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

Welcome, everybody. It's my first in-person one in a while. So I'm very excited to have George here. Welcome, everybody. We have George Kurian, CEO of NetApp. I'm Meta Marshall. I traditionally have done networking and communication software, but we're adding enterprise software to the mix with Katie's assumption of the Director of Research role. For the record, just so we get it out ahead of time, if you have any questions, go to the research disclosures page at morganstanley.com/researchdisclosure.

So let's jump into questions now. So NetApp has been at the forefront, really, of adapting towards a hybrid world. How did you build these relationships with the public cloud vendors and get all of these vendors to kind of buy into your idea of a hybrid world?

We started the work 7 years ago. We saw that enterprises that we were speaking with wanted to deploy their core applications that run the business on the public cloud over time. We began with what you call a customer-managed offering where our software would be able to be procured through the marketplaces of an Amazon or a Microsoft Azure, for example, but the customer would manage it. We saw growing adoption of that set of use cases and then began to work with the cloud providers several years ago actually to make it fully managed, meaning the cloud provider manages the entire environment for the customer, and it's easy to procure, it's built into the cloud providers' contracts and provision. And I think on that, we are clearly ahead of everybody else in the market. We have a good amount of work going on with Microsoft Azure. We expanded that offering with Amazon FSx for NetApp ONTAP more recently, and we have work going on with Google as well. And then in addition to cloud storage, we've added on cloud infrastructure monitoring so that somebody who uses their storage environments with us can also get performance analytics, utilization, all of the things that they would expect from an infrastructure with an organic product called Cloud Insights, which has grown nicely, and then have done what we call for storage for computing environments with our Spot portfolio. So now we have cloud storage in 2 flavors: customer managed, hyperscaler managed, cloud monitoring and cloud computing management, which we call cloud operations. And all of them performed exceptionally well for us this year.

Perfect. You just mentioned they've done exceptionally well. We saw that business grow 98% in the last quarter in fiscal Q3 with what you mentioned kind of the Google and AWS relationship still to ramp. When you think about achieving the $1 billion plus of ARR target you guys have out there for fiscal '25, what do you think of the components of that? Is that still primarily Microsoft? How do we think of the -- how the relationship -- the different relationships with the different cloud providers ramp?

I think the majority of the opportunity is still in front of us. We are in the early innings of the ramp. I think that's reflected by the fact that our dollar-based net retention rates are very high, 170%. So you'll see us growing more customers, more applications per customer with an expanding cloud, storage footprint, more data services in addition to cloud storage on the storage side, and then the ability to cross-sell and upsell cloud operations to the cloud storage customers and vice versa. And then, of course, scale that through routes to market, both the hyperscaler routes, especially Amazon and Google [ get scaled ] and then the managed service provider route that CloudCheckr for us brought on. So I'm really excited. Clearly, we know we're ahead of our $1 billion ARR target. We also have seen gross margin attainment ahead of what we had originally indicated where it's already ahead of the corporate average. And we'll give you the next milestones on that road map at our Investor Day in a couple of weeks.

Got it. How do you think about barriers to entry here? You mentioned you're ahead of your competitors. You've been more front-footed. How do you think about barriers to entry? And then how do you continue to build out these relationships with maybe some of the other cloud providers, whether it be IBM, Oracle? Just how do you think about that?

We are ahead, and we intend to stay ahead. We don't think that everyone is going to sit back and let us have it as open landscape. But I would tell you that we've done a lot of work not only in our software, but in the way that, that software integrates with the cloud providers' landscapes to really make it differentiated. We've added data services, for example, that provide us the ability to make our solutions a lot more sticky and valuable to customers. So for example, over the last week, we've not only had customers look at our cloud storage to help migrate workloads from Russia, but they've also asked us, "Hey, can you tell us that I don't have any more data sitting in Russia so that I'm fully compliant with sanctions?" So we continue to add intellectual property to deepen that competitive moat and then scale route to market engagement, which is another point of differentiation for us. I feel good about the disciplined approach that we've had to expanding our cloud portfolio, and you'll see us continuing both organic acceleration as well as sort of disciplined acquisition to complement.

