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

Hi, everybody, thank you for joining Tim Long, IT hardware, comm equipment analyst at Barclays, very happy to have with him here from NetApp, CFO, relatively new CFO. But oddly enough, I did a fireside chat with this fine gentleman at their headquarters a few weeks ago. So we get to turn the tables a little bit here. So maybe I think you got to read a little disclosure, and then we'll start out.

Yes. Just make sure I read the safe harbor. So 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 then 10-Q filed with the SEC and available on our website at netapp.com. NetApp disclaims any obligation to update information in any forward-looking statement for any reason. Thank you.

Okay. Thank you. I appreciate the time. I know it's pretty crazy times for everybody. So got a few kind of hot topics here, but maybe we'll start off. You're still relatively new to the CFO seat at NetApp. So maybe talk a little bit about kind of your first year and maybe the priorities that you're focused on, and then we'll get into some of the parts of the business.

That's great. First, thank you so much, Tim, for having me, and happy to be here. So yes, first year at NetApp, very excited. It's a great company with great technology and great future. The key priorities are no surprise, focusing on revenue growth as well as profitability expansion. So basically, from top line to the bottom line, focusing on various elements, including our investment on the portfolio side, making sure that we're investing in growth opportunities with high ROI, all of our project from an R&D perspective and also looking at the go-to-market space, selling and marketing and making sure that we're investing our resources where we have the highest return on investment from a revenue generation perspective. On the -- and obviously, with the focus on growth and profitability, the fallout of that is continuing to improve on free cash flow generation. The company has had a great record of being very disciplined in investment, very, very disciplined in where the OpEx goes and also very disciplined in cash generation. And so my goal is to improve on that as well as continuing to focus our capital allocation like we've done in the past on continuing to invest in the business as well as returning capital to our shareholders. As you know, this year, we're returning up to -- actually, over the last few years, including this year, returning up to 100% of our free cash flow to our shareholders through dividends and buybacks. So happy to be here.

Great. Great. Let's get into sort of topics that we obviously get a lot of questions on, and we got to start with the product gross margin. Really great performance last quarter. You got the question a million times rising NAND environment. How do you deal with it? So maybe walk us through how you see the moving parts around product gross margin. I think it was a very big surprise, most in the hardware world, had pretty nice surprises. We can never tell with pricing or what's in inventory. So just give us your view of how to frame the outlook for product gross margins, particularly in the light of at some point, you're going to be facing more directly the increased NAND costs.

Yes. So we ended our Q2 with the product gross margin of 59.5%, which was a nice sequential improvement relative to the first quarter of the year. A lot of it was driven by improved cost, our cost structure. We did have -- we did lock in some good pricing on NAND for this fiscal year. And so for the remaining couple of quarters for fiscal '26, we expect product gross margin to be more or less stable. And the way we sort of think of it in the future is, obviously, if commodity prices are higher and we see headwinds on the product gross margin line, in the storage industry, we would pass increased prices or commodity prices as price increases to our customers. Just like also in a deflationary environment, we also pass the benefits in terms of price adjustments to our customers.

It's a good -- I mean I tend to think of this as if the prices are up for the key components, you're raising pricing. Most customers are probably buying on a dollar basis. So maybe they wind up buying less bits. But from a financial standpoint, it could be similar revenues and gross margin percent. Is that a good way to think of it?

I think that's a reasonable way to think of it. Our customers tend to plan and budget on a dollar basis. And so let's say they have budgets of x millions or x dollars, then they would basically come to us with what problems they're trying to solve, and we work rather to find the best solution for them in terms of what type of kit or what type of hardware/software we basically are offering. And then in the years where NAND prices are higher, they may get a little bit less of a footprint. In the years where NAND prices are lower, they may get more of a footprint. So that's a reasonable way of looking at it.

Okay. Yes. And in past cycles, I know you weren't there, but I'm sure you've looked at it. Just talk a little bit about how the company has managed through the changing commodity environments.

