Suse SA
XETRA:SUSE
Earnings Call Analysis
Q2-2023 Analysis
Suse SA
Investors were greeted by SUSE's new CEO, Dirk-Peter van Leeuwen, and Interim CFO, Jonathan Atack, underscoring a leadership transition during a challenging fiscal quarter. Highlighting the importance of experienced stewardship, the company's recent changes at the top are vital as SUSE navigates through a period of internal reorganization and external economic headwinds.
SUSE experienced a quarter shadowed by a tougher macroeconomic climate, causing customers to tighten their belts. The factors leading to this included cost-management by clients and a strategic sales reorganization that, in retrospect, did not yield anticipated benefits. The company's performance in the cloud was lackluster, slower than projected, reflecting a wider market trend of clients optimizing their infrastructure costs. All these elements contributed to a subdued ACV, a modest 1% growth in adjusted revenue in Q2, and an EBITDA margin of 32%. Notably, their ARR climbed by 6% to $658 million, driven by both new and existing customers, a silver lining in an otherwise cloudy quarter.
Despite the financial headwinds, SUSE remains committed to innovation, primarily focusing on security enhancements and high-performance computing capabilities tailored for AI workloads. New product releases and updates, like the Linux distribution supporting confidential computing, SLE Micro for containerized workloads, and Rancher, a Kubernetes management platform, showcase their strength in product development. Supplementing this, SUSE is poised to further capitalize on its cloud marketplace presence by introducing NeuVector, consolidating its objectives of product leadership and market growth.
A consistently strong adjusted gross profit margin of 92% and increased investments in R&D and G&A demonstrate SUSE's commitment to product innovation and staying economically resilient despite rising fiscal pressures and an 8% increase in total operating costs. Looking ahead, the revised forecast expects mid-single-digit percent growth for adjusted revenue, with the core segment growing at low single digits and emerging revenue by around 10%. EBITDA margins are predicted to be mid-30%, while adjusted unlevered free cash flow conversion is anticipated to exceed 50%. Notably, the company plans to reduce the share-based compensation expenses in the coming fiscal years, aligning with market conditions and internal cost optimization strategies.
Dirk-Peter van Leeuwen outlined a strategic organizational transformation pivoting towards a regional model to foster closer customer relationships. The four regions defined include Asia Pacific, North America, Latin America, and EMEA, each to be steered by dedicated general managers. Such structural changes are expected to strip away complexities in customer interactions and enable a more nuanced understanding of end-users' needs, ultimately poised to propel SUSE into its full growth potential.
Van Leeuwen, leveraging his wealth of experience in open source software, signaled a strong belief in the open source model's potency. His observations on product excellence and SUSE's cultural strength set the stage for future growth strategies. Targeting enhanced go-to-market approaches and full-portfolio selling will be central to his leadership playbook, aiming to optimize SUSE's positioning in competitive markets.
In closing, SUSE's leadership reaffirmed a vision for growth despite current tribulations. The company anticipates leveraging its proven business model and growing markets to its advantage. With organizational changes underway and a continued focus on customer-centric approaches, SUSE maintains confidence in meeting its long-term ambitions, indicating that the best may yet be on the horizon.
In response to analysts' queries, CFO Atack discussed the churn, acknowledging that while there are varied reasons for customers moving away, including project completions or a switch from paid to free products, upsells continue to show robustness. The churn and downsell have somewhat tipped revenue dynamics, hinting at a near 100% net retention rate in the core business. The management team underscored the ongoing robust nature of mission-critical product upsells—an important part of sustaining growth amid market challenges.
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Good morning to you all, and welcome to our presentation of SUSE results for the second quarter 2023 financial year. I'm Matt Jones, Investor Relations at SUSE. I will now hand over to our new CEO, Dirk-Peter van Leeuwen and our Interim CFO, Jonathan Atack, who are going to take you through a few prepared remarks before we move to Q&A. But before I do that, can I remind you of the disclaimer on Page 2 of the presentation, which contains important notices on the information provided in the following presentation. DP, over to you.
Thank you, Matt, and good morning, everybody. It's a great pleasure to be here today for my very first call as the CEO of SUSE. I've obviously known SUSE for many years. First of all, as a peer, as a competitor, and now I'm here as a CEO because I really see the significant opportunity that we have to accelerate our growth in order to create value for our customers.
SUSE has a very long, strong culture and an industry-leading talent, which -- with deep expertise and a comprehensive product portfolio. However, I can also see that SUSE has not yet reached its full potential. And this is in part a result of the internal challenges that we're having.
