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

We'll go ahead and get started. Thanks, everyone. Before we start, NetApp has asked me to read their safe harbor. 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 are 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 statement for any reason. All right. With that out of the way, I'd like to introduce Mike Berry, CFO. Thank you so much for joining us.

Kevin, thanks for having us.

Great. I thought a place to start would be maybe a brief intro of the company, your market position and kind of how that's evolved over the last couple of years.

Sure. So again, thanks for having us. Good afternoon, everybody. So NetApp has always been, and we will continue to be a leader in storage and data management. We enable our customers to build their intelligent data infrastructure. For a long time, our secret sauce has been ONTAP, which is our software, and that really brings us rich data management capabilities. So -- and as we look back, we were one of the early pioneers in unified file and block, and we've been in business now for a little over 30 years. We've now transitioned that to the hybrid cloud as well as cloud has been a big part -- our cloud storage. And when you think about NetApp, think about we can support any workload anywhere in any location are -- the things that we focus on, again, are data management, data protection, and data security. It's interesting. You talk to every investor in the first question is AI. You talk to most of the customers and the first question is data security, and it's all about that. So that's what we bring our customers, and that's what we focus on. And we've as well expanded into the cloud storage that we've talked about. And again, we've been around for about 30 years. Hey, we're everywhere internationally. And we've introduced a lot of new products. There's a lot of good secular growth that I know we'll talk about.

Yes. Great. No, that's a great intro. Maybe since you reported recently, I thought it would be useful to maybe just do a brief summary of the quarter. Any highlights and key takeaways you think are important from the results?

Sure. So we had a really strong start to our fiscal '25 that we're -- it's funny to say fiscal '25, it's only September. So if you look at some of the underlying metrics, our all-flash business grew by 21%. We're clearly gaining share there. That's our third straight quarter of super good flash results. Keystone, which is our "as a service" grew by more than 40%. And our first-party and marketplace cloud storage grew by almost 40% in the quarter. So those are the big growth areas. In the quarter, we had billings growth of 12% and revenue grew by 8%. We were then able to, as we always like to say, hey, we hit our commitments on the bottom line. Operating margin at 26% and EPS of $1.56, which are both records for our Q1. Now we took our beat in Q1 and we rolled it forward as well as raised a little bit in the second half. So a really good start to the quarter. Really good metrics. This is our third straight quarter, Kevin, of growth in billings and revenue and we're super excited about that.

That's great. I want to touch on some of the products in a bit. But maybe you could talk a bit about just kind of the demand environment you're seeing today. I think you've talked about macro uncertainty. So what are you seeing? How is that kind of impacting sales cycles and kind of the customer appetite to engage right now?

Yes. So we've said it's an uncertain market, but it's relatively consistent with what we expected. And we're cautiously optimistic. There are some geos and segments that are coming out a little bit, and there are some that continue to struggle. But it's exactly what we thought in terms of that. There's a lot of, obviously, noise in the geopolitical environment as well. I mean, gosh, who knows, is it going to be a soft landing. I think all of us are probably happy hey, rates can come down now a little bit. What that does, we'll certainly see whether it frees up spending or it's more how they spend it. So we'll see how that goes. A couple of months ago, we weren't really talking about a recession. Now, I think, everybody is -- it's in -- we're not seeing it. I think people are thinking that, that may be a possibility. But we've seen continued growth. If GDP is 2% to 3%, that's where we sit today, and we don't expect a major change either way for the rest of our fiscal year.

Yes. So maybe digging into some of the products, like C-Series has had really good traction. That -- it feels like that's really resonating with the customer base. So maybe if you can talk about maybe the runway for growth there. kind of the new markets that, that product line is kind of opening up for you, maybe starting with that, I think, would be helpful.

Sure. So for context, we have hard disk and hybrid drives and then flash. There's a big secular movement to flash largely as customers look to replace old 10K drive, the hard drives. And that's really where capacity flash is helping us quite a bit. We've seen that in the -- and we have high performance. We have capacity flash and then we have our hybrid drives. That's -- interestingly enough, it's opened up a market that we couldn't get to before. And it fills all the different workloads from VMware to database to file shares. And that's been a big part of our growth. That's a product that we introduced several quarters ago, and it's really driven a good bit of the growth for us. And we expect that to continue. Again, that midrange 10k market is the biggest market in storage and that's probably where you see that price sensitive. But it's also interesting, we've talked about some of our customers as they go down the path of the -- of Gen AI, we had a very large customer that's actually using C-Series for that. So it's going to fill in all the different workloads. It's really just dependent on the workload and the price point of that customer.

