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

Before we get started, I'm going to read a quick safe harbor statement for NetApp. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risk and uncertainty. Actual results may differ materially from the statements made today for a variety of reasons, which I 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 their forward-looking statements for any reason. With that out of the way, I'm delighted to welcome NetApp's CFO, Mike Berry. Thank you so much for being here and taking the time to be with us.

Thank you, Wamsi. Happy to join. Thanks for reading that, by the way.

I always appreciate referring a copy of this. Well, you just reported earnings last week, noted some caution on the demand environment. But you also hope for some better growth in the second half of the fiscal year. Maybe you can help us unpack that a little bit.

Sure. So as we talked about during fiscal '23, like everybody else, hey, the macro is the macro. As we look at fiscal '24, we feel really good about making sure that we're doing what we can to control what we can. So as we go into '24, and I know we'll talk about it, we have a much better product lineup around capacity flash, entry level as well as block. We've already made a number of changes to our go-to-market, and I think we'll talk about that as well. Hey, goodness, hopefully, FX continues to not be an issue going into next year. And then, of course, the fund that we had with premiums around our gross margin. So as we look at that, we do feel really good about being aligned with our customers in terms of their investment priorities around cloud, around optimization, around AI. I'll only say that once. Thanks for not asking about it, by the way, in all of these different areas, both on-prem and in the cloud. And the other thing I do want to make sure we've had a lot of discussions with investors is, hey, the guide that we gave, it's a very normal linearity. NetApp, good or bad, typically, call it, 48% of revenue in the first half, 52% in the second half. Now the growth rates in the first half are a little skewed because we benefited from backlog last year. But outside of that, we feel like it's a very realistic guide that we gave.

Okay. So if we think about what is embedded within that guide, right? There's a fairly large product revenue decline, say, about 10% or so. [Technical Difficulty]

Unpack that a little bit. So when you take a look at Q1 and then the implied guide for rest of the year. If you normalize for backlog in the first half of last year, the growth rates actually get a little bit better. So in Q3 '23, product revenue declined by 19%, in Q4, declined by 17%. If you normalize for backlog in the first half of '24, those growth rates actually get a little bit better. And then towards the end of the year, it's not a hockey stick. It's a little bit of growth. And again, that goes back to we feel so much better about the product portfolio that we have. The go-to-market changes are not insignificant. It's fine to have, say, hey, you have great products. Now you need to make sure you align your go-to-market and you give your sellers what they need to succeed. And we're going to do that as well. Also, and I know we'll talk about it as it relates to product margins, Wamsi, is, hey, keep in mind, margins are both cost and revenue. And we want to make sure that our team has the flexibility around pricing, NAND's half of what it was 6 quarters ago or 4 quarters ago. And so we also want to make sure that they have the flexibility, and we've baked that into our plans and also guidance as well. So -- and the great part about those new products is those are areas that we haven't played in before. That kind of middle market capacity flash, hugely important entry-level flash and then block only. So we're also excited about going to get net new that we've not been able to do in the past.

Okay. So you spoke about go-to-market a few times. What are the changes that you are making specifically around go-to-market and also around how are you -- the selling motion around the new products?

