Netapp Inc (NTAP) — Q1 2017 Earnings Call Transcript

Hello, and thank you for joining us on our Q1 fiscal year 2017 earnings call. With me today are our CEO, George Kurian, and CFO, Ron Pasek. 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 a 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 second quarter, our expectations regarding future revenue growth, improved profitability, including cash flow and shareholder returns, our expectations about our ability to drive operational and financial performance, 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, including the macroeconomic and IT spending environment, our ability to successfully pivot to the growth areas of the market and enable customer migrations to our strategic solutions, our ability to expand our operating margin, our ability to reduce our cost structure, streamline the business, and improve efficiency within the planned timeframe, and our ability to continue our capital allocation strategy and invest in strategic opportunities. Please refer to the documents we file from time to time with the SEC, specifically our most recent Forms 10-Q, our Form 10-K for fiscal year 2016, and our current reports on Form 8-K, all of which can also be found on our website. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. I’ll now turn the call over to George.

Thanks, Kris. Good afternoon, everyone. Thank you for joining us today. In Q1 fiscal year 2017, our focus on the disciplined execution of our strategy yielded solid results on both the top and bottom line. We delivered revenue above the midpoint of our prior guidance range with both operating margin and EPS above our previous guidance. Over the course of the quarter, we strengthened our position in flash and hybrid cloud while continuing to transform our business to operate more efficiently and lower costs. We’re clearly making progress, but still have work to do as we operate in a low growth macroeconomic and IT spending environment. We are controlling what we can and are increasingly confident in our ability to execute as we streamline the business and pivot to the growth areas of the market. We believe these actions will return the company to revenue growth with improved profitability, cash flow, and shareholder returns. Let me remind you of our key priorities in delivering on this commitment. First, we are executing on our data fabric strategy and the strategic solutions that form the foundation of how we enable customer success in the data powered digital era. Second, we are substantially reducing costs and systematically streamlining our operations while maintaining our ability to deliver innovation and lead the market. And third, we’re committed to a robust capital allocation program, which includes a combination of share repurchases, dividends, and investment for the long-term growth of the business. I'll start with an update on the first priority. Ron will update you on the other two. Our strategic solutions aligned to customer's top IT priorities. This alignment drives our confidence in our ability to lead in the fastest growing segments of the market. In the first quarter, strategic solutions represented 61% of net product revenue and grew 24% year-over-year. Conversely, net product revenue from our mature solutions declined 24% from Q1 a year ago. As expected, the impact of the declines in mature solutions is lessening, which will allow the growth of our strategic solutions to reaccelerate the business and return NetApp to moderated revenue growth in fiscal year '18. Our customers are transforming their IT organizations for success in the data powered digital era. They are prioritizing investments to modernize their data centers to lower costs, increase simplicity and agility, extract more value from their data, and integrate cloud resources with on-premises environments. Clustered Data ONTAP replaces legacy frame array environments to deliver next generation enterprise storage for efficient management of data growth and service provider-like flexibility across flash, disk, and cloud footprint. We continue to gain new customers and migrate existing customers to Clustered ONTAP. Clustered ONTAP was deployed on 82% of flash systems shipped in Q1, up from 65% a year ago. We saw continued strong customer demand with unit shipments of Clustered ONTAP systems growing 35% year-over-year. The installed base of Clustered ONTAP in 7-Mode systems continues to grow in total and Clustered ONTAP is now running on 32% of that growing install base. We're building on this strength with the newest generation of ONTAP which further simplifies customers' ability to deploy modern enterprise data center and hybrid cloud environments. Introduced in Q1, ONTAP 9 builds the foundation for a data fabric, bridging new and traditional data center architectures, making it easy to manage and move data where it's needed across flash, disk, and cloud resources. Customers can choose the architecture of their choice, engineered and converged systems, software defined storage, or cloud, all with industry-leading efficiency, performance, and density for flash environments. No other storage solution offers customers this range of capability, flexibility, and investment protection. Also introduced in Q1, ONTAP Select, a scalable software defined storage solution helps customers achieve their business objectives by bringing together the ability to deploy storage with cloud-like agility and granular capacity scaling, with the proven features of the industry's number one storage operating system. ONTAP Select offers the flexibility to deploy ONTAP on commodity servers with the customer's choice of hypervisors. It simplifies operations and lowers training requirements by providing consistent management across all ONTAP data storage, whether on-premises or in the cloud. Flash plays an important role in IT transformations as customers seek to gain a competitive edge through greater speed, responsiveness, and value from key business applications as well as efficiencies through consolidation and lower power requirements. Customers are replacing hard disk installations with flash, making flash the de facto standard for new on-premises deployments. In this transition from disk to flash, customers cannot forego enterprise data management and data protection