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

All right. So why don't we get started? I'm Aaron Rakers with Wells Fargo covering the IT hardware and some of the semi space. Pleased to have with us this morning, Kris Newton, Vice President of Investor Relations with NetApp. Kris, thank you, first of all, for joining us.

Thanks for having me.

Perfect. So I think we're going to start with the fantastic safe harbor statement. Is that right?

I know what everyone is excited to hear today. So let me just get into that. 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 our most recent 10-K and 10-Q filed with the SEC and available on our website at netapp.com. We disclaim any obligation to update information in any forward-looking statement for any reason.

You nailed it.

Thank you.

Great job. I'm going to start, you guys just reported this past week and obviously had conversations with a lot of investors and myself and colleagues. So I want to start with maybe just a question of as we think back at the results, and the discussions you've had, just where do you think people are underappreciating maybe the NetApp story right now?

Sure. So the headline on Underappreciating the story has kind of been consistent for a while. I don't think people fully understand the benefit that the Public Cloud business does for the company as a whole, right? It helps our Hybrid Cloud, the traditional on-premises business. It helps growth margins. It's a great growth engine and new customer attraction business for us. So that's probably the most misunderstood, a little bit on the quarter, our Hybrid Cloud business, which is what everyone thinks of as the traditional NetApp on-premises business, performed really well in Q2 in the face of some significant FX headwinds, we still did a great job on product revenue, and we see that was good. But looking forward, right, we do see some macro conditions that will -- we expect to have an impact on the hybrid cloud business where we've spent most of our conversations in the 2 days since our earnings has really been around the public cloud business. Now that revenue grew 63% year-on-year. Public Cloud ARR grew 55% year-on-year. Those are great growth numbers. However, they weren't as high as we had anticipated. There were a couple of reasons for that. We still are very confident in the overall opportunity and what Public Cloud brings to NetApp. And I don't want to preempt some of your questions, but I'm sure you want to dig deeper into that Public Cloud number.

Maybe unpack a little bit of that incremental weakness? I know that you adjusted the ARR expectation exiting the year. So maybe help us bridge what we maybe would have thought of 3 months ago to kind of what we're thinking now.

Yes. So there were 3 primary drivers of both the below expected performance of the Public Cloud business as well as what we think will have an impact on the exit rate for ARR. So the first is the overall macro environment. I think you've heard all the cloud providers and seen it in software providers. SaaS providers who do consumption business that there's an optimization happening in the cloud. Unfortunately, that's created a slight headwind to the cloud storage services that we offer. It's a great opportunity for Spot, however, and Spot is definitely benefiting from that. Spot is a compute optimization service to help customers lower their spend. So that's benefiting, but it is a bit of a headwind on the consumption side of storage services. We also saw a small number of very large customers with project-based workloads. So I think EDA, chip design and that small number of customers, unfortunately, coincidentally ended, came to a natural conclusion of the life cycle of those projects. So I'll dig into the chip design one because it's the one I'm most familiar with, we spend a lot of time understanding what was happening with that customer. So about a year ago, they started their new chip design process. They run a bunch of simulations. They test and tweak the design, they run more simulations. And through that whole process, they're saving all of that work so they can reference back to it. When they finally get to the final piece of art that they want to save and their chip design, all of that work in progress is meaningless now and they delete it. They just keep the few files that are related to the final piece of art. It's a great business in the cloud because on-premises, they would have to buy for their maximum storage and then let that capacity lay fallow until their next life cycle of chip design. In the cloud, they can really optimize their spending to go along with that life cycle. So we saw a pretty significant downdraft because of that. It was probably the biggest headwind we faced in the quarter. Talking to those companies, there are new projects that they expect to start, right? The quest for better chips never ends. There are always new EDA style projects happening. Those will likely start next year. Exactly when, is that Q3 or Q4, how they ramp over time, it's a little uncertain. So that's why we're not giving quarterly guidance, just an exit rate guidance. And then the Cloud Insights product, which is a natively developed product that we saw some challenges with in Q4 of '22 and talked about. We've been working on refining that go-to-market motion, dealing with the customers in a different way, refining our sales process on that product. There's good early signs of improvement there. We had a good number of new to Cloud Insights customers in Q2, but we want to take a conservative stance on that product. And so we're basically not expecting any incremental growth from that going forward.

