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

Welcome, everyone. I'm Kieran Kenny. I work on Morgan Stanley's IT hardware research team. And I'm pleased to welcome Mike Berry, NetApp CFO. Mike joined NetApp as CFO in early 2020. And previously, he was CFO at McAfee, CFO and COO at FireEye and CFO at Informatica. He's brought a wealth of financial acumen and additional operational rigor to the company. Before we get started, NetApp asked me to read their safe harbor. 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 made 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 their website at netapp.com. NetApp disclaims any obligation to update information in their forward-looking statement for any reason. I also want to point you to Morgan Stanley's research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that, Mike, thank you for joining us today.

Kieran, thank you very much. We really appreciate Nasdaq and Morgan Stanley inviting us. Happy to be here. And good morning and good afternoon. Good evening to everybody.

Great. So one of the aspects about the NetApp story that's most interesting is that you've been able to rapidly scale your Public Cloud business, while still growing your on-premise Hybrid Cloud business. Going forward, do you believe growth in both businesses is sustainable? Or is there a risk that growth in your Public Cloud business ultimately results in slower growth in the Hybrid Cloud on-premise business?

Yes. Great. Thanks for that question. We certainly get asked that a lot. We feel very good about being able to continue to grow both sides of the business. And there is obviously some correlation. So we think that -- look, for the last 6 quarters, we've been able to grow both Hybrid Cloud as now we've broken out that segment and the Public Cloud business. And our customers are starting to think of us much more as a cloud company. And as they're looking to really drive their movement to the cloud, but also their digital transformation, which continues to be a big driver, that allows us to provide services and product both in Hybrid Cloud and Public Cloud. And through some of our acquisitions and all the work we've done building us as a cloud company, we're able to reach new buyers. So we feel very good about not only being able to really drive growth in the Public Cloud, but also on Hybrid Cloud, there are so many new initiatives there, so many new workloads, unstructured data because -- and I'm sure we'll talk about it, Kieran. One of the reasons why I joined is, "Hey, I don't think about NetApp as a storage company. I think about us as a data company, driven by software and cloud." And we think both of those are enduring drivers of growth between cloud and digital transformation. So yes, we continue to feel good about both sides of the business, and there's a lot of great synergy there. As you know, ONTAP is the engine across both of those, Hybrid Cloud and Public Cloud. So we get to really get a lot of synergies, but we also see what customers like in each of those. So yes, in answer to your question, we do feel good about being able to grow both Hybrid and Public Cloud.

Got it. That all makes sense. On the sales initiative side, what sales initiatives do you have in place to help ensure that you maintain balanced growth in both Hybrid and Public Cloud?

Yes. So thanks for that. So we've made a lot -- so Cesar Cernuda, who joined us almost 18 months ago now, has really brought a great new view to our sales and go-to-market teams. So in the past, we had, I'll call it, separate sales teams that were focused on their core business and then one focused on Public Cloud. This year, in our fiscal '22, we've actually brought that together. So our sales teams are now responsible for selling both Hybrid Cloud as well as Public Cloud. We don't want our great sales folks in front of customers trying to push them one way or the other because of how they are compensated or measured. We want to do what's right for the customer. So they have quotas in both sides of the business. And by the way, for them to hit accelerators, they have to hit both numbers. So you can't just go and knock it out of the park in one area and not the other. We want that balanced. And again, doing the right thing for our customers as well. Importantly, we also have separate sales teams that are faced off against the hyperscalers to really help them as they're pushing cloud into their customer base, burning down their commitments. And then, of course, we have the customer success renewal teams that help across all of that. So we feel much better about the alignment to drive growth in both businesses. And as you know, every year -- and actually, we have half year plans now, which we really like because it gives us the flexibility to make changes as we go. But as we all know, gosh, knowing the world's changing every day, every morning, you wake up, there's something new. So it allows us to be responsible to our sales teams, but also allows us to be flexible in terms of how we compensate them and drive our business forward.

There is a debate in the market right now around how much of demand, especially in the on-premise hyper cloud business is cyclical or secular in nature. What -- like if you look at your pipeline and the data there, what's -- like do you have a sense for how much of demand going forward is more cyclically driven or secular driven?

