Netapp Inc (NTAP) — Q3 2020 Earnings Call Transcript

Thank you for joining us. 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. 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 fourth quarter and full fiscal year 2020, our expectations regarding future revenue, profitability and shareholder returns and our ability to improve execution, gain share, reaccelerate growth, and expand our sales capacity without increasing total operating expenses—all of which involve risk and uncertainty. We disclaim any obligation to update our forward-looking statements and projections. Actual results may differ materially for a variety of reasons, including macroeconomic and market conditions, the IT capital spending environment, and our ability to expand our total available market, acquire new accounts, expand in existing accounts, capitalize on our Data Fabric strategy, improve our consistency of sales execution, and continue our capital allocation strategy. Please also refer to the documents we file from time to time with the SEC and available on our website, specifically our most recent Form 10-K for fiscal year 2019, including the management's discussion and analysis of financial conditions and results of operations and risk factors sections and our current reports on Form 8-K. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of GAAP to non-GAAP estimates are posted on our website. I'll now turn the call over to George.

Thanks, Kris. Good afternoon, everyone. Before I get into our results for the third quarter, I want to take a moment to talk about Ron. Today we announced that Ron has decided to retire by the end of the fiscal year. I want to recognize his many contributions since joining NetApp in 2016. Under Ron's leadership, we have increased product margins by 10 points, nearly doubled our earnings power, and raised our dividend by over 100%. He has played a pivotal role in helping NetApp navigate a transformational period as we focus on becoming the leader in hybrid cloud data services. I think you'll agree that he's always been a true and honest broker. Knowing that this is his last earnings call before retirement is certainly bittersweet for me. We continuously think about what's next for the company and that includes thoughtful proactive succession planning. To that end, Ron and I have been talking about the prospect of this transition for some time. During the search process, we have been focused on finding the right person to take on the role of Chief Financial Officer, and I'm very pleased with the quality of candidates. I expect that we will have someone in the role before the end of the quarter. Ron will stay on to ensure a seamless transition and I'm grateful for that.

Thank you, George. Let me start by expressing my deep appreciation for the opportunity to work alongside the talented team here at NetApp. These past four years have been incredibly rewarding. The team has proved to be collaborative, innovative, and empowering, and I'm proud of what we have achieved during my time here. I also want to thank the investor and analyst community, as it's been a genuine pleasure working with all of you. This is an exciting time for our industry and for NetApp, and I look forward to helping our next CFO transition into the role.

