Darktrace PLC

LSE:DARK

Earnings Call Analysis

Robust Revenue Growth and Margin Expansion

The company experienced a significant year-on-year growth in Annual Recurring Revenue (ARR) and revenue, both scaling up by 27.4%. The focus on efficiency and profitability led to an 800 basis point increase in the adjusted EBIT margin, bringing it to 21.5%. This performance has led to a revised guidance for adjusted EBITDA margins, now at a minimum of 21%, up from the previously stated 18-20%. The R&D team's innovative products are crucial drivers for the company's enhanced upsells, indicating that investments in product development have been fruitful.

Robust Growth and Raised Future Expectations

The company experienced significant growth in Annual Recurring Revenue (ARR), achieving a 24.4% year-on-year increase. Revenue growth was even more impressive at 27.4% for the period, with a remarkable acceleration from Q1 to Q2. Due to this strong performance, the company has raised its revenue guidance for the second half of the year.

Margin Expansion and Upward Adjusted EBIT Guidance

The adjusted Earnings Before Interest and Taxes (EBIT) margin soared by 800 basis points year-on-year to 21.5% for the first half. This performance has led to an upward revision in adjusted EBITDA margin guidance, now projected to be at least 21%, compared to the previous estimate of 18%-20%.

Balance of Investment and Profitability

Management emphasized ongoing investments to foster growth for the fiscal year 2025, although without providing specific guidance for that period. Significantly, the company intends to align its margin comparisons year-over-year rather than between interim periods, expecting a more typical trend of higher first-half margins relative to the second half and full year. Moreover, contractual economics are positioned well above reported margins, signaling room for potential improvement as the company advances towards steady-state target margins.

Stable Customer Retention Amid Financial Adjustments

Churn rates remained stable, unaffected by market fluctuations. Interestingly, Research and Development (R&D) expenses declined as a percentage of revenue, diverging from the industry's upward trend, due to the self-maintaining nature of the company's products. Strategic investments are currently prioritized toward Go-To-Market and marketing initiatives to leverage newly developed products; however, the company anticipates refocusing investment on R&D interfacing areas as these initiatives gain traction.

Industry Trend Toward Integrated Platforms

The company notes a shift in the industry towards integrated platform solutions rather than siloed services, recognizing the need for comprehensive security across different domains. This holistic approach is seen as vital in an industry that is consolidating to cover previously blind spots in technology visibility.

Strategic Market Positioning and Partnerships

In a competitive space with players like Palo Alto, CrowdStrike, and Microsoft, the company maintains its position and touts a deep partnership with Microsoft. This strategic alignment with market leaders is an asset in fostering growth and stability.

Guidance for Positive Net ARR Growth and Targeted Market Expansion

The company guides positive net ARR growth for the second half of FY24 and details its approach to achieving growth without a proportional increase in headcount. The growth strategy includes enhanced focus on upselling/cross-selling, targeted efforts in the U.S. market, and an ongoing shift toward strategic account involvement. While channel partnership contributions have not yet significantly impacted financials, this is a long-term strategic lever aimed at improving market access and driving subsequent growth.

Earnings Call Transcript 2024-Q2

[Luk Janssens, executive]

Hello, everyone, and welcome to Darktrace Plc's First Half 2024 Results Call for analysts and investors. I'm Luk Janssens, Head of Investor Relations. On the call with me today are Poppy Gustafsson, our CEO; Cathy Graham, our CFO; and Max Heinemeyer, our Chief Product Officer. We published our results at 7:00 a.m. U.K. time this morning. And as always, we released a video presentation by Poppy & Cathy, lasting about 40 minutes that gives a thorough review of the performance of our business for the period to 31 December 2023.

Based on your feedback for our earnings call, we've chosen not to replay that 40-minute presentation here and instead leave more room for an interactive Q&A. If you haven't had a chance to watch that video, please go and check it out on our IR website.

To ask a question, please raise your Zoom hand in the call and the operator will bring you up to verbally ask your question. You can also submit written questions in the chat function. If I can ask you to limit yourself to 2 questions, so we can give everyone a chance, that would be great. Let me hand over to Poppy Gustafsson to make some brief opening remarks, and then we'll open up to you for Q&A. Poppy?

[Poppy Gustafsson, executive]

Thank you, Luk. And of course, thank you to all of you for your time and interest in Darktrace. And hopefully, many of you, if not all of you, will have seen the presentation that Luk talked about. But to refresh your memory, we have had some very strong headline results. So we delivered 24.4% year-on-year growth in ARR and revenue growth for the period was 27.4%. Within those strong results, what I was particularly pleased with is the marked improvement in momentum from Q1 into Q2. And off the back of that, we are raising guidance for revenue for the latter half of the year.

Furthermore, adjusted EBIT margin was up 800 basis points year-on-year to 21.5% in the first half. And then I can remember at the time of the IPO when the business was close to breakeven, and we were sat in a virtual room very similar to this one. And we were saying that the business will be capable of doing a mid-20s adjusted EBIT margin when we're aiming for that 30 states. And some of folks on the call looked a little skeptically at us, well, less than 3 years hence, and we're really pleased to be able to deliver on that. We have increased guidance for adjusted EBITDA margins to at least 21%, up from 18% to 20% previously.

So taking a step back and looking at these highlights together, what you are seeing is that the business has delivered improved momentum whilst delivering on profits and cash, all whilst having made that significant investment into that Go-To-Market business to lay the foundations for our future growth. It really does feel like spring is in the air, and we look forward to building on the improved momentum as the year progresses. We've had our heads down working hard on executing through all of that Go-To-Market investment, and it is a real pleasure to start seeing those investments shining through.

So at Luk promised, we will be leaving more of this call open to your questions. So with that, let's dive straight in. Operator, I think we're heading to you. Can we take our first question, please?

[Operator]

[Operator Instructions] We'll take our first question from George Webb of Morgan Stanley. George?