Yes. Sure. So -- and the great news is we've already made all those changes. So we had our Converge, which is our in-person sales meeting for the first time in 3 years, and we all know why that is. So we talked about it on the Q3 and the Q4 call. For good or bad, we wanted our account managers, who is the face to the customer to make sure that they were -- they had incentives and that they were focused on both, call it, on-prem and cloud. So we set those comp plans up such that it was -- think about it as kind of 60-40, and then we asked them to do a lot of other stuff as well. And as you know, the buyers are typically different, especially in the larger enterprises. So we didn't do them a favor by asking them to do a lot. And then at the end of the day, hey, when you ask them to do lots of things, typically, you're not going to do well at either of those. So what we did going into this year is 3 really important areas. We took the account managers said, hey, your primary focus is on flash. Go sell all-flash and we then set the comp plans up to be simple and very clear around that. The cloud specialist teams that used to sit under those account managers we broke out, and we have aligned those with the hyperscalers because the hyperscaler go-to-market motion is different than ours. So we want to make sure that we -- they align to Azure, Amazon and GCP that we break those out. And very importantly, that we align with their account segmentation because their accounts may be different than ours. So that's super important. And guess what, their focus is first-party cloud storage, go get that. And then for CloudOps, that's a separate group. Now the account manager there will, of course, be, hey, make sure you do the right thing for NetApp. We don't want confusion to the customer, but very clear lines with those 3. And then sorry, there's 1 more, which is -- and we've talked about it in the past, is building the customer support group -- I'm sorry, customer success, I apologize for that, which is focused on activation, usage and renewals. And like most of the companies you follow, renewals will typically be in a separate group. Go focus on going to get net new either refresh or new storage systems, go focus on first-party cloud storage, that pulls a bunch of capacity from that team, and it's super important that then we realign those motions. Now look, for the top 20 or 30 biggest customers we have, renewals is all part of the sales process. But the rest of it, we can pull out. And that we started last year and will accelerate it in '24, all under the guise of the OpEx envelope that we have.

So on your first point, right, so what is -- what's specifically changing on the AFA sales motion to drive better AFA sales growth?

So there, it is -- we are aligning that sales team. Number one is from a comp plan perspective, the vast majority of their comp is focused on that. Go get all-flash. They now have the products that they haven't had in the past, and we've pulled out the cloud piece. Now again, if the customer wants to migrate to cloud, great, do the right thing, but comp plans and focus not only the account reps but also the [ SEs ], which are super important there. So now they have a great product lineup, and it is -- that is your #1 job, 1, 2 and 3. Before we would say, hey, you need to do this, you need to do that to get the President's Club. You need to do all 3, hey, we didn't do them any favors. And that's really the focus. In addition, there's a lot of changes around go-to-market, marketing, the way we address those markets as well. And it's not only enterprise, but also obviously commercial. And then importantly, setting the incentives up for the channel to also support that, which we could have done better at.

And since you said that you're segmenting renewals kind of differently, these are net new logos or opportunities that you're tracking for the AFA kind of sales motion. Where are you taking that share from? Or who do you think you will take that share from.

Yes. So importantly, there's 3 areas of focus, and then we'll get to the share. Number one is obviously net new. The other thing is refresh. And again, that is connected with renewals, so they have to work together. And then it's add-ons. There's a lot of that as well, hey, I need new controllers. My data continues to expand. I need to increase the size of my system. So it's all of those 3. Today, we've been too focused on our account base for all the right reasons. So when we look at going to get share, we look across all of them. Obviously, as the world moves to all-flash, we feel really good about being able to take share from, call it, the legacy providers as they make that move as well as some of the other large ones. And you certainly know who they are. We won't say anything pejorative about any other of our friends.

All right. Sounds fair enough. So maybe switching gears a little bit. What are the new products? And maybe if you could just quickly recap those. And why would those be incremental and not cannibalistic to what you're currently offering?

Sure. So we'll focus on the storage systems side. There's obviously a lot on the cloud side as well. So the big 1 is the capacity flash, where we have not had the right product to go after that, especially in the mid-market where we can go after get net new. We either had to candidly discount our high-performance flash or push [Audio Gap] because we didn't have that product. So that's the biggest one. It's already been introduced. It's already out there. We've seen great interest from our customers. It was just introduced in Q4, so it will take a little while. But we did see a couple of very large deals, for instance. So we're super excited about that. The other piece is the low-end flash where we've not been able to play. So it's an A series where again, we've had to discount the high performance, and that's an area where, especially in a tougher macro, we felt like we were missing out on a lot of opportunities. And then the third one, which has just been introduced, our ASA product line as block only. And now look, we have a lot of customers that use our products for block, but this is to go again get areas where we've not been able to go get because most people look at NetApp as file-only. And we're not, we do file, we do block, we do object. So this rounds out all of that. And again, those are net new areas that we've not been able to address with our product line. And again, we will give them all the flexibility they need from a pricing perspective to go get those opportunities.

