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

Perfect. Good morning or good afternoon, everyone, depending where you are. My name is Amit Daryanani, the IT hardware and networking analyst here at Evercore. And we're delighted to have with us NetApp as for our next fireside chat. And we have Lance Berger, Director of Investor Relations from NetApp will be here with us. We'll keep the fireside chat around 30, 35 minutes. I'll spend the first 20 minutes sort of going through some of the questions we have lined up, and then we'll open it up to the questions from the audience as well. If you have questions, please feel free to e-mail them to me, if you like. Or better yet, if you can use the chat function under the broadcast, and you can type your questions there. We can answer them as we go along, I'll lead them sort of into my discussions with Lance. So with that, Lance, thank you very much. I appreciate your time today. And really, Lance, I guess before I dig into the session and all the questions we have, I was hoping if you could maybe spend some time recapping a recent earnings call, right? You guys just reported numbers recently, a fairly impressive set of numbers, I would say. Sales, I believe, are up 11%. Your fiscal '22 guide, I think, called for sales being up 600%. So maybe just touch on what are you seeing in the marketplace and give us a quick recap of your earnings call, and we'll take it from there.

Sure. Well, firstly, thank you for hosting us today. It's obviously nice to be with you today, Amit. I think entering fiscal '21, we had 2 clear priorities for the business, right, really returning to growth in our core storage business and obviously scaling our cloud business. I think we really put an exclamation point on both of those goals last week as we had a strong finish so -- to what turned out to be pretty unprecedented year for everybody, including everybody on this call. Our performance was pretty broad-based as demand recovered faster than I think most people expected in the marketplace. And I think that improved demand environment really returned growth to product, which is critical for us, which was up 6% with All Flash at 11%. And I think that's really critical for the strategy of the company as well as the investor narrative, right? So when you think about NetApp, one of the push and pulls on the bull and bear case really has been around this idea that cloud is potentially cannibalizing the core storage business. So the fact that we're growing product revenue and we're doing it while taking share, I think, really goes a long way to counter those arguments. So we're excited about as we look into next year, that product revenue growth really continuing. As we said, we expect total revenue next year to grow 6% to 7%. Cloud ARR finished strong, as you'll probably talk about at $301 million up 171%. So this year was a really pivotal year for us, for the cloud business, in really substantiating ourselves across a lot of different product portfolios within our suite as well as really rolling out our customer success team on the sales side. So we were really pleased with how we finished the year. I also -- I'd be remiss if I didn't mention the cash flow. Mike would probably slap me on the hand if I didn't. He's a big cash flow guy. We delivered an all-time high cash flow in Q4. Obviously, the collection cycle is healthy. It didn't have -- the DSOs were healthy exiting the quarter. So we felt really good about the mechanics of the cash flow kind of going into this year. And I think as we look into fiscal '22, we noted on the call that we expect our cloud franchise to reach 425 million to 500 million ARR exiting the year. And importantly, with cloud gross margins that will be accretive to corporate average as we go through the year, which is a new disclosure. As we get into Q1, we will likely roll out some incremental disclosures around the cloud business, which hopefully, the market will be receptive to. And the other thing is that we expect to grow earnings at 12% while delivering cash flow -- free cash flow again above $1.1 billion. So I'll just stop there.

No, perfect. That was a great overview, Lance. So -- and to your point, you're right, we will get into cloud services in detail in a few minutes because it is hard to have a discussion on NetApp at this point without cloud services business. But before I go there, I do want to touch on a broader topic, which is I think the pandemic fundamentally really accelerated the demand for digital transformation, if you made. So you're doing about a shift to remote working, learning. And even given when life goes back to normal, I suspect, it will be more hybrid versus not. So all of that in my head entails that companies want a much more flexible IT infrastructure versus what they've had in the past. So maybe you can just talk about what does all of this mean for NetApp? And what sort of opportunities does it present for the company?