In our primary market say it for Linux we are 1 of the 2 players in the global arena where I do know that customers want and need a choice. The container market is continuously growing and is strong. We have industry-leading products here. So there's a tremendous opportunity for SUSE in our markets. It depends on us making the right moves to unlock this.
I will share more details of my initial perspectives and priorities shortly. But first, I would like to hand over to Jonathan, who recently took over as our interim CFO following Andy Myers departure. He will take you through the details of our Q2 performance. I'd like to take this opportunity to thank Andy Myers for his dedicated service to SUSE and wish him all the best in his future endeavors. Jonathan, over to you.
Thank you, DP, and hello, everyone, on the call. As you saw from our trading update, trading was weaker than expected in the second quarter. We continue to operate in a challenging macroeconomic environment, which is driving customers to manage their cost bases and to conserve cash. Furthermore, earlier in the fiscal year, we executed a sales force reorganization, which led to some distraction during a critical period and with hindsight has not delivered the expected benefits.
While still a high-growth channel growth through our cloud route to market was also lower than expected, reflecting the wider slowdown in the cloud as customers seek to optimize their own infrastructure costs. Together, these challenges have led to downward pressure on our ACV, revenue and cash flow.
We are reporting 1% growth in adjusted revenue in Q2, the same at constant currency and 5% for the first half. Our adjusted EBITDA margin was 32%, reflecting continued disciplined investments across the business, including an increase in R&D spending to drive product development. For the first half, our margin was 36%. ACV was down 6% for the quarter, impacted by the external and internal challenges.
Total ARR of $658 million was up 6%, driven by higher ARR from both new and existing customers. Our net retention rate was 102%. Finally, we delivered unlevered free cash flow of $18 million, equivalent to a conversion rate of 34%, impacted by lower ACV and by some customers seeking shorter contract lengths to preserve their cash flow. In the first half, conversion was 77%. Now let's spend some time on the operational highlights. SUSE continues to leverage its open source business model to drive innovation, and we recently announced new capabilities across our product stack primarily focusing on security. Our latest version of Linux launch in June is designed to deliver high-performance computing capabilities, which are essential for AI workloads.
It is also the first edition of our Linux distribution to support the entire spectrum of confidential computing, a new approach, which allows customers to process fully encrypted data in the public cloud and at the edge, supporting innovation delivered by the major chip manufacturers.
In parallel, we released SLE Micro 5.4, our lightweight operating system, which is purpose-built for containerized workloads, making it the optimal choice for edge devices. And in April, we launched a new version of Rancher, SUSE's leading Kubernetes management platform offering users and independent software vendors, the capability to create customized user experiences, significantly enhancing their ability to manage increasingly complex Kubernetes environments.
We also added new pay-for-components to enhance the value of Rancher Prime. Prime customers now have access to SUSE's customer engagement platform, SUSE Collective, which includes exclusive support materials and Rancher Prime's AI assistance will provide real-time support to customers by the Rancher Prime [ Slack ] channel. We also continue to make progress with our plans to enhance our cloud route to market and we'll be adding NeuVector to the hyperscaler marketplaces later this year.
At SUSE, ESG is fundamental to our plans for sustainable growth, and we've made good progress over the first half of the year in this respect. In June, our emission reduction targets were approved by the [ SBTi ]. During a period of significant change, our employee NPS has remained stable and on target. This is also reflected in our voluntary attrition rates, which have declined over recent quarters.
And finally, we are proud to announce our AAA rating from MSCI, the highest possible and our prime status from ISS, recognizing our exceptional ESG performance and disclosures. Looking ahead, we remain committed to advancing our ESG agenda and driving positive change within SUSE and beyond.
Now let me talk you through some of the key deals we secured in the quarter. Q2 was another quarter in which SUSE signed significant deals with customers. These deals included cross-selling of Rancher NeuVector and Harvester to a leading semiconductor design company, an existing Linux customer. A renewal with upsell with a major German automotive manufacturer, expanding their relationship with SUSE based on our best-in-class support.
And finally, 2 of Japan's largest banks chose to renew their SLES subscriptions, continuing our long-standing partnership of over 10 years. Let me now take you through the details of our financial performance, starting with revenue. Total revenue in the quarter was up 1% to $162 million. This comprised core revenue of $132 million and emerging revenue of $30 million, down 1% and up 11%, respectively.