Thank you, Ron. Now, let's turn to an overview of the quarter. Despite the top-line challenges, we continued our operational discipline, highlighted by strong gross margin, cash flow, and operating leverage without the benefit from anticipated ELA revenue in the quarter. These results reflect the strength of our business model as we take deliberate steps to better capitalize on our opportunity and return the company to growth. However, macroeconomic headwinds and unpredictability in large enterprise purchasing behavior persist. Customers are on a journey to the cloud and they are looking to NetApp to help them as they grapple with the complexities of data management in hybrid multi-cloud IT environments. With our Data Fabric strategy, we help customers address these challenges, giving us access to new buyers and workloads, as well as increasing the relevance of NetApp to companies both large and small. We not only have opportunity in the public cloud, but we also have increased our value for on-premises deployments. Our ability to deliver real business value to customers' hybrid multi-cloud environments fuels my confidence that we can return to growth. While we see exceptional opportunity ahead, we are planning our business assuming no change in external factors for the foreseeable future. To improve our execution in this environment, we laid out a plan at the start of the fiscal year to replicate our proven areas of success by getting in front of more buyers with our full portfolio. We are on track to increase sales capacity by approximately 200 primary sales resources by the end of Q1 fiscal year 2021 without adding to the total operating expenses for the company. The majority of the sales headcount will be deployed in our Americas geography. They will be focused on acquiring new accounts and engaging new buyers like cloud architects in existing accounts. We are seeing early signs of success by expanding our reach and focus on new customer acquisition. Our dedicated acquired districts continue to deliver strong growth across all metrics—sales, units, and customers. The growth of these metrics accelerated in Q3, as did the growth of the pipeline, pointing to continued progress in coming quarters. While the acquired districts performed well, we still need to broaden our share of wallet at our largest customers. We are making progress here. However, it is in our largest accounts, which have the greatest exposure to the macro, that the demand environment is the least predictable. In Q3, our all-flash array business, inclusive of all-flash FAS, EF and SolidFire products and services, increased from Q2 to an annualized net revenue run rate of $2.3 billion. We introduced new all-flash array and hybrid flash array platforms as well as a SAN-optimized all-flash array, which delivers a simplified and dedicated SAN experience. Our core storage offerings continue to gain industry accolades. Last quarter, NetApp took the highest ranking in the leaders' quadrant of Gartner's Magic Quadrant for primary storage. In Q3, NetApp was named a leader in IDC's file-based storage MarketScape with the recommendation that customers in need of hybrid cloud solutions should consider NetApp because of our expanded product portfolio, investments, and vision. Our building blocks for private cloud deployments—SolidFire, NetApp HCI, and StorageGRID—enable customers to bring public cloud-like experience and economics into their data centers. Our private cloud business, inclusive of products and services, grew 10% from last quarter, attaining an annualized net revenue run rate of almost $350 million. To meet the increasing demand for Object Storage, NetApp announced new StorageGRID software platforms and the ability to tier to Azure Blob Storage. IDC named NetApp a leader in its object-based storage MarketScape, citing our vast experience in unstructured data. They recommend customers consider StorageGRID when dealing with petabyte-scale data sets across various deployment locations because of its unique hybrid multi-cloud integrations. Based on the last month of Q3, our annualized recurring revenue for cloud data services increased to approximately $83 million, up 146% year-over-year. We are now generally available with both Cloud Volumes Service and Cloud Volumes ONTAP for all the leading hyperscale cloud providers: Microsoft Azure, Google Cloud, and Amazon Web Services. Additionally, we added cloud compliance as a feature to Cloud Volumes ONTAP, which helps customers comply with today's privacy and other data regulations. We continue to see a healthy mix of customers new to NetApp in our cloud services as they enable us to acquire new customers and reach new buyers, as well as expand the data sets managed at existing customers. Our deep integration for a broad and growing range of use cases with the leading public clouds and industry-leading technology for on-premises storage solutions gives us a sustainable competitive advantage. Let me share with you a few customer examples to illustrate how our data fabric strategy allows us to acquire new customers, expand our footprint at existing customers, and increase our strategic value. A U.S.-based research hospital in one of our acquired districts chose to go with NetApp on-premises and in the cloud. Our ability to connect their data centers to each other and to multiple public cloud providers, all with a consistent management interface, placed us well ahead of the competition in addressing the customer's requirements. A global retailer and current NetApp customer has halted its on-premises IT spending in favor of a Cloud First Strategy. They plan to migrate their large SAP HANA environment to the cloud to gain flexibility and speed of scale using Cloud Volumes ONTAP and Azure NetApp Files. Because of our ability to help the customer easily migrate to the cloud, we will retain not only the data currently managed by NetApp in their data centers but we will also move competitors' on-premises footprints onto NetApp in the cloud. And finally, on our Q1 call, I told you that we were working with a Fortune 10 company to migrate its existing data centers to the cloud. That customer now has line of sight to move 100 petabytes of data, largely from our competitor systems to Azure NetApp Files. By partnering with them to achieve their cloud-first initiative, we have elevated NetApp from an infrastructure provider with a minority position in their data center to a key strategic partner. The power of our Data Fabric strategy increases our strategic relevance to customers, which creates long-term value for NetApp and our shareholders. It enables us to reach new buyers through new pathways, address new workloads, expand our presence with existing customers, and it drives our innovation agenda, which we advanced significantly in the quarter. We are delivering an enormous amount of value to a growing number of customers. Only NetApp has the strategy, the innovation portfolio, and customer experience to help customers succeed in hybrid multi-cloud IT. Our strong business model, resulting from the hard work we conducted to improve gross margin and our cost structure over the last several years, enables us to navigate the dynamics of the macro economy and customer demand environment while making the strategic investments necessary to cement our leadership in hybrid cloud data services. With that, I'll turn it over to Ron for more details on the quarter and our expectations. Ron?

