Coveo Solutions Inc

TSX:CVO

Earnings Call Transcript 2024-Q1

[Operator]

Good afternoon. My name is Jenny, and I will be your conference operator today. At this time, I would like to welcome everyone to the Coveo First Quarter Fiscal 2024 Financial Results Conference Call. [Operator Instructions] Mr. Moon, you may begin your conference.

[Paul Moon, executive]

Good afternoon, and thank you for joining us today. With me on the call are Louis Tetu, Coveo's Chairman and Chief Executive Officer; and Brandon Nussey, Chief Financial Officer of Coveo.Before we get started, I would like to note that certain statements made during this conference call are forward-looking statements within the meaning of applicable securities laws, including those regarding our plans, objectives, expected performance and our outlook for the second quarter and fiscal year 2024. These forward-looking statements are given as of the date of this call, and while we believe any statements we make are reasonable, they are based on current expectations, which are subject to risks and uncertainties, and actual results could differ materially. We do not undertake and expressly disclaim any obligation to update our forward-looking statements, whether because of new information, future events or otherwise. Further information on factors that could affect the company's financial results is included in filings we make with Canadian securities regulators, including under the section titled Risk Factors in the company's most recently filed annual information form, which is available under our SEDAR-plus profile at www.sedar.ca.Additionally, some of the financial measures and ratios discussed on this call are either non-IFRS measures or operating metrics used in our industry. A discussion on why we use these results, and where applicable, the reconciliation schedule showing IFRS versus not-IFRS results, are available in our press release and our MD&A issued today, which may be found on our Investor Relations website at ir.coveo.com and our SEDAR-plus profile. Please note that unless otherwise stated, all references to financial figures are in U.S. dollars. Lastly, slides accompanying this conference call are available for viewing and accessible on our IR website under the News & Events section.I will now turn the call over to Louis to begin. Louis?

[Louis Tetu, executive]

