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

Hello, everybody. Thank you for joining us here for a NetApp fireside chat. Tim Long here, Barclays Hardware Comm Equipment analyst, along with George Wang on my team. We're happy to have Mike Berry with us, EVP, Finance and CFO at NetApp, to give us some insights on the company and the business. Before we get started, I'm going to read the safe harbor for NetApp. 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 obtain information in any forward-looking statement for any reason.

Okay. With that, thanks, Mike, for joining us. Maybe we'll start off with a few kind of finance and high-level questions here. NetApp delivered a very strong quarter last week. Revenue, operating margin, EPS all exceeding guidance once again. Could you talk a little bit about some of the drivers that you're seeing? We're seeing somewhat broad strength on back to office and macro recovery, but above your insights and what's particularly driving the recent strong performance at NetApp?

Sure. Before I get started, Tim, George, thanks for having us. We're always happy to be here, and thank you to Barclays for allowing us to participate. And good afternoon, good morning or good evening to anybody watching this event. So yes, we had a very strong Q2. We were excited about the results. For the last 6 quarters, we've grown both our Hybrid Cloud and our Public Cloud. We broke out those segments for you at the beginning of fiscal '22. And I think what you see is our advantage around data. Our data fabric strategy really starting to take hold. And if you take a look at the growth drivers, all-flash grew by 22% year-over-year, and that was a very similar number to the last quarter. So we're continuing to see great growth there. And then obviously, in our Cloud ARR saw really strong growth across ANF, Cloud Insights as well as Spot. And that's really starting to add to the growth profile of NetApp, both from a revenue and a margin perspective. If you take the midpoint of our guidance and you take a look at year-over-year gross margin increase, it's about $400-some million, and over $100 million of that is now coming from cloud. So we're starting to see not only contributions to revenue but also profit growth as well. And so not only good, strong top line growth, but really great operating leverage, more than 50%, I believe, of our incremental revenue went through the operating income line. So a good strong quarter across both the Hybrid Cloud and Public Cloud.

Great. Great. And maybe just looking forward a little bit, can you talk about kind of strategic priorities? I imagine further growing that cloud business is part of it. But if you can just touch on the 2 or 3 main priorities for the company as you head into calendar '22?

Sure. So yes, Tim, you hit on one of them. If we look at the Hybrid Cloud business, growing all-flash, big focus for us. We like the growth in the object business as well. So I would put those 2 there. And then clearly, scaling our cloud business. And that's not only cloud storage, it's also optimization and monitoring, which is Spot and Cloud Insights. Then we're really excited about the CloudCheckr acquisition, which brings more of what we call FinOps to our customers as well. And then just at a high level from a company perspective, just like everybody else, we're dealing with this, virtual work, but also, at some point, we'd like to return to work. I'm actually in our office -- one of our offices in Texas. So from a corporate perspective, those are the big priorities and then getting our folks back when it's safe and appropriate as well.

Mike, it's George here. Can you talk about supply chain impacts? Obviously, pretty strong execution in the last 2 quarters in light of the supply chain environment. Can you briefly give more color on those and any efforts you guys are making to mitigate the impact?

Sure. So let's -- so first of all, in Q2, supply chain really didn't have much of an impact on the financial results. There was no impact to revenue. From a margin perspective, we did see some incremental costs. But largely, most of Q2 was big when we saw that. So let's back up for a second, George. We really started to see impacts -- future impacts to our business about halfway through the quarter. And I'm going to break it up into 2 areas. One is revenue, the other is cost. So from a revenue perspective, our ability to deliver our products is really based on not so much drive, storage drives, either HDD or SDD (sic) [ SSD. ] Pricing has stayed relatively consistent. Supply has been good as well. For us, it's really the components. And obviously, we need to ship a full system. So the ability for us to obtain the components that go into a lot of our products is really where we are focused. And then from a cost perspective, it is really around -- we have seen increases in all of our costs, but it's really around the much, much higher freight and expedite charges as well as -- look, we have some wonderful vendors and suppliers, and we say thank you to all of them. We're all trying to deal with this tough situation. We also have some suppliers that have said, "Hey, if you want to stay in line, you're going to have to pay more." So that's the part that we've baked into our gross margin guidance for the second half. And then, I would be remiss to not say the internal supply chain procurement team has done an awesome job. Every day, 24 hours a day, they're dealing with this. It's an ever-changing situation. And every morning, I wake up and I kind of flinch. I look at the -- I am like, gosh, no, I hope there's not another variant and who knows what happened in supply chain. So the team has been doing a great job. And again, we really thank our great suppliers who have worked with us through this. And we'll continue to work through this as we get through '22.

