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

I want to just get started, Mike, with kind of an overview -- quick overview of the company.

Who is NetApp? What do you guys sell and who are your customers?

Great. Well, good morning, everybody. And Jason, thanks for having us. We're thrilled to be here, and thanks for reading the safe harbor. We appreciate that. So NetApp, we are a cloud-led, data-centric software company. So we have come a long ways in our journey. I think we're turning 30 this year at NetApp. And what we do is we allow companies to manage their data on-prem in the cloud. In addition, we provide cloud operations for them once they deploy in the cloud to manage those more effectively, monitoring and compliance. We started out as on-prem data storage, and we've made that transition over time. We're big believers in the Hybrid Cloud, especially as it relates to our customer base, which are typically the largest customers in the world, Fortune 1000, governments, public sector. We have about 11,000 employees at NetApp, all great employees that help our customers manage their data. We are worldwide in virtually every country in the world and then certainly the U.S. public sector are some of our biggest countries, but in Europe and in Asia as well. So that's NetApp -- and go ahead.

How many customers do you have?

Over 30,000 -- we have customers everywhere in the world, again, mostly focused on larger customers.

Got you. Okay. And you reported your Q4 earnings last week. What were the key takeaways from the quarter and for the fiscal year?

Yes. So we had a very solid quarter, even given some pretty significant constraints around supply chain that we've talked about. So for the quarter, revenue was right at about at the midpoint, but we did better on gross margin and EPS. For the full year, we grew revenue about 10%, and that was across both our -- what we call our Hybrid Cloud, which is the software and hardware that we put in customers' data centers as well as Public Cloud. We had great earnings in terms of expansion of our operating margins up 300 basis points year-over-year to a record 23.7%. In addition, earnings per share was about $5 for the first time in the company's history. We were constrained by supply chain in terms of not only Q3, but our Q4. You also saw that a little bit in cash flow in terms of some of that got pushed to the end. So we exited the year in a really strong point or a strong position, again, about 10% revenue growth. Our cloud business is now over $500 million in ARR. So that is a real business as we go into next year. We have elevated backlog as we go into next year, again, because of supply chain. So we feel really good about as we enter next year, not only for the Hybrid Cloud, but the Public Cloud business. And again, $500 million of that cloud business is getting to be a real business.

Got you. And what comments do you guys make on the demand environment?

So we said, hey, we haven't really seen much of a change in demand as we went through the second half of the year and as we look into this year. So we feel good about that both on-prem and then certainly from a cloud perspective. As you look at all the CIO surveys and yourself as well as your colleagues put out there, digital transformation, movement to the cloud and then certainly security continue to be 3 of the big initiatives, and we feel like we're very well positioned in those priorities.

And maybe a quick comment on your balance sheet?

Yes. So I've been at NetApp for a little over 2 years. And when I joined, I remember I looked at the balance sheet and said, "Wow, I like that." So look, we have a great balance sheet, very strong cash position. Net cash, now about $1.5 billion. And that's the other thing. Thanks for saying that. In the year of fiscal '22, we returned over 100% of our free cash flow to shareholders through dividends or share buybacks, while we continue to invest in the business. So a very strong balance sheet. We did do a debt raise about 1.5 years ago right after COVID hit. All of that is fixed debt, and we pushed those maturities out as well.

Okay. And on the Public Cloud side, you announced a target of $2 billion exiting fiscal '26, correct?

Correct, '26. And we're in -- we're just entering fiscal '23 right now, 3 years.

Can you walk us through your products, your portfolio of cloud products and your strategy? And really what's driving the growth there?

Sure. So when you look at Public Cloud at NetApp, we really break it into 2, call it, product groups. One is cloud storage. So think of this as when our customers want to deploy storage in the cloud, we have what we call CVO, which is a bring your own, it's basically our ONTAP software that they can take, deploy in the cloud. And then we have what we call Cloud Volume Services, which is a fully managed service through one of the hyperscalers. And that is about 60% of the cloud business, this cloud storage, also data services wraps in there, [ dedupe ] replication, cross-region replication, other things that help them manage our storage.

And then can you give people a concrete example of a customer that would use like AWS or Azure NetApp software for an application?

