Netapp Inc (NTAP) — Q4 2015 Earnings Call Transcript

Hello, and thank you for joining us on our Q4 fiscal year 2015 earnings call. With me today are CEO, Tom Georgens; and CFO, Nick Noviello. This call is being webcast live and will be available for replay on our website at netapp.com along with the earnings release, our financial tables and guidance, a historical supplemental data table, and the non-GAAP to GAAP reconciliation. As a reminder, during today's call we will make forward-looking statements and projections with respect to our financial outlook and future prospects such as our guidance for the first quarter and full fiscal year 2016, our expectations regarding areas for investment, expectations regarding market acceptance of clustered Data ONTAP, our ability to drive growth and operational and financial performance, our expectations for our evolving business transition and our expectations regarding our business model and FY 2016, all of which involve risk and uncertainty. Such statements reflect our best judgment based on factors currently known to us and are being made as of today. We disclaim any obligation to update our forward-looking statements and projections. Actual results may differ materially from our statements and projections for a variety of reasons. We describe some of these reasons in our accompanying press release, which we have furnished to the SEC on a Form 8-K. Please refer to the documents we file from time to time with the SEC, specifically our Form 10-K for fiscal year 2014, subsequent Form 10-Q quarterly reports, and our current reports on Form 8-K, all of which can be found on our website. During the call we will discuss non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of our GAAP and non-GAAP results is provided in today's press release and on our website. I'll now turn the call over to Tom for his commentary on the quarter.