Thanks, George. As a reminder I'll be referring to non-GAAP numbers, unless otherwise noted. As George highlighted, in Q3 we delivered solid margins and operating leverage in the face of revenue weakness. Despite the demand uncertainty, we generated strong free cash flow and remain confident in our product leadership and strategy to reaccelerate growth going forward. Before discussing our guidance, I'll provide further detail on our Q3 performance. In Q3, net revenues of $1.4 billion decreased 10% year-over-year. We had zero ELA revenue in the quarter, although we had expected approximately $50 million. Product revenue of $787 million decreased approximately 19% year-over-year. Moving down to P&L: Software maintenance and hardware maintenance revenue of $556 million was up nearly 5% year-over-year, with better execution in our renewals business starting to deliver results. Deferred revenue increased 6% year-over-year in Q3. Gross margin of 67.8% was above our guidance. Product gross margin was 55.4%, which is an increase of 2.8 points year-over-year. The year-over-year improvement was driven by continued sales force discipline, an increase in all-flash product mix, and cost reductions. Q3 was the 12th straight quarter we increased product margins year-over-year when adjusting for the benefit of ELAs. The Q2 to Q3 seasonal decrease in product margins was driven by customer and product mix. We've seen almost no degradation in product margins as a result of increased NAND pricing. The combination of software and hardware maintenance and other services gross margin of 83.6% increased nearly 200 basis points year-over-year, driven by continued productivity improvements. Q3 operating expenses of $640 million increased approximately 2% year-over-year, driven by annual merit increases. Operating margin was 22.2% and in line with our guidance. EPS of $1.16 was down 3% year-over-year but well within the guidance range. We closed Q3 with $3 billion in cash and short-term investments. Our cash conversion cycle was a positive one day, an increase of 12 days year-over-year. DSO of 53 days was up two days year-over-year. DIO was 22 days, an increase of seven days year-over-year. And DPO was 75 days, down three days year-over-year. Cash flow from operations was $420 million. Free cash flow was $388 million, representing 28% of revenue. We are maintaining our expectation for free cash flow to be in the range of 19% to 21% of revenues in fiscal 2020. During Q3, we repurchased 8.2 million shares at an average price of $61.20 for a total of $500 million. As of the end of Q3, we had $640 million remaining on our original $4 billion buyback authorization. Weighted average diluted shares outstanding were 229 million, down 26 million shares year-over-year, representing a 10% decrease. During the quarter we paid out $108 million in cash dividends. In total, we returned $608 million to shareholders in the quarter. Our fiscal Q4 cash dividend will be $0.48 per share. Now on to guidance. As we've noted over the past several quarters, the demand environment continues to be challenged. As a result, we expect Q4 net revenues to range between $1.455 billion and $1.605 billion, which at the midpoint implies a 4% decline in revenues year-over-year including 0.5 points of currency headwind. Consistent with normal seasonal sequential decline in gross margin from Q3 to Q4 associated with product revenue being a larger portion of the overall revenue mix, we expect consolidated gross margin to range between 66% and 67%. We expect Q4 operating margin to range between 23% and 24%. We expect earnings per share for Q4 to range between $1.28 and $1.36 per share, which at the midpoint implies an 8% increase year-over-year. The midpoint of our Q4 revenue guidance implies that total fiscal 2020 revenue will be down 10% with ELAs being approximately 1% of total revenues. Our Q4 guidance also implies fiscal 2020 gross margin of 67% to 68% and an operating margin of approximately 21%. We expect fiscal 2020 EPS to be down approximately 7% year-over-year and within the range we guided last quarter. As George noted, we are seeing early signs of success from our strategic investments in sales coverage, which provides confidence in our ability to return the company to long-term growth. I want to again thank the NetApp team, our shareholders, customers, and partners for making the last four years a rewarding experience. With that, I'll hand it back to Kris to open the call for Q&A.

Thanks, Ron. We will now open the call for Q&A. Please be respectful of your peers and limit yourself to just one question so we can get to as many people as possible. Operator?

Hello, good afternoon. Thank you for allowing me to ask a question. Ron, I'm not certain what we should expect for ELA revenue in the guidance for the April quarter. However, even if we exclude ELA revenue from the guidance, it appears that product gross margins will decline by a few hundred basis points. Am I overlooking something? Additionally, would this decline be due to component cost challenges from NAND, or are there other manufacturing costs we should consider? Thank you.