So I guess what I'm hearing a little bit is on the one point, your cloud business is actually doing what the cloud structurally is meant to do, which would be that absorption effect on the demand side. The second one is just a transitory thing. It's the development cycle. I guess the other argument would be is that, that starts to lessen as the business becomes more diversified.

Exactly. And I think that is 1 of the things that maybe people didn't fully hear on our call. While we were disappointed with the performance of our Cloud business. It still grew nicely. We saw a great number of new customer additions. The number of customers with more than $1 million in ARR more than doubled from a year ago. So there's a lot of good structural underpinnings. We can see that the base both of total number of customers and of large customers is growing, and that, over time, will support a smoother growth plan because you won't see the impacts of any 1 or a few number of customers dialing up or down their capacity.

Yes. That's perfect. And then maybe this is a question back to the Hybrid piece of the business. You've got a group of hardware companies that are across the spectrum as far as backlog, right? Like you've got some companies that have significantly still elevated backlog levels. And I believe you guys don't have much backlog level. Is that -- that's a fair assessment. So your view of the macro softening might be quicker compared to some of the others.

Right. Yes, I would say if you put like Cisco on 1 extreme with like backlog that seems to last for years or something and NetApp, Pure Storage kind of at the other extreme with limited backlog. We had seen some level of elevated backlog while we manage through some of the supply chain hurdles. But this quarter, we were able to work that down pretty substantially and we're seeing more seasonal normal levels of backlog now.

That's perfect. Maybe I'm going to take 1 step back and just think about more of the strategy piece of it and talk a little bit more about Public Cloud. Maybe for the audience and those on the webcast, just unpack the cloud business again. What it is, maybe the relationship you have with Azure and AWS now. And really, the -- what I want to get at is when we think about cloud strategies, NetApp is really very much fundamentally or competitively different. Your integration with those cloud guys is definitely a differentiator.

Yes. So I'll start with the cloud storage services. I think that's the easiest for people to put in a bucket with NetApp. We deliver storage on-premises. We moved that to the cloud, starting close to 10 years ago now by putting our ONTAP OS available in the marketplace. Today, storage services represent roughly 60% of our cloud ARR, and it does drive -- we see good growth and good new customer additions there. And in that cloud storage services, there are 3 primary categories of service. The first is a fully managed service. So that's your consumer, you're maybe an app developer, you know your app is going to require storage but you don't know anything about storage. You don't want to know anything about storage. So you can go to the cloud and get a fully managed service. In Azure and AWS, that fully managed service is actually a cloud-native service sold by the cloud providers themselves. So it is branded, sold through the cloud providers, fully integrated into their console. It's not a marketplace offering. It is a true cloud-native service and that is -- that means those guys are in charge of selling it. And there is no difference in how they view it than any other of their cloud native services. We also offer a customer managed service that's cloud volumes ONTAP. That's the one we've had in marketplaces for almost a decade now. And that's if you're a storage administrator and you've got a cloud mandate or you've got a bursty workload and you like dealing with storage, perfect service for you to take. And then we offer a number of data services that kind of surround that. So we have a product called Cloud Sense that helps you understand are you in compliance with privacy regulations. We've got ability to help customers detect unwanted or atypical usage of data or access to data to improve your cloud security. So all told, that's about 60% of our cloud ARR. 40% of our cloud ARR is what we call cloud operations, and that's really helping customers optimize their cloud infrastructure, get more out of what they're doing. That is composed of 3 main pieces as well. The first is Cloud Insights, that's, again, a natively developed product. It is based off of OnCommand Insight, which was on-premises heterogeneous infrastructure, monitoring and management tool. We move that to the cloud, and it's a great cross-sell opportunity into the NetApp installed base. Then we have Spot, which was a company we acquired, and I'm going to put CloudCheckr, which was also an acquisition in that same bucket. And that does FinOps, right? So you're helping people reduce their cloud spending, understand where they're spending on the cloud and bring that overall build down very popular right now. And then finally, and the most recent acquisition we did is a product called Instaclustr. That's an open source database management setup. It helps customers make sure they're on the latest and most accurate version of those open-source databases. It also helps drive storage usage, right? So no one is going to choose the cloud because of the underlying storage service offerings, right? They choose the cloud and then they figure out what service offerings meet their SLAs and their requirements. Instaclustr is a decision point for customers, right? They're going to decide that they want to use Cassandra or some other open source database. At that point, if they're through the Instaclustr door, we can then direct them into the NetApp. So it helps move the NetApp storage purchase earlier in the cycle, and is a huge growing opportunity as most applications are built on some sort of open source database these days.