Thank you, Paul, and thank you all for joining us today. I'm very excited to share with all of you the significant progress we've made during the quarter on many fronts. Last quarter, we announced our Coveo Relevance Generative Answering capability, a powerful and natural extension of our industry-leading solutions that combine large language model technology with the secure indexing and relevance capabilities of the Coveo Relevance Cloud AI platform. We saw unprecedented demand for this capability, particularly among our existing enterprise customers seeking to incorporate generative AI solutions that are secure, accurate and trusted. I am pleased to report that this demand has further accelerated in the first quarter, and we have launched our design partner and advisory group program with a total of 45 enterprise customers, including companies such as Informatica, Synopsys, VMware, Xero Software and Zoom communication.Our first quarter SaaS subscription and total revenue grew 20% and 16%, respectively, both on a constant currency basis. Adjusted operating loss for Q1 was $2.8 million compared to $7.5 million last year, coming in well ahead of our guidance and representing a significant year-over-year improvement. I'm also pleased to report that we are improving our adjusted operating loss guidance for the fiscal year, while reiterating our full year revenue guidance.In addition to these exciting developments with Coveo Relevance Generative Answering and our financial results in Q1, we had multiple 6-figure net new land transactions with SAP Commerce customers, and bookings with Salesforce customers came in ahead of our expectations. Additionally, we had a record quarter in terms of both total and SAP Commerce pipeline generation. While we remain optimistic due to these positive developments, we continue to experience a macroeconomic environment that is similarly challenging to last quarter, in particular for sales conversion with new customers.During our last conference call, I spent a lot of time discussing the recent breakthroughs of generative AI and the immense potential of using large language models, or LLMs, within enterprises. Importantly, I emphasized the existing shortcomings of many solutions in terms of accuracy, content currency, security and cost and presented how Coveo Relevance Generative Answering can effectively overcome these challenges. Our enterprise clients' brands cannot hallucinate in answering their customers and stakeholders. Security cannot be compromised. And the content needed to feed generative AI comes from multiple sources. By combining LLMs with our leading Coveo Relevance Cloud AI platform, we can address critical enterprise use cases as we ensure secure consolidation of content and delivery of precise, contextually relevant information to end users.In essence, Coveo Relevance Generative Answering is a natural extension of our commitment to power the most trusted digital experiences for enterprises because we own the software stack necessary to handle the real-time unified indexing, security, precision and relevance all necessary to feed generative AI at a global scale. For the enterprise generative AI use cases we see, we believe that the prompt engineering and grounding we provide is a critical element, and we are just scratching the surface of its potential.With the customer-facing events we have organized so far, including webinars and one-on-one meetings, -- we have recently showcased our groundbreaking Coveo Relevance Answering solution to more than 600 people across hundreds of enterprises, many of them CIOs and senior IT and digital leaders among the top 200 companies within the Forbes Global 2000. Due to the high demand, we have additional customer meetings and demos planned for the rest of the summer and into the fall. The feedback from these meetings has been unequivocal. With Coveo Relevance Generative Answering, we are addressing the most pressing challenges discussed at the executive, Board and IT levels of an organization and where stakeholder pressure is felt the most. And with a recent CNBC survey published online on June 23, indicating that nearly half of tech spend from companies is going into AI, enterprises have the added pressure of evaluating and selecting the right solutions with fast time to value that will show positive results.Since launching our Coveo Relevance Generative Answering beta program in June, we've seen an overwhelming response from our existing customers looking to leverage our AI platform, expertise and trusted partnership to collaborate on effective solutions. As I mentioned previously, we have carefully selected a total of 45 customers to be part of our early access program, including 20 premier and standard design partners, along with 25 customers in our Coveo Relevance Generative Answering advisory group. Additionally, a number of other customers have expressed a keen interest in our product as part of our early access program. As per the current time line, our 20 design partners can expect staggered product access during this quarter with the advisory group receiving product access starting in the fall, followed by general availability during fiscal 2024. To encourage early adoption, we are offering attractive pricing for Coveo Relevance Generative Answering with long-term pricing expected to be launched later this fiscal year.With Coveo Relevance Generative Answering, we have started with service, workplace and website use cases, which are an immediate fit for the solution. We also see an interest in relevant generative answering from Commerce customers will require a combination of catalog and rich content search. As we've done with almost all of the solutions we provide to our customers, Coveo is customer zero for Coveo Relevance Generative Answering, which went live on our customer documentation site on July 19. This creates a secure, accurate and relevant generative AI experience to help improve the ability of Coveo users and customers to self-serve by providing direct written answers generated in response to question and links to the relevant source documentation, both integrated with the full power and security of Coveo AI-powered search and navigation.The strength of our Coveo Relevance Cloud AI platform is our ability to index and securely unify disparate sources of content and understand the intent of each user. Our search and recommendations capabilities and the ability to do true 1-to-1 personalization securely, a differentiator of the Coveo Relevance Cloud AI platform, becomes the key foundation for what we're doing in Coveo Relevance Generative Answering. This is an AI platform we have been developing for over a decade and continues to be why we believe we are uniquely positioned to be one of the first companies to solve the challenges of providing generative AI solutions that enterprises can trust at scale.A final thought on perhaps the most critical factor in successfully deploying Coveo Relevance Generative Answering for our enterprise customers is cost. As many of you have likely seen, some of the large software companies have released pricing for their CoPilot generative AI solutions, which result in at least a 50% increase in price for customers. Similarly, any existing Coveo customer adding relevant generative answering will trigger an upsell and increase their ACV. However, at Coveo, we believe we are uniquely positioned with a technical approach that effectively addresses this concern by offering a cost effective solution for managing LLM adoption. By limiting the corpus of information fed to the LLM, exploring the use of different LLM, managing the prompt size and answer lens according to specific use cases, utilizing pre-selected queries and employing various other strategies, we enable our customers to access the benefits of generative AI commensurate with the cost, ensuring a high ROI.Before moving on from the topic of Coveo Relevance Generative Answering, I would be remiss not to mention our recent win at the 2023 AI Breakthrough Awards, where our Smart Snippets feature, which we introduced back in 2021, won for Best LLM Application. Utilizing Coveo's AI platform alongside an LLM framework, Smart Snippets interprets user quarries and provides the most relevant paragraph for answer without requiring users to click through links. As we've said previously, we have been working with LLMs long before they became a buzzword this year, and we believe this award further reinforces our AI leadership.From a go-to-market perspective, we believe we have the right partners in place to pursue our growth ambition. As an SAP endorsed app, Coveo is not just a partner, but the partner of choice globally for SAP Commerce customers who require best-of-breed AI-powered search and recommendation solutions to help them compete with digital experience leaders. And with SAP's go-to-market teams fully aligned with ours, and the advantage of full commission and quota relief for their sales personnel for selling Caveo products, we have a significant opportunity to co-sell alongside their global sales team. SAP serves 96% of the largest 2,000 enterprises globally and has the largest e-commerce enterprise installed base as measured by gross merchandise value, valued at more than $1.5 trillion across both B2C and B2B customers.In our service line of business, Salesforce remains an important partner and customer given their global reach and undeniable success. As a Salesforce Summit ISVforce partner, we stand among the top 1% of partners within their ecosystem, dedicated to delivering innovative service solutions to enterprises worldwide. Through various customer engagements, including those related to generative AI for service, we actively participate in major events like Salesforce's Dreamforce to communicate and demonstrate how our complementary solutions drive value for our customers. And recently, Coveo became an Adobe Gold partner, which provides us access to technical expertise as well as program and marketing resources that can help drive our business with Adobe customers in our website line of business. We are pleased with this expanding partnership in which our platform scalability and rapid time to value has helped to set us apart with many joint enterprise customers.We had a number of exciting wins during the quarter. In commerce, we won significant new work with one of the largest wine and spirits distributors in the U.S. This customer had previously launched their own B2B commerce portal that had a subpar search experience, and they realized this would negatively impact their business in the long run. After a competitive process involving other competitive package solutions with a bias towards one particular provider and build-it-yourself tools, we ultimately won due to 3 key factors. First, the maturity of our enterprise AI platform. Second, our unique ability to handle the complexity of their B2B catalog. And third, our strong partnership with SAP. By implementing Coveo, this customer expects to significantly improve product search relevancy, reducing the time and effort customers need to build orders, leading to increased adoption, revenue growth and the ability to leverage product and content recommendations for upselling and cross-selling. Future plans include extending Coveo to their sales portal to benefit internal sales staff and enhance customer support.Also in commerce, we won new work with a pioneer in the automotive industry with a global presence in wholesale, retail and franchise operations, offering products from top brands, supply chain services and automotive maintenance. We demonstrated the value of our mature AI infrastructure through a business value assessment that highlighted the rapid time to value that Coveo could offer. With Coveo, the customer can easily scale its search functionality across various brands and use cases while managing everything through a single platform and index. We demonstrated how Coveo was the only suitable solution to support search in their intricate B2B environment, including complex catalogs and customer entitlements.In service, we recently secured a significant project with a permanent leader in higher education for search and knowledge management and to improve end user proficiency. Our success in winning against a search-as-a-service provider can be attributed to our trusted partnership with Salesforce, superior technical and AI capabilities and the ability to reduce resource maintenance. The customer recognized the value we bring through improved customer and employee experiences, particularly in enhancing self-service proficiency and agent interactions for students and staff.Finally, we won a significant workplace contract with a leading financial services company, specializing in investment advice and retirement planning. During the competitive process where several providers were evaluated, we won the contract by demonstrating Coveo's maturity as a leading AI SaaS solution with a strong focus on user experience. Coveo's value proposition centered on relevant workplace search for their extensive employee base of over 50,000 people with a primary focus on enhancing the experience for approximately 20,000 financial advisors and supporting office admin. Collectively, these customers have recognized the value of our leading platform and that working with Coveo is a subscription to AI innovation and a strong on-ramp for enterprises seeking to deploy our innovative and high ROI offerings quickly and securely.With that, I will now hand the call over to Brandon to discuss our quarterly results in more detail. Brandon?

