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

All right. I think we're going to go ahead and get started. I'm Matt Cabral. I cover IT hardware here at Crédit Suisse. And we're very please to have NetApp joining us. We have the CFO, Mike Berry. So Mike, thanks very much for carving out some time to join.

Matt, thank you. And thank you to Crédit Suisse for having us. We are thrilled to be here.

Great. Before we jump into the conversation, I wanted to hand it over to Kris Newton, who is just going to read a brief safe harbor to get us started.

Yes. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risks and uncertainty. Actual results may differ materially from the statements made today for a variety of reasons, which are described in our most recent 10-K and 10-Q filed with the SEC and available on our website at netapp.com. We disclaim any obligation to update information in our forward-looking statements for any reason. And with that, I'll pass it back to Matt.

Perfect. Now that we're compliant, Mike, I guess, 2020 understatement of the conference of the year, it's been a challenge. Maybe just to kick off the conversation. As you're talking to customers, they are starting to think about 2021, maybe just a sense for how they are looking at their budgets and just the priority that they are most focused on?

Sure. Well, and as you talked about, I mean, gosh, darn, 2020, I don't think -- obviously none of us could have predicted this. So it has been super challenging and obviously has pressured IT spending. So as we look into 2021, our customers continue to talk about their digital transformations. And I think what --- at least from my perspective, what we saw in '20 was when everything hit, and the shutdowns happened, the focus on a lot of companies was making sure that their employees could work, be productive and work securely. And I think we all saw a shift in spending there. Hopefully, towards the back half we saw them say, okay, we feel better about that. Our employees are productive. They are working hopefully securely, and now they shifted to their digital transformation. So, I mean, look, going into 2021, I think there is a couple of things we all need to watch. One is obviously the veracity of the vaccines. We're super excited to see the early results from those. And then, of course, with the change in administration, does that do anything? We don't know. In terms of what they're going to do from a tax perspective or regulatory, hopefully, things continue to move along. But those are things that we're watching. We feel really good about where we are, helping our customers make that transition through that hybrid cloud transformation.

Got it. And maybe building on that a little bit. The near-term demand environment is still pretty choppy out there. I guess, heading into next year, from your perspective, does that continue -- do you think we're sitting with some pent-up demand? So maybe there is a bit of a snapback as we get into 2021? Just curious your perspective. And how big of a factor do you think the path of COVID is on that trajectory from here?

Yes. So as we look into '21 and as we -- calendar year '21, as we talked about on our last call, we think it's prudent to take a measured approach. There's still a lot of uncertainty. And as we go through the year, we're going to make sure that we're positioned appropriately. I think that COVID has a couple of significant influences. Certainly, we talked about the vaccine. That's one of them. What does the new administration do around that as it relates to that certainly matters as well. And I don't know if there'll be a big snapback. I think as we saw during the year, the bigger question I have is, will they continue to reallocate to those digital transformations. And that's what we've seen. At some point, when we get into '21, hopefully, we'll start to feel this move behind us. We understand what's going to happen from a regulatory and an economic perspective, and we'll get more visibility. We feel good about our position and what our customers are telling us. But we do think in the -- at least in the first calendar quarter that we need to take a measured approach.

Got it. And one more bigger picture sort of demand question for you before we jump into a little more detailed questions. I think larger customers have been a source of strength for you guys over the past couple of quarters. Maybe talk a little bit more about what you're seeing in that cohort of customers. And maybe compare and contrast a little bit to what you're seeing in more the SMB side of the equation?

Yes. Great question. And as you know, NetApp -- the large majority of our customers are larger enterprises or governments. So that's where we spend most of our time. And I think what -- as we just talked about, what we saw is, as they continue to move down the path on digital transformation, they'll be the ones to lead that effort. And then certainly, from an economic perspective, those are the companies that have weathered what we've gone through a little bit better. We don't have a lot of exposure to SMB. And gosh, darn, you take a look at that and those poor folks. There's been a lot of struggles in that area. So that -- for us, that's been a nice thing. Also even within enterprises, the industries that have struggled, leisure, airline, transportation, well, certainly, there -- we have some wonderful customers in there. It's not a big part of our business as well. So I think we've been in a very good spot as we've gone through COVID. Hopefully, coming out, we continue to leverage that strength.