Yes. I think when you look at it, look, I mean, when George took over as CEO, I think he had a distinct vision for the company that really was around not pushing against cloud. I think a lot of the other peers in our universe really because of their portfolios, really had to push against cloud as an adoption -- from an adoption perspective. And George, I think, took the contrarian view at the time and really pushed against that thesis and said, no, we're going to embrace the cloud. And I think what you now have, when you're talking to customers, is not only a cloud-connected flash portfolio that is best-of-breed. We still have the hybrid solutions, if that's the direction the customer wants. We have Keystone, which allows a lot of flexibility from how we structure the deals. But I think most importantly, we future-proof the new applications that customers are bringing online. If they choose to move those workloads to the cloud, right, whether it be Azure, GCP or AWS, whether it be in Kubernetes, whether it be with our spot portfolio. I mean we have a portfolio of solutions that really help the customer through that journey. And I think to your point, the pandemic accelerated that journey in a lot of ways. So I think cloud has been a headwind to on-prem storage for a number of years now. George saw that coming, and he's -- the team has embraced it full-throated. So we feel really good about kind of the next steps from a journey perspective for both our customers and the company.

Absolutely. Any plans -- does return to office scenario provide any tailwinds or headwinds for that? I mean, I guess, how do you think about return to office scenario for on-premise storage products?

Yes. It's interesting. I mean, obviously, the on-prem demand cycle has been improving. I mean, I think we've seen that both in our results and the results of our competitors. You've seen that in all the forecasts kind of going into the remainder of this calendar year and into next. And I think when you think about projects that were put on pause because people did not have the resources or the urgency to get them pushed through. I think what you're seeing now is a reengagement both from a CapEx spending perspective, whether it be CapEx or OpEx, however they want to structure it. But more importantly, now realizing that you are going to have disruptions in service. You are going to have unexpected circumstances. Pandemic was a great example of that where you really need to -- all these things that you had on your road map of how you want to operate as an IT platform with inside your customers, I think they're excited to engage with us. And we're obviously excited about what the next year brings for the company.

Fair enough. I think maybe just to touch on cloud data services, and you sort of mentioned this upfront, the $301 million ARR above the high end you guide for April. And if you think beyond the 2022 number that you provided, you also have a fiscal '25 target of $1 billion, if I'm not mistaken. Can you just talk about the road map you see over the next several years? And what enables you to these targets, be that $425 million to $500 million or even $1 billion? What are the components that gets you there?

Yes. So it's interesting, right? I mean I think if you go back, it's interesting because if you look at some of our competitors that are talking about this cloud transition, we introduced cloud ONTAP, the software-only version of our ONTAP OS in the cloud 7 years ago. So this is not something that is just turn a light switch on. It's been in the planning for some time, obviously. I think we recognize the opportunity to expand beyond storage management and optimization into infrastructure monitoring and compute management and optimization services, which really led to the development of cloud insights as well as the acquisition of Spot. So if you think about the different pillars of the cloud opportunity, you have the core storage piece, which is broken into really 2 fundamental pieces, Cloud Volumes ONTAP which is, again, is a software-only version of our flagship OS, which storage admins can host the workloads in the cloud. You have Cloud Volume services, which is really a by the trip service offering, where we're actually integrated into the back end of the hyperscaler platforms where they can sell it as a first-party service. And I think the interesting part about that model is that the sales reps at our public cloud partners retire quota against those. So we are part of their selling menu. And that's a meaningful go-to-market motion that I think is probably underappreciated by the market. And then obviously, we have Cloud Insights, which used to be OnCommand Insights, which traditionally was an on-prem solution, which we have moved to the cloud. It's organically developed. So just to kind of throw that in there from the inorganic versus organic. And then Spot obviously, is the acquisition that pushed us into the compute optimization part. So we feel that we have 3 real growth drivers in the business in the near term. Mike has talked -- Mike and George have talked extensively about using that last, let's call it, 30% of free cash flow to continue to add on from an acquisition perspective the opportunities within the cloud opportunity. So you will have the organic growth, which obviously when you look at the net retention rate of 252% last quarter, is obviously healthy. But -- and that's an apples-to-apples number, but obviously, continue to add in the portfolio through acquisitions.

Fair enough. And I vividly remember the cloud ONTAP launch. I think it was either right when George started or the year before he did, but It was premises, the data fabric story at that point, what I recall.

Yes. I mean the data fabric, it was really -- I think for a number -- for a couple of years, it was hard to grab on to how tangible that was for the customers because customers moving mission-critical workloads from the cloud -- from on-prem into the cloud is a journey. It is not -- you don't just move your SAP workload overnight from on-prem into Azure, for example. But we are certified on a lot of mission-critical applications. I think that's where the sweet spot for us is, where that performance tier meets the cost intersection of the cloud. And we have unique opportunities, particularly with -- when you think about the model we have with Azure. But obviously, with GCP and AWS as well.

