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

Well, folks, thanks for joining us for our next session here. This is Simon Leopold, Raymond James data infrastructure analyst, with our session with Kris Newton, who runs the Investor Relations team over at NetApp. I've been entrusted to read the safe harbor. So before we dive into our fireside discussion, let me just go through this real quick. 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 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 statements for any reason. So with that, Kris, welcome, and thanks for joining us.

So I've got a few questions, and the folks in the audience can use the features on the screen to send me questions online, which I can see. But Kris, I want to start out -- the way I'm starting out all of my sessions is just -- let's talk a little bit about supply chain. Now I'm conscious that for NetApp, this has not been as big an issue in terms of affecting your business with some others in my coverage universe, but if you could just talk a little bit about what you guys have experienced in terms of any kind of supply chain constraints, limitations on your ability to meet sales targets, et cetera?

Sure. So on our most recent call last week, we talked about there are some headwinds that we're seeing to supply -- from the supply chain in our product revenue category. There's also some temporary increases in freight and expedite charges that are creating headwinds to the product gross margins. Ultimately, we're very confident in the durability of the demand environment, and we believe that the headwinds we're seeing in terms of constraints and increased prices are temporary, but we're navigating through them and we -- but the team is remaining focused on the things we can control.

And I think, last week, you did talk about some kind of pressure on your product gross margin. Is this something you're able to quantify for us at this point.

Yes. Absolutely. So going into the beginning of this year, we thought that product gross margins would be roughly 55% for the full year, now -- and they were there in the first half, but now we think for the full year, product gross margins will be about 54%, and that's all related to these headwinds.

And in terms of the kinds of components, I'm assuming that some of your largest portion of bill of materials are memory chips, so primarily NAND and some DRAM but that doesn't seem to be the market that's most affected. What kind of components, and I know you did mention logistics, but what kind of components are you seeing the tightest constraints?

Yes. Since things like power supplies, some semis. So smaller things that probably don't have a big influence on the overall BOM in terms of price but are very important in terms of shipping the product.

And have you implemented any price increases for your customers as a result of making these adjustments? And if so, when and how much?

We did a small price increase to list prices on November 1. We will, of course, honor all the deals that are in flight right now. So you shouldn't really expect to see any impact from that price increase until Q4. And as you know, customers are great about accepting price decreases. They're a little harder to pin down when it comes to price increases, but we -- our sales teams are quite disciplined and focused on selling value.

And in terms of what's going on in the balance sheet, are you building up inventory and making any kind of purchase order commitments? And if so, do you have added risk in terms of having built inventory that customers don't end up canceling and you get stuck?

Yes. So we started building up additional inventory in Q4 of last year and have retained higher inventory levels, you could see inventory turns declined to 13% in this most recent -- or 13x in this most recent quarter. We don't see any indication of phantom demand out there. And so we think, ultimately, the components that we've purchased today will get used as we move forward.

And so the issues seem to be on the supply side, not the demand side. So maybe could we pivot a little bit and just get your take on what does the demand look like? And what do you expect would be the growth in the storage market over the next year?

Yes. So we see companies really increasing their spend as they move to utilize more cloud services, as they're doing digital transformations to modernize existing infrastructure, gain flexibility and monetize the data they have in their own infrastructure. Leverage new technologies, like container technology. Ultimately, we read the industry analyst market forecast, just like everyone else. I think they are currently projected kind of low-single digits for total storage spending. But within that, the spending on all-flash arrays is significantly higher, kind of, I think it's 10% to 15%. And that's a space where we're overweight, right? A good portion of our revenue today comes from AFA, and so we think we'll benefit from that looser market, shall we say, or that faster-growing market.

And what's your response to folks who talk about this long-term trend of public cloud adoption. And I think sort of the idea is that the endgame is all workloads going to public cloud. And if you're on-premise, that's bad. And I know we're going to talk about your public cloud services, but what's your thinking about cloud adoption as it affects the on-premise and product part of your business?