Okay. So your AFA growth, I mean, did slow fairly materially over the past few quarters. What is the key reason for that? And I know in the past, George has spoken about penetration of the installed base. Where are we with penetration of the installed base and where can that go?

Sure. So as we talked about, especially in the second half of last year, in a tougher macro, we saw a big step down from really 2 areas, U.S. HITECH, which is a big customer base for us. And you all saw it in the newspapers what they did around their cost structures and certainly, spending went with it. They are typically the purchasers of the high-end flash and then the large enterprises worldwide as well. So that's where we had focus, which again leads to the importance of capacity flash. If it's going to move down a little bit, we want to make sure that we're there. So that -- those were the biggest drivers of the flash decline. That got a little bit better in Q4. It was down 12% on a run rate in Q3, down 4% in Q4, not great, but better. And then from a penetration, we're at about 35%. Hey, it's a big number, thankfully. And so we do expect that to incrementally continue to move up. It's like 1 or 2 points a quarter. We got a lot of questions about, hey, would there be an inflection point. A lot of that is when it comes up for renewals or they're going to move to the cloud. And then -- so it's more of a thoughtful progression versus just, hey, I'm going to go, do something different because CapEx, nobody likes to write-off fully depreciated equipment. So it's -- we think it will continue to be a nice function -- linear function. 70% to 80% is probably about the right number that we said we think we can get to flash. But I think that depends on, obviously, the technology, the workloads and the cost effectiveness.

So are you seeing that like within your own sort of AFA versus non-AFA mix, how many of your customers are looking at this through a TCO lens? And maybe anecdotally, can you share anything around sort of how that TCO is tracking?

So TCO -- I'll answer this from the CFO perspective. It matters a lot. Performance matters TCO and then, of course, the environmental aspect matters a ton. And that is where flash is just so much more effective and optimized for customers. So it is a big piece. Now workloads matter. So they're also not going to say, hey, we can go to flash just for those reasons, if spinning disk still works. And I know there are some other folks trying to really move that base. We're more focused on that capacity flash moving those 10K drive. And we've talked a lot about the environmental advantages of our product. It is a big piece, and it's only going to get more important.

Okay. What's changed in the public cloud for NetApp, right? I mean we sort of -- if you rewind back maybe to the Analyst Day, like 1.5 years ago, right, there were high aspirations for public cloud. You guys have done a lot. I mean candidly, you were one of the first to go be able to put some of your boxes in like some of the Azure data centers, and there was a lot of heavy lifting to be done with respect to public cloud. So what do you think is kind of led to maybe some of the revisions that we have seen since then?

Hopefully, everybody is awake now. Yes. So hey, we still have great aspirations for cloud. And let's kind of break it up between cloud storage and CloudOps. We feel great about specialty Cloud storage because we are the only ones. Again, we'll continue to say this with a first-party service in the 2 largest hyperscalers in the world. And with Azure, we deploy our hardware in their data centers and then they sell that as what's called ANF, Azure NetApp Files; with Amazon, it's called FSx for ONTAP, and that is where they've deployed our software in their data centers. So 2 different deployment models. GCP still does a little mix of both. That is their product, they sell it, we get a rev share and they get quoted and measured on it. So that's where we've seen most of the growth. And again, that is a lead that we think is virtually unsurpassable. Why? I'm not going to speak for the largest customer company in the world. But hey, we're in almost all their data centers. And in some of them, we have multiple pieces of hardware because that's where a lot of the growth is. So what we saw is very good growth there, and then CloudOps, we did the acquisitions, mostly around optimization and then certainly around monitoring that we do with Cloud Insights. So we've made a lot of great investments in those products. What we saw is, hey, when the macro hit, you saw it not only, obviously, in the cloud growth, but also more than half of our business in cloud is consumption. And it's a great thing for customers because you can ramp up, but guess what, you can ramp down. You don't have to wait for your subscription. It's not a start and end date. So just like a lot of the big high-flying software players, you saw that consumption come down. So the macro hit a couple of ways. The other thing is, even though we're not focused on lift and shift, most of our cloud storage is going to be on net new applications in those clouds. I think you've seen a lot of companies take a step back and just look at the economics of cloud. And as -- again, as a CFO of NetApp, hey, it's fine to put net new there, the economics of lifting and shifting in existing application is challenging to say the least. So I think you've seen that as well. We still feel very good about it. But hey, we've also taken a step back, especially around CloudOps. We've brought in a new executive, Haiyan Song, and we're excited about her coming in. We need to optimize that, do some more integration in the back office, also connect that with cloud storage that we haven't done as good a job on. So that's why we've taken a step back on acquisitions, specifically related to CloudOps. And we've guided for '24 that the majority of the growth should come from cloud storage. We still expect CloudOps to grow, but cloud storage is the growth engine going into next year -- this year.