And Lance, you sort of touched on this very unique sales relationship that you almost have with Azure where their salespeople are essentially selling your cloud data services in those right workloads, obviously. I get this a lot from clients, from investors on kind of your cloud data services business. So it would be really helpful maybe if you want to talk a little bit about how is the relationship different across those 3 of the public platform rates, Azure, Amazon and GCP? And do all of them need to look like Azure for you to be -- for this to be $1 billion business or not really?

No, not at all. I mean I think if you look at Azure, there's a few nuances, right? So if you look at -- if you look -- we're fully integrated from a technical perspective. So I think one of the things that's lost sometimes in the discussion, too, is the fact that we're using the same OS that we use on-prem. So it's a singular OS that runs across both our on-prem solutions and our cloud solutions. So when you have a singular OS, it makes it a lot more interesting from a scale perspective for the cloud providers to fully integrate it. So if you think about how some of our competitors have gone about building out their storage portfolio in the last 15 years, a lot of it's been through acquisition. So they have kind of a portfolio -- a blossoming portfolio of operating systems that their customers have to manage where our relation with Azure, GCP, AWS, it's a singular OS. So I think that's really powerful. With Azure, we've integrated the OS into the back end. They sell it as a first-party solution. Unique to Azure is that we actually have -- NetApp own systems in their data centers, right, that really accelerate the performance and give the customers kind of those Tier 1 application workload performance needs that they have. And I think when you look at GCP, the fundamental difference between Azure and GCP is that GCP is basically a software-only model, right? So you think about the margin structure of the business is a little bit different than that CapEx that we own and then runs through from a depreciation perspective. And then AWS is kind of its own animal, right? I mean AWS has taken the approach of having kind of arms-length relationships with the ecosystem and just making everything available in their app store. What I would say, though, is that none of these relationships are stacked right? I mean I think as we've gone through this process over the last, let's call it 18 months to 24 months, we've had a lot of learnings within the cloud business, both at our company, the customers as well as the partner. So I think what's happening is that people -- our customers are figuring out how to best utilize our technology. And you should expect those relationships to evolve over time.

Perfect. And this wouldn't be a surprise to you, but when I sort of polled investors ahead of spending time with you today, I think 95% of the question are really around cloud data services and 5% was around on-premise dell and competition. That's what -- and what I soon realized was I could spend the entire time talking about each thing that's perceived as competition to cloud data services very specifically. So maybe the question I would have for you is, you are the leader, NetApp is the leader in cloud data services, but there are a whole host of other vendors that are trying to do the same stuff or have comparable offerings now. What -- how do you think about competition? And in Azure, I think it's very clear to understand what sets you apart. But how do you think about competition? And why won't this de facto relationship that you have at Azure I mean not get replaced by someone else? What's the barrier to entry there?

Well, I think the barrier to entry with Azure and GCP, in particular, is a level of technical integration, right? We had -- I think it was upwards of 200 and 300 engineers that have Microsoft and Google badges that actually sit on site at these companies, not so much the last year, but you get my point, right? I mean it's been a long journey from a technical integration perspective. And I think if you look at the on-prem market and kind of where you get the scale, it's really hard to get to scale from one OS at Dell or one OS at HP. I think what you get with NetApp is both the performance tiers and the ability on -- particularly on the file side. And that level of integration, I think, is going to be really hard to replicate. And if you -- people that have followed our story closely realize that we were slow to market with our expectations from cloud data services. We had to pull the $400 million to $600 million. A lot of that false start was how much heavy lifting had to take place with our partners, both on the back end from a whether it be figuring out how to get the latency down to where it needs to be and figuring out the routing ecosystem within the their data centers. Or the front-end heuristics where you need to have this -- we're still white listed. Azure as one example. I mean we're -- this is a -- definitely a process. So to expect our peers to go and turn a light switch on and just kind of throw the name cloud behind it, I think they have a long journey ahead of them, as do we. And we feel really good about the position. I think if you look at the on -- one of the arguments is, well, you're taking money from one pocket to the other. It's like well, actually, that's not the case. We're winning new workloads from incumbents in the cloud. And we also have a very -- the on-prem storage market is really fragmented, right? So you have this market share that hovers between 10% and 12% on-prem. If we can't get 10% to 12% of the workloads moving to the cloud with the best cloud solution, then shame on us, right? So when we think about it in that dynamic, we get really excited about the opportunity set.