Thank you, Kris, and thank you all for joining us. We are not pleased with our results in the fourth quarter, and on today's call, I will outline the key reasons for our disappointing performance as well as the steps we are taking to position NetApp for the next phase of our evolution. I will then turn the call over to Nick to provide additional detail on the quarter and our expectations going into fiscal year 2016. Before we open the call for questions, I will return to summarize the reasons for our continued confidence in the business. As I've discussed on past calls, the IT industry is undergoing a radical shift as customers rebalance their IT investments to take advantage of the cloud. IT organizations will deploy a mix of on-premises and cloud-based resources, which has slowed the growth rate of the storage market. Every IT vendor is faced with this transition and the successful ones will evolve their business to incorporate this new reality. We are well positioned for the era of cloud computing and with a robust portfolio of hybrid cloud solutions that enable customers to meet the current and growing demands of their business, while adopting new technologies and delivery options. NetApp itself is also undergoing a significant transition with the conversion of our customers to clustered Data ONTAP. On our last call, we talked about the execution challenges in our Americas commercial business that materialized late in the third quarter. We also discussed the need to increase our go-to-market capacity. After a thorough analysis of these challenges, it is clear that we underestimated the disruption that the transition to clustered ONTAP has had on our direct and indirect pipeline. The disruption has been most acutely felt in our Americas commercial geography due to the heavy concentration of large enterprise customers in the U.S. Clustered ONTAP is a re-architected and modernized version of the ONTAP technology. It is our platform for the next decade of innovation. However, to fully realize the benefits of this technology, customers have to update existing storage management processes and migrate their data. While the value of clustered ONTAP is driving momentum with new customers and new workloads in existing customers, many of our largest installed base customers have been resistant to upgrades until feature parity with the traditional version of ONTAP was achieved. This is even true in cases where customers have standardized on clustered ONTAP for new workloads elsewhere in their environment. The inhibitors to upgrade have now been mitigated with the generally available release of clustered ONTAP 8.3. Our largest customers now see a path to the advanced innovation and functionality of clustered ONTAP and are planning for migration. Since most of the upgrades occur in conjunction with hardware refreshes, we have seen delays in new hardware purchases until planning for process changes and downtime windows can be completed. This planning can be complex and as a consequence, customers are deferring hardware refreshes and extending the life of existing gear. The financial impact to us is lower product sales and increased short-term service renewals. The complexity and duration of clustered ONTAP transitions have implications on several dimensions. First, it reduces predictability in some of our largest accounts. We saw that in Q3 and it continued in Q4. Second, our smaller accounts, which are often partner-led, are similarly facing this transition. While the installations tend to be less complex, we are often dependent upon our channel partners to guide them through the process. Those partners that have made an investment in clustered ONTAP training, typically our largest, have had a good year. However, others who are not as well-versed in selling clustered ONTAP have seen their customers defer upgrades, which has negatively impacted our channel business. And third, the effort to drive this conversion has adversely impacted our ability to acquire new footprints and new customers. The net impact of these dynamics has resulted in an insufficient pipeline to meet our bookings objectives. To drive pipeline expansion we are taking concrete actions. First and foremost, we must accelerate the adoption of clustered ONTAP within our installed base now that the feature inhibitors have been removed. This requires an investment in training and migration services. The objective is to unlock the tech refreshes that are waiting for clustered ONTAP upgrades. Some of these upgrades at our largest installations are complex and will be driven through direct engagement. But others are far simpler and can be facilitated by our channel partners. Therefore, our second action is to invest in the training and assistance necessary to build the confidence and competence in our broad partner base. And finally, to offset the diversion of field focus in addressing these issues, we need to be actively engaged in acquiring new customers and new footprints through both direct and indirect channels and we will continue to invest in our sales capacity to create additional bandwidth. Overall, we remain confident in the value proposition of clustered ONTAP and our customers' commitment to the transition. Certainly, we see some customer consideration of alternative cloud-based models, but we do not see as much risk from on-premise alternatives. It is unlikely that customers will adopt competitive technologies that have fewer features and require even more complex migrations when compared to clustered ONTAP. Therefore, we are confident that our investment in accelerating clustered ONTAP migrations will unlock business. Likewise, the need to broaden our reach to address more customers through sales capacity expansion, both direct and indirect, is an investment that we expect to yield positive results. While our once-in-a-generation re-architecting of ONTAP has created a complexity for our sales channels that we are addressing, the rest of the portfolio has shown excellent progress. Looking ahead to the next generation of IT, we see the cloud as the biggest transitional force in the industry and for many use cases, it provides flexibility, economics, and functionality that cannot be achieved with on-premises solutions. We are focused on accelerating enterprises' ability to realize the full potential of the cloud, while recognizing that they will deploy a hybrid model with both cloud-based and on-premises resources in their IT environments. Our strategy for the hybrid