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

All right. Good morning, everyone. I am Sidney Ho. I cover semiconductors, semi-cap equipment and IT hardware at Deutsche Bank. The next company we have is NetApp. NetApp is a provider of hardware, software and services in the network storage and data management solutions market. While traditionally an on-premise storage solution, public cloud services is increasingly becoming a larger part of their business. So today, we are very excited to have NetApp's Mike -- EVP and CFO, Mike Berry. Welcome, Mike.

Thank you, Sidney. Thanks for having us.

Sure. [Operator Instructions] And one more thing before we start. I have to read the safe harbor statement on behalf of NetApp. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risks and uncertainties. Actual results may differ materially from those statements made today for a variety of reasons 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 any forward-looking statement for any reason. Well, I'm -- like I said, I'm actually getting pretty good at this.

So with that out of the way, let's start with a few questions on the near-term market environment. So Mike, you saw broad-based strength in your businesses while reporting upside to your fiscal Q1 results and also guided fiscal Q2 above Street estimates. Can you give us an update on what you're seeing in the demand environment? And how you see the enterprise IT spending recovery trending going forward?

Sure. Again, Sidney, good morning, and thanks for having us. We're thrilled to be here. And good morning, everybody, on the webcast. So yes, we -- and we'll talk about it, I'm sure, when we get into the discussion. We actually started to see some of the enterprise spending pick up in the second half of our year last year. That continued into our fiscal '22. And we saw steady broad-based buying across the quarter, really driven by similar macro trends, which really is the, obviously, the movement to the cloud, digital initiatives as well. And as we look at our -- the cloud and digital initiatives, that encompasses a lot of things. And so we saw that pick up at the second half of last year, and that certainly continued into our Q1 this year. And as you mentioned, we have guided up again for the year, so we do expect to see those trends continue through fiscal '22.

Just based on your orders and design activities, are you seeing any delays or slowing down of plans as the Delta variant has spread and the return of office may be a little bit more delayed than some have thought a few months ago?

So not really. We certainly have some customers where you have to do business in person. And we've -- us and other companies have had to deal with that throughout last year and this year. I think if you look at the return to work, we've all gotten pretty darn good at it, things like this. So we don't expect that specifically really to have any material impact. From the whole Delta thing, for us, it's really an -- and I know we'll talk about it. It's more of a supply chain inflation, what's happening there versus can customers get into work. People have gotten pretty darn good at working in the hybrid environment, and we think that's going to continue, unfortunately, for a while.

Got it. Just on the market share. On your last earnings call, you talked about gaining share in the storage market, especially -- particularly in the all-flash array market. What do you think is driving those share gains? And how do you think about the opportunity for further share gains going forward?

So we think it's really driven by a couple of different things. Certainly, we're super excited about the product that we have. We'll talk a lot about ONTAP. And as we know, ONTAP goes across all of our different products, drives a lot of the value that we see in all-flash. And as we start to see some of those legacy customer bases come up and they're either going to refresh or renew, that certainly is an opportunity for us as well. And then importantly, because of what we're doing in the cloud, that also allows us to penetrate that group as well. Keep in mind, pick your favorite market share number, mid-teens across all of storage. But the cloud for us is a really great opportunity to not only grab new customers but then also be able to, I'll say, go sideways into their on-prem environment as well. So we think it's both of those helping to drive our all-flash gains. We feel really good about our product. And as we all know, that's really what drives sales.

Great. Speaking of cloud, last week, Amazon Web Services, AWS, announced the general availability of Amazon FSx for NetApp ONTAP. As a starter, can you talk about what exactly is that? And maybe generally, how would you describe this partnership with AWS? And what does it say about NetApp in the cloud?

