NetApp, Inc.
Q3 2015 Earnings Call Transcript

Published: 1 Dec 2015

[Katy Huberty:]

Okay, let's go ahead and get started. Good afternoon, I'm Katy Huberty, Morgan Stanley U.S. IT Hardware Analyst and I'm very pleased to welcome NetApp’s Nick Noviello, CFO since 2012. Before that Global Controller of NetApp and held several senior finance roles at Honeywell in the past. I'm going to read quick disclosure and then we're going to jump into Q&A. We'll leave a few minutes for your questions at the end. Today's discussions may include forward-looking statements regarding NetApp's future performance which is subject to risk and uncertainties. Actual results may differ materially from the statements made today for variety of reasons which are described in NetApp's most recent 10-K and 10-Q filed with the SEC and available on their Web site at netapp.com. NetApp disclaims any obligation to update information in their forward-looking statement for any reason. So, with that, thank you for joining us.

[Nicholas Noviello:]

Thank you. Thanks for having me today.

[Katy Huberty:]

So, to start off the discussion, I want to ask about the bigger picture strategy at the Company, increasing NetApp has talked about leading in the next generation Software-Defined Data Center. When you look at the business, today it is still mostly selling infrastructure, hardware. So talk a little bit about what that transition might look like over time and the timing?

[Nicholas Noviello:]

Sure. So I think I would first draw a distinction between software-defined and software unlike and software-defined meaning we use our operating system and our operating system as a way whether in the cloud, near the cloud and in integrated system in a converged system to help manage data and help customers manage that data regardless of the environment they operate in. In terms of the future of the Company and how sales will look in the future, we certainly would expect that overtime there will be more software as a component of sale, but that takes place over time and customers will work through between now and then, the hardware they need in order to help them transitions with hybrid cloud environment. So that hardware again could be in a converged system, it could be in an integrated system. So we see that as part of the sale go forward. Although that mix can change over time and net-net what we’re trying to do is help our customers through the software, through the operating system manage the data that they are trying to manage. Again, whether it’s in their house or in a hybrid state, meaning it’s in their own environment plus in the cloud.

[Katy Huberty:]

As you shift investment towards cloud and flash and software-defined technologies and focus on harvesting the possibility in the traditional segment, you and everybody else in historic market have seen traditional storage decline. Does that actually accelerate as you more aggressively shift investments, or do you think the current high single-digit decline rate is sustainable?

[Nicholas Noviello:]

Sure, I think so first of all couple of pieces there. So we’ve looked at the traditional and we felt that that shrink is around 9% rate so high single-digit rate. We have on the other side a small but fast growing element of portfolio growing at about 20% rate in flash in all of the other elements of portfolio that we feel quite good about. We do have to manage the two. And we’ve been managing actually the decline of 7-Mode and the decline of our OEM business for some time now. We will continue to manage through this change and towards the other elements of the portfolio that are actually doing quite well; some small, some growing hybrid, flash, all of those pieces that we feel very good about. And again that is all about helping our customers manage data in this hybrid environment of future.

[Katy Huberty:]

The Company has talked a couple of times about not wanting to trade the flash portfolio with any other Company. Talk about what drives that confidence in the context of all these starts up in the space, growing very fast? And do you feel like the Company now has a full flash portfolio, or are there potentially areas where you may set up investments whether that would be organic or inorganic?

[Nicholas Noviello:]

Sure. So in terms of the flash portfolio, the elements of that portfolio that make up volume and material volumes of the business today are on the ES portfolio and then the All Flash FAS portfolio. ES in the second quarter which is the E-Series All Flash array grew 65% year-on-year and the All Flash FAS grew 445% year-on-year. Both of those are strong pieces of portfolio. The E-Series is a price performance tuned type of application, data management comes in as substantial data management on the All Flash FAS side. All Flash FAS from a technical and a commercial side of the fence competes well if not better than any of the startup vendors that are out there. So when we look at that we say we feel good about this portfolio. I wouldn’t ever say that we stop at that point in time or we just relaxed at that point in time. That includes our own development and that includes looking at inorganic development or inorganic pieces or portfolio in flash or otherwise that we could look at. So on the inorganic side, technology tuck-in is typically what we have looked at over time. We will look at M&A, we do build in even in our cash view and our view of how we utilize our free cash flow, M&A is important there. So and that is technology based and flash is part of that journey or that aperture if you will.