capabilities. With our highly differentiated portfolio of All-Flash-Array offerings, NetApp is uniquely positioned to enable customers to consolidate onto flash and create All-Flash data centers. IDC ranked NetApp number two in the All-Flash-Array market with a significantly higher share than we hold in the overall storage market. Last week we won the flash memory summit best of show for the most innovative flash memory customer implementation and swept all six brand leadership categories for all flash NAS and unified NAS SAN arrays in the 2016 brand leader survey. Our advantages in this market are reflected in the continued strong growth of our All-Flash-Array business, which grew approximately 385% year-over-year to an annualized net revenue run rate of almost $775 million, inclusive of All-Flash FAS, EF, and SolidFire products and services. The majority of this growth was again driven by high demand for the All-Flash FAS. In Q1 we further enhanced the All-Flash FAS with increased speed and data efficiency capabilities, guaranteeing 3X performance improvement over hard disk arrays and four to one data reduction. NetApp was first to market with 15 terabyte flash drives, which in combination with storage efficiency features in ONTAP 9 delivers a flash optimized enterprise class storage platform that is the best in the industry for mixed workload consolidation. We are displacing our competitors' legacy SAN frame array architectures with the All-Flash FAS. It enabled us to break into a large U.S. based healthcare company, which had been a decade-long competitor stronghold. We replaced the competitor's SAN infrastructure for the customer's mission-critical SAP environment. The All-Flash FAS beat out the incumbent and a newer All-Flash competitor on performance, features, and resiliency. Not only were we able to reduce the data center floor space required for this workload by 95%, but we were also able to provide the customer with a path to the hybrid cloud. The All-Flash FAS addresses requirements for next-generation enterprise storage for customers who want to improve existing infrastructure and processes. For enterprises and service providers who are building multi-channel public and private clouds, SolidFire delivers a storage solution that is operationally simple, able to deliver predictable services and scale as services need to grow. Its unique web-scale style architecture enables customers to easily build best-in-class service environments. In Q1 we delivered new SolidFire innovations across software, hardware, and systems along with the new model for purchasing storage, FlashForward capacity licensing. The latest version of the SolidFire element OS software offers a more intuitive user interface and a robust implementation of VMware Virtual Volumes for VMware operations, including native per virtual machine quality of service. The latest SolidFire platform, which doubles performance and capacity can be easily added to existing clusters, allowing customers to rapidly deploy the newest flash technology without forklift upgrades or controller swaps. FlashForward Capacity Licensing unbundles storage software from hardware in an efficient software purchasing model with perpetual transferable and pooled enterprise-wide licensing. IT transformations are also enabling customers to accelerate time to market, improve customer satisfaction, drive innovation, and gain a competitive edge by getting more out of their data. NetApp data management solutions accelerate third platform analytic solutions by delivering an open, scalable enterprise-grade platform for building customers' critical data legs. To enable the real-time enterprise, customers can run analytics in place on existing data stores without copying or having to ensure data consistency across silos. For customers who want to leverage the nearly endless compute on-demand capabilities of the cloud to accomplish cost-effective data analysis, NetApp data fabric cloud sync service provides a simple automated way to get data into Amazon Web Services, run the desired cloud analytic service, and the data back to where it is needed, whether on premises or in the cloud. We showcased cloud sync at AWS Summit last week, and you can expect to hear more about how we empower customers to leverage cloud resources and integrate them with their existing IT investments over the course of this fiscal year. Our data fabric strategy enables data management that seamlessly connects disparate systems, software stacks, clouds, and data centers. We give our customers the ability to manage, secure, and protect their data across flash, disk, public and private cloud resources, all at the scale needed to accommodate the exponential data growth of the digital world. More and more customers are telling us that they choose NetApp because we enable their cloud strategies by providing data portability and cloud integration. Coupled with our industry-leading next generation enterprise and web-scale storage solutions, we're helping our customers transform for success in the data powered digital era. We accomplished a lot in Q1, our focus on disciplined execution and pivot to the growth segments of the market is yielding results and starting to change the trajectory of our business. We introduced substantial innovation across our portfolio that helps our customers as they transform to modernize their data centers to lower costs, increase simplicity, extract more value from their data, and integrate cloud resources with their own premises environments, and we will introduce more exciting innovations at our Insight User Conference in Las Vegas next month. We're making progress, but we still have more work ahead of us to return the Company to long-term growth and to our target operating margin. We are streamlining the business and reducing our cost base to position us for future success by allowing investments in strategic opportunities while accelerating our ability to deliver shareholder value in the form of improved profitability and cash flow. Our first quarter results provide early indicators that our strategy is working and I am very confident in the NetApp team’s ability to successfully evolve the company. I’ll now turn the call over to Ron to walk through our Q1 financial performance and expectations for the second quarter.

