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

Hi. Good afternoon, everyone. Welcome to the Bank of America Tech Conference last day, getting through the afternoon sessions. We appreciate all your time. We've been fortunate to host several meetings of this conference, and I really appreciate all of you showing up and participating. Feel free to throw questions at us on your webcast interface, I'd be happy to ask them on your behalf. With that, let me welcome Kris Newton from NetApp. Most of you already know Kris, heads IR at NetApp and has done a phenomenal job. I have to say, Kris, you've been one of the most responsive IRs, so kudos to you on that.

Thank you.

I really appreciate your help. So Kris, I know you wanted to make a quick statement first.

Yes. And quickly get the safe harbor out. 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 we 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 in the forward-looking statements for any reasons. Back to you, Wamsi.

All right. Thanks, Kris. Yes, I guess the best place to start maybe would be the most recent of your reported quarter. I mean, you had very solid numbers. Can you just talk about the demand environment and sort of what areas in particular were the levers for the upside in the quarter?

Yes, sure. We saw that in areas that are still experiencing surges in COVID, demand is still impacted. We expected the economies around the world to continue to recover in line with improving health conditions. When we look at like the IMF or the World Bank forecast, the U.S. probably will lead the recovery followed by Europe 6 to 9 months later. And then the rest of the world after that. In our Q4 specifically, U.S., Canada, Western Europe and parts of Asia recovered faster than I think anyone really expected at the outset of the quarter. And we saw continued movement as -- or we saw customers move forward with project spending, again, in line with improving public health. And throughout our fiscal '21, we saw enterprises spending on cloud and digital transformation initiatives. So not expecting like a massive sudden snapback as spending didn't dry up. But in areas where their ability to transact business because of in-person requirements, there could be some catch up. And overall, we feel that we have a really strong value proposition for cloud and digital transformation initiatives. I think that advantages us, and we expect those trends to continue as we move through this fiscal year.

Okay. Great. Thanks. So one of the things that really stood out, which was very impressive was the performance of cloud data services, CDS. And I guess, can you talk about what the underlying drivers of that were? Was it just rolling out more data centers? Was it more customers? Was it more usage or anything that you can help like characterize that?

Yes, absolutely. And first, I'm going to do a small correction only because I'm really trying to make sure that I learn it myself. At the start of fiscal '21, we've moved away from CDS because we expanded our cloud offerings to be more than just data-centric offerings with the acquisition of Spot. So it is now public cloud services, or PCS.

Yes.

So sorry, I just -- I feel like that's my public service announcement. And the underlying drivers were really both related to existing customers spending more and us being able to add new customers. In Q4, we saw an increase in total cloud customer count of almost 140%. Over the course of the year, we added about 1,500 new-to-NetApp customers. So those are people who hadn't been buying from us before. They came in, right, with the -- with public cloud as their first NetApp purchase. And then the dollar-based net revenue retention rate was about 252% in Q4. That's net of churn. So that's people who bought us in Q4 a year ago, what they spent in Q4 this year. It's been consistently over 200% since we started sharing that data. We are building off of a small base. The cloud services flywheel is just now kicking in. And over time, we expect that number to normalize to industry averages, but I think it's great to see customers who buy our cloud services want more of them, customers who have never worked with NetApp are interested in working with us because of our cloud services and then we have this great opportunity to work through the entirety of the NetApp installed base.

Yes. No, that's great. That's great context. So when you think about that net retention rate, what would you say the industry average numbers look like where you could trend to?

Yes. I've seen everything from kind of like 110% to 140%. So we have to see kind of where we are, but definitely would expect it to be north of 100% as we see huge value in what we bring for customers. We see the opportunity for them not only to expand with the existing services they buy from us, but also an opportunity to cross-sell them. So cloud volumes customer can now become a Spot customer or vice versa.

Yes. So Kris, you mentioned just now that there were a lot of new-to-NetApp first-time customers. Were those driven by sort of your hyperscale partners? Or was that -- like what was the genesis of being able to tap into so many new customers?