Yes. So we are -- obviously, we're super excited. It was a big day for us last week at Storage Day. So what they announced is, as you mentioned, Sidney, the general availability of FSx for NetApp ONTAP. It's a fully -- it's a native AWS fully managed service, delivering block and file storage for Windows and Linux instances, all within the AWS experience. Importantly, it's a first-party service. And what that means is that it will be sold, build, run and supported by AWS. For us, this is a great thing because it's based on ONTAP. Again, we'll talk about, hey, NetApp is really a software company, and that's what you see here. This brings all the performance scalability, APIs that customers use on-prem and allows them now to use it in the cloud, bringing the agility, scalability and the simplicity of a fully managed service. So we're super excited about that. As you take a step back, and we've talked about this. If you look at the 3 major -- the 3 hyperscalers, so now this is FSx ONTAP, software-based, first-party service with Amazon, with AWS. We have the Azure NetApp Files, which we've talked about a lot, which is again a first-party service with Azure. That's more hardware-driven, and we've talked about that, and we'll get into that when we talk about margins. And then we have GCP, where we're fully integrated in the marketplace. That's more of a reseller arrangement. Hey, those are 3 of the biggest companies in the world. We'll never speak for them. We're super excited about the position we have in all of them and to help them move their products along as well. At the same time, we think it really speaks volume for the competitive advantage we have at NetApp, the power of ONTAP. And most importantly, you look across the competitive spectrum, nobody else has this. And so we feel really good about our position going forward in terms of the competitive moat. This is truly cloud storage. It's not cloud washing. And I think that what we've done with our -- those hyperscalers really shows the value of our products to them.

Wonderful. Staying with public cloud for a second. At a high level, you're seeing very strong growth in the public cloud business. I think it was up 150% year-over-year. ARR is also exceeding like $330 million. Can you talk about where you are seeing the most traction in your public cloud business? And where you see the most opportunity going forward?

Yes. So opportunity and where we're seeing traction all kind of go together. So keep in mind that what we offer are true cloud services to our customers. And I'll break it into 4 buckets for the investors, and we've talked about this before. And the first 2 kind of go together. The first 2 are cloud services. You have Cloud Volumes Services, which is a fully managed service. That's where you'll see Azure. That's where you'll see, obviously, FSx for ONTAP. We have CVO, which is where we -- where somebody then will use our software in the cloud, in one of the public clouds. That -- we call that fully managed and bring your own. Then we have Cloud Insights, which is our monitoring solution, which is more than just cloud monitoring. It also manages storage, and we're doing a lot of great integration there. And then you have Spot, which is our optimization product, which allows our customers to optimize their cloud spend. So all 4 of those, we're seeing great traction. The really interesting part is, and we've talked about this with margins, only the CVS portion is really hardware-based. Everything else is software cloud across that. And what we saw in Q1 was continued growth, especially in our Azure NetApp Files, and Spot did very well. Everybody continued to grow as we expected, but those were the standouts in the quarter.

Great. That's helpful. Maybe switching over to talk about supply chain. You are facing a challenging supply chain, but seems to be doing a pretty good job navigating the headwinds. And you committed to invest incremental dollars to inventory and to help mitigate supply chain risk. Can you give us an update on what you're seeing in the supply chain now? And if those issues are just increasing cost for you or actually not allowing you to book some of the revenues?

Yes. So as we know, it's very fluid. When I get up in the morning and open up my iPad and would look at The Wall Street Journal, I kind of half cringe and think, okay, what are we going to see today. It's super fluid. Look, we have a great supply chain and procurement team. We're probably a little bit different than other companies in that because we have ONTAP and we have that consistent operating system, we're able to do a little bit more, I'll say we have a little bit more flexibility in making sure that we can deliver those orders. But we're working very closely with our manufacturers, our partners, our customers to make sure that, hey, what they want to purchase, we can deliver. And yes, we've invested incremental dollars in inventory. We've extended our commitments pretty significantly to try to get through this. And again, that single software platform helps as well. So as you see us go through the year, we've baked in what we see today in our margin guide. Again, it's very fluid, and we are relying a lot on, again, that great supply chain and procurement team and, I'll say, to our vendors as well. Everybody is getting pushed, and you hear that from across the board. Unfortunately, it's probably going to last at least through this year. And then you get the inflationary pressures and stuff like that as well. So it's lot of fluidity in here. We focus on it a lot, but we do have some advantages and the flexibility we can provide.