Got it. I want to jump into the portfolio a little bit more and start off on the product side of the business. So all-flash had a pretty solid quarter. I think you're up 15% in Q2. You talked at the Analyst Day about a 9% market CAGR longer term. I guess when I look at product, I take some of the third-party data, the majority of that product business. Maybe just talk about, is that sort of trajectory in all-flash enough to drive sustained growth for product going forward?

Yes. So as you talked about, so it's only 25% of our installed base. So we think we have a long way to run there. And as we talked about at Financial Analyst Day, when you look at the core storage market, we think that this is where most of the growth is outside of some of the other areas. So we feel like we're really well positioned for that. And as we help take our customers to the cloud, we, again, believe very strongly it's going to be a hybrid cloud environment. And even as they look to either go hybrid cloud or public cloud, that they're going to still have a lot of data on-prem. And as we've talked about, our big driver is the growth in data. So as we look forward, we feel good about where we are with our all-flash solutions. We've talked about the importance of software and also the ability to serve those workloads. So we do feel that it can continue to drive growth. And as it becomes a bigger part, not only of product map, but also keep in mind, the tangential benefit it has to our support lines as well, we think that that's going to continue to be a good tailwind for us.

And on that point, so 26% of the installed base is sitting on all-flash now. I think at the analyst meeting, you guys talked about something like 70% as maybe being the longer-term opportunity. It's sort of been a gradual path. It feels like a couple of percentage points per quarter. I guess, is there a tipping point that we hit where it becomes more step function change towards that end state? Or do you think this is really kind of a gradual progression that plays out over the next several years?

Yes. If I looked out, I would argue more for -- I think it will be gradual because as customers make those decisions, I don't think you're going to see a bunch of them. They're going to just say, hey, we're going to move all our data to the cloud, and we're going to stop going down the path on hybrid cloud, which is really where we've been successful, and we think the market will still go. Plus a lot of that happens with the refresh renewal cycles. So customers have a path. If they bought CapEx in the past, I don't think you're going to see anybody do big write-downs or do other things. I think it's going to be a gradual transition.

Got it. And sort of bringing it back to the comments that you started with about, how near-term is still a little bit more choppy from a demand point of view. Just curious what you're seeing from a competitive or a pricing standpoint. And maybe related to that. You talked about an initiative that you have, the Run to NetApp program. Just what you're seeing there and what you think that's doing in terms of driving some new footprint over to the company?

Yes. So a lot of questions -- we're getting a lot of questions on the competitive environment. And what we said is, hey, look, there's really not been much of a material change. It's a competitive market. And you're going to have Dell, a very large successful company, Pure, HP, really are the big competitors we have in that all-flash market. And we feel very good about going up against each of them because, yes, while we see them in the core market, we rarely see them in a public cloud deal, because of our products are so differentiated there. So -- and look, pricing has always been competitive. No one is acting irrationally, thankfully. Every once in a while, somebody does something crazy, but it's an isolated incident mostly. And on the Run to NetApp, that's been a long-standing program that we've had. And we've reinvigorated that over the years. We brought that back specifically as Dell introduced their new midrange product to really focus on that opportunity. And it's been very successful, not only from bringing in deals, but also bringing future pipeline.

Got it. I also want to talk about the public cloud services business that you have. And it was up nicely in Q2 on a sequential basis. And I think you guys talked about a target of near term $250 million to $300 million of ARR exiting this fiscal year. Maybe just talk about the drivers underneath that strength. And I know you guys closed a couple of acquisitions in Q1. Maybe talk about how that's folded into the portfolio and the path forward there?