Right. Okay. Support revenue was down quarter-on-quarter, which was kind of surprising. What were some of the drivers behind that? And how should we think about the trajectory over the next few quarters?

Yes. Given the importance and profitability of that, you can be assured we spend a lot of time on that. So look, here's the -- let's talk about support. Over the last 10 years, even with some variability in product revenue. Support revenue has continued to grow, albeit it gets a little choppy by quarter. The #1 thing to look at there is growth in deferred because the 90% plus of support every quarter comes off of deferred. And so what you saw again is grow -- and I'll talk about that. It's not only product sales that drive net new support, which is typically going to be a 3-year multiyear agreement. Hey, renewals is hugely important as well, and those are typically 1 year. And it is not a linear recognition through the year. So you get a little bit of bumpiness. We also get a little bit of what we call onetime. So somebody renews late or they do a co-term, you can get additional revenue in a quarter. We saw that in Q3, Q4 because of the linearity of when we do bookings and renewals, those are typically, Wamsi, back-end loaded. So that's why Q4 came down a little bit quarter-on-quarter. We fully expect it to grow in Q1 quarter-on-quarter, and we expect it to grow year-over-year in fiscal '24.

Okay. And so just around the timing of renewals and sort of thinking about the cadence of what has happened with product. The renewals piece is so big that even though you've had this product decel, you don't really expect that to kind of be material enough to impact forward quarter-on-quarter sequential growth rates even going into Q1?

Even going into '24. So this is super important, which is keep in mind that the support revenue is driven again by new products, and there is some. We'd like it to be more, but also renewals and in a tougher macro, you have customers that will typically use the [ phrase with ] their assets. They'll run them for a little bit longer, which means they'll renew. You can see that in the financials. So if you look quarter-over-quarter at deferred revenue, and when you see some short term growing by a bigger number than long term, then that tells you, hey, they're doing more renewals, renewal billings, then they are net new product, which will drive a 3-year agreement typically. Someone's going to buy CapEx, they're going to want at least a 3-year support agreement. So you can see that. And in Q3, you saw short-term grow over $100 million. And then in Q4, it grew almost $100 million. So you can track it that way. They're both super important. But keep in mind that product revenue does matter, but so does renewals.

Right. Okay. That's helpful. Maybe switching gears to product margins, right? They were pretty strong in the quarter. Can you talk a little bit about your confidence on the stability as it comes to gross margins, particularly because there's been so much talk about. And sort of what we're hearing from resellers around discounting and just sort of a much tougher pricing environment.