Sure. So again, there's 2 flavors of that. A customer can use our software, again, we call that CVO Cloud Volumes ONTAP, deploy that in AWS or Azure or GCP, and then they can self-manage that. So if a storage admin wants to manage it in the cloud, they will do that. They can also buy a fully managed service where AWS or Azure or GCP supplies that. And importantly, with Azure, the product was called Azure NetApp Files. It is a first-party service where Azure sales team actually sells it, get quoted and get measured on it. It's their product that we provide.

It's not through the marketplace is the point.

That's correct. Yes. With Amazon and with Microsoft Azure, those are first-party services not through the marketplace. With GCP, you do buy that through the marketplace. Now the important part is it's fully integrated into the [ console ] for all 3. So we have a very deep relationship with them. We've worked on integrating our products into their console. So it looks and feels like their first-party service. Exactly.

So a customer building a new app could choose to deploy Azure NetApp Files or AWS, FSx. Why would they choose your technology there versus something else or something that's maybe kind of more of a branded Azure or AWS service?

So it's going to depend on what they wanted, what workloads they want to deploy in the cloud. And we've always talked about when -- at the beginning, you said who is NetApp. We are really a software company. And ONTAP, which is our file storage software is by far the best. And when you talk about deploying high-performance workloads in the cloud, you can buy a file software from virtually our storage from any of those providers. If you want to have a multi-cloud environment as well as Hybrid Cloud and to be able to, as we call it, Data Fabric, moved seamlessly on-prem in the cloud, that's when you're going to look at NetApp as being by far the best product. And so we actually deploy hardware with Microsoft. So the SAP, high-performance workloads can be deployed in the cloud. The FSx offering is software, but it gets better and better. And we just announced a couple of weeks ago, certification with SAP workloads in Amazon. So multi-cloud, Hybrid Cloud to be able to move back and forth between on-prem and in the cloud is where we really shine. So that's the cloud. That's 60% of the cloud ARR business. And then CloudOps is really broken up into 2 pieces, FinOps as we call it, where you're managing your cloud deployment, and we are helping you optimize that spend either through any of the -- either on-prem or with those cloud providers. And this is where this part of DevOps is starting to really play into it. And then we also offer a product called Cloud Insights, which helps you monitor your cloud storage, again, mostly in the cloud. We also have an on-prem product as well. So that's about 40% of the cloud ARR. Cloud Insights is an internally built product that we rewrote our on-prem software to fit. And then that's where most of the acquisitions have come in cloud.

[indiscernible], yes. And can you talk about what happened in Q4 with the CloudOps business?

Sure. So we had grown that business super well over the last 3 quarters. In Q4, we had some issues in terms of some of our larger customers that had deployed on-prem and in the cloud through Cloud Insights. We're using both of our products. And as they deployed in the cloud, they weren't going at the speed that we had hoped or expected. And we had some of the larger renewals come up where they didn't renew. We hope to get them. Hey, these are big customers, we talked about who we sell to almost all of those customers we sell on-prem and into cloud. And then from a Spot perspective, which is our optimization product, that's -- keep in mind that, that's a consumption business, it's not a subscription, start an end date. And you'll see some of that usage go up and down, and we saw some of that consumption drop in Q4. All of that hit at the end of the quarter, at the end of our Q4. And as a part of that, we did see a little bit higher turnover in the Spot sales team as we entered the fourth quarter. So all of those we've addressed, we know what those issues are, and we feel good about that business as we enter '23.

And can you talk about, I don't know, potential macro downturn, the appeal of that business, that the appeal of that value proposition?

Yes. So we think that, that's really important as customers continue to deploy to the cloud. All companies, when you look at their P&L -- probably not all, the vast majority, the highest growth expense item in that is cloud. As they deploy the cloud again, whichever hyperscaler that they want to deploy to or use a private cloud. So what we do is we help them manage that spend as they deploy to the cloud. And we feel really good about Spot's position. We also bought a company called CloudCheckr, and they brought us into the MSP market, where MSPs are pushing hard into that. And again, that will help the cost side as well as in public sector. So as companies look to optimize their cloud spend, we think that the product offerings that we have across all of those segments is very well positioned.

And can you talk about how Spot prices their product?

Sure. So we typically will earn our money as we help customers save. And there's a couple of different products in there, there's an entry-level product. And then the job is to cross-sell up. Keep in mind that Spot again integrates into the console. They're really helping them as they deploy in the cloud to make sure and point those workloads to the most cost-effective solution, be it if they're using Containers or Kubernetes. So we get paid as a percentage of the savings that the customer gets.