Movements are the same at constant currency. Group ARR grew to $658 million, up 6% year-on-year, supported by continued growth from new and existing customers. Our revenue was impacted by the ongoing macroeconomic uncertainty, slower cloud growth and lower-than-expected traction from the sales force reorganization earlier in the year.
The slowdown in cloud growth has been widely observed in the marketplace as customers react to market conditions, and we have seen the impact of this with slowing growth in our cloud revenues. In our core business, we have continued to see the resilience of our mission-critical customer base with upsell continuing to make a significant and strong contribution. However, we are seeing some offsetting reduction in revenue from down-sell and churn.
Emerging continues to see growth driven by new business and upselling, albeit under some pressure. Furthermore, the suspension of sales to Russian customers and legacy product runoff reduced our revenue growth by 1 percentage point.
Our net retention rate of 102% demonstrates continued upsell to our existing customer base. Foreign exchange movements, the suspension of sales to Russian customers and legacy product runoff reduced our ARR growth rates and NRR by around 2 percentage points.
Let's now turn to our ACV performance. Group ACV was down 6% to $131 million, comprising core ACV of $108 million, down 5% and emerging ACV of $23 million, down 10%. Movements are the same at constant currency. ACV performance was impacted by the internal and external challenges I referred to you earlier.
The external challenges put pressure on new business in particular, where potential customers are exercising more discretion on when to initiate projects. This was compounded by the sales force reorganization, resulting in lower sales and rep productivity in the period and reduced focus on new and smaller deals. Additionally, there is an apparent trend towards customers looking to reduce contract lengths to preserve cash, and we have seen this particularly in end user renewals.
Looking more broadly at the first half, emerging ACV was up 4% and core ACV down 3%. Performance by geographies was mixed, reflecting the dependence of quarterly ACV growth on the available renewal pools. ACV grew strongly in Europe, Middle East and Africa, including a significant renewal with upsell as a long-standing customer.
We delivered strong growth in Asia Pacific and Japan, which is also supported by some large renewals. And in North America, phasing of renewals and fewer net new customers led to ACV declining by 12%. Our performance by route to market included a 2% decrease in our end user and cloud ACV, driven by lower sales through the end user route market, partly offset by continued growth in cloud.
ACV from independent hardware vendors and embedded customers was down 25%, driven by lower hardware shipments in the broader market, a shift to selling through other routes, primarily through cloud service providers and challenging market conditions in Greater China. We continue to make disciplined investments to drive innovation and future growth, as can be seen on the next slide.
SUSE's Q2 adjusted cost of sales grew broadly in line with adjusted revenue versus the prior year, resulting in a consistently high adjusted gross profit margin of 92%. Total operating costs increased by 8% to $97 million in Q2 or 11% at constant currency, driven by investments in people across R&D and G&A functions and differences in timing of spend versus the prior year, partly offset by a lower headcount in sales following the reorganization in the first half.
Within these movements, sales, marketing and operations costs decreased by 4%, reflecting the lower sales headcount. R&D costs increased by 17% driven by continued investments in product development, yielding the new versions of Linux and Rancher, which we announced earlier in the year.
G&A costs increased by 27%, driven primarily by differences in timing of spend versus the prior year and some wage inflation in line with market conditions. This resulted in an adjusted EBITDA margin of 32%, down 4 percentage points versus the prior year. More broadly, our margin trajectory remains strong, underpinned by our growth and our disciplined approach to costs.
And in the first half, our margin was higher than last year. Although not included here but referenced in the appendix, our share-based compensation costs remained flat versus the prior quarter at $12 million in Q2 and below our previous guidance of $15 million per quarter following the sales reorganization earlier this fiscal year.
Going forward, we are taking a more targeted approach to share-based compensation, reflecting wider market conditions and expect noncash P&L charge -- expect the noncash P&L charge to be less than $12 million per quarter in the second half and reducing to less than $10 million per quarter next fiscal year. These estimates are before the impact of potential wage inflation.
Now let's look at -- look further at how our profits have been converted into cash. Our cash conversion in the first half was 77%. The change in deferred revenue of negative $4.2 million was impacted by the lower ACV but also by 1 large multiyear customer moving from full payment upfront to annual payment terms in the second quarter.
Future payments are committed but do not appear in deferred revenue or our cash flow this year. Instead, the commitment is shown in our remaining performance obligation, which was up 15% year-on-year to $142 million. The move to annual payments also impacts our weighted average contract length as this only considers the proportion of contracts which are paid upfront. Without this change in payment terms, our average contract duration would have been 19 months versus 18 months on a reported basis.
