So if someone claims layoffs, it’s part of normal performance management. Our focus is on upgrading talent while removing underperformers.

Operator, Operator

Our next question comes from the line of Kingsley Crane of Canaccord Genuity.

Kingsley Crane, Analyst

I wanted to touch on the pilot program. You mentioned you lowered entry price points for pilots. Can you give us a sense of the magnitude of that change? Has the minimum fee post-pilot also changed, and what upsell are you seeing?

Tom Siebel, Chairman and CEO

The standard pilot for generative AI is about $250,000. We also have a free 14-day trial for the AWS generative AI, which allows extensive experimentation. This is helping drive engagement and interest.

Kingsley Crane, Analyst

Is it about timing, or are you expecting investment nature to continue into next year?

Tom Siebel, Chairman and CEO

Investments will continue next year, as we are seeing strong consumption rates from our customers. Our predictions about consumption levels are proving remarkably accurate.

Operator, Operator

Our next question comes from the line of Sanjit Singh of Morgan Stanley.

Unidentified Analyst, Analyst

With a couple of quarters of the consumption model under your belt, how would you frame the quality of those customers that opted for the consumption model?

Tom Siebel, Chairman and CEO

Regarding quality, we measure it based on conversion rates and consumption levels. Currently, we're seeing a 70% conversion rate, and consumption levels are tracking close to our earlier predictions.

Juho Parkkinen, CFO

Our professional services revenue represented 9.3% this period, which is lighter than our expected long-term model. Partners remain a crucial part of our go-to-market strategy.

Operator, Operator

It looks like we have time for one last question. Our last question will be from Pat Walravens of JMP Securities.

Owen Hobbs, Analyst

What would you say are the top one or two federal use cases for generative AI that you’re seeing with those new federal degenerative AI deals this quarter?

Tom Siebel, Chairman and CEO

Our largest federal use case is predictive maintenance for the United States Air Force, known as the PANDA system. This system aims to create a unified federated image of data across several weapon systems, providing insights and operational efficiency.

Owen Hobbs, Analyst

Could you explain why there has been an increase in accounts receivable from last quarter to this quarter, despite relatively stable revenues?

Juho Parkkinen, CFO

Accounts receivable dynamics often reflect the timing of invoicing, so the increase is simply a matter of invoicing timing.

Tom Siebel, Chairman and CEO

Ladies and gentlemen, I think we’re at the end of the program. We appreciate your time and attention. Thank you, and we look forward to talking with you next quarter. It appears to be game-on in the AI industry at a global scale, and I can assure you we are very much in the game.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today’s conference. Thank you all for participating, and have a good night. You may now disconnect.