Yes. And so when we think about that ARR, that 60-40 split, is it cloud services grows faster than cloud ops? Are they both kind of equally -- equal in terms of the growth rate? And I think at the Analyst Day, you talked or you previously outlined, I think, the cloud ops piece of the business, you estimates like an $11 billion TAM. I'm curious of what the growth profiles look like between those.

So also at that Analyst Day, we said kind of in the future, we still think it's going to be roughly a 60-40 split. That said, if you look at just kind of what's been happening currently, it is a 60-40 split today even with the performance that we saw in Q2 on cloud storage. We're seeing in the cloud ops that we've added a number -- a good amount of ARR through acquisition that's got it up to that 40%. So really, there's been tremendous growth in the cloud storage side in order to maintain pace to keep the ratio steady even though we've been adding ARR through acquisition on the cloud ops side.

And I want to go back to kind of the thing I was kind of pointing out was the degree of integration. Maybe double-click on where you're at as far as Microsoft Azure files, integration there, AWS, FSx and Google kind of comparing and contrasting, if you will, where we're at in the ramp of those and the integration.

You got it. So in all 3 clouds, we are a cloud -- we are a native service integrated into their cloud consoles and that puts NetApp in a unique position our competitors are not there. Microsoft Azure has been our longest relationship, right? So that was the first cloud native service we offered. The Microsoft team sells that product, we deliver the service. We've been deploying hardware against that in the Azure data centers to support that service. Really good partnership. We've seen strong go-to-market and joint integration with those teams. It took a long time to get fully integrated into their data centers and their cloud consoles, but the effort from both companies is definitely paid off. In Amazon, we offer a software-based solution. And so that's FSx for NetApp ONTAP. FSx is Amazon's file system X which is sort of their generic file system. We're the first branded proprietary file system that they've offered. They have some others, Lustre and SMB, which are open source, and then FSxN is really the broad-based solution. Again, their sales teams are selling it. They use it to bring down the big enterprise licenses that they're delivering. In Google Cloud, we are also a cloud-native service integrated in their cloud console. Our sales teams are responsible for generating that demand. So in Azure and AWS, we say we're a first-party service because they're the first party selling the service. We're not there in Google. However, their sales teams can use the NetApp storage services to draw down the enterprise accounts and enterprise contracts that they sell. So there is some benefit to their sales teams for NetApp being integrated into their consoles.

Yes. And I want to go on to the Microsoft relationship because I think it's important. You've talked about, I think it was 75% to 80% kind of targeted gross margin on the cloud business over time. I know we're probably not there at this point, right?

Not yet. Because of some of the lower revenue numbers, Q2 cloud gross margin was just right around 68%.

Right. And I think one of the important levers there would be as that business scales, you actually absorb the fixed cost structure, right at the Microsoft relationship? Because again, for those that aren't -- you're putting your hardware in Microsoft, the other ones actually, your OS sits on their own hardware.