Yes. So we don't believe that all workloads for the foreseeable future will shift to the cloud. I think there's a lot of IT spend that will remain on-prem, a lot can be done more cost effectively on-prem. I hear from our CFO all the time about the sticker shock around some of our cloud bills. So I have to imagine that we are not an outlier there. And so I think companies will ultimately end up operating in a hybrid multi-cloud environment and exactly where that water line is and which workloads belong where. I think it'll vary company to company and potentially evolve over time. But the fact that there is that hybrid environment really does benefit and play into NetApp's strengths, right? We can offer customers symmetry of their storage experience on-prem and in the cloud and across multiple clouds.

So that pivots us nicely to talk a little bit about public cloud services. So for NetApp, that's not just one thing. So particularly for somebody who's relatively new to the NetApp story, how do you explain public cloud services to them?

Right. It is a bundle of services and many are services that people don't -- that aren't storage related and therefore not what people would normally associate with NetApp. So a little -- a very fast kind of overview and history of our cloud services journey. We started about 7 years ago. We made on tap our flagship storage operating environment available initially in the AWS marketplace. And that initial focus was how do we leverage the cloud to deliver a low-cost backup and disaster recovery service to our installed base. Pretty quickly, we saw that enterprises were trying to figure out how they move workloads to the cloud. And in order to address that need, we expanded our cloud partnerships. We started working with Azure and Google. And we brought forward Cloud Volumes Service, which was a fully managed service that have all the application certifications and integrations to support mission-critical production workloads in the cloud that started as a marketplace offering and then has evolved over time to the point where Azure initially has integrated it into their cloud offering, sell it as a first-party service. Their sales teams are selling it. Most recently, Amazon announced FSx for NetApp ONTAP, which is a variant of Cloud Volumes Service. It's a fully managed service, run, build, supported by Amazon. Again, their sales teams are selling it. And then in Google, it is a marketplace offering. NetApp is responsible for selling it, but customers can use Cloud Volumes Service for Google Cloud as a way to draw down their existing enterprise commitments with Google. So we got that storage engine moving well and really addressing production workloads, non-NetApp customers in the cloud. And we saw an opportunity to expand beyond storage. And so we looked at infrastructure monitoring, which was a service -- or a software package that we had been selling for on-premises environments in the form of on-command insight. We were able to convert that to a cloud offering, and that led to the development of Cloud Insights, and we saw the opportunity to add cloud management and -- or compute management and optimization services, which led to the acquisition of Spot. And together, those 3 primary services, Cloud Volumes, Storage as a Service, Cloud Insights, which is the infrastructure monitoring service and Spot, which is all around compute management and optimization services, are the primary growth engines in our cloud services. And together, they create a great set of tools for CloudOps and DevOps teams for their multi-cloud infrastructure requirements. That's where we've been focused. That's kind of how we've evolved and really happy that the clouds have recognized the value that we can bring in their choice to sell our services.

So good outline for us now when you guys have reported, you talked about the annualized recurring revenue, the ARR. Can you maybe put that in perspective of where are you and what are your targets. So for folks who historically followed NetApp, this is sort of a new metric for modeling purposes. Maybe give us a little bit of context here.

Sure. We recently actually broke out our business into 2 segments, the hybrid cloud segment, which kind of represents the traditional NetApp that people know where we're selling fully integrated systems and software to enterprises, getting that kind of capital, upfront sale and the ongoing support revenue streams associated with it. And then a public cloud segment, which is really our portfolio of products delivered primarily as a service and available through the leading cloud providers. So we're disclosing revenue, but I think ARR is the way that everyone likes to think of cloud, it's a good leading indicator of where revenue is growing. And for the first half of this fiscal year, Revenue was up about 113% in the first half. We give guidance for ARR, not revenue, and we've raised our expectations for the exit ARR for this year to $510 million to $540 million. That includes roughly $35 million to $40 million exit ARR from a recent acquisition of a company called Cloud Jumper. The remainder is we continue to raise the expectations on the organic business as well.

You mean CloudCheckr?

CloudCheckr, sorry, yes. There's so many clouds. Sorry to get my clouds crossed. I appreciate you correcting me.

Well, maybe there was another acquisition I missed, but...

We did an acquisition of a company called Cloud Jumper about 1.5 years ago.

Okay. So what I did want to ask about some of the components to this ARR. And so you had acquired Spot and CloudCheckr more recently. And superficially, they sound very similar. And so maybe help us understand what those solutions are doing for your customers and how they're related to each other.