[George Webb, analyst]

Two questions to pick off with, please. Firstly, with regards to the market backdrop, I guess we've heard from other players in the cybersecurity space, a little bit of mixed messaging around the demand environment at the moment. Palo Alto more mixed, CrowdStrike more positive. It sounds from you like the environment is perhaps more stable. But could you elaborate a little on what you're seeing and the deal pipelines -- and then secondly, on EBITDA margin, very strong in the first half, over 25%. The guidance for the year of at least 21% suggests quite a lot of incremental costs in the second half. If we were to assume that you were to finish FY '24 at 21%, how do you think about the shape of the margins beyond FY '24? And do you think this step-up in margins can be sustained?

[Poppy Gustafsson, executive]

Yes. Thank you for those. Let me take the first half and then perhaps I'll pass to Cathy to talk a little bit about the second half in terms of the financials. So bigger picture, what have we seen out there with other security players? We saw earlier this week some stellar results from CrowdStrike, clearly signaling they we are having no letup in demand, whereas as you referred to, sort of Palo Alto had signaled a little bit of a sort of slowing in terms of their demand cycle. From our perspective, I suspect what we're seeing there is a significant battle being played out to accumulate a vast data sets on all of the "known bads."

And we're seeing that battle between Palo Alto, between CrowdStrike, between Microsoft and there is a significant competition for that market share and who can achieve the biggest collection of knowledge of that "known bads" and we are sort of observing that with interest. But as I talked about in my presentation, that's not our battle. So whilst there was a question there was how -- is it the macro that's shaping some of the results that we've seen, my interpretation is it more of that market competition between those vendors as they really try and grapple for that largest collection of data, but that's not something that impacts us at Darktrace because, as I remind you, that is not our battle.

We are not in the industry of going out and collecting the biggest possible data set on "known bads", -- we are in the business of presenting our AI to the data. We give our AI to the organization, and we protect it from the inside out. And in fact, we sit alongside Palo Alto, we sit alongside CrowdStrike, we sit alongside Microsoft. So coming back then to the macro? And are we seeing that affecting our results. No. I think we've -- Cathy has talked about the fact that we have seen market stabilization. We really feel that the impact that we have demonstrated in terms of our financial performance, so that building momentum from Q1 to Q2 is a consequence of our own investments in our organization. And it's our actions and it's our achievements that's reflected in that rather than external factors. But with that, I will hand over to Cathy to talk a little bit about the second half.

[Catherine Graham, executive]

And I think that, that's a good transition from what Poppy just said. We are still in the process of some investments that we'll be talking about more over the next sort of 3 to 6 months. And we want to make sure that we are in a position in the rest of FY 2024 to have invested what we need in order to drive FY 2025 performance. Now we're not giving guidance on FY 2025. But I think that what we would say is, first, on margins; compare year-over-year and not interim periods because as we've discussed previously, certainly, we always see even if you normalize investments just because of our cycles, first half is usually higher than second half and full year.

But sort of more importantly, I think, looking forward, we are comfortable that our contract economics remain above the margins that we are reporting. And so directionally, as we move forward through the rest of 24 through 2025 that that continues to be the state directionally, we're moving towards our steady-state target margins, and there's certainly room to do so just as with everything else, it won't always be in here.

[Luk Janssens, executive]

Great. Thank you for your questions, George. Operator, we'll take the next question, please.

[Operator]

Our next question is from Charlie Brennan at Jefferies.

[Charles Brennan, analyst]

Hopefully, you can hear me. Congratulations on the results today. Can I ask about the other dimension of the competitor news flow that we've seen over the last couple of weeks, which is the idea of vendor consolidation and platformization as Palo Alto tried to introduce? As they drive that platform strategy and even as they temporarily give some product away for free, how would you think that you set as an independent vendor alongside that strategy?

And I guess we know the answer because your churn is unchanged. But are you seeing any evidence that sales cycles or renewals are being impacted by some of that behavior -- and then secondly, just as a smaller financial question; I think in the steady state model, you assume that R&D as a percentage of revenue would be trending higher. It's actually trended lower in the period. Is that just a timing difference? And what explains that timing difference? Is it a lag in hiring? Or is there any particular projects that you pushed to the right?

[Poppy Gustafsson, executive]

Great. Thank you, Charlie. So in there, we've got a question around platform approach and whether we're seeing that reflected in the industry and also where that's reflecting on our own business performance and then the piece around R&D. I'll give a quick high-level answer, and I'll hand over to Max to talk a little bit about the industry and then Cathy will take the last bit in terms of the R&D percentage. So we are very much seeing a shift to taking a platform approach. And there is now wind acknowledgment that it is not sufficient to think about business in silos. So you could have world-class e-mail security, but if your cloud security is not, then you still are just as exposed as by not having any security at all.

So you are only as strong as your weakest link, which is a mantra that we have had since the earliest days and why we've always thought about offering such a broad platform. And I suspect what you're seeing in terms of the industry and the consolidation is a race to acquire technologies that provide visibility and coverage into areas that many organizations are otherwise blind to. And we've always been incredibly proud that we've been able to see into the darkest corner of any organization in any type of [ Gen Subsets ] from a very early point. But Max, over to you, I don't know if you further want to add there, and I'll ask Cathy to touch on the R&D point.

[Maximilian Heinemeyer, executive]

Yes. Thank you, Poppy. -- thanks, Charlie, for the question. It's a great one. So while you're absolutely right that there's a drive for platformization. I think we need to be very conscious of what the written vendors mean by that and what we mean by that because absolutely, there's this fierce battle as Poppy mentioned earlier, between the Palo Altos and the CrowdStrike and the Microsoft to consolidate the traditional known bad approach and get as much visibility into that data set as possible and replace the legacy technology with their own next-generation technology. Now we also have a native AI-driven platform that we've been working on from the ground up for over 10 years now. But we are not citing that bet, right?