[Katy Huberty:]

How do you think about the balance of hybrid versus All Flash arrays longer term, are we starting to see All Flash with cost coming down cannibalize the hybrid market?

[Nicholas Noviello:]

Sure. First of all what we’ll look at the very beginning is what works best for our customers. So, we are not and NetApp is not going to be in a position or will not say to customers you should only look like this for your environment. We are much more apt to go to customer to try to understand what are their challenges that they are working through and then try to help them to understand how to most efficiently and effectively build that environment or morph that environment if you will, through those challenges using our data management operating system, which could be a hybrid or an All Flash environment, either way. So net-net we are kind of agnostic as to the approach what we want to be doing is helping our customers to manage data across the task through whatever medium that looks like.

[Katy Huberty:]

The All Flash FAS array is relatively early in its life, I don't know how much data you have, but do you have a view yet on what your win rates are in that business when you go up against one of the startups like pure stores?

[Nicholas Noviello:]

So on the win rate side, so first of all, we have seen a great ability with the existing installed base of customers and with new footprint with the All Flash FAS. We wouldn't get into talking about win rate versus one or another competitors specifically. What I would say is, there is probably some misperception out there that we are either technically or commercially challenged versus competitors or startups with our All Flash FAS and I would say on both of those measures that is absolutely not the case. From a technical perspective we meet if not beat all and from a commercial perspective the same. So I think a lot of those perceptions of what NetApp must have on the flash side or what NetApp doesn't have on the flash side through data that we will continue to show, we’ll get rid of those misperception overtime.

[Katy Huberty:]

Okay. And shifting to cloud where we're seeing increased adoption workloads shifting to some of the off-premise vendors. How do you work with AWS or Google or Microsoft or IBM top player, is there an opportunity to sell software to those customers or do you have a direct relationship or is that mostly working with your enterprise customers to connect their on-premise to these cloud of environment?

[Nicholas Noviello:]

Sure. So actually I think on that side there's actually opportunity on both ends. So on both ends maybe first on the cloud vendor side. So NetApp again, what are we trying to do is enable the operating system and enable our customers the path or the access to the hybrid cloud that means they are going to be owning infrastructure. We expect them to be owning infrastructure trying to make that infrastructure as efficient as possible overtime, but also needing to and wanting to access the public cloud. And by the way by accessing public cloud not being stuffed with one, but having choice, okay. So, with respect to the cloud vendors or those hyperscalers, there is an interesting partnership as an example of Amazon. So what is NetApp help, NetApp helps Amazon access enterprise workload. That's a great thing, that's mutually beneficial. To a customer, if you think about NetApp private storage, what are we trying to do? We're trying to smooth and we've been working on smoothing the connection between NetApp or between that storage through to AWS. So I can take a workload and moving to AWS and take advantage of that compute capacity or next week I can take that workload and instead of moving that to AWS, maybe I want to move it to Azure or to SoftLayer or to somebody else. So the power of the focus if you will on the data management side of fence is really trying to enable customers in that hybrid landscape of the future access to use of - smoothing of the use of their movement from one cloud to another. We think that affords them high availability, high efficiency in a future and we think from the hyper scale side, it sets up really an interesting partnership, because NetApp is a party who is trying to help smooth that relationship in hybrid world which is by its kind of definition pretty complicated.

[Katy Huberty:]

So at a recent conference the topic of that partnership Ecosystem came up and we talked about a little bit as the world gets more software-declined overtime. What are some of that partnerships that exist that present opportunity, but how could that evolve longer term, what type of new partnerships could we see add to the NetApp.