Thanks, Karl. As you're aware, we don't specifically guide product margins. However, we anticipate about 1% of ELAs for the year in Q4, down from 2% previously. In terms of component costs, there was only a slight change quarter-to-quarter from Q2 to Q3, which resulted in a 0.1% headwind to gross margin. Additionally, there are various factors at play; for instance, a higher flash mix generally improves margins. Similarly, an increased software mix contributes positively to gross margin. There are many dynamics involved, so I wouldn't place too much emphasis on component costs.

I think with regard to the Q4 guide, the gross margin picture is affected by the fact that the mix between products and services leans more to products than it did in Q3. That's the typical seasonality that we see in the Q4 seasonal pattern. So we are not seeing anything specific other than just the mix of product and services being a little different than it was this quarter.

Thank you. Best of luck, Ron, and thanks. It's great to meet you and hopeful as well. Thank you.

Thanks, Karl.

Thank you, Karl. Next question.

Yeah. Hi, guys. Thanks for the question. Congratulations on the retirement Ron. Good working with you. And I wanted to just go back to these ELAs. I'm calculating if you're saying 1% of full year revenue, I mean the exact calculation on that's about $55 million. I'm assuming this is a rough estimate. It could be $50 million. But just three months ago you guys thought it'd be $100 million. And I'm just wondering why you continue to think you've got visibility here and we have so much uncertainty on these ELAs and why include them in the guidance given all that?

We can see some of them. They're still difficult to predict, but they always were back-end loaded, so some of the ones that we expect in Q4 probably going to slip out of the year. That's really it. But it's a very different year than last year. Last year, they're front-end loaded. This year they're back-end loaded. As we told you, they're difficult to predict in a quarter. And then, if they come at the end of the year they're difficult to predict than they're going to come in the year. So it's just that simple. Having said all that, we still are really happy with the gross margin performance of the underlying product revenue. It's very strong. It won't be a headwind because of the ELAs year-over-year.

I think, as Ron said, Rod, these ELAs are meant to make it easier for the customer to buy and they benefit from the structure of the ELAs to be able to buy more product more easily. We've always said they are choppy and hard to predict. We have deep engagements with the customers that we are structuring ELAs with. And we had we thought one in the quarter that has moved out, and that's why we've also taken down the range from 2% to 1%. So we're trying to do the best we can to give you a view of what's available and we're balancing that with the probability that some of them may not happen in the year.

Could you elaborate on the fact that you mentioned it's one George? Are you referring to a few ELA deals that would total $100 million? So is the $55 million perhaps from a couple of deals? Can you provide any clarity on that?

I believe these transactions are inherently large and involve only a small number of customers. In fact, 1% or 2% of our total revenue is not significant, and such transactions are quite rare. Each one tends to be unpredictable and substantial. I'll stop there, Rod.

Okay. All right, thank you guys.

Thanks Rod. Next question.

Hi, thank you. I know you just guided Q4, but can you give us any sense at all on how we should look at fiscal 2021? You have NAND pricing moving up again, your compares are quite easy, cloud data services seems to be doing better. Can you give us some guidepost on fiscal 2021? Talk about maybe at least some of the puts and takes on revenue and also on gross margins, if you could please?

We are not providing guidance for the next fiscal year at this time. We will share that information in the future. However, I can tell you that we are on track with our goal of adding 200 incremental sales positions to enhance our coverage of new accounts and improve customer acquisition by the end of Q1 of fiscal year 2020. It typically takes around four quarters for new sales representatives to become productive, so we expect to see most of that productivity reflected in next year's results, which should enhance our year-on-year performance compared to this year. We are already observing early benefits from our investments in acquisition accounts and districts, which are positively impacting our progress throughout the year. Regarding product gross margins, as mentioned, we are maintaining strong margins across both products and services, thanks to the uniqueness of our offerings, our efforts to enhance business productivity, and our sales team's discipline in realizing the full value of our products. Regardless of the ELA situation, we believe our gross margin business model is robust. We have managed our operating expenses carefully, adding sales personnel without increasing the company’s overall operating expense structure. We'll update you on our plans to maintain this operating expense discipline next year. Overall, our business model is solid, and I am confident that the investments we are making this year, in conjunction with our strong product portfolio, will lead to positive results next year.