Yes. Mike, maybe if we can pivot over to the public cloud and the cloud data services business. It's obviously been pretty strong growth there. You guys have been acquisitive as well. Could you just talk a little bit about how we should think about the business as a whole right now? How is it differentiated from peers as you add these other capabilities to it? How hard is it to sell these services instead of maybe something that's native from the cloud players themselves? And do you expect that those cloud players will be partners and competitors over time? And just maybe just a little bit on how you think of competitive landscape?

Sure. So let's talk about the cloud ARR. It's not just cloud storage. So if you think about our cloud ARR, think about 4 areas. The first 2 are cloud storage. It's cloud volume services, which is a fully managed service. That's what -- when we talk about ANF, for instance, Azure NetApp Files or FSx for ONTAP, those are services. Also, Cloud Volumes ONTAP, which think of it as a bring-your-own software. That's ONTAP that runs in the public cloud that we sell and they also -- they'd be in the hyperscalers. And then we have Cloud Insights, which is our monitoring tool that's internally developed. It's really a NetApp sales function or a sales process. And then we have Spot. And then put CloudCheckr right with Spot, and that's kind of the FinOps. So those are the areas of our cloud ARR. And as we've said, while we don't break out each of those components specifically, the storage piece is the majority, but it's not the large majority of that business. And if we talk about specifically the relationship with the hyperscalers, look, it's 3 of the greatest companies in the world. We're super proud to work with all of them. You referenced native integration. We -- and this is really the competitive advantage we have, Tim and George, is, we are natively integrated with all 3 of them. And let's go through what that looks like from a -- our longest relationship has actually been Amazon, but our newest announcement is M. Let's focus first on Microsoft with Azure. Azure NetApp Files has been really a great growth driver. We introduced that several years ago. It took a little bit of time to ramp up because keep in mind, when it was announced we were still working on some parts of the product plus we have hardware deployment in their data centers. So it's a little bit capped by how fast you can get those out. Now we're almost everywhere we need to be. And we're really talking about incremental data centers or adding our hardware to existing data centers, where we're seeing great growth from their customers. And then, fully native first-party service. They sell it and their sales team are comped and measured on it. We have a sales team that also faces off with them. Then you talk about our newest announcement, FSx for ONTAP. And that is the newest release with AWS. Fully native first-party service, where again, they are selling the product, and then we are supporting it. We also have a sales team that supports them as well. The difference with ANF is that is a software deployment and a little bit different. Again, each company comes at it differently, and we respect any of their business practices. They did not want to announce it until it was fully GA. So when we announced it in September, you could buy it that day. So a little bit different than ANF. But again, it's software, not hardware. And then we are natively integrated with GCP, that is still mostly acquired through the marketplace. We feel really good about that relationship. We'll see where that goes. But again, when you talk about our competitive advantage, full native integration, we've been at this for, gosh, 7 years with some of these folks. Again, super proud to work with all of them. They all have their own storage products. We know that. But we also know that they've made the effort, the investment to partner with NetApp, and we are the only ones that they've done that with. Whether they do it with somebody else, that's their decision. We would never speak for them. But we feel like we have a really good relationship with each of the 3. I feel really good about the competitive situation. We have a product set that no one can even come close to match.

Okay. Great. Great. Maybe a follow-up here. I think last quarter, you talked about 179% net dollar retention rate in public cloud. It's, obviously, a pretty impressive number there. Can you drill down a little bit into that and give us some insights as to how that's so positive? What are you seeing in this vertical? And what are the things that are -- tend to be added on? Is it kind of those 4 different buckets, are you seeing more of those? Or maybe if you could just give us a little highlights on what's driving that very positive result?

