NetApp, Inc. (NTAP) Earnings Call Transcript & Summary

Okay. Good afternoon, everyone. Thank you for joining our virtual tech conference. Unfortunately not in-person this year, but I'm glad that nonetheless, you're all taking the opportunity to, hopefully, safely dial in. I'm Wamsi Mohan, IT hardware and supply chain analyst at BofA. We're delighted to have NetApp with us today. We have Kris Newton, VP of Investor Relations. I also want to remind everyone that we will be hosting a call with CEO, George Kurian, later this month, and I'll be sending out details on that as well as part of our CEO Call Series. I believe, Kris, you have a disclaimer to go over.

I do. Thank you, Wamsi, and good afternoon, everyone. Just quickly, I'll read our safe harbor. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risk and uncertainty. Actual results may differ materially from the statements made today for a variety of reasons described in NetApp's most recent 10-K and 10-Q filed with the SEC and available on our website at netapp.com. NetApp disclaims any obligation to update information in any forward-looking statement for any reason. That's it.

Okay. Great, Kris. Well, good to hear your voice again. We appreciate you taking the time.

I think maybe to kick it off, and it's something that's been on a lot of people's minds is the CFO transition that's happened recently. Could you maybe just briefly give your thoughts on how you see things maybe shaping slightly differently? And I know there's an Analyst Day where I'm sure we'll hear a lot more detail, but can you just briefly talk about how you see the differences?

Sure. And I have to commend Mike for his ability to come in to accompany on the first day of local shelter-in-place ordinances and pull together his team without ever meeting any of us in person. So we had a lot of Zoom calls and video conferences. And I would say it's been an interesting shift from Ron to Mike, both really strong CFOs. But it's clear that Mike's history in software colors his view and the types of questions he asks of his team. So hard to really give specifics about differences that might occur between the 2 in a normal environment, but what have been clear is Mike really does have a long history in software, and I think that change for NetApp is probably appropriate. We've always been a software company. We've largely monetized our software IP through the sale of hardware. But with the rise of our cloud data services, with increasing customer interest in things like ELAs, consumption model and software kind of taking a more stand-alone role in the minds of customers, having someone with that software background, I think, will be really valuable and appropriate. So I'm excited to see what happens when we can actually sit down in the office together and go on the road together and have those kind of more informal conversations that Zoom isn't always great at delivering.

Yes. No, we're looking forward to that time, too. So the demand environment, obviously, has been pretty volatile. Can you share some color on what you're seeing from a recent demand trend perspective in this quarter so far? And how have different regions progressed given there's been some easing in some regions?

Certainly. So it remains a very fluid environment, like you said. And I think it's too early to call any real change. It remains -- the limited visibility is pretty much everywhere, but we continue to work with our customers through virtual means. As the COVID pandemic progressed around the globe, kind of our Q4 business followed that. We saw the impacts on APAC first, EMEA and then flowing into North America. Some of the Q4 -- in Q4, we saw some challenges for getting goods to customers in highly regulated areas or there being customers available to take delivery on goods in highly regulated areas. And as the easing at stay-at-home orders are happening, that's largely moving behind us. But I think too early to say that we have much better visibility today than we did on our call a couple of weeks ago.

Okay. So when we think about the outlook here, clearly, there is some revenue challenges, but EPS was sort of -- experienced a lot more negative leverage. Can you talk about the puts and takes over there? What was driving that incremental negative operating leverage?

Sure. So I'm going to pin it largely on other income. So for the past several quarters, other income has been a tailwind to our business, but we expect it to be down in Q1, and ultimately -- and as the year-on-year compare equates to about a $0.10 headwind to EPS. The change for other income to the headwind is largely from FX, lower interest income on cash and mark-to-market on our investment portfolio.

Okay. And, Kris, how about on a sequential basis, when you look at it on a sequential basis, though, you do have sort of some headwinds around OpEx as well. Can you talk about the sort of moving pieces around OpEx?

Yes, absolutely. So we guided to OpEx of $660 million to $670 million, which is up about $13 million year-on-year. About $30 million of that comes -- $30 million to $35 million of that comes from the additional week that we'll have in Q1. That's largely offset at the op margin line as we expect roughly an equivalent amount of services revenue. There is a variable comp reset that happens at the start of every year where we go into the year assuming that we'll make our plan. And so we need to accrue variable comp against 100% attainment. That's about a $15 million increase. And then we're seeing some benefits in Q1 from lower travel and related expenses due to the COVID lockdown and a little bit of help from FX.

Okay. Great. How about on the product gross margin side? I mean just looking at overall gross margins and sort of thinking about the mix between product and services, it feels as though the product gross margin is under some pressure. Anything unusual there? What would you call out as sort of key drivers over there?