Got you. When you guys first got into this business, this CloudOps business, you have a lot of customers that sort of scratch their head and says, how does this fit in with the rest of NetApp.

So we were cognizant of making sure that when we did that acquisition -- when we entered into that, that we did it through an acquisition for a brand name that had a great brand, and that was really Spot. So Spot was the first entrance into that. And then Cloud Insights, which we bring along, that's more of a storage monitoring. So we had that route to market as well. So yes, it was NetApp, but we've kept the Spot brand name. And when we acquired CloudCheckr, we'll bring that into Spot as well. So yes, NetApp is the overall umbrella, but really the customers know Spot or CloudCheckr or now Instaclustr, which is our newest acquisition.

Can you talk about that one?

Sure. So we just closed on that a couple of weeks ago. We feel really good about that. So this is a fully managed service for open-source data and workflow applications. Fully managed service, and we feel great about this because it moves us closer to that day 1 decision as the customers deploy in the cloud. And there's great cross-sell in connections with Cloud Insights, with Spot and super importantly, with our cloud storage. So we really love the synergies that it brings as well. So early days yet. We just closed on it a couple of weeks ago. And we did say, and you asked about cloud operations. hey, we've done a lot of acquisitions. We feel really good about it. But we also want to take -- we're going to take a step back. And hey, folks, this is not a negative, this is a positive. We want to build that foundation so that we can continue to do acquisitions in cloud operations, but we need a couple of quarters. Let's get it integrated. Let's make sure the go-to-market is working really well, the products get integrated as well. So we have -- we're going to take a little bit of a step back in the first half around cloud operations. Again, let's build that foundation so we continue -- can continue to add acquisitions as we go through '23 and '24.

Got you. Okay. So I guess as you think back and reflect on the -- all the acquisitions that you've done in that space and what could you have done better in your mind?

So we can always do better. I think the areas that we could have done better is integrated faster the go-to-market. And we talked a little bit about Spot. And again, when you do acquisitions, this is a great discussion. Do you believe it standalone? Do you integrate it? From a product perspective, we've done a really nice job, I think, of integrating it so that the customer gets 1 platform, 1 experience. From a go-to-market perspective, we probably should have integrated that sooner, made sure that we had more focus on backfills versus leaving them standalone, and that's something that we will do much faster related to CloudCheckr and Instaclustr. Leaving the brand name, leaving the knowledge because that's what you buy when you buy a company like that. But hey, let's make sure that we understand what those areas are and that we can run that more from a go-to-market.

Got you. Yes. I mean, I think it's fair to say you guys have done incredibly well with your cloud business. I think everyone has been looking at all the acquisitions and wondering like are you doing too much. So maybe you were doing a little bit too much, but it seems like you've got some great assets there and now you just got to kind of optimize. And how long do you think it will take for you guys to kind of get through some of the issues like Spot you mentioned, Cloud Insights you mentioned.

So we just closed Instaclustr a couple of weeks ago. So what we really said is, hey, for the first half of fiscal '23, let's make sure we build that foundation. We'll do all this stuff that we're going to do anyway. We'll still look at acquisitions related to cloud storage. If there's a great asset there, we'll look at it. But we -- what we've really said is for the first half, let's make sure to build that foundation, and we'll continue to look for acquisitions. The market's changing, valuations probably coming back to be a little bit more affordable. Let's let that work its way through the system. So we're ready in the second half.

And what did you -- if you had to add up in your head, how much did you spend on all the acquisitions?

Over $1 billion since I started. Yes.

Since you started?

Yes.

Question is what kind of return are you going to get on that $1 billion?

So we feel really good about the return that we've already gotten. We think that Spot has been a super great acquisition, [indiscernible] for 3 quarters in fiscal '22. It performed very well. Keep in mind that Cloud Insights is all internal. So that was internally developed. CloudCheckr, we've only owned now for 6 or 7 months. And Instaclustr, we've just brought on. So when we look at our use of cash, again, we used 100% of free cash flow to return to shareholders. That's a big piece. So we will balance continue to do acquisitions [ based ] and then the return that we think we can get through the share buyback. So we look at all of the acquisitions, if we don't think that we can earn more than our cost of capital, then we won't move forward on those transactions. So we don't disclose what we look at. Most companies from a cost of capital perspective, pay NetApp, so we borrowed. I think our cost of debt is a little under 3%. Cost of equity, you're probably talking about any company our size, total cost of capital somewhere around 10% or 12%. We want to earn more than that. So hopefully, that helps. You're welcome.

