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

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Good afternoon, everybody. I'm Aaron Rakers at Wells Fargo. I'm the IT hardware and semiconductor analyst here, and excited on the heels of a great solid earnings release last night to have a quick discussion with NetApp. We've got with us Kris Newton, who heads up the Investor Relations for the company. I think, Kris, before we go into some of the questions, I think you wanted to say a quick comment on safe harbor.

Yes, please. I will run through it quickly. Today's discussion may include forward-looking statements regarding our future performance, which is subject to risk and uncertainty. Actual results may differ materially from the statements I make today for a variety of reasons, which are described in NetApp's most recent 10-K and 10-Q filed with the SEC and available on our website at netapp.com. NetApp disclaims any obligation to update information in our forward-looking statements for any reasons. Back to you.

Perfect. It sounds as if you've done that a few times, and you nailed it.

So Kris, I want to start -- I mean you guys just reported results last night, and you raised the full year guidance. You talked a lot about the cloud narrative, which certainly we will get into. But I wanted to maybe start the question with maybe the softball, which is as you've engaged with investors maybe post last night's results, or for that matter over the past couple of weeks or past months, help us understand, is there pieces of the NetApp story that you think people are still trying to wrap their arms around, maybe not fully understanding or appreciating and just how the company has evolved and maybe what still needs to be understood a little bit better?

Sure. I think the cloud business is so new for NetApp and it's so exciting. It is an area where people are still learning and really digging in on. That said, I think there's -- people are learning, there are a lot of questions. But the thing that I think in that focus of trying to understand the cloud, what people miss is the big picture, right? We've got this amazing hybrid cloud strategy, where we're helping customers, both in the cloud and on-premises. And because of that, we're the beneficiary of some enduring and fairly sizable trends of the shift to cloud as well as digital transformation. And those ultimately support not only the growth in the Public Cloud segment, but also our Hybrid Cloud segment. And so we've been known for doing great data management and great file services for a long time. Today, we've got a truly differentiated cloud platform. The gross margins that are accretive to the corporate average. And because of the scale and profitability and cash generation of the Hybrid Cloud business, we're able to fund that growth while driving operating leverage through the business and dropping -- fueling growth and dropping profitability to the bottom line. So I was trying to remind everyone, it's great to focus on the individual pieces, but actually, together, they're greater than the individuals.

Yes. And I think on that kind of topic or question, one of the things that I think maybe people -- this is a journey that the company has been on for a while, right? This isn't just something that we've talked about over the last 12 months, but maybe help us appreciate the importance of that journey, right? And it's not necessarily -- you will have competition, but this is something that wasn't spun up in a short period of time. This took a lot of work to get where you're at today.

Yes. We started our cloud journey over 7 years ago, making ONTAP available in the AWS Marketplace, expanded that into other clouds and then started expanding with additional services, which has all been really important. We started with the thought that, hey, our customers want to leverage the cloud, we can offer some backup and recovery options for them with ONTAP in the marketplace. Then we realized there is a big need for an enterprise-hardened file service in the marketplace, and that led us into a different style of conversations with the cloud customers or cloud partners, first with Microsoft who basically decided to natively integrate our fully managed storage service, sell it as their own in order to meet that big demand for file services. In Q2, Amazon announced a similar arrangement where they're selling a fully managed service based on ONTAP technology to their customers. And what's unique is once you're fully integrated into that cloud console, it's their sales teams who are selling it, they're billing it. So customers who have big enterprise contracts with the cloud customers can easily consume NetApp technology, regardless of what cloud they're in. And so that level of integration really streamlines the purchasing, the billing, operations support. And customers don't have to worry about contracts or product installations or patching. And today, we are the first and only storage environment natively integrated into each of those clouds. And for us, that creates a massive go-to-market growth engine since those big companies are selling on our behalf.

