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

Hello, everybody. Welcome to Day 2 of Barclays TMT Conference. Tim Long here, IT hardware, commu equipment analyst at Barclays. We have Mike Berry, CFO of NetApp, with us this morning for the session. So thank you, Mike, for joining and thank you, everybody. I'm going to just read the safe harbor quickly. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risk and uncertainty. Actual results may differ materially from the statements made today for a variety of reasons described in NetApp's most recent 10-K and 10-Q filed with the SEC and available on their website at netapp.com. NetApp disclaims any obligation to update information in any forward-looking statements for any reason. Okay. Mike, maybe we'll start off just kind of high level here, talk a little bit about strategic priorities for the company as we look into 2023.

Sure. Well, thank you, Tim. Good morning, everybody. Thanks for having us. Yes. So let's take a look at NetApp as we go into calendar year and then our fiscal year. As we've talked about for the last several quarters, we think we're really well positioned around our priorities aligning with what our customers and CIOs tell us their priorities, are even depending on where the macro goes and that's really around data-driven digital transformation, cloud transformation. Clearly, security continues to be a concern as it should be. And a lot of the stuff we do around data protection and our products, both on-prem and in the cloud help that as well. So -- and we're focused around really growing the all-flash business. We've talked about that. A lot of our customers continue to want to buy, as we call them, hybrid solutions. They're especially in a tighter macro. There's a lot of workloads that work well there. And then, of course, a big focus for us is growing our cloud business, not only cloud storage, but also around our CloudOps, specifically around optimization and monitoring. And our go-to-market teams are really focused around not only driving increased penetration into the customer base, but also driving net new, and that's really where the cloud plays in order to us -- that's really the net new customer engine for us. So even going into what may or may not be a tighter macro, we'll see where we go. We feel like we're really well positioned. We're going to do everything we can Tim to control what we can control around running the business.

Okay. Great. Great. Let's maybe let's start with the cloud. And obviously, there's a little bit of disconnects last quarter. So maybe start with that and then kind of roll into just your broader offering and how you compete with other storage vendors and even native offerings from some of the cloud players.

Sure. So if I could, can I do the second one first?

Sure. Okay. Sure.

Let's just kind of put it in context with the cloud business is. And hey, we remain super excited about that business. We think that we have -- not think, we know that we have a competitive advantage. We have products that nobody else does. And we'll talk about that with our relationships with the hyperscalers. So if you look at the cloud business, about 60% of it is cloud storage. And this is going to break into what we call fully managed services, and this is where you have ANF, which is Azure NetApp Files, FSx for ONTAP, which is the Amazon solution. Both of those are first-party services that those sales teams and those companies sell that's powered by NetApp. They're fully integrated. Their sales teams get comped and measured on those. And then we power those. We do -- we provide those services through providing hardware to Microsoft -- excuse me, and then it's all software with Amazon. And then we're also fully integrated with GCP. And that's really important. That's the several years we've spent with them, fully integrating so -- and it looks and feels and it is like their service. So that's an important element there. The other 40% is CloudOps and the biggest pieces there are the optimization solutions with Spot and CloudCheckr, which especially in a toughening macro, we feel really good about. This helps them manage their cloud spend. And then you have Cloud Insights, which is a storage monitoring solution that we've moved into the cloud. So that's what the business composes of. Importantly, about a little over half of that business is consumption instead of subscription. So this is -- it's a great business model when it's growing, and you've seen even some of the software names, which is, hey, consumption allows the customer to burst up or down depending on their needs. So what we saw in Q2 is a couple of areas. We had a couple of a small set of customers that had -- this is one of the great use cases in the cloud, as they can burst data. They don't have to buy on-prem hardware and allow them to burst a lot of data and the project that we talked about was the chip-based design, where they can add a lot of data and they had done that over many quarters. We knew at some point that, that project will come to its natural end. This is an execution issue on us, Tim. We should have seen it sooner. And basically, when they're done with that project, they delete most of the data and they have the -- what they need. So that was of the 3 things we talked about. That was the largest issue in the quarter. We also saw some customers optimize their consumption. They may have, for instance, 2 years of backup that they had moved on to the cloud. They said, "Hey, we don't need to, we'll reduce at the 6" or they move data back on-prem because they had capacity, and that's a way for them to save their OpEx. So that was number two. And then number 3 is Cloud Insights, which we feel really good about the product. It's been a great cross-sell into our base. Think about this as managing your storage in the cloud. As we've moved our larger customers and they've moved to the cloud, they continue to use us on-prem. It's a product called OCI, OnCommand Insight that allows them to manage their storage environment on-prem. Cloud Insights is the on -- is the SaaS solution. And so they were basically using both of those. We sold them a certain amount. They thought that they would move faster to the cloud. That hasn't happened. So when those renewals come up, they're either downsized or reduced. We're not losing customers because there are customers on-prem as well. But that renewal motion has been challenged. Tim, that's the same thing we talked about in Q4. So there's some execution there. There's also some macro that we have to deal with. We still feel really good about the cloud business. It's $600 million, now growing at 50% plus. The number of customers that have more than $1 million of ARR have doubled. So underneath that large customer movement, it's still really good metrics, cross-selling into the base and then also selling more products. So that's what happened in the quarter. We feel great about specialty cloud stores where we have a competitive advantage. And you asked about competing with folks. Nobody else has a native first-party service embedded in the cloud. We are the only ones with the 2 largest.