Any other questions? Yes. The question is you take us through your $6 billion in revenue and kind of break it down according to its components.

Sure. So we break -- we have 2 segments at NetApp. We have what we call the Hybrid Cloud segment, and we have the Public Cloud segment. If you look at the revenue for the year, I think it was about $5.7 billion. The majority of that still is in the Hybrid Cloud segment. I believe the Public Cloud revenue was about $400 million. The rest of it is in Hybrid Cloud, and that's broken out between product, which is the hardware and the software we deploy. And then about $2.3 billion, $2.4 billion was the support that we offer. And then professional services is another $300 million or $400 million that we help implement. So as you look at the revenue components of NetApp today, that's where we sit. And again, the ARR number is the forward-looking future that we expect to generate on that ARR.

Yes. And you're -- our model shows that the Public Cloud business will reach about 10% of revenue this fiscal year. So -- and you've guided ARR and there's some math you can do to figure out what the revenue will be based on that ARR. So if you're able to hit those guidance numbers on the Public Cloud ARR, you should cross 10% of revenue from Public Cloud, which I think would be a pretty big milestone for you guys. But maybe talk about the growth rates, too, because I know you've talked about Public Cloud contributing a lot of the growth over the last couple of years. Can you walk us through that?

Sure. So Public Cloud grew by 99% last quarter. So super great growth. We've guided for fiscal '23 at the midpoint organically, right about 50% growth in Public Cloud. And then you add Instaclustr on top of that. So we expect to exit fiscal '23 with total Public Cloud ARR of about $800 million. And then on the Hybrid Cloud business, we have guided to, call it, mid-single-digit growth. And importantly, in Q4 was our fifth straight quarter of growth in product revenue, which had been some of the concerns. We expect to continue to grow product revenue as we go forward. That's driven by our All Flash products, which continue to do great. That grew by 12% last quarter on a very big number. Object Storage and then hybrid storage as well. So going into '23, that's what we laid out for guidance from a revenue growth perspective. And the great part about the Public Cloud business is it already is accretive to the total company gross margin. So even in Q4, where it dipped down to about 68%. We expect that business to generate between 75% and 80% gross margins. There's a lot of drivers to that. One is as we deploy more infrastructure, especially with Azure NetApp Files, and we continue to drive revenue through that. We're going to leverage that base, which is great. Most of the acquisitions are software or cloud, where the margins are almost always going to be above the company average. Instaclustr will come in, call it, in the mid-60s and then we'll get that up. So if you look at the components of revenue growth next year, I think almost half of that is coming from Public Cloud, and that will be the same thing for gross margin as well. So it's a significant driver to the financials of the company. And again, that's why we feel good about that business as it gets bigger and bigger because it's going to drive up the margins.

Is that why you just spent $360,000 yesterday?

So yes. So this is a third -- so let's say, I've been the CFO here for a little over 2 years. So third time I did an open market purchase. So hey, this one of the things I always love about NetApp is, hey, we're not a dividend stock, but we pay about 2.7%, 2.8% yield. I look at the growth opportunity, and I know we're going into an uncertain economic environment. I feel great about NetApp. My family does now too, because most of our wealth is tied up in NetApp. And I look at it and think it's a -- if you look at the business, and this was even when I started 2 years ago, you have a great core business with wonderful customer base that's generated -- that's growing mid to upper-single digits, generates a bunch of profit and cash so we can go invest in the cloud business. Cloud storage is a natural extension of what we do on-prem. It's ONTAP in the cloud. That's really what it is. And then the CloudOps piece, which allows us to extend into the cloud and help our customers manage their cloud environment better. That's -- I mean, that's growing at 50%. So within NetApp, you have a great core business that's generating a bunch of cash and profit that allows us to invest over here. The sum of the parts valuation to me is super interesting. Plus, hey, every day you wake up and you get almost a 3% yield. I'll do that every day.

Yes, go ahead, Colin.