cloud and our portfolio of solutions provides customers with the only consistent way to manage, secure, and protect their data regardless of where they choose to store it. NetApp hybrid cloud solutions weave together disparate data elements into a single integrated architecture, giving customers control and choice with the flexibility, elasticity, and ubiquity of cloud resources. The customer feedback on our hybrid cloud strategy has been outstanding. It's viewed as relevant, compelling, differentiated, and real. Even for customers who are not ready to go mainstream on the cloud components, the completeness of our story and the enablement of their future direction are proving to be reasons to buy NetApp solutions today. NetApp private storage for cloud gives customers the flexibility and economic benefits of a multi-cloud solution without the risk and regulatory concerns associated with relinquishing data stewardship or the threat of cloud vendor lock-in. During the fourth quarter, we further augmented our cloud solutions with new models of SteelStore as an Amazon machine image, giving customers an efficient and secure approach to backing up cloud-based workloads. Additionally, for customers who want a scalable, durable object storage solution for long-term archives, we have delivered on a major new release of StorageGRID Webscale which adds support for industry-leading storage efficiency, support for Amazon S3 as an integrated object storage tier and introduced the StorageGRID 5660 appliance. We also released updates to OnCommand Cloud Manager and Cloud ONTAP, giving customers new capabilities to speed business innovation and IT responsiveness. We offer enterprises a choice of cloud providers and the ability to select based on cost, performance, and service levels. Our cloud solutions demonstrate our commitment to enable customers to fully realize the flexibility and economics of hyperscale clouds and to do so as a seamless extension of their on-premise environment. Other new elements of our portfolio have shown excellent progress this past year. Almost half of our enterprise customers are buying multiple solutions from our portfolio, proving that we are much broader than just ONTAP. Unit shipments of branded E-Series, inclusive of the all-flash EF family grew by 45% from Q4 a year ago and more than doubled in fiscal year 2015. E-Series augments our storage offerings with a high-performance SAN array for environments that do not require the level of data management provided by clustered ONTAP. Additionally, OnCommand Insight, in use at the largest companies in the world, continues to exhibit strong growth with orders in the fourth quarter nearly doubling from a year ago. OnCommand Insight allows IT organizations to monitor their heterogeneous storage infrastructure and optimize asset utilization, which is critical as they manage through constrained spending environments. Much of the acceleration of the growth of these products in fiscal year 2015 resulted from bringing product specialists into a single organization focused on bringing new products to market. We recently added our hybrid cloud products to this organization, and it will continue to be one of the areas of increased investment. We are excited by the increasing thought leadership of our cloud offerings and the sales momentum of the newer products, but it has been more than offset by the slowdown in the aggregate ONTAP business. New investments in traditional ONTAP deployments have been declining with unit shipments down 30% in fiscal year 2015. But the story of those customers who have made the transition to clustered ONTAP is a cause for optimism. Clustered ONTAP delivers a software-defined, flash-optimized, cloud-enabled operating environment with a set of enterprise-wide data management capabilities independent of the underlying hardware. Customers can grow incrementally and non-disruptively with the flexibility of a wide range of deployment options from conversion-integrated systems to third-party arrays as well as software-only and cloud options. We see a growing number of clustered ONTAP customers up 135% in fiscal year 2015 from the prior year. The bulk of this growth came from new to NetApp customers, which were up roughly 250% in fiscal year 2015. The number of repeat clustered ONTAP customers was also robust, growing more than 140% in the year. Additionally, shipments of clustered nodes grew 138% from Q4 a year ago and for the full year, they grew 163%. The attach rate of clustered ONTAP continues to increase with roughly 50% of FAS controllers shipped in the fourth quarter going into clustered environments. Once transitioned to clustered ONTAP, we see customer growth above current industry growth rates. Clustered ONTAP is also a vehicle for our leadership in key emerging segments of the storage industry. In converged infrastructure, FlexPod had another good year with unit shipments up almost 20% this year. More than 70% of our FlexPod systems are shipped with clustered ONTAP. All-flash FAS with clustered ONTAP is the only unified scale-out all-flash array on the market and gives customers the ability to deploy a high-performance node in their storage pool without having to make compromises. The clustered ONTAP-based all-flash arrays have demonstrated the ability to match the performance and efficiency claims of the point product all-flash solutions, while uniquely delivering the scalability of clustering and the industry-leading data management of ONTAP. Rather than creating yet another island of infrastructure, NetApp seamlessly integrates flash into our data management framework that not only extends to disks but to the cloud as well. Shipments of all-flash FAS grew significantly at more than 350% from Q4 a year ago and for the full year, they grew 260%. In the fourth quarter, 72% of all-flash FAS arrays shipped as clustered configurations. Ultimately, we remain confident in the innovative value proposition that clustered ONTAP offers IT organizations as they build out their hybrid cloud environments. Customers and partners who have made the transition to clustered ONTAP are growing and this underpins our confidence that now is the time to position investments towards our three priorities of accelerating the migration to clustered ONTAP, regaining traction in the channel, and increasing our sales capacity. I'll now turn the call over to Nick to provide details on the fourth quarter and our expectations for the first quarter and fiscal year 2016. Nick?