Thanks, George. Good afternoon everyone, and thank you for joining us today. Before we get started, I’d like to remind you that we will be referring to non-GAAP numbers today. Also please note that year-over-year compares are against a 14-week quarter we had in Q1 of fiscal 2016. With that, let’s get started. We executed well in the first quarter, and overall are pleased with our results. Q1 net revenues of $1.29 billion declined approximately 3% year-over-year and were within our guidance range. Excluding the approximate $40 million benefit to software maintenance and hardware maintenance and other services revenue from the 14th week we had in Q1 of last year, net revenues were roughly flat year-over-year. Product revenue was $660 million, and for the first time in several quarters, was essentially flat on a year-over-year basis. As we've discussed, we expect the growth of our strategic solutions to improve our overall product revenue growth trajectory over the course of fiscal 2017. Though we still have a lot of work to do, the product revenue results are a good indication of the progress we’re making here. The combination of software maintenance and hardware maintenance and other services revenue of $634 million were down approximately 6% year-over-year due to the extra week in Q1 fiscal 2016. Gross margin was 62.4% and within our guidance range. Product gross margin of 46.7% was flat sequentially. Although product gross margin remains below where we’d ultimately like it to be, we feel good about the stabilization. On a year-over-year basis, product gross margin was down about 4.5 points. Software maintenance gross margin was relatively flat year-over-year, while hardware maintenance and other services gross margin increased just under 4 points year-over-year. Operating expenses of $652 million decreased 13% year-over-year. This decline reflects the early results of our transformation efforts, as well as the benefit of the return to a typical 13-week quarter, partially offset by SolidFire. Operating margin of 12.1% was above our previous guidance range. As I discussed on our last earnings call, aligning our cost structure with the opportunities in front of us is my top priority and completely within our control. Although we have made progress on this front, we will continue to take additional steps throughout the year to permanently lower our cost structure including, but not limited to headcount reductions, and continue to drive greater efficiencies across the business. We will continue to communicate specifics as these savings are realized. Our effective tax rate for the quarter was 16.6%. Weighted average diluted shares outstanding were 282 million. EPS of $0.46 was $0.07 over the high-end of our prior guidance range, reflecting lower operating expenses, higher revenue, and a benefit of our share repurchases. Our cash and balance sheet metrics remain healthy. We closed Q1 with $4.4 billion in cash and short-term investments, with approximately 13% held by our domestic entities. We repaid the SolidFire loan in the first quarter from global profits. We remain deeply committed to completing by the end of May 2018, the remaining balance of our share repurchase program that we announced in February 2015. In Q1 we repurchased $175 million of our stock, and paid approximately $53 million in cash dividends. Today we also announced our next cash dividend of $0.19 per share, which will be paid on October 26, 2016, to shareholders of record as of the close of business October 7, 2016. Deferred and finance unearned services revenue was up 8% year-over-year. Inventory turns increased to 24 and DSO was 35 days. Q1 cash flow from operations was approximately $228 million versus $129 million in Q1 a year ago. We generated strong free cash flow of $192 million in the quarter. Representing about 15% of net revenues, free cash flow grew over 100% year-over-year. Now to guidance, as George discussed, we are aggressively pivoting to the growth areas of the market while at the same time transforming the Company in order to streamline the business, drive greater efficiency, and rapidly address the changing market. As we've outlined today, we executed well against our plans in Q1 and are encouraged by the early signs of progress that we're seeing. While we still have a lot of work to do, we remain confident in our ability to continue to execute against the plans we outlined for fiscal 2017 on our prior earnings call. For Q2, we expect net revenues to range between $1.265 billion and $1.415 billion, which at the mid-point implies a sequential increase of 4% and a 7% decrease year-over-year and a difficult compare. We expect Q2 consolidated gross margins of approximately 62% to 63% and operating margins of approximately 13% to 14%. And finally, we expect earnings per share for the second quarter to range from approximately $0.51 to $0.56 per share. With that, I'll hand it back to Kris to open the call for Q&A.