We're looking to consolidate other things and to get visibility into every bit of digital estate and coverage area to drive efficiency gains and do the behavioral approach. We're not learning the breach we are learning the business. So we don't see a change in that competitive landscape for us at all, right? We sit alongside Palo Alto. We sit alongside CrowdStrike. We sit alongside Microsoft, we have a very deep and intimate partnership with. And just to remind everybody that it's not the breach we're trying to learn, but we're learning the business of the customer. Cathy, over to you.

[Catherine Graham, executive]

Great. Thanks, Max. Charlie, on the timing on R&D spend, then the slight decline as a percent of your revenue, one of the factors, and this is something that you'll see in most businesses is that depending on the timing of the development cycle and where they are, you'll either have more capitalization or you'll have more expensing into that -- into the financial statements. And so that has been a part of this. I'll remind you that we actually did see cash compensation expense go up by almost 16% period-over-period.

So we continue to invest. But from a longer-term perspective, I think what I'd say about thoughts going forward is that we've just come out over the last year, 1.5 years of one of the most productive development cycles that we've seen in the company's history. We did significant enhancements to cloud and e-mail. We brought out PREVENT and HEAL. So in no way are we in a position where we are underinvesting. I'll remind everyone that we've always said that our R&D spend is going to be lower than most of the rest of the industry because things that the rest of our peer set have to spend money on maintaining their existing products with armies of people to do so, we don't have to do so because our product sort of maintains itself. However, if you think about investment in a broader sense across the company and the fact that the R&D group has produced a set of fabulous products and a set of things that we can push into the marketplace.

And by the way, have been one of the drivers behind the increase in upsells that we've seen over the past year or so. You can't invest everywhere at once. With all of those products and product enhancements coming out -- it's been incumbent upon us to really push a lot of our investment into the Go-To-Market and the marketing side to increase awareness and the ability of our business to get those products actually into the marketplace. Inevitably, once that engine is completely turning in the right way, investments will naturally flow back into the areas of R&D that interface with that and putting those as a primary driver for investment.

[Luk Janssens, executive]

Thank you for that, Cathy, and thank you, Charlie, for the questions. Operator, if we can have the next question, please?

[Operator]

Our next question is from Rahul Chopra at HSBC.

[Rahul Chopra, analyst]

Can you hear me? I have 2 questions. First is in terms of the Go-To-Market strategy. I mean, obviously, there's been a benefit from channel partners. Could you just give us a sense of what is the mix of new ARR coming from channel partners? And how you're thinking in terms of internal hiring process, given the increased focus on channel partners? That's the first question. Second, in terms of the net ARR growth has been -- you're guiding to positive net ARR growth in H2 24. Obviously, you have a lot of levers next year, you're talking about, again, channel market and focus on increased focus on strategic new accounts in the U.S. I just wanted to understand how you're thinking about net new additions as we go into 2025 in terms of the trajectory there?

[Poppy Gustafsson, executive]

Yes. Thanks for the question. How about I take it first because that's some levers to growth is sort of quite an interesting one. And then perhaps Cathy, you can sort of bring it up with any of the sort of financial detail that's needed. I am -- with the investments that we're making in the Go-To-Market organization, the ultimate ambition here is how do we scale to a business that is able to deliver on the growth ambitions of the organization without necessarily having to scale headcount alongside it.

So we're trying to decouple the growth from the headline growth. And the investments that we have made to the Go-To-Market have been all about putting those foundations in place. And whilst all the foundations have come in place, the returns we're going to expect to see at different times. And channel is one of them, but it's going to have a long-term sales longer term to deliver on some of that. So let me come to what you see in the near term. First of all, we needed to get better at that sort of upsell and cross-sell. And that's absolutely something that you're now starting to see pull-through in the numbers, particularly across Q2, where we had very strong sort of cross-sell opportunity. The second aspect to that is in terms of the U.S. market. It is a single biggest contributor to our ARR, but it's the single biggest market.

How do we make sure that we're getting more of that? So we have taken big steps to get the U.S. team really in place and really good management into that team, some really good leadership and some really good experience to recruit into that U.S. organization. And we're seeing that. The U.S. team as a whole is performing really well. I'm being really pleased with some of those early indications around their sales productivity. Channel. Now as -- sorry, another one, strategic. So this is going to have a slightly longer cycle. As you can expect, selling into a large organization has a sales cycle that is longer than an upsell to an existing customer.

Selling to strategic is something we have always done. It's always been part of our business, but I would love to see us be able to do more of it. So in terms of that strategic build, we're starting to have some really good conversations with some very significant customers. However, those customers will buy in a different way. It may be that we see shorter-term contracts at first that then roll into that bigger contract, which means that bigger contract will take longer for that to pull through into the ARR.

So we have not baked that expectation of an increase from strategics into our current guidance, but it's something that we would love to see through this calendar year. The last piece of that is channel. And I can hear your question saying, are you driving more through the channel yet? And the answer to that is no, and we wouldn't necessarily expect to see that shift reflected in our financial performance just yet. As a reminder, about 1/3 of the business that we do is indirect, but the relationships that we have with our channel partners are relatively tactical. So we use them as a mechanism to get access to that end user.

What we're investing in is to shift that relationship to be far more strategic, how do we support the partner in achieving their aspirations and then them driving a lot of that business without necessarily Darktrace having to do as much of that driving aspect. So with the passage of time, we would want to see more of that business coming through the channel, but it is not something that we would anticipate seeing in this fiscal for sure. And it's something that is much more of a longer-term investment. But with that, and in case of anything -- I'm not sure you want to back that up with Cathy and I will leave you to answer the second part.

[Catherine Graham, executive]

So I was just going to say I'll confirm that somewhere north of 1/3 of our revenue has a channel relationship. But over the past 6 to 9 months, particularly, we've done a significant expansion of our channel organization and really are refocusing from being, in many ways, an operational support for the sales group to co-sell with the channel to developing programs for a bunch of -- for key channel partners to actually sell independently and to work much -- to invest in us as we invest in that is probably the best way for have it.