Thank you, Tom. Good afternoon, everyone. We are disappointed that our performance in the fourth quarter fell outside of our previous guidance ranges. As Tom discussed, we are experiencing not only a market transition but a transition related to clustered ONTAP. We achieved our financial targets in the first half of fiscal year 2015, but in the second half a combination of FX headwinds and weakness in our Americas commercial geography negatively impacted results. While we are confident in our strategy and technology, we need to retool aspects of our business to position NetApp for long-term growth and strong sustainable shareholder returns. We expect that there will be disruption related to this transition in retooling during the first half of fiscal year 2016 but that by the second half we will return to a growth trajectory and to our business model. I will talk through this further after I review Q4 and fiscal year 2015 results. Net revenues for Q4 were $1.54 billion, down about 1% sequentially and down about 7% year-over-year. Our results fell short of our previous guidance range due to the impact of continued weakness in our Americas commercial sales geography and unfavorable foreign exchange rates. FX headwinds reduced sequential growth in Q4 by about two points and year-over-year growth by about three points. For fiscal year 2015, net revenues were $6.12 billion, down 3% from fiscal year 2014, reflecting about a point of foreign exchange headwind. Our revenues were on plan in the first half of the fiscal year, but lower-than-expected branded revenue negatively impacted the second half. Branded revenue was 93% of net revenues in Q4 and at $1.44 billion was up 1% sequentially and down 7% year over year. The year-over-year decline reflects four points of foreign exchange impact with the remainder due to weakness in our Americas commercial geography. OEM revenue of $102 million was down 18% sequentially and down 7% year over year, in line with expectation. For the year, branded revenue was $5.6 billion, down 2% from fiscal year 2014 and flat when adjusted for FX, again reflecting weakness in our Americas commercial geography. OEM revenue was $473 million, down 19% from last year, as expected. OEM revenue ended the year at less than 10% of fiscal year net revenues and has normalized to a level of revenue that we will no longer be discussing separately. Indirect revenue through the channels and OEMs declined to 79% of Q4 net revenues compared to 81% in Q3 and 83% in Q4 last year. From a geographic perspective, all geos performed as or better than expected in Q4 when adjusted for FX with the exception of Americas commercial. Americas' commercial revenue declined 8% year-over-year, primarily driven by the challenges Tom talked about associated with our clustered ONTAP transition and sales coverage. Product revenue was $913 million in the fourth quarter, down 2% sequentially and 12% year over year. Adjusted for FX, product revenue was down 8% year-over-year. Over the course of fiscal year 2015, including in the fourth quarter, we saw an increase in the number of short-term support renewals. We believe these renewals would show up on the balance sheet largely in short-term deferred revenue as an indication that customers remain committed to NetApp, but are not yet ready to do a tech refresh and to upgrade to clustered ONTAP. The combination of software maintenance and hardware maintenance and other services revenues totaling $626 million in the fourth quarter was up 3% year-over-year or 5% adjusted for FX. Non-GAAP gross margin of 62% was down 2.6 points from Q3 and below our prior guidance range. Product gross margin of 53.4% was down 5 points year-over-year due to FX headwinds, higher discounting, and unfavorable product mix. Software maintenance gross margin was down almost a point year-over-year but flat to Q3. Hardware maintenance and other services gross margin of 62.6% was relatively flat year-over-year, reflecting increased revenue offset by infrastructure investments in people and projects. For fiscal year 2015, gross margin of 64% was almost a point above fiscal year 2014 and at the high end of our previous guidance range. Non-GAAP operating margin for the fourth quarter was 15.6%, below our previous guidance range due to lower revenue and gross margins. We held operating expense dollars flat from Q4 a year ago, aided in part by favorable foreign exchange. However, operating expenses rose as a percentage of revenue, as we were not able to reduce costs in the business at the same pace as the revenue declined. Operating margin for the full year was down just over a point from fiscal year 2014 and a point below our previous guidance. Q4 non-GAAP EPS of $0.65 was below our prior guidance range due to lower revenue and lower gross margin. Our non-GAAP effective tax rate was 16.5% for fiscal year 2015 and 16.7% for the fourth quarter, slightly higher than prior guidance reflecting normal course year-end true-ups. Q4 weighted average diluted share count of 313 million shares decreased by almost 4 million shares from Q3 due to repurchase activity in the quarter. Over the course of the year, we reduced the weighted average fully diluted share count by 8% to 321 million shares. Now, turning to cash and balance sheet metrics. We closed fiscal 2015 with just over $5.3 billion in cash and short-term investments, approximately 11% of which is on shore. Inventory turns decreased to 16 due to a buildup of finished goods to support a higher anticipated level of demand than was recognized. Days sales outstanding increased to 46, reflecting typical seasonality. Deferred revenue was up $88 million in Q4 versus Q3 and up $97 million from Q4 last year. Free cash flow of $359 million was about 23% of net revenue in the fourth quarter. Over the course of the year, we generated $1.1 billion in free cash flow, marking the fifth consecutive year of strong performance. At approximately 18% of revenue, fiscal year 2015 free cash flow was within our previous guidance range. Finally, we repurchased approximately $246 million of stock and paid $51 million in cash dividends during the quarter. We completed the $3 billion share repurchase program we announced in May 2013 a year ahead of our original schedule. We also commenced purchasing stock related to the $2.5 billion share repurchase program we announced last quarter. As you may recall, our board of directors authorized $2.5 billion of repurchases by the end of May 2018 with the first $1 billion of repurchases expected to be completed by the end of May 2016. We have enhanced our capital structure, and during the year once again delivered on our commitment to return capital to shareholders while continuing to invest in the business. Through dividends and share repurchases, we have returned approximately $3.5 billion to shareholders since May 2013. Today, we announced an increase of 9% to our next cash dividend to $0.18 per share of the company's stock that will be paid on July 23, 2015. We have now increased the dividend 20% since announcing the program in May 2013. At current stock prices, the new dividend rate represents a yield of approximately 2%, which reflects our confidence in the long-term strength of the underlying business and our ongoing commitment to driving shareholder value. Now, I'd like to spend a few minutes discussing our business outlook and guidance. We remain confident in our business over the long term. However, consistent with Tom's comments, we are in a period of transition and consequently expect some impact while we retool the business for the future. The disruption related to this transition will impact the first half of fiscal year 2016, but by the second half, we expect to return to a growth trajectory and to our business model. Related to this transition, we are focused on balancing disciplined investments with profitability to drive our business priorities and ultimately generate value for shareholders. With respect to our expense structure, we are intent on returning to a level of operating expenses commensurate with our operating model. We are committed to looking for efficiency, taking cost out of our structure, and redirecting resources and people to the highest return activities. We recently executed a set of decisions across our cost structure that will generate savings in fiscal year 2016, including a reduction of our global workforce by approximately 4%. For fiscal 2016, we expect net revenues to be no better than flat with FX headwinds and limited top-line predictability in the first half and an overall recovery in revenue growth in the second half. Though ultimately dependent on revenue mix, growth, and our continued actions to drive down costs, we expect fiscal 2016 gross margin as a percentage of revenue to be down about one point from fiscal 2015, ultimately related to the clustered ONTAP transition. We expect operating margin as a percentage of revenue to be down one point to two points for the year but to return to our 18% to 20% target operating margin range by the second half. We expect a year of continued strong cash flow generation as well as deferred revenue growth. Finally, we expect to continue to repurchase our stock, and based on the current prices, reduce share count by another 5%. This equates to a return of over 100% of free cash flow to shareholders again in fiscal 2016. We expect our Q1 net revenues to range between $1.275 billion and $1.375 billion, which at the midpoint implies a sequential decline of approximately 14% and an 11% decrease year over year. This is despite a 14-week quarter in Q1, an event that occurs every six years. As we begin the year, we expect to continue to be negatively impacted by FX as well as disruption related to the transition to clustered ONTAP and a one-time increase in lead times due to a factory move. We expect Q1 consolidated non-GAAP gross margins of approximately 63% to 63.5% and operating expense before the 14th week to be approximately flat to Q4. That said, given the decline in net revenues and gross margins and the increase of operating expenses, we expect Q1 non-GAAP operating margins of approximately 6% to 7%. Based on our stock repurchases in Q4 and in the first 10 days of Q1, we expect our diluted share count for the quarter to be approximately 315 million shares and non-GAAP earnings per share for Q1 to range from approximately $0.20 to $0.25 per share. In closing, NetApp is uniquely positioned to help customers as they navigate the transformation of their IT deployments by providing a bridge from the choices of today to their requirements for the future. We are firmly convinced that the investments we are making today will position NetApp for long-term success and enable us to quickly return to our operating model. Finally, our capital allocation strategy continues to reflect confidence in our ability to generate significant free cash flow, which will enable us to invest both organically and inorganically in the business as well as continue to return significant capital to our shareholders through share repurchases and dividends. Now, I would like to turn the call back to Tom for summary comments. Tom?