Sure. So they're both ways to help customers reduce their spend in cloud environment. So CloudCheckr is a SaaS-based solution that gives comprehensive visibility of cloud resources that help public sector. They've a great public sector business, which is important for NetApp, a good enterprise business and a managed service provider business to help them control their cloud costs. CloudCheckr and Spot, while they do sound kind of similar, they ultimately are complementary. CloudCheckr is focused on cost visibility, reporting and allocation of resources and Spot really provides continuous automatic -- optimization, hard to say automatic optimization of cloud operations. So think of CloudCheckr as more of a front end on your spend visibility, what am I spending and Spot as a back end that helps automatically make sure that you're spending the least on the compute cycles that you're purchasing.

So one of the things that was interesting to me was when you first started talking about the cloud services was, we made an assumption that, well, this is selling into the installed base, customers who are used to using NetApp and now use public cloud that's the target market logically for public cloud services. And I think you've talked about actually expanding your customer base that you're securing customers who are not traditional NetApp storage customers. Can you speak to that particular trend? What's happening in terms of landing nontraditional NetApp customers through public cloud services? And how should we think about that as a trigger to convert them to being on-prem customers as well.

Sure. So there's a whole bunch of different vectors for new customer acquisitions that we see in the cloud. The first is in customer size. So NetApp historically has sold into large and midsized enterprises, the types of systems we sold probably weren't a great economic fit for some of the smaller companies. But now in the cloud, there's really no barrier -- size barrier to entry. So we're able to address a broader swath of customer types. Also, we've got Azure and AWS, 2 of the largest companies on the planet, selling our services. So we get the breadth of their sales teams and reach into all of their customers since we're a first-party service. And then we've expanded beyond -- or sorry, sticking with the kind of the storage services. As workloads move to the cloud because NetApp has a 15% market share on premises. That means the odds are that the workload that's moving from on-prem to the cloud is coming off of somebody else's gear. And we certainly see that as well. So there's an expansion of our storage footprint. And then finally, we've expanded beyond just storage services into compute and other optimization services, which help us bring in DevOps and CloudOps buyers into the NetApp portfolio as well. We've long said that the things that we're doing in the cloud make us a more attractive partner to the percent of IT spending that remains on premises. And we definitely see that. We've got customers who maybe weren't big NetApp customers or weren't NetApp customers at all, they end up moving on to NetApp in the cloud because that's what their cloud provider is recommending for them. And they want a symmetry of experience, right? They want to be able to use the same tools in the cloud as on-prem. And so suddenly that makes NetApp a much more interesting and strategic partner to that customer.

And you've got partnerships with the hyperscalers and the cloud providers. And I guess one of the sort of logical questions is why are they doing partnerships? Why don't they go into this business themselves. So theoretically, if what you're doing is so valuable, wouldn't the hyperscalers want to provide the solution and vertically integrate that strategy? What's the logic there?

Sure. So the cloud providers have a lot of money, but ultimately, that budget is limited. And I think they are much better off differentiating against one another at the application layer than the underlying storage layer. You're probably not going to win a customer because of the type of stores you have available in your cloud. You might lose a deal because you can't support an existing enterprise workload. So I think just, one, nature of business, they probably have better investment opportunities. They have a great partner in NetApp to provide a robust enterprise hardened file system that allows enterprise workloads to move to the cloud without having to be refactored. We also have 30 years of experience and 30 years of hardening in ONTAP, which no matter how many engineers they have, they can't get that kind of years. So I think there's some innate value that we can bring to them that makes them want to partner with us. And again, I think they've got better opportunities to differentiate against one another at an application layer.

And there's another dimension we're seeing to the recurring revenue models within the industry, and that's the pivot to as-a-service. So now I'm aware NetApp has an offering called Keystone, but it does seem to us that you've put a much greater emphasis on your as-a-service solutions into the public cloud services as compared to some of your competitors that seem to be much more focused with on-premise-as-a-service. Could you maybe help us understand the decision why the emphasis on public cloud services as opposed to an on-prem-as-a-service and understanding you have both, the emphasis is different than some of your peers.