We'll now open the call for questions. Operator?

I just wanted to ask about the cDOT conversion, because I ask about it every quarter, and it seems like you made good progress this quarter at 32% of the install base. At what point do you think this just continues to grow linearly towards or how do you see this progressing? Should we just assume it continues to grow kind of at the rate it has been the last few quarters? And then I also wanted to ask about gross margins. By your comments there I assume that you're seeing pricing relatively stable. You don't see any issues as you move to cDOT or anything like that with pricing. So if could just kind of comment on that as well, it would be helpful.

First of all, I'd just say that we're pleased with the progress on cDOT penetration of our install base and new customers. I think when you think about our install base, it's a very large install base that we've built up over 20 years and it's growing and so the percentage of systems that we represent is a very large number. The cDOT conversions are lumpy. They go up and down. The pace at which they move are tied to customers' IT spending and their readiness for conversion. In aggregate, you're seeing us continue to progress the conversion of the install base. I would just say that we're planning the business around any particular quarter-on-quarter model. I think in aggregate, we're pleased with the progress and we continue to want to get our customers over to the clustered ONTAP, and you're seeing that. In terms of gross margins, I think a couple of things. The first is the value proposition of All Flash FAS clustered ONTAP are showing up in the differentiation and customer acquisition and the shipments that we are delivering to customers. The gross margin model that we showed last quarter to this quarter has stayed stable, and the market remains competitive, but we differentiated technology in the market as well as we outlined in our cost focus. We continue to do work in the supply chain on both the cost of goods sold as well as the operating structure of the Company to support that model.

I think I'd remind you what I said last quarter as well. Discounting is a function of what we're seeing in the marketplace plus product promotions we're running and so we're still doing some of those but deemphasizing certain ones and emphasizing others.

I just wanted to confirm that I heard you correctly, that the installed base is still growing and related to that, would you expect your services business to return to growth in future quarters?

The install base is growing. That's correct, Simona. It's a very large number and it's growing. I think in terms of the services business, the first thing I'd just tell you is the year-over-year compare was from a 14-week quarter last year to a 13-week quarter this year, and if you adjust for that, the services business is essentially flat. If you look at our deferred revenue, it shows strength reflecting the nature of the long-term contracts that we have with customers, as well as the strategic value and the business criticality of our solutions.

Do you expect that to grow in future quarters instead of remaining flat or fluctuating?

Yes, as the install base grows, that services revenue will grow as well.

I wanted to ask, the mix that's in there, I assume a lot of that is All-Flash FAS versus SolidFire and E Series. If you could confirm that first. And then ask about competitive dynamic. It seems pretty intense right now and I guess my question is why is AFA so much more intense than the traditional storage business?

First of all, the progress we've seen this quarter reflects continued success with All-Flash FAS. We're encouraged by the advancements with SolidFire as well, particularly with new customer acquisitions driven by the NetApp sales team. However, as we've mentioned before, SolidFire currently has a minimal impact on revenue. This aligns with our outlined plan, and we're optimistic about the early signs of progress. Regarding the All-Flash Array market, larger system vendors that have integrated All-Flash offerings into their enterprise-grade storage continue to capture the majority of enterprise storage footprints. The progress we've achieved with our All-Flash arrays highlights the uniqueness of our clustering technology, as well as the storage efficiency, performance, and reliability of our products. Therefore, we feel very confident about our current position.

U.S. public sector revenue grew this quarter. Are you starting to see larger deals and do you expect that to continue as we go into the fiscal year-end for that segment? Thanks.