Sure. So we feel really good about the cloud business. Another really good quarter. As you mentioned, Matt, I think 21% up sequentially, over 200% year-over-year. Some of that's obviously due to the acquisitions. So sitting underneath there, you have our core Cloud Volumes products. Obviously, you have some of the things that we do around other software like our Spot, which is our acquisition, some of the other stuff we did around VDS, but it's really that core product and then a couple of the acquisitions. The core products have performed very well. We talked about the growth accelerated in Q2 versus Q3. It was 120% in Q1, and it accelerated in Q2. While we didn't break out the Q2 numbers and we won't going forward, we did talk about, hey, the 3 acquisitions we did represented about $44 million in ARR as of the end of Q1. That did continue to grow led by Spot. Spot has continued to grow very nicely. So as we look to the end of the year, the $250 million to $300 million, we feel really good about that. As especially we start -- continue to ramp Google, as we continue to drive growth with Amazon, the ANF product with Azure has been a big driver for us, and we expect that to be in the future as well.

And then maybe looking a little further out on the horizon. I think the target that you gave at the analyst meeting was $1 billion of ARR by fiscal '25. And just curious, sort of, looking out that far, what gets you comfortable with the trajectory? I guess, especially, it has been a little bit of a slower start, at least to get to this point. So just thinking about sort of confidence in that path and net new customer wins versus maybe taking some of the on-prem footprint and starting to migrate that over.

Yes. Great question, again. And to your point, because of the forecasting that we did that caused us to, hey, we take a step back. I think we've learned a ton over the last 2 years in the cloud business. Quite frankly, we didn't have when the company gave its original forecast, which is understandable. We've worked now so much more with the hyperscalers. And all the development, all the sales, all the training, all the stuff that we've done with them to enable not only their sales team, but our sales team, gives us a lot more confidence as we go into the future that we have a better view of how that should transpire from a trajectory perspective. So I mean, look, it's out 3 to 4 years. It's a big number. We feel super good about it. Also, very importantly, we want to put that stake in the sand because we are driving for that. We've talked about our 2 priorities: regain share in core storage; and scale public cloud services. And that's what we're going to focus on through '25. We have also talked about, hey, we will likely do some acquisitions during that time. We do think the majority of that business will continue to be the organic build. But we also want to add on acquisitions where we can to fulfill portfolio holes. So we feel like we have a very good footprint. And on your comment, we view cloud -- and this is what we've seen with the dollar-based net retention we've disclosed in the data -- is we view cloud as 1 plus 1 is 3, not a substitution for on-prem. Because as we see our on-prem customers deploying the cloud, we actually see both of those raise up from a level perspective in the spending. So it's not like they roll out in the cloud and then they pull down here. Again, if we believe data is a driver of our growth. It's the key metric. Hybrid cloud is here to stay. We view that as additive, not a substitution, Matt.

And maybe on that last point, one of the questions I get a lot is just trying to think through what the economics of that shift looks like? And understanding historically customer used to buy an array, all-flash or disk or whatever it was. They paid a certain price. I guess, as synthetically, they're trying to recreate that capacity on top of Azure, GCP or whatever else. I guess, is there any rough math, any rule of thumb that we should think about as sort of how that dollar per gigabyte changes from on-prem to public cloud services?

Yes. So I think I've been here 9 months. I probably have been asked that question almost every day. So here's how we -- because we view it as additive, not substitution, that's actually a very difficult math to go through, because you can't make the assumption that it is, hey, I go from on-prem to cloud, and I pay this much and then I pay that. Plus, more importantly, the cost structure for the customer as well as us is very different. So what I would encourage folks to look at is, is that when we talk about the gross margin in the cloud business, because that's really where the rubber meets the road, in terms of us being able to get the gross margin, which takes into account pricing, takes into account cost structure, which is very different. Over time, our goal is to get that to the company average. Once you do that, then we become certainly a lot less ambivalent in terms of -- less ambivalent to where that revenue comes from, because we're trying to drive gross margin dollars. So I would encourage folks to keep looking at that. We understand, hey, we talked about in September. We don't do segment reporting at this point as cloud gets to be a bigger part of our business. We know this will come up. That's why we talked about the gross margins, Matt, was that very question.

And let's talk about that a little bit more because that was an area where just the scaling of the gross margins on top of your public cloud services, just how we should think about that? And as sort of as your revenue run rate increases going forward, just how we think about the path of gross margins along with that?