Okay. Great. Great. I think maybe talk a little bit about kind of cross-sell of your cloud offerings and how you're able to and maybe while you're at it on-prem -- pulling more on-prem because still a lot of these are new to NetApp customers, so leveraging the on-prem into more cloud business and maybe cross-selling across these offerings?

Sure. So let's do -- we'll do the, call it, net new to NetApp -- lots of N's there, sorry. And that's really driven by not only ANF, FSx and Spot has been a great net new NetApp as well. So they come in either through the native cloud service or through optimization because they don't -- they may or may not be a NetApp customer. We've talked about in terms of our core base. It's still less than about 15% of our customers have a cloud solution. So there -- it's a little bit like the all-flash solution. There's a ton still of cross-sell into that. Now if you look at the enterprise customers, it's a much bigger percentage because the bigger customers have moved faster to the cloud. So that's the net new engine. It continues to be a great growth driver. And then once they come in, then we cross-sell. Probably the bigger cross-sell is our existing hybrid cloud customers, as they make the journey to the cloud. It not only may be Keystone, which is as Azure service but then more importantly, as they burst into the cloud, you see that. So a lot of the cross-sell that we do -- and we'll do deals where, hey, they'll refresh or renew and then they'll also move to the cloud. They may use -- because part of cloud storage, they can use the fully managed service or what we call bring your own, which is they use ONTAP and then they deploy them in the cloud. So in cloud storage, you have, hey, fully managed and then you have bring your own. And that's the big cross-sell that we see. That's a storage admin saying, "Hey, I want to move to the cloud, I'll manage it myself." That typically happens with our sales team. versus the hyperscalers. They're going to sell that fully managed service.

Okay. And then the -- talk a little bit about net dollar retention. I think we're around 140%. What's driving that positive result and whether you kind of see that trending over time?

Yes. So the dollar-based net retention was 140% last quarter, I think, down from 151%. We had talked, hey, we still think that -- and that's a little bit of a cross-sell. Again, think of that as a same-store type measure. We -- that continues to drive good growth. The percentages will come down just by the nature of its measuring against the bigger base every quarter. We've talked about, "Hey, that's probably 120%, 130% because we still want to have that cross-sell. But again, in cloud for us is also that's really the net new engine as well. Now those customers will typically come in, start a little bit lower, then they'll deploy in the cloud. They'll make sure it works, usually a backup or another workload that's not a production workload, then you'll see them take the data down and then they'll build it. So that takes a little bit more time, which is why that dollar-based net retention is pretty important because those will be customers on-prem, and then they'll follow the same pattern.

Okay. You mentioned Keystone. Could you talk a little bit about kind of traction there and what you think that will do as far as ramp and help with visibility for the business?

Sure. So we feel really good about Keystone as a product. And so this is our Azure service. So if you look at the hybrid cloud solutions, we offer either on-prem, Keystone Azure service which they can deploy in the cloud or in their data centers or ours. And then, of course, you have cloud, which to us is the ultimate Azure service. So for customers that are making that journey and they're not ready to deploy on-prem -- in the cloud or they have workloads that will work better on the hardware solution. We've seen that as well. So we feel good about it. That for us is it's a stepping stone really to the cloud. It also is something that through the channel we can offer as well. So it's making progress. But again, for us, it's part of that full solution of, hey, if you really want Azure service, the ultimate solution is cloud, but we will go where our customers want. We've seen good traction there, but we also want to be able to offer for them, hey, wherever you want to deploy, we're there.

Okay. Good. And I just want to see if we can go a little bit deeper on the cloud hyperscale partnerships because, as you said, it's something that others don't really have. So you talked about their sales reps being commissioned off this. How have those engagement worked as far as you got to GA and how quickly were they able to ramp? And how much motivation is there on their side to do this? I'm assuming it's somewhat customer-driven as well. But maybe if you can kind of go a little layer deeper on that.