Thanks, Katy. We are encouraged by the progress with U.S. public sector. I'll just tell you there was no specific pattern that we noticed. We also continue to monitor the U.S. public sector spending patterns as we head into the November election season. So we feel good about our position in the market, the competitiveness of our offerings as well as the progress we're making with some of the agencies, but we'll continue to monitor the sector as we head into the November season.

I have a housekeeping question for Ron and then maybe a strategy or market insight for George. Ron, on the OpEx, specifically the general administrative side, it looks it was kind of at very low levels or multi-low levels. Is that level sustainable or is there even more room to get more efficient there or were there some type of benefits that happened this quarter, just for modeling for kind of long term run rate for that, why it came down a lot both sequentially and year-over-year, even though year-over-year I understand the week, but sequentially it came down a lot too, and compared to history it's really low. And then George, on the insight for the market, any impact to Brexit? Your company had a full month of sales and revenues through the month of July. Did you see any order delays? Did those come back in August, or is it creating a little more uncertainty in the UK, and how should we think about any impact there that you are seeing?

Sure, Jim. Regarding G&A, this is the early stage of the work we have discussed about transformation across all support functions and some line organizations as well. Some changes occurred faster than we anticipated and will continue through Q2, although perhaps not at the same levels. However, it represents a permanent reduction in G&A levels and is part of our strategy.

With regard to Brexit, I think both in terms of the commercial impact as well as the FX impact to our business, they were immaterial this past quarter. It's too early to tell. And so we monitor in discussions with our large customers, but we didn't see anything material to our business.

Thank you. And just as reminder, if everyone could keep it to one question, so we can get to as many of you as possible. We'd appreciate it.

Hi everyone. This is calling in for Amit. I wanted to revisit the product gross margin issue. It has remained below 50% for the second quarter in a row. There has been discounting and promotional activity. Could you explain how the margin profiles of strategic and material product businesses might vary, especially concerning strategic increases?

There is no material difference between strategic and mature in terms of product gross margin. In terms of our overall gross margin, as we said, as part of our focus on cost management, we continue to take a hard look at every category cost of goods sold, as well as the cost of goods on the services side. And so we continue to work to maintain our gross margins in aggregate in the ranges that we've guided to.

Yes. As I look at the strategic product growth area, you exited FY 2016, I think it was a 21% rate and you put up Q1 here at about a 26% rate. So that acceleration, obviously terrific execution. As we look out for the remainder of the year, is this something that is sustainable? You talked about a difficult comp in Q2, but I don’t know that I have the level of detail in between the two segments between strategic and mature. But is that acceleration in FY 2017 sustainable?

So question as strategic revenue grew 24% in Q1 and we feel that we are encouraged by that growth rate year-on-year. It was 14% in Q4 year-on-year. So we feel good about the process in the strategic solutions. As I said, we think that as the mature solutions become a smaller percentage of our business, they become less of a headwind in terms of overall revenue growth. And our plan is to get product revenue back to growth at some point this year.

I wanted to take a longer term view and understand some of the things that you’ve done here recently for the quarter. How should we think about your ONTAP select, as well as the purchasing model of FlashForward for your SolidFire solutions? Or put another way, how you guys thinking about the model implications from software defined storage, or rather that de-bundling between software and hardware going forward?

Let me take that from a customer perspective, and then Ron can comment on the financial implications. First of all, from a customer perspective, we think that the value of differentiated storage and data management capabilities as we’ve always said is software, and we have among the best storage and data management platforms in the industry without question for traditional enterprise with Clustered ONTAP and for web scale enterprise with SolidFire. So we feel very good about our position in those markets. The software value of those products protect and differentiate gross margin. ONTAP select is an offering that we’ve made available to customers, who have the engineering capability to integrate software with systems for specific deployments. I think the range of customers who have that level of engineering capability is small. And so we think that the preponderant majority of our business will continue to say integrated systems. With regard to SolidFire's FlashForward licensing model, it essentially allows customers to simply procure the software so that they can build the pool of storage that is enterprise-wide and then buy hardware as they need it and integrate it under that software umbrella. Typically, what we have seen with that type of model is that it allows us to get larger footprint sooner in customers as they standardize on SolidFire for a broad range of use cases.

I'll just add that what you're describing is a way that our customers can consume our products and we're well aware of the change. It is a very small piece of our business, not material at this point, but it's something we do want to accommodate.