George, appreciate that color. If I could really quick? On the ELAs, what is the hesitancy that you're seeing at the customer base, particularly because they don't necessarily have to shell out the cash upfront? So why is this not an indication that they're kicking the tires around other products? Or how should people read this hesitancy around signing ELAs?

I think first of all with regard to our competitive position, the data that we mentioned about our ability to win new accounts and gain share in new districts proves that we have strong competitive positions. With regard to these accounts that we are doing ELA discussions with, we are deeply, deeply involved in those accounts. We've got many years of experience dealing with them and we don't see that they're headed to an alternate architecture or alternate buying motion. I think these transactions are complex. They require coordination across many departments and the customer. We've always been transparent about the fact that they're lumpy, right? And there's very few of them. So my own view is ELAs are 1% to 2% of our business. The majority of the business is extremely healthy. These customers that we are in discussions with we have other ways to pursue meeting their needs beyond the ELAs and we are using that in other parts of some of these accounts. So we'll tell you more as the ELAs come through and we get more visibility into some of these discussions going forward.

Okay. Thank you.

Thanks, Wamsi. Next question.

Thank you, good afternoon. Just looking at the product revenue trajectory, the decline accelerated in the January quarter, despite an easier compare. Can you just talk about where you saw some of the incremental weakness in January?

I believe the decline was partially influenced by the ELA. If the ELA had performed better, the situation would look quite different. Regarding the ongoing weakness in product revenue, particularly with the largest enterprises, these segments are most impacted by the uncertain macroeconomic conditions affecting buying behavior. We are working to diversify our exposure by bringing in new accounts, and we have seen positive outcomes from those efforts. I hope that eventually, these two trends will align positively in the near future.

Thank you. Ron, congratulations on your retirement.

Thanks Katy.

Thanks Katy. Next question.

Thank you. Congratulations as well, Ron. Yeah. George and Ron, I just wanted to ask about the Cloud Data Services business. It is kind of moving higher. But it seems like the last few quarters, you've been adding more partners that you GA add and more products and solutions. And I think, we're at pretty much four quarters in a row where the kind of the sequential growth was about $10 million, give or take $1 million in that line. So, could you just talk a little bit about what you think it will take for that line to inflect a little bit more? Or is it more experience with the partners or other products? Or what do you think it will be that will make that line start to move a little more aggressively higher? Thank you.

Thanks for the question. There are two things that we believe will allow us to move that lineup. I think the first is we continue to do enablement and training, and we are acquiring more new customers every single day. These workloads or applications that we serve in the public cloud, they are important applications, right? They're mission-critical applications, high-performance applications. And so it takes a while for the customer to get comfortable with the usage of our technology before they adopt and expand. We are seeing some of the early customers who did proof of concepts with us starting to move some workloads. And now are starting to broaden their book of business. So that will take a little bit of ramp-up time. The second is, due to overwhelming demand. And the fact that operationally, we are in the early phases of a multi-region global rollout. We have a process that we've agreed on with the hyperscale cloud provider, which they call white-listing, where the customer requires registration for us to manually approve them being onboarded. We are in a window where we're working hard to remove white-listing. And that will allow us to scale in a much more automated fashion. So those are the two key things that we need to get through to be able to scale it even faster.

Okay. And I assume we're still on track with the long-term targets here?

We have clear signs of the favorable demand patterns, and as we see that, the market opportunity is clearly there to get. And that's clearly our goal and intent. As we said, we are about a year behind where we wanted to be because of the time it's taken us to get these services to production readiness, and so we're going to continue to push to see how we can get to that target. And we'll keep you updated on progress.

Okay. Thank you.

Thanks, Tim, next question.

Yeah. Thanks for taking my question and also congratulations Ron. It's been great working with you. I apologize to go back to this discussion. But maybe just trying to understand the math a little bit more given I think the questions I'll get is, if I look at the lumpiness in the ELA business. And I appreciate that that lumpiness will continue. I think it's important to kind of understand what you're saying about the gross margin. So if I assume the ELA gross margin is close to 100%, it seems like your implicit guide on gross margin is back into the mid-65% range. So I guess what I'm asking is, what am I missing? And I can appreciate the mix of the business is a variable in the April quarter. But I'm just trying to think about if ELAs aren't there, how do we think about that gross margin structure going through the course of the next couple of quarters?