Sure. So let's jump a little bit more into and we'll focus on the big 3. So even though AWS is the longest relationship we've had, most of the work and the biggest number in that cloud storage has been A&F. So that's been multiyears in the making, not only to do all the back office integration where when you're a customer and you buy ANF, it is another Azure product. There, we've deployed hardware in virtually all of their data centers. So -- and I won't speak for the sales motion of those big 3. They can -- they do that very well. For our perspective, we wanted to make sure -- so typically, you're going to see at least two units, right, primary, backup and all the data centers. We've then seeded that over the last 3 years. They focused mostly on the high-performance workloads because that's really their customer base. And for them to be able to really pull all of that business in terms of server network and storage. Again, we won't speak for them. We feel like our product, and we know is, hey, if you want to run a high-performance workload like the chip design, there's really only one solution, and that's NetApp because of our ONTAP software. So you've seen us build that. ANF has grown very nicely, and it is the biggest piece of that cloud storage. And again -- and then we have sales teams based off against ANF. So once they sell it, then we help go deploy it because our teams are the storage specialists. FSx has been now GA for a little over a year. That's a pure software solution runs in their data centers. It was available pretty much everywhere in the world when it was announced. And what you see there is because it's software, the customer uptake has been great. But it is not the big data migrations, high-performance workloads, it's more started with backup or other secondary as they've gotten used to it. And then we do expect that to ramp. It's still a pretty small number. The great part about that is, "Hey, it's all software, the margins are great." The software will get better from a performance perspective, but it does have to catch up to the hardware. And that GCP is offered mostly through the marketplace, but we are fully integrated in the back office. We'll see where that relationship goes. Again, great technical and customer connections there. And then for us, it's now -- again, we have those 3 teams. Once they sell it, then we help go deploy it and push the storage solution.

Okay. Maybe last one on the cloud vertical here. On the gross margin side, so it's something you're trying to ramp up. Maybe walk us through the progression to get to the kind of 75%, 80% gross margin range for this business.

Sure. So I guess about a year ago, we started to break out the segment reporting where we showed the margins for hybrid cloud and cloud and if you look at the historical data, that's grown very nicely. It's right now about 68%. It's still accretive to the company average. And a lot of that has been the scale we've built around A&F and then the new software solutions that come in. So our goal is to get that between the 75% and 80% over the next couple of years, and there's really 3 big drivers there. One is just scale. And we bumped up to 70% last year. We had to start doing capitalizing some software that pulled it down a little bit. We talked about that at Investor Day. So we're right about 68%. The path to 75% for us is continued scale. And as -- the nice part is as we continue to deploy CapEx with a little bit with GCP and then with Azure as well, those are typically going in data centers that have existing business versus us seeding new locations, and that's a much faster ramp. So that's going to help. In addition, as we grow Spot, Cloud Insights, those are cloud and software margins. They're going to be higher than that average. That's going to drive it up. And then the big thing for us as well is hey, we're depreciating all that hardware over 3 years. We're going to start to, in end of fiscal '24, the second half, you're going to start to see that cross between CapEx and depreciation, which is all the benefits that our on-prem customers get from using assets past their depreciable life, we're now going to get going into the next couple of years, and that's going to be a big driver of growth. So we feel good about 75% to 80% and then part of that, too, Tim, was, hey, as we do acquisitions, and I know we'll talk about that, those will be focused around cloud and software with higher margins. And the fourth piece is, hey, FSx, which is still pretty small. Fiscal '24 needs to be the coming out year for there, and that will help as well.

Right. Okay. Perfect. I was hoping maybe we could pivot a little to kind of on-prem more traditional storage. Obviously, everyone here at this conference is concerned about macro impacts and some companies are backlog, some are more lean now. So maybe just give us your sense of kind of what you're seeing on macro impacts to the storage market and how you think the setup is for the next multiple quarters here on more of the on-prem business?