Thanks, Nick. NetApp is in the midst of two transitions, one faced by all IT vendors, the shift to the cloud; and one that is NetApp-specific, the transition from legacy ONTAP to clustered ONTAP. We are confident in our ability to navigate these transitions, but expect some amount of turbulence over the course of fiscal year 2016. Our disappointing top-line growth in the second half of fiscal year 2015 has likely resulted in some market share loss, but we are confident in our ability to gain share going forward. Our best-of-breed solutions compete effectively against point products and are integrated to a broader vision for the hybrid cloud that only NetApp can deliver. Our portfolio of data management solutions offers a differentiated approach that enables customers to solve today's problems with a technology set that provides a path to the future, improving their ability to navigate through the evolving IT landscape. Clustered ONTAP is the foundation of a data fabric vision, providing customers efficient and consistent data management that spans the hybrid cloud and unifies isolated data resources. OnCommand Insight, FlexArray, and Cloud ONTAP help drive our value proposition outside of our installed base. Our flash solutions deliver industry-leading performance coupled with enterprise-hardened software. NetApp private storage for cloud, SteelStore, and StorageGRID Webscale offer customers a secure way to leverage the resources of the hyperscale cloud providers. We have three clear priorities for investments: accelerating the migration to clustered ONTAP, regaining traction in the channel, and increasing our sales capacity. Our strength of conviction in the benefits of those investments comes from the fact that customers and partners that have moved to clustered ONTAP are growing. It is our imperative to transition more customers and partners to clustered ONTAP. We believe that these investments will drive long-term revenue growth, although that growth will be somewhat muted and will ramp over time as we work through our transition and shift to the hybrid cloud. We expect the investments we are making today will be catalysts for growth and drive improvements in the second half of the year, putting us back on our operating model in the second half of fiscal year 2016 and with momentum going into fiscal year 2017. Before closing, I want to thank the entire NetApp team for their dedication and focus on execution as we work through this transition. At this point, we will open up the call for Q&A. As always, I ask that you be respectful of your peers on the call and limit yourself to one question so we can address as many as possible. Thank you.