Now you're not seeing a lot of this come through in increased channel participation yet because there's -- they've built out a lot of things that have some contingencies around some other work that we're doing around packaging and products and product benefits. And really, we need to dovetail those 2 things together. But this is short-term initiative of having those things come together such that the work that the channel group, the global channel organization has done to be able to create partner programs and develop partner relationships as we move into FY '25 can start to drive those things.

Now your other question was about ARR added, I think, going into FY '25. So I think the things that -- while we're not giving '25 guidance, and we really haven't talked about that yet, we are talking directionally about the fact that we have shifted that we are comfortable that we're seeing a reacceleration and a return to year-over-year growth in the second half of this year. We believe that continues into next year into our -- the second half of this calendar year and into our FY '25. I'll remind you that you should probably look at what the comps will be in those periods. -- because the improved performance and driving of new sales in addition to the stepped-up performance that we've had in upsell business. If you layer that over top of the comparables for particularly the second half of this calendar year, I think you would be answering your own question in terms of what we think directionally growth should return to.

[Luk Janssens, executive]

Great. Rahul, thank you for your question. Operator, can we have the next question, please?

[Operator]

Our next question is from Alex Short from Berenberg.

[Alexander James Short, analyst]

Two for me, please. So firstly, -- could you please provide a bit more detail around the significance of the FedRAMP in process designation. Clearly, there's direct potential benefits in terms of the opportunity for strategic deals in the federal space. Do you think it could also afford you estates in the market that could indirectly help drive strategic deals in the commercial space? And secondly, just a small one on churn. Regarding the effect of the COVID cohort turnover on churn, just to be clear, we should still expect a gradual increase in overall net retention rate despite that headwind, but just at a slower rate than would otherwise be the case. Is that correct?

[Catherine Graham, executive]

Let me start on that one. That was both -- with all of those questions. So on FedRAMP, -- what the designation that we announced on earlier this week indicates is that we have done all of the work and proven that we have done all of the work to be ready for the final audit, and that is the process into which we are going now. The signal that sends to the federal marketplace is that there is a defined now a defined timeline for when they could be purchasing FedRAMP products, FedRAMP-enabled and required product from us that is now inside of what they would expect that their sales cycle would be. So that's a very strong signal in value.

And by the way, it puts us in a club of very small number of FedRAMP high. There's a number of people who have FedRAMP medium, but to have FedRAMP high designations is actually limited and still rather limited in cybersecurity. So we're very pleased with the way that's going. We expect that with the work that we've done, we'll be on the shorter end of the timelines to get our full designation and certification rather than on the longer end. Does this have any impact on commercial strategic deals is sort of the second piece of that question? And the answer is it could.

There are a number of commercial customers and prospects that we have, who for their own commercial businesses or business that they do with various government agencies, need to have sort of the commercial equivalent of the FedRAMP high environment. And so the fact that we will have that in place does actually open doors for us on some strategic commercial opportunities.

And going to your last question, you asked about the churn and net dollar retention patterns going forward. What you're alluding to is the fact that we've said that over the next sort of 12 to 24 months, we may not see our -- particularly in that dollar retention, accelerate rapidly. And the reason for this has nothing to do with what will be performance in the current periods. We about 3 years ago, had a large cohort of contracts that were signed in the post-pandemic kind of pent-up demand period. And given our multiyear contract structure, these are now all coming up for renewal.

And similar to what we say -- what we've said about RPO and slow growth in RPO, just the absolute value of those contracts rolling through is going to make -- is going to, no matter even with improved performance, it's going to sort of tamp that down a little bit, probably for the rest of this calendar year and into -- maybe into the beginning of the following calendar year. But as those renewals sort of roll through we will then see a reacceleration. And again, the performance in this case will come before the metric increases, but it is not a result of anything that's happening today. It's the result of something that happened 3 years ago.

[Luk Janssens, executive]

Great. Alex, thank you for your question. Operator, if we could take the next question, please?

[Operator]

Our next question is from Michael Briest at UBS.

[Michael Briest, analyst]

Yes. Great. And congratulations. A question on the commission changes that you've launched this year. I think, Cathy, you said in the full year numbers, there will be about a 3 percentage point impact on margins. There's a new number that's in the report, the commission expense, which I don't know if this is the right number way to look at it, but it's about 15% of sales and last year, it was 14%. So from that, should we conclude that the effect is less.

Maybe you could explain that number in the context of -- does it include the capitalization and amortization effects? Is it before them? It's just a number that needs some context. And then Poppy, just on the sort of success with cross-sell and upsell, it seems to be improving. You didn't give a percentage of customers with 4-plus products. So as far as I can see in the deck this year or in the presentation. Maybe you can give some commentary, at least around PREVENT and HEAL. And if you can update us on that number would be great.

[Catherine Graham, executive]

Let me take your question -- your first question first, Michael. With regard to commissions, if you look at that expense line, you could see actually 3 lines in that table. There is a capitalized number as well. But let me remind everyone what's happening here, which is that on the expense, what we're doing is we've changed the way we pay and deal with the commissions right through P&L from basically paying 50% upfront 50% after 1 year to paying 100% upfront. What that means is that instead of under our prior plans where we capitalized 50% of commissions and expensed 50% over 1 year.

We are now capitalizing 100% and writing those off expensing them generally over 3 years. So there's a bit of non-normal in those commission calculations this year because what we have in commission expense this year is effectively 1/3 of FY '24 commissions flowing through and half of -- half of 50% effectively -- or 50% of the prior year's commissions flowing through in that expense.

So the best way to sort of tell you how to look at it separately is if you were to look at that expense number, Michael, you should think about in FY '24 expense, somewhere in the neighborhood of, say, 35% of that expense is from prior year periods, old commission plans that are still running through the FY '24 books. -- in a full expense fashion. They were -- that's the second half that didn't use to get capitalized. That will go away basically by the end of the first quarter of FY '25, and you'll start to see more normalized expense again on the commission side.