Understood. So last question on the near-term stuff. Your implied second half fiscal '22 growth only suggests a seasonal growth on a sequential basis despite expectations of improvement in enterprise spending. Why are you only thinking about typical seasonal growth? And how does uncertainty from the supply chain we just talked about, and maybe the Delta variant, factor into this versus demand you're seeing from your customers?

Yes. So thanks for asking the question, and we talked about this on the earnings call. So let's take a step back for a second. Hey, we bumped up our guidance across the board for the year, 8% to 9% growth. When you look at the operating margin guidance, even if we come in at the low end of that, it's a record for NetApp. We've never been above 23% before, and almost $5 in earnings per share. Certainly, that would be nice to start that number with a 5. So we're super excited about the year, so let's start with that. As you look at the seasonal patterns, and this is one of the things that makes me scratch my head a little bit, but I understand, hey, folks need to model the business. There's 4 areas I'd ask you to think about when you look at the back half guide. Number one is, as we talked about in the first question, hey, we did start to see enterprise pick up in the second half of last year. We had a really good and strong Q3 and Q4. So as you look at the back half, it is a tougher compare, certainly, than it was in the first half. Oversetting all of this, when you look at '22 to '21 growth, you've got COVID. And I -- Sidney, I just don't even know how to model that. Hopefully, we all don't have to live through that again, but I'd ask everybody to keep in mind, hey, there's nothing normal about the seasonality really in any business at this point. The other thing is, keep in mind, hey, the mix of revenue continues to change for the good. We get more and more recurring revenue every day in our support and our cloud business. That's going to influence not only year-over-year but quarter-over-quarter seasonality. And then the last part I'd bring up, and we were super open and vocal about this. Hey, we got some FX benefit in the second half last year. By the time we get to the second half this year, assuming rates stay where they are, we don't get as much of a benefit. So you take all that together, I don't think it's a subseasonal guide, and I'd ask you to keep all those things in mind. And I go through that long, tortured explanation because we're going to talk about this, this year and most likely next year. So thanks for that.

Okay. Sure. Maybe past these near-term stuff, maybe I'll think about some of the longer-term questions. So we have seen an increased focus on as-a-service, on-premise offerings throughout the storage industry. Can you talk about what your customers are telling you about a need for pay-as-you-go services and on ONTAP's strategy in this market?

Sure. So yes, certainly, we've seen a lot of discussion about as-a-service versus, I'll call it, CapEx on-prem. Our goal is to meet the customers where they want to go from a financial perspective. Some still want to do normal CapEx purchases. Others want to do leasing in Keystone-type products, and we have that. We're super excited about some of the things we've talked about. I'll get to that in a second. And then, of course, for us, really the as a service is cloud. And so what we want to make sure is that across our hybrid cloud journey, be it on-prem, hybrid cloud, Keystone, which is more of the, I'll call, it's similar to some of the other competitor stuff, and then of course our growth in cloud, we think we'll continue to see that evolution. But it also moves back and forth. And some customers would rather buy on-prem, and some would rather go as a service. We have introduced several enhancements to our Keystone Flex subscription in terms of new features for service providers. Now we have the integration with Equinix colocation services. And we have -- we're building more and more connectivity to the cloud through Keystone as well. So yes, we're starting to see that. It's -- for us, it's not a massive shift. And where we see it the most is obviously in cloud ARR.

Got it. Speaking of cloud ARR, as you continue to build out this public cloud business, can you give us a sense what portion of the business comes from new customers who are brought over to NetApp by your public cloud capabilities? And what portion is coming from existing NetApp customers, who want additional functionality for their hybrid cloud. What has been the historical run rate? And how do you think that might change over time?

Yes. So I would point to a couple of numbers here because -- we won't break out the exact percentages, but we do give you the data for you to really look at it. One is, hey, the dollar-based net retention, 192% last quarter. That is, by definition, existing customers. It's like a same-store sales measure. We've seen that grow. Now the percentages have come down, the law of big numbers starts to matter at some point. But we have said across the board, hey, we think the cloud business will be our main driver of net new logos for a couple of reasons. Going back to what we talked about before, it's an addressable market where you don't have incumbents. It allows us to go to anybody, doesn't matter what storage they have on-prem, we can sell them and offer that, not only us, but obviously, the great relationships we have with the hyperscalers as well. And so we will continue to focus on net new coming from cloud, and we think that will be the major driver. So when you look at 155% revenue growth, 192% dollar-based net retention, you can see that both of those are growing, not only our ability to cross-sell, upsell to our base, but also adding a lot of net new logos in cloud.