Yes. I guess, what's kind of the implications of kind of the -- the increasing cost effectiveness of flash, right? And maybe if you can talk about the breadth of the use cases that you're seeing and how that's maybe evolved over the last couple of years. I think that -- and I want to get to the AI discussion, for sure, in a minute, but...

I figured we couldn't not talk about that. So flash has just become more and more economical, especially in the last year with what's happened to pricing. So as it's moved down from the 15k, now down in the 10k, does that hit nearline drives? We'll see. I think there are still a lot of things that have to happen for that to be the case. So again, it's opened up a lot of different workloads. For us, it's opened up a market that we've not been able to get to, Kevin, because we either had to take A-Series and kind of fill it in or push up our hybrid solution. So it's given us views to net new workloads in our customer base as well as net new customers, which is super important for us. And from a margin perspective, we like it because it is higher than hybrid drives. So -- and when you drive net new there, that's certainly good for us and our customers as well. And the use cases, it's not just capacity, lower cost. Again, we're actually seeing some AI workloads being filled by capacity, which, I think, is great.

Yes. That's really helpful. I guess you mentioned A-Series. Can you just kind of talk a bit about -- I think you've made some traction there. It's still early, it sounds like. But talk about kind of where that fits in the portfolio? And I guess it's -- this concept of the unified storage product, right, and so if you can touch on that as well, that'd be helpful.

Sure. So our unified -- we do file and block and we've done that for a good bit of time. And that really goes back to ONTAP, the capabilities of ONTAP. So our new A-Series high-performance we just released, and that's going to address a certain part of the market, especially in block. It - while we do it today on unified, that's more dedicated and there are certain use cases that fills that bucket. So it's just relatively new, but we are excited about the pickup we've seen as well as the pipeline build. These -- all the new products are great, but they do take several quarters to actually...

To ramp up, yes. So I guess on to the AI question or the AI opportunity, right? I guess how does NetApp think about their market position. There's a lot of a lot of discussion right now, a lot of growth, but how do you kind of frame the market opportunity? And kind of how are you approaching kind of that market right now?

So AI, for us, is and has been -- it's a real business, and it always has been. And if you break up AI between what we call predictive AI, think of that as analytics, we've been doing that with a lot of our customers for a good bit of time. And this is where they're really taking machine learning and doing their analytics. So we've been doing that for quite a while. Gen AI is something that's new, that's coming down the path. And what we've said is as our customers, they're really spending time getting their data states ready. George talked on the last call, we had 50 wins of customers doing modernization of their data lakes. So as they want to make that transition on Gen AI, predictive AI, big business, we've done it, we'll continue to do it. They have to get their data states in order. They're obviously spending a lot of money on GPUs, in servers. And then storage will come as they move out of model training in the inference. And we think inference and RAG is really where they're going to drive all that data. Because today, hey, you can do model training in the Internet. But inference and RAG you're going to generate a bunch of new data, and that's where we think storage will really pick up. And again, everybody, including NetApp, we have a bunch of AI initiatives as well, but we need to get our data estate ready. So -- and -- but you do see a lot of customer spending around that modernization to get ready for Gen AI.

Yes. Yes. And I think you have a partnership with NVIDIA as well. Can you maybe talk about that and how that maybe differentiates your -- or kind of the approach you're taking that may be unique from some of the other storage players.

Well, if you talk about Gen AI, that's all focused on unstructured data. And NetApp likely, we think we have the world's largest data estate of unstructured data. So the CEO of NVIDIA was kind enough to call us out on stage at one of their last big events as, hey, this is where a lot of the unstructured data sits. We have multiple partnerships with them in terms of certifications and so our NetApp AI pod is certified on all of their GPUs. We have certifications across the board with them. They, of course, have relationships with pretty much everybody. But we feel really good about being one of the first vendors to get that certification, and it's both an A-Series and C-Series, which is super important. So -- and we think that, that relationship will continue to expand.

Yes. I did want to ask about your public cloud kind of solutions and kind of, I guess, the evolution there. Like, what percentage of the business is it today? And how do you think about kind of the growth in that segment of your business?