Yes. And a part of that, right, and I'm definitely going to ask you about supply chain constraints, but I'm going to keep down this path of cloud, given the importance of it. And you just reported, I think it was 80% growth in your ARR on the Public Cloud, I think $388 million. You expanded your target or guidance for the full year, I think $510 million to $550 million with, I think, some inorganic CloudCheckr contribution. So for those that are simplistic like myself, remind us again how I think about ARR relative to the growth of the revenue from Public Cloud that you're generating and then kind of segues down into the effect that, that's accretive to the business model from a margin profile perspective as well.

Sure. So ARR is a leading indicator of the direction of revenue, right? So if you think of kind of the average of ARR for the past couple of quarters, divide it by 4, you'll get an idea of revenue, right? So ARR is typically calculated kind of exiting the quarter as revenues, the sum total. Also to help people understand kind of the trajectory we're on. We've been sharing dollar-based net retention numbers. So that's net of churn. So that means a customer who spent $1 with us in Q2 fiscal '21 is now typically spending $1.79, right? And those are pretty high numbers. They've been consistently high, albeit off a small base, but we expect that to continue to grow as customers have the opportunity to buy more and more services and see greater utilization with NetApp.

Yes. And you bring up the point of net dollar retention, 179%, it is high, right? And I think it was even 190-plus percent the quarter before. Is that driven by data growth? Is that driven by services -- help me maybe unpack that a little bit as we look forward.

Yes. It's driven really by a combination of the two. So one of the great things about data is once you create a bit of data, you're going to replicate it, grow it, right, you never throw that stuff away. So data just naturally tends to grow. But we're also focused on a full suite of CloudOps offerings, and so selling the Spot services, bringing container technology to our customers, giving cloud insights, which is a great data, or infrastructure monitoring tool. So not only is there sort of a natural evolution of growth based on data, but also the cross-sell, upsell opportunity.

So again, just so I'm clear. So pricing it on a data under management basis just naturally should grow that retention -- that net dollar retention. And then you layer on, like you said, Spot, maybe you can help us appreciate the recent acquisition of CloudCheckr underneath that as well. And do I think about that as being the strategy, right? We see NetApp just continually layering on additional feature functionalities to drive that attractive net dollar retention growth.

Yes. So it's interesting how customers use the cloud, right? It often becomes a test and dev environment. So you'll see customers stand up a ton of virtual machines run a project for a while. And then the great thing about cloud is you can tear that all down and not have any economic overhang. So we see that in our customer base. We also see customers moving enterprise workloads to the cloud, which tend to be stickier. And then there is a CloudOps persona that we see emerging within companies who are looking to really operationalize cloud in the same way the IT operations person used to operationalize the data center. And so we're looking at how do we bring together a number of services for CloudOps and DevOps people to make them be more successful in the cloud and give them a real robust suite of multi-cloud infrastructure management tools and optimization capabilities.

Yes. And at the end of the day, you've just taken up the guidance for the full year. I think you said $35 million to $40 million contribution from CloudCheckr. Again, that acquisition, just help us appreciate that. That's a fairly good sized number, ARR on that acquisition and help us understand that opportunity.

Yes. So CloudCheckr provides recommendations for customers to better optimize their overall cloud spend, right? So it's not -- and I think this is an important point, it's not helping them optimize the portion of spending in the cloud they're using NetApp technology for. It is just like Spot, a fully heterogeneous, you don't need to have ever met NetApp or use any NetApp tools before to find value out of these optimization services. So again, as customers are seeing that cloud sticker shock, technologies like Spot and CloudCheckr can help alleviate that. Additionally, CloudCheckr has a really great public sector business where we see affinity with our large U.S. public sector business, and a really good managed service provider business, which we think will use CloudCheckr as a lead in helping managed service providers ultimately optimize their own operations and help their customers optimize their operations.

That's perfect. So we roll this all together, you raised the guidance with the ARR. The question I got last night asked of me was you stuck by the $1 billion ARR target by 2025. Is that conservatism? I mean I guess some would argue, why does that not get pulled forward? And obviously, you've executed well. So just the thinking around that at this point.