More broadly, we are seeing some customers requesting annual payment terms as they look to conserve cash. The decrease in adjusted EBITDA and a negative change in deferred revenue led to adjusted cash EBITDA of $115 million, down 32%. This lower adjusted cash EBITDA was partly offset by lower commissions paid and the core working capital inflow versus an outflow in the prior year.
CapEx, cash taxes and leases paid remained broadly similar to the prior year. This resulted in adjusted unlevered free cash flow of $91 million in the first half, up 11% and representing cash conversion of 77%.
Moving now to our guidance for this year and beyond. With our recent trading update, we reduced our guidance for fiscal year '23. Given the continued uncertain environment and the changes that we are now making in the business, we believe that the revised guidance is appropriate under the circumstances.
At this point in time, a major part of our full year revenue is underpinned by a business that has already been booked. As we look ahead, the biggest swing factors that remain on the cloud revenue and retrospective consumption contracts, which can vary significantly from quarter-to-quarter and have a direct impact on reported revenues. As a result, I am reiterating our guidance today.
As indicated in our Q2 trading update, we now expect reported adjusted revenue growth for the year to be mid-single digits percent and the same at constant currency. This comprises core revenue growth of low single digits percent and emerging revenue growth around 10%. Given the available renewables and high visibility of our H2 pipeline and our normal sales cycle, we expect the second half to be back-end weighted. As a result, we expect similar Q3 adjusted revenue to Q2 across both core and emerging solutions, followed by a stronger Q4 to deliver our fiscal year '23 guidance.
We expect our adjusted EBITDA margin to be in the mid-30% range. with a slight headwind from exchange rate movements since fiscal year '22, which are increasing reported OpEx. We expect adjusted unlevered free cash flow conversion to be in excess of 50%. This cash conversion includes the impact of the specific customers' change in payment terms we saw in Q2 and assume some softness in upfront payments for the remainder of the year.
Our medium-term guidance remains unchanged, and we expect to build steadily towards these performance levels over the coming years as the fundamentals of our business model and market growth rates remain strong. With that, I will hand over to DP, who will now share his initial perspectives and priorities.
Thank you, Jonathan. So talking about my initial perspectives, I've been in this business for over 2 decades with experience and leadership position in the open source software. Most of the time actually was spent as a market leader, as most of you know, in the role of General Manager in several global regions where I drove significant growth.
So these are global markets that I know very well. And however, I got to say, of course, being CEO of SUSE is new to me. But I spent my first 2 months getting to know SUSE and its key stakeholders. So I want to talk a little bit about that.
In those first 60 days, I visited 6 offices around the world, hosting town hall meetings, learning about what attracts people to SUSE. I've met over 55 customers and partners held over 50 one-on-ones with colleagues. I've combined this feedback with my existing experience of working in development source community. And therefore, today, I'd like to share my initial perspectives of SUSE from this journey.
First of all, our product portfolio is uniquely positioned to evolve with the changing needs of our customers. There's an unstoppable demand for faster and more agile and more secure data processing and workload management. And customers need to be able to deploy the compute power where their operation is demanded.
SUSE's products deck allows our customers, partners and open source communities to rely on us for comprehensive solutions, ensuring that they can run their application safely and securely, whether they are in the cloud and data centers or on the edge.
Secondly, we have a strong company culture with an industry-leading talent mix. SUSE attracts people who are passionate about working in open source communities. For many of this, it's more than a job and that leads to great innovation and deep expertise. The open source model is critical to the success of our company, and we are in the middle of a new digital transformation.
Software consumers want to move from owning and to experiencing software. Ownership of software is often based on the proprietary software intellectual property and its patents, with sales based that are on [indiscernible] and functions. Experience, however, is based on the usage and the availability where and when you need it and on an open source -- source code. This is an undeniable trend which we are benefiting from.
In an open source world, code is freely available to all. This enables sharing and cooperation and it delivers the best solutions as it is in meritocracy where the best idea wins, which leads therefore, for exponential innovation. This is why I believe so strongly in the open source model and why it is so critical to our success.
At SUSE, we are experts in turning open source projects into enterprise products, that is our particular skill taking freely available [indiscernible] solution that our large enterprises can rely on for the business-critical operations. That's why our customers pay for support for certification, security and safety.
Now bringing this together, notwithstanding the recent performance, I can see tremendous opportunity for growth, especially now that we can make the right moves to [ unlock it ]. So let me therefore address some immediate opportunities. So the strength of our product portfolio, a coach expertise has given SUSE a solid foundation, but we haven't reached our full potential.