So product gross margin does have some amount of seasonality. So I'd recommend that we compare against Q1 a year ago when product gross margin was roughly about 53%. In our implied product gross margin guide for Q1, there is some headwind from FX and then also a little bit of headwind from higher NAND pricing and higher manufacturing and freight costs related to COVID. A lot of goods get moved around the globe and the cargo holds of passenger airplanes. And with that capacity being way down, it is a little bit more costly to get things from point A to point B.

Okay. You mentioned NAND pricing, Kris. So I mean NAND pricing clearly is on a -- somewhat of an upswing. We just actually hosted Western Digital in the last session, and they were talking about continued expectation of NAND pricing moving higher, at least in sort of the next quarter. So as we think about the outlook here from a NetApp perspective, can you walk us through a couple of things? One, sort of the revenue impact that you guys see over time, right? Like as you go through some quarters of this, how long does it take to actually flow into revenues where you're able to pass that through? And secondarily, on margin, both sort of as NAND prices go up and down, the timing of that margin impact, that would be helpful.

Sure. So I'll start with the first part of your question, our current view on NAND costs for the remainder of the calendar year. So like everyone else, we saw prices increase in the first half of this calendar year. We're kind of working on a model that implies roughly flat NAND pricing as we move through the second half of the calendar year. I think there -- you're right, that definitely depends on the supply and demand dynamics. But from where we sit today, that's kind of our best forecast, which I think leads into the impact of NAND on the business. So we've really driven our sales team to focus on gross margin and be -- for them to be mindful of gross margin in deals. As NAND prices were decreasing over the past year or so, our sales team did a great job at capturing that value. And today, we see product margins on our all-flash arrays being higher than our disk and hybrid arrays. As NAND prices go up, we look to our sales teams to maintain that captured value and stay focused on margins. But there will -- there is the potential for some headwind to margin as prices go up to the extent that the sales team can't retain that value.

How much does NetApp engage in sort of using the balance sheet to be opportunistic around buying inventory? Or is this a time where that sort of makes sense? Or are we at a such unpredictable demand point that this is sort of not the time where you would flex that balance sheet capacity?

Yes. So a couple of years ago, when NAND prices were dramatically increasing, at least I think it was a couple of years ago, everything since we've been in COVID lockdown starts to flow together. But when NAND prices were dramatically increasing, we did use our balance sheet to hold extra inventory. And then as prices started coming down, we were flushing that out because we didn't want to be holding overvalued inventory. I think given the lack of visibility and our expectation that NAND prices will flatten out, we don't anticipate holding significant inventory.

Okay. Got it. If we step back and look at sort of what some of our surveys that we've done, both on the CIO side and on the VAR side, there's been some deceleration on both fronts for this year at least. Some of your competitors have spoken about work from home and school from home and things like that, that have sort of been providing some offset. Some other ones have seen cloud usage pick up. So what are the puts and takes that COVID is having on your business? What are things that you think are structurally getting more favorable for you and things that maybe are cyclically more unfavorable?

Sure. So I think 1 thing that is clear through the entire COVID experience is the importance of data. And we see customers continuing their digital transformation projects as they're looking to respond to the challenges of remote working, digital business. A lot of that implies shifting parts of their spend to the cloud, looking for kind of virtual desktop solutions. So everything that you've described, we've seen. I think on-premises, customers are still buying. They are still deploying. They are maybe less open to trying new things. They're looking for more familiar solutions. And we think that will ultimately benefit us as well given the predominance of ONTAP in IT enterprise data centers.

One of the things that -- I mean this is clearly an uncertain environment. But even prior to this, I think, if we looked at the trajectory of the CDS business, the cloud data services business, the uptake was happening at maybe a slower rate. And I understand it's a complex thing to do. It's sort of not really been done before you're out at Microsoft and numerous data centers, there's some high-level of friction to overcome. But you did pull your targets this current quarter. So can you explain maybe what was the thought process behind that? Is it reasonable to set -- reset those targets again? Or what sort of time are we talking about? And how important is CDS like just strategically for you guys?