We expect the gross margin for the quarter to be between 66% and 67%. Last quarter in Q3, it was about 68%. In Q4, we will see a higher proportion of product revenue, which is the main factor affecting margins. The product margin guide used for this is actually higher than Q3 due to ELAs. Although it might not be entirely visible, I assure you that everything is consistent.

Okay. I understand that ELA attributes are impacted after the initial software contributions. Additionally, there are hardware-only revenues that come in, which have lower margins. This is not a variable at this point.

That's correct. There is now a difference in margin between all-flash and hybrid that we didn’t have in the past. The margin for all-flash sales is significantly different compared to hybrid. Additionally, the mix of software plays an unpredictable role. In the last quarter, Q3, we observed that software made up a smaller portion of the total compared to Q2, contributing to a slight decline. There are numerous factors at play here.

Okay. Thank you very much.

Sure.

All right, thanks, Aaron. Next question.

Thank you for your questions. Ron, it was a pleasure working with you, and I wish you the best in your future endeavors. George, in looking at your guidance for the April quarter, I have some assumptions regarding the all-flash array. It appears that you are heading into fiscal year 2020 with a high single-digit decline in all-flash array revenues. As you adjust the sales force and reload, how should we consider the growth expectations for this specific area of flash array? Are we aiming for double-digit growth? If so, what gives you confidence beyond just adding 200 more salespeople? I also have a follow-up.

I think this year the all-flash array business has been affected in two dimensions. One was the fact that our largest customers, who were most impacted by the macro, were heavily all-flash customers. So from a product mix perspective, the fact that our biggest accounts underperformed or bought less impacted our all-flash business more substantially than it impacted pretty much every other product in the company. The second is that the ELAs were also heavily all-flash-oriented. So both of those have been contributing factors to the year-on-year declines in the all-flash category. We expect the work that we're doing with the deployment of additional sales force resources, as well as focusing our compensation plans and our sales objectives on returning to growth in the all-flash category, to be able to drive our business at and above market growth rates. And we'll tell you more about that as we issue the FY 2021 guide. But we are taking actions to focus our sales force on the best-in-class product in the all-flash category which is ours, right? And we have every confidence that we should be able to meet or beat the market next year.

Sure. And a quick follow-up. I understand ELAs have a material impact on product margin. But excluding ELA, NAND prices are going to go up and they're going to go up much higher than where they are today. So how are you able to manage product gross margin independent of ELA? Because I perceive ELAs as volatile and there's no way I could model that. So I just want to think about the increase in bill of materials and how you're going to be able to manage that?

So, Mehdi, there are two points to address: first, as you observed this quarter, NAND prices increased by about 4% from the previous quarter, which has had a minimal impact on our gross margin. This is because, contrary to common belief, NAND does not constitute a large portion of our cost of goods sold; much of it comes from software and other components. Therefore, while we do expect NAND prices to rise this year, it shouldn't significantly affect our gross margin due to the various other components involved.

Is that because there's another replacement cycle approaching? Is there a premium? While NAND is a small portion, I understand its price is increasing.

Listen, I think first of all for the drives in our platforms, we typically pass the cost on to our customers, right? I think NAND is not an embedded component of our system, it is a consumable that we pass on to customers. And so we don't try to mask the commodities in terms of the drives in our system. And so there will be, at some point, as the market adjusts upward, if that is the trajectory, we're going to be discrete about making sure that we pass on some of that to our customers, right? And so we've had that history. I think the industry as a whole has had that history. And we'll disclose it when we do it, right? I think with regard to product gross margins, they've been strong this year and even without ELAs because of the fact that our sales force has been enabled and we know how to sell the value of our offerings. A substantial portion of that value is actually software that both makes our systems the most efficient in the industry, but also allows our customers to uniquely take advantage of hybrid cloud capability that nobody else in the industry has. And so we are differentiated in software. That's proven out in the ability to hold gross margins in a tough economic environment.

Clear. Thank you.

Great. Thanks, Mehdi. Next question.

Yeah. Thank you. George, can you just talk a little bit about the wider demand environment that you're seeing and if it's changed at all versus the prior few quarters? And then I guess given it's been about a year since you've been calling out macro as a headwind, what gives you confidence that these larger deals are just actually being pushed as opposed to either competitive losses or some sort of a secular shift in customers thinking about their on-prem footprint more broadly?