Thanks. I have a simple question and a follow-up. Tom, a question for you on the transition on clustered ONTAP. I'm just – I was looking at the last transcript and on there you talked about ONTAP meeting the technical requirements of your largest customers and most demanding customers. But it sounds like it was kind of a release and it didn't? What I'm trying to understand is what you thought three months ago and what you think now in terms of this actual release and how the customer feedback has gone? What exactly went wrong and what's causing this transition, frankly? And then just for Nick, I understand the operating margin decline that you spoke about. I think you said down to about 6% to 7% in the first quarter. What's the gross margin direction? I assume it's going down. I'm trying to understand how much is negative OpEx versus gross margin. Thanks.

Yeah. I think – first of all on clustered ONTAP, as we went into the year and even as the year progressed it seemed like things were picking up. We felt on prior calls like we were talking about optimism in the second half and knew we were going to get easier compares on the U.S. public sector and we certainly saw that come to fruition. And the other side is the breadth of the product portfolio. We had a lot of new products in the portfolio, whether it be E-Series or StorageGRID or OnCommand Insight. The other key thing was that we had the release of 8.3 coming, 8.3 of clustered ONTAP. And it was my full intention that that was going to be a big growth stimulant for us. In terms of feature gaps relative to prior releases and 7-Mode, in terms of customer inhibitors, those have been substantially closed. In fact, almost entirely closed. The really key one on this was around high availability for our most complicated workloads. Not only closing features; we’ve got a lot of compelling functionality here that doesn't exist in any of our raw products or any of our competitors' products. Also built in this was a set of tools to help with the transition around the FAS2000 family, we had efficiency capabilities to make clustered ONTAP the natural target for the FAS2000 as well. And we had a lot of performance enhancements particularly around all-flash FAS and other things around quality of service. So from a technical perspective, I think the confidence was very high that this was going to be the release that customers were going to go to. And certainly the new customer wins validated our confidence in the value proposition. This was the one that customers were going to migrate to. All that, everything that I previously said, remains unchanged. There is no evidence that customers are rejecting this technology or it isn’t meeting their expectations. Our flaw here is that we underestimated the complexity of these transitions, the planning associated with it, and frankly, the dependence on us to help them through that. That’s on us. It’s entirely our fault and it's up to us to fix it. The good news here is that there isn't a technical impediment. The product is exactly what we expected it to be. We need to power through this and get our customers to transition.

Hey, Kulbinder. It's Nick. Let me address your question on the gross margin direction and the operating margin perspective for Q1. The gross margin for Q1 should be in the 63% to 63.5% range. That includes about a point of foreign exchange pressure in there. To get to the operating margin, you have to mind a couple of things. First, this 14th-week quarter is a once-in-a-six-year event. If you build that in, we've actually taken the revenue down on a sequential basis more substantially than we've done in prior Q4 to Q1 transitions. So if I normalize out that 14th week, I'm down about 15% sequentially versus my typical 10%. Right? You take that down at that 63% to 63.5% gross margin, then you have to go through the operating expense side. Our operating expenses for the first quarter will be flat to Q4 before the 14th week. If you add in the 14th week, that's an additional about $40 million of expense. So to summarize, the gross margin percentage range should be about 63% to 63.5%, including about a point of FX pressure, but you need to think about the implications of the 14th week on operating expenses.