Yes. And look, we have a very experienced team on the supply management side as well as, obviously, on the leadership side. And in past cycles, we've managed through it really well. In fact, during those periods also, we saw increased EPS. And so we're -- we have processes, and we're very focused on that, as you would expect. The way to think of this whole situation though, if I sort of want to step back and look at our financial statement or our P&L, we really also focus on gross margin. I mean our gross margins are very healthy last quarter. We delivered a gross margin of 72.6%, which is really healthy when you look at the competitive landscape. We focus on gross margin, but we also focus on gross profit dollars. This is a key leverage for the sort of leverage points for the P&L. And so if I sort of want to look at that line and dissect how the various components of the gross margin line, we talked about the product gross margin, but there's a few other things that are happening within that line as well. One of them, if I want to think -- if I want to sort of stay in the Hybrid Cloud segment, one of them is our Keystone business, which is smaller but growing at a very healthy pace. In the first half of fiscal '26, the business grew approximately 80%. This also -- it has an accretive effect on the professional services margin. Within that same business we have -- sorry, same segment, we also have our support revenue that attracts 92-plus percent margin, very healthy. And then when you look at the rest of the components, our Public Cloud business, Public Cloud segment, that has been growing at a really healthy pace. Last quarter, if we adjust for the divestiture of Spot, that segment grew around 18% and delivered 83% gross margin. And so we're also targeting in that segment 80% to 85%. So we're sort of towards the middle of that range. But the point is that segment is growing. And so from a portfolio perspective, we have high growth and high margin components of the revenue as well. And so the mix is favorable for us going forward relative to gross margin.

Okay. Great. Great. Yes, I did want to transition to Public Cloud, so it's good you brought that up. You mentioned the 18% growth ex Spot. Optically, it's still going to be overall challenged on the growth rate until you anniversary the divestiture of Spot. But how are you thinking about the growth of that business on an organic basis? Obviously, the first-party storage is very strong. So maybe give us your sense of how well that piece of the business is growing and what will that growth rate kind of like once Spot is fully gone.

Yes, of course. So yes, so by the first quarter of '27 would be probably the first quarter we're sort of year-on-year totally clean because we still have the tail end of Spot in the fourth quarter of -- that was in the fourth quarter of fiscal '25. And so when you look at the businesses, as I said, the Public Cloud segment ex Spot grew at around 18% last quarter. Within that, the first party and marketplace, the business -- the portion of the business you mentioned, grew at around 32%. So it's growing at a fast pace. This is really the growth engine of the Public Cloud segment. And it's growing really for a couple of reasons. One, we continue to see healthy growth just basically driven by the growth rate of the cloud. In addition, we continue to enhance the capabilities and the offering. And so we have -- we continue to add features into our Public Cloud across the 3 hyperscalers. Basically, we are with Microsoft, Amazon and Google. When we -- when the business first started, it was very much in a narrower swim lane focused on Public Cloud environment. And now we're beyond that. We're also -- there's also exposure into the sovereign cloud and distributed cloud. And so there's more with the more features and capabilities. We're able to sort of expand the presence in the offering. Most recently, we brought block to our offering at Google in addition to the Amazon -- our offering at Amazon. And so we continue to make improvements. In fact, we also -- a couple of weeks ago, there were some announcements around integration with AWS AI on the Amazon public cloud, basically our native solution there. And so we continue to expand the capabilities. And the business is, as I said, we're targeting 80% to 85% gross margin in that segment. Last quarter, we were at 83%, and there's no reason for it to improve from there.

Okay. That's helpful. Yes, basically 10% of revenues now. So it's pretty differentiated from competitive storage companies or peer groups. So are you -- you guys have a very big lead in this cloud-based storage as a service. Are you starting or are you expecting to see some of the more traditional on-prem peers trying to develop this type of business model? Or is it they're so far behind, it's going to be difficult for them to replicate the success you've had?

Look, at the end of the day, we're focused on our capabilities and our offering. And we haven't -- so far, we haven't seen similar offerings in the marketplace. We have quite a bit of differentiation also in the offering itself because it's sort of -- it's all based on ONTAP, where you can also -- for customers who use ONTAP, Hybrid Cloud and Public Cloud, they have the capabilities to sort of move also seamlessly between the two. And so there's quite a bit of differentiation in that service.

Okay. And I believe there's a pretty healthy mix of new to NetApp as well in the Public Cloud. So talk about how you get those wins. I mean it helps to be cross-selling and have the hyperscaler sales force selling the solution on their own. So is that the main driver of the non-NetApp on-prem piece of that business?

This is a great point. So yes, I mean, it is a different another route to market for us. If you think of it as sort of our go-to-market routes, that's another route to market for us. And it does also attract new customers to NetApp, especially if you think of the customers that we typically don't reach with our on-prem business, smaller- to medium-sized businesses, for instance, that don't typically fall within the large enterprise target audience for our on-prem business. Those tend to be, obviously, new adds to NetApp. And it's -- as they grow, obviously, they could also expand into cross-selling into the on-prem business as well. So all in all, it's a great segment for us, and it's seen a great growth.

Okay. Great. Maybe if we go over to the tech conference, we got to talk AI. So in the context of NetApp and storage, obviously, it's been -- a lot of the AI has been large language models on big cloud. So there hasn't been a lot of storage arrays being sold. But you talked about a lot of data lake modernization. So a lot of customer accounts really growing. So maybe walk us through how you think AI more on the enterprise side is going to benefit NetApp.