That is absolutely fair. And I'll ask you this last question, cloud data services, I do want to cover all the topics with you. The one aspect I personally struggle with a lot, Lance, on this business is, I sort of understand the $425 million, $500 million and $1 billion narrative. The pie always shown with is the predictability on a quarterly basis with this business and what sort of confidence any one of us can really have all the numbers that are put out there, right? And so I'm just curious, how do you enhance the predictability of this business for investors for [indiscernible] totally.

Well, So I think, firstly, you hit your numbers. I think that's -- you have to build credibility around that. And that was really what fiscal '21 was about. Obviously, scaling it, but doing it in a predictable way. The last 18 months, we've learned a lot about this business internally, how the customer -- what the customer engagement process looks like, what the ramping of solutions look like once we land the workload. It's a grow and expand model, right? So when you think about the predictability, we talked a little bit about on the call about it being -- there being some seasonal cadence to the business on a quarterly basis. We want people to be mindful of that. Obviously, with Q2 and Q4 being the robust quarters and then Q1 and Q3 being the less robust quarters. That's really being driven by the half-on-half comp plans that we put in place. But when you talk about visibility and predictability, one of the big investments that we've made are -- we have made and are continuing to make is around the customer success team, which is any good SaaS company has to have -- after the hunters go out and win the business, you have to have a customer success team that really drives that renewal base over time. I mean the vast majority of your revenue in a SaaS model is going to come from renewals, right? So we're investing heavily in that. This year -- this coming fiscal '22, and I don't think people probably appreciate this, and that's on us to make sure that everyone understands it. Our core on-prem sales force has not carried cloud quota up until fiscal '22. So it's been kind of a bifurcated sales motion internally with our -- obviously, our cloud sales team, specific sales team as well as the public cloud partner sales forces. But now we're adding that customer successful layer, and we're also adding that quota very -- requirements to our core team, which is huge, right? I mean to have your entire sales force be held accountable to selling cloud, I think it should go a long way in that -- building that predictability.

Say predictability, I might read that as upside at this point, if the whole sales team is going to have quotas over here. But the point is well taken for sure. Maybe we'll move on to some of the other topics, in the interest of time here. The supply chain, logistics issues, that's something that's come up fairly consistent with everyone. I think it was really notable that NetApp really didn't have a mixed supply issue per se or a supply side issue. Can you just touch on what are you seeing over there? And the point I would love for you to talk about is, to the extent that there is inflation, commodity inflation, memory and other things, how does NetApp react to that dynamic?

Sure. So look, I mean, last year was -- we're talking about the supply chain dynamics. I mean last year was a huge test for everybody's supply chain team, right? I mean that was an unprecedented year. I think what we realized and we've known for some time is that we have a really good supply chain team. And I think if you look at -- we're working closely with our suppliers, and we have confidence that we'll continue to replicate what we did last year into this year. And as Mike mentioned on the call, I think one of the avenues aside from those relationships and history of performing well, we're going to be carrying a bit more inventory to make sure we can meet demand and we don't build backlog unnecessarily. And I think we're also going to be signing longer-term contracts that kind of lock in those prices as well as lock in that supply. So we feel good about it. Obviously, there's going to be unforeseen things that potentially come up. I mean Malaysia, for example, in the last couple of weeks, has been kind of a hot button topic. Those things are hard to foresee, but we feel good about where we stand today. And obviously, if you have some price inflation, there's a balance between passing that on to customers and your gross margin profile. But I think the good thing for us is that we do have a slightly different makeup relative to our peer set on the component side of things. We're not particularly exposed to DRAM. We're not universally exposed to flash. HDD, seeing how the pricing is actually a tailwind on a year-over-year basis for most of the year. So we feel good about that. But obviously, like everybody else, we're going to have to manage through this on a real-time basis, and we're keeping a very close eye on it.