Okay. Got it. You mentioned some of the other features that you're expanding upon, but maybe are there other things that customers are asking you for to kind of complement their cloud portfolio?

I think that all of our sort of execution road map is based on deep discussions with customers. I think when we started in their marketplace, they said, "Hey, make it easier to adopt." And so we've built in capabilities, for example, to make it a native service with the cloud providers. There's lots of innovation going on with them around their architectures, broadening the applications that we serve, building new ways for customers to consume that. Today, it's primarily a consumption-based offering. I think there's people that want us to give them committed contract kind of capabilities. So lots of both technology and business innovation. I think the road map, as we said, in terms of Cloud Insights and our Spot portfolio is super well engaged with customers. I think they want us to do more on 2 directions. I think one is, hey, take on more and more of my infrastructure management capabilities. So you've done well in storage, you're doing more in other parts of infrastructure management and then, hey, give me a more broader range of data services so that I can do more and more of my data landscape with you guys.

Got it. A debate we still see from investors is whether you can sustain all this cloud success without cannibalization of the on-premise business. How do you think about that balance with customers and just with the business in general?

First of all, cloud growth is not offsetting on-premises investment at a macro level. If you look at the growth rates of both of them, they have -- industry growth rates are both positive trajectory, right? So I think that on-premises will have sustained investments, certainly not at the level of cloud, but it's going to be low to mid-single-digit growth rates on premises. With regard to the cloud environments, we see the opportunity. We're about a 15%, maybe 20% share player on-prem, which means that even if cloud were fully substitutive of on-prem, we would still find 4 out of 5 opportunities to be additive to NetApp. So we think there's still plenty of room to grow, both in sort of taking competitive customers as well as growing new workloads. We mentioned on our earnings call a Nutanix customer that chose to go to NetApp and a Dell customer that goes to NetApp, and we're pleased with the progress there.

Got it. In this post-COVID environment or at least looking at infrastructure as you return to the office, are you seeing any changes with customers on how many of their workloads they're planning on moving to cloud or just the pace of change or maybe even the opposite of the things that they're looking to kind of take down from cloud and move to on-premise?

I would say it's sort of the 2 big things that we've seen clearly are people are serving customers and employees in a digital model more and more because they can't have as many interactions face-to-face or customers now having experienced the digital model, say, "I want you to serve me the way that you did before." And as a result, they're externalizing their IT assets, meaning moving it beyond their data center footprint, which is driving really cloud. And so I think that's a secular trend that we don't see resetting. I think we have an opportunity as that trend intersects the applications that we're really good at to significantly capture footprint in that cloud migration. The second is, I think, certainly, the events of the last few days, but sort of over the last several quarters has been the growing concern around the security and protection of data, so ransomware's up some absurd number, 1,800% or something year-on-year, and so people are clearly worried about that. And we have good solutions to both detect and enable recovery from a ransomware attack.

Got it. You mentioned earlier that M&A was going to be kind of a portion of your strategy going forward. You recently closed CloudCheckr in the most recent quarter and saw it contribute $35 million to your Public Cloud ARR. Realizing it's early days, but just kind of what level of interest have you seen from customers and what kind of traction do you expect there?

All of our acquisitions have been -- we've been disciplined acquirer, super excited at the performance of our -- the acquisitions. I think Spot has been a stellar acquisition. And we see over time, CloudCheckr and Spot becoming the leading player in the growing sort of [ SynOps ] market, right, which is around, "Hey, I've got so much cloud spend. I'm wasteful. I need to get it more efficient." We not only have a tool in CloudCheckr that allows us to detect where the waste is, but also with Spot to actually remediate that waste, which no one really has been able to do so far. I think CloudCheckr also gives us access to a new and developing route to market, which is around managed service providers, where people like Rackspace or Arrow and Avnet have built out a -- the ability to buy cloud and manage cloud environments on behalf of lots of smaller customers, and they see CloudCheckr as a really good tool where it allows them to save money on behalf of their customers and share the benefits of that with their customer and keep some for themselves. So it's a new route and new technology.

Got it. I mean just in terms of that, what are you seeing from the likes of the Rackspaces or kind of these managed providers as a go-to-market kind of for some of your new cloud products?