Sure. I've gotten that question in almost every conversation I've had since we announced last night. And ultimately, I would say it's more of a factor of the fact that we haven't updated the out-year expectation while we've been continually updating the nearer-term expectation. We're holding an Analyst Day in March of '22, and I think that's the appropriate time to really look at the long-term model and reassess and re-up and provide any updates to some of those longer-term expectations.

Yes. Perfect answer.

So I guess watch the space is the answer.

Yes. That's perfect answer. And kind of in that same context, I mean, the gross margin profile of this business, and maybe I'll go back to an earlier question, the first deployments you actually made in on these cloud relationships, actually, we're putting NetApp infrastructure inside these cloud environments. And where do we stand today? Because is that kind of the path going forward? And does that -- or does that change and drive even further gross margin accretion for the model just because I'm looking at a 70% plus gross margin business growing at a healthy clip. Obviously, that starts to drive a mixed discussion on the gross margin as we move forward, too.

Yes, absolutely. So today, only two of the services that we offer have any sort of hardware associated with them. And that's Azure NetApp Files, where we're deploying systems in the Azure cloud, and Cloud Volumes Service for Google where we're deploying in colos near the Google Cloud. Everything else is software-based, and that's how we were able to get to the accretive gross margins ahead of where we thought we would be. So as software -- increased software-based solutions increased in the mix, that will help support increasing cloud gross margins. Also as the utilization of the hardware that we've already deployed increases, that will help support increased gross margin and just revenue scale. So over time, and what that time is, we're not quantifying yet, but over time, we think we can get to SaaS-light gross margins of 75% to 80%.

And that's inclusive of you'll have a continued piece of the business that has a hardware -- NetApp hardware component to it for the foreseeable future.

Yes. We're definitely working on delivering more and more value through software. But certainly, for performance and integrated hardware software stack can't be beat. And Azure NetApp Files is the -- really offers a Ferrari level of service, right? They've got fast, faster and fastest as their service levels. So for at least a portion of that business, I think there'll always be some integrated hardware, but maybe for some of the less performance required, we would look to deploy software. But right now, everything seems to be all steam ahead.

Yes. That's great. And the final couple of questions on the cloud. I mean when I look at, let's just call it, $510 million at the low end of your guidance range of ARR this year targeted exiting the year, maybe I strip out CloudCheckr. But to me, it sounds like we're still in the early innings of kind of the full breadth of each of those 3 partners really ramping at scale. It sounds to me like Microsoft has definitely ramped fairly quickly. Google is a little bit behind that, and we're still early innings on AWS. Is that a fair assessment? And if so, how -- do I think that the ramp from Google, from AWS could even be quicker than what we're seeing at Microsoft. I'm just trying to think about that rate of acceleration of this opportunity for NetApp...

Right, right. And so I'll narrow my response to the fully managed storage service that those vendor -- those cloud providers are selling. It takes some time for them to ramp. Their sales teams need to become aware of the offering. Customers need to become aware of the offering, right? It just needs a little bit of ramp time. We saw a good ramp with Azure NetApp Files. And I think we learned a lot about how to make our cloud partners successful, how to reach out to customers to make them aware. So could we potentially see an accelerated ramp-up on the services that were brought to market later? Potentially. We'll have to see. But definitely, even if things move at the pace that A&F moved, that's a great story.

Yes. Yes. So moving to the other topic that I'm sure you spent a time of time talking with investors about, you and everybody, it feels like, is obviously supply chain constraints. So there's obviously an element of that built into the guidance into this next quarter or through the next -- this back half of the fiscal year. So maybe for those that didn't listen to the call last night, maybe you can help us appreciate what is factored in, what is the company seeing right now? And I guess, how are you reacting or any expectations of when maybe some of those supply chain constraints start to ease?