Sure. I mean, why fight against the giant tidal wave of the shift to cloud, right? And it feels like our competitors, our legacy competitors who are trying to say, no, no, no, you don't need to go to the cloud. The cloud is an experience, not a destination. They can't even provide a cloud experience because it takes weeks to set up an initial footprint of a legacy competitive as a service offering, which is remarkably different than click a few buttons and you've stood up a cloud environment. So I think there is a shift-as-a-service because customers want to preserve cash, protect liquidity, especially during kind of this crazy tumultuous time we're living in, but I think fighting against that big tidal wave to the cloud isn't a long-term winning solution.

And when we think about the sort of broader base NetApp historically was thought of as a storage company. And with the public cloud services, you kind of have push the boundaries of being a pure-play storage company, how should we think about sort of the longer-term perspective of does NetApp want to evolve from these storage routes? Or do you sort of stick into this foundation of being a specialist in storage.

Sure. So I feel like we're already evolving beyond kind of the traditional storage buyer and reaching out to DevOps and CloudOps teams and seeing success there, but there is a real benefit to the focus that we've had on storage. I think it's enabling -- it's put us in this position where we can win, and that probably will remain at least the very large trunk of our growing tree.

And I think you alluded to this a little bit earlier that the business is biased towards flash, so flash being solid state memory as opposed to the spinning disk. Where is the industry and where is NetApp in terms of this transition from our disk drives to all-flash solutions.

Yes. So as we look at our installed base of systems under active support contracts, that measures in the hundreds of thousands and roughly 30% of those systems today are all-flash arrays. Long term, we think that, that can go to maybe 70% as the cost of flash continues to come down as QLC gets more broadly adopted and there are more workloads that become -- that make sense economically to get placed on flash.

And how do you think about NetApp's ability to differentiate in the sense of, it does appear that storage is sort of a function that organizations picked a storage supplier for on-prem, and they tend to be pretty sticky. And sometimes that's good news if you're the incumbent, bad news if you're trying to break in, what creates the dislocations that allow you to land new customers.

Sure. So we saw a dislocation not too long ago, which was kind of that initial shift to flash, where for all the workloads that were going to flash, they became kind of a jump ball. And you see NetApp's market share in the flash space being significantly higher than our market share in the traditional hard disk market. And again, I think that is because of that dislocation. We were able to take advantage of that. I think cloud is the next big dislocation, right, and customers looking again for that symmetry of experience on-prem and in the cloud. And so we've got a big strategy to turn that shift to cloud to our advantage. Data Fabric is a key differentiator for NetApp and our embrace of cloud and our ability to help companies deploy the applications that run their businesses on the leading -- on the world's biggest cloud providers today. I mentioned that, again, because our market share is somewhere in the neighborhood, just splitting the flash and the disk market share in the neighborhood of 15%. That means 85% of workloads that are moving to the cloud are coming off of somebody else's gear, which gives -- and our position in the cloud gives us an opportunity to participate in a much bigger portion of that than we would on-prem because as you noted, the on-prem can be really sticky. That's helping us reach new buyers, new customers and ultimately, I think, will create preference for NetApp on-premises.

And I guess the other dynamic we've observed in the market is, in general, high-end storage solutions have been weak, whereas the midrange market seems to be growing quickly. And I think your portfolio is more biased towards the midrange as opposed to high end. So that seems to be working in your favor. And I presume some of what's going on is the newer generation of midrange solutions just to address more use cases. Could you talk about what's going on in terms of the use cases and how that plays into NetApp's market share position?

Sure. So there are, I think, a couple of things. that are driving the growth in the mid-range market and particularly at the expense of the high-end market. There's so much more flexibility and ease of use for customers in that kind of traditional midrange space that you just never saw in the big high-end frame array space. So I think there's always been a customer desire to use more mid-range, but there was kind of a performance echelon that the high end could achieve. You saw that get eroded with flash coming into the mix. And so mid-range systems utilizing flash could get a lot more performance than some of the high-end systems. Additionally, with NetApp, we've created a way to virtualize across our storage infrastructure so that customers can gain together multiple systems to drive greater performance out of their storage pool. They're also able to create these very large storage pools with a shallow high performance and a deep more capacity-oriented and get that kind of singular management framework. So kind of both market customer demand and then some technology innovation that have helped advantage midrange.