Yes, I think -- it's an interesting question, again, it kind of goes back to the first one, which is the things that are driving growth in our pipeline across Hybrid Cloud, Public Cloud, NetApp as a whole is really as customers look to migrate to the cloud, but making sure that, hey, we all know there are some workloads and data that's never going to leave on-prem. We're a big believer still in the Hybrid Cloud world. And as they move to cloud, what's really driving that is obviously cloud migration, but it's also digital transformation. And as we talked about a little bit, Kieran, all the new workloads that are there in unstructured data around artificial intelligence, machine learning, all of those things are also driving new use cases, which is driving our pipeline as well. And we think all 3 of those, and look, there's going to be more data created every day and people have new uses for it. And that goes back to is NetApp a data company driven by software or are we an on-prem storage company. And we feel like every day we move further and further down the path of being a company that helps our customers manage data. We have data fabric, which allows us to do it across both. And the really big thing for us is we feel like we have a very unique and really, nobody else can touch our position in the Public Cloud, native integration to all 3 of the big hyperscalers. We're proud to work with all of them, go-to-market integration and first-party service in 2 of the largest ones. So we feel that, that also brings us a competitive advantage across that whole spectrum. And again, going back to your first question, we feel good about being able to drive both of them. We know in the past, there's been some cyclical spending, we're all subject to that. Your business, our business, but we feel really good about how we've set up for future growth in the sustainability of that growth.

That's a good segue to the discussion on Public Cloud. And you just highlighted some of the key points of differentiation for NetApp. What gives you the confidence that you can sustain this momentum over the next couple of years, especially as competitors start to ramp their own Public Cloud type offerings?

Yes, so thanks for that. Everyone's chasing public cloud, which is great. It's a great growth market. We feel like we have such a wonderful advantage. And look, we've been doing this for a long time. So we've had relationships, again, proud to work with all 3 of the big public clouds, that go way back. And -- but we're very unique in that people can say, hey, we have integration. And certainly, anyone can sell through the marketplace and it's a great way to reach customers. We are natively integrated into all 3 of the public clouds. We have first-party services with, Azure NetApp Files, the newly announced FSx for NetApp ONTAP with AWS and some of the integration we've done with Google Cloud as well. That is unrivaled across any of our competitors. And they can talk about integration, great. But you know what, if you want to be in their environment, behind the console, part of the AWS or Azure products, we're the only ones that are deeply integrated and have native integration and first-party service where their sales teams are comped to sell it. And that's not easy as you know. It's taken us a long time. And we've gone through this with ANF, it's now really hit its inflection point. We're excited about FSx and the work we do with Google as well. We think we have such a great advantage. And more importantly, customers are starting to see that. And they know that NetApp can provide it across their whole spectrum of data, not just on-prem, Hybrid Cloud again, as a service, if they want to use Keystone, that's great. We love that product or move to the Public Cloud. So we think that we have an unrivaled advantage across that product set.

Yes. It's a great point on AWS, FSx, ONTAP as well. I think -- if I remember correctly, that was a partnership that took 2 years or so to build that product and offer it. So what -- on AWS, FSx, ONTAP specifically, could you talk about early demand there? I know it just launched back in August. And then when should we expect more of a meaningful contribution to Public Cloud ARR from that offering?

Yes. So we're super excited. And again, very proud to work with one of the great companies in the world here. A little bit different than ANF is FSx is -- and this is the way that they like the go-to-market, which is great. We're happy to follow that. The announcement was actually not, we're working on the partnership or we've agreed to it. It was when it was GA-ed. So there was a lot of work here that went on in both companies to get the product ready. And then when that announcement hit in early September, it was, it's GA, you can buy it and use it and it works. Very different than some other companies go to market. So we're really excited about that because hopefully, that builds that pipeline quickly. It's also a little bit different than ANF and that it's all software from our perspective. So it's deployed worldwide inside their infrastructure. We don't need to ship hardware or get data centers up and running. So we hope that it means a little bit faster rollout, but we also know and learned a lot from the ANF rollout, which is, people are a big part of this and making sure that between all the sales teams and marketing and the messaging, everything is rolling. And by the way, customers need -- they're still going to want to test it. They're going to want to make sure it works. They want to go put workloads in there. So there's still that period of time. So we feel really good about the early indications. Customer interest has been great. The partnership with AWS has been awesome. So we do expect to see that ramp. For the rest of the year, I would say, let us get that rolling going into '23 is when we think it will really start to inflect and make a much bigger contribution. But we're super excited about it. And we did learn a lot with our ANF relationship as well, which is going to help all of us.

That's great. Earlier this week, you raised your fiscal '22 PCS ARR by roughly $50 million at the midpoint. Given the stronger-than-expected ARR for this year, how is your confidence in your fiscal '25 target of $1 billion in cloud ARR change? And should we expect any upside to that target?