Yes. I think it's across the board, right? NetApp-driven sales, partner-led sales. And I think it is the value proposition we bring in cloud is so unique that it makes customers look at us, right? We help enterprises move existing enterprise workloads to the cloud without having to refactor them. We offer companies a consistent framework and management interface across multi-clouds. And we have all the application certifications for enterprise apps that people want to run in the clouds. And we're taking that enterprise experience, and hard end services and moving them into the containers and Kubernetes worlds with things like Project Astra, Spot Ocean and some of the recent announcements we did around Apache Spark.

So Kris, I know that you guys have sort of made the most headway at Azure. But even there, you're probably -- it's on a fraction of their data centers. Can you give us some update on like how that rollout has been? How many of their data centers are you in? How many more can you get to? Any sort of color there.

Sure. The thing I never really thought I'd be talking about when we started doing this cloud stuff is like physical location of things, but it really is important. So anyone can get real-time updates of where we are in any of our cloud partners on cloud.netapp.com. And specifically for Azure, you can also go to the Azure products by region page on azure.microsoft.com. We're currently available or about to be generally available in 29 of the Azure regions with Azure NetApp files. And many, many more with cloud volumes ONTAP, which is the software-only version. We've been working really closely with Microsoft to make sure we're prioritizing regional deployments based on demand and expected demand. We started with our hero regions and then continue to move out from there. As we talked about on the last call, they are driving us hard to build out additional global capacity, and that was all encompassed in our CapEx guidance for FY '22. So we're really excited about the opportunity to continue to work with them and our other cloud providers. And I will take this opportunity to remind everyone of the cloud services we offer, cloud volume service is the only one that is hardware dependent. The remainder, so cloud volumes, ONTAP, Spot, Cloud Insights are all software-based services.

Can you help us think through what that revenue split might look like on sort of -- with the ones that are coupled with hardware and cloud volumes versus everything else?

No. We're not going to break that out. I think, again, there's a huge opportunity to cross-sell and upsell, right? The portfolio is really interesting. And I will point out that at our Analyst Day in September, we noted that the gross margins for cloud were below the corporate average. And that we thought that when we got close to $500 million in ARR, that they would start to equal the corporate average. But we got there a lot faster. And as we noted on the Q4 call, we're actually approaching corporate gross average with the cloud gross margins. So kind of the blend of services shouldn't matter. Over the course of FY '22, we expect that cloud will come accretive to gross margin.

The real -- the fact that you're overachieving on these gross margins faster than you thought is coming because the mix is better, or what exactly is driving that sort of faster than expected gross margin improvement?

So utilization rates really help. The -- as we deploy the systems, we are depreciating them and some of the early systems are coming off depreciation now. And then again, we've got this mix of hardware-oriented and software-oriented services. And so as we have more and more software services that will help drive up the gross margin.

One of the questions I got from investors here is really around the net pace or incremental pace of net ARR adds fiscal '22. Like why shouldn't that be a lot greater than fiscal '21? Because you now have more productive sales reps and you have more partners as well, bigger, larger footprint. So when you put all these together, shouldn't you have net ARR adds that are higher than what you experienced sort of in fiscal '21?

So don't forget, in '21, we had a decent amount of incremental ARR coming from acquired companies. But we don't expect to repeat in acquisition -- incremental ARR acquisitions in '22. So I think we can continue to grow and accelerate. It's the beginning of the year. We did already lift the floor in our exit '22 ARR expectations, and we'll keep monitoring it over the course of the year. We do expect some seasonality. So as you saw in '21, Qs 2 and 4 were stronger, had more incremental ARR adds than Qs 1 and 3, and that will -- we expect to happen again in this coming year.

What was the reason, again, for the seasonality?

So NetApp sales reps are selling our cloud services in addition to our cloud partners. And they have their own bit of seasonality where there are some additional kind of end-of-period incentives that come to play in Qs 2 and 4 that drives them.

Got it. Okay. That's helpful. Maybe shifting away from public cloud services. Can we talk about -- a little bit about the broader storage market, like what you -- what are your expectations for aggregate market growth? Do you see pent-up demand, particularly given that we went through a year with COVID where IT spending got reprioritized in many different ways?