Yes. So great question, and let's go back to September. There's really -- there's a couple of drivers to point to on this. So we, at least today, because of the workloads that are being deployed in the public cloud, we are putting hardware with some of our hyperscalers to drive the growth. So that shows up in our cost of goods sold. Over time, while we know there will be some hardware required because of again depending on the workload, high end workloads need hardware, we are also going to start introducing and we're working with our partners on software-defined. And once we get that rolling, that will have a significant benefit to gross margins. In addition, as that hardware works its way through the P&L, because there's a finite life to that depreciation, that will also help. And then, thirdly, just the scale. And for us, the ability to grow on top of that fixed cost base will enable us to drive those up. So as we talked about, look, we're a little below company average. We're not that far. We feel very good about that progress. As we grow, introduce more software-defined, and as that hardware works its way through the P&L, we think that there's going to be some nice growth in that margin.

Got it. Last public cloud services question for you. You talked about it a little bit earlier when you were just walking through the wider competitive landscape. And it does feel like an area where you guys really have an offering where competitors aren't fully there yet. Maybe just help us understand the customers that you're seeing on the public cloud side of things, I guess, how many of those are existing customers versus net new? And for those new customers, maybe is there a gravitation pulled back to the on-prem data center, where you're seeing a bit of an uplift in what your traditional business, for lack of a better term, is able to do going forward?

Yes. It's a super interesting dynamic. So we certainly see existing customers moving to the cloud, and that's part of the growth. But our new logo engine is really based in the cloud. That's where we see the most new customers come on. Because this is our ability to go. If somebody has storage with one of our competitors, we all know that, that's a hard lift, and that's a hard transition, takes time. This is the way that we go at them in terms of bringing them on for public cloud. So when that on-prem footprint or something else changes, we can, as you call it, go backwards. We've actually seen born in the cloud companies come, deploy on the cloud, and then we have conversations about hey, how about your on-prem footprint? Do you also want to support private cloud or something else? So we see that as well. And part of the dynamic is a lot of folks will come on. They'll spool up. It might be the end of their fiscal year. They might be introducing a new product. So they need that elastic capacity. Then once they see how easy it is, then we start to see them build. So it is a great new logo engine for us. And in addition to getting our existing customers over to the cloud, this is really how we go against some of those competitors that have that on-prem footprint.

Got it. I want to shift the discussion and talk about gross margins a little bit, particularly on the product side. Fiscal '20 was a really strong product gross margin year for you guys. And it stepped down a little bit through the first half of fiscal '21. Maybe just help us understand sort of the puts and takes there. And then going forward, I know you talked about sort of staying at 53% roughly for the balance of this fiscal year, improvement thereafter. Just the swing factors we should keep in mind for product gross margins going forward.

Yes. So 2020 was a great year. Obviously, I think it was 57% in Q2. The vast majority of that was driven by -- that was the low point of pricing in NAND and the company certainly benefited from that. As we came into fiscal '21, prices rose on NAND. Q1 and Q2, we talked about they're up mid-single or mid-double-digit teens year-over-year. It's not a small number. In addition, we had this thing called COVID. So -- and we talked about some of the things that we had to do around making sure our customers -- we kept them during that time. So we had some pressure, and we called it COVID-related pricing. That's what really brought the margins down for the first half. As we go into the second half and what we saw in Q2 is, it's really starting to matter at NetApp, and we'll talk about this every quarter. Mix matters a whole bunch. And as we did more, not only AFF, but more high-end AFF, that has a bigger percentage typically of add-on software that we sell, which helps drive those margins up higher -- more. And hopefully, in the second half, we'll see a little bit of lightening of the pressure on NAND pricing. So 53% in Q2. What we talked about is, hey, it's hard to shape demand for high-end versus regular AFF. So as we said in the second half, we expect that to return to a more, call it, normal distribution of product mix and then a little bit of help with NAND, which is why we felt comfortable around the 53%. We did say coming out of COVID, look, our goal is to get margins back into the mid-50s in product. And we talked about that. A lot of activities around, obviously, a lot of engineering, again, software-defined. We've talked about Astra and some other things in Insight. So we feel good about the product margin. More importantly, the products that we have to support that goal.