Sure. So hey, let's step back for a little bit. If you look at the last -- because there's -- we've got a lot of questions about this. The last 5 years, product margins at NetApp have been 54%, 56%, 53%, 53% and 50% this year. They dropped down to 50% because in the last 6 quarters, the supply chain has been difficult, and we've had these wacky premiums that we've been very clear of $40 million to $50 million a quarter. Q2 '22, it was 55%. Q4 '23, it was 55%. We had a trough, and we all know why. So going into next year, we feel good about 55% for a couple of reasons. One is, as you said, Wamsi, hey, NAND is down half, right? Now everybody gets that benefit. You'll see it in pricing. We have not assumed in any of our guidance that we're going to take any of that to the bottom line. We assume we will be flexible in the market, and we talked about that, especially related to new products. In addition, the big jump from Q3 to Q4 is the majority of the premiums finally went away. This is where we had to pay an enormous amount of money, and I won't say the word I'd like to say in public, an enormous amount of money to buy low-value products that went into distribution, and they took quite frankly advantage of the market, the supply engine, demand disconnect. That's largely gone away. Going into '24 that's baked into the Q4 number. We get even a little bit more in Q1. And then in addition to that, FX will help, hey, last year, that was a 2 to 3 percentage point hit because every dollar in revenue goes to COGS. So we feel really good about the 55%, still leaving room to be flexible around pricing. And keep in mind, too, mix matters, not only mix within all-flash, but the more all-flash we do, the better that helps margins as well.

And that's kind of consistent with your go-to-market investments in your plan so that you think that as that product growth sort of improves, migrates towards all-flash, but also towards high-end all-flash, that should also be a contributor to your year-on-year margin [Technical Difficulty]

Is in the middle. And in addition, we've also done other things like we -- now we have the NetApp One where you can buy all the software. I mean we've also simplified pricing that we think over the long term will help as well. So of all the numbers we talked about next year, I think 55% is one we feel really good about making sure that we can still be flexible on the top line.

Understood. What about on OpEx, right? Like you guys obviously had a fairly large restructuring that you announced a couple of quarters ago now. And as we think through your guide, right, you're talking about keeping OpEx largely flat. So why aren't we seeing a larger benefit? What are some of the offsets? And what kind of flexibility do you think you have as you look at the demand environment changes?

Yes. So thank you for that. And there was -- we certainly expected a question on the call about, hey, walk the OpEx, but everybody want to talk about AI. So we get to that. So hey, let's -- we feel really good about OpEx. Let's talk about the restructuring. So we announced that in Q3. If -- and we talk -- we disclosed head count. Hey, folks, we added about 1,000 people at NetApp between Q3 of '22 and Q3 of '23. Now 300 or so of those were from an acquisition. But like everybody else, we added a good number of folks. The restructuring reduced our head count by, call it, 900 to 1,000. It largely reduced it back to where we were entering '23. That's about a $20 million a year in OpEx benefit going into Q1 on a year-over-year basis. If you walk Q3 to Q4, Q3 was 677, you add the comp -- I'm sorry, Q4 to Q1, add the comp reset, which resets. That's about $20 million a quarter. So you add that and then you add Converge, which is our in-person sales event, $12 million, you get to that [ 705 to 710 in Q1. ] That's a little bit above [ 702 ] last year, and the big thing there is really Converge, offset by the benefit of restructuring that offsets a lot of merit and benefits that rolled from last year because even with head count, hey, merit has been a driver for all of us. So that's why we said, hey, relatively flat for the full year. Q1 probably a little bit higher because of Converge. Q2 will have Insight, which is our in-person customer event. And then it rolls through the rest of the year. Now hopefully, OpEx is a little bit higher because we do better, but that's not baked in right now.

Got it. Okay. That's helpful. I know we're almost out of time here, but let me quickly ask you about free cash flow. You returned almost 150% of free cash flow last year. You're targeting 100% this year. So hey, why is this the right framework? And secondarily, within that, like why not raise the dividend that's been kind of flat now for about a couple of years?