[Nicholas Noviello:]

Sure, so I think on the partnership side, NetApp has been from a commercial, from a technical perspective a friendly partner really over it's a lifetime and has kind of built its business that way, we continue to do that and whether you look at the Cisco relationship for one or the relationships through the channel, those are win-win relationships and we look to advanced those. So on the Cisco and FlexPod side of fence, we obviously look to advance that relationship that is good for both parties. In terms of partners in the channel, we have as part of the move to cluster data on tab, really look to bring education to the channel, look for leverage in the channel and that has been built out even more substantially over the last six months and change. Our cTAP program is another example of that. I think from the partnering side of the fence, you should expect to see NetApp continue to be front facing in terms of partners we brought in a new channel lead here in our fourth fiscal quarter. Again to build out those channel relationships and ensure that we mature those relationships, because we understand as a company that the channel is a leverage point and those partnerships are really leverage points that are win-wins on both sides.

[Katy Huberty:]

You just mentioned the cTAP program which is moving customers from 7-Mode to Clustered and ONTAP. The installed base penetration today is 17% that's been growing each quarter. How long does it take to runoff 7-Mode and fully transition the customer base? I know you have been support till 2020. Is that the time horizon or is there anything you can do to accelerate that?

[Nicholas Noviello:]

So first of all, 17% of installed base as of the second quarter transitioned to Clustered Data ONTAP. I think when we look at that we feel good about it. Obviously we like it to be faster sooner. Obviously, we also know that nine months ago, we had to more or less admit that we missed some pieces and we had to build out some pieces in that transition. And back to your question on partnerships, I think the work with the channel and the work in the partnership has been really important and helping in that transition. So the move from 7-Mode to Clustered Data ONTAP happens over time. We don't expect it to happen overnight. We expect some customers even by the time of 2020 may still be using 7-Mode and still may want to use 7-Mode and that's okay. So overall, we expect that the installed base will move when we look at that percentage of shipment of CDAT in the second quarter versus the percentage of shipments in the second quarter last year. It is up substantially in terms of the installed base also up very nicely. So we're on a trajectory we like. We obviously like to see it accelerate. I think that the cTAP program is an example of getting - looking for leverage points if you will. I see the channel has an enormous leverage point for moving this new technology and as we smooth out not only the channel relationships, what the program looks like as we move forward our top E-3 transition that we announced all of these things help in the move to Clustered Data ONTAP and we think that installed base will move overtime.

[Katy Huberty:]

As part of this transition you've announced incremental investment, early shift in investment as it relates to the sales and the service support as customers move through somewhat of a painful upgrade. At what point do you need to get in the transition where you can pull back on some of those expenses and let the incremental margins flow through?

[Nicholas Noviello:]

Well, I guess, I would think about it as perhaps not pulling back on the expenses as much as getting more leverage from the expenses and the investments we're making. And that's why I would actually say that the work on the channel is great. It's a leverage point not only in terms of perhaps where the dollars go, but how much work can be done, because all of a sudden we're talking about a set of own NetApp people who do the work with customers, but we're talking about 100s of channel partners that can help do the work and get paid for it and be able to roll through partner services and all of those things as well. So I think that the cTAP program’s the beginning. Really I would position it as part of looking to make investments for high return activities and then over time getting leverage off those investments. I don't necessarily see a pulling back. I see getting more leverage off of it. Over time, things like the cTAP program or things like other programs, we might end those investments. That's just a matter, if you get leverage then it becomes part of the ecosystem or it becomes of your operating environment and you no longer need to have that specific. That's what we look at over time and we've had that happened with a variety of things over time.

[Katy Huberty:]

And coming into this fiscal year, you originally expected a return to revenue growth by the end of the year which is in April. You have pulled that back, talk about what's driving the more caution stand? Was it a faster drop off of the traditional business? Was it slower uptake of the new product?

[Nicholas Noviello:]

Overall, we've been just wanting to be cautious around the macro environment that we've seen. I think both our Q1 and Q2 results were basically right in line with what we had projected for each quarter, with earnings on both a bit better, but we also want to be cautious here, we don't want to be out [indiscernible] obviously, our operational challenges nine months ago is something that is fresh in our minds and we just want to be thoughtful as we move forward here. Moving the operating system and moving Clustered ONTAP with our customers is not an overnight event. We think it is going very well, it is going to plan, but in terms of revenues for the Company, we want to conscious of not only that but also the environment we're operating in.