And I guess, last year at 57%, is that an achievable number for the business longer term? Or was that sort of a perfect storm of NAND pricing, benign competitive environment and maybe that's more of a high watermark we should be thinking about?

Yes. What I would tell you is it was largely the perfect good storm. Now on any given quarter, possibly, we could hit that again. I think, for us, from the competitive environment, us driving customers, and then keep in mind, importantly, mix matters as well as it relates to margin because if -- as you do more AFF, more software, also more goes to support. And this is the other big part that I want to make sure investors look at is, yes, product margins matter, I get it. But with the push and -- because we talked about billings growth of 10%, product or total revenue of 3%, product decline 3%. The difference between that is more is going to the support. That goes to the balance sheet, comes off deferred. So more and more I'm going to push folks, hey, look at the total company gross margin because, again, mix and revenue recognition do matter here.

And one more on product and a little bit gross margin, a little bit just kind of wider product. I got this question a bunch coming out of the quarter. I'm sure you did, too. Just the strength in software that you saw -- and you mentioned mix toward all-flash, kind of, mix toward high-end within all-flash. Can you just help us understand a little bit more about just what that looks like? How the software attach compares across the portfolio? And I don't know if there's any way to quantify sort of how much more uplift or attach there is for high-end all-flash versus the rest of your portfolio?

Yes. So we've had this -- we've gotten this question a lot, too. So not for the future to help with this because I think people are actually trying to model this way. So here's how I would describe it as spinning disk. You get not only hardware, but you certainly get the operating software to operate it. You need that. As you go into all-flash, it becomes much more software-centric, and that's ONTAP, right, as you look at the benefits of ONTAP, which goes all the way to the cloud. So when you go into all-flash, you have the bigger proponent of ONTAP. Again, you get the operating system, which is the software portion, but you also -- there are also supplemental software packages around performance, protection, all the things that you're doing in those high-end boxes. So you see a bigger preponderance of software, which is really the value that ONTAP brings to the AFF boxes. So as you go spinning disk to all-flash, software matters a whole bunch more. And then that also goes to support as well. And it's a pretty significant difference. Here's the analogy I'd use, and we're not an airline. Think about an old DC-9. It was all manual. Think about an A320, it all runs on software. It's a little bit the same in terms of, hey, all-flash needs that software, and it really makes it hum. Spinning disk, a lot less software.

Is there ever a world going forward where it goes one step further and maybe you decouple that software from the hardware? So maybe there's not that box that goes along with that? Or is that kind of a step too far as you guys think about, at least the on-prem side of the business model?

Yes. We thought -- obviously, we thought about this a lot. The one thing I'd say is one big learning for me, Matt, coming from the software world is say, hey, everyone's going perpetual to SaaS. It's an easy transition. Yes, you have to live through the trough. It's a big difference here because that hardware is actually super important, and it matters, and it is truly an integrated box for us. So -- and it's part of the value that our customers see. So the way we look at it is we don't want to force a business model transition unless our customers want to buy that way. So we'll continue to keep our finger on the pulse to the extent that they want to. That's why we've done things like Keystone and we'll have more flexible pricing. I think this as well -- this is a -- this is a journey, not a, hey, we're going to cut it off because, again, the hardware does matter in our business, and it does bring value.

Got it. Thinking about the trajectory going forward, this is a factor the company talked a lot about last year, and I know a little bit before your tenure. But just bringing on 200 new quota-bearing heads, I think you guys hit that target a quarter ahead of time if memory serves me right. I guess, maybe just an update on where that cohort stands now. And just how we think about them contributing to wider productivity in the ramp going forward?

Yes. So we did -- we brought those folks on earlier than we expected, which has been great. They have -- as watched the productivity, it kind of falls into a couple of different camps. The folks where we put in existing territories where we had, call it, 3 reps and we needed 4, their productivity is going to be faster. Where we've put into a new land territory, where, hey, we want to go drive new logos, that's obviously going to take a little bit longer. So -- but we've seen good productivity across each, a little bit better in the ones that went into an existing territory. But we absolutely made the right decision, and we're excited about those folks continuing to contribute as we go into next year.