Yes. So I felt good about it when we gave it in September last year. Every day I work in NetApp, I feel better about it. So look, we've seen -- and again, and we've talked about it. FSx, well, that wasn't announced. We certainly hope something was going to come down the path. We've seen really good growth across ANF. Cloud Insights has done wonderful. Spot has been a great acquisition. We just added CloudCheckr, which feeds right into that, that optimization part of the world that FinOps that we think is going to be super important. Certainly, for CFOs like me, every time you look at a P&L, what's the largest growth in that P&L, Public Cloud spend. So we're really excited about the FinOps part of the world. In addition, our ability to do acquisitions. And we said, inorganic acquisitions will always be a part of the $1 billion. So we feel really good about it. Now when we think we're going to get there, what that looks like, we'd ask you to please come in March to the Investor Day. We'll give our longer-term targets at that point. But from a near-term perspective, Kieran, I feel better every day about our ability to hit that and eclipse it. And then with the gross margins we've seen there and the great uptick as well, really think that's going to be a big contributor financially. If you look at the throughput in our midpoint of our guidance, a lot of that gross margin increase is coming from public cloud. And I think that's going to continue. So we're excited about that as well.

Great. Shifting over to the supply chain side of things. Starting with your Hybrid Cloud business, how are supply chain and logistics bottlenecks impacting your ability to meet near-term demand? And then what steps are you taking to mitigate those impacts?

Yes. So just one personal note. What I'd say is supply chain delay it's just all over the place. I think we ordered a range that's now been pushed out another 6 months. So it's hard to get anything. So in our business, a couple of things around supply chain. Let's talk about demand and then we'll talk about the cost side is for core storage media, for HDDs, SSDs, DRAM, those kind of core components, there's really no issue from a supply chain perspective and pricing has been largely consistent pretty much what we thought it was going to be as we look into next year. And we do expect to see, hopefully, supply and demand always moves with some of the buildup in capacity, especially in -- around SSDs, hopefully, that helps with pricing there. Put that aside for a second, our supply chain issues are really around the componentry around that. And while we can get storage media, you have to ship a full box for it to work. So that's where a lot of the work has gone on. Publicly, we'd say we have a bunch of wonderful suppliers that have really worked hard with us, and we appreciate all of that. From a cost perspective, it's much more on the freight and expedite. And it's not only getting parts from our suppliers into our manufacturing sites, but it's also us getting those then to our customers. And we all know you can't open a paper reading not only has the freight to ship ocean gone way up, but gosh, you never know when it's going to actually hit the land. So a lot of people have reverted to using air freight, everybody is going after that limited space in the belly of the plane. So that's been our biggest issue, and quite frankly, expedite where, we'd love to help you, NetApp, but gosh, if that's going to cost us more, we need to pass that through. So that's the pressure on the gross margin side. But from a supply perspective, it's really that componentry. And we got a great supply chain and purchasing team. Kudos to them. Good or bad for them, I pretty much talk to them every day. They're working 24 hours a day because most of our suppliers are in different time zones. They are doing everything they can to make sure that we're able to hit our targets and deliver to our customers.

Understood. Is the Public Cloud business affected at all by supply constraints, either positively or negatively, like are customers adopting PCS faster because of supply constraints impacting capacity expansion on-prem?

I think that's a great question. And 2 answers to that. So from a detriment perspective, it really doesn't have an impact. Yes, we do ship product, especially for ANF, but we're in that part of our business where it's largely okay. So it has not had an impact there. And we're -- we've been able to meet the obligations that have been expected of us, especially with Azure, and we're excited to be able to do that. On the other side, on the positive side, I think there's 2 things. One is, yes, I do think it will help drive cloud growth because it's a lot easier to school up in the cloud that have to actually go procure product. And then you get not only the supply chain issues, but then you get the labor issues as well. So I think that, that does help. The third part that will be super interesting, and we see this even with my team and NetApp is, if you can't procure the product, I think the renewals business will continue to be strong because at that point, it's much -- makes a lot more sense just to go renew what you have then go do something new where you have issues. So I think that, that will be an interesting dynamic as we go forward.

Got it. And then you talked about this a little bit already, but could you comment on how we think -- or how we should think the gross margin trajectory should progress over the near term, and then over the medium to long term, once cost inflation starts to ease a bit? On the positive side, you're mixing into more software-rich storage arrays and more cloud revenue. But then near term, you talked a little bit about some of the freight and logistics cost headwinds. So just how should we expect gross margins to ebb and flow near term and then maybe 2-plus quarters out?