Yes. On the long term, I think the total storage market will be relatively flat, and that's just looking at a blend of IDC, Gartner and other market expectations. When you peel that back, it looks like the flash market remains the growth segment in the overall storage business, probably growing about a CAGR of 7% through '25 or so. Specific to the near term, there probably will be a bit of upsurge in on-premises spending that will benefit both flash and hard disk or hybrid flash arrays. We see economic indicators lifting that tends to lift IT spend, which tends to roll through to storage as well.

Okay. Okay. So given that backdrop, how should we think about all-flash array growth. I mean, you guys obviously reported a very strong quarter of growth. Comps were also a little bit easier. But as you think about sort of the growth in AFA, what would you say are the key drivers? And how much of that is about market growth can come from sort of market share gains from competition? And where particularly or which regions or which competitors are you really taking share from?

Sure. So as you noted, Q4 was a great all-flash quarter for us. Our all-flash run rate revenue hit $2.9 billion, which was an all-time high for the company, it was up about 16% year-on-year. And in all of FY '21, about 45% of our total revenue came from the flash business. We think we have huge opportunity there still, even though it is a big chunk of revenue for us. About 28% of our installed base, as measured by systems under active support contracts, are currently all-flash. So there's great opportunity to continue to drive through our installed base, which will help support our aspirations to grow faster than the market. We made some improvements to our enterprise sales coverage primarily in the Americas over the course of FY '20, really tightened our focus on flash. I think that's paying off. When I look at the competitive environment, I think our cloud-connected all-flash arrays give us an advantage. As you mentioned, one of our big competitors is going through a fairly significant transition that requires a forklift upgrade. And whenever there's a forklift upgrade, it really reduces the incumbent's advantage. The customer is going to have to learn a new tool set. They're going to have to do a full data migration. And I think that -- so there is already a door opened just by the fact that there was going to be that upgrade required. And then I think the door got opened a little bit further because of COVID. No one wanted to roll out new systems during COVID. There are some missteps. And first-generation products are never quite what everyone wants. So flash is great. We definitely see benefits for customers and for NetApp, but we also offer disk-in and flash or -- and hybrid flash arrays. And there are reasons why customers would want to go with those. And so we can really have a very strategic dialogue with customers about what the right fit is to meet their business requirements and not try and force specific technology to them.

Yes. No, actually, that's a good point. So when you think about the other like HDD-only or in the hybrid. What sort of use cases are you seeing for those? What sort of workloads are people deploying with that infrastructure?

Yes. So hard disks are great for any workload that has long sequential reads and writes. HFAs can still be the most economically advantaged solution if you don't require the utmost of performance in flash and if you're kind of debating the TCO benefits.

Okay. So from a mix -- from a growth perspective, is there a way to think through these 3 categories and say, like, how much do you think from a market growth perspective you have growth in all-flash versus hybrid versus all disk?

So we definitely believe that we can gain share in all 3 parts of the storage market. As I noted earlier, the Flash will be the growth year segment. The others are probably, on the long haul, flat to slightly down, because we service all of those segments with ONTAP, we have the advantage of being somewhat indifferent and can be more focused on the customer requirements.

Okay. And then on -- in all-flash, right, you noted sort of high 20s penetration of installed base. When I think about the installed base of NetApp, there's probably a certain segment of the installed base that just does not need all-flash as a use case. So what percentage of that installed base do you think is likely to ultimately move completely to flash?

Yes. We've said like north of 70% at some point will likely be all-flash. Now when some point is probably is dependent on a lot of additional factors, but I think you can see penetration levels in that neighborhood.

Okay. And so when we take that in the context of where we are today, have you seen already -- I mean, you've been shipping all-flash systems now for a while. Have any of the all-flash systems themselves come up for replacement already?

So all-flash tends to have a longer usable life than disk, right? Less moving parts, makes sense. So customers probably are keeping them closer to 6 years.

Okay.

So yes, we're probably right around that time where refreshes are happening. Some customers may choose to refresh earlier. So they probably have been happening kind of steadily just in the background.