Sure. So think of this as both cross-sell and upsell because they're both super important in the cloud business; obviously, it's a big part of it as well as renewals, those 3 pieces. So when they start in the cloud, they typically will start with CBS, a managed service. And then -- or you'll see them maybe get started with Spot because, optimization is -- we need CFOs like me to look at P&Ls all day and the number one growth across most P&Ls is cloud spend. So the optimization is a huge focus. So they typically get started with that. They may add on CVO. They may add on Cloud Insights. But then also keep in mind, a big part of that is the additional capacity. It's the upsell, not just the cross-sell. And when you look at the cloud ARR. We have, for instance, in Cloud Insights, Spot, CVO, you're going to have a subscription business where we book it upfront and recognize it. But also a lot of hyperscalers go to market with a [ pay-cut ] where it's capacity-based. And that, while you don't have a subscription model, it's a wonderful economic model because as customers deploy more in the cloud then, obviously, those fees go up as well. So it's both adding new products but also adding capacity.

Just in terms of the gross margin for the public cloud, it's encouraging to see the gross margins now accretive versus the company average by posting 71% last quarter. In light of long-term goal of 75% to 80% for the gross margin long run, can you just give more color in terms of any progress you guys are making to achieve that kind of long-term goal?

Well, thank you, George. If you look at -- because we supply -- we also produce and give you last year's numbers, that gross margin number has gone up a good bit. And it's really been driven by 5 different drivers. One is just scale. And when we talk about scale specifically, it's scale related to ANF. In terms of deploying that hardware and you need to deploy it and sell it. and then it goes from there. So the utilization of the hardware has been a big piece of it. Keep in mind that of the 4 pieces we talked about with cloud, ANF is really the one big driver of hardware. There's a little bit with the other 2, but that's the biggest driver. Everything else is software or cloud. So then you go to CVO, software margins. That's grown very nicely. And then CI and Spot have cloud and software margins as well. So as those grow, it helps move those up. So it is better utilization, better scale, more software in that mix. Keep in mind, too, that it's ONTAP that drives everything that we do in the Hybrid Cloud and the Public Cloud. And it is a common software platform, different than when we sell it on-prem and our customers are the ones, rightfully, so they get the benefits of all the ONTAP efficiencies that we built in. We're the ones that get that in the cloud because as we -- as ONTAP gets better and better, we get those efficiencies in the cloud. So that helps as well. And then as we look at doing new acquisitions and the growth of those, that's also going to add to it. So that's why we look at it, George, and say, if you look across the SaaS market and once companies get to about $500 million, and this is general, but if you look at the peer group, they typically will start to see breakeven or lower margin, operating margin. But they are going to be typically 70 -- mid-70s gross margin. And then as you get closer to $1 billion, closer to 80%, a lot of that will depend on continued software mix, but also acquisitions, right? So acquisitions will play in there, which is why we gave the 75% to 80% range. We feel really good about being able to get there just based on the business mix to growth. And what we've seen over the last year in the growth in that gross margin line.

Yes. Mike, can you talk a little bit on this -- on kind of the hybrid model and the cloud piece? How much pull-through are you getting from on-prem customers to the cloud? How much is kind of new revenue business to NetApp and, therefore, kind of expanding the customer base for you? And does it kind of go both ways, where you can get a cloud business and work it into some -- maybe some on-prem hardware?

Yes. So thanks, Tim. It does work both ways. So let's focus on the big driver of customer growth, which will be our cloud business. And we've said that -- I mean, if we have pick your favorite industry number, 15% of the on-prem storage market. We're super excited because that's 85% of that, that we can go get in the cloud. And so our number one focus for our cloud business is to drive net-new logos as well as clearly help our customers move to the cloud. Now -- and I want to be super clear, we think 1 plus 1 is more than 2. When they deploy in the cloud, if we look at that customer cohort, they also do better on-prem than the cohort that does not go to the cloud with us. So it talks about that halo effect of NetApp across all of their storage, be it on-prem or in the cloud. So we expect cloud to be the #1 driver of customer growth. And then clearly, we also -- when we will get a net-new logo, there's the opportunity for us also to get their on-prem business as well. And that's a motion -- it's a bigger motion to go get that moved to the cloud, although we're starting to see, as we sign more net-new, also the ability to get their on-prem business as well.