[Katy Huberty:]

This past quarter discounting and the pricing environment impacted gross margins by a couple of 100 basis points, something that other storage vendors have talked about. So, when you think about that change, do you feel like its other competitors stepping up on the pricing front, or is it NetApp now that you have made investments and put the cTAP program in place, starting to go on the offensive and willing to discount whether that would be the projected installed base or win new customers?

[Nicholas Noviello:]

So I think in terms of and maybe I’ll differentiate it a little bit. So we did talk in our second quarter about the variance year-over-year in product gross margin, and two points of that variance were discounting. In our first quarter and in our fourth quarter kind of going backwards about a point discounting, so it’s up a bit. The pricing environment and the environment is a bit more aggressive. I would say that we are also looking at being aggressive in a set of situations in environments where we see investment today translating to return over time. Because of the positioning of where we are not with Clustered Data ONTAP, I think we feel more confident in making those investments because we see the opportunity to bring on installed base, new installed base or new footprint in existing customers that’s a good thing. That’s a good thing for the long. So we’ll look at making those pricing actions to get in the door. The other side would be that we certainly see the ability to do that but at the same time run levers to ensure that we hit the operating margins we want to hit. So on that call or on the call a few weeks back, I talked about the expectation in that pricing environment or that aggressiveness of the environment would continue, but at the same time we talked about operating margins for Q3 and we talked about operating margins of 18% in essence for the back half of the year. So that shows you or I hope identifies the fact that there are other levers in the business that we are operating at the same time that we go after that higher discounting footprint and installed base.

[Katy Huberty:]

Sure, And then as you think about gross margin longer term, do you think the business recovers to the legacy level of margins as you get through the transition maybe the pricing environment comes down or do you see it largely as managing the OpEx to deliver an operating margin figure?

[Nicholas Noviello:]

Sure, I see some of both. First of all, we look at product gross margins in the second quarter were impacted by 2.5 points of foreign exchange that obviously normalizes out over time. So I think that is something that we will be looking at. We also manage productivity and the supply chain and we will be working that as well. We also look at inside the stack of gross margins, it’s not only about product gross margins, it’s the leverage we get on the service side of the fence and the services margins have continued to be strong and we’ve done a good job I think the team has done a good job in managing and leveraging that cost structure. So overall, I think there is upside potential on gross margins of the Company. I don’t want to get too far ahead of projecting a number at this point in time, but I do think that there is opportunity there. And in addition, we have opportunity down in the operating expense side. Though what I want to make sure or I want to make sure I’m clear on is that we don’t look at leverage on the OpEx side as we’re going to slow sales capacity or we’re going to slow development of new products. Really it’s a matter of saying no. Sales capacity ensuring sales capacity is in place, ensuring we’re building sales capacity, ensuring we’re developing new products that must continue. Can be efficient made more efficient, but it must continue the rest of the structure can be made more efficient. So I don’t want it to come across that we are going sacrifice growth potential or new product development potential just for making the operating margins of the Company Right. Our job is to be able to do both.

[Katy Huberty:]

Okay, and from a business model transition, we talked earlier about over a long period of time software mix will increase. Does that put upward pressure on margins or they are offset that you lose some hardware scale [indiscernible]?

[Nicholas Noviello:]

Yes, I think in terms of gross margin percentage and increasing software mix is obviously going to benefit gross margin percentage, but gross margin dollars are going to be less over time. But this is a transition that takes place over years and I think it will be our job to manage the pieces as we go there.

[Katy Huberty:]

This last quarter free cash flow was pressured, but you expressed confidence that the free cash flow rate as a percentage of revenue will come back in the second half. So talk a little bit about what were the factors that took free cash flow lower and how you can reverse that?

[Nicholas Noviello:]

And I think it’s a perspective really on the first half of the year. The first half of this year was a pipeline rebuilding period of time and frankly a credibility rebuilding period of time. So, in our first fiscal quarter as an example product revenue was up 25%, that’s going to impact cash flow. The second quarter was off not like that but it was off as well. Those things are impacting cash flow. We also had a once in 5/6 year event in the first quarter of a 14 week quarter. Those things move some of the metrics around working capital metrics per share move around because of that. So I think there are set of pieces there that pressured cash flow in the first half. We are projecting mid-teens for the back half of the year, so really a return to the model that we would expect to have over time.

