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

Hey, everyone. Welcome to the third day of Cowen's 2021 TMT Conference. I'm Karl Ackerman. I'm the senior analyst here at Cowen, covering semiconductors and storage hardware. I'm pleased to present to you, Kris Newton, Head of IR at NetApp. Kris, thanks for being here.

Thanks for having me.

So today, we're going to have a fireside chat format. If you'd like to ask any questions during the presentation, please do, and you may submit those questions on the portal or you can also send me questions directly at karl.ackerman@cowen.com. Kris is going to read a safe harbor, and then we'll move into Q&A. So Kris, please go ahead.

All right. I'll make this fast. Today's discussion may include forward-looking statements regarding our future performance, which are subject to risk and uncertainty. Actual results may differ materially from the statements I make 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 and our looking statements for any reason. All right. Back to you, Karl.

Great. Thanks. So Kris, you reported last evening, revenue is up 11% year-over-year. A growing mix of all-flash arrays and growth of the company's cloud software offerings. I guess, what do you think was the biggest surprise to the team that you saw this quarter relative to your prior expectations?

Sure. So we outperformed all the guidance that we had given previously. And I think we saw the U.S., parts of Western Europe and parts of Asia recover faster from the COVID economic slump than expected, which was great to see.

Got it. So I guess during this conference, we've been asking all companies to discuss the level of visibility each has in the second half of the calendar year. And just based on kind of the order backlog, inventory on hand, and really just kind of continuity of supply. And so I guess with that backdrop, I was hoping you could discuss for us your ability and strategy to meet demand over the next couple of quarters, including whether demand is outstripping your ability to supply, even for the July quarter?

Yes. Obviously, visibility is always better, the closer in it is. But we're really confident in our value proposition and our position with customers. And you can see we gave good full year guidance of 6% to 7% top line revenue growth last night. When we look at the supply chain infrastructure, we've got a great supply chain team, and they did an amazing job throughout COVID and making sure that we had ample supply to meet customer demand. Negotiated and managed through a lot of challenging logistics that were caused because of the COVID challenges. We expect them to continue to perform well as we move through FY '22. We're not seeing real inflationary pressures along the component pricing, but we are seeing longer lead times. And so as we talked about on the call last night, we will increase our inventory levels. You should expect to see our inventory turns come down. They were 18 in Q4, and our CFO said, people should expect something closer to 12 to 13 inventory turns going forward. And so that really is -- we just want to make sure that we have ample supply to meet customer demand. And that's not any specific component, but kind of generally speaking across the board, just raising inventory levels.

Got it. No, that's very helpful. On gross margins, as you indicated, there's perhaps some less inflationary pressures. But I think costs in general had kind of risen across the semis and hardware supply chain over the last couple of quarters. Maybe not just at the component level, but also elevated delivery costs. And so I guess, I was hoping you could kind of characterize the pricing environment today and whether you've been able to pass along some of that burden from perhaps whether it's expedited freight or whatnot to some of your key customer accounts and how you manage that expectation going forward?

Yes. It's amazing. Customers are much more apt to take price declines than they are price increases. And so over the course of fiscal '21, we did see some gross margin headwinds related to increased shipping costs. Cargo capacity was dramatically reduced. And so everything -- all the expenses went up. It was true of Q4 as well and probably will continue to be a bit of a headwind as we move through next fiscal year. When it comes to the commodity components themselves, we'll see NAND pricing to be down year-on-year in our first fiscal half, and then that will revert to be up year-on-year in the second half. Hard disk pricing is probably looking to be down year-on-year over the course of the year for us. And ultimately, when you bring all that together, we expect that those commodity components will roughly be flat year-on-year. DRAM is certainly going up pretty dramatically in price. But it's a pretty small part of our bill of materials. So we don't expect to have much impact from that.

Got it. That's very helpful. I guess I'd like to pivot to end demand. Last evening, you did offer an initial outlook for fiscal 2022. And I guess, how do you see the growth trajectory between all-flash arrays and maybe hybrid arrays in the context of your guide? And second, could you comment on whether some of the pickup in activity that you're seeing is happening whether it's in private cloud, in colo facilities? Or is it really kind of also coming from maybe traditional enterprise and SMB accounts?