We are excited at the opportunity to expand through multiple routes. Clearly, hyperscaler routes, huge reach, early in the going. SaaS and ISVs, we have a growing number of really well-known SaaS brands that basically become aggregators of customer demand, people like SAP and others. And then managed service providers. So we're executing on all those fronts.

Got it. And can you just speak for a second about how Fylamynt, your most recent acquisition, kind of complements the cloud portfolio?

Yes, Fylamynt allows customers that don't have advanced programming skills in their IT teams to be able to integrate our Spot portfolio much more easily. So it's kind of what they call a low code or no code programming environment that allows you to basically use English language instructions to integrate your cloud computing landscape with all the tools that we have. So it just makes it a lot easier, which in turn allows us to both bring on more customers and expand the footprint that we have in those customers quickly.

Got it. I mean how do you see the M&A environment currently? Obviously, there's been a reset of some valuations amongst maybe some of the software set. Do you see that as an opportunity? Do you think there needs to kind of be a reset period where people come to grips with that? Just how are you seeing the M&A environment currently?

I think valuations have gotten progressively more realistic, which is a good thing. I think we will always be a disciplined acquirer. I think we've shown you the logic train of how we've built out our cloud portfolio. We'll continue to do that, right? We have a lot of customer conversations going on. We have lots of discussions with the cloud providers going on, and we'll just be methodical about how many of those we do. We do see the opportunity, as I said, to expand our position in cloud and won't hesitate to do that. But you'll see us be disciplined around balancing that with capital returns.

Got it. Maybe turning back to the quarter and circling up on supply chain. Investors were maybe a little bit surprised in kind of the step-up and impact that -- given that we hadn't picked up on major lead time extensions. Can you just walk us through when supply chain worsened and just how you kind of see that improving throughout the year?

Supply chain has been a challenge for a few quarters now. I think we've been aggressive in the market to acquire all of the major components of our systems, memory, deep processors and storage, and hold it on our balance sheet with prepaid contracts. I think you've seen that reflected in inventory turns over the last few quarters. We saw 2 issues in Q3. I think the predominant one was decommits from one of our suppliers in the middle of the quarter, actually, a couple of suppliers in the middle of the quarter on demand that we had been guaranteed to meet. And so we have to scramble to do some open market purchases. These were certainly not sort of large items in terms of our total spend, but we had to do some significant open market purchases to guarantee our ability to meet demand. And the second is air freight and logistics, which is certainly not -- we're not the only ones affected by that.

Right. And just how do you see that improving throughout the year? I mean, certainly, largely had a conversation with the one supplier who had some decommits. But is that improved just by they have more availability? Is it by diversifying the supply chain? Just how do you see that improving throughout the year?

We're constantly -- I think there's sort of 3 ways that we mitigate the impact of supply chain. I think one, clearly, we've taken pricing actions. We took a second one, as I said, on February 22 -- February 28. That sort of has to play out where we have to allow customers that have contracts in flight with us to honor that certain customers that have sort of guaranteed pricing won't be part of that. But over time, certainly, towards the end of this quarter and really over the next couple of quarters, that should come into effect and benefit us. The second is the logistics ecosystem impact of Omicron hopefully eases. So additional air freight and air cargo capacity. And then on supply chain, on silicon, we think it will remain constrained for a couple more quarters at least, right, through the first half of our fiscal year -- coming fiscal year, but should get better over time. We're doing multiple things to work around it, creating alternate sources of supply, engineering, qualifying architectures that don't include some of these components. So lots of different work going on. And some of those have already been in the market and showing some results and others yet to come. So lots of work going on.

Just in terms of what we've seen with a lot of the other enterprise names is that as soon as you're going to put into a price increase, maybe you're giving a little bit more visibility in demand from customers trying to get orders than before those price increases. Just what are you seeing just in terms of visibility into demand or just visibility and demand, either because of your price changes or just availability of the overall IT stack?