[Brandon Nussey, executive]

Thank you, Louis, and thanks again for everyone for joining us on our first quarter conference call. Before I get into the details, I'd like to quickly summarize the main highlights and takeaways for the quarter.We delivered 20% constant currency growth in SaaS subscription revenue for the quarter, which was ahead of our guidance. Product gross margins improved 200 basis points to 83% on an adjusted basis, which I view as best-in-class and a great long-term indicator of the profitability of our model. We delivered significant improvement in adjusted operating loss that was well ahead of our guidance at prior year levels, owing to our ongoing focus on efficiency. We are improving our adjusted operating loss guidance for the year and remain well on track to be cash flow positive in our next fiscal year.We saw a record pipeline generation in Q1 in the aggregate, excluding any impact from Coveo Relevance Generative Answering, which has just started to hit our pipeline numbers in the current quarter. As Louis mentioned, the early signs of demand are promising. Our SAP partnership also continues to show encouraging early signs with pipeline building and some early customer wins. We believe these activities bode well for the future.However, as you've heard from other enterprise software companies and from Louis earlier, the macroeconomic environment remains difficult, making new bookings more challenging. And as mentioned on our last earnings call, we will experience some exceptional non-recurring churn related to certain niche Qubit products, which will primarily occur in Q2 and Q3 of this fiscal year. Despite this, we are reiterating our SaaS subscription and total revenue guidance for the year, which will result in approximately 20% organic growth in SaaS subscription revenue, excluding the non-recurring Qubit churn I just mentioned. So with that said, let's get into the details.For the first quarter, SaaS subscription revenue was $28.5 million, an increase of 20% year-over-year, and total revenue was $30.5 million, growing 16% year-over-year, both on a constant currency basis. Excluding the impact of legacy Qubit churn I mentioned, SaaS subscription revenue grew 22% year-over-year.When looking at bookings in the quarter, despite the challenging macroeconomic environment, we saw contributions across commerce, service, website and workplace use cases, including sizable transactions from our SAP and Salesforce alliances. We also booked significant new work with a large financial services company adopting our workplace offering and joining our Coveo Relevance Generative Answering advisory group. Just as last quarter, on an annualized contract value basis, all of our lines of business continued to experience double digit growth.Our net expansion rate as of June 30 remained steady at 109% compared to the 110% we reported in our Q4 results. When excluding the legacy Qubit churn, our net expansion rate was 111% for the quarter. We continue to expect our NER to remain within our target range of between 105% and 115% for Coveo, excluding the legacy Qubit churn as our gross retention rates remain high and we have good visibility on our upsells and cross-sells.Current SaaS subscription remaining performance obligations, or cRPO, as of June 30 was $94.4 million, growing 12% year-over-year. As mentioned in previous quarters, we typically expect cRPO growth to approximate our growth rates in our ARR. In Q1, our cRPO and overall RPO was affected by the timing of renewals, some shortening of contract lengths given the macroeconomic environment and the impact of the one-time churn we are managing with Qubit. Overall ARR growth was largely in line with our revenue growth, and outside of Qubit, we have seen no change in our gross retention rates, which remained at very healthy levels.Moving down the income statement. Our first quarter gross margin improved to 78% compared to 75% for the same period last year. Adjusting for share-based compensation and other payments, adjusted gross margin was 79% for the first quarter, an increase of 3% compared to a year ago. Product gross margin was 82% in the quarter, which was 2% higher than the prior year. And on an adjusted basis, product gross margin was 83% for the quarter, also a 2% increase compared to the year ago period.Operating loss for the quarter was $7.6 million, a significant improvement compared to a loss of $13.3 million a year ago. Adjusted operating loss for the quarter was $2.8 million, which was significantly improved compared to $7.5 million a year ago and meaningfully ahead of previous guidance due to strong expense management.We generated $1 million of cash from operations in the quarter, which puts us well on track to burn less than $10 million in cash from operations this fiscal year as previously communicated.So finishing now with guidance. Our guidance continues to reflect the challenging overall macroeconomic environment, which is impacting new bookings. We anticipate that bookings momentum will improve as the year progresses in part thanks to Coveo Relevance Generative Answering, along with our partnership with SAP, but we do not expect these bookings to have a significant impact on our revenue in fiscal 2024, given the nature of our revenue model. With that in mind, for the second quarter of fiscal 2024, we expect SaaS subscription revenue to be between $28.8 million and $29.3 million, total revenue in the range of $30.8 million to $31.3 million and adjusted operating loss in the range of $1.5 million to $2.5 million.We expect the legacy Qubit churn to be highest in our second quarter and to have a similar impact on our Q2 SaaS subscription revenue growth rate as it did in Q1. For fiscal 2024, for the full year, we are reiterating our guidance for SaaS subscription revenue and total revenue at $118 million to $120 million and $127 million to $129 million, respectively. Excluding the legacy Qubit churn, we expect our core growth rate on SaaS subscription revenue to be approximately 20% for the year.Due to our ongoing efforts on efficiency, we have improved our guidance range for adjusted operating loss to a new range of $11.5 million to $13.5 million as compared to the previous range of $13 million to $15 million. We continue to expect cash used in operations of less than $10 million in fiscal 2024 and to achieve positive cash flow from operations in our next fiscal year.Both our second quarter and fiscal 2024 guidance assumes FX rates roughly in line with where they are today for SaaS subscription and total revenue growth, along with adjusted operating loss. For the full fiscal year, our total revenue growth and adjusted operating loss guidance includes the impact of the completion of our end-of-life process for our self-managed license and maintenance revenue, which represented approximately $900,000 of revenue last year.Lastly, after the completion of our substantial issuer bid we announced on July 12, our Board has authorized a normal course issuer bid to purchase up to approximately 5% of the issued and outstanding subordinate voting shares. As of June 30, we had approximately $201 million in cash and cash equivalents prior to our SIB buyback of approximately CAD 31.5 million, along with an undrawn $50 million revolving credit facility and no debt. As we've guided in the past, we estimate we require less than $15 million to achieve positive operating cash flow by the end of our fiscal 2025. We believe we have the capital available for focused investments, including potential M&A activity. We continue to believe we are maintaining the right balance of a clear line of sight to profitability and making the investments necessary to capture leadership in an exciting time for the company.So before moving to Q&A, I'd like to formally invite our analysts, institutional investors and members of the financial community to join us in Toronto at the TMX Market Centre on November 16 for our second Annual Capital Markets Day. There will be a lot to update you on, including many of the topics discussed today, and we look forward to hosting you during the half day event. You may already have received a save the date with registration details to follow, but please reach out to our IR department by e-mailing [e-mail] if you need additional details.And with that, operator, you may now open the line for questions.