Fair enough. And then if I think about the top line trajectory that you've had, and there's only been a few other -- few elements that have enabled this growth for you. But I think one of the things has, been NetApp's ability to take share from vendors at least in the last few quarters, maybe the last couple of years, really, given you've had a really good product portfolio. One of your peers has had struggled in consolidating their portfolio, if you may. But I'm curious, given some of the recent enhancements that others don't, for example. How does NetApp -- how do you think about the durability of your share gains as you go forward?

I mean it's a really interesting question. Obviously, I think one of the priorities George put out last year was -- were share gains, particularly within All Flash. I think we accomplished both of those goals. That is obviously the goal going forward. It's hard to bifurcate how much of the goodness is us executing versus taking share in the different customer sets. So there's a lot of moving parts into that question. But how I think about it personally, we don't talk about this too much, but since I'm not -- I don't have C by my name, I can be a little bit more -- I don't know how you want to call it, but I'll give you my view, which is we went through an OS upgrade about 7 years ago where we went from our legacy 7-Mode OS to our clustered ONTAP. And that was a major, major overhaul to the OS. And it was super painful for our customers, right? I mean it was super painful. We -- I think our product revenue was down 12 straight quarters year-over-year. So any time you ask a customer to do a forklift upgrade, it's not a pleasant discussion. I mean the solution on the other side may be better, which, by all accounts, I think anyone that's moving to an OS upgrade would make that argument, right? But the point -- I think the bigger point is, is that when you ask your customers to do a forklift upgrade, right, it then raises the question, well, the incumbency is really around the pain of doing that forklift. I mean within storage, the market share is so sticky because of that. And I think If we look at -- I'll just use Dell as an example. I think they have a $30 billion midrange footprint. You assume that the life cycle of a solution is 5 to 6 years. That's $5 billion to $6 billion that comes up for refresh every year in Dell's midrange. Are we going to take a big piece of that? Probably not a big piece as far as Dell is concerned. But from our perspective, given where our market share is, it's incremental goodness for us that we can insert ourselves into the RFP process in a customer that maybe historically had been very, very committed to a legacy OS that the competitor was offering.

No, that's really fair. I vividly remember the transition you had to go through with the Cluster-Mode and all the pain that caused across the portfolio. So -- and you're right, I think Dell has to go through that process at some point and get to the other side of it for things to stabilize from their perspective, at least. Let me ask you this because this is one of the questions that comes to up a fair bit, too, is how does one react, again, thinking of your peers, so how does one react when they're losing share? Do they result to pricing? Or it's certainly not been surprising to watch our gross margins hold up really well. But do you worry that pricing could become a factor, especially with the share gains that you're having?

I mean the share gains -- I mean, look, I mean what's a big number for us may or may not be a big number for Dell. I mean I think what we have found thus far is that the competitive set is acting rationally. And I think that's the biggest driver. I mean any time you have a market where share gain is moving around, the worry is that you get irrational behavior, right? And we haven't seen that. I think if you look at all the different competitors that are coming at it from a technology perspective as opposed to a price gouging perspective. And I think that's healthy for the entire industry. I think you've seen that dynamic in our product margins, right? You haven't seen our product margins really take a hit from a competitive pricing perspective. And our goal, obviously, is to continue to keep product margins kind of in the current -- the range where they are. And hopefully, over time, as we migrate to increasingly all-flash portfolio, that's a tailwind for product margins in the [ format ].

Got it. That's actually a good segue. We have a couple of questions here from folks in the audience virtually. One of them is on the all-flash array business. Maybe, Lance, you can just talk a little bit about what you're seeing on the All Flash side. Last quarter, your growth was about 11%. That was somewhat below what Pure Storage did. But how do you think about your All Flash business? How do you view the growth rates there as you go forward?

Yes. I think if you look -- I mean, if you look at the industry growth rates, we obviously kind of have -- we're constrained by the overall storage industry for the most part, right? I mean if the storage industry is growing 20%, then that's great for us. If it's shrinking 20%, that's bad for us, right? So I'd start there with -- you have to play in -- the core storage business is constrained by what the market has been for them to a certain extent. So I mean, if you look at IDC, I think the growth rates for All Flash are probably upper single-digit growth for the coming year, with core storage being kind of in the mid-single-digit growth. So to the extent that that's our baseline and then add share gains on top of that, that's where we should end up being if we have a successful year next year. I think, again, going back to the original point of proving that the cloud business is truly additive to the value of NetApp and the value to the customers is that we can do that again this year. And I think it will go a long way, especially in a recovery year where everyone should be performing better.