[Katy Huberty:]

You’re currently returning the 100% free cash flow to investors. How do we think about what is the sustainable rate going forward?

[Nicholas Noviello:]

So the last time we had an Investor Day that we really talked about long term guidance, we talked about at least 50% return of free cash. I think over a 100 you are right, those types of numbers don't sustain overtime, I think what's most important here is that our focus is on one offsetting dilution and reducing share count over time and two, having a dividend, that grows overtime. Both of those have matters we look at and we look at cash generation the firm is very strong in cash generation and then capital allocation at every Board meeting we'll continue to do that and I think we'll continue and I would expect that we continue to be very forward in our view of what capital allocation looks like as a firm.

[Katy Huberty:]

I'll ask one more question and we'll see if there are any from the audience. Tom Georgens the prior CEO, when asked about acquisitions on last few years, he commented that there was somewhat of a fear of getting out that after the data demand deal and so, his focus was looking more tuck-in acquisitions that maybe went under the radar screen. Obviously there has been a change in leadership, you also have your largest competitor EMC who is arguably out of the market or hands are tied given their announced to acquisition by Dell. Is there a change in thought process as it relates to acquisition and the potential size of acquisition given the current environment

[Nicholas Noviello:]

So, I would say first of all on the M&A side of fence, we've talked about cash generation, we've also talked about cash usage, M&A has been part of that and we'll continue to talk about that. We have said that, tuck-ins make a lot of sense. We don't have an internal guy that says we must do X number of transactions every quarter, every year anything like it. It has to be tuck-in, let’s say that from a technology side, we see real value in, will we be brought transactions, absolutely where we look at larger transactions even transformational acquisitions we will and that said the larger they are the few and farther between they become. So, it's really a matter of - I wouldn't say the limiting our scope to only looking at one type or size, I think that our job is to look broadly and then at the end to deliver on the acquisition side of fence only those things that we think really advance the value of the firm, no surprise. So from time-to-time people say well, I think, I heard your name associated with X and that's large. Well, we're going to be invited to take a look at things, that shouldn't be too surprising. That said we have to employee and we do deploy a really disciplined approach to looking at acquisitions and to ultimately deciding to move forward or to pass all together on transactions.

[Katy Huberty:]

Okay. Understood. We have about a minute and half left. So if there are any question from the audience we can take those now. Questions? No maybe.

[Nicholas Noviello:]

Everybody wants to go home.

[Katy Huberty:]

Yes, everybody wants to go and get a cup of coffee. So, I mentioned the acquisition of the EMC by Dell do you see or believe that there will be any disruption or potentially benefit of that?

[Nicholas Noviello:]

Yes, we believe there is disruption happening now. And the disruption is really a variety of things, number one from a customer perspective, trying to understand what we will just look like going forward. I think the discussion of or rumor of asset disposition along the way will have customers concerned. Certainly the channel side as well we'll have some concerns. For us, what does that mean that really means there is additional opportunity. So when I think about our CRM, my expectation there is more opportunities or more opportunities that we feel like we can go after than before and we can go after with a very current technology with a thorough view on the hybrid cloud future with a Clustered Data ONTAP today with new customers and new footprints in the existing customers. So I think those are all really good things, now we're not going to kid ourselves that others aren’t looking at this disruption as well, but I think disruption exists not only up through transaction close, but for a period of time post that as they settle into what does integration looks like, what this new company will be, et cetera. So we look at all of that as opportunity and to the degree here is ability to gain installed base in that we absolutely want to run after it because installed base is very sticky once you have it.

[Katy Huberty:]

And it comes at a time where you set up investment in the channel and your own sales resources, [indiscernible].

[Nicholas Noviello:]

And we had the technology for it, and that future facing technology that is key for a hybrid cloud future.

[Katy Huberty:]

Good, great, thank you very much for your time.

[Nicholas Noviello:]

Thank you so much.