[Operator]

[Operator Instructions] Your first question is from David Weiss from Scotia Bank.

[David Weiss, analyst]

You previously provided interested parties a demo of your generative answering capability in mid- to late-June, which seemed to us to be very impressive. So in this environment, generative AI has been a buzzword and a meme, and there are several capable firms out there that are also investing heavily to generative AI. Some are also even applying retrieval augmented generation, as has been discussed by your firm. In conversations that you have with customers or more generally, has there been any indication of an increase of competitiveness when customers are considering solutions in addition to Caveo?

[Louis Tetu, executive]

Actually, that's a very good question. I'm glad you asked. First of all, generative AI is a broad category, and there are many applications. Our specific applications are around AI experiences and the ability of large enterprises to deliver experiences to their customers, partners, dealers, employees and stakeholders. In that specific context, we believe our approach to the many challenges of bringing Gen AI to the enterprise use cases is very unique. Many -- even some of the large platform vendors, while they can potentially provide solutions in that area, it is typically only using content fed into the LLM that resides entirely within their software. Coveo has the ability to generate answers, essentially, in in-context that are highly secure and from multiple sources of content. And so far, we have not seen any equivalent in the market. We have not seen any company deliver it to market as we have because this is now live on our site. We are customer zero. And we have not seen as much interest because we have dozens of customers already engaged in our beta program, and those are all very large enterprises, and we've already released pricing for that. And the feedback finally that we get from those customers who are the kind of customers that have typically seen all the large stack vendors is that they're extremely impressed and also believe that our offering is very unique.

[David Weiss, analyst]

Okay. Great. Switching to ACV. You have provided us with some ACV values of about $160,000 on average at your last Capital Markets Day. Is that still roughly the average level that you're seeing, or has that grown quite a bit beyond that?

[Brandon Nussey, executive]

It continues to tick up as we cross-sell customers, continue to focus on the enterprise end of this market as well, and we've seen that continually move up. As Louis was mentioning, Generative AI becomes the next big opportunity to upsell and cross-sell customers, and we expect that to contribute nicely to average ACV as well.

[David Weiss, analyst]

Okay. Great. And then in terms of the guidance on adjusted operating loss margins, the improvement for the year and for next quarter, I suppose. Could you speak to where most of that is coming from in terms of the breakdown between sales and marketing, R&D and G&A line items?

[Brandon Nussey, executive]

Yes. Obviously, we're trying to put money with where it has the greatest return. You're seeing the important gross margin line continue to increase, which is important for the long-term health of the model and gives us available operating expenses, obviously, to spend beyond that. So right now, the most important things are obviously generative AI and all the important product work going around that, and we'll continue to make investments there. And as well, just general sales and marketing awareness. It's exciting time, obviously, in this space, and we need to make sure that that message is well understood by our prospects and customers. And so we have energy going around that in terms of sales and marketing spend.Lastly, SAP, as Louis mentioned, it's off to a great start. Lots of early promising signs there. And we want to make sure we put our shoulder behind that alliance and invest accordingly. So everything outside of that is subject to a lot of efficiency review internally, just to make sure that we can continually improve the overall efficiency and profitability of the business while making sure we make those key investments.

[Operator]

Your next question is from Richard Tse from National Bank Financial Markets.

[Richard Tse, analyst]

So obviously, generative AI is fairly new to the commercial market. But given how prominent generative answering seems to be of your pipeline, does it sort of change your strategy at all from the time of the IPO? Do you have to sort of lean into this more now that it's such a huge opportunity, or maybe you kind of elaborate on that a little bit?

[Louis Tetu, executive]

Yes, a very, very interesting question. Obviously, this is a very positive event for Coveo because we've been in the business of leveraging AI for a dozen years now, specifically in the area -- using AI and machine learning specifically in the area of delivering digital experiences. Generative AI is an extension to that. Generative AI cannot be a separate channel. And so the stack -- the software stack that we have that already handles search at high levels of security with massive amounts of -- massive volumes and variety of content and delivering highly individualized experiences to very large audiences and very diversified audiences across the world is an incredible raw material for generative AI and an incredible complement. So we're continuing to invest. I think the fact that we have all that software stack that we built with the cumulative work that we've done with hundreds of the large global brands and massive data sets, and again, I repeat within one single platform that we innovate in every day, is creating an amazing platform to deliver generative AI.So we're investing heavily in generative AI, but it's a natural extension of what we do. Again, as we said last quarter, Coveo had prior experience working with large language models. And in fact, we won an award for that in AI with a technology named Smart Snippets. So for us, this is such a natural. Let's not forget that at the same time, we have similarly important investments in the commerce area where we're working on algorithms that optimize outcomes, revenue and margins, and we're making massive investments in that area as well. So everything that deals with the application of AI to achieve the -- essentially to enable enterprises to gain the AI experience advantage is our area of investments for us. And yes, that includes Gen AI as a big catalyst right now of both investment but also, frankly, a catalyst of our differentiation.

