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

Welcome, everyone. I'm Katy Huberty, IT hardware analyst of Morgan Stanley, and I'm pleased to welcome George Kurian, CEO of NetApp this afternoon. During his tenure as CEO, George has capitalized on growth opportunities in flash storage and more recently, cloud storage while investing responsibly and returning capital to shareholders. Prior to serving as CEO, George was Head of Product Operations, where he was responsible for the strategy and development of NetApp's product portfolio. Before we begin the discussion, let me just point you to Morgan Stanley research disclosure website at www.morganstanley.com/research disclosures. And I also want to read on NetApp's behalf that 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 NetApp's most recent 10-K and 10-Q filed with the SEC and available on their website at netapp.com. NetApp disclaims any obligation to update information in their forward-looking statements for any reason. So with that, George, thank you so much for joining us. The way I want to run the discussion is to start out by talking about the demand environment and then move to NetApp's competitive positioning in storage and recent share gains. But then I want to spend a good amount of time at the end of the discussion on cloud data services, given that NetApp is ahead of the competition in scaling its cloud business and yet the valuation multiple doesn't necessarily reflect that yet. And I think the more investors understand about the business, the more credit you'll get over time.

So if that is okay with you, let's start around demand. If we look at NetApp's business over the last couple of quarters, you returned to growth earlier than many of your enterprise infrastructure peers after investing in sales capacity and cloud services over the last couple of years. Do you now see growth is sustainable from current levels? And what are some of the incremental opportunities that you're investing in?

Thank you, Katy, and thank you to everyone for joining us today. Thanks for the invitation to present, Katy. I think, first of all, we feel very good about the focus and execution in our business. You hit the highlights. We are clearly focused on 2 priorities: growing our all-flash array business with share gains in the on-premises market and scaling cloud data services. We have seen the benefits from the investments we made in sales capacity last year pay off through the course of really good pace of business throughout the last few quarters and share gains in our all-flash array segment. We are guiding Q4 to a 6% year-on-year growth. We haven't guided next fiscal year. We will do so when we get to it, but we feel prudently but really positive about the pace of progress in our business. In cloud data services, we are in the early inning of a significant opportunity. Enterprises have moved only a really small percentage of their workloads to the cloud and haven't really deployed business-critical applications on the cloud. We are an important component of making that capability happen in all the world's leading cloud providers. We are investing or accelerating some investments in sales capacity, in data center deployments, and in certifications and R&D based on the real demand that we see for our services in discussions with customers and cloud providers. And we expect that to pay off just like the payoff from our investment in go to market did this year. So over the next 12 months, we should see benefits from those investments, Katy.

That's great. So logic would suggest that after the CapEx freeze last year that calendar '21 or your next fiscal year should really be a period of recovering CapEx demand. Is that how you see the next year playing out? Understanding that you haven't provided guidance for your next fiscal year, but just qualitatively, do you see a spending recovery? And many of your peers last week on earnings called calendar 2Q, which would be your July quarter, a period of demand inflection when that particularly commercial market starts to come back. Is that -- do you agree with those views around what the shape of the recovery and timing of the recovery might look like?

Listen, first of all, we are much more positive and optimistic of our business at this time this year than it was at this time last year. We have seen a broadening book of business through the past 3 quarters. In the first fiscal quarter of our fiscal year, we saw the larger -- largest enterprises that had the capacity to weather long-term downturns drive the spending in our business. The last quarter, for example, we saw a lot of national enterprises as well as growing public sector momentum across the globe. And as we look over the next few quarters, listen, we track 3 things to give us confidence of the road map ahead. One is public health data, which is vaccines, new case rate decreasing, and frankly, the human cost in lives decreasing. The second is the shape and timing of stimulus not only in the U.S. but in some other geographies. And the third is the clarity on tax and regulations and trade regimes. I think we think that all of that should get better over the course of the year. So next year, we feel really good about our prospects. We're being prudent as we kind of navigate the still uncertain market. Things will get better, but we're going to let you know, as we guide the next fiscal year, what it looks like.

If you take a longer-term view, is there an argument that COVID has actually reshaped in a positive sense long-term storage demand with a more distributed workforce and emphasis on digital transformation. And did that mean that we could actually see your product revenue or even hardware revenue inflect to growth over the next 4 to 6 quarters?

COVID clearly has accelerated, like you said, digital transformation projects, whereas before COVID, digital transformation was a nice to have. The impact of COVID has made it a necessity in many industries and a big driver of benefit in others. And so we see that in the nature of the projects we are engaged with. Data and hybrid cloud are key enablers of digital transformation. We're well positioned to capture that trend. So I do think that data growth has continued regardless of COVID. In fact, it's probably accelerated so that customers in remote working environments can share data and work better together. So we think, overall, the market is set to do well for us over the next year, 2 years; and we think that the position that we have is really, really well set up for success. We are positioned really well in hybrid cloud. We are well positioned in data management and data services, and we're focused on executing. And we'll take those on.