Excellent. NetApp has done a lot of M&A in the past. If I look at just last year, you made 3 acquisitions in Talon, CloudJumper and Spot, and there is more this year. Can you talk about how those deals enhance your product offerings? Longer term, how do you think about the role of M&A in your business? Is it more bolt-on? Or is it more to supplement the cloud opportunity? Or can we see something a little more outside your current businesses?

Yes. Thanks. Great question. So let's kind of break down the M&A strategy into 3 buckets. And the first one is a little bit what you've talked about. We will continue to look at what we call tech and talent where we can do an acquisition that brings not only great talent, but also think of it as a road map accelerator for the cloud business. And this will be almost exclusively focused on cloud. So that's what you've seen with Talon. That's what you've seen with CloudJumper. That's what you saw with the most recent transaction that we did. And those are going to typically be smaller transactions where they're just going to fit right into the -- to our product road map. We will also look at, the second bucket are, I would call them Spot-type-sized deals, where we look at new products or services that extend our platform in the cloud. Those will typically have much higher ARR. Spot was somewhere around, call it, $300 million. It's going to be obviously a little bit bigger spend there. And then there's the bigger bucket, which is, hey, we'll always look at other transactions. We're focused on 1 and 2, and that's where the activity is. Never say never, but it's certainly -- we're not looking at anything transformational. We're focused on 1 and 2.

Great. Maybe jumping a little bit to a different area, talking about profitability. So public cloud profitability to start off with. This is -- first quarter you disclosed the gross margin of the public cloud service, and it's a huge milestone. That's already above 70%. What's the best way to think about profitability of the business, both on gross margin and operating margin as you scale to a $1 billion ARR business?

Yes. So we were super excited to get to 70%, actually higher than the company average. So again, let's go back to the discussion we had on what are the components of that business. So keep in mind that the Cloud Volumes Services is really the only business that has hardware. And as we've talked about that, and this goes to the free cash flow discussions as well, we will -- we expect to continue to deploy hardware specifically to support Azure NetApp Files for the rest of this year and likely into fiscal '23. Because we're still seeding new regions and geos as they roll them out, which is great. Once you get past that, it's more of a, hey, we'll add capacity, replacement. There will still be some CapEx, but we expect to see that come down a little bit. Now the great part is, we've talked about, hey, better utilization, more regions. As you add the capacity, each one of those pieces of hardware actually has much better productivity than the first ones do once you seed that region. So we expect -- and we certainly expect to see those margins continue to increase. And then the other 3, CVO is all software. That's where FSx ONTAP falls, cloud Insights and also Spot. So as those become a bigger percentage of the business, we do expect it to increase. So we've talked about, hey, if you look at competitors that have SaaS cloud businesses and they get to $1 billion in ARR, it's typically between 75% and 80%. For us, it really depends on a couple of things. What's the mix of business? How do acquisitions play into that? And then the third part of that really is, hey, the FSx ONTAP, the great part about that is it's all software. Now there are some workloads that we do expect will need hardware because of the high-performance nature. But as software gets better and better and better, can we have that as a bigger deployment in the cloud? That's a little bit, I would almost call it, of an upside to that number. But that's certainly our expectations. We feel really good about that traction.

Got it. So while we're on the topic of profitability. I also wanted to ask about the hybrid cloud side of your business, especially on the product business. Do you expect the gross margin of the product businesses continue to grow from the current level, call it, mid-50s given the mix shift towards all-flash? Or are there other factors that we should think about?