Sure. So we're seeing kind of demand across the board. Our exposure to SMB in our traditional storage business is pretty low. So where we saw real strength was in large enterprise and enterprise accounts. And we see companies building out private clouds and doing a lot of digital transformation initiatives, but also looking to modernize their more traditional data centers through the use of flash and other more modern technologies and architectures. When it comes to the growth rates of flash and -- versus hybrid arrays, flash systems are expected or the flash market is expected to grow faster than the hybrid market. And so that should be a faster grower for us as well. And we are confident in our ability to continue to gain share in both markets because of the value proposition that we offer both uniquely for just the storage array, but also with all the cloud connectivity that we can bring. I think -- did I miss one of your questions? Or did I hit them all?

No. Yes, I think so. Yes, just -- well, it was the growth trajectory between all-flash arrays and hybrid arrays in the context of your outlook, I don't know if you have a maybe a finer point on that, but...

Yes, sure. We look at the IDC data to try and get a sense of forward-looking markets. And I think flash is expected to grow about 7.5%, whereas HFAs are anticipated to be more flat. And so I think that would be -- we expect to outpace market growth in both, but that would give you an idea that you'd see greater growth in our all-flash business. We grew 11% year-on-year in Q4. So that would kind of imply something similar going forward. And we definitely see that mix shift in our business towards all-flash. The all-flash arrays carry greater software, which ultimately helps support gross margin. They're both more software-rich and a little bit more expensive at the initial point of sale, which helps drive the maintenance lines as well.

Got it. No, that's helpful. I'd like to follow-up on AFA in a minute. But I guess, sticking with the fiscal '22 outlook regarding your -- kind of your OpEx outlook. And I guess, it's growing in the context of the overall revenue, which is great. And I think certainly needed as you continue to invest and fund some of these cloud initiatives. I think one of the concerns I've heard from some investors this morning is your ability to rein in OpEx if COVID resurges and demand will not pick up as expected for the next couple of quarters. And so could you just discuss your ability to manage costs in the current environment if that were or were to not occur?

Yes. Most of our costs are -- as our CFO, like say, ultimately, all costs are variable. So there is flexibility there. You probably -- if you look over the history of NetApp, we've tried to be really prudent in managing our expenses. We have, while investing in an ultra high-growth cloud business, held OpEx relatively flat but for variable comps since FY '17. So we'll continue to manage our expenses prudently. Our plan is to grow expenses slower than revenue growth. But you also shouldn't expect us to have a dramatic reaction to a onetime impact. If we see a sustained change to the environment, we have the ability to react quickly. But if there's a temporary shock that happens, we probably won't react to that because that wouldn't be -- that wouldn't set the company up well for the long term.

Yes. I appreciate that. Yesterday, you did report record annualized all-flash array revenue of $2.9 billion. You spoke about your ability to outgrow the market for fiscal '22. I guess beyond converting your installed base, what do you think is maybe your 1 or 2 primary advantages relative to peers that may allow you to gain additional opportunities maybe at both new and existing accounts?

Sure. So as we look at our installed base of systems under active support contracts, that measures in the hundreds of thousands and roughly 28% of those systems are currently all-flash arrays today. So there's still plenty of headroom within our installed base to convert customers from HFA to all-flash arrays. Probably that whole market won't convert. There's lots of good reasons why people would choose HFA or even hard disk arrays. But still plenty of room to continue to grow. When we look at the competitive landscape, I really think the cloud connected nature of our all-flash arrays is the thing that sets us apart. And just generally speaking, the actions that we've taken to embrace customers' journey to the cloud and support them on their cloud initiatives and digital transformation initiatives really helps drive our AFA business. We see a lot of customers doing AI-enabled digital transformations, and that's a real sweet spot, where NetApp can help with the performance of our AFAs, the data efficiency capabilities and then the ability to set up automated tiering of cold data to blob storage in the cloud. So I think that cloud connectivity and our overall cloud stance really helps us gain share in the AFA market.

Got it. That's very helpful. With regard to your current outlook for fiscal 2022, what can you tell us regarding exabyte growth per box for hybrid arrays. Specifically, the hard drive component providers are expanding capacity points, 18 terabytes and even 20 terabytes in some cases. But given on-prem enterprise spending is still recovering, are you seeing customers gravitate toward lower capacity points to save costs? Or are they going more toward those higher capacity points?

Yes. It really depends on the customer. We've qualified a wide range of disk drives in our systems. I think everything from sub-1 terabyte to some of the larger arrays. And so it really does enable customers to create a blend of spindles and even using some flash to accelerate the hard disk drives to get the right price performance level that they're looking for. This is an industry where the capacity points of individual drives, be the hard disk drives or SSDs, continues to move up and we'll keep a pace of that.