We are closely engaged with our customers. Clearly, we don't see signs of any phantom demand, right? I think we've been working with customers, for example, to say I'll take partial shipments because I'd like to start building out this environment even though I don't have all of it. And so we're pretty closely engaged with all of our big customers and have good visibility. I would tell you that, as we said on the earnings call, demand outpaced supply in Q3. And clearly, we see that even for this coming quarter, Q4. With regard to what we see over time, clearly, inflation is not a surprise to anybody in the industry. I think it's pretty well understood in the market. We think that customers buy in dollars, not in systems. So they'll buy probably fewer systems with the same budget this year and probably smooth things out. So if there's a soft landing, hopefully from all of this, it will be that demand sort of probably is stronger over a more graduated period of time.

Got it. As we get towards an equilibrium of supply-demand maybe later on this year, just can you walk us through if there's any product refreshes that we should be mindful of, either kind of later on this calendar year or into next year?

Nothing out of the ordinary. We're executing on product plans as we speak. I think we continue to bring more capabilities to the market as part of our systems road map and clearly accelerating range of capabilities on the cloud road map.

Got it. Just as we look forward to your Analyst Day kind of later on this month, can you just walk us through some of the objectives? Clearly, you guys are running well ahead of some of your cloud targets. So there's obviously some updates there. But just kind of what you hope to accomplish with that Analyst Day.

I think to give you an update on our business, clearly, update you on elements of our cloud portfolio, where we see that business heading. We know we're well ahead of our $1 billion ARR target. So give you the updates on that and sort of what's the next horizon for that business. The outlook for our hybrid cloud business, our systems business, where we have strong footprints in all flash and object storage, sort of the workload profiles that we're seeing and where we see that over the next few years, and then how that translates into improving gross margins over time and disciplined OpEx management and updated capital allocation framework.

Got it. I mean you noted a couple of price increases that you've put into place. I think some of the competitors within the space have maybe had some more limited price increases. Are you seeing any changes to competitive landscape or just ability to kind of negotiate with customers based on differences in price increases across the space?

It's always been per transaction and the good teams get the price increases landed and the weaker ones don't, right? So we got to keep working on that. I think that -- so it's been competitive. Storage industry has had a history of passing through commodity price increases to customers and, conversely, price benefits to customers as well. And I see this as one of those.

Got it. Are there any questions from the audience? I want to give an opportunity. There's a question back here.

So just a quick one. NAND pricing. How is -- that is expected to inflect and go up much quicker than originally expected due to the Western Digital and Kioxia chemical contamination. Can you give us any kind of update? Is that affecting your, a, supply? And then two, how do we think about the pricing and the impact on your -- either your calendar Q1 or calendar Q2 gross margin?

We have multiple suppliers of solid-state technology. And Kioxia is a smaller one of those. They are not a large supplier to us. We have been aggressive in the market, as you might have seen from our inventory turns, to procuring supply ahead of demand to guarantee supply. We'll continue to do that. And then in terms of the total storage kind of cost of goods, we signaled that there are lots of puts and takes across that whole basket, some configurations going down in price, some configurations going up in price. But I would just say, at the total storage level, which is where we manage the business, we should be pretty consistent year-on-year.

Because this is a relevant topic this week, can you quantify your European exposure and anything -- if you're seeing anything different given the geopolitical issues right now?

I think it's early to comment about what we see. Clearly, we've been spending time on ensuring that we are in compliance with the sanctions regime. The Russia business is a small percentage of our total business, immaterial to the total company business. I think in terms of the impacts, clearly, there are impacts on the Russia business itself, which is the primary, and then there's probably derivative impacts over time. It's too early to quantify. I think we'll monitor it. I think in terms of our scenario planning, we see this one scenario which says, "Listen, this is -- cooler heads prevail, and over time, things get back to a new normal, maybe not as integrated as it was before, but still sort of a single global operating framework." And then the other is, "Hey, there's a new cold war." There's puts and takes in both, right? So our business in Germany benefits from increased military spending and our dominant footprint in that market. Conversely, the energy infrastructure, part of our business in Germany, probably suffers a little bit. So we're still working through that. We feel we have a strong presence in Europe, and we're going to continue to push to grow our footprint there ahead of the overall market.

All right. Any last questions? That was my last question, was about Russia or Ukraine. So with that, I think, George, thank you so much for being here today.

Thank you, Meta. Thank you.