So CDS, I think, is really important for us strategically. We -- not only does it give us access to new customers, both traditional enterprise customers that we've never dealt with before, customers were buying a traditional NetApp storage array may not have been economically feasible for some of the smaller businesses. And it gives us access to born in the cloud, cloud-only people or cloud-only businesses. And so for us, it's really exciting. We did make the decision to withdraw the targets we had out there. As we've talked about in the past couple of calls, we're roughly a year behind where we thought we would be. As you mentioned, there's a lot of work to get integrated with the cloud into their native cloud consoles to get gear up and running in their data centers. So a lot of hard work. We are now generally available in AWS, Azure and Google Cloud and very excited by that. We are still white-listed in Microsoft, and that is a function they put on solutions that are in high demand to avoid a negative customer experience of going to try and access that solution and it not being available. We're working really closely with them to get white-listing taken off. And I want to be clear that our decision to remove the targets are not a reflection of the demand we're experiencing. Our partnerships or any aspect of the business is much more reflective of the fact that we're about a year behind, and with new executives, kind of looking at the business, talking about having an upcoming Analyst Day, it seems prudent to just remove that hurdle or that target and then think about how we'd like to discuss the business holistically at our September Analyst Day.

Okay. That's helpful. So, Kris, when you think about -- you mentioned your GA at the main cloud providers. Are you -- do you think that NetApp's business at these providers will be roughly similar to the market shares that they command in sort of public cloud space? Or do you think that there are reasons why you might be over- or under-indexed? And you think that you'll do -- there's better integration at some versus the other?

I think it's probably more reflective of their focus and ability to capture enterprise workloads ultimately. The NetApp Cloud Volumes Service is a high-performance shared storage platform that enables customers to deploy enterprise workloads in the cloud. And so I think while their overall business might have different varying sizes kind of their share in that enterprise workload might be different than the total business.

So one of the things that I think George has spoken about before is customers who are looking at CDS, it sort of gives them some comfort to know that they have a cloud strategy in place that can support sort of an easy migration if they wanted to enter the cloud and have the pathway there. Has that created more traction for your on-prem products as well?

Definitely. We hear from customers and partners time and time again that the NetApp's cloud strategy is one of the determining factors for why they choose to use NetApp on-premises. So having that pathway into the cloud is really important. But it's also -- we see customers who don't use NetApp choosing us in the cloud. The Cloud Volumes Service, Azure NetApp Files. Basically, customers choose a performance level, a service level, and that's all they need to know. Do I want fast, faster or fastest? And with that performance and the fact that it is a standard file protocol enabled customers to move enterprise workloads to the cloud without having to refactor the applications. So we've recently been officially certified for SAP HANA in Google Cloud. And we are Microsoft's solution of choice for high-performance computing, SAP, database, windows virtual desktop and the Azure VMware service. So more and more kind of enterprise workloads that are moving into the cloud, NetApp is a good recipient of that.

Okay. Great. Kris, so hybrid cloud deployments have been gathering more mind share. And when you look at sort of some companies that have a broader portfolio, like the biggest player in storage, for instance, do you think that, that puts them at a strategic competitive advantage? We hosted Michael Dell earlier today. He was talking about how there might be a lot of consolidation for stand-alone players. The fact that you don't really see a lot of storage IPOs coming to market, how will you think about -- I mean, clearly, NetApp has been a material player in the storage industry for, I don't know, a couple -- or 2 decades. So when you think about sort of your position in that market and what you'd see for the industry and consolidation, how do you think NetApp is positioned there?

We've talked about the potential for consolidation in the storage industry for some time. We've also said that you shouldn't expect us to be a consolidator of legacy on-premises technologies. We're really focused on executing against our strategy. We think we can return our storage business to growth. We saw some good leading indicators in Q4 even despite the COVID thing -- COVID pandemic. And then also we want to be really focused on scaling the cloud data services business, making sure that we're helping customers expand, not only their existing footprint, but add services to what they're doing with NetApp and then bring more customers into the mix.

Okay. There's a lot of sort of maybe investor questions and maybe some concerns around the fact that Dell recently refreshed its midrange product line. I know that there is a viewpoint that these sort of transitions are tough to execute on, creates opportunities for competitors, but at the same time, the product seems to have gotten quite good reviews. How are you thinking about this changing if you think that it does change the competitive landscape?

Yes. So I think it does create an opportunity for competitors to go after a big legacy installed base. And you could expect NetApp to do everything we can to take advantage of that opportunity. We have some sales incentive programs encouraging our sales teams to go after legacy Dell midrange. I haven't gotten feedback from our field yet on any experiences they have with the new midrange product. So I can't speak to that. But definitely, I think it opens up opportunity for us, not only to go in with our industry-leading file and block storage platforms, but also to talk to customers about a real pathway into the cloud.

Okay. That's helpful. Kris, just if you can just talk about the competitive landscape, and let's focus on all-flash arrays for a second. It looks like Pure has been sort of a little bit more of a standout in terms of relative growth rates. What do you think you would attribute that to? I mean if you rewind back a couple of years, I mean, you guys were growing tremendously fast in all-flash. What do you think has changed for you? And do you see sort of the market having shifted in some material way? Or what do you think explains this outgrowth at one of your competitors?