I want to pivot now to maybe some more of the financial balance sheet topics. So I think you've talked about but for folks who maybe didn't tune into your analyst event, could you talk a little bit about use of cash, what are your priorities in terms of buybacks, dividends, acquisitions.

Right. And since you mentioned our last analyst event in September of '20, I will put a plug-in for our upcoming Investor Day, March of '22. Hopefully, everyone will join us there. We can talk a lot more about the long-term strategy and framework of the company, but what we laid out at our last Investor Day in terms of use of cash is we're unlikely to return greater than 100% of free cash to investors. So of that free cash dollar roughly 30 -- roughly 50% will go to paying the dividend. That's certainly the first call on cash. We view dividends as permanent and something that should grow over time. The next 20% of free cash flow roughly will go to buybacks to offset dilution. And certainly, as the stock continues to appreciate. We'll have to spend a little bit more there. So that might grow to be something more than 20%. And then finally, we're trying to earmark roughly 30% of free cash flow for M&A activity to help accelerate growth in the cloud business.

And you've done a few acquisitions in the last year or so. So maybe help us understand the basic philosophy of what your targets are intended to achieve, whether it's in terms of accretion, diversification, new market entry, growth drivers. What's sort of the prioritized criteria.

It's a little bit of all of that. And right, it's sort of -- there are a lot of targets out there. Some are smaller ones like we did with Data Mechanics, which is really a tech and talent kind of acquisition. Some provide incremental ARR like CloudCheckr or Spot did. We see the ability to continue to expand and offer a better -- a broader suite of services to the DevOps and CloudOps buyers. So I think we're -- there's kind of a logical, does this make sense for NetApp? Does this make sense for the type of buyer we're trying to reach. But again, always looking at tech and talent and then incremental ARR. And certainly, we're not averse to larger kind of transformational acquisitions, but by and large, those are fewer and further between and certainly have a much higher bar for success. And so you'll probably see a lot more of the smaller tech and talent and incremental ARR acquisitions.

And is there sort of a typical timeframe after you do deals to maybe take a breather and focus on integration where I think about the CloudCheckr deal is relatively recent. Is there a normal cadence, should we think about it that way?

I think we definitely want to make sure that we're giving each acquisition we bring on the right amount of support and attention to ensure its successful integration into NetApp, but probably the cadence of acquisitions is more determined by the targets and the pricing environment than anything that NetApp would do.

And then maybe from an operating model perspective, I think a number of companies we've talked to and through earnings season have talked about, the potential for operating expenses to rise as a result of a postpandemic, meaning we start traveling again. Obviously, we're not doing that today. But how have you thought about what happens to your expenses? Is there a step function or a gradual recovery as travel and entertainment comes back into the mix, if you start seeing inflation on payroll and things like that. What's happening in OpEx?

Yes. So we see our OpEx rising. We've been kind of adding to the OpEx stack to invest in cloud, certainly, when the world reopens, there will be increased T&E, probably not to the levels it used to be. I think CFOs have kind of realized that it's nice to have some of that money to themselves. But our goal is to grow our OpEx at a rate lower than that of revenue. So we're looking really continued growth in the hybrid cloud business, which is highly profitable and throws off a lot of cash, and we can use that to invest in the public cloud business, which is a hypergrowth business and then continue to see good top line growth and a more rapid bottom line growth.

So I want to close on a question I typically close on these sessions with is, what do you think is the least appreciated aspect of NetApp story?

Yes. Well, so first, I would say we're the beneficiary of some quite sizable and enduring trends, the shift to cloud and digital transformation. Those support our ability to not only see good growth in our public cloud services but also drive continued growth in our hybrid cloud segment. I think people often miss how important those 2 things are together that they -- 1 and 1 equals 3 and the unique position we have with the cloud service providers today, being a first-party service and having the benefit of those companies selling on our behalf. And then you bring all that kind of good revenue growth together. Our business model has great leverage in it. And so we continue to grow operating margins and profitability while we invest in the future to drive continued revenue growth.

Well, great. Well, Kris, I really appreciate you joining us today and the folks who dialed in as well. So with that, we'll wrap up our session with Kris Newton of NetApp. This is Simon Leopold, signing off. Thanks a lot.

Thank you all.