You mentioned earlier the share gains in storage in recent quarters, I know there's been a lot of talk about some of that coming from Dell's slower power store ramp. But this last quarter, you talked about a broader range of legacy competitors that you're taking share from. Just talk about how your storage portfolio is differentiated versus particularly the legacy companies and where that market share is coming from.

I think there are 3 key elements that we see customers talking to us about as they think about their storage environments. One is the mid-range architecture is the growing part of the storage market. It has, because of multiple technology trends like clustering and open networking and scale out, become the sweet spot of how customers can build highly capable storage environments. We have been the long-standing leader in the mid-range market, and some of our competitors are going through big transitions in their mid-range portfolio that provides us opportunity. The second is flash. I think the combination of ONTAP software plus flash gives us a really strong position in the market, performance leadership, really good storage efficiency. And then the third is cloud. I think what we are able to tell our customers is any investment they make in learning and deploying our technology is 100% investment protected because you can use the same technology in the cloud. And frankly, we accelerate customers' migrations to the cloud if they choose to do so. So I think those are the 3 key leverage points. We can apply those leverage points against any on-premises competitor. I think Dell clearly is the largest one, but they are also the most resourceful. I think they're -- even if they get their mid-range product portfolio to a better place, which we expect them to do over time, we think that there are several other places, new workloads and also, frankly, several weaker competitors to get share from.

Given your prior role, you're very close to the storage technology market and, of course, NetApp's own road map. When you think about the road map over the next 3 to 5 years in storage, what are you most excited about? Are there adjacencies that can drive another leg of growth for NetApp in the future? And do you think about capturing those organically? Or should we expect more M&A?

I think we'll, first of all, see a combination of both organic and inorganic. We have innovated the preponderant majority of our data services and data management portfolio organically, and I'm super excited about 2 or 3 things going forward. First is the applications that customers want to deploy for artificial intelligence and analytics are replatforming from some of the legacy Hadoop-style landscapes into much more cloud-native architectures, and we have compelling technology for that. The second is we have been working on and are bringing to market a really fantastic set of tools for cloud-native computing and cloud-native storage, and you'll see us scale that up over the next 12 to 18 months. And then the spot acquisition gives us the ability to address the adjacency of compute optimization like we do with our organic portfolio for storage optimization. So overall, I think our portfolio has come into a lot of newer areas, which I'm excited about, and we're just going to execute like we've done in the cloud business heads down, focus on the customer and take it every day.

Over the last couple of quarters, your business has benefited from a favorable pricing environment and higher flash mix, which carries higher margins. Is there room for further margin expansion, particularly on the product side as flash increases the mix? And you've talked about a mid-50% product margin target. What's a reasonable time horizon to get there?

I think you're exactly right, Katy. There are 2 things that drive our confidence in the ability to get to the mid-50s product gross margin targets. The first is the increased contribution of flash as a percentage of the overall product mix. Flash has a higher gross margin profile because of the software composition of a flash-based system. The second is NAND costs getting incrementally more favorable. We've said that in our guidance for Q4, you should see gross margin stays roughly the same as they were in Q3, which was an improvement to the first half of the year. NAND prices have no longer a headwind in the second half sequentially to the first half. They're sort of net neutral to where they were a year ago. And then I think, as we head into next fiscal year, NAND prices should be a little bit of a tailwind. So I think those are 2 key components. We have said that post COVID, we have every expectation to be in the mid-50s in terms of product gross margins. We've tried to be a good partner to customers. We've also had to deal with a little bit of supply chain, freight and transportation costs during COVID, but I clearly see opportunity to get back to the mid-50s once the impact of COVID has reduced a bit.

Someone is asking over the webcast about sort of the potential for NAND prices to start drifting higher just given the strong recovery of demand across technology markets and the potential for tighter supply. Do you see that as a reasonable probability that, over the next 3 or 4 quarters, NAND prices go against you? And if so, how would you expect it to impact margins?

I think it's a little early to tell. I think we have good conversations with our suppliers. We have deep relationships with multiple of them. And so we are observing what's going on in the market. I think that it's honestly too early to tell whether it will cause it to drift upward or not. In terms of what it does to -- in a normal environment, for the customers who we deal with on a transactional basis, not those that have master purchasing agreements with us, for those that we deal with on a transactional basis, we don't hedge the price of the commodity. We pass it through to customers or, if there's a benefit, pass that through, too. I think we've been a little bit more prudent about doing that during the COVID environment because, honestly, we are trying to be a good partner to customers and maintain long-term relationships. But that's kind of our typical posture. We pass it on and customers make decisions about whether on the margin they want to deploy an all-flash configuration or hybrid flash. We have got really compelling technology in both. And so we can always sell them a hybrid flash environment if we need to.