The -- you won't get to full normalization until FY '26, sort of when those plans have been the new plan structures have been in place for 3 years in their third year. The other thing that I'll warn you about and that you should just take into consideration is that one of the things that we did as a part of the entire sort of compensation restructuring was not just commissions, but there was a shift -- there was a shift from more commission, less base salary to a more balanced, so base salaries went up and commission opportunity went down a little bit.

In the long run, you should expect to see commissions as a percentage of revenue come down just a bit because more of these salespeople's compensations have been moved into fixed compensation, but start to look for normalization at the end of this calendar year and through full normalization in 2026.

[Poppy Gustafsson, executive]

And then Michael, the second part of your question was about product adoption and why we not disclose why more for why the percentage of customers taking 4 or more products in the way that we used to -- very simple answer to the question of that, in that all of that Go-To-Market investment, we've made the next stage of that cascading down is, of course, with our brilliant CMO, Chris Kozup, and he's just finessing the final parts of the positioning, the products and platform adoption and just doing a little bit of product work, which we will be very keen to show you our launch on April 9, if you are interested.

So we're just conscious that we want to marry up those disclosures in line with a lot of that product positioning. But if I can, I can just give you a little bit of a voice over on some of those works, just to give you the assurance that it's going phenomenally well. And of course, that R&D that we look back on being one of the biggest in our history is, of course, reflected in the way that our customers are buying as well. I think I'll come to Max specifically talk about HEAL in a moment. But what you see is that now one of the biggest drivers in terms of new and upsell ARR is a lot of the products that -- like e-mail and cloud that are contributing a big part of driving that.

And as we launch new products like PREVENT and HEAL, we see them following in that sort of product adoption that you do in the likes of e-mail, which is, of course, now one of our big dominant drivers of a lot of our ARR achievement. So it's going very positively. It's all trending in the right direction. We feel very encouraged by that. I encourage you to dial in on the April 9, just for a little bit of tidying up around the positioning and productization of some of those. But with that, Max, I don't know if you want to touch anything further on there?

[Maximilian Heinemeyer, executive]

Yes. Just a bit of color around that, I think. We see that customers are really starting to think their teeth into PREVENT and HEAL and particularly because they're hungering for becoming more proactive. -- we see that a big part of the industry is so focused on detection and response on that always eternal game of [ wake 'em all ], finding a threat and then shutting it down, that customers really want to step out of this vicious cycle and want to become proactive to minimize the chance of disruption before and maximize stopping threats and adversaries as much as they can before the incident even happens. And as the market is starting to adopt this proactive mindset and is baking that into their ideas of how to run good security, we see that both HEAL and PREVENT are in great positions, especially HEAL with incident preparedness or your people, your processes and your technology.

[Luk Janssens, executive]

Thank you for your questions, Michael. Operator, if we can have the next question, please?

[Operator]

Our next question is from Rob Owens at Piper Sandler.

[Robbie Owens, analyst]

Great. Curious on the strategic customer front. And I guess, realizing it's still early in this life cycle. Maybe you can compare and contrast what you're seeing through strategic customers versus the mid-market velocity business here as you exit the half year? And then for a second question, I also realize it's pretty new here with your cloud solution, just how attach rates have been conversations with customers as you look to get more holistic visibility across the customers' environment.

[Poppy Gustafsson, executive]

Thank you. Let me take that. And Rob, I think, to you. So strategic deals and the velocity there. And is it a shift from your sort of typical mid-market customer I think we're going to -- I'm just going to reiterate the point that we have always sold into the strategic market. So it's always been a part of what we do. What we're trying to achieve is that it's going to become more of what we do. So this isn't wholesale new, it's just driving more of our new customers from that strategic part of the market. And the reality is, it is different to enterprise. I think it's both in terms of the teams and structure that you have to support those organizations, which is reflected in the Go-To-Market investments that we have been made in terms of growing out those teams, but also in terms of the cycle.

So firstly, it is a longer sales cycle. I would love to do the strategic deals in the same quick cycle that we do the rest of it, but I think that's pretty unrealistic. But what you do see as well is you're much less likely to be able to land the full product set from day one.[ Break ] And it's just on real estate side, where you're talking to about cloud architects, you were talking to e-mail security professionals. You're talking to network security professionals. There's a number of individuals that you need to bring alongside. So for those strategic deals, I think you will see much more of this sort of land and expand motion rather than just the lands, lands, lands that you're perhaps used to in terms of our mid-market business.

So we are undertaking all of the investments necessary to achieve that. You see that in things like the account mapping and the building out of the customer success and technical presales and the technical specialists to support those deals. In the terms of what are we seeing, you're absolutely correct, not to include any expectation of that expansion of strategic deals this fiscal year. We certainly not included that in any of our guidance. but we are encouraged with the early signs.

We are encouraged with the quality of the conversations that we're having with large strategic accounts and we're getting the early signs of those smaller deployments that will potentially lead on to bigger deployments in the future. So feel encouraged, but not yet going to be recording as in the numbers for the 6 months ahead of us. In terms of the second half of your question... Cloud product, that's probably a Max question. Max, over to you.

[Maximilian Heinemeyer, executive]

Absolutely. Great question there, Rob. Thank you. So in terms of a new cloud product, while it's too early to share any numbers. Let me give some commentary on Nuclear products there. And let me start by reminding everybody that we love the trajectory that our cloud product is taking that PREVENT in HEAL and that we saw in ENA, which by the way, we launched in 2018 that might only be of our biggest growth drivers at the moment. So it's always about compounding on what we have and seeing these products going to fruition over time. But what I can absolutely say is that cloud security remains a hot topic for organization as digitization continues and cloud space, the top priority for CIOs and CISOs.