Perfect. And another one, just kind of going back to the cloud data services discussion. Is NetApp looking to be a meaningful player in other cloud service opportunities beyond storage and management? And how big could these options get from NetApp over time?

Yes. I mean we talked about -- a little bit earlier about the infrastructure management and getting into the compute optimization. I clearly will not front-run our executive and strategy team on what verticals we may or may not get into. But I think we have the assets today to continue to deliver on the commitments. And then we will supplement our current portfolio with additional M&A. So we feel good about the road map. I think George's enthusiasm for the $1 billion target came through on the call. I think as people had realized, Mike can be sometimes a little conservative, which is a healthy balance, right? And we're trying to have a healthy balance. So his conviction, I think, in raising the lower end of the cloud ARR to $425 million, I think, spoke to that confidence level. And we will continue to do bolt-on acquisitions. And again, I won't signal which verticals that may or may not be.

Totally fair. But it does sound like just with Spot and some of the other stuff, areas will be broader than just storage and data management. I mean at [ Midland ] is going to be monitoring in the view that you talked about, right?

Yes, absolutely. Absolutely. I mean even if you look at just the big 3 pillars today, you have Cloud Insights, which is outside of core storage and you have Spot, which is outside the core storage. So we are clearly diversifying that portfolio, so we are not dependent on, let's say, strictly Azure to build out a $1 billion business, right? I mean it's Azure NetApp so I should say. So it's a growing portfolio. It's diversified, and there's no reason to expect that we won't continue down that path.

Fair. The last one from the audience here was -- and maybe I'll broaden this out a little bit. But free cash flow generation, you said this up. But it's one of these things that I think people focus less on about NetApp, but I feel like people should is very impressive free cash flow generation. Maybe just talk about, a, how does that free action generation work? But the question that someone had was capital allocation, how do you think about that? And how do those priorities shift, if at all, the next few years?

Sure. I mean I think if you look at free cash flow, look, I think billings is -- we talked about revenue growth being 6% to 7%. We talked about billings growth being higher than that. That obviously is good news from a free cash flow perspective. I think in the coming year, we have a few onetime items that are a little -- that offset that, right? We have some real estate investment after selling our current property. So we have about $50 million of that CapEx guide is real estate, onetime real estate related. We have kind of what I would characterize as ramping CapEx for the core Azure NetApp Files solution as we kind of broaden the portfolio there and get off of white listing. But we will come back to maintenance CapEx below $200 million for -- before too long. So how does that translate into capital allocation? I think Mike has tried to be clear about this, which is dividend is the first call on capital. We raised our dividend by 4%. And then buybacks to offset dilution. So for any modelers out there, keep your share count at 2 29 in perpetuity. And if we're opportunistic on the buyback, then you'll see that in the share count. And then that last 30% tranche really goes opportunistically to strategic M&A. And the balance between strategic M&A and incremental buyback will really be driven by the opportunity set on the M&A side as well as the ROIC on doing incremental buybacks, right? So there's moving parts in there. But what I would say is, from an optics perspective and how people are thinking about capital allocation, I would lean towards incremental M&A with that remaining 30% as opposed to incremental buybacks at this point is how I think about it.

Perfect. That was really helpful. I have about 50 seconds left in our slot over here. Maybe I'll pause here. A, thank you for your time. This has been really informative. I've actually learned more about cloud services than I knew before. So thank you for that. But I do want to turn the floor back to you, Lance, on the things that I didn't touch on that you think investors should be aware about. Any points you want to make sure you want to highlight, I'll turn the virtual mic back to you for that.

Yes. I appreciate it. First of all, thank you for hosting us today. It's always nice to see you and get in front of the investors. I would just -- in closing, I would just say we're excited going into fiscal '22. We put a lot of work into the last 5 years in building out this cloud franchise. We've done it now in a way that is -- we have the building blocks of the go-to-market piece as well as the technology piece. And this will really be the first year that we have both of those in unison. And we're excited about the opportunity set. And I think Mike and George and Chris would echo that. You're muted.

I did well the whole way except this, but I'll just say thank you, Lance. And thanks, everyone, for your time. Thank you.

Great. Thank you.