So, let’s talk a little bit about working capital. It looks to me like your cash conversion cycle was hitting a multi-year low. This year you had very strong collection. Just wondering how we should think about DSOs and cash conversion cycle going forward and do you expect free cash flow to be in the mid-teens as a percent of revenue for the year?

We saw a significant improvement from quarter to quarter, which is typical for DSO. Q4 was somewhat back-end loaded, resulting in a temporarily high DSO. Now, it's returned to a more normal level, though it remains five days longer than it was in Q1 last year. Additionally, we benefited from very low inventory, which is likely the lowest we've ever had. However, this level is somewhat unusual and may not be sustainable moving forward, but we do expect it to be better than last year. We remain focused on working capital as part of our transformation efforts and are committed to driving improvements in this area.

Hi, this is Bob Hahn for Brian. Just a follow-up question for Ron, when you mentioned promotional activity, and mentioned reducing some programs and growing others. Could you be more specific in where you're driving more or less promotional activity, and to what extent do you think gross margin pressure is within your control in temporary?

What I described last quarter were two promotions which are still running. One was on flash and one was on cDOT. Some of those are running at a course, not needed as much anymore. We're looking at additional promotions that I don't want to talk discreetly, they tend to be really important to us at a given time. That's really a function of what's going on in the marketplace.

And broad breaststrokes, as we accelerate certain strategic technologies to market, we pivot our focus there with promotions and other things for a period of time, and we brought down on the pieces that are more mature or well penetrated. And I would just continue to think about that as part of our ongoing portfolio management.

Could you clarify the categories you've outlined? What is currently included in the mature category? Are customers still expanding their legacy ONTAP 7 environments? Additionally, in the strategic category, what portion is still considered legacy on-prem arrays that are operating with clustered cDOT?

So, mature is essentially the OEM products that include E-Series and are legacy FAS OEM products, 7-Mode systems, and add-on hardware. Add-on hardware is equipment that is purchased after an initial configured system sale, for example, add-on storage. The strategic solutions include our clustered data ONTAP operating systems, All Flash Arrays, the branded E series OnCommand Insight, SolidFire, and some of our hybrid cloud solutions. There are customers who are adding on to some of their 7-Mode environments for purposes of business continuity, for purposes of this is an application that I don’t want to migrate to clustered ONTAP, because it's an IT area that they're no longer investing or they feel that their current environment is good and so you see people continuing to add-on in small numbers systems and add-on storage to their 7-Mode footprint. The majority of customers that are deploying new configurations as represented by the percentage of shipments out the door are deploying clustered ONTAP configurations.

George, can you talk about the relative growth rates of your All Flash FAS versus the growth rate of EF All Flash series as you currently see?

The EF series is focused on a much smaller range of use cases, primarily the performance-oriented segment of the market where customers want industry-leading performance for specific dedicated environments like databases. All Flash FAS represents the focus for the broadest range of customers who are looking at replacing disk-based solutions for general purpose storage environments with All Flash configurations. And SolidFire uses flash-based technology to build web scale cloud designs for customers, people that want to replicate what Amazon or Google or Facebook have deployed in their datacenters in their own environments. And so those are three pieces. We think that All Flash FAS and SolidFire will be the majority of the business going forward.

It's Sean Ryan for Steve. So real quick, looking out the back half of the year on a competitive landscape, what do you kind of see happening with Dell EMC? Are you seeing them get more aggressive, as they combined, and what do you think there might happen with HP Services? Are any of these going to change the competitive landscape?

Well, first of all, let me say that from a technology perspective, we feel very, very good, we have taken flagship customers from both EMC and HP this past quarter as with our All Flash technology, and we feel that as customers look to build All Flash data centers, we've got a technological lead that is very strong and the road map of both All Flash and hybrid cloud solutions from us is resonating with customers. Every transaction is competitive. And so to the extent that we are displacing competitors in large accounts, these are highly competitive transactions. We think that that nature of the competitive dynamic will continue. And so what we're doing on our side is both building differentiated capacities in software as well as dealing with the cost structure of the company, both in COGS and OpEx to allow us to compete effectively in the market.

I would like to discuss your go-to-market strategy. I observed that your indirect revenue increased by a few percentage points sequentially. What is your focus in that area? Is there any seasonality involved, and do you have a sufficient direct salesforce? Where are you currently making your investments?