So given that you haven't passed as much on during COVID with NAND prices coming down here the next couple of quarters, that's why it could be a benefit to gross margins. You're sort of catching up to the pricing over the last couple of quarters.

That's right.

Okay. So as I said in the beginning, I want to spend a fair amount of time on cloud data services. A lot of your competitors and just generally infrastructure companies are talking about cloud, ARR and cloud data services. Some of them include things like traditional maintenance or financing in that number. Your cloud data services is NetApp software running in the public cloud. It's a pure read on a public cloud business that's growing within NetApp. So just with that as context, the business got off to a slow start if you look back 18, 24 months ago, but it's hit an important inflection point over the last year. Talk about what is now driving improved organic growth rates in the business.

I think, first of all, it's taken a lot of really hard work to get our core technology deployed, certified, integrated into the different cloud providers, data center ecosystems, I think that there's a lot of operational work as well to get here, right, between our support teams, our selling teams, our technology teams to make this a seamless customer experience. We run the most important workloads in many of the world's most important cloud. So things that run a company's business, SAP, high-performance computing landscapes, virtualization environments, mission-critical databases, so these are not workloads that customers would just sort of lift and shift or if it's a new deployment, just throw it on the cloud. The way that our business is inflected is really a reflection of the maturation of our overall cloud business. We have been really pleased by the pace of new customer acquisition that has accelerated steadily over the course of this year. And we think that the majority of the enterprise application deployments on the public clouds is still to come. We are in the second inning of a 9-inning ball game, and that is an enormous opportunity for us. With regard to once the customer is onboard, dollar-based net retention rates have stayed north of 200%. Yes, it's early going, but those are very encouraging numbers because customers expand quite substantially once they start to use our service.

In the near term, just looking at the January quarter, cloud data services growth, just sequentially, what you added to revenue, was a little bit slower. Talk about why that was. And do you expect that growth rate to normalize in April and why?

Like all early companies, we are early in the cloud market. I think that I don't read anything particularly negative into the quarter. We had really good pace of customer additions. We saw some instances where customers had deployed dev and test environments with us, sort of tear those down and then not get their production deployment yet onboard with us during the course of the quarter, which, given where we're at, yes, they can affect the number. But we have really good line of sight into our Q4 business pipeline. It's an expanding range of opportunities. And at the midpoint in Q4, we would add quarter-on-quarter the same amount of business as we added in Q2 over Q1. So we're not sort of reaching uncharted territory to deliver the Q4 number. So we've got work going on to deliver that. We feel really good about the mix of customers and workloads that we're seeing, and we'll just take it a quarter at a time.

And those dev test workloads that were slower to move to production, do you see those deals coming through in the April quarter?

Yes, they'll come through over the next few months, right? I think some will come through in the April quarter. Some will come through in our fiscal Q1. These are big mission-critical environments like SAP. So customers take the appropriate amount of time to deploy it. I think we're very confident that they like our technology and are going to move forward.

And looking out over a number of years, you're forecasting really significant scale, $500 million run rate by the end of fiscal '22, over $1 billion by the end of fiscal 25. What are the friction points to scaling cloud data services to those levels? And can you achieve those numbers organically? Or does there need to be some degree of M&A?

I think, first of all, we think that we can get a preponderant majority of those targets through organic growth. We wouldn't lay it out if the majority was through inorganic. I think that being said, we feel that there are opportunities to expand our strategic relevance to customers to build a deeper competitive moat through inorganic transactions as well. And you'll see us be disciplined about the number and the nature of those that we do. I think the majority of the -- sort of the really tough innings are behind us. I would just tell you, getting the technology cloudified and integrated and deployed as a service with billing and operational integration is behind us. I think what remains ahead is cutting through the noise of the cloud discussions at customers, getting in front of more customers together with the hyperscalers and executing. I think that's the majority of it.

How should we think about the competitive environment for cloud data services? For instance, what's the risk that the cloud providers just introduced their own cloud file storage offerings or go to your competitors and have many different storage vendors offering file storage on their platforms? And one, is that a reality? And two, why is NetApp solution more compelling than what those offerings would look like?

So I think there are 2 reasons that we are going to continue to stay -- 2 areas that we're going to continue to stay focused. First is innovation. We're going to continue to have the best offerings for customers that, in addition to core file storage, we've added data services like backup and data compliance and data security as sort of built-in capabilities on our platform that adds differentiation. With Spot, we now not only can help you deploy storage. We can add compute. So we're continuing the innovation paradigm. The second is you've got to stay close to customers and help meet their needs, right? We don't expect that the market will have no other competitors. Listen, the cloud providers have their own offerings, but they're choosing to work with us. Other companies may choose to compete with us in the cloud world. We have a lead, and we're going to stay focused and execute and double down on our advantage.