Right. So if you look across our cloud portfolio, the vast majority is a true SaaS offering. It's our software sitting on cloud-based hardware that somebody else has created. With Azure and Google, we're actually deploying our fully integrated storage systems against that opportunity. It is a bit of a drag on gross margin today because we're having to invest ahead of the opportunity. We're also taking the depreciation against gross margin. However, the usable life of these systems is far outweighs the depreciation life. So once we kind of swing through that, there will be some good tailwinds to cloud gross margin. Also as the percent of software-based offerings grows, that will also help us get to that 75% to 80% target.

That's perfect. So as the financial analyst, I have to ask kind of now some number of questions, right, and see where we go with this. So is there anything you could share with us as far as some of the key metrics, if it's average term dynamics or retention dynamics with regard to the cloud business that you've seen so far? Anything that you're willing to share?

Sure. So our net base -- our net revenue dollar-based retention rate in Q2 was 140%. That's down, which we had expected. As the base grows, there's no way that we can still maintain the 200-odd percent retention rates that we had seen previously. It's still well above the industry average and kind of above our target of 120% to 130%. So that number has been going strong. I mentioned that we more than doubled the number of customers with cloud ARR in excess of $1 million, and we still see continued growth there, good growth of new customers. Most of our cloud services are actually consumption -- well, about half of -- on a revenue standpoint, little over half are consumption based. So there are no terms, right? It gives customers the ultimate flexibility to dial up or dial down. It's great when they're dialing things up, you can get caught on the wrong side of it like we did this quarter. Cloud Insights, portions of the cloud volumes ONTAP. That's the customer managed storage service and portions of Spot are subscription services, and those are typically a year in nature.

That's helpful. Do you think that, that consumption mix changes at all over time? Is there efforts to kind of lessen that, if you will, volatility up and down.

So I think in Spot and some of the FinOps services, we've definitely been working on more subscription services. I think with the storage services, customers want that ability to dial up and dial down. So we'll stay there.

And then any metrics you'd share as far as what percentage of NetApp's hybrid customers are actually using as well this idea of the cross-sell opportunities.

Sure. So we cross-sell across our cloud products. And so we're seeing a good uptick in number of customers who use multiple of our cloud products. But we also have the opportunity to cross-sell from our on-premises customer base, which is large into the cloud as well as use cloud as a foot in the door and then come back around and sell on-prem. So today, less than 15% of our traditional on-premises customers are also using NetApp in the cloud. And for NetApp, we're only about 15% market share on-premises. So that means 85% of workloads that are migrating to the cloud are migrating off of competitors' gear. And if those are enterprise workloads, if those are workloads that are best dealt with a high-performance file system, NetApp really is the only solution. When you go to AWS and you say, hey, I'm migrating off of competitor X to you, AWS, your -- AWS is going to put you on for infrastructure, they think they put you on. And NetApp is one of the products that they sell, right? It is a cloud-native service, same with Azure. And so that's enabled us to get a foot in the door in customers that were formerly competitive strongholds.

I think you might have alluded to the answer to this question. You're only 15% market share, but if you had a customer that was a hybrid customer is deciding to make this cloud journey and move some of those workload applications to the cloud offerings. Is that not cannibalistic or is it...

I mean, if we had north of 50% market share, I would be worried about that. But again, the vast majority of workloads that are coming from on-prem into the cloud are coming off of somebody else's gear, and it creates a huge opportunity for us, and we do see a number of customers who are moving off of competitors' gear onto NetApp in the cloud.

So we shift gears off the cloud. We've talked a ton about it. So -- but that is the story for NetApp as you speak with investors. But the hybrid side of the business, obviously, a lot of discussion always around flash. And I know that you disclosed earlier this week, your flash run rate business. But I think the target you have is like 40% to 45% of your installed base by fiscal '25 being on all-flash arrays. I think we're up low 30s right now.