Sure. So if you take public cloud revenue as a whole, about 70% of it is cloud storage and about 30% of it is what we call cloud ops. And that's more optimization and authorization of your infrastructure. If you look at cloud storage, the biggest part of that is our first-party relationships with the 3 hyperscalers. And, not only are we the only ones with 1, we're the only ones with 3, where they've taken our technology, embedded it into their solutions and then sold it as their own product. They're all different. Azure is different than Amazon is different [indiscernible] and we -- and some of them, we actually deploy our hardware in their data centers or their use-software. And it's a huge competitive advantage because it's not only the work to implement those solutions, but they're -- fully integrate it into their console and so it looks and feels because it is their product. That is, by far, the fastest-growing part of that cloud revenue, and it grew again by 30% to 40% in the last couple of quarters. There is a shift from what we call bring-your-own or third party, where they've taken our software, Kevin and deployed it in the public cloud. But as -- instead of buying from us, most people are going to want to buy from the hyperscaler because there's hundreds of billions of dollars of unused commits out there, and that helped them burn that down. So we fully expect that will be the trend. To see first-party and marketplace grow, the rest of it declined, the great part about that is we should get through that by the end of the year. And public cloud revenue grew by 3% this quarter. We certainly expect that to be double-digit growth as we exit fiscal '25.

Yes. I think you talked about some -- the differentiation that you offer there. I guess maybe if you can talk about competitive landscape today, I think you've talked about some competitive displacements that you're successful with. So maybe just talk a little bit about what you're seeing there, both from kind of incumbents and maybe even new entrants coming into the market.

Yes. So NetApp has always had a great installed base, and we love all of our customers, and it's been a great spot for us. The introduction of C-Series especially has enabled us to go after 2 things that we could do, but not as well as we would like. One was net new workloads in our customer base. And then the other thing is net new logos. And as our customers are preparing, especially for AI and modernizing their data state. That's when we can now start to play. And it again goes back to ONTAP, the data protection, the data management that we are uniquely qualified for. We've now been able to do better at driving those net new workloads. A big part of that, and I know we'll talk about it is, hey, the go-to-market has done really well in going after those net new workloads. And especially as we continue to move renewals to our customer success team, that frees up a lot of capacity for that team to go chase net new.

Yes. I guess, has AI or Gen AI created more -- is that more of an opportunity? Or a risk? Are you seeing more new entrants kind of come in? How do you think about maybe AI creating a bigger TAM, but maybe more competition? How do you weigh those 2 when thinking about the opportunity?

Oh it's far outweighs the opportunity. We look at that -- there's not a lot of risk in our mind for a couple of different reasons. One is, hey, Gen AI is going to run on unstructured data. Even some of the small entrants that are there to do training, they don't have the data management capability. They don't have the performance. They don't have the security that enterprises will look to do when they roll out Gen AI. And the other thing is we have that great enterprise footprint that gives us a head start as well as we talked about all the certifications that we have with NVIDIA as well. So again, predictive AI, big business, doing it today, Gen AI is something that, we think, is going to drive significant growth, but in '26 and beyond, because customers have to get through that data modernization phase.

Got it. And I wanted to ask about Keystone. I know that product has been seeing some really good growth rates. It's a small part of your business today, but I guess, qualitatively, how would you kind of characterize the opportunity set there? How big can that get? And maybe when does it make sense for customers to go down that route?

Yes. So Keystone's done really, really well. And I think the team has not only positioned a great product, but also the way we position it is we want to give our customers choice. And if they want on-prem, great; they want to use Keystone, which is basically them doing a leasing-rental model from us on-prem, great. And then they have cloud, which is for some customers, the ultimate "as a service." So Keystone, we think, is -- there are some customers that want to stay there, great. Others are making that transition to public cloud and it grew over 100% last year. This quarter, it grew, call it, 60%. And again, that's something, I think, with the economy, there's probably some influence there. We don't try to influence that purchase. It's -- we'll let the customer decide. And to us, we're relatively ambivalent on-prem, Keystone or cloud, great. Here's the great part about all that, Kevin, it's ONTAP across everything. So if they want to deploy Keystone and then later on move to the cloud, it's the same software or if they want to bring it back on-prem. So it's a great solution. It fills a niche, but we're going to let customers decide.

Yes. You alluded to go-to-market. I guess it feels like the set of products and capabilities have continued to expand. And it does feel like NetApp's gone through kind of an evolution in terms of go-to-market. So maybe if you can maybe walk through the history a little bit and then kind of where we're at and kind of the tweaks you've been making more recently?