Yes. So I think there are really 2 factors there. So in the near term, for fiscal '22, we've said, hey, we expect to be around that 55% product margin. As we add more -- as AFF becomes a bigger percentage, that helps, offset a little bit in the near term by component pricing. And I'm sure we'll talk about that at some point. As we've said, overall, we expect the component pricing to be a slight tailwind in the first half and then be more of a headwind in the second half as we look across all of our materials. So yes, we -- that we expect to continue from a mix, offset a little bit. Now going into next year, I think it really depends on, hey, what happens with that mix and then where do component prices go. Coming out of COVID and this whole supply chain, gosh darn, we're worried about '22. Hopefully, some of that gets a little bit easier next year, but that's really going to depend on the economic as a whole.

Got it. If I look at the software and hardware mix, which you added up your software. So I think it's somewhere around 73%, if you include software, support and public cloud. Is there an upper limit in terms of what that mix could go? Obviously, there's implication on corporate margins, given software is much more profitable.

Yes. Great question. And cloud. And as cloud -- and it's starting to really drive not only the revenue growth, but certainly the margins. We'll always have some hardware in the business, is the expectation. Again, there's workloads and customers that are going to want to have hardware deployed. Again, it's an integrated appliance, so software goes with it. So I don't think you'll see that ever go to, call it -- it will never go to 100%. Will it get above 80%? I think, really, the big driver there is how fast does cloud grow. What is it -- and when we bring in acquisitions, does that help as well. We do expect to continue to see it increase. But there is a point where you should expect to have some hardware in the mix for the foreseeable future.

Okay. So as I look at the near-term margins, I know we talk about supply chain and whatnot and inflationary component pricing environment. I want to get a better understanding of how NAND pricing impacts your product gross margin. Overall, how much of NAND is a part of your building materials. And how do you think about passing along some of the higher NAND prices to customers? And what is the typical delay from high NAND pricing to higher product prices?

Yes. So it's an interesting question because that really gets back to, hey, the competitive pricing environment and what does everybody do. And as we've talked about, Sidney, hey, within a reasonable percentage, it's -- you're not likely to see us or anybody else try to pass on specifically NAND prices. We look at it as a whole. NAND is a part of the BOM, but it's certainly not a significant part. It's getting bigger every day, but we do HDDs and DRAMs and everything else. So as you look at all of our bill of materials, we do expect, again, NAND to be a little bit higher in the second half. For us, it's more of -- especially at this point with the supply chain, some of the vendors are doing things like surcharging and other things to make sure you can stay in line plus deliver the products. We're a little bit more focused on that than simply NAND. If that whole bill of materials shifts significantly, then we'll look at whether we do price increases or we do other things. But it's in a relatively small range moving around. So at this point, we're really concerned more about supplying it than what does it mean for pricing.

That makes sense. Sorry, jumping around a little bit, but this is supposed to be a catch-up question. NetApp has done a good job in differentiating itself through continuing to expand its public cloud offering. But are there parts of the strategy that you believe are still misunderstood by investors?

Yes. So it's a great question. And I think when people asked me 18 months ago why I joined, I said because I think that -- when I look at NetApp, I look at it as a software company who can continue to drive differentiation in a mammoth opportunity in the cloud. And I think you're starting to see that. And I'll talk to you and everybody else about, hey, while there's a lot of integration and relationship, for instance, ONTAP goes across everything. Our sales team now is selling all products. So there's a lot of synergy across, I'll call it, both those segments. But when you look at them, they are 2 very different ones. And you have a high-growth, very good gross margin cloud business; and then you have the hybrid cloud business generating a bunch of cash and growing nicely. And I'm going to keep pushing, hey, sum of the parts. But here's the one thing to look at, too. When you look at the cloud business, also understand, by definition, the hybrid cloud business is actually more profitable than NetApp as a whole because there is some investment in cloud. And when you do that, I look at that and say, that's a really, really interesting story, especially given the synergies and efficiency we drive across with one platform. So we'll continue to push on that. And we talk about it at every earnings call. You know I love cash flow. We also generate a bunch of cash. That gives us a lot of flexibility to not only make sure we're doing the right thing from a shareholder perspective, but also grow the business.