We have a new leader of our go to market organization, Henri Richard, who is focused on accelerating our penetration and returning product revenue to growth, but the indirect channel is an important strategic asset to NetApp. We work closely with our channel to help them accelerate capabilities into the market for our All-Flash Arrays, for cluster data ONTAP as well as for SolidFire. We also had a strong quarter on the OEM side, which is reflected in both the mix of mature as well as the mix of indirect channel. And so we're going to continue to focus on the right mix of direct and indirect and the channels are a really important part of our go to market model.

Thank you for taking my question. So just following up on the OEM strength, is that part of the business stabilizing at this point? Do you expect any growth there?

OEM is down substantially from years past; it is still dependent on the business of our end customers. But to the extent that there is material seasonality to that business, it's a smaller percentage of our business this year than it was in the past. I'll just leave it there.

And just following up. With the incremental improvement that you've seen on the mature product side, do you expect that to continue to be the case as we go through the fiscal year and quarter-over-quarter, the year-over-year pressure eases?

Yes, you should continue to see that decline throughout the remainder of this year and probably into next year. It won't go to zero, but the decline will slow as the year progresses and we go into FY 2018.

This is David Ryzhik for Mehdi. What percent of the growth in cDOT unit shipments is due to All-Flash FAS? And also if you can characterize the adoption rate of cDOT in U.S. public sector as well as by geography?

We don't provide specific adoption rates by geography, but overall, we are satisfied with the progress of cluster data ONTAP across all regions. The largest portion of our installed base is in North America. Looking at the remaining areas, we still have a significant number of systems that need conversion, presenting us with an opportunity in the upcoming quarters. Regarding the mix of all flash and hybrid systems, we guide our field to offer the best value solution under the clustered ONTAP framework. If a customer prefers flash, we sell them flash; if they want to stick with hybrid, we offer that as well. Our primary objective is to market our clustered operating system and systems to as many customers as possible. All flash systems are experiencing faster growth compared to hybrid systems. I'll stop there.

Just want to go back to the product, the medium to longer term outlook on product margin. Should we just expect, where you’ve been the last few quarters is where the business is going to be trending, just like more competitive environment, lower volume, and that’s really where you guys are going to be tracking over the next, I don’t want to put a specific timeframe on it, but over the maybe next year to year and a half, or is there something in the product mix that's coming up, that could really drive that back to near historical levels?

Yes. What I tried to intimate on my prepared remarks was that we’re not happy with where it is. I'd like to see it grow. But to some extent, we can do certain things on the cost side, the offering side, the mix side. But to some extent, it’s a function of the competitive environment. So although I’d like to have it grow, I can’t tell you for sure that it’s going to happen. You’re right. It's historically at a very low level. It puts pressure on the business model. I’d like to see it higher, but I also want to be competitive.

And just to clarify one thing. I'd imagine the All-Flash Arrays carry a higher product margin. So how should we interpret that as far as reflecting your overall product margin? Does that mean the other products are being discounted more and that’s the results we’re seeing here?

No, I really don’t think you should assume that there is a huge difference in product margin pre-flash and traditional storage. So that’s not what's going here at all. This is really just a function of the competitive environment.

I was wondering, with the progress you’ve made in the SolidFire integration, is M&A a priority? Can you update us on your capital allocation priorities?

Yes. So the priorities are very, very clear. We’re prioritizing the share repurchase. We’re on track to make the commitment to be done by May of 2018 on the $2 billion that we've outlined. Also the dividend, continue to pay, and hopefully, we’ll see the dividend. To a far lesser extent, you’ll see us being inquisitive. There are some things out there that we might be interested in and they’re not pretty big. They tend to be small IP-based acquisitions, but that’s how we think of the capital allocation strategy.

We’re focused on bringing SolidFire to the broadest range of our customers through our broadest set of go-to-market partners. We’re pleased with the initial progress. But we have a lot of work to do and so we’re going to see focused on it.

Just on the operating margin targets that you’ve laid out getting back to the high-teens, hopefully exiting this year and then doing that for the full year next year, if we just think about the controllables around that versus the growth prospects and mix, can you sort of outline the big three, two or three things that would drive margins higher from here?