Got it. For the few minutes we have left, I want to shift down the P&L a little bit. OpEx is an area where, before your tenure since you've come on board, the company has done a good job managing within sort of a flattish cost envelope. But I know you're talking about that being the way to think about it going forward. Maybe just help us understand, especially as the business does return to a little bit of growth, just how realistic that is and how you're able to kind of fund investment at the same time within that flattish cost dollar going forward?

Yes. So that's -- we will continue to be very disciplined about where we spend money, not only in OpEx, but obviously, in COGS. There are some there as well. Our first goal, as always, Matt, to reallocate internally. And as we focus in different priorities, you'll see that. That's what happened in August when we did the action in terms of, hey, let's move resources from one product to the other. We'll continue to do that. Certainly, we want to make sure that, look, we have margin targets we want to hit. As the company continues to grow, we'll be disciplined. However, we would also say, we're going to go after our targets. My goal is OpEx or cost is always going to grow lower than revenue. That's to drive those up. But we do want to make sure we're funding growth. And -- but we're not going to do it crazily. We're going to make sure it's prudent, and we're going to make sure there's a return there. So that is the goal. If we start to see revenue grow even faster or we can pour a little bit of gas on, especially the cloud business, we'll take a hard look at those.

Got it. Another thing you guys talked about is starting to reinstate the buyback in Q3 and going forward. Just a quick 2-part question around that. I guess, first, what gives you confidence that now is the right time? And second of all, just how do we think about the pace of repurchases starting to come back from here?

Yes. So as you know, we stopped this in March when there was a lot of uncertainty. Based on what we saw in the first half of the year, we felt better about the -- what was going to happen economically as it relates to COVID. You look at the vaccines, again, feel good about it. I think it's going to take a little while, obviously, to work its way through the system. And -- but we also want to make sure, hey, let's be prudent about our share count, and we've generated year-to-date over $300 million in free cash. So we thought this was the right time. We're going to step into it lightly. We're going to try to be flexible. Also, as we look at offsetting dilution, just keep in mind that that's going to be on an annual basis because this is like free cash flow. Some vesting happens in a quarter. So think about that offsetting dilution more on an annual basis, Matt. But we do think it is the prudent thing to do, and we talked about at Financial Analyst Day. It's a big part of our capital structure.

And at the Financial Analyst Day, the other piece that you talked about within capital allocation is 30% of your free cash flow for either opportunistic buybacks or M&A. Maybe just help us understand puts and takes around that. What would drive you in one direction versus the other? And if it is in the M&A direction, is larger M&A part of the thought process from here?

Yes. So this was part of, I would say, NetApp pre me. Post me, I want to make sure that we are doing the right thing from a shareholder perspective, but we're also investing in the business. So we want to make sure and allocate, hey, part of that free cash flow, we want to look at acquisitions. Our focus is on smaller bolt-on acquisitions that fill a product hole. That will be the focus. So 1 year maybe a little bit higher; 1 year maybe a little bit lower. It really depends on the acquisition pipeline, multiples, all of those things. And look, our focus is on smaller ones. But if there's something larger, we'll take a look at it with 1 very strong proviso, which is it has to be right. We have to be completely convinced it's the right move. And because we really want to make sure and maintain that investment-grade debt rating, so we may bump up a little bit, but we want to pull it right back down. So staying within our capital structure guidelines, but yes, we'll certainly take a look at them. But our focus is on smaller bolt-on deals.

And does it sound like then for that 30%, the preference is M&A to the extent that the opportunities are there? Or is it really just a year-by-year case-by-case basis as you go back and forth between M&A versus buyback?

Long term, the goal is that, hey, we want to make sure that we're funding acquisitions. So -- and so I would look at that 30%. That's something we want to do. To your point, great point, Matt. It will bump up and down. But we do want to make sure that we're investing in the business.

Perfect. Well, unfortunately, with that, I think we are out of time. So Mike, thank you very much for carving out some time. I appreciate you joining for the discussion.

Absolutely. Again, thanks to Crédit Suisse. Matt, thank you for having us. We are thrilled to join. And everybody stay safe. Have a great holiday.

Thanks.

Thank you.