Nick, you said you'd return to normal growth in the second half of the year. I just wanted you to clarify that, because I think Q1 is going to be down low-double digits year over year. So are you expecting some well-above seasonal quarters in the back half to get to the market growth, because it's just hard to make the math work on that?

So first of all, Brian, a couple points. What I'm saying in terms of revenue for the year is don’t expect any more than flat. What I'm saying in terms of the operating margins of the company, I would say that the operating margins in the back half we expect to be back in the range that we've talked about before, which is 18% to 20% in the back half. I also expect that from a cash flow perspective as we get into that back half of the year we're going to be back to the cash flow ranges we've discussed generating, which is 17% to 19% on free cash flow. I'm not talking about market growth here; I'm talking about not expecting more than flat revenues, but expecting us to return to those target percentages for profit margin and cash flow as a percentage of revenue. The other thing to note is that we've taken costs out and you should expect that we will be focused on costs as we roll through this year.

Hi. Thank you. Tom, I was hoping you could give us a couple of metrics on how much your installed base has transitioned to clustered ONTAP, considering that it's taking a bit longer? I think you mentioned that 50% of the nodes are going to clustered ONTAP, so I'm trying to reconcile that with the slow adoption by customers. I'm just trying to understand what gives you the confidence that customers will start to adopt clustered ONTAP later in the year. Thanks.

Yeah. In terms of shipments, if you look at the various categories of the products, we are well over 50% of the shipments; we're over 70% of the bookings. Our largest machines are in the 80% range. Our mid-range machines are in the 70% range. The low end of machines really weren't, because of a bunch of technical reasons, really weren't going to convert over to clustered ONTAP until 8.3, and that's happening now. So 50% of the models, but the models that are targeted for clustered ONTAP are well up in the two-thirds to three-quarters. That’s an important metric that we track constantly. It’s not the only metric, though. The metric that's also important is what percentage of our installed base has converted over? The methodology by which they convert to clustered ONTAP typically involves buying new equipment and then migrating the data over. So most big ONTAP transitions occur in conjunction with tech refreshes. If the customers are saying okay, 8.3 is the least I'm looking for in my planning process, I'm not going to buy hardware today and then move to it and then do another migration in the future. I’m going to do both at the same time. And that’s where the delay comes in. We could ship 100% of the new systems with clustered ONTAP on them, but if old machines aren't being upgraded then those customers aren't buying those new systems. So what percentage of our big customers are moving to clustered ONTAP? The reason if they lost their patience or weren't going in a different direction, we would have seen them go there by now. At this point in time, the customers that are at this stage are onboard. They are continuing to do service renewals; we certainly see that. We saw our deferred revenue actually grow year-over-year, which indicates that people aren't buying the tech refreshes, which hurts us on the product side, but they are renewing and continuing to run this equipment. It’s not like they’ve made other decisions. There is a lot of pent-up business behind that, and we need to power through it. And could we have been more prepared for it? Absolutely. That's the lesson we're learning here today. The constrained investment environment is where we are investing our money to get customers through this transition; the healthiest thing for our businesses is to gather our installed base as possible to clustered ONTAP.

Okay. Great. Thank you. I wanted to ask about direct versus indirect. Tom, I believe you said there was a focus on regaining traction in the channel, but if you go back to the Analyst Day, there was some talk of consolidating to some of your larger partners. So just wondering how much of changes in the channel have had an impact on your business?

Yeah, I think certainly as we look at our channel base, we have a very, very large number of channel partners and a long tail of active partners that aren't doing much business. Much of our business is concentrated at the top. Clearly, making our largest partners more successful has been a focus. In fact, our largest partners had a pretty good year last year in terms of our reseller partners. The channel is also seeing the dynamics around clustered ONTAP. Those that have made the investments were the first to go; that was going to be a differentiator for them and they’ve done a good job getting their customers transitioned, being trained, and actually using this to sell to new accounts. Others who are behind this are watching customers not necessarily upgrade, which is impacting not only the NetApp business but also our mind share with them around the other elements of the portfolio. I think we needed to get the channel partners trained up, get them through that transition, and actively engage them with the rest of the portfolio.