Got it. Okay. Okay. That's helpful. Can you talk a little bit about what's happening in the supply chain? I mean, obviously, there's been a lot of questions around component availability, the impact of higher logistics and freight costs and just price escalations and inflationary pressures. So maybe address a few of the different things around there.

Yes. I mean certainly, segments of the semi supply base have extended lead times. They're indicating cost pressures as the demand for what they're offering outstrips the supply. It reduces the flexibility to react to changes in our customer demand. And so we see those kind of constraints lasting through this calendar year, at least. We've been working proactively with our suppliers and manufacturing partners to mitigate those risks wherever possible. We've got a great supply chain team. They did a great job throughout COVID and have good confidence in their ability to continue moving forward. As we noted on the Q4 call, we don't expect any of these constraints to impact our ability to meet Q1 demand. But you can see we're raising our inventory levels, and that's not any specific component but just across the board. So that we can make sure that we're as responsive to our customers as possible. And given the low cost of capital and the fact that we don't anticipate that to have an impact on gross margin, we feel good about that investment to make sure that we're doing everything we can to meet our customers' demand.

Got it. And just on that inventory point, right? I mean, you guys just reported a phenomenally strong free cash flow conversion quarter. What were some of the drivers behind that? And are we going to see some sort of -- I mean, version, I guess, as we look at Q1 here, given the fact that, I mean, the free cash flow profile of the company, normally, which is in sort of the 20% [indiscernible] 10 points more than that in the quarter?

Yes. As you noted, Q4 21 free cash flow of $521 million was an all-time high for NetApp. And you should probably expect something to come back normal. Typical seasonality for our cash flows tend to be with Q1 at the low end. That's related to lower revenue levels. There's merit and other kind of bonus payouts that happen in Q1, and then you see cash flow step up over the course of the year. We said in '22, we expect to generate at least $1.1 billion in free cash flow, which is sort of on par with what we did this past year. We'll be continuing to invest CapEx to meet that cloud demand. We also have about $50 million in onetime CapEx expenditures related to facilities as we move our Sunnyvale headquarters to San Jose. We're also doing some moves in our Wichita, Kansas. And typically, if you look at operating cash flow, it tends to mirror our non-GAAP op income. I mean, I expect that, that -- there's no reason why that wouldn't be the case going forward. It could be a little bit lower in '22 because of the working capital impact of some of those expenses around cloud and facilities. But again, I think '22 should be the high watermark for our CapEx expenditures. So again, we think operating cash flow and ultimately free cash flow should kind of trend in line with op income.

The HQ shift, how much of a savings, net savings can that yield?

On the whole, we owned our Sunnyvale facilities and the depreciation and operating expenses for that facility is probably about the same as the lease expenses in San Jose. So no savings, sort of a flat exchange, but definitely a better environment for the employees and I think a nicer place to have investors and customers come meet with us.

Okay. Yes, looking forward to going there. What about -- you mentioned on the competitive landscape a little bit around some forklift upgrades that might need to be done at your largest competitor, but how about the other players that some of which are focused purely on the all-flash market. Are you seeing much competitive pressure from them? What about the pricing environment? Anything you can share around that?

Yes. Even throughout COVID, the pricing environment remained competitive as always, but there was nothing -- no one was acting irrationally. And it's important to remember that as all of those companies, NetApp and others, are competing for the on-premises dollar, the way we're monetizing our value is through fully commoditized componentry. But what people are buying is the software. And so that helps everyone stay rational in these pricing environments. I haven't seen any significant shifts in the competition. I think what sets NetApp apart from everyone in the on-premises world is what we're doing in the cloud. We certainly hear that from customers. It makes us more attractive that we're helping them on their hybrid cloud journey.

Have you guys experienced a spike in SSD and HDD pricing, or any shifts in pricing recently given the fact that there is this new proof-of-space cryptocurrency that seems to be dominating discussions in those areas and creating some tightness in supply/demand environment for both SSDs and HDDs?