[Richard Tse, analyst]

Okay. And just sort of a related question. I appreciate the focus on the adjusted operating loss and the improvements there, and obviously, that's great to see. But kind of going back to Gen AI, given that it's such a kind of a hot sort of theme now, are you investing as much as you can? And should you be maybe sort of accelerating that investment to sort of capture the opportunity lots there?

[Louis Tetu, executive]

I think I'll start, and Brandon, feel free to add. We're investing massively across the board. One of the unique advantages of Coveo relative to many vendors in the space is, again, that we have one single platform in that our customers really subscribe not only for the current product, but to our ongoing innovation in that platform. And as we've said in other conference calls, we release innovation 20 times a day to all of our customers simultaneously across the world. So we already have a sizable R&D team that is, in some cases, larger than the overall size of our competitors, all functions combined. So we're making big investments.Sometimes in the area of research and development, it's not a matter of brute force. It's really a matter of -- to drive innovation and take them to market, meaning that you can reach the law of decreasing efficiency. So we're not constrained. The direct answer to your question is we are not constrained by our ability to invest. As you know, we have a very strong balance sheet. We're not trying to save money every quarter. We're just becoming more and more operationally efficient. And right now, we think we are ahead with our investments. We see that we're certainly the -- one of the first ones, if not the first one, to deliver those specific capabilities at scale for the enterprise. So if our head of R&D were here today, and my colleague and co-founder, Laurent of Coveo, he would say that he is not at all constrained with investments right now.

[Richard Tse, analyst]

Okay. And just a last quick one for me. Is the margin profile for generative answering the same as the current portfolio, or would it be higher or lower?

[Brandon Nussey, executive]

Too early to say definitively on that one, Richard. We're taking our best guess based on the data that we're seeing come in and the cost that we best estimate will come from leveraging some of the LLM technology. We think so, but it is too early to say that definitively.

[Louis Tetu, executive]

That being said, if I can add. We have ways in our design where we believe that we probably control costs better than most. Generative AI, the use of Gen AI and LLMs is extremely expensive as a raw technology. It is about 1,000x the cost of a query to run an LLM answering. Now, a rich search page with all the dynamic navigation and the suggestions, the ranking triggers about 10 quarries. So it's about a ratio of 10:1. But our design specifically addressed early on the main issues we knew because we're quite familiar with these technologies. And frankly, we pay the bills every quarter to AWS and others to process billions of queries and et cetera. So being familiar with that, we did incorporate in the design some cost measures, in fact, cost optimization measures where we believe we will be able to optimize the cost, utilizing pre-selected queries managing the prompt engineering property, limiting the corpus of information fed to the LLM. Exploring the use of different LLMs. We're not bound to any specific LLM technology.So for us, the LLM technology is really only the answering part. It is not the source of the answer. So all the relevance of security and the accuracy and the traceability is managed by the Coveo platform, which all together contribute to limiting the cost as well. So we think with the early adopter pricing that we've released and the more definitive pricing that we will come up with at the end of the year, as Brandon mentioned, we will be able to keep our gross margin well within boundaries.

[Richard Tse, analyst]

Okay. Thank you.

[Louis Tetu, executive]

Which will not be the case of everyone in the industry, I guarantee you.

[Operator]

Your next question is from Thanos Moschopoulos from BMO.

[Thanos Moschopoulos, analyst]

So Louis, how do you see LLMs kind of impacting the sales cycle amongst prospects who are not familiar or less familiar with Coveo? And so what I mean is that I'm sure your existing customers know that you're the right choice as far as helping them adopt LLM technology. But just given all the marketing noise, some of the claims from some of the startups out there and so forth, are you seeing any impact in terms of sales cycles with new prospects as they try to sort through what's hype and what's real?

[Louis Tetu, executive]

Yes, it's an interesting question, but I have a clear answer for it. First of all, obviously, we went to see our customers first because they understand the challenges associated with large scale individualization -- individualization, pardon me, of digital experiences and what that means in terms of security, relevance and so on. In terms of new customers, remember that our target markets are enterprises. So we deal with a reasonably sophisticated audience across the board, whether we're dealing with large manufacturers, tech companies, financial services companies, healthcare or retailers, which are our main markets. And so typically, they are reasonably aware of the issues. And of course, we make a point to remind them of the fact that you can't use generative AI if you're going to breach permission. Typically, large brands can't hallucinate. And you have compliance and traceability and need to link to the source of truth. And they understand that you can't treat Gen AI separately from search channels, et cetera.So it's reasonably easy, Thanos, to make the argument even to a new account. And in fact, if anything, right now in the knowledge, certainly in what we call the knowledge use case areas, which are essentially workplace applications, customer service type of applications, et cetera, it tends to differentiate us even more in those new situations. We will further follow with more announcements to the market as it relates to commerce applications of Gen AI. But for now, the big applications are in answering for customer service, in particular, and really the whole area of knowledge management for the large workforces. And in that area, even in new customers, we're actually better positioned than ever because we can make it work in a highly integrated and secure fashion.

[Thanos Moschopoulos, analyst]

Great. And then just a quick one for Brandon. The professional service gross margin was obviously quite strong this quarter. What might we -- the run rate kind of look like going forward? Would it run 10 factors, or is that a sustainable improvement in gross margin?

[Brandon Nussey, executive]

Yes. I think as you've heard from us in the past, Thanos, services, we do try to strike the right balance of leveraging external SI relationships and delivering some of that work on our own. This quarter is a bit of an outlier, I'd say. We're generally targeting 20%, 25% margin in that line. We had a good quarter margin-wise just based on how the work fell this quarter. But I think going forward, keeping it in the 20%, 25% range is the right range for us.