Yes, of course. And so as we see AI moving from training to sort of training large language models to inferencing, we think this will also create opportunity for data storage or data storage modernization on the enterprise side. And so we talked about having 200 wins last quarter, which if we compare it to the same quarter in the prior year, it's almost double the number of wins. It's just -- we continue to see good momentum in terms of activity and wins in that space. We view these -- when we look at these wins, we categorize them into 3 categories. One is data prep. This is where enterprises are getting ready to implement -- for AI workloads, things like data lake modernization and data infrastructure modernization that enables them to have sort of a unified view of the data. And so that's one category. The second one is training and fine-tuning of large language models, either they're training their own model or fine-tuning sort of a pre-trained model to optimize it for their own data. And then the last category is inferencing. So you can think of inferencing or rack type of applications. And so the -- if we look at those sort of 200 wins, they're roughly around 45% of them was in the data prep type of category, around 25% in the training type of category and around 35% in the inferencing side. Now we think the last category, which is the inferencing is what drives really the data infrastructure and sort of data -- sort of our part of the market as it grows. If AI were to be successful, obviously, more and more inferencing will be adopted by enterprises. And that, in our mind, would create a nice tailwind and sort of growth engine for the data infrastructure.

Okay. Yes, investors like to see a revenue number, percentage, whatever. Do you envision these different AI use cases that NetApp has involved in a year or 2 from now translating into you having the ability to say x percentage of our business is now driven by AI? Or will it be too difficult to parse out with kind of the core business?

Well, this is the goal, Tim. We'll -- I mean, we'll -- as it becomes a more sizable portion of our revenue, then we should be able to be to quantify it and talk about it more in terms of the dollars [ and cents ].

Okay. And would there be any margin differentiation or difference with this type of more advanced use cases relative to kind of the traditional storage business?

It's probably too early to tell. I mean for me now, I would say probably not necessarily. Now if there's a certain element of data, let's say, services or software, bigger software element, then there could be some. But for now, I'm assuming that it's sort of in line with the current business.

Okay. Okay. Maybe back to -- you gave a forecast of, I think, 3% or so growth for next year at the midpoint. Talk a little bit about kind of the moving parts when you think of the businesses. Obviously, we're going to have very good growth on the cloud ARR piece. What's kind of underpinning the rest of that growth dynamic into fiscal '26?

Yes. So there's -- I would say a couple of things. In addition to the cloud continuing to grow at a healthy rate, I mean, we talked about the 18% ex Spot. So expect it to be in the sort of the high teens range. We expect, obviously, continuing growth in all-flash for the remaining part of the year. In fact, we're forecasting the second half of the year to be growing -- to be accelerating relative to the first half of the year. I think ex Spot, we're projecting around 5% or so growth for the second half of the year. Within that, there's also -- when we look at the U.S. public sector, we did see some weakness in Q2. We also see a subseasonal growth in Q3, but we think by the time we get into Q4, we would be getting back to normalcy. Obviously, this is -- this was a short-term effect from the shutdown, and we don't expect it to have a long-term effect on the business. And so when you put all this together, that gives us sort of -- we're close to that sort of 3% you mentioned.

Okay. And you mentioned all-flash array. It's been a pretty good move for NetApp. Obviously, it tends to be a little bit better margin, maybe 2 years ago or so, 2 or 3 years ago, really more aggressive with QLC NAND. So maybe talk a little bit about what you see the all-flash mix doing. And a little bit more exposure to QLC, maybe for some secondary workloads. What is that doing to kind of market share and ability to enjoy better margins maybe at not the highest end of the market but that mid-tier of the market?

Yes. So what -- if you look at our market share development over the last couple of years, we did gain share in all-flash. And part of that is some of the dynamics you mentioned. Obviously, part of that is also all-flash portfolio and our ability to compete very effectively. And of course, ONTAP is a big element of that. And so when I look at these dynamics going forward, those are the same type of dynamics that should allow us to continue to sort of see more traction and potentially gain share in the space. As of last quarter, we had around 2/3 of our Hybrid Cloud segment, very much on -- in all-flash. And so that continues to grow as a percent of the total.

Okay. And it's still a pretty small percentage of the installed base that's on it. So how does that translate to upgrades and as you're looking out the next few years?

Yes. If you think of the installed base, we're around 46% of the installed base sort of refreshed from hard drive. And so if you think -- the way we've seen it develop and the way we think of it also going forward, we think that should continue to increase approximately 1 percentage point a quarter. So to get to that sort of 60%, let's say, it's going to take us a few years. We still have a few years of growth ahead of us. And those, obviously, as you said, our all-flash array business tends to attract a little bit better margin. So that also, in a way, provides us sort of a tailwind to the margin for the future.