So we saw the first signs of the macro being a little bit more choppy was about a year ago in January. We saw a substantial step-down from that level of uncertainty into a much more sort of uncertain environment in Q1. I think from Q1 of our fiscal Q1. I think from then on it's stayed relatively in the same territory. I wouldn't say it has gotten worse. It is reflective of three or four key things. I think the first is buying cycles are longer and the amount of spend per transaction is smaller. I think we have consistently seen a higher rate and number of transactions across a broader range of accounts, especially as we've added sales capacity through the year. And so, that's indications that we can win in net new accounts, but that the average transaction size is more muted. You also see the fact as we've said where people are buying for now versus buying capacity for the long-term. Even though you hand people incentives to buy a larger transaction, they're more sort of comfortable buying for the short-term. Those are some of the key things. With regard to what gives us confidence that we can return to growth, listen, I think first of all, we have relatively easy compares in the first half of next year. We've put in capacity ahead of that window to get our sales teams productive. We've got work to do to enable all the 200 that we put in place. But the results from the new deployments of resources, in terms of customer wins, units, sales volume, use cases, have all been really encouraging. With regard to these large customers that we are engaged with, we have deep relationships with them. We know when they're making an architectural choice to go to the cloud because we are an intimate part of those cloud discussions with many. And frankly, as we said in our prepared remarks, some of them going to cloud might be a near-term hindrance to revenue growth, but they give us a much broader revenue opportunity in the medium-term, right? We mentioned the Fortune 10 company, which as they've moved to cloud has given us a maybe 3 to 4 times larger opportunity than we had on premises. And so, we're excited about that opportunity in those accounts that are choosing to move to cloud.

All right. Thanks, Matt. Next question.

Good afternoon, guys. Appreciate you taking the question. Ron, from me as well congratulations, it's been great working with you. Really enjoyed it.

Thank you. Appreciate that.

George, I understand that you mentioned you don’t believe the spending environment is becoming more challenging. However, when I exclude the ELAs from the strategic revenue, it looks like the declines in the January quarter were slightly more favorable, but that comparison seems much easier. This leads me to think there might be some additional pressure in the spending environment. I wanted to confirm I interpreted your comments correctly. Additionally, regarding the new sales force ramp-up, do you feel your productivity is meeting your expectations at this stage? We're seeking context not only around product revenue but also regarding the strategic product revenue spending dynamics.

Listen, I think that we're seeing the environment is choppy, right? We are seeing that customer spending, enterprise IT spending for on-premises data centers is choppy and that has been true for a few quarters now. Do I have enough data to say, it's a shade better or a shade worse? I don't have that data, right? I'm just saying it is pretty choppy and uncertain. I think with regard to the sales force productivity, we've always said it's between three and four quarters, roughly four quarters for a new account manager to be fully trained and equipped and ready. We said that we would be adding increments of 50 headcount starting in Q2 of fiscal year 2020 and finishing at the end of Q1 fiscal year 2021. So we would have four chunks of that. We are on track with the hiring, and we're working hard on enablement, right? And so, I think if you do the math, the majority of the productivity impact of that headcount is actually next fiscal year. And listen, we'd love to move the productivity impact earlier and we're doing everything we can, but I think that's where you should reasonably model it.

Okay. Okay, great. Thank you.

Thanks, Ananda. Next question?

Yes. Thank you. I wanted to ask about any potential impact you're seeing from the coronavirus in your supply chain, given that most of your key suppliers are in Asia, in China. So, any constraints there? Or given that you're still early in the quarter, and you tend to be more back-end loaded by the time you get through the quarter that shouldn't be an issue?

Listen, our Q4 revenue guide does not include any disruption to our supply chain from the coronavirus. So far, two elements of our business and their potential impact on coronavirus, right? On the demand side, we don't have a large business in China. We, as you know, prosecute that business through a joint venture with Lenovo, who are the distributors of our technology in China. Our customers do large amounts of business in China, so I would model on the demand side that our impact to us is a second-order derivative, right? With regard to the supply side, with regard to our supply chain, yes, we like others have a supply base that is built—that has a meaningful footprint in China. And we are working pretty hard on contingency planning to minimize disruptions. So far, we have not seen any, but I think there's probably likely some, and we're working hard to minimize that.

