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

Hello. Thank you for joining. Tim Long here at Barclays. Good afternoon. This will be the breakout session for NetApp. We're happy to have Mike Berry with us, our EVP and CFO of NetApp, a relatively new CFO there. Before we get into our Q&A, I'm going to throw it over to Kris to give a quick disclaimer.

Thanks, Tim. 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, which are described in our most recent 10-K and 10-Q filed with the SEC and available at netapp.com. We disclaim any obligation to update information in our forward-looking statement for any reason. I'll hand it back to Tim.

Great. Thank you. Thank you, Mike, for joining. I want to start off kind of a higher level one for you. You've been at the company, I think, 9 months or so now, so just curious of your impressions. You've been around the tech world a long time. I'm sure you knew NetApp coming in. But any kind of high-level takeaways about the company, strength of the company that maybe you didn't have a full appreciation of until you kind of got under the hood in the role?

Sure, and good afternoon, everybody. And Tim, thanks, certainly, from Kris and I, thanks to Barclays for having us. We're thrilled to be here. So yes, I mean, gosh, it's almost been a year now we're getting on it in terms of when I joined NetApp. I certainly knew of the company, being a customer of NetApp. And going into it, I was really excited after doing all the diligence and talking to George and the team about not only the company's products -- I'm a big believer, it doesn't matter where in technology you are, products really drive the boat, the great products the company had as well as, certainly, the go-to-market position. Lots of companies spend a lot of money to try to get anywhere near where NetApp is from a go-to-market perspective. Then certainly really excited about the cloud business that the company had already embarked on. And then as CFO, the financial stability, the cash flow generation, the leverage in the business, I thought was great. All of that stuff has come true, all the good things that I thought. The 2 that I would probably highlight as being even better than I expected, one is the cloud opportunity. I think as -- especially as we've gone through the last couple of quarters but, more importantly, looking forward, the momentum in the business, I think, is great, and we really, really feel good about the future of the cloud business. I think the data fabric strategy that NetApp has started a long time ago is really great, and it's the right strategy. The other thing as a CFO is, look, I really love the financial stability as well as just the business model of the company. And all the investment that we've been able to put, Tim, around bringing in new sales teams, focusing on R&D investments to drive growth while building really a pretty substantial cloud business within NetApp, infrastructure-wise as well as, obviously, go to market, has been great. So all of those things I thought were good. Those are the 2 I'd highlight as being even more impressive than when I started. And then, of course, I've done all of this through my living room or my office in Dallas. For those of you who don't know, I started the day the shutdown started. So kudos to the management team, to Kris, to everybody on my team for helping in that. It's been a crazy 9 months working almost all remotely.

Great, great. Yes. Crazy timing for you as well. Appreciate that backdrop. Maybe let's just talk a little bit about the near term. Obviously, you just reported recently some really strong results. So maybe, at a high level, what do you think is driving that? I mean I think we did see across the sector a little bit more of a rebound last quarter across the board. So how do you feel about kind of the sustainability of what we saw last quarter for the overall industry and for NetApp?

Yes. So for NetApp, in particular, we would point to a couple of things around our results. One is going into the year, and we talked about this coming out of Q1 as well, I think George did a great job really focusing the company on the key priorities: regaining share in the core storage market and scaling our public cloud services. And we've not only us as a management team but the whole company has really rallied behind that. And I think bringing that focus has been super important. Certainly, the investments that we made, I touched on a couple of those just a couple of minutes ago, bringing on the new sales folks, adding that additional quota-bearing capacity, I think, has been super important, and it will continue in the future, to your comment about the sustainability, as well as all the R&D investments we've made across the business. And I think all of that has helped. But overarching all of that is, again, you talked about the NetApp data fabric strategy, the ability for us to tell what I think is the best story in the industry around managing the data on-prem and in the cloud and to do that across that data fabric strategy, I think, is really starting to resonate. So I think all of that helps, and that leads to your second part of your question, which was the sustainability. All of that, we're still obviously focused on in the second half. We feel really good about our position in cloud, focused a lot on the all-flash market, which is the growth area of storage and then, certainly, our ability and our focus on being disciplined around operating expenses but making sure that within that envelope, we're investing to drive growth. I think that's helped in the first half, and I sure think it will help in the second half of the year as well.

Okay. Great, great. Maybe -- you touched on cloud a few times. That's obviously an area where I think, following some other storage companies, they aren't really as aggressive or as successful playing in the cloud world. So maybe give us a little update on kind of where you see that business. Obviously, you've added a few acquisitions to it, and it's been growing organically pretty well. I think it accelerated last quarter. So maybe just give us an update there? And what are the kind of guideposts we should look at to help see further growth in that line to get you to the ultimate $1 billion target that you're looking for?