And I've been personally talking to a lot of our customers on new cloud capabilities in the last weeks and months on the front lines. What I can share is that organizations we talk to do view our new cloud capabilities as highly interesting. Their cloud security needs have not been fulfilled by existing products to completion, particularly the need for combining visibility on misconfigurations, good real-time threat detection response is something that our product is receiving great feedback on. It does blend several capabilities that are usually seen and purchased in different product silos. And that's where we help customers cut through the alphabet soup in the cloud as they do realize that CSPM security management is just not enough.

Customers love the architecture visibility we do provide and also the combination of various capabilities that are usually segmented in different products in the cloud. And let's also not forget at the end of this bit of commentary that while we just released a significant new upgrade to our cloud capabilities, we had cloud detection response for several years. So we've been building on our cloud expertise in the visibility, detection and response area. I'd say that having our AI provide deep business and IT context does help our customers become more proactive instead of just waiting for the incident to happen.

[Luk Janssens, executive]

Thanks for adding that color Max. And Rob, we appreciate you getting up at 4:30 this morning to join us for this call live. Thank you very much. Operator, we'll take the next question, please?

[Operator]

Our next question is from Victor Cheng at Bank of America.

[Hin Fung Cheng, analyst]

Congrats on maybe going on to the FedRAMP program. I mean you've talked a lot about the opportunities there. Maybe if we think about the cost side, is there any impact in terms of the cost to the certification process and the long-term running cost to run maybe infrastructure in a separate environment. And secondly, just thinking about pricing as well, -- can you talk a bit about how much growth has been from pricing? Or what's the opportunity going forward as well in this regard?

[Catherine Graham, executive]

So let me take the FedRAMP piece. So yes, there have been significant costs to get our federal division to the point at which it is. But we always knew that and have essentially budgeted for probably 3 years of investment before we started to see any return. And that was just something that we built into our expectations in the very beginning and feel as though we are on track with the investments that we have made and are going to get out of this.

With regard to ongoing running costs of that, actually, what we see is that they won't be materially different than the running cost of your typical commercial organization. We will have to incur some separate costs that probably will have to scale up ahead, but it shouldn't be material in the context of Darktrace. And the pricing in the federal market is generally adjusted to be able to cover those sort of additional -- it's not necessarily administrative but additional structural costs in the federal market. So we don't anticipate that, that's a market where we're going to having a big disconnect between where we are today and what we would be producing at full run. Great.

[Luk Janssens, executive]

Thank you for your question, Victor. Operator, may we have the next question, please?

[Catherine Graham, executive]

He had one more. On pricing. Yes. So one of the things that you asked about, Victor, you can see one of the things that we don't sort of really discuss is pricing of individual products. And the reason for this is because there are so many factors that discount or really influence where a customer will come out multiple products within the platform, sizes, sizes of deployments and all of those things. Further, we are doing with the product positioning work, a bunch of pricing work as well.

So I think that you can imagine that we're looking at whether or not there are places in our market where we could be able to operationalize that a little bit better. But you can probably also see that given where our net dollar retention is -- it's not really possible that we've been driving just -- driving anything by just price increases. I think from our commentary, you should think that we do think this is an opportunity for us as opposed to anything that will be a drag going forward.

[Luk Janssens, executive]

Thanks for clarifying that, Cathy, I'm sorry to cut off the last question. Thank you, Victor. Operator, can we have the next question, please?

[Operator]

Our next question is from Ben Barringer at QVC.

[Ben Barringer, analyst]

Can you hear me?

[Luk Janssens, executive]

Yes, we can hear you, Ben. Operator, why don't we try Ben again? Have we got another question in the queue? And then can we come back to him, please? Yes, of course.

[Operator]

Our next question is from David Vignon from Stifel.

[David Vignon, analyst]

I have a follow-up on the U.S. Federal business. Could you give us some color on the size of the opportunity for that trades in that market? What kind of contract size can we expect other trades in the future? And on that as well, are you now investing more in building a larger team in the U.S. Federal business now that you have are getting closed at least towards the full-fledged federal designation? And the second question is on the U.S. business as well. Can you quantify the share of net new pay that is coming from the U.S. in FedRAMP?

[Catherine Graham, executive]

Let me start with the FedRAMP question and the federal environment. So it's got a lot of similarities to what we've discussed in terms of strategic -- the strategic opportunities and the strategic market, which is that it is -- it's a long sales cycle. And for some period of time, will be quite young people, right? And so we don't try and forecast at this point, putting a lot of revenue in from that simply because you don't know in what size, in what period and for how long those contracts would be. That is a market where you can have contracts that run anywhere from 1 year at several hundred thousand dollars a year to 10 years at hundreds of millions of dollars a year. So it is a very, very large market, and it has the potential for some very serious sizes of deals.

That said, as a new entrant to that market, we would expect to be doing something that's very common in the sort of government marketplace, which is to be acting as a part of a consortium or a group of companies delivering pieces of a solution and that we would not be the recipient of all of the contract value in something. But again, what I'm going to say is we do have, as we said in that release, we do actually have some of our technology operating in existing smaller agency customers and in what I would say are proofs of concept value and trials in some of the larger potential customers. So we feel very, very good about it, but it is lumpy and unpredictable. So I'd urge you not to put those kinds of things in.

As far as ARR in the U.S. goes, we don't split it out. You'll see it more on the revenue side, which you can see and given our subscription model, this shouldn't be surprising to you. It's gone up as a percent of revenue, about 0.4%. 0.4% over the last year. But a small growth in that shouldn't be very surprising to you given the structure. The better way for me to give context for you as to what's happened there is to say that in both -- in the macroeconomic environment and in the changes that we made ourselves at the beginning of this year. The U.S. was the hardest hit, and it has come back to a more sort of typical level, it is the fastest. So it got the hardest hit and it's made the most progress.

So -- and there's a lot of reasons for that. It's where the competition tends to live and therefore -- and a lot of -- and the large market opportunity, there were periods of time where we were talking about competitors poaching our salespeople and sales management so that we had much shorter tenure of salespeople in the U.S. and as we all know the longer the tenure, the more effective the salesperson. So we've seen an awful lot of progress in that. We would expect to see that continue to play out through it. But at this point, we're not going to break it up by ARR.

