Earnings Call Transcript - NTNX Q2 2023

Operator, Operator

Hello and welcome to Nutanix's Second Quarter 2023 Earnings Conference Call. I will now turn the conference over to your speaker for today, Rich Valera. You may begin. 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?

Rajiv Ramaswami, President and CEO

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 continued to see businesses prioritizing their digital transformation and data center modernization initiatives 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 several partners improved compared to 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 a bank in the APAC region, who had been running 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, allows 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?

Rukmini Sivaraman, CFO

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 a 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 resolve 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 the 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 said, operator, please open the line for questions.

Operator, Operator

Our first question comes from Pinjalim Bora with JPMorgan.

Pinjalim Bora, Analyst

Congratulations on a strong quarter. I would like to revisit the investigation you mentioned. Could you clarify what happened? It sounds like it involves an underpayment to a vendor. Am I correct in my understanding? Please help us grasp the situation in simpler terms.

Rajiv Ramaswami, President and CEO

Yes. Let me start, and Rukmini can explain the details. The first thing I want to emphasize is that the fundamentals of our business remain unchanged. This issue does not affect our market opportunity or the demand for our solutions. We are working diligently to resolve it quickly and are focused on driving sustainable profitable growth. Rukmini, could you elaborate on the specifics of this matter and what actions we are taking?

Rukmini Sivaraman, CFO

Sure. We discovered that certain evaluation software from one of our third-party providers, which was intended for evaluation purposes, was instead used for validation, interoperability testing, and proof of concept over several years. This matter is ongoing, and as mentioned on the call, we were unable to disclose expense information due to this issue. We have also announced that we expect to be delayed in filing our 10-Q until the matter is resolved. However, we still believe that our top-line results and reported free cash flow remain unaffected by this. Looking forward, we are pleased to raise our revenue and ACV billings guidance, and we remain confident in our free cash flow guidance of $100 million to $125 million for the year, considering the potential impact from the use of this third-party software. Additionally, the free cash flow guidance includes the effect of approximately $33 million from settling litigation and about $12 million in cash usage in Q3 for nonrecurring tax obligations related to part of our employee RSUs vesting this month, along with other anticipated cash outflows that were not included in our previous guidance for annual fiscal year '23 free cash flow.

Pinjalim Bora, Analyst

Yes, I understand. Rajiv, in discussions with some of your partners, it seems that the VMware opportunity is developing. However, I want to highlight that the complexity faced by large VMware customers, who are using tens of thousands of VMs and may consider Nutanix as an alternative, poses a challenge. Transitioning from VMware to Nutanix can be intricate, so I’d like to know what steps Nutanix is taking to reassure these large companies about moving their VMware environments to Nutanix. Additionally, how are those discussions progressing?

Rajiv Ramaswami, President and CEO

Absolutely. We are currently engaged with many of these prospective customers who are looking to explore their options and manage potential risks associated with the acquisition. We have a long history of handling migrations. Typically, we deploy our solution on top of existing VMware platforms, where customers are running vSphere, and we introduce our software-defined storage, AOS. Over time, some customers may opt to transition to our hypervisor, AHV. We have extensive experience in migrating for our customers, and we understand that as the environment size increases, the complexity also rises. Usually, migrations are performed one workload at a time; customers start with a specific use case and gradually expand to others. While historically, this focused on computing, we now also handle databases and all mission-critical workloads. However, we acknowledge that this process is complex and will take time, which is why we haven't included any significant benefits in our fiscal '23 outlook. We anticipate that these cycles could take nine to twelve months for some of the larger deals.

Operator, Operator

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

Jim Fish, Analyst

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?

Rajiv Ramaswami, President and CEO

Yes, Jim, there is indeed a push and pull in this situation. Starting with the macro environment, we are experiencing strong performance from our renewals, which has been consistent. This helps mitigate the risk in our business model and the guidance we provided. We have factored in the current macro environment, and we are noticing increased scrutiny. This has resulted in a modest increase in the average sales cycle, meaning it takes a bit longer to close deals. We observe this trend among both new customers and existing clients looking to expand, as they are being more cautious and taking additional time to evaluate the economic aspects and total cost of ownership benefits. However, we continue to demonstrate strong TCO advantages compared to legacy infrastructure. When clients are considering upgrades or modernization, they compare hyper-converged infrastructure to traditional three-tier storage, and we can present a better TCO and a more modern approach to building a cloud platform. This dynamic remains unchanged. While the VMware situation will benefit us in the long run, it may not have immediate effects. In the short term, we are seeing heightened engagement. To summarize, our renewals business provides a solid foundation, while we experience slight elongation in new business deal cycles, coupled with increased engagement from VMware. We have done our best to incorporate all these factors into the guidance we shared.