Yes. So great question. So Colin's question was, would we sell hardware into those hyperscalers. So Azure NetApp Files, we provide our hardware, Colin, we don't sell it. It's part of the service that they provide. So the economics with them are -- and we've -- I think this year in '23, we guided about half of the $300 million in CapEx that we'll spend will be targeted towards Azure as well as GCP to deploy our hardware in their data centers to run it as a service. Sits on our balance sheet, but it's all in the economics of what we provide. And especially, I mean, Azure NetApp Files has grown great. They've done a wonderful job. We love all of the hyperscalers in the relationship that we have. That's allowed them really to go after those high-performance workloads as they move into the cloud. And that's the business model that we have. I don't know if we'll -- I think we'll keep that. Who knows -- never say never, but we're very comfortable with that relationship.

I wanted to dig into the kind of current split in your business and the transformation you're going through, because I think that's where -- in my estimation, that's where some investors get hung up because you have a lot of these kind of businesses where you have kind of this traditional business and it's -- in your case, it's still growing, but in a lot of cases, it's shrinking where these companies are going through transformations. And then you have this other piece that's much smaller today but growing really fast. It creates a modeling challenge for investors, and it creates sort of a question on like what's the next 3 or 4 years going to look like and what's the slope of the curve on both elements. How do you get people comfortable that the 90% of your business that's sort of more traditional storage and generally tied to kind of on-prem data centers? Do you get people comfortable that, that business is not going to be a melting ice cube over time?

So great question. We get that a lot. As we look at the Hybrid Cloud business and our comfort around what we guided at Financial Analyst Day, is we're in the parts of the on-prem storage that is the growth areas and that's All Flash and Object as well. And we are big believers again. And I don't look at the on-prem competing with Public Cloud. As you look at Data Fabric, the ability for our customers to deploy on-prem and in the cloud and they have that investment protection as they do that. Again, it's all the same software. That's the area that we think will continue to grow in storage. Keep in mind that our business is based on, yes, we sell hardware and software, but it's based on data. And data is growing at significant rates, and we think it will continue to grow. And as our large enterprises and governments continue to deploy on-prem and in the cloud that we think that we're in a very good spot there. And then keep in mind, too, that this cloud business is not this tangential not related. It is storage in the cloud or on-prem. It's the same software. And that storage admin can run both of those. And we have cloud manager that connects that. So they're not disparate businesses. And the CloudOps part, what we really love about Instaclustr is as they deploy database as a service, that's going to pull storage, that's going to pull the other infrastructure services. So we're trying to build a company that's based on having those synergies around Hybrid Cloud where they're not disparate. Hey, this is a low-growth business. This is a high growth. And our sales team, by the way, are selling both. So as they -- as we deploy that, the sales team is getting [ comped ] to sell both on-prem and in the cloud. It's not an either/or because we want to make sure that we're bringing our customers, hey, what works for you, we want to follow them, and we don't want there to be any conflict as it relates to compensation.

Any other questions? All right. Why don't we just wrap up with my standard wrap-up question, which is, what do you feel that investors most underappreciate about NetApp?

I think it's what we just talked about, which is that the cloud and the on-prem business are related, that they're -- we do feel like that they can grow together, and you have this largely very fast-growing hypergrowth business, which is, hey, it's a real business, $500 million in ARR is not a small number. Yes, as it relates to the Hybrid Cloud business that's smaller. And as we continue to grow, that there's synergies, we feel good about growing both. I think there is always a worry rightfully so of hey, can you continue to grow both Hybrid Cloud and Public Cloud? We feel good about being able to grow both. And then if you look at that, and you do the sum of the parts valuation and you pay a nice dividend, we feel really good about where we sit. And we're returning 100% of free cash flow to shareholders being very prudent. And then the last thing I'll say is, hey, the one thing I wish -- you do Financial Analyst Day and then you spend the next 3 or 4 days thinking about what should I -- could I have said? Hey, we feel really good about being able to grow the operating income and the leverage. And I think there was some perception which is, hey, margins aren't going to grow because you're going to invest a lot in CloudOp. We grew margins 300 basis points in '22. We feel very good about being able to continue to grow the leverage, both dollars and percentage. And I think you'll see that as we go through the next couple of years.

Fantastic. All right. Thank you, Mike. Thanks, everybody, for joining.

Thank you.