It was 33% last quarter. It's been moving about 1 point every quarter. So we measure that based on number of systems, right, so not customers because customers have a lot of stuff in their environment, but total number of systems, and that measures in the hundreds of thousands. So you don't see rapid change because customers aren't going to rip nondepreciated assets out. In the past couple of quarters, we've actually seen good growth in our hybrid flash business, so that's -- systems that are some combination of disk and flash. Last quarter, we also saw good growth in our QLC-based flash products. So that's a capacity-oriented lower price point, lower performance than the TLC flash solutions. That performed well. And that seems to be in keeping with some customer macro concerns and the desire to preserve as much budget as possible. That number will continue to tick up. We have the benefit of a singular operating system that spans all the media types. So we can be a little bit indifferent to customer choice. And if in economic downturn, customers choose to retrench to a different style of underlying media, that's fine. We're not -- we really have completely virtualized the underlying media, both from what sits inside a system, we've also virtualized the systems themselves. So customers can create a pool and they can add all-flash arrays or hybrid flash arrays or even all disk arrays to that singular pool, manage it logically and they don't really need to be so tied up around the underlying infrastructure. Now that said, there's a lot of reasons why people want to move to flash, and we think that will continue to grow. But again, we offer customers that flexibility because we have the single management layer.

And I think 1 interesting thing in the traditional storage market is that it's still a relatively fragmented competitive landscape, right? I think your numbers too -- you've got 15% market share. So in all-flash, it seems like maybe that's changing a little bit. So how would you characterize NetApp in the context of the competitive landscape for all-flash as that continues to be an issue with bigger piece.

So we're also #2 in the all-flash market. Dell is #1 in both markets. NetApp is #2 in both markets. We have higher share in the flash market because it is less fragmented. And as that market grows, right, the growth does accrue to a smaller number of players, which should benefit us over time.

The final couple of minutes I have left, I just want to ask 2 questions. One, just thinking about the gross margin, there's a lot of variables going on right now around probably NetApp like others have been able to implement some price increases, the same time, we're starting to see some deflationary component costs. So how do we think about -- and we talked a little bit about the cloud gross margin. But how do you think about the product, the hybrid cloud gross margin as we move forward?

Sure. So looking forward, there's a number of tailwinds that will benefit the hybrid cloud product gross margin. So we are currently paying $50 million to $60 million in premium and expedite fees per quarter to source sufficient supply, right? Everyone knows about the proverbial golden screw that used to cost $0.01 and now cost $50. So it's been a huge headwind to our product gross margin. We've absorbed that, right? We've not passed that on to customers. You can see the hit that we took in product gross margin. Then NAND prices tend to fluctuate, that storage media is a good portion of our bill of materials. We pass those commodity prices up and down on to customers. So we did some price increases when NAND prices were going up. Now NAND prices are going down, our intention will be to pass that back to customers. It's never perfect, however. And so in Q4, you'll probably see some benefit -- where we'll see some benefit from the declining NAND prices. But also as we move through fiscal '24 and those premiums go away that will be a significant tailwind to product gross margin.

That's perfect. And then the final quick question, just I kind of know the answer to this, but I'm just going to put it out there, right? The capital return component of the story is an important piece of it.

It is. So today, we offer a dividend, it's $0.50 per share per quarter and that's been pretty steady. We view that as sacrosanct where it's not going to get cut as our intention, dividends are permanent and ultimately should grow over time. Then we've tried to earmark roughly 30% of free cash flow to acquisitions. Now, we've taken a bit of a pause. We said, hey, we're pausing cloud operations acquisitions, while we focus on integration, make sure we get those products right, really sharpen our focus there. We initially made that commitment for the first half of the year, we've extended for the remainder of the year. And as such, we're returning greater than 100% of free cash flow to shareholders both in the form of dividend and now with some accelerated buybacks. We did $500 million of buybacks in Q1, slightly less in Q2. There should be some more bump up slightly in Q3 and then a dip back down in Q4. We've taken share count down by about 4% this year.

Kris, thank you so much. I appreciate the time.

All right. Thanks for having me.