Jim Fish, Analyst

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?

Rukmini Sivaraman, CFO

Thank you, Jim. Those are all good questions. Let me break that down. As I mentioned earlier, we are not providing comments on expenses for Q2 or looking ahead. However, regarding free cash flow for Q2, we are pleased with the performance. We previously discussed DSOs, which were 28 days. This figure was unusually low in Q1, but it returned to more typical levels in Q2, generally falling within a range of 30 to 45 days for our payment terms. For your second question, we are confident in our full-year guidance of $100 million to $125 million for free cash flow, which takes into account the potential impact from the ongoing matter concerning third-party software use, as well as the $33 million settlement and the one-time $12 million tax obligations we talked about.

Operator, Operator

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

Mike Cikos, Analyst

I had a couple of questions. I want to clarify something about the Audit Committee. Is this investigation we are currently undergoing completely independent from the anticipated $33 million expense you mentioned for the litigation settlement in the third quarter?

Rukmini Sivaraman, CFO

That's correct, Mike.

Mike Cikos, Analyst

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 commence its investigation? When did Nutanix engage outside counsel? I'd just like to see if we can get a timeline for how these events are playing out under the hood? Again, just because we have this limited guidance that we're being provided today.

Rukmini Sivaraman, CFO

Yes. Thank you, Mike, for the question. If I understand that there's limited guidance here, Mike, what I can say is that given this review is ongoing, 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 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.

Mike Cikos, Analyst

I wanted to express that I'm having difficulty understanding some of the legal aspects involved here. I realize that you are indicating the third-party provider was using software for evaluation, but I want to clarify what that means.

Rukmini Sivaraman, CFO

Yes, let me try…

Mike Cikos, Analyst

Yes, and I'm trying to see, is there an impact on revenue as a result of this? Or is it entirely expense-based? 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.

Rukmini Sivaraman, CFO

Thank you, Mike. Let me clarify some of those points. You are correct that we do not believe this matter will affect our top-line metrics, specifically revenue and ACV billings, which we have disclosed and are guiding to. That's one part of it. In terms of the second part of your question, what was that again? I believe there was one more question after that.

Mike Cikos, Analyst

Yes. Yes. So...

Rukmini Sivaraman, CFO

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

Operator, Operator

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

Aaron Rakers, Analyst

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.

Rukmini Sivaraman, CFO

Thank you, Aaron. We're pleased to have increased our revenue and ACV billings guidance. You're correct that the half-over-half comparison suggests a decline in ACV billings when looking at the second half versus the first half. One factor, as you mentioned, is the modest lengthening of sales cycles that we noted in Q1 and saw again in Q2. We have incorporated some conservatism regarding new and expansion ACV billings in our overall guidance. However, when considering the year-over-year growth rate, there is still significant growth expected for the second half. This encapsulates our perspective on the ACV guidance for the year and the expected second half results.

Aaron Rakers, Analyst

Yes, very helpful. Regarding free cash flow, I apologize for revisiting this, but in the first half of the year, you generated around $109 million in free cash flow. If we consider the adjustments you've mentioned and look at the midpoint of the $100 million to $125 million range, adding back the $33 million and the $12 million you referred to still shows a significant decrease compared to the first half. I realize there are unquantified aspects to the investigation. My question is whether there are any changes in the free cash flow dynamics, like working capital adjustments in the second half of your guidance compared to what you experienced in the first half. I'm trying to understand why free cash flow in the second half is projected to be lower than in the first half beyond the factors you've described.

Rukmini Sivaraman, CFO

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.

Operator, Operator

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

Jason Ader, Analyst

I wanted to ask about the third-party evaluation software, as it may be confusing for some people. I think they might be curious about what exactly is being evaluated with that software.

Rajiv Ramaswami, President and CEO

Yes. Maybe I'll give you some color, right? So eval software has meant for evaluation 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 eval 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.

Jason Ader, Analyst

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?

Rajiv Ramaswami, President and CEO

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 for the usage and use cases that we were looking at.

Aaron Rakers, Analyst

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?

Rajiv Ramaswami, President and CEO

Yes. We provided an example of a repatriation in our prepared remarks. We are definitely observing that customers, particularly in many regions, are becoming much more cost-sensitive when considering the public cloud. They are evaluating when and for what purposes they should move to the public cloud, focusing on cloud economics as a significant factor. For instance, one customer is currently running a crucial production workload in the public cloud but decided to migrate it on-premises to achieve a better total cost of ownership and enhanced support experiences from vendors. We're noticing a more nuanced approach now, where organizations are carefully considering what workloads to move to the public cloud rather than simply transitioning everything.