So I think the reason why NetApp saw a slowdown in our all-flash business was related to some of the sales execution challenges that we talked about over the course of all of FY '20. We clearly were not in enough deals. We saw that when we were competing, we were able to win. We just weren't getting enough of that path. So to address that issue, we added 200 quota-bearing sales reps, primarily in the Americas enterprise sales force. That helped us -- is helping us close those coverage gaps. Early indicators point towards positive activity in areas where we've created -- we've dedicated hunter districts or areas where we're highly focused on acquiring new customers. Those are pointing in the right direction in terms of growth in business, in customer acquisitions, in pipeline. And that's held true even through the fourth quarter, dealing with all the COVID impacts. So that kind of positive early indications led us to be really confident in that strategy. We completed the hiring of the 200 sales headcount a quarter ahead of schedule, and we did that without increasing the total operating expense envelope for the business.

So, Kris, where did your, I guess, analysis show that you were under-indexed? I mean we spoke about NetApp being in business now for a couple of decades. How did it end up in a position where it was under-indexed in sort of the U.S. in a fairly major way if you're talking about hiring 200 resources? What is it that you think led to that? And what were the areas that you found that you were under-indexed, where you think you can now regain some market share?

Yes. I wouldn't say there's a specific geographic or vertical area that we needed to solve. I think we were just spread a little bit too thin. Some of that came from managing a much more complex business than we did 20, even 10 years ago. We were probably over-rotated towards overlays and the like, and so we got that better squared away. And I think you could expect us to continue to keep a really sharp eye on that. We have a new head of go-to-market, who will be joining us in July. And I think our sales coverage, what we're doing with customers, will be a high priority for him.

Okay. Got it. And can you just talk a little bit about sales productivity? I mean given that there's been stay-at-home orders, like, how has the parade and pace of conducting business been?

Sure. So we are out there generating demand every day. It's a little bit different when you're doing virtual calls, but one of the benefits of having our history and our brand reputation is that we're a known name. And so the calls aren't necessarily totally cold. And we're able to get the right type of conversation with customers, especially as customers are looking to continue forward with digital transformation and cloud initiatives. Our CEO, George, always likes to point out that he can be far more productive in helping the field than ever before. Pre-COVID, people would expect him to get on a plane, fly somewhere, do a handful of meetings, get on another plane, fly somewhere else. And so in a week, he could only meet with a handful of customers. But now he's doing calls around the globe. He likes to always talk about starting his morning in Europe, spending mid-day in the Americas and then wrapping up in Asia at the end of the evening. And so it definitely -- the concept of videoconferencing and people's willingness to have virtual meetings does provide a little bit of benefit that way.

Can you also talk about this pending split between sort of CEO and President titles? Like what was it that led to that decision?

I think as we look at the way the market is evolving, having a fully integrated marketing, sales and services organization makes a ton of sense. So with Henri's retirement, we looked for someone who could kind of bring all of that together in a more modern style. And so Cesar seemed perfect for that given his long experience at Microsoft.

Okay. Great. I think we're almost at the end of our time over here. So I got 2 questions, Kris. One is as you look at sort of where the stock is, obviously, you guys throw off a lot of cash flow. The market clearly is concerned about something going wrong in some ways. And I'd be curious to know what you're seeing in your investor conversations that you would say is maybe misunderstood in the story. And secondarily, as you think about NetApp and sort of longer-term outlook and market share, do you have thoughts around -- what does it mean for the management team to declare success in some ways? I mean what are the benchmarks? Is it market share? Is there something else that you would look at to say, hey, we're taking this company on the right path longer term, and we can look back and claim success?

So I'll start with your last question first. I think we're highly focused on smartly returning to growth. So you can -- everyone can expect us to maintain the physical prudence that we've displayed for the past several years, but find ways to return the business to growth. The specific metrics by which you can measure us, I will save for our September Analyst Day. And then your first question was what might investors misunderstand about our story. I feel like the investment community is getting more and more educated on our cloud data services and how that is a unique differentiator for us. We saw what appears to be an inflection in the Q4. One data point doesn't make a trend, but there's definitely positive growth, and we are quite heartened by that. And I think as that business continues to scale and grow, the proof of the value there will help investors really understand why we're so bullish on our cloud business and what it means for NetApp long term.

Okay. Great. Well, Kris, we're just about out of time. So I really appreciate you taking the time. And I'm sure investors appreciate the candid views at such a difficult time from a macroeconomic standpoint. So thank you again for taking the time and making this happen, and we look forward to speaking with you soon.

Well, thank you for having me, and I look forward to seeing you someday, hopefully soon.

Thanks, Kris.

All right. Thanks all.