Yes. So -- and thanks for the question because we get a lot of questions about the product portfolio rightfully so. And it's interesting, and I've been doing this long enough with -- every time you miss, everyone points it to go to market, the go-to-market. It's -- hey, we need to give them credit. The go-to-market has really executed well. And you can introduce all the new products that you want, but if the go-to-market doesn't catch it and do well, it's going to fall down, and it has not. So let's back up for a bit. NetApp has your classic, I'll call it, 2-tier distribution where you have account managers, SEs, partner organization, super important. As we started to expand in cloud, we started to ask that -- think of that as the core sales team, Kevin, to do more than just on-prem. Do on-prem, but now we want you to sell cloud. And we bumped up, every year, the percentage of comp that was on cloud where -- and we raised our hands and said, "Hey, we went too far." We asked them to do too much. So going into fiscal '24, we said we're not going to do that anymore. Core sales team focus on selling storage, specifically flash. You've now got a great portfolio, go. And then the cloud specialists that we have, they're actually lined up against each of the hyperscalers go-to-market, and that's become much more effective. So focus brought a lot of great focus and performance. In addition, now going into the year, we've added AI specialists, because there is some specialization there. We try not to do a lot of specialists because that's just -- hey, that's a lot of cooks in the kitchen. But the go-to-market has executed very nicely. And in addition, we have, like, for instance, our -- USPS is a big segment for us, customer base. There, we have specialists because you need it. Otherwise, it's mostly geo, territory based. And it's -- hey, kudos to them, they've done a really nice job. And they've also caught the new products really nicely, capacity flash. And then the last thing, I mentioned earlier, like most technology companies, we're trying to move most of the renewals in-house where we have a customer success team responsible for that, that is at a much lower cost. And the great part is it frees up a bunch of capacity in the field. So we're able to still go get all those net new workloads without having to increase that cost, which has been great.

Yes. And I think you also -- do you have a separate federal team, like, in terms of verticalization?

We do.

Like, how does that kind of fit in? And any key verticals that you're particularly focused on or where you're kind of investing in terms of go-to-market?

We break out, publicly, our USPS, which is federal and state and local in the U.S. In the geos as well, we have a very large government segment there as well. So we don't break that out separately. That's just the U.S. part of it. That's probably the biggest sector because, again, governments are -- have their own nuances that come with that. So we try not to do, again, specialization underneath the geos. There is a little bit of, hey, some folks have high technology. And then, of course, AI will fall into certain sectors.

Yes. So we've kind of walked through some of these product lines and the go-to-market. I guess when you look at all the levers of growth, if you were to -- I guess not ranked, but if you look at, like, the top priorities right now and the drivers of maybe durable growth over the next couple of years, how would you kind of stack rank that in terms of opportunity right now?

So I would stack rank it this way. Flash #1, it's not only the growth in our customer base because about 40% of our controllers under maintenance are flat, so there's still a big, big opportunity there. And then with capacity flash as well as with -- especially as that secular growth of 10k drive. Then I would say probably AI, not in '25, but in '26, '27 and flash is a part of that. Cloud storage continues to grow really nicely. We feel really good about that. And then block storage, I only put that last because it's the most nascent. It's where we're starting, but it's the biggest part of the market. And while we do unified file and block, this is an area we can be super aggressive here, and we've said it because it's all white space for us. This is -- there's no cannibalization. It's all net new. So over time, that one should move up. But as we look to '26, that's how I'd rank them. And we talked about this at Investor Day kind of laying out those same road tracks.

And you kind of alluded to this briefly, but on the partner ecosystem, I guess where are we in terms of how important they are in kind of influencing deals and kind of just the breadth and depth of that, the partner ecosystem? How is that going to evolve over the last couple of years?

So it's always been good and it remains good. This was not an area that, I think, we had to invest in. And it's a great partner group as well as they're super important partners, not only just for distribution. And you see in the 10k, I mean a lot of business goes through them, but more importantly, to drive net new business. And I think our focus over the last couple of years has been much more on hey, we want you to drive net new business. The economics are there for you if you do it. Yes, there is, call it, the passing paper, important part. But the partner team has done a really nice job in terms of driving programs to drive net new business, not just moving paper, which is super important and necessary, and that's been the focus over the last couple of years.

Yes. Any questions from the audience? I did want to ask about, I guess, gross margins. I mean, I think you've seen some nice expansion there. I guess for folks maybe a little bit newer, if you can break down the components, right, that are driving that. How much of that is kind of mix shift? How much of that is pricing? If you can -- and so I guess -- and then if you can comment on the durability there and how you see that kind of expanding -- gross margins evolving over the next couple of years.