Sure. So happy to go through that knowing that we're not giving guidance for '23, but we'll kind of say, sitting where we are today, what we see. So in total, if you put it in context, we are able to maintain our total company gross margin of about 68%. That's what we guided for this fiscal year. Let's break up the 2 parts. From a Hybrid Cloud perspective, yes, we'll see pressure in the near term around freight and expedite. We've built that into our guidance. At the same time, to your great point, Kieran, we also will continue to see our mix go up in terms of more AFF, less spinning disk, more hybrid and all-flash, which has a higher margin component. So that will have a nice upward pressure. And we've seen that throughout the last 4 quarters before, unfortunately, we hit the supply chain issue. So as we get through this in the next 2 quarters, I said 2 quarters, I said 3, I said 4. I don't think any of us know that. Certainly, we hope it and everything you read and we hear in the industry, people are hoping by the second half of calendar '22 hopefully, it starts to lighten we'll see that. We'll see if that happens. But assuming that, that pressure goes away, we do think that you'll continue to see the upward margins. And we've talked about product margins right around that 55%. On the other side -- and then by the way, support continues to grow, 92% margins. That will always have an uplift as well. On the Public Cloud side, now I think we're at almost 72% above the company average. And again, on a dollars basis, as we add that cloud revenue, I think of the $400 million at our midpoint of guidance increase year-over-year in gross profit, Public Cloud is over $100 million of that. So it's really starting to add to the growth of the company. That will also have an upward pressure. And if you look at that business specifically, our ability to grow revenue, more software-only, better utilization of the product that we've shipped and the benefits that we get across ONTAP, all of the efficiencies and new acquisitions that we bring in, we feel really good about getting that side of the business up to that 75%, 80% target we've talked about.

Do you have a sense for at what ARR scale you need to get that business to, to get into that 75% to 80% gross margin range?

Yes. What a great question. Here's -- if you look at the comps, which I -- we can certainly look at our business, all -- and we look at a lot of the other businesses, not only software, but when you run a cloud business, you always have some infrastructure, right? So you have that. There -- it's not the wonderful software margins where it's basically you have R&D down in OpEx and then it's just support in the COGS line. So we'll always have some build in our cloud infrastructure. We've looked at it and said, at $500 million of ARR, that's even where we are today. That's a real business. We need to start showing margins. I think that gets us closer to the 75%. Once you get to $1 billion, gosh, that 75%, 80%, and you look at other comps and there's a couple out there that get -- have already gotten to $1 billion of ARR and their margins are right around that 80% number. So without giving a guidance, that's certainly our targets, and we would also look at that and say, if other folks can do it, so can we. My 1 big caveat there is a lot of that depends on mix and acquisitions. And what I don't know is, inorganically, some may fall in, it may take us a while to get it back up there. Even CloudCheckr is right in the wheelhouse of where we are today in Public Cloud. So that's one thing, Kieran, if we do some other acquisitions, it may move that a little bit. But in general, that's the path we look at.

Got it. And then at your 2020 Analyst Day, you talked about targeting OpEx growth below revenue growth over the long term. And so far, despite a pretty difficult supply chain backdrop and labor market, you've been able to manage those costs well. Do you feel as confident in your ability to demonstrate continued operating leverage improvements over the next several quarters despite the incremental inflationary headwinds you've talked about?

Yes. So we continue to feel -- so yes, we continue to feel really good about our ability to -- and I think it goes back to this, which is, there's -- from a CFO's perspective, there's 2 really easy things to do. One, you can cut costs. It's easy. It's hard, but it's easy. The other thing is you can spend money without knowing if you're going to get a return. I give kudos to all the 11,000 people at NetApp. We have really started to drive the discipline. And they had it before, but we're doing even more so. And Cesar has been great. Anthony and Brad running their BUs, we want to invest. That's what we're here for to grow the business, but we need a return on that investment. And where can we reallocate dollars to go drive that growth. So I continue to feel good that there's more and more reallocation to drive growth, especially in Public Cloud, but also our ability to add sales, marketing, R&D and tie that directly to revenue growth. We continue to get better. Now to your great point, the backdrop is -- look, I'm not an economist, I don't think inflation like this lasts forever. Hopefully, it's more episodic. And as we get through this towards the end of next calendar year, it mitigates a little bit. But we've also benefited all of us from an incredible economy, low interest rates, low inflation. It looks like that's going to change a little bit. So we all have to adapt. As a part of that, we did implement some price increases in the beginning of November. I think most of the industry did. That has not been really much of a practice. I think you'll see that become more common, especially as our suppliers pass those on. So we'll watch that. We'll -- but overall, yes, we do feel really good about being able to drive up margins really because of the discipline of the team.