Yes, we've been operating in an uncertain macroeconomic environment, for some time now, but many of our challenges are internal. And addressing this gives me the opportunity to accelerate our growth. So what are the these challenges?
Well, first of all, we need to improve our customer intimacy by working with customers and partners rather than as products and salespeople, we need to engage deeply with our customers and help them develop their architectures. So that SUSE is more than just an item on a [ bill of materials ], but rather a partner in designing the best technological solutions for our customers.
Secondly, we need to move closer to our customers and power regional leadership, focus on local expertise, presence and presence will build trust and remove some of the barriers and complexities of doing business with SUSE. Thirdly, we are not effectively leveraging SUSE's whole product portfolio.
We need our reps to be capable of selling the full portfolio. They need to have the right incentives and skills, and they should be backed up by industry-leading product specialists. Now to capitalize on these opportunities, we have already taken some swift actions. I have simplified and strengthened my leadership team, reducing the number of positions and ensuring clear and purposeful accountability.
Part of this transition is that I'd like to welcome our new Chief Revenue Officer, Werner Knoblich to SUSE. Werner has been a senior commercial leader in the open source for more than 2 decades, including 18 years at Red Hat where he grew the EMEA business from $20 million to $1.5 billion.
I'm also making our organizational structure -- changes to our organizational structure by implementing a regional model. This will enable the customer intimacy, which is so important to me and to our customers. This model comprises of 4 regions: Asia Pacific, North America, Latin America and EMEA. And we have already appointed strong general managers to lead these regions.
So moving beyond these changes on the next slide, we will continue to set up our organization for success over the coming quarters. For the stages towards accelerated growth that we're talking about here are the following. For the second half of the current fiscal year, achieving our guidance is our #1 priority. We also continue to evolve our organizational structure to ensure the industry standard and ready to scale.
Beyond this, we'll develop and execute our long-term vision in collaboration with our customers, our partners, our employees and the open source contributors. Underpinning this plan is the strength of SUSE's business model today. which is enabling us to invest and make the right moves to unlock future growth.
This model is based on delivery of mission-critical open source infrastructure software in rapidly growing markets. our subscription-based products, which with a diversified enterprise customer base and multiyear contracts with upfront payment to drive high cash conversion.
We are making the right organizational changes. Our markets are growing. We're having a strong product portfolio. We work in a truly customer-focused open source model, which has proven to deliver the best innovation. I am therefore very confident that we are well placed to deliver on our long-term potential. So that concludes our presentation for today. I'd like to now hand it back to the operator for Q&A.
[Operator Instructions] The first question comes from the line of Toby Ogg from JPMorgan.
Yes. Firstly, Peter, just from my side. So you talked a lot about some of the internal challenges there and a lot of it is sound weighted to the sales organization. So I guess the first question from my side, following your period of assessment over the last couple of months, is this really where you think the crux of the issues have been?
And then secondly, just digging in a little bit more on the sales force component, you talked about lots of different elements there, improving customer intimacy and then moving to a more regional model, solution selling and so on. Could you just talk a little bit about sort of what the roadmap from here looks like in terms of implementing all these different things and any associated hiring as well that might be to come with that.
Yes. Thanks, Toby. Thanks for the question. So it's a 2-stage question you're asking. If the sales reorg was the crux of the issues. And then secondly, what we're doing moving forward. So effectively, the way I'd like to phrase it here, and I'm with this company only 60 days, right, so bear in mind that I'm still learning as we go. But honestly, working in a sales organization with an open source product line, it is very important that we're super close to the customer. And that customer intimacy is more than just about understanding the products. It is also understanding how our customers architect their solutions and how then our full portfolio fits into the solution. And in order to do that, we need to be close to the customer. We need to have a relationship with the customers and believe to be a point of contact, and we need to be very early in the sales cycle. So those are the things that we will focus on moving forward as we are improving our presence and our ability to sell our [ core ] portfolio to our customers. I hope that answers both of your questions.
Yes, that's great.
The next question comes from Laura Metayer from Morgan Stanley.
Two questions for me, please. The first one is you mentioned a slight increase in churn. Could you please clarify if that increase in churn is coming from customers moving from paid to free products of SUSE or moving away from SUSE products or combination of both?