Okay. And when you're looking at kind of just the overall mix of the business, obviously, the Public Cloud is going to be faster growth. Keystone is smaller, but very high growth and the maintenance services business, pretty stable growth. So is this a dynamic where the recurring revenue percentage as well, given some of those pieces underneath will continue to tick higher for the company?

That's exactly how this works. I mean you described it much better than I would, Tim, but that's exactly how I think of it.

Okay. You mentioned public sector. You do have a fair amount of exposure there. So I guess the next quarter, still a little subseasonal. So that's just some conservatism around when we'll start to get approvals flowing and that type of thing. But outside of that, there's a lot of focus from the federal vertical, it seems to modernize. So do you think once we get out of this post-shutdown mode, we'll see that segment of the business in a much better growth algorithm heading forward?

Yes. So as I said earlier, what we've seen in Q2 and what we're seeing in Q3 is temporary. This is all sort of a result of the shutdown. We don't see a long-term effect on the business. And so to the extent that IT spending from the government side sort of increases in the future, we would be beneficiaries of that, and we should see that materialize in the business.

Okay. And one of the areas, other verticals that was a little bit more challenging was EMEA. A lot of macro situations over there. It seems like it was a little better last quarter. Where are we in the cycle for the Europe business?

So the nice thing about EMEA is we talked about it being sort of down in Q1. But in Q2, it came back nicely. I mean what we see is in Q2 is places like U.K. and Germany did well. It has a lot to do with GDP growth and how the GDP sort of the -- yes, GDP growth develops in various countries. We do have really a strong presence in EMEA. Our team did really great in the second quarter. And so we expect to continue to do well there.

Okay. Maybe just going back to the Public Cloud business. I think there was a period, maybe it was spot, but there was some elements of the business that were just far too lumpy and not predictable. When that's anniversaried and you got more of this first-party and marketplace storage, do you envision other offerings and other technologies? I mean you're getting block in, you're doing kind of some of the blocking and tackling and getting all the relevant offerings into the big 3? Do you envision either M&A or other solutions that NetApp can offer to leverage the pretty big installed base you have with those customers?

Look, from an M&A perspective, we're a technology company, and we'll continue to look at options for value-enhancing tuck-ins that would be basically good, nice complementary for our product portfolio. At the end of the day, we want to make sure we have the most competitive product portfolio that allows us to continue to drive the growth of the business, the profitability and value creation.

Okay. And then just back to Keystone, you mentioned the 80% growth, very impressive off a smaller base. Are you seeing customers wanting that type of consumption model? Is it a push model still? Is it a pull model? How do you see that happening? And how is the sales force at adding on this could be challenging if I'm selling an array for $100 compared to a Keystone for $30 over 3 years in a row, 4 years in a row? How do you manage that transition? And will that limit revenue growth a little bit until you get it up to more scale?

Yes. Well, look, we typically go -- we're very customer centric. We typically go wherever our customers want to go. We would -- we're always happy to propose to our customers the best in that suits their needs. And so in the event where Keystone is that, we're happy to work with them there. And if it's not, then obviously, in on-prem sort of CapEx solution would work. That's sort of one view. In addition, I would say it also depends on the customers. Some customers who aren't as sort of -- who are more sort of focused on this preferred subscription model or a consumption model would go for a Keystone agreement. From a NetApp perspective and from a sales team perspective, the team is compensated either way. So there's no sort of incentive. One way or the other, the team is incentivized to sell all of our services and provide the best service to our customers.

Okay. Maybe one last quick one. Would you say because others are trying for that on-prem business to turn into as-a-service business. Everyone wants less hardware and more recurring. The strong position you have with the hyperscalers and how mature that model is, how does that translate to helping Keystone be differentiated from what a Dell or an HP or others want to do?

I mean the Public Cloud business is an as-a-service business, right? And it's nice. It's all consumption based. Some of it is subscription. And so it's a nice complementary service business to the Keystone business. So if you think of, let's say, if I go back to some of the comments I made earlier about some smaller-sized customers who are not necessarily very large enterprises -- who would prefer to sort of get exposed to NetApp through the Public Cloud business, they could also be good customers or good sort of target customers for our Keystone service. So that's also -- they're very -- these 2 businesses are very complementary.

Okay. Great. Great. I think we're run up on time. Thanks for, I think, being the last presentation of the day, I believe. So really appreciate you coming out. Thanks, everyone, for listening, and thanks a lot.

Thank you so much, Tim, and happy to be here.