Operator, Operator

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

Simon Leopold, Analyst

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.

Rajiv Ramaswami, President and CEO

Yes, Simon, that's a good question. I don't think we have that level of visibility because much of this is somewhat anecdotal, and we’ve observed it for both new and existing customers. Typically, in the past, expanding within existing customers has been easier and quicker compared to acquiring net new prospects. However, we are noticing a lengthening of the deal cycle for both groups, although it's only a modest elongation at this time. For instance, something that a VP may have initially budgeted for and decided to proceed with is now being closely examined at the CFO level, which raises questions like whether the expenditure is necessary at this moment or if it can be delayed, along with queries about the total cost of ownership benefits that need to be quickly quantified. This illustrates the dynamics we are witnessing, although it's challenging to pinpoint specifics as it varies significantly by customer. We are observing these trends in both new acquisitions and expansions.

Simon Leopold, Analyst

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.

Rukmini Sivaraman, CFO

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.

Operator, Operator

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

Ruplu Bhattacharya, Analyst

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?

Rukmini Sivaraman, CFO

Thank you for the question, Ruplu. Again, 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.

Ruplu Bhattacharya, Analyst

Okay. Maybe one for Rajiv. You mentioned that customers are being more cautious with deals and that there has been a slight increase in the sales cycle. This quarter, we added about 490 new customers, which is the lowest number since 2017. Can you share your thoughts on this lower net addition? Are there any competitive factors influencing this? Additionally, what effect do you think foreign exchange rates have, especially with the dollar strengthening? How is the pricing environment looking, and are you adjusting prices downward? I'd like to hear your insights on the new customer additions and the competitive landscape, as well as your thoughts on pricing.

Rajiv Ramaswami, President and CEO

Yes. I will discuss two points, and then Rukmini can address foreign exchange. Firstly, we are concentrating on acquiring higher quality new clients with higher average selling prices rather than simply increasing the number of new clients. We aim to ensure that our efforts in winning new clients are impactful, leading to larger deals, enhancing our sales productivity, and creating more opportunities for expansion. Therefore, our focus is more on the quality of new clients rather than just the count. The number of new clients is more of an outcome rather than a target we strive for. Secondly, we are maintaining our pricing. Our unit prices have been stable and have not decreased. Now, Rukmini, you may want to add your insights regarding foreign exchange.

Rukmini Sivaraman, CFO

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.

Ruplu Bhattacharya, Analyst

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?

Rukmini Sivaraman, CFO

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.

Operator, Operator

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

George Wang, Analyst

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?

Rajiv Ramaswami, President and CEO

Yes, I think we are very excited about that route to market, as we are relatively new to using it. It represents a growing business opportunity for us. Last quarter, we mentioned that the largest deal was secured through that channel. We are still in the early stages of this effort and continue to build our relationships with service provider partners. We are working to enhance our product capabilities to offer as broad a range of services as possible. This is an ongoing journey, and it will take several quarters before it becomes a significant part of our business. Currently, it remains a small portion of our overall operations.

George Wang, Analyst

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?

Rajiv Ramaswami, President and CEO

Absolutely. I would say it's becoming increasingly important in the context of the VMware-Broadcom acquisition. For us, it's always been a blend. We would definitely like to see more customers using AHV, which would mean that our AHV percentage of workloads continues to increase. At the same time, we see a significant opportunity to insert ourselves into other hypervisor environments, which used to be our standard practice many years ago. We aim to continue this approach as there are still substantial opportunities available. Our model with customers often starts with us operating on top of a third-party hypervisor alongside our complete solution stack, such as our software-defined storage. Over time, these customers may choose to migrate to AHV. Additionally, many new customers opt for AHV from the beginning. We want to maintain a balance between these dynamics, as we clearly want customers on our hypervisor and sell them the entire stack. However, we also want to target those using other hypervisors to integrate into their environments. So to summarize, we are trying to find a comfortable balance, and overall, it's continuing to mature. More customers are adopting it, and the ecosystem is expanding. We have third-party certifications from companies like Red Hat now, making it ready for all mission-critical workloads at this stage.

Operator, Operator

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

Thomas Blakey, Analyst

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.

Rukmini Sivaraman, CFO

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.

Thomas Blakey, Analyst

Given the recent feedback regarding the macro environment, I sense a slight decrease based on what I've gathered from the past couple of earnings calls, alongside our strong results. Could we receive some insights on the higher net dollar retention rate linked to these renewals? Where do those numbers stand and what has been the driving factor behind that?

Rukmini Sivaraman, CFO

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

Thomas Blakey, Analyst

Yes. From the renewals, yes.

Rukmini Sivaraman, CFO

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 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.

Operator, Operator

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