And then the second question is around the slight revenue decline that you've seen in the core segment. Could you please give us more color on the down sell that you're seeing and give us an idea of where the [ NRR ] stands in core. I guess if the group [ NRR ] is 1% or 2%, the core revenue NRR must now be negative? And are you seeing customers moving from the paid version of the of Linux to the free version of Linux that you're seeing in Rancher? Any color here would be great.
So Jonathan, can I ask you to take this question?
Thank you, DP. Yes, of course. So you asked about the increase in churn and the reasons for that. I mean there can be a number of reasons why customers move away from us. It can be the end of a project. So if they simply run a project and they decide not to continue, then that happens. You asked about the move to pay from pay to free, I mean we don't necessarily have great visibility on that, but that certainly is the case in some instances. So you will, for instance, see a customer has not been actually requiring the support. So they decide not to pay for it, and they decide to adopt it themselves. In some cases, they can also reduce the volume of the products they're using or they may move to a different channel or route of consumption.
I mean they've been using a product that's towards a tender service life, they may move to another more current product. and that can have an implication as well, although that probably can go into downsell [indiscernible] that comes in down some. So all of those are features that play through it. And there's no particularly strong pattern. It can -- there are a variety of those in the mix that we've seen. Overall, downsell is probably the most significant contributor to the slowdown in the growth that we've seen. There is some churn. But having said that, I would stress that upsell does continue to remain quite strong. I mean, that's an important part of the growth. The mission-critical nature of the products is absolutely true. And when we look at our key contracts, the vast majority coming to renewal, we see increases in ACV, and we see increases in pricing. And across the board, we're seeing an average reduction in discounts. Is that enough for you? Or DP, anything to add to that?
Would you mind giving us an idea of what the NRR is for the core business? Is it below 100% now?
I think given the trends that we're seeing at the moment, it may continue to reduce, but at the moment, I think it's probably close to 100%.
The next question comes from Frederic Boulan from Bank of America.
Question to DP, First of all, maybe if you can step back a little bit and discuss some of the differences in approaches that you're seeing at SUSE versus what you've experienced at Red Hat over the years. I mean you discussed some changes to the sales approach this morning. What about product development or monetization strategy? Any other key areas where you think that the business could be optimized. And I mean, just in particular on the pricing side, there was an issue in terms of upsell on the -- to the paid version on Rancher. Previous management was engaged in a multiyear pricing exercise. So any thinking on pricing strategy more broadly?
Yes. So generally, I'll repeat the question. So the difference in approaches between SUSE and [ Rancher ]. And then secondly, product development and monetizing on our business in key areas of optimization really. The -- for me and the reason, of course, why I joined this company is that the 2 companies are pretty similar companies. And the technology is very similar. And one of the other things that I can really tell as customers need choice. And therefore, it is important that there is a good alternative in the market. And so with all the great stuff we're having I'm seeing the only 60 days in that I'm having here that the fastest way to optimize is work on our go-to-market. And that's what I've been presenting that we're doing right now. And that's where there is a lot of opportunity for us, but it equally takes some time to get it to the level where I want it to be in. And that really is about selling a full portfolio, not just selling 1 product, but making sure that we understand the journey that our customer is on.
And as an expert in the journey, has the capability to position our entire product portfolio and make sure that our customers successfully implemented. So that is really where the focus is going to be. As for your question around pricing, I haven't really looked into it, let's say, historical thing. I don't know if Jonathan wants to comment on that.
Yes. Look, I think certainly, in the last 2 years, pricing has been an increasing area of focus for us. There's a lot more discipline around that. And I think the processes we have in place enable a better level of review and a more consistent approach. We have been able to -- we have put through some price increases in the last year. And we're also getting much better discipline around the discounting. So I think I mentioned earlier, the general trend is for average discount levels to be reducing. And alongside price increases of around 7% to 5% in different product areas, we are seeing a benefit from that. Obviously, at the same time, we are seeing some reduction in volumes through the other market mechanisms that we've discussed earlier. And we can continue to explore opportunities around differences in price elasticity.
We have, in some areas, reduced prices with a view to driving additional volumes. And there's some channel differences as well. And for instance, within the cloud mechanics, and we've seen the -- whilst the cloud growth in revenue remains relatively strong, it's slowing. And within that, we're seeing a higher proportion of reserved instances. So again, better quality long-term business, but reserve instances tend to be at a lower overall price point than the pay-as-you-go contracts. And that proportion of reserve instances is in general, increasing. So a number of different dynamics going there. But overall, I think, an area of focus, better quality analytics and some good progress.
The next question comes from Charles Brennan from Jefferies.