[Operator]

Your next question is from Adhir Kadve from Eight Capital.

[Adhir Kadve, analyst]

Maybe I'll switch gears a little bit more on to the SAP endorsed partnership there. It's been live for, call it, 6 months or so. Can you speak to that partnership a little bit more in terms of the size of the contracts you're seeing? Obviously, you've mentioned that SAP is a massive driver of e-commerce. And maybe just the sales cycles with regards to those contracts and any other things you'd like to call out from the SAP endorsed partnership would be great.

[Louis Tetu, executive]

I can comment on that. First of all, we officialized the partnership with SAP in March and really launched in the field after SAP's fiscal year changes at the end of April and May. So we started the enablement campaigns and so on. And we're rolling out more and more enablement campaigns against -- with their sales team and et cetera. We are very active with that. We had -- last quarter, we had an amazing -- I shouldn't use the term amazing, but a great pipeline generation quarter. Lots of it, parts of it was with SAP. So clearly, we're seeing a big ramp here. And there is no surprise here because as a reminder, as part of the endorsed agreement, which again, very few company -- software companies across the world who are partnered with SAP enjoy. The SAP sales team gets full commission on the dollar sold to the customer and full quarter relief. So there's a high degree of interest, in fact, to push the solution in the market. That being said, in the last quarter, we started -- we won again some major transactions with SAP. One of them we commented on with a large -- very large North American liquor and spirits company. And again, the pipeline is very, very healthy. We expect this to hit bookings towards the third and fourth quarter.

[Adhir Kadve, analyst]

Okay. Great. And then I'll jump on the --. Sorry, go ahead. Okay. Great. And so then for my second question, maybe I will just jump on the Relevance Generative Answering as well. For Louis maybe, you've mentioned the set of criteria on previous calls with any generative AI tool that they need to address, well, like you said, sourcing content, indexing security or hallucinations. Within the beta program, are you effectively saying that a lot of these issues are being resolved by relevant generative answer?

[Louis Tetu, executive]

100%. That's precisely the positioning. And beyond the positioning, that is what we are -- how we are differentiating. And what we said essentially, and the interesting thing about Gen AI is obviously, just to remind a bit of history over the past 8 months, let's not forget that this all started with ChatGPT in the hands of laymans and people writing poems on iPhones on a Saturday night dinner. And people got all excited. Obviously, being in the space and familiar with LLMs, back in December, when this all came out, our organization was very quick to understand, I would say very intuitively and instantly, that this wouldn't be obvious within the enterprise that unless you had the guardrails of security, getting the data plumbing right with the ability to reach multiple sources of content, which you need to feed Gen AI, making sure that it's highly secure, that you don't want to breach permission. And for an organization, it's a Maslow scale. It's a non-starter for a CIO. You just cannot generate answers if you don't understand the user or the individual at the other end and can't isolate the corpus of information securely. It has to be rooted in verifiable truth. It has to scale and master any complexity at the enterprise level. We're talking about hundreds of millions of documents delivered to millions of users sometimes every day, and really, the ability to tune in the AI to drive outcomes and connect the entire journey.So all of that, again, if I summarize, the ability -- compromising security, compromising truthfulness, linkage to source of truth, veracity and verifiability and cost is a non-starter. So it's binary. So as we said publicly, our strategy in Gen AI was last to hype but first to results. And I think so far, I'm very pleased with the progress and the fact that we're actually -- we actually have it live on our site, and we're actually rolling it out live with our customers.

[Operator]

The next question is from David Kwan from TD Securities.

[David Kwan, analyst]

I guess just want to clarify. So the guidance for the full year doesn't include any impact from your new Gen AI solutions. Just, I guess, given that you haven't finalized kind of the pricing that's expected towards the end of this year.

[Brandon Nussey, executive]

Yes. Look, our guidance is a balance of reflecting no change in the current macro, which as we mentioned, continues to be challenging, with the expectation that generative AI bookings will begin to contribute in the latter part of the year, along with uplift from all the promising signs from SAP. Those will start in terms of bookings, while it starts in terms of pipeline, translates into bookings and then ultimately into revenue. But given the revenue model, we don't expect a meaningful contribution in the current year from those items. So hopefully that addresses the question.

[David Kwan, analyst]

No, that does. That's helpful, Brandon. And maybe it's challenging to address this question, but a lot of questions that I get from clients is just trying to help size up the opportunity here for you guys. And understanding that you guys haven't finalized kind of the pricing, but is there anything you can help us put into context? I know if you look at -- I think you guys talked about, for example, CoPilot and kind of the pricing relative to what customers might be paying. But just trying to get a sense of what the possible uplift, even if it's a relatively broad range, could be with, say, an existing customer, call it, 160, 175, wherever it is right now, 1,000 in ACV a year, kind of where -- what kind of uplift could we see?

[Louis Tetu, executive]

Right. So it's obviously early, but we can give you a couple of educated observations on the topic, not conclusions. Look, today, we've rolled out Coveo Relevance Generative Answering with an early adopter pricing that is a significant percentage of the subscription that customers currently pay. And we haven't seen these customers overreact, I would say, to that because they're fairly educated and they understand that there's a reasonably high cost to this. They also all understand that the alternative to Coveo, which offers them an enterprise-ready and already trusted platform to execute generative AI, that the alternative is to build it themselves or with large SIs or so on, and so it's far more costly.Our introductory early adopter pricing, which is until the fall until we release more precise tiered pricing, is equivalent to 40% of the subscription price, what we call the applicable subscription price because we have customers using Coveo across the board between commerce, service, workplace and websites. So depending on the use case that they put it on. And if you compare that in the markets, Microsoft initially launched also with 40%. Salesforce launched with a fixed fee, kind of a different strategy with a lot of limitations around tokens and so on at $360,000 minimum. We have a minimum also of $150,000 on the SaaS revenue, and we add some professional services to that. ServiceNow came out at 60%, but also with a fairly convoluted set of entitlements around tokens and et cetera.So look, it's initial, but we think that customers right now have a high appetite, and we don't see a lot of pricing pressures there. What we're anxious to measure, and I'll close on that, is the value -- the additional value that this creates. And really, as we close the loop, as we roll out these improved digital experiences that include Gen AI, relevant generative answering combined with search and et cetera, with the ROI we're already measuring as we do the AB testing, we look forward to seeing more value. And of course, we want to price accordingly.