Yes. So in Q1, coming off -- compared to Q4, we don't expect commodity cost to have really any material impact on the product margins. In the first half of our fiscal year, we see NAND pricing to be down slightly year-on-year. That will revert in the back half, and we expect NAND pricing to be up slightly year-on-year. And for the year, it's -- NAND is probably up slightly. Even with some of the demands created by Chia and other cryptocurrencies for hard disk drives, we see a slight decline year-on-year in hard disk drive pricing, probably not as much as in typical years, but I think those dynamics together have led us to expect product -- gross margins and product commodity costs to be relatively flat on the year.

Okay. So you don't have any issues with availability of product, at least not in the first half of the fiscal year as far as you can tell for now?

We're working really hard to make sure that we've got sufficient supply kind of across all the components we use to meet customer demand and barring any unforeseen changes, we feel pretty good with where we're at. We've got -- one of the great things about what we do is we've got a lot of flexibility in how we configure systems for customers. We've got drive capacities everywhere from 900 gigs to 16 terabytes, and that's HDD and SSD, so that we can find a blend of capacity points and a combination of drive capacities to meet the customer requirement, whereas if you're delivering a server or a PC, you don't have that same level of freedom.

Right. Okay. That's helpful. And then -- well, how should investors think about in a rising -- like in more inflationary NAND environment, let's say, as you -- what's your ability to pass that along? Is it a matter of discounting going down? How should people think about that? That's number one. And number two, the impact of margins as you go through sort of a cycle of this NAND pricing going up and down?

Sure. We try to manage commodity costs through discount levels, as you noted. Customers are much -- take price declines much more readily than they do price increases. So in periods of rising commodity prices, there may be some headwind to gross margin, but again because what people are really buying is the software that helps negate some of the fluctuations on the commodity pricing.

Okay. So -- and then so on the way down, when commodity prices are coming down, you tend to -- are you able to hold your pricing better on your products, so then the margins sort of get hit when commodity costs are going up and there's a lag effect before you can put the pricing in or pass that like lower levels of discounting in, and then on the flip side of it, as commodity pricing is coming down, you get those -- you recover those margins through the course of the cycle?

So generally speaking, NetApp has historically kind of tried to always pass the commodity price fluctuations, positive or negative, on to our customers. Timing is never perfect. And so you might see some benefit in periods of declining prices and some headwinds in periods of rising prices.

Okay. But we shouldn't -- do you try to also like still keep your margin on top of the increased commodity price? What I mean by that is like you're actually not just raising the price to offset the cost per se, but you're also making margins that would be commensurate.

And we don't do cost-plus pricing, but we definitely are cognizant of the margins we get from deals and try and ensure that there is a margin that we feel is befitting of the value we're bringing to the customer.

Okay. That's helpful. I just want to touch on one last thing here because I know we're almost out of time. So Kris, just on capital return, right? What's the latest? Where do you guys stand on that? The stocks obviously had a big run from sort of a year ago -- sort of doubled from then. So compared to where the stock is today, how do you guys think about capital return buybacks?

Sure. So for FY '22, we expect that we'll generate at least $1.1 billion in free cash, which allows us to continue to deliver on the commitments we laid out at our Analyst Day. So dividend is our first call on free cash. It takes about 50% of our free cash, and we just raised it at the start of the year to $0.50 per share. Share repurchases are also an important part. We will continue to do buybacks to offset dilution. And towards that goal, the Board just approved an additional $500 million in buybacks. And then the remaining -- and that buybacks will take about 20% of free cash flow. That leaves us about 30% that we want to use to invest in the business to drive growth. So M&A probably related to our cloud services offerings, we think there's huge opportunity there. And so we want to make sure that we're investing appropriately to go after that. Those percentages are probably never perfect in any given period. But on the whole, that's sort of the framework that we've been using to think of our uses of cash. And if we're looking out over the M&A landscape and we don't see a great pipeline for opportunity that could benefit the business longer term, we would use that to do accelerated buybacks. But right now, we really see investing in the business as the best opportunity and best usage of that cash.

Great. Well, unfortunately, these sessions are not too long, and we're out of time. So Kris, thank you so much for joining us today, and I look forward to speaking with you soon.

All right. Well, thank you for having me. It's been great.

Thank you so much, Kris.

Thank you.