Yes. So hey, great debate. And I know there are some of our investors, hey, more dividends, some say more share buyback. Here's where we have landed as a company, which is -- so today, the dividend at $70 is almost 3% dividend yield. Hey, folks, we're not going to chase that up. You can get 4% to 5% in a savings account these days. So we think it's a really good foundation, and we've signaled [Technical Difficulty] We've taken a step back. But going forward, that will be a part of our growth thesis. The other thing we said is we will modulate the rest of free cash flow around share buybacks because it allows us to be more flexible as we go through the year. So we've looked at it. We've debated. We've decided as a company and a Board, let's leave the dividend where it is for '24. We'll continue to look at it. But again, with rates the way they are, we're not a dividend-yielding stock. As a big shareholder, I think it's a great benefit, but I also -- hey, that's permanent, right? You start raising the dividend, it becomes permanent. I'd rather have the flexibility as well as George to do more share buybacks. And if we want to be incrementally leaning forward on an acquisition. Hey, if you're paying the dividend, that's tough to pull that back.

And how do you think about the cadence of share buybacks and how programmatic are you about that versus opportunistic?

So last year, we did about 60% in the first half and 40% in the second half. We've signaled we'll be at least that front-end loaded this year. So hey, here's what I'd say, anything that starts with a 6 or 7 were a buyer in our stock and hey, we were buying back when it was over 90. So we will front-end load that was -- even if it takes available cash down in the first half because it will build in the second half. And we will be opportunistic depending on where it goes. And again, I think in the second half, Wamsi, this is when we'll start to think more about, hey, are there acquisitions that can support the storage business or CloudOps as we go into the second half. So -- and we'll leave flexibility for that.

And maybe last one, just talking about M&A, right? Like where are the areas that you see that would be interesting for NetApp from an M&A perspective? Is it more on things that would be add-on on the AFA side to build out the stack in some way? Or is it more on the cloud side? And particularly, I know you've taken a step back in CloudOps, is it? So where specifically do you think that there is opportunity for NetApp from an M&A standpoint?

Yes. So we're -- hey, there's still a lot out there. Valuations still need to come down a little bit. So -- and we think they will. Our focus is on 2 areas. What are the data services that we could bring on. They really wrap around cloud storage, either on-prem or in the cloud, because that's where -- again, that's where our strength is. There are some areas around CloudOps, around all of this SecOps, CloudOps, all of those FinOps that we've made a big investment in. So we'll continue to look at that. I think in the past, we would -- I would raise my hand and say, hey, I would rather see those acquisitions have a little bit more synergy to the core business, either on-prem or in the cloud. However, there are some good CloudOps as well. That's, I would say, probably in priority order, data services first, CloudOps second, not to say that second is out, but we kind of go that way.

Okay. I know we're almost out of time, but I did want to ask you 1 last question. And this is really -- And there's so much of a worry of a macro slowdown. I think you guys have done a great job in being able to manage your EPS and free cash flow to be kind of flatten to slightly up in a very tough macro environment. If the macro does get worse, is the focus to maintain that bottom line like the highest priority? Is it on free cash flow? How do you think about navigating a tougher macro environment? And what sort of -- you already got like maybe 10% plus product revenue decline, right? Like, I mean, we're going to talk about something that's got to be a lot worse than that for a worse outcome on margins or EPS. What sort of guide points or guardrails would you say there are to be able to navigate that?

Yes. So thanks for the question. Here's -- hey, that's not our plan for this year. We -- our expectation is the macro stays relatively consistent. And you look at all the things with the jobs reports and interest rates and stuff. Hey, I'm not an economist. I kind of wish I was because he could be wrong all the time. As we look forward, what we said is we expect the macro to be relatively consistent. Like every company, we have, hey, if it gets better, what do we do? If it gets worse, what do we do? And there are areas around each of those that will focus. We have plan Bs and Cs just like everybody else. I would give the team a lot of credit. We've done, I think, a really good job as a management team reallocating and that's what we would do first. How do we continue to drive growth while maintaining margins and EPS? What we don't want to do is cut so much that we hurt growth. But what we also want to make sure is that, hey, that incremental spending has to have a return. Quite frankly, I think we do better at making sure we don't hurt growth versus make sure that incremental spending drives growth. Again, we added a lot of those folks, and we've not been able to grow the company. So we have plans either way. I can't give you the bookends good or bad. We will be flexible. We watch this all the time. And it's a big -- obviously, like every company, it's a big focus.

Awesome.