Hi. Thanks. I just wanted to focus a little bit on the back half and the recovery and the confidence you have. Are customers indicating they have migration plans? Or how long does a typical migration take? Is this purely a function of having enough people to do the migration? Or are you going under the assumption that the one-year service renewals will convert to product sales at the end of the extensions? And then just directly related to that, understanding customers are unlikely to move to other on-prem solutions, is there any reason why we shouldn’t anticipate that customers might use this transition to negotiate price, because it sounds like the gross margins are going to go back to sort of the normalized level?

These migrations include hundreds, if not thousands of machines in dozens of countries. There is a planning cycle that they need to get through to start a migration, and we need to help them with that. When we talk about investments and helping them through that, we will be directly involved in some cases; for others, it will be our best interest to do so and the customer's best interest. But the goal is on these massive accounts - once they get this rolling, you will have a process that may take some time. While they're in the planning cycle, they're not inclined to make large hardware purchases around equipment that they aren't going to use right away. Our point of focus is on helping them through this initial cycle, which is a lot of planning, learning the tools we have, and perhaps offering our professional services resources to address the problem.

Half of the gross margin pressure is related to foreign exchange. We expect to normalize through that; there is investment built in, but there is also foreign exchange built in, so you should keep that in mind.

Okay. Thanks, Tom. I guess you've talked about the cloud, but there are many shifts going on in storage. You've got a product in the converged category doing well there, congratulations, but when you look at hyper-converged, hyperscale, the start-ups like Nimble and Tintri, software-defined, object storage – I know you've got a product there – and then obviously, just the cloud storage vendors or the cloud companies in general, how do you rank these as secular shifts that are hurting you and possibly going back to your earlier comment that you've lost a bit of share this year?

We talked about radical transitions; the cloud transition dwarfs the impact of any of those other technologies. Some of these small companies, their incremental revenue year-over-year might be $50 million or $100 million, while cloud-related investments start much higher. The cloud is not just the hyperscalers; it also includes products like Microsoft Office 365. Our view on the cloud is to embrace it and find a way to monetize it. We spoke about NetApp private storage, offering customers a way to leverage the flexibility of the cloud while keeping the data on their network. Our strategy is to make the data management experience seamless across all domains, regardless of whether data is on-prem or in the cloud.

Hi, Tom. Thank you. I wanted to ask about competition. You talked a lot about the transition to 8.3, but can you speak to the level of competition you see? Do you think your installed base is flat or declining at this point?

The installed base is growing, and we continue to sell new systems every day. If there was a competitive push that was taking us out of all those environments, we would see that demand decrease, but we're not. In terms of the broader competitive landscape, we see EMC and other server vendors in every competitive situation we are in. The landscape includes start-up vendors, but they are not ubiquitous like the others. In terms of new workloads, these fall into various categories whether it’s analytics, VDI, or cloud workloads. The cloud is central to these workloads. We want to compete aggressively with clustered ONTAP in high-performance databases, and all-flash FAS will allow us to do that. The new application developments and the cloud are changes we embrace moving forward.

Thanks a lot. Nick, I just maybe wanted to go through the math for the full-year revenue expectations. If I look historically, July quarter tends to be about 23% of the full-year revenue contributions. If I play that out this time around, I get your sales to be down 9%, 10%. So I'm curious, which of the next three quarters do you think will be stronger to get you to a better trend than down 8%, 9%? Help me understand that math.

What I'd indicated is that we took down the front quarter and expect to recover as we get to the back half of the year. I do expect that the linearity is going to be a little different and that we will be back-end loaded. In addition to that, we won't have an FX compare in the second half of the year, at least at these rates. Those combined effects should be considered for revenue guidance.

Thank you all for joining us on the call today. We spent time discussing our cloud strategy, which is working well for us. The new products, E-Series and OnCommand Insight, are meaningful businesses growing significantly. Our primary focus is on transitioning from 7-Mode to clustered ONTAP, where we need to improve our support to customers. We're making investments to drive growth, and if those investments materialize, we're optimistic about regaining our operating model in the second half.