Sure. So let's talk a little bit about what's in that cloud business, and then that will lead to the answer. So the major part of that business is what we call Cloud Volumes. It's Cloud Volumes ONTAP, which is more of a software solution, Cloud Volumes Services, which is a managed service that helps anybody that wants to deploy storage in their cloud to do it very quickly. We also have what we call our Cloud Insights. That is more of a monitoring tool that's also we had it on-prem, now we're moving it to the cloud. And then you mentioned the acquisitions that we did, added about $44 million of cloud ARR as of the end of Q1, the largest of that being Spot, which is really our cloud compute optimization. That was such a great acquisition for us for multiple reasons: brought new capabilities for us, very synergistic to what we do in the cloud, also gave us access to those cloud buyers. Certainly, every virtually storage admin knows who NetApp is. We're making great progress getting the name recognition in the cloud, and that certainly helped. So all of those have continued to grow nicely. We talked about organic growth, on a percentage basis, actually accelerated last quarter versus Q1 on a year-over-year basis. So that was great. Spot has continued to perform well. And as we look forward to that $1 billion mile marker that we put out there, we do expect our organic products and what we have today to continue to be the majority of that, but we also are going to continue to add inorganic opportunities to the cloud business where we see adjacencies that we think are, again, add synergies to the platform. Not that we don't think we have any "holes" in what we do today. It's more about adding new capabilities. So we do feel good about that. We've talked a lot, Tim, about the margin profile as well as getting that to the company average, which to us is super important, so that as our customers move back and forth or they expand into the cloud, from a gross margin perspective, it will continue -- it will be additive. So yes, all things good there. A lot of work done, a lot more work to do, but we feel super good about the opportunity.

Great. Great. And maybe related to that, can you talk a little bit about the go-to-market for these cloud-based services, both -- within the NetApp sales force? Are we looking at different means of compensation? Or how is that handled? And then maybe just touch on kind of partnership with the cloud stores themselves and how that can open up opportunities for NetApp in this line as well?

Sure. So from a go-to-market perspective and cloud, let's break it into those 2 parts. First of all, within NetApp, we certainly have our core sales team that can sell cloud as well. Certainly, they focus mostly on the core storage business. But to the extent that they can in their accounts sell cloud, they'll certainly do that. We also have a separate cloud sales group who's responsible for not only selling cloud but also working with the hyperscaler partners as well to not only deploy it but expand that. And then that's the second part of your question, which is with Azure and GCP, those are first-party products where they sell those, think of it as they're selling their own solution powered, certainly, by NetApp. And the important part about there is that it retires quota for their sales team, which is super important. And then AWS, like virtually everybody would go through the Marketplace, which we've done for many years. So there's -- and there's a lot of help each of those groups give each other, certainly. And from a comp perspective, we -- our core sales team has always been comped on the amount of business they bring in. The cloud team has comped on ARR. So we're trying to make sure that, that compensation flows with the way the business runs and how we report it.

Okay. Great, great. That's helpful. Any low-hanging fruit left in this business or now that you're kind of up in GA across the board on partners and cloud platforms and products?

So I don't know if I call it low-hanging fruit, but I wouldn't call it, hey, we really have to reach for it. We feel good about where we are. And let's take each one of them again. AWS, mostly through the Marketplace, we had a long-standing relationship with them. That was obviously one of the early partners that we had. From an Azure and a GCP perspective, a lot of work on the integration, technical as well as getting into their management platforms, enabling their sales team, super important, so we've made a lot of progress there. And as we expand, so for instance, FedRAMP, we've now rolled out FedRAMP with Azure, which opens up another market there. There's a lot of important things that we need to do to continue to expand that. All of it right in front of us, and we know what those things are. So I don't know if I determine it as low-hanging fruit, but the nice part is we know what we need to do. And we've got a lot of questions about, hey, cloud, in terms of given the road maps that we gave, it's pretty clear, Tim, the company has made great progress over 2 years. We know a lot more about the business today than we did a couple of years ago, and we get better every day. So understanding what the road maps are, what product we need to do, more importantly, what we need to do from a go-to-market perspective, we just continue to execute on that every day.

Okay. Great, great. Another area that was strong in the quarter was All Flash, continues to do well, and you still have a lot of the base to go. So what are you hearing as far as success there? And can you talk a little bit about maybe parsing out a little bit of what is new to NetApp for All Flash and what is just kind of a move from legacy systems upgrading to all-flash and staying on NetApp?