Cloud data services margins are still below corporate average. So how should we think about the revenue run rate where you'll reach corporate average and then scale to more mature levels?

Yes. We've said, Katy, that we think that cloud data services over time from a gross margin perspective would be accretive to company gross margins. Today, we're a bit behind company gross margins, but we have seen a good trajectory through the course of this fiscal year in the cloud data services gross margins. I think the second is with regard to the 2 components that get us to where it's above, one is essentially scale in the business. As these offerings reach maturity and productivity and scale, the utilization of the technology that we have in the cloud providers, that'll drive gross margins up. I think that the second component of that is an increasing software mix, where our software components become the majority of the cloud value add. And I think though, on the second, the acquisitions that we've done, which have been predominantly software-based by the end of this fiscal year will be accretive to company gross margins, so that's a good leading indicator. We expect by some point in fiscal '24 that the overall cloud business will be accretive to company gross margins. And we're tracking to that.

Okay. Many infrastructure companies have pivoted towards an as-a-service model, so pushing companies or offering to their customers to buy on-prem equipment as a service in a cloud-like model. You have an offering called Keystone. Talk about how strategic that is. What's the real interest level from customers? And do you ever see that business model overtaking traditional CapEx buys? Or is it just an add-in service that provides choice to customers?

We see customers interested in a broad range of procurement options. I think we continue to see many of them continue the CapEx-style transaction. They have mature business processes around that, around procurement and deployment, and I think we see that continuing. We are able to meet customers' OpEx interest like the as-a-service interest through a variety of mechanisms. Our public cloud clearly is the easiest and fastest way for a customer to get an as-a-service offering from us. If they want to deploy it in their data center, we have Keystone from NetApp as a service or we have a growing number of partners who offer partner-managed, partner-delivered as-a-service offering. So we think, listen, it will be a part of customers' needs, and we will meet them. Do we see a broad mandate of customers going all as a service? We honestly don't.

Okay. There's a question here on the webcast asking -- I guess it's 2 parts. One is what was the reason for your recent mixed shelf offering? And then somewhat related to that, you, like most companies, slowed the share repurchase during COVID. How are you thinking about returning to the share repurchase as demand comes back and the business stabilizes?

Okay. I mean, in terms of our offerings, we will continue to do what the market wants us to do. So we're not averse to trying out different things to meet customer needs. With regard to the capital allocation profile of the company, we have laid out a plan that has 3 components to it. The first is increasing cash flow by driving cash flow from operations. We've done a good job. We're up double digits year-to-date. I think you'll continue to see us prudent in terms of investing where there's opportunity but being prudent in terms of expenses going forward. I think the second is, with regard to the uses of cash, we've said that we expect dividends to be about 50% of free cash flow. We think that, over the course of a year, we'll continue to sort of offset dilution and keep our share count in the same neighborhood that it's always been. I don't think you should expect us to drive capital returns to shareholders substantially above free cash flow because we want to maintain investment-grade credit. So I think dividends at 50%; buybacks in the range of 20%; the remainder 30%, either to invest back in the business for long-term growth or to maybe do some more buybacks. I think that's the model that we've laid out. I think the recommencement of buybacks was an indication that we have better visibility, right? So I think while -- we're just being prudent. We're being disciplined. There's no question that we think the next 12 months will be better than the last 12 months.

Right. Good. So we're running up on time, but I want to just ask one last question to wrap up, which is what do you think, after meeting with investors today and recently, what do you think is most underappreciated about the NetApp story?

I think, first of all, we are a company that is a software company that's positioned at the intersection of 2 really important trends: one, the growth of data in value and scope requiring better management, protection, security; the second is the reality that the vast majority of enterprises' IT architecture for digital transformation is hybrid IT, hybrid cloud. We are well positioned for both of those. We have been focused executing our game plan, where we have been able to drive up our share in the all-flash array market and start to scale a significant cloud business that, over time, is accretive to the company's margin profile. And we have been a disciplined manager of capital. Operating margins are north of -- will be north of 20% this year. I think returns to shareholders, we've been disciplined about dividends. We've recommenced buybacks. And we've been a disciplined acquirer of complementary acquisitions. So I think that's the quick summary, Katy. We feel really good. We've had 3 really strong quarters, and we've got 1 more to go to finish the year. And I'll just tell you that we are incredibly grateful for the blessings of being able to have our team operate in a world without tragedy amid such a difficult year. I hope you all stay safe and well. Thanks for having me.

That's a great way to end the discussion. Thank you so much for joining us, George.

Thank you, Katy.