Sure. So if we take a look at our hybrid cloud business, we had a good Q2 in a tough environment. We had talked about supply chain was an overhang. That's getting better every day, thankfully. We entered Q2 with, as we said, elevated backlog, largely due to supply chain. We exited it with seasonally normal. So everybody has backlog moving around from our perspective, as we go into the second half. It's similar to what we saw, I would say, back in fiscal '21 before we all had fun with the supply chain situation. So as we -- our 2 biggest products here are obviously all-flash. That continues -- it grew 2% year-over-year. It's now about 33% of our installed base, which, thankfully, is a very big number. The hybrid solutions, which from as fast as we call it, has actually grown nicely the last couple of quarters because those, hey, workloads work very well there, and it's more cost advantage. So we've seen some of our customers shift to that, which is great. We have object as well, and we want to be able to give them the solutions that fit their needs. We're not going to try to jam them into just all-flash for the sake of all flash. So as we looked into the second half, we started to see some of our larger customers, specifically in the high-tech vertical and can't pick up the paper in the morning without seeing all the fun people are having in terms of the unfortunate layoffs and other issues. We did very well in our fiscal '22 in the service provider segment. Think of everybody that provides services outside of the big 3 and then thankfully, we have a great business in Europe, but we all see what's going on over there with the unfortunate Ukraine conflict. So as we looked into the second half, we started to see some deals push or, hey, we have this project, we're going to chunk it into multiple steps, and we're going to take it a little bit slower or simply budgets come down. Now storage, we feel continues to be, again, a priority. You can't delay it forever because data continues to grow, but as we looked into our second half of the fiscal year, we're also cognizant of, hey, the calendar flips in January, and that straddles our quarter -- fiscal quarter. So we wanted to be prudent in terms of our second half. We still feel really good about the products. But hey, we're starting to see some macro slowing. And we also wanted to bake in Europe. Unfortunately, people can't even heat their houses these days. So we need to see how that plays out.

Okay. And maybe talk a little bit about NAND, was a big component of COGS for the products, and we've seen some good declines there. So how does that factor into the financials of the company and maybe the capacity that your customers are going to acquire from you?

Yes. So this has been an interesting thing for me. The NAND market is -- the drama is incredible. It just goes up and down. So -- and 2 pieces -- so let's do NAND and then we'll do premiums. So NAND will help everybody in the industry. Obviously, we've seen pretty significant declines in pricing. You've seen some of the manufacturers actually pull back on some of their capacity. They need to drive that supply down, so the pricing goes up. For us, after we exited Q4 and we had the unfortunate situation with the contamination, we did put some more NAND on the balance sheet so we could meet our customers' demands. You'll see that inventory work its way through the rest of the fiscal year. And then the benefits of the lower pricing will roll through the P&L. How much of that we take to margin versus pricing, we'll see because everybody gets us advantage. For us, the bigger driver on margins is the premium issue. And this is really more of a NetApp issue, where we've had to procure analog and low -- call it, low-value products in the open market, and we've been really open publicly that, hey, that's about a $50 million number every quarter. That's going to work its way down. And that's a big tailwind as we get to the second half and more importantly, fiscal '24. So all of that stuff plays, we feel good about that. It's not going to go to 0 overnight. We have some of that inventory as well. So both of those, and that's baked into the guidance we gave. I think the big question, Tim, is, hey, what does the industry do with the NAND reductions because as you've seen, it goes down and then it goes back up. So is that a temporary dislocation, we'll have to see.

Right. Okay. And then maybe, obviously, when we're talking about cloud, there's a lot going on, a lot of different products, solutions. What should we look out for on the traditional all-flash product cycles, innovations? What's going to be different there over the next year or 2 that can help NetApp maybe take some market share?

So most of our -- as we've talked about, hey, we're really a software company and most of the -- what you're going to see around product is additional enhancements to ONTAP. And the great part about that is we can used at both on-prem and in the cloud. Because ONTAP runs, obviously, our on-prem solutions, it's also what powers all the cloud storage in the cloud as well. So most of the stuff you're going to see there, I mean, we've talked about, hey, better storage efficiency, QLC and lower cost we focused on. But -- and while we don't talk specifically about road maps, we do new releases at least twice a year in ONTAP, and that's really focused around, hey, better utilization, better efficiency and also making sure that we are meeting those new workloads like AI and ML that we're able to support those, not only in the cloud but on-prem.

Okay. Maybe touch a little bit, NetApp does have a lot of kind of maintenance software, so a lot of revenues coming off the installed base. And I imagine the last few years have been net pretty good. So installed base probably looked little bit better. So maybe just talk about that kind of recurring revenue for the company outside of cloud, just on the core business.