Okay. Great. Great. That's helpful. Maybe just get over to all-flash array, which was another positive number, as you mentioned last quarter. Obviously, it's a little bit more competitive there. And -- but you still got a long way to go given only 30% of the base is on all-flash array. So how do you envision that curve working? I mean, obviously, some of the older systems need to be upgraded. So I would imagine we can start seeing a more rapid move. And how do you think about retention for those deals as they come back up and you maybe see some new competition?

Yes. It's interesting when you look at the industry and Lance, who works with Chris, does a great job of walking through this. So if you look at the spending in this market, it's actually quite -- it's a lot more diversified in terms of who has that market share. In all-flash, it's a much smaller group. There's really 4 or 5 of us that have a much bigger share of the market. So to that point, all-flash now cleared $3 billion of all-in revenue, which is great. So it's a very large piece of our company. And it's about 30% of our installed base controllers now are with all-flash. That's seen a really steady, a nice steady growth, almost kind of 1%, maybe 2% a quarter. It goes up. And to your point, Tim, we typically see that happen when it comes up for renewal or there's a refresh opportunity. And we continue to expand our -- within our base, but then also -- it's also a driver for net-new as well. So there's nothing that we look at that say that, that historical growth shouldn't change much. Is there an inflection point at some point? You made a great point which is, these typically happen when it comes up for renewal. And so we do expect it to be a nice steady growth as well. We've said, probably 70% to 80% of our installed base at some point may be all-flash. There is still going to be a market for spinning disk. There's workloads to do just as well there with hard drives. And then -- and from a cost perspective, all-flash just gets better and better every day. So we do think it will be certainly a majority of our business, probably never gets to 100%. We've ballparked 70 to 80, feels about right. But we think it's going to be a nice, steady growth. We have several more years of really strong growth just to get up to that number.

Mike, it's George again. You outlined some capital allocation plans this past quarter. Can you elaborate more on the M&A strategy just given especially acquisitive kind of stands in the public cloud front? Any particular vertical you would prioritize in terms of the future bolt-on deals?

Sure. So George, on your -- let's just do the capital allocation and work our way down. So we've said going into this year, we expected to return about 70% of our free cash flow to shareholders either through dividends or share buybacks. We talked about 50 and 20 because of the wonderful thing, which has been the increase in stock price. Our goal around the share buyback is to offset dilution, keep it at about that 229 fully diluted share count number. So instead of 50-20, you're a little bit more half and half right now really driven by those dynamics. And the whole goal there is to leave about 30% of free cash flow for acquisitions because it's an important part of our growth. If we look at our M&A strategy, I'd put it kind of in 3 buckets. One is, we will continue to look at what we call tech and talent acquisitions, where Data Mechanics, for instance, is one that we just did, where you buy a group -- where there's a group of folks. Great product, that's really a roadmap accelerator for us, and it's a build versus buy. So we acquire the people and the product. And then we take that and we integrate it into one of our existing products. We have Spot. We did an acquisition a while back that added security. So that's really roadmap accelerator of smaller deals. Then you move into the Spot and the CloudCheckr type deals, which is really an adjacent product or service to what we already do. Again, that's a build versus buy, but this is where we would go do larger acquisitions, where you're buying a significant amount of ARR, you're buying a company. And then we would then add that in, and there's going to obviously be synergies. We typically will leave that standalone for a period of time just so that they can get their feet under them. We don't mess around with the go to market. We keep our teams focused on what we talked about earlier, which was growing Hybrid Cloud and scaling Public Cloud. And that's what we'll do with CloudCheckr. The third piece is, just like everybody, we look at larger acquisitions. And we would clearly be very, very, very disciplined around that. But never say never. If something comes along, we think really, really moves the needle in our cloud platform strategy, we would certainly take a look at it. But -- and that's not just the 30% of free cash flow. Keep in mind, we have a wonderful balance sheet. We have a lot of ammunition if we want to do those transactions, but we're really focused on 1 and 2.

Mike, HCI is an area that comes up as well as a pretty good growth area, where you guys may be are little under-indexed. Can you talk a little bit about that market, how important you think it is and how NetApp can play there?