It's really just one about the margin outlook actually. I normally expect changes of strategy to cost some money, particularly when that involves reinvestment into a sales organization where costs come before revenues. And yet your full year margin guidance is unchanged in the mid-30s. Are we just so far through the year that you don't have enough time to spend some money and implement the initiatives you want? Or should we be thinking the, I guess, mid-30s, it's a wide range. Are margin scenarios lower than 35% considerably more likely than scenarios above 35%?
Jonathan, you want to take it?
Of course, DP. Thank you. And Charles, thank you for your question. Yes, look, I mean, you made some very good points there. The outlook for the year and the forecast for the year are still very much predicated on the kind of SUSE as is and the plans that we have at the moment. Obviously, we've reflected known changes, and there's been a number of changes at the senior management and within the organization. So that's all taken into account. We have also some ongoing assumptions about the investments that we're going to make or expect to make in the rest of the year. That includes particularly headcount and we have allowed for a certain degree of increase there. And again, this is all taken against the backdrop of the expected growth in revenue.
So there's the ongoing debate about the balance between growth and margin and we have some flexibility for managing that in the rest of the year. Obviously, with DP relatively newly on board, he's looking at the changes that he will make making plans and there may be some further actions during the year. But at the moment, I think it's still fair to say the outlook is based on the current organization and the majority of the actions that the new executive leadership team will be taking will impact more significantly in the next year and beyond. DP?
Yes, that's a fair answer. And as I mentioned in my earlier slide, the initial actions I took really to take us through the year and then the actions we're currently looking at are setting us up for success in the following year, and that's still simply going to take some time.
And can I just press you on the timelines there. Things like customer intimacy don't come overnight. Those are relationships that build over time. Do you think about '23 as being the consolidation year? So '24 can definitively be the year of accelerating momentum? Or should we think about '24 as being another consolidation year as you bed in some changes and it becomes more of a '25 story?
Well, I think it's going to be mixed. It's definitely not the case that on the first day of the next fiscal year, this thing is all perfect. It's going to take time. Let's be honest about this. We have a lot of work to do. And if we want to achieve the level of customer intimacy, as we call it, that I am aiming for and that I know what good looks like, then I also know this takes time. We have to build this relationship, we have to train our people. And given that I'm 60 days in, you can expect in the later point, probably our next quarter, we have a more definitive outlook on how we expect this to then materialize into revenue.
The next question comes from Johannes Schaller from Deutsche Bank.
Just one on the financial side on free cash flow. I mean, we've obviously seen a few customers moving from upfront payments to annual payments now. Can you just give us a little bit of a sense in terms of the customer breakdown or revenue breakdown kind of how many are paying still upfront? And is there any visibility you have on when that kind of transition at some of your customers is ending? Do you see more asking to pay on an annual basis? Is that going to be an ongoing theme for a while?
And then maybe a slightly more higher level one for DP, if I could. I mean you obviously came from Red Hat with probably a certain expectation into SUSE in terms of what you would find and customer feedback. And you said you've spoken to quite a few customers already. What was it that you would say that surprised you the most in those customer discussions compared to the expectations you had?
Thanks, Jonathan. I'll pass it on first to Jonathan for a question about the financials.
Thank you, DP. And Johannes, yes, look, this is an important question and sensitivity for us. The -- there is a trend towards a number of customers asking to go into sort of annual renewals even if they've got a longer-term contract -- annual payments, even if they have a longer-term contract. It's not a big proportion at this point. And we don't know if it's a structural trend or something that is probably more temporary during the period of uncertainty that there is out there. The impact of this has been a shortening of average contract length, and we see a lower ratio of TCV to ACV, which impacts the cash flow, as you said. In Q2, there was 1 very particular large renewal, which went from a 3-year contract paid up from to a 3-year contract paid annually.
So that has had a more significant impact, particularly in Q2 and that is visible in the results and in the cash flow that we have seen. So overall, it's not a huge impact outside of that deal so far. And we are seeing a significant increase in the remaining performance obligations, which is a contracted but not paid part. So at the end of the day, it's cash that we will get in the future even if it comes at a little bit of a delay. So it's not necessarily a bad thing, particularly as you probably get less of a discount with that kind of contract. So a number -- again, a number of dynamics there. But overall, the impact on the cash flow has probably been exaggerated in Q2. And it's not -- and so we will expect to see a slight improvement moving forward.