Sure. So on the revenue side, we're definitely seeing demand outstrip supply. And we are seeing, in our product revenue, headwinds from supply chain constraints. We didn't quantify them. And even in the face of those constraints, we ultimately raised our overall revenue expectations for the year. So we're confident in our ability to meet as much of the end demand as possible. We did quantify the impact on the product gross margin side. And again, it's only the product revenue that gets impacted by the supply constraints. Support revenue is what it is. It's rolling off the balance sheet, the cloud revenue. Again, largely delivered through software tools, so not impacted. Initially, at the start of the year, we thought that our product gross margins would be roughly 55%. That's where they were in the first half. But based on the temporary increases in freight and expedite charges, we see an impact where we now expect the full year product gross margin to be closer to 54%. So we'll see those headwinds there. We did do a list price increase early in November. Because we'll honor all the deals that are in flight, we probably won't see much of an impact of that until Q4. And when all of this rectifies itself, I think that still remains to be seen. There are some early indicators that some of the freight and logistics constraints might be loosening up, but then you get a headline with a new variant of concern with COVID, and that just throws everyone back into a spiral of we don't know what's happening. So largely speaking, we feel good about our ability to source supply. Our partners have been great. Our supply chain team has been bar none. But definitely, it is creating some headwind, and we'll have to see how it plays out as we move through fiscal '23.

And in the midst of that, I know a lot of -- I know you guys didn't quantify the impact, but how would you characterize what you're asking your customers as far as lead time visibility, any kind of qualitative comments of how the backlogs kind of changed? Or how much -- I don't historically think of NetApp as being a big backlog type company. But how much has that changed over the course of the last couple of quarters, given the environment we're in?

Sure. So there are definitely some extended lead times, it varies product by product, and it is an incredibly fluid situation. So there's not kind of a perfect static answer for that one. Regarding backlog, I would say the companies who were talking about their increased backlog are the companies that missed revenue. And so I'm not going to talk about backlog.

All right. I will leave it at that. You guys don't carry much inventory, right, on a relative basis. So you made $155 million of inventory coming out last quarter. But one of the things I do see is you do have purchase commitments, right, coming out of the quarters. I think we'll wait until the 10-Q comes out here in another day or so, but have you -- what are you seeing or what are you being asked as far as purchase commitments, off balance sheet commitments to try and get past some of these supply chain concerns? I think off-balance sheet commitments, for reference, is I think $954 million coming out of fiscal 1Q in total. Just what's going on that side of managing the business?

Sure. So starting in Q4, we did start increasing our inventory levels, kind of seeing the storm clouds on the horizon. I think the off-balance sheet total purchase commitments that you'll see in the Q are pretty similar to the levels that you saw from Q1. We're working and being creative and flexible in sourcing everywhere and however we can. We're working with partners. But it is -- again, it is a challenging environment that does create some need for creativity and higher inventory levels. Our inventory turns came down to, I think, about 13% in Q2, and I expect that they'll stay at that level while we're in this challenged environment.

Okay. A couple of other kind of quick questions on the minutes we got left. Competitive landscape. Dell isn't really growing. The storage business, I think, was more or less flat this last quarter on a revenue basis. They continue to talk kind of qualitatively about demand strength for PowerStore. Pure Storage had a decent quarter last quarter. So just characterize to me, understanding that cloud is a big narrative but just that traditional competitive landscape you're seeing in storage?

Sure. I think none of the legacy players that we have competed with in the past and still compete with in the kind of enterprise data center space have a true cloud story, and that helps set us apart. On the whole, the enterprise data center environment, competitive environment hasn't changed dramatically. I've always been a believer, and I think history proves out that with focus, the pure-play vendors can be a full stack provider all the time. And I think we're seeing that now when you look at the growth rates of NetApp and other focused players against the broad full stack vendors.

Yes. And you mentioned last night, I think it was you grew -- I think it was over 20% in your flash business. You're...

22%.

22%. So your $3.1 billion of annualized revenue, you're still only 30% of your installed base that's all flash. It's kind of just checking down the list, like 1% or 1.5 percentage point a quarter. Is that how we see it? Does that change at all? Is there any accelerant to that?