Yes, it's -- you mean the $2.4 billion of support revenue? And that's -- and when we say ARR, that's only cloud. It's not connected to any other purchase. When you look at our total revenue, almost $3 billion is recurring. So the support revenue for us is obviously super important. It's grown nicely. The great part about that is all-flash has a bigger software component than the hybrid solution. And you'll see that roll through the support numbers as higher basically software support, which is great. So that's been obviously a very important part of our revenue stream. As we go into the second half in '24, we may see some customers say, "Hey, I may not want to do a refresh, but they'll end up renewing their support." So we brought in a new team, a new individual who's building that customer success team. One of the big go-to-market motions that we will continue in '24 is to move that renewal motion into that group. Hey, there are some customers that it needs to stay in the core sales team, got it. But most of that renewal motion can be done like almost everybody else in the industry with that customer support team and that -- because it's such an important revenue stream for us. That will also free up productivity with the core sales team. So we're excited about that. That's also the cross-sell upsell renewal team will have on in cloud as well. So yes, it's -- there's $4 billion of deferred revenue on the balance sheet in short term and long term. And it's -- like most technology companies, that's a huge revenue stream for us.

Right, right. Okay. Maybe take it to the finance part here, talk a little bit about capital return deals, buybacks and then maybe separately, just margins, gross and operating, what levers do you have to pull? And some of this will be coming back, as you mentioned, from higher cost and whatnot, which ultimately should normalize?

Yes. So, hey, we'll start at the top and then get to the capital allocation. So from a margin perspective, we do -- we've talked about, hey, we feel good about getting back to those mid-50s product margins in the fullness of time, and that time really depends on what happens with the economy and our ability to roll more than anything the premium savings through the P&L. So we feel good about that as well as -- and gosh, I've made it like 25 minutes, and I haven't said FX. So that's the other thing. I mean that's been a huge headwind to us because we procure almost all of our COGS in U.S. dollars. So when you look at the gross margin headwinds, about 300 basis points last quarter year-over-year was simply due to translation of FX. Then when we go down to operating expenses, we're obviously being very prudent about where we invest. We want to continue to invest in growth. But if, hey, growth is going to slow, we're also going to slow OpEx. And then, of course, incentive comp matters in there as well because, hey, if we're going to pull the numbers down, that affects all of us. That now goes to the shareholders. So those are the things we can control. From a capital allocation perspective, we entered the year and said, "Hey, we're going to put CloudOps acquisitions on the back burner." And this was really -- so we can, hey, CloudCheckr, Instaclustr 2 pretty big transactions within 6 months of each other. When you add 300 people in each of those and about $70 million of total ARR, we want to get that integration right and Spot in CloudCheckr, there's a lot of work there. So -- and that is not where we had the issues in Q2. That was -- those are performing fine. But we want to make sure and get all that integration right. So what we said is, during that time, we're going to up the buyback a little bit. So if the free cash flow number, call it, $1.1 billion that we feel good about for the year, $430 million in dividends, that stayed relatively consistent. And then it's really that $700 million of buyback. And we've always said Tim, hey, we're going to move that around based on the M&A pipeline. And so we will front-load those as well and spend a little bit more than 100% of free cash. You shouldn't expect us to be crazy and go lever up the balance sheet to do that because we want to make sure that we're using cash to drive growth.

Okay. Yes, I did -- you mentioned integration. So maybe it was kind of a lot of deals in a fairly short amount of time. So probably the last one here, but maybe talk a little bit about how you guys have learned about integration and kind of where you are with these different deals that you guys have done, and when you come back out of this window and you start looking again, will the company be in much better place to seamlessly roll something into the portfolio?

Yes, great question. So -- and we are still looking, by the way, and that's the other part is, from an M&A perspective, let's the valuation reset that we've seen in the public markets make its way into the private markets. And so it's -- in our mind, it's a little bit more of a timing issue. So in Q4, we talked about Spot. We didn't do a good enough job again execution of fully integrating that sales team, where we were minimizing the risk if we saw some attrition. And you're always going to see that and acquire companies. So our goal is around Spot and CloudCheckr to really integrate the go-to-market. While there are different products, it's the same use case and solution to our customers. And then the back office build one platform that basically does both of those. So that's a work in process. Instaclustr, which we feel really good about, still relatively stand-alone there. We need to integrate that more with the core sales team. Because when people deploy in the cloud and use open source, that's a natural solution then into their storage environment. So that still is work in process. But hey, all that G&A back office will do that. The product teams are working for us. It's really the go to market and make sure that our sales team -- we can't give them too many things to sell. How do we say, okay, that's a core sales team and this is a specialist group, and that's really the work going on. So that when we do other acquisitions, we can drop them in. The other thing I'd say is, hey, we feel really good about data services and data management, which really supports cloud storage. So -- and there's a lot of great opportunities across both of those segments.

Okay. Excellent. Thank you.

Thank you, Tim. Happy holidays.

Appreciate the time. Thank you for joining. Happy holidays.