Yes. As you mentioned, the cost structure, particularly operating expenses, is a key focus. We expect to reduce our run rate by approximately $130 million as we exit Q4 2017 compared to Q3 2016. This reduction will mainly come from operating expenses and, to a lesser extent, from cost of goods sold. These are our major initiatives to enhance profitability, especially if we do not see growth in revenue. We are targeting an operating margin for the year of 15% to 17%, which includes SolidFire. Additionally, we anticipate reaching around 18% in fiscal year 2018 with SolidFire included.

And just to clarify one point on mix, it sounds like from everything I've heard on the call that there's not a major mix assumption that has to happen obviously. The strategic business wants to grow but, is there anything we should think of that would be a major swing factor around gross margins going forward?

No, not at all.

Last quarter you talked about customers acting with caution due to an uncertain macro. I didn't really hear you touch on that much this quarter. I was just wondering if you've seen any improvement in terms of purchasing patterns in the storage market in general? Would just like to get your take on that.

The quarter came in line with expectations, and in line with historical linearity. I would say that the macro continues to be uncertain. I don't think that we've seen a fundamental shift in the macro environment. I would say that solid-state storage is clearly seeing interest because of the really quick return on investment, the substantially better total cost of ownership, and so people are prioritizing that potentially within their spend envelope. But I think overall from a macro perspective, it's still relatively choppy.

Between the stabilizing product revenue on the year-over-year growth basis, as well as the product gross margins, stabilizing plus 50% of your market value and net cash position, I think you guys are effectively trading at five times fiscal year of free cash flow. So my concern here is that you guys become a prime private equity target, and will you look to return cash to shareholders at an accelerated rate in order to make sure that the long term-oriented shareholders are protected from private equity firms basically cherry-picking off what is a very attractive asset?

I think first of all, we've laid out our plan for the Company, which includes driving the strategic solutions to growth. We've said that the mature solutions will become less of a headwind, and that is playing out and the quarter is the representation of that playing out. We've optimized the cost structure to continue to deliver favorable set of both free cash flow and operating cash flow metrics that in turn gives us increased confidence that we can support the capital allocation program that we've laid out. We've laid out a capital allocation program that includes dividends, share buybacks, and the investment of capitals for strategic activities, and we remain committed to that.

For George and Ron, continuing the discussion on capital allocation, if the model plays out as you expect for 2017 and '18, I would like to understand your reasoning for remaining committed to the buyback program. Given that the stock is likely to rise, why not redirect some of that capital toward the dividend, especially as the yield decreases with a higher stock price? Is that part of your strategy? Ron, it seems there's a strong commitment to the dollar target. Could you share your thought process on how you are hedging against that target in light of this question?

Yes, sure, it was a comment made certainly before I got here. It's the type of thing our long-term investors want to see. I think of the dividend as something we give people regardless of what's going on. And some investors really to see pay only dividend some months as to only do repurchase. So we do a combination of both and keep both happy. I think your question is good, but at the same time we made the commitment. We're going to follow through on the commitment.

This is Manjar on behalf of Maynard. I would like to confirm your guidance, which suggests that operating expenses will rise sequentially in Q2. Can you please provide clarification on this? Additionally, how should we consider operating expenses for the second half of the year and as we approach the end of the fiscal year?

Yes, you are right. We came in lower than I thought we would in Q1 and so there is a very slight increase to OpEx in Q2 if you look at the midpoint. As I try to intimate, the cost reductions always come very smoothly. There are other things we spend money on that cause little blips through the quarters. However, in general, I think as we exist the rest of the year, you should see the OpEx continue to come down through Q3 and into Q4.

We are pleased with our Q1 results and the clear progress we're making with our strategic solutions, but we still have more work ahead of us, and we remain focused on disciplined execution of our strategy. We're committed to the fundamental change that we outlined with the three key priorities. Let me remind you of them once again. The first one is to pivot to the faster growing parts of a market and align ourselves closely with our customers' business and IT transformation priorities with our focus on the strategic solutions portfolio. The second is to reduce costs by streamlining and improving the efficiency of our business. The third is to support and continue with the robust capital allocation plan that we have, that includes shareholder returns and investment for the long-term growth of the business. We brought a lot of innovation to the market in Q1. You can expect to see even more exciting innovations this year, some of which we'll showcase at our Insight User Conference next month. I look forward to speaking with you all again next quarter. Thank you.