Yes. So -- and thanks for asking, Tim. And I saw it in your last note. We made the decision last year to really to move away from HCI. It's a good market for some folks. We found that it really went to a much more lower deal size, lower transactions and, quite frankly, lower margin. So we made a big bet in HCI, but we backed away from that last year. So we're really not focused on that market at all. We reallocated a good bit of those resources to all-flash and to cloud. So you shouldn't expect to see us talk much about that. And I'm glad you asked because we just, we've moved away from that market. Some people are in it. That's great, wonderful for them. For us, we're focused on all-flash object and scaling our cloud business. We won't be investing much, if anything, in the HCI business.

Okay. Great. Great. One other I wanted to touch on is a little bit more broadly sales force and kind of focus. Could you talk a little bit about how you, as a management team, help manage the priorities where you want to focus and the resources that you have? So how are you kind of -- and particularly as you add more capabilities into the public cloud offerings, how does that play into the dynamics around your distribution and your go-to market?

Yes. Great question. So César Cernuda, who has been our President now for, gosh, I think it's going on about almost 18 months, came in -- coming into fiscal '22, what we did is we used to have 2 separate sales teams, call it, Hyper Cloud and Public Cloud. We have now -- that sales team is now responsible for selling both Hybrid Cloud and Public Cloud. So they have quotas in both. And they also -- by the way, to hit accelerators, you have to hit your number in bulk. You can't just hit one and not the other. So that was a big push that César did rightfully so to bring that together in fiscal '22. Importantly, we also have specialized cloud sales team that is faced off against the hyperscalers. So we have a group that works with the Azure team. We have a group that will work with the AWS team and then with the Google team as well. They work with them to really go into those common customers or new ones and burn down commitments or make sure that we're helping them get cloud storage or CI or anything else they might want to use. So they are mostly focused around the storage part of that with the hyperscalers. And then we're also building our customer success team. So as you know, when you get to $1 billion of ARR in cloud and software, renewals, cross-sell, upsell is the majority of it, right? There is obviously net-new, but the customer success is a big part of it. So our ability to do what other folks have done with that model, we're also building that as well. So a lot of changes. And then you talked about as we do new acquisitions. So for instance, the CloudCheckr team, we'll keep them largely standalone. They have a great U.S. public sector business. They have a wonderful business in the MSP channel, the managed service providers. Well, we certainly have channel folks as well. We're going to leave that standalone. We'll integrate that over time. So our goal is, specialists do matter in that. And it -- never say -- everything is a little bit different. It's not always binary, but we will likely keep them standalone and then integrate them in, once we feel like we can integrate it into the core sales team. But again, we don't want to mess up what we're doing in the core business, and we want to keep those acquisitions growing.

Great. Great. I think we only have 1 minute or 2. So maybe just one last one, back to the cloud partnerships. It sounds like you got a great motion where NetApp is selling and they're selling as well your services. So are there any holes, any opportunities with any of the big 3, where you may be not getting the full portfolio out that could be kind of a step function for your ARR as you roll it out?

As we look at our ARR and our $1 billion target, I would be remiss to say, we feel better about that target every day. Great traction this year. The first-party services with -- that we have with ANF has done really well. We're super excited about FSx. And we're really excited about the future with GCP. Similar to the larger cloud business, there's certainly a size order there as well. So we really like the work we're doing with them. We're excited about making -- increasing that. There's no real hole. What I would say is, technology and stuff, we feel really good about. We've done a lot of work. A lot of work that goes on is around the sales and marketing and dealing every day with them and their customers and making sure that we're helping them. And as we look at acquisitions, we're also thinking about what else could we provide them in their sales channel as well, not only them but also us. And FinOps is a perfect example of that. So no big holes, Tim. But certainly, as we look at it, we're excited about the relationships. Again, 3 wonderful companies, we're proud to work with all of them. They're all a little bit different. So we're also trying to adapt to each of their different go-to-market motions.

Okay. Great. I think we're out of time. So thank you very much, Mike, for your time and insights today. Good luck with the meetings and, yes, look forward to seeing you in person soon.

Yes. Me, too, at some point.

Thanks, guys.

Thank you.

All right. Thank you.

Have a great day.