I think for the foreseeable future, it will be kind of 1 point a quarter. That -- the way we measure that number is it's active systems -- or systems under active support contracts in the installed base, that measures in the hundreds of thousands, and that denominator is growing. We're seeing some tech refresh of older disk and hybrid flash arrays with all-flash arrays, but also customers are still buying hybrid and disk arrays and they're refreshing hybrid and disk arrays with hybrid and disk arrays. And we're seeing greenfield opportunities with flash. So a lot of moving parts. And again, the base number is so large. I don't expect huge swings. So 1 point of quarter feels pretty good, and there's still a lot of upside to help refresh our installed base as well as gain net new opportunity.

Yes, that's perfect. And the final kind of line of questions I just want to ask you, and I can appreciate you've got an Analyst Day coming up, cloud's going to be talked about, but I'm sure the other part of the equation is going to be free cash flow generation, balance sheet and, for that matter, what's been a very attractive capital return story. So how -- remind us again how you -- how the company is thinking about capital return, balancing that versus maybe leaning in a little bit more around M&A, strategic things around cloud? Yes.

Sure. So we expect to generate over $1.2 billion in free cash this year. And that's even in the face of kind of increased CapEx spending this year for some facilities and continued investment into the Azure NetApp Files infrastructure. The way we think about capital allocation is our first call on capital is the dividend. That's roughly 50% of free cash flow. Then we'll look at buybacks to offset dilution, roughly 20%, although with the stock price appreciation. It does cost a little bit more to offset the dilution. And then finally, that 30% is really targeted for M&A to help accelerate our cloud business. Ultimately, I don't think we'll be returning greater than 100% of free cash flow, but that's kind of the framework we have in mind right now.

And when you think about that framework and the free cash flow generation, because I would assume from a working capital management perspective, there's probably not any significant drivers. I think you had negative mid-teens or low teens cash conversion cycle. So assuming free cash flow stays where it is, I mean, that framework, I mean, how do you think about the cash on the balance sheet to kind of how is the company might think about the cash on the balance sheet to run the company, what's maybe required?

Yes. We do have a substantial amount of cash on the balance sheet. Certainly can be used as dry powder and acquisitions to help accelerate the cloud business. If we're not -- but then also, we could again look at accelerated buybacks. I think right now, the payback on investing in the cloud business is probably one of the stronger things that we can do with our capital.

Kind of rounding out the discussion, I mean, again, coming off the heels of last night's results. As we think about the Analyst Day and as you think about the execution of what the company is doing, is there anything from -- aside from component cost and mix that we should be thinking about from a margin profile perspective? You've kind of been running this business model very effectively. And I'm thinking about EBIT margin drivers as we move forward. Just remind us again, as we look at EBIT, you've outperformed these last couple of quarters, is there anything that says like we couldn't continue to see incremental operating margin leverage in this business model?

There's nothing that would indicate that you won't. We'll continue to deliver operating margin leverage. Let me not get tripped up over too many double negatives. Our expectation is that as we continue to drive growth, OpEx will have to rise, but it will rise at a pace lower than the overall growth of the business. And for the first half of the year, over 50% of the revenue growth that we delivered dropped down to the bottom line. And so we expect, again, to see great leverage in the business model, even as we continue to scale the cloud pretty dramatically.

That's fantastic. Kris, I think with that, we're running close on time. Is there anything that you want to leave us with? Or anything I didn't ask? I can't really ask how the current quarter is going, right, because we might have had an update last night. But anything I should have asked that wasn't?

No. You started off asking the question that I usually close with, which is what don't people understand about NetApp. So again, I'll just reiterate that we've got 2 great segments in our business, both are growing and they're additive together to yield great leverage through the business model. And we're excited about the opportunity ahead.

Okay. Great. Well, we look forward to the March Analyst Day. I appreciate you taking the time this afternoon.

All right. Well, thanks for having me.

Yes. Thanks, Kris.

Yes. Bye all.