Got it. And then you reiterated a couple days ago, your target for $1.2 billion in free cash flow for this year. If you think about fiscal '23 and beyond, is there room for additional cash flow leverage or free cash flow margin expansion beyond the 20% level you've been at the last few years as CapEx starts to moderate?

Yes. So thanks for that. Let's do operating cash and then we'll shift the free cash for your -- the last part of your question, Kieran. So if you look at the last, call it, 3 or 4 years, when I joined NetApp, one of the things that really excited me about was, wow, what a great business model, great operating leverage, the ability to drive cash, which gives us a great balance sheet and gives us all kinds of flexibility there. If you look over the last 3 or 4 years, and it moves around a little bit with -- really based on working capital timing. Non-GAAP operating cash flow largely about the same. They're almost right at 100% correlation in terms of that. It will move again a little bit with working capital. So as we grow operating cash flow, we would certainly expect to continue -- or operating margin that, that's going to translate into cash. Assuming again, business model doesn't change and all that stuff, and that's our assumption. So on the operating side, we do expect to see that continue to grow with operating margin expansion. On the free cash flow side, fiscal '22 and fiscal '23, we have a little bit of a step up in CapEx. This year, it's really related to some facilities here in San Jose, where we moved our headquarters but also Wichita and some other locations. That will mitigate a little bit into '23. And then the product that we've deployed with ANF, we're still in the seating there. We're almost in all the data centers. But as they expand and as we put more in existing data centers, we expect to see that CapEx be a little higher in '22 and '23, but that shouldn't modulate to a more normal number. So net-net, free cash flow should get better as we exit '23. And as we talked about, as the cloud business matures and as that gets bigger, and we bring in more acquisitions that are more software-based where, as you know, more subscription deferred revenue growth drives cash as well. Typically, cloud companies will have free cash flow margins ahead of operating margins. So it will be interesting to see how that plays out. A big piece of that will be the acquisitions that we do going forward, Kieran.

Okay. So I think you partially answered this next question, but I'll ask it a little bit differently. So like over the last decade or so, NetApp generated roughly $1 billion of free cash flow annually. And it's been fairly stable in that range. Is there a reason to believe there's upward pressure in the sustainable free cash flow rate over the next decade? And if so, is it largely tied to the cloud business, which you just alluded to a little bit.

So yes, let me answer it directly. I think if you look over the last 12, 15 years, and actually, I did before the earnings call, I think the most NetApp ever generated was about $1.4 billion in operating cash flow. And again, that's always been -- almost always been correlated with OpEx. So I think the direct answer to your question is as we continue to look and hopefully drive operating income growth, there's no reason that I would sit here today and tell you cash flow shouldn't follow that growth. And as long as we're able to grow it -- now Public Cloud matters, yes. But the Hybrid Cloud business, we all know that's where most of the cash flow generation is today, and then that's helping to fund Public Cloud. As Public Cloud matures, $500 million to $1 billion of ARR, that starts to get to its own scale where it's not going to be, I'll call it, cash use but cash generative. So both of those are super important. But overall, at the NetApp level as we grow operating or operating income, I would expect to see operating cash flow grow with it.

Understood. I know we're -- we have a minute left here. I'd love to sneak in 1 last question. But Mike, based on some of your investor conversations, what do you think investors most underappreciate about the NetApp story?

Yes. So I would focus on 3 things, and 1 is from the CFO version. The first thing is the hybrid multi-cloud strategy and that we are the beneficiary of what we talked about before, which is what we really view as enduring growth drivers. Cloud, digital transformation, more and more data, more and more workloads that -- and again, that part, I think, is underappreciated. The second part is, this is really a software company. This is not an on-prem product company. What we do, 80% plus of our engineers are software engineers. And the value we bring through any of our products like most technology business, it's all driven by software. Does hardware matter? Absolutely, but the value sitting in software. And then the third part for me is we have a great balance sheet, we have a great business model. The ability for us to drive revenue growth to the bottom line, generate cash, and thank you for that question. I always love to talk about cash, and then invest in growth, be it in the operations or through inorganic. I think those are the 3 that I look at and say, hey, when I joined almost 3 years ago, I really love number three, I didn't appreciate 1 and 2. And I think that, that's really started to show through in the results.

Great place to end. Mike, thank you again for your time today. If anyone has any follow-up questions, don't hesitate to reach out. Thank you, everyone.

Thank you again, and thanks to NASDAQ.