Yes. So there's certainly multiple sales motions in there. There's -- as you talked about, we're now at about 26% of our installed systems that are all-flash. That's just shown a nice steady growth pretty much every quarter, and we expect that to continue so that's certainly one motion. We do feel good about, especially with some of the opportunity around Dell's transition, the ability to go grab new logos there as well. So -- and so all of that plays into there. All Flash revenue up 15% on a run rate basis year-over-year, which was great. That goes back to the first discussion we had about setting the priorities around All Flash and our focus on really the big growth in the on-prem storage market. So also, we continue to introduce a lot of new features. And a lot of that sits with our -- with the #1 asset of the company from my perspective, which is ONTAP. The company has always been a software company. ONTAP has always been super important. And that is even more relevant as you move into all-flash because of the importance of the software. Again, always been a competitive advantage and all the enhancements and investments that we've made has really helped, as we talked about at Analyst Day. 80% plus of our engineers are software engineers. That's what they do. And I think we're starting to see the value of that investment and that focus in the results.

Okay, great. You talked about the pretty low percentage of the installed base on all-flash. Do you see that transition occurring kind of as systems are upgraded? Or do you see maybe an acceleration of the move to all-flash as the benefits that come along with it compared to disk, become more heightened over time as you introduce new products? So do you think there can be an acceleration of kind of upgrade cycle from the customer base?

Yes, great question. And I'm starting to see a trend because we've been asked that question multiple times. So typically, it does follow the -- when the existing system comes up and there's a renewal, that's typically when -- obviously, they'll look at it before then because there's not a lot of companies in the world that are -- or management teams that want to have a write-down of the existing assets. I do think -- at some point, it would be interesting if we saw an inflection. It would probably be driven by -- as they do their digital transformations, as they're looking at the cloud, how are they going to then support their data infrastructure. And potentially, we could see an inflection. We haven't modeled that in yet. That would certainly be a nice upside. We're assuming that it's going to continue the very nice trend that we've seen, but I would call it more on a linear basis. It's possible that we see an inflection point, and it would probably be driven more by that. But there -- we also want to take into account the realities of, hey, there is a little bit of time, there's certainly existing hardware and how does that manifest itself over time. Certainly, we're driving -- we hope we see some of that, but we're not planning on it.

Okay. Great, great. You mentioned software being at the heart of the company. One of the other metrics that people look at is just the growth of the software and maintenance businesses combined. What's your outlook there? I'm assuming some of this is driven by installed base, which seems to be growing but there's also other upsell opportunities. So how do we think about potential growth of those kind of software/hardware maintenance lines?

Yes. So thanks for that question, and I'll even go back a little bit at the Analyst Day. So as we talked about, software always been a big part of the company. I probably just talk about it a lot more because it's what I like to talk about. But probably more important is this gets to the R&D road map, though, and also where the business is going. So software always been a big part of the integrated appliance. As you move -- as AFF, or All Flash, becomes a bigger part, because of the benefits that ONTAP brings to the all-flash technology, we see more software because there's more software bundles come with it, right? The other part is, keep in mind, cloud -- really, the underpinning of cloud is software, and it's the ONTAP software. So as we go to that, add that in your head in terms of, call it, cloud revenue and then -- or software revenue. And then you get, as you talked about, the support line. And this is a part that I talked a lot about at Financial Analyst Day, which is that number has been $2.1 billion, $2.2 billion for 7 or 8 years. It is, to me, the definition of recurring revenue. There's $3.7 billion on the balance sheet, and it's shown very nice, consistent stability and more recently started to grow. The other part is, as we sell more all-flash, there's also more of that, that is allocated to support, so it goes to the balance sheet, which is great for future growth. So billings in the quarter, up 10%, total revenue up 3%, product revenue declined by 3. The difference there, certainly, cloud is in that number, in the billings number but, more importantly, more of it was, as we say, carved -- the support goes to the balance sheet, which is why, going forward, Tim, you'll hear me talk a lot more about total gross margins. Yes, product margins are important. But as more goes to support and that becomes a bigger percentage of our revenue, that's going to flow through, and you're going to see that in the services margin. So a little bit of that you'll hear about going forward as well. And if you take software revenue and software maintenance and cloud, it's already more than 50% of our revenue.

Right. Great, great. Yes, that is helpful. I did want to just dig down on that product gross margin side because it is still something that's of interest to folks. I know there's been a directive over the years to grow that number. There's been a lot of internal focus on it, and it's done well recently. I believe now moving to all-flash has been accretive to that. When we look forward, what are the kind of metrics we should look at other than commodity pricing? What else can we look to potentially improve that product gross margin line?