[David Kwan, analyst]

No, that makes sense, Louis. I think you've obviously highlighted in kind of the core platform of, say, commerce and service, in particular. Just to touch the ROI that you can deliver, it'll be interesting to see kind of some of these early use cases with some of these customers, what kind of ROIs can be generated. So that's helpful.I guess the last question I've got is, so it sounds like I guess there's about 45 customers are showing these beta tests kind of split between these design partners and the advisory groups. Can you -- I think you talked about how I think it was the design partners had earlier access I think this quarter, and then the advisory group customers are going to be next quarter. But can you just kind of talk about the differences between those 2 groups of beta test customers?

[Louis Tetu, executive]

I think they're across various industries, both of them. They're similar in size. They're all very large, mostly global organizations. Very large data sets, large audiences to serve. There's not much difference outside of the appetite of the earlier group to engage with this with, to be honest, a sense of urgency. I think in many cases, we see organizations that had literally a board and top level mandate to engage. And we and I have personally been engaged actually with a number of CEOs of global 5,000 companies in large banks. And I was today with the CEO of a large well-known truck manufacturer in the U.S. And it's -- they are all -- they believe that this is an 8- or 9-figure opportunity for their companies, and they want to act on it.

[Operator]

Your next question is from Paul Treiber from RBC Capital.

[Paul Treiber, analyst]

Just a couple quick ones. Just in regards to your comments on pricing. At a high level, do you expect generative AI will have similar gross margins as your existing software? You're basically, you're pricing it so it has similar gross margins?

[Louis Tetu, executive]

Well, it's -- the question is whether we expect it to have similar gross margins? I would answer probably -- I would turn the answer upside down, in a way. That's what we will drive towards as we discover the cost of this and so on. Right now, we're taking early adopter customers at a fair price. And we already know, we've set the boundaries to make sure that we protect our margins as much as possible. We will become, as you can expect from us, Paul, you've known us, and we will -- we expect to become much more surgical about it. And you're -- we're getting used to the kind of gross margins that we love, and we don't expect to get really far from that ZIP code over time.

[Paul Treiber, analyst]

I guess that explains why there is the first phase of preliminary pricing until you finalize that and understand the cost.

[Louis Tetu, executive]

That's right.

[Paul Treiber, analyst]

Second question just on sales cycles. You mentioned macro as a headwind, but then also the enthusiasm for Gen AI. Is there a potential that you could see Gen AI reaccelerate sales cycles at some point?

[Louis Tetu, executive]

Potentially, but too early to conclude. We don't like to draw conclusions based on opinions. We'd rather drive based on data. So a little early to tell, but stay tuned. It's a scenario. It's a possibility. I'll leave it at that for now.

[Brandon Nussey, executive]

Thank you, Paul.

[Operator]

Your next question is from Kingsley Crane from Canaccord.

[William Kingsley Crane, analyst]

So just want to clarify on the RGA Design Partner program. So is this directly related to customer interest? And then does this supersede, or does this take place of the self-service comments made on the last call?

[Louis Tetu, executive]

The first part of your question is -- pardon me for having you repeat the first part of your question. If it was limited to customers. I missed the --

[William Kingsley Crane, analyst]

Yes. Just confirming that all of these partners or customers are interested in the product or if there was some other selection criteria.

[Louis Tetu, executive]

Yes. They are all customers of Coveo because they all have the infrastructure to feed Gen AI, because the stock that they have in place from Coveo already handles the multiple source -- the secure access to multiple sources of content as well as the ability to deliver that content in a highly personalized and relevant fashion, which is the ideal ingredient to feed the answering part, which has -- pardon me for bogging, getting it down into the details, but that's really, really important. Unless you have that actually, we don't know as a firm how you can make this work otherwise within an enterprise. So that was your first question, right?

[William Kingsley Crane, analyst]

Yes, that's correct. And then I'll just pivot to more a financial one. So current RPO, I believe, down $1 million in the quarter. So just want to confirm from an RPO perspective the impact of Qubit churn. And then more generally, your expectations for changes in contract duration moving forward.

[Brandon Nussey, executive]

Yes. So look, RPO is -- we've always used this as a proxy to approximate what's going on with overall ARR. It's a bit of a secondary metric, but given it's a GAAP measure, that's -- we've used it as that indicator. What I'll say is what remains unchanged is our gross retention rates. We have not seen outside of the Qubit churn really any movement whatsoever in terms of our gross retention rates. And our overall ARR growth was in line with our overall SaaS revenue growth. So this quarter, that metric was just really affected by the 3 things I mentioned on the call. Timing of renewals as we have more renewals in the back half of the year than we had in this past quarter. Contract duration length. No surprise in a macro environment like this, customers tend to want to renew for a shorter duration. So that impacts overall RPO. And then as you mentioned, just the Qubit churn of which we will be realizing the bulk of that in this coming quarter. That played a role in the RPO as well for the given quarter. But underneath the covers, the core metrics of gross retention rate and growth in the ARR remained unchanged.

[William Kingsley Crane, analyst]

Okay. Well said. Thank you both for fitting me in.

[Operator]

Your next question is from Taylor McGinnis from UBS.