[Luk Janssens, executive]

David, thank you for your questions. Operator, could we have the following question, please?

[Operator]

Our next question is from Ben Barringer from QVC.

[Ben Barringer, analyst]

Let's try again, shall we. Can you hear me okay?

[Luk Janssens, executive]

Loud and clear.

[Ben Barringer, analyst]

Great stuff. I wanted to double-click on George and Charlie's questions. First of all, around the Palo Alto commentary. Specifically, they talked about fatigue in the market. So I'd like you to comment on that. And then second of all, the implication of their bundling strategy is some pricing pressure. So I'd just be interested in your comments there. And then I've got a second one for...

[Poppy Gustafsson, executive]

Yes, let me take that. Thanks, Ben. So fatigue in the market is Palo's fatigue affecting Darktrace. And the answer is no. I think we've talked about the performance that we've seen has shown an improved momentum from Q2 to Q1. And that is the consequence of actions that we have taken is off the back of our investments in our Go-To-Market and that is driving that momentum. We've historically talked about the macro, what sort of 18 months ago when we commented on the fact that it had softened, but it has subsequently stabilized. And as far as we're concerned and baked into the guidance as we look out for the rest of the year, we've just assumed that this is what the macro situation looks like.

If it improves great, but we're not relying that in order to deliver our results. In terms of the competitive and whether we're seeing any pricing pressures and reflecting us into an organization, -- we're not seeing that. We're seeing the ARR that we're generating on a per customer basis is going up. But I remind you that we are not competing with the Palo Altos and the CrowdStrikes, and the Microsofts in the world. In fact, Microsoft is a very significant partner of ours. And we are a business that deploys alongside a lot of all of those products each and every day. So whilst there is a bit of ebb and flow, as those 3 big vendors compete to consumers much sort of attack data as they possibly can and take market share from one another. That's not a dynamic that we see read across into our organization.

[Luk Janssens, executive]

Great. And your second question for Cathy, what was that, Ben?

[Ben Barringer, analyst]

Sure. So we are rapidly approaching the steady -- the medium term, steady-state model. And so it's more like a short-term steady-state model. I talk to me a little bit about your thoughts on updating that and if you're obviously not going to give us an update now. Talk to me about the buckets of cost within that and where you see the largest room to push and maybe go higher than that mid-20...

[Catherine Graham, executive]

Sure. So first, let me start by saying thank you. We actually have made tremendous progress on our profitability over the last 3 years since coming to the market. And by the way, have done so well making some tremendous investments in the future. So we're actually very, very proud of that. And as I said earlier in this call, I'll point out that we believe that our contract economics, sort of steady -- our standard contract economics continue to be strong. We haven't seen them erode. And so if they are above where we are today, we do believe that there is room to move forward to move this quarter.

This is something we assess on a regular basis. But we're coming out of a big period of change, then than we kind of want to see how that goes. Is it possible that at some point, we will reassess and change where we believe our steady-state margins are. Yes. But for all the reasons that we've talked about, that the changes that we've made, what the next generation of investment in R&D is what is happening in the marketplace. -- now would not be the time for us to be doing those kinds of changes.

[Luk Janssens, executive]

Great. Thanks for your questions, Ben, and we also enjoyed your Darktrace quote in the standard newspaper this morning. So thank you for that. Operator, can we take the next question, please?

[Operator]

Our next question is from Harvey Robinson at Panmure Gordon.

[Harvey Robinson, analyst]

Ben asked one of my questions. A second follow-up question for me really is if you look at are comments on SIEM, it sounds like they're making some pretty strong progress there. Could you just talk to how that gets with what you're seeing? Because I noted that the Analyst Day you held your cyber AI analyst was a core product for you?

[Maximilian Heinemeyer, executive]

I'm by to take that. I assume the last bit was just noise on the background. So let me be super clear that our Cyber AI analyst, our investigative AI is not a competitive product to any of the other products we're seeing out there in the market at the moment, not XIM, not MDR or XDR solutions. All of these solutions focus in one way or another on consolidating the big data problem of understanding the threat landscape from a known bad perspective, EXIM from a next-generation SIM perspective, XDR from consolidating that non-bad problem via different data sources.

That is not what the AI analyst is doing -- the problem we are addressing with the AI analyst is by using cognitive AI automation to really automate that human aspect of investigations, not finding evil, but then taking the next step to understand an investigation dig into the data. So I wouldn't say what they are doing with innovating that legacy environment of SIM is affecting us in any way, shape or form years. So we're not competing with them. This is not something where we struggle for budget lines against each other.

[Harvey Robinson, analyst]

And a follow-up question. Just ask a follow-up question on the cash position. I mean, obviously, margins are doing very well and cash is going to go through very nicely. You've obviously done some buybacks in the past. Is there a sort of a steady rate of cash you think you need to have on the balance sheet, i.e., is the retention for a much bigger capital return at some point?

[Catherine Graham, executive]

Yes. Certainly. So obviously, I'm a CFO, I like cash on the balance sheet, particularly in uncertain times. It's nice to be in a position where we did not over the past year, 1.5 years, have to make any trim backs. We simply kept investing and capped as you've now been generating cash on that. There are sort of opportunities for us to continue to do buybacks. We also like having sort of the dry powder available to do things that are more strategic. At this point in the market cycle, we are probably seeing more opportunities come across our desk for people who are in a position where they're having to make a decision about the capital structure or ownership of their businesses going forward.

You can probably tell that we're pretty picky as we've only done one acquisition in our history. But we do continue to look for things that would particularly be interesting from a technology standpoint, either because it's a technology that we don't internally have -- we could develop the core competency in but could get to market a lot faster if we did something. And honestly, I think we like to keep our options open on that to be able to act quickly. And so at this point, I mean, I think that we're going to say that we're not planning a large return of capital in any way we have uses for these things. But we continue to assess our cash balances and potential uses going forward.