Yes. To that point, kudos on my predecessor, I think Ron did a wonderful job bringing focus to that around the product gross margin. So I was able to step right into that nice positive momentum that he had built. So when we look at that, yes, commodity prices certainly matter. We've talked about some pressure around COVID-related pricing, which all of us are facing, given where the economy is I think going forward, there's a couple of mechanisms. Again, as you look at the product gross margin and the other eye, please look at total margin because as the mix continues to shift in the business and based on why our customers want to consume, just make sure we don't get too focused on product and don't look at total because of the support contribution. And then, of course, as cloud grows, that's going to show up in that other line, too. So mix matters as it relates to the product gross margin, which is a big part of it is that as we come out of whatever the post-COVID world looks like, just in terms of where pricing goes will certainly matter. And then as we continue to grow cloud and our drive to get cloud margins up to that total company average, that also will hopefully have a big impact on the total. So always focused on product gross margins, but there's also a direct correlation then with the total.

Great, great. Maybe talking about so much of the business being off the balance sheet and a lot more recurring in nature overall, it might be a good way for you to remind us about the capital return philosophy of the company, particularly as we come out of the COVID world.

Yes. So on the capital returns, as virtually everybody I'm sure knows, we did -- at the end of March, we put our buyback on hold just as the unfortunate pandemic hit and there was a lot of uncertainty. Coming out of Q2, as we've looked at not only the results in the first half, even though we still all have a lot to get through, probably in the next 3 to 6 months around COVID, we do feel better about the stability of the business, the cash flows, so we have now returned into the share buyback mode. As we talked about at Financial Analyst Day, we want to continue the dividend. That's a super important thing to us. And while we know that people don't "buy" the stock because of the dividend, it's still a very healthy dividend yield, so we want to maintain that. But we also want to be responsible to the shareholders by offsetting dilution for the equity plan. So that's really the goal of the share buyback. Now since we're going to do it in the second half of a fiscal year, please don't assume we can offset everything in 6 months. That's more on an annual basis as the goal. And then really the thing there, Tim, is to make sure we have -- we're doing the right things from a capital returns, but we're also using some of our free cash flow to drive growth. And every year, every day, we look at, hey, what's the acquisition pipeline, what does that look like, do we want to use more of the cash there versus share buybacks, and that's something that we look at every day, and we will continue. So expect that to move around a little bit. But over time, we kind of laid out that, hey, 50% of free cash to dividends, 20% share buyback and then 30% to fund growth in the business. But again, that will munge around a little bit, certainly, by quarter, but that's more of a long-term market.

Okay. Maybe just one last one for you. We're running out of time here. But looking out, you've got a lot going on. You haven't been there long, but there's a lot of different moving vectors that we talked about here with business model changes and products and whatnot. What are your priorities for the next year or 2 as you look out across the organization and which do you want to accomplish?

Well, 1 priority is actually to meet my team in person, which would be nice.

A lofty goal.

Yes, a lofty goal for all of us. Yes, sorry. Joking aside for a second, so a couple of the key priorities for me is, certainly, we have a great public cloud services business. It's really to scale that business. We -- our goal is to get to $1 billion of ARR by -- in fiscal '25, exiting '25. We want to make sure that we scale that, that we have the infrastructure because that's a very large business in and of itself by that time. So that's super important. Also making sure that as we look at our OpEx, and not only OpEx but also COGS, there's obviously the discretionary dollars there as well, is how we are always reallocating our dollars to drive growth. I think the decision to add the 200 sales reps was absolutely the right thing. The ability to invest in the business is super important to us. And I'm a big believer in hey, the best way to be able to grow margins and cash flow over time is to grow revenue appropriately. And so that's a big focus as well. Certainly, acquisitions and inorganic will continue to be a focus for the company. Again, we are focused on smaller bolt-on. But that means, hey, you have to evaluate the right companies, you have to make the right acquisitions, you have to be able to fund them. And then very importantly, gosh, you have to do the right integration. So acquisitions is a big piece. And then Kris and her team do a fantastic job with our Investor Relations team, helping them wherever they need it in terms of outreach not only to the sell-side but also the analysts and really driving home where we see the value in the business because when we sit in a couple of years, and hopefully, we do this in person in San Francisco, and the cloud business is cranking, we're going to start talking about, hey, shouldn't you value NetApp on the sum of the parts?

Right, okay. Great, great. That's a great overview. Appreciate the insights. Kris, thanks as well. Tom, thank you very much. We'll wrap it up there. Everyone, enjoy the rest of your day. Stay safe, and have a great holiday.

Thank you. Happy holidays, everybody.

Thank you.