Thank you, Jonathan. the other part of your question was about coming from Red Hat what surprised me the most. And yes, I can tell you that, of course, I was expecting a number of things. And then looking at the go-to-market, I could see there is a huge opportunity for improvement there. But honestly, what surprised me the most was the culture. It's very much a very strong open source culture. There's a high level of enthusiasm and there's a high level of collaboration as well as the technology that we're having. And we have a lot of great technology that I think we have a great opportunity to market to our customers and really to do a better job at branding ourselves and giving customers that alternative that they're looking for.
[Operator Instructions] The next question comes from Will Wallis from Numis.
Two from me. Firstly, just on -- you've given some guidance that you expect Q3 revenues to be sequentially relatively flat. That does leave quite a lot to be done in Q4 to get to mid-single-digit revenue growth. Obviously, that does is quite -- there's a range there. But say, to get to 5%, it does leave Q4 requiring pretty significant growth. I wondered what gives you confidence in that? And my second question for DP really. Can you give us your perspective on the -- on how significant the change in relationship with SAP that seems to have happened at the beginning of this year with SAP moving much closer to Red Hat will be for SUSE over the medium to longer-term.
Sure, Will. I think I'll pass it first to Jonathan for the first part of your question in terms of the Q3. And I think Jonathan, you will explain how ACV leads to revenue, right?
Absolutely. Thanks, DP. And Will, thank you very much indeed for your question. Yes. Look, I mean, for the rest of the year and looking at the phasing between Q3 and Q4, Obviously, we've got a fair amount of the revenue for the year is already booked. So in excess of 85% is already booked revenue. And that includes some revenue that's booked from the deals that have been done in Q3. So the ACV expectations for Q3, again, at this stage in the quarter, we have got obviously much better visibility. ACV delivery tends to be back-end loaded. So there is still some uncertainty perhaps there, but we've got good visibility of what has been booked, what is committed and what is deemed highly likely, and we've got some good coverage there.
So the ACV for Q3 that will contribute a bit to revenue in Q4 is also there. And then when we look at the rest of the -- what we need to do to deliver and where there is some element potentially of uncertainty or risk upside or downside going forward. Cloud revenue is booked and recognized in the shorter-term.
So we still need to see delivery in Q3 and Q4 there. It's an environment where we've seen some slowdown, but I think we've taken some reasonably conservative estimates moving forward and the retrospective consumption contracts, of course, are another area where there is some volatility. And again, we've taken a view there that does see some increase in the second half. And that obviously is an area that can be sort of pretty binary in terms of some pluses and minuses. So those are the assumptions that underpin it -- and underpin the split and the phasing. So we have a fair degree of confidence, but it will still need some good performance in Q4.
Thanks, Jonathan. And I'll address the question about SAP. I think it's safe to say that the SAP relationship with SUSE is 1 of the strongest and longest [indiscernible] in partnership with the 2 organizations. It's really, really a long-standing over 20 years partnership. We see that SUSE and Linux Enterprise server for SAP applications was and remains an integral part of the rise with SAP reference architecture. Linux Enterprise is leading limit for SAP HANA with 80% -- 85% of the market and 100% of the SAP Business One version of SAP HANA. 70% of all SAP applications are running on SUSE Linux Enterprise server for SAP. So it's actually a very strong relationship that continues to be strong.
The fact that there is choice is something that the market is accepting. We are therefore equally a choice for any other vendor because we also have a very strong portfolio in other parts of the market.
The last question comes from Deepshikha Agarwal from Goldman Sachs.
I just have one, and I think this is more to DP. I think you talked about like currently from where you see that one area is basically thinking about like customer intimacy and looking at the product portfolio. And I think even Jonathan talked about that there would be further considerations like depending on how the strategy develops. So what are the other areas potentially that you see that like that needs to be looked deeper into and there is scope of opportunity from the current vantage point?
Yes, that's a great question. And some of that is still in development as you will appreciate being 60 days in I really did a lot of activities in terms of getting to know the company, getting to know the people, the customers, the partners and even the analysts, et cetera. So the immediate challenges were pretty clear for me, and I mentioned we addressed them. The intermediate challenge is that will set us up for the next fiscal year are still very much in progress. And so I would like to get back to all of you in the next session to give more color on other opportunities that we've identified and that we will be working on. So I believe there are no more questions, right?
There are no further questions at this time, yes.
All right. Well, then I'd like to thank everybody for joining this call, and we hope to stay in touch and to talk to you next time.
Thank you.
Ladies and gentlemen, the conference is now concluded. You may now disconnect your lines.