So this is going to take a while. Are you okay with that?

Yes.

So hey, if you look at NetApp from fiscal '21 to '24, we -- gross margins -- total gross margins have increased from, call it, 67% to 71% to 72%. Operating margins have gone from about 21% to -- we've guided now 27% to 28%. The drivers are, let's start at the top. We've been able to grow revenue, and that's the easiest way to grow margins. So revenue growth has helped. The components of the revenue growth are super important because we talked about this. In product, it's been mostly flash, and flash, on purpose, has cannibalized the hybrid business, and we did that for a reason. In addition, thankfully, support continues to grow at low to mid-single digits but at very high margins. So that has helped gross margin. And then cloud now finally, we're going to -- we expect to see that growth and those margins are back above 70%, which is what we had expected. So when you look at the gross margin growth, most of that has been in revenue growth and revenue mix. Certainly, we've benefited from lower component costs. But all that's largely washed out, Kevin, when you look '24 to '25. And then take it 1 more level down, we've also been able to drive operating margin growth because the team does an awesome job at managing OpEx. And it's a little bit like that location, location, location thing. We try to say, in every new thing, if we want to invest incrementally, what can we kill, what do we need to stop doing to go invest there? We've introduced a slew of new products with largely a small increase to the R&D envelope. Sales and marketing has continued to drive revenue growth with largely the same envelope and the G&A teams do a great job of being efficient. So it's really a corporate mandate, which is, hey, we want to make sure and be able to drive efficiencies. I mean, I would -- hey, when I started 4.5 years ago, it's probably -- the thing I had the least appreciation for was the leverage in the model at NetApp because it all goes back to we monetize our software through the hardware sale, but we are, at heart, a software cloud company and the margins there are just different. And you've really seen that over the last couple of years.

Yes, that's great. Maybe a question on just capital allocation. I know the company has a history of returning cash to shareholders. You talked about some of the puts and takes in terms of OpEx growth. But I guess, how do you think about the right balance of investments in the growth versus shareholder return, right? And maybe even potentially inorganic growth via acquisitions?

Yes. So a great question. So we look at investments, especially in product as either be in OpEx for R&D or acquisitions that are, call it, tech and talent, and that's really, Kevin, a roadmap acceleration, right? Instead of building it, you'll go buy it, you'll integrate it. We'll focus on that from an M&A perspective. In the past, we focused -- we've done acquisitions around what we'll call adjacencies, where you buy businesses that bring into new markets. Those haven't performed as well as we would like, candidly. So we've taken a step back there and said, "Hey, let's focus on tech and talent to make sure that we're investing enough in the product. And then, of course, there's larger acquisitions that everybody looks at that we'll continue to. But we're focused on the smaller tech and talent. That then enables us to take -- well, this year, 100% of free cash flow and allocate it to dividends and share buybacks. So over the last 2 years, we've driven down share count by 4% a year. And then going into this fiscal year, we upped our dividend as well. We can't chase the yields of the investment grade but it is a nice, call it, foundation of return. And so that is the goal going forward. We'll focus on acquisitions, but they'll be mostly the smaller tech and talent.

Yes. Okay. That's very helpful. Any other questions from the audience? I may end it with just a question on, I guess, what are you most excited about kind of the NetApp story over the next year or 2? What's --maybe what are you most excited about/what's maybe the most underappreciated kind of from the investor base?

So I'm most excited about continuing to drive leverage in the model, even though all the questions we get about are what about component costs. And hey, the model just -- it does, it has a leverage. And I think I'm most excited about -- and I'm confident about that, and we talked about it at Investor Day, there's more sector growth drivers now than we've ever had. The new products, we've never had the product slate that we have. The cloud storage is finally starting to grow like we thought it would at really good margins. And our ability to continue to drive leverage and shareholder value while growing the business, we feel great about. And here's the other thing, if -- we will continue to manage it. We'll be prudent managers, we always have been. So I'm -- hey, I get up every day with 1 goal in mind, which is how do you increase shareholder value. And that, to me, is the leverage in the model and the ability -- when you can grow revenue at NetApp at the same time, boy, that's just -- that's a great equation.

Great. Well, I think that's a good place to end it. Mike, thank you so much for being here. Really appreciate it. Thank you.

Kevin, thanks for having us. You bet. Thank you, folks.