Great, which is actually my next topic, is your favorite topic, cash flow. And I'll be remiss for not asking that. So you recently raised your free cash flow expectations to be over $1.2 billion for fiscal '22, which is ending April. That's roughly 20% of your revenue, which is great. How do you think about cash flow dollars and margins going forward as you continue to invest in public cloud? Is there room for cash flow leverage in terms of the margins as that business continues to grow?

So I think the answer is absolutely yes. So let's break it into 2 pieces. We'll do operating and then we'll do free. So operating cash flow, we would expect to continue to move with operating margins. If you look at non-GAAP operating margins and you correlate that to cash flow, outside of some wacky cash taxes or something like that, over a long period of time, they tend to move together. And so as we expect to drive margin growth in -- on the P&L, I would expect to see operating cash flow continue to grow as well. The cloud business, then you start, this is where's the discussion about the CapEx part. I mean we guided around $230 million this year. There's 2 big drivers: One is continuing to deploy hardware to support the CVS business. We also have, I'm going to call it, more of a onetime facilities increase from a couple of locations in Wichita and then the new location in Santana Row. That's why I do expect, hey, CapEx should probably go below $200 million starting, hopefully, next year, but certainly after that. And I also think we can leverage that because, again, you get that initial investment out of the way. We'll always do some facilities, but not at this level. So yes, I do expect to see operating and free cash flow margins continue to move with the efficiencies and the growth on the P&L.

Wonderful. Just a reminder for the audience, if you have any questions, feel free to type it in. I will try to ask those questions as we almost wrap up with this one. So maybe one question for you. In terms of capital allocation, Mike, you gave a plan at your Analyst Day last year to be up like -- return up to 70%, 75% of free cash flow to shareholders. But can you give us an update on how your thoughts around capital allocation have adapted since your Analyst Day? Has your appetite for buybacks changed at all since you gave that plan?

So we're still pretty much sticking to the overall allocation. It's going to move around a little bit, if you look at in the shareholder allocation, call it, 70%. And it's also going to move around each quarter. So we are still -- hey, the dividends are still the first call on capital. We view that as the best way to return cash to shareholders. We increased the dividend from $0.48 to $0.50 per share per quarter at the beginning of the year. We've said, hey, we will continue to offset dilution to make sure we don't go above the 229 million shares outstanding. That leaves us about, call it, 30% for acquisitions, and that's super important for us to have that. Now I'd also say I'm also very cognizant, hey, we have a -- you look at about $2 billion of excess cash. We'll always have some debt. I think it's good in the capital structure, and we did the refinancing last year. That was a great transaction. So as we look forward, we want to continue to make sure we have dollars for acquisitions. But we're also cognizant of, hey, on a timing basis, if that cash continues to build, we will continue to look at it and say, should we do something? At this point, we're sticking with the allocation because we feel good about the M&A road map. But we look at it and talk about it every day, Sidney.

Great. The last question for me. Are there anything else that you think -- I mean we talked about the public cloud strategy. But are there anything else that you believe investors should focus on that you don't think is well understood by them?

So I -- so great question. Thank you. I think over the last 12 to 18 months, we've talked a lot to you and investors about really 3 things. One is, hey, we're really a software business, and you're going to start to see that in the margins and also the product road map. The cloud business has tremendous growth, and we think that we have a differentiated position there. And I think, again, on September 2, I think you saw that come through loud and clear. And then the third part is, from a financial perspective, we do expect to be able to grow revenue, and we have great leverage in the model. And you're starting to see that as well. So those are the 3 areas that I would continue to focus. And then that obviously leads to, hey, the sum of the parts gets to be a really, really interesting discussion. Once you get to $0.5 billion in ARR, that's a real business, Sidney. And we're -- so we're super excited about that. So all of those go together, and I would just keep hammering on that as well. Feel really good about this year. And coming out of COVID, knock on wood, hopefully, we all get to return to normal at some point. But we feel good about the position around cloud, digital transformation and what our customers are asking us to do.

Excellent. I think this is a good time to wrap up here. Thank you for the time, and enjoy the rest of the day if you have meetings.

Hey, thank you. And again, thanks for having us. Thrilled to be here. Have a great rest of the conference.

Thank you.

Thanks, Sidney.

Bye-bye. Bye-bye.