[Luk Janssens, executive]

Harvey, thank you for your question. We have 3 more people to rattle through. I want to be conscious of everybody's time. If we could limit the next question, just one question each. Operator, can we have the next question, please?

[Operator]

Our next question is from Patrick O'Donnell at Goodbody.

[Patrick O'Donnell, analyst]

I'll stick to one question as well. So it's about the partnership with the Danish government body. It might be one for you, Max, but looking to see the potential for further replication of that across government bodies and obviously, within the Danish sort of government, but you've gone from sort of the tax authority with a pretty meaningful contract, it looks like. And I'm just trying to see, can that be rolled out further? What's the scale of that? What's the potential optionality with the governments and the European side?

[Poppy Gustafsson, executive]

Shall I touch on this one quickly. So what you're referring to there is an announcement with a customer, which we've disclosed and published is obviously, in particular to this customer, and there's something a press release there that's available on our website, so anyone to take a look at this. Public bodies, such as the Danish Tax Authority has always been part of our customer base. And we talked earlier about everything that we're doing with FedRAMP and really expanding out a lot of those activities with those government bodies. But I do just want to take this moment to remind you that we have an incredibly diverse customer base and organizations such as the Danish tax authority is an example of that preexisting public body customer base that we have. That said, we're very pleased with that particular account. It's something that we talk to about public, and I'll point everyone's attention to having a look at that on our website.

[Luk Janssens, executive]

Patrick, thank you very much. Operator, we'll take the next question, please?

[Operator]

Our next question is from Andrew Ripper at Liberum.

[Andrew Ripper, analyst]

Yes. Can you hear me okay?

[Luk Janssens, executive]

Perfect.

[Andrew Ripper, analyst]

Just going back to upselling. You said that ARR for existing customers is up 12%. Just wondering in terms of how you drove that was that sort of direction from the leadership? Or did you actually change sales incentives to encourage that?

[Catherine Graham, executive]

The answer is yes and yes. So over the past year, when it was more difficult to get people to a year, 1.5 years to get people to trial software that they didn't believe they had budget for. It was easier to get them to expand their relationship and to take on additional protection with existing customers than it was to get new customers or new prospects to trial the software to start with. So that was directionally the piece from the top. We did, at the beginning of this year, actually put in incentives in compensation plans to put people a bit more focus on the upsell relationship.

So it was something that we wanted to do through this year. We had always, through most of our history, then you'll remember the terms we use land, land, land, and we needed to start building that muscle. So it was a combination of both direction from the top and the incentive plans to back that up. And I believe that what you should think about sort of in the more medium to longer term is that we try and go back to more of a balance on that over time.

[Luk Janssens, executive]

Thanks for your question, Andrew. Operator, we'll take the final question, please.

[Operator]

Our final question is from Nehal Chokshi at Northland Capital.

[Nehal Chokshi, analyst]

Congratulations on the strong bottom line results. Poppy, you mentioned that U.S. SME conversion rates have improved. A couple of questions on that. First, when you're talking about conversion rates, does that include land and expand or just land deals? And then has this metric improved while, let's say, the pipeline dollar per SME salesperson has at least stayed constant or increased?

[Poppy Gustafsson, executive]

Yes. Let me start by second that, and then I'm going to defer to Cathy just to make sure that she marks my mathematics homework. So what we're talking about here is -- to Cathy's point earlier, we want a more productive and more effective sales organization. And a great way to do that is by making sure we attract the best talent, but then we retain them. And hence, Cathy's comments talking about the tenure. And where we've seen a particular market improvement is retaining those brilliant people within our U.S. organization.

And as a consequence of that, we are able to identify that the productivity of levels of those organizations is improved compared to an organization that has a shorter average tenure. So that's the measure that we're referring to is not necessarily divided between that new and upsell. It's the overall productivity, the overall contribution of those quota carriers within the organization. But to add a little bit more detail, I'm going to turn to Cathy.

[Catherine Graham, executive]

Yes. So let's pull that apart just a little bit. Over sort of a 12- to 18-month period, you saw productivity fall off in terms of new. Not so much that not so much the conversion rates were different. It's just there was less business to be had. And so there was that shift to upsells. What we've seen, particularly in the U.S. market that Poppy was talking about is that production in the U.S. has sort of come back up to where it was in those pre-periods not entirely on new. But to the point where in aggregate, we're seeing production having come back, and that's -- that's a good sign.

Now the challenge for us is to continue to accelerate the new. And frankly, that's more of a lag issue than it is what's going on in the business today issue. If you think particularly, let's just talk about the middle of our marketplace, you've got a sort of 3-, 4-, 5-month sales cycle. You've had people who were focusing on upsells, so not building as much of a pipeline, there was not as much of a pipeline available to build. Now that there's some normalization there, it will take a while for that pipeline to get built and work through. So I think you just have to keep in mind that from a productivity standpoint, there's a bit of a lag that we think you'll see come through as we work through the second half.

[Luk Janssens, executive]

Thank you. Nehal, thanks for your question. And that concludes our earnings call. We appreciate everyone joining us today. On behalf of Poppy, Cathy, Max and the entire team at Darktrace, I want to thank you for your ongoing support and interest. Hopefully, you can feel the enthusiasm from this team about the quarters ahead. Kitty and I would love to hear of the new format of this analyst and investor call is preferred. So do drop us a line about that.

We certainly enjoyed the engaging Q&A with everybody today. We look forward to seeing many of you on the management roadshow over the coming days, and I'm also taking numerous members of the leadership team to conferences in the coming weeks and months, and we look forward to seeing you there. Catalyst wise, it would be great to have you join us the launch of Darktrace live on the 9th of April, a virtual event you can register for. And also in April, we'll publish our usual fiscal Q3 trading update. That concludes our call. Thank you very much.