[Unknown Analyst]

This is [ Daniella ] on for Taylor. Just 2 questions for me. First, on NER. It only dipped in 1Q to 109%, 1 point. Is this an indication that you're seeing demand stabilize amongst customers, or what is the rate there?

[Brandon Nussey, executive]

NER overall was basically unchanged from the prior quarter. We've targeted this in the 105% to 115% range, basically unchanged. We continue to see expansion opportunities from our customer base. And of course, the internal teams are focused there right now with all the product enhancement work that's going on, particularly around Gen AI. So all of that bodes well for NER, especially given that gross retention rates, again, outside of that Qubit churn, are unchanged. So we do expect the headline metric of NER to be affected by this Qubit churn that we'll encounter in the upcoming couple of quarters, but we'll make sure to segregate that so everybody can understand the impact and the difference there.

[Unknown Analyst]

Perfect. And then second, current subscription RPO declined quarter-over-quarter in Q1. So why is that? Is there anything to highlight? Is there really deep dollar or customer churn or changes in duration? And then as a follow-up, the 2Q subs were up guide in place 2% quarter-over-quarter growth. So how do we think about that in the context of cRPO, sequential growth being down in 1Q?

[Brandon Nussey, executive]

Yes. So again, I'll just echo what I previously said on cRPO. The core -- the most important drivers of gross retention unchanged. Overall ARR growth continued to mimic our SaaS revenue growth. Really, cRPO was just affected by timing of renewals this quarter, some of the Qubit churn, and then lastly, contract duration length that you mentioned. It's really just a timing thing and variability as to when those contracts come up for renewal this year versus prior periods. And I missed the last part of your question there.

[Unknown Analyst]

I know the second was just as it relates to the 2Q sub guide, which implies 2% quarter-over-quarter growth. How do you think about that in the context of cRPO sequentially growth being down in 1Q?

[Brandon Nussey, executive]

Yes. No, think about it the same way. Our focus is on growing that SaaS revenue line. Q2 overall growth will be affected by this Qubit churn that we are going to navigate. Outside of that, kind of the core business, we continue to -- we'll continue to see growth rates in and around where they've been, balancing the impact of the macro with some of the promising signs we're seeing around generative AI and SAP.

[Operator]

Your next question is from Suthan Sukumar from Stifel.

[Suthan Sukumar, analyst]

First question is on the partner ecosystem. So it's good to hear that you guys see growing traction with the sales force in SAP channels. But as the partner channel as a whole, can you speak a little bit about what contribution did the overall partner channel have on revenues this quarter? And how has that been evolving over the past few quarters? And has there been any change in the profile of the customers that have been coming through this channel?

[Louis Tetu, executive]

It's pretty much the same split. So Caveo, we grow pipeline coming from a combination of sources, our marketing programs, our ABM programs, then our partner channels. So we're thinking about companies like systems integrators like Accenture, E&Y, Deloitte, et cetera. So we have 150 partners across the world that -- of various sizes, obviously, in specialties that generate referrals to us. And then obviously, our major alliances and their field operations that -- who require us. One thing I might call out is what's particularly interesting about SAP, in particular, in commerce is the size. What we're seeing in addition to the growth in number is the size, the average size, which is certainly not smaller and the type of accounts that are generating. But the direct answer to your question is there is no fundamental change in the mix in terms of source of business for the company.

[Suthan Sukumar, analyst]

Okay. And just the last one for me, just on capital allocation. So obviously, between the SIB and your plans for the NCIB, still have a very healthy balance sheet and plenty capacity here with the access to debt. Can you talk a little bit about your parties for M&A, and sort of what opportunities do you see from an inorganic perspective? Is it really sort of technology, bolt-on type of opportunities? Or are there some other meaningful scale opportunities you can target?

[Brandon Nussey, executive]

Sorry, just to clarify. You said inorganic, right, not organic at the end?

[Suthan Sukumar, analyst]

Correct. Yes, that's right. Yes.

[Brandon Nussey, executive]

Go ahead, Louis.

[Louis Tetu, executive]

Well, I think we're constantly looking. So first of all, we're seeing valuations get back into more accessible territory, which is -- we're very -- or we try to be a very disciplined organization on behalf of shareholders. And as many of you know, the valuation -- the private valuations did not quite follow the public valuations. I don't think the appetite for the exact mark-to-market was as good -- as strong in the private equity firms and the VC firms. And so as a result, we've not paused. We continued to build a pipeline of companies to buy. But we remain very, very disciplined to make sure that everyone would be accretive for shareholders, or bring the opportunity of a large strategic differentiation for the product, which leads me to the strategy.So we continue to be active in looking for opportunities to buy. The first category are technology tuck-ins. So we're obviously interested in anything that is adjacent and complementary to our tech stack that serves our mission of creating a better AI experience advantage for enterprises in commerce, service and workplace website areas. We certainly remain interested in looking for any competitive purchase to consolidate in the market. And then the third category are probably potentially big plays that are adjacent to what we do, and again, compatible with our mission. But I was listening to Charlie Munger and Warren Buffet recently and said, we just can't find anything good enough to buy, and in the meantime, we're just going to keep the cash. So I'm not saying we won't. I'm just saying we will not be compelled. We're not charging ahead to buy something just for the sake of buying something and make it look good in Excel. That's just not what you can expect from us.

[Suthan Sukumar, analyst]

Have a good night.

[Louis Tetu, executive]

Thank you.

[Operator]

There are no further questions at this time. Please proceed with the closing remarks.

[Louis Tetu, executive]

Thank you, operator. And I want to thank everyone on the call and very smart questions and thank you for asking those. And we look forward to talking to you some more. And on behalf of Coveo and all our team, thank you all for attending our first quarter earnings call. And with that, operator, you can now end the conference call.

[Operator]

Thank you. Ladies and gentlemen, the conference has now ended. Thank you all for joining. You may all disconnect.