Okay. Thank you.

Thanks. Good afternoon. Congrats Ron on your retirement. I'm thinking you might have a future as a NAND analyst going forward. You may not like the job. In terms of questions, I was just curious this may be in the rounding of the numbers but it looks like sales through channel were a little weaker year-over-year. I was wondering if you could talk a little bit about that? And also, a similar question on the public sector markets was there any changes relative to your expectations there? It seemed like it came off a regular sort of end to their October fiscal year? Thank you.

So with respect to the mix of channel, I mean, that vacillates–it's usually 80/20, as vacillates around that mean. There's nothing underlying there that was is permanent or unusual.

With regard to the public sector business, mostly performed according to plan. I think we saw a pretty normal pattern of business in our public sector.

And just as a follow-up to that any initiatives to sort of maybe reaccelerate your business there? I know, one of your smaller competitors has been focusing on that area. Do you see that as a threat? Or is this more just tied to general budgets?

Listen, I think we have a variety of ways to broaden our relevance in the public sector. We are working with some of our cloud provider partners to be part of their initiatives and to serve our men and women in uniform in new and interesting ways. So we'll tell you more about that as we bring those to market.

Okay. Thank you very much.

Thank you, Steve. Next question.

Thanks very much. George, if I remember right, it was approximately six months ago you'd mentioned about increasing sales force by 200 and you mentioned it again. I was just wondering, is the tempo or the cadence of that going faster than expected, in line with expected, slower than expected? Because what I'm trying to do is figure out the softer guidance. Is it being impacted at all by that sales force transition? Or is it more macro and just longer decision-making timelines? Thank you so much.

With regard to the sales force, we said that we would add 200 incremental sales resources to allow us to acquire new customers. We laid that out in four quarters sort of saying that we would start in Q2 of this fiscal year and finish at the end of Q1 of fiscal year 2021, and we are on track. As I said in my prepared remarks, we are bringing good candidates on board and we are generally on track. We also said that it would take a typical new sales rep about four quarters to get productive. So if you do the math, the majority of the benefits of that investment really are next year, right? With regard to Q4, the change or the softness is really for us being a little bit more conservative on ELAs going from previously what we thought would be 2% down to 1%, maybe a shade below 1% in that range, right? And so I think that's the majority of the change between what you saw previously and what you see now.

Thank you so much for the clarifications and detail that's greatly appreciated. And Ron we'll greatly miss you.

Thank you. Appreciate it, Jim.

Thanks, Jim. Next question.

Thank you for taking the question and Ron congratulations on the retirement. I wanted to see if we can maybe talk about your overall philosophy regarding return of capital. You've been buying back a lot of stock, another $500 million this quarter, paying a good dividend over $100 million. And so you've been exceeding your free cash flow and you're almost out of the authorized $600 million. So I assume you're going to update us on that at some point. But I guess what I'm trying to get to is the long-term philosophy. And does the transition of CFO mean that you'll want to wait for the new CFO to set a philosophy? Or how are you thinking? Thank you.

Well, yeah, I think it's going to coincide with the change in the fiscal year when we give the guide. Obviously, we'll give some clarity around what would happen to the capital allocation policy. But the dividend is permanent, that's not going to change. If anything, it's going to go up as we proceed from here on out. And to your point, we're almost done with the $4 billion share repurchase. So you could see that getting to an end fairly soon and the company will probably re-clarify what the next tranche will be going forward. And I'll let my successor determine that with George.

I'll just say that Ron and I have had a common philosophy and a shared one around the sources and uses of cash. I don't think you should see a radical departure from our belief that cash is an important asset for both investing in the long-term health of the business and in terms of providing returns to shareholders. So, I don't think that you should see us make a radical departure from that philosophy going forward.

Great. Thank you. That's helpful.

All right. Thanks Simon. Next question?

Thank you, Ron, and best of luck. It's been great to have you here. I want to focus on the last seven years, particularly regarding product revenue on a quarter-to-quarter basis, excluding the ELAs. The average growth appears to be about $39 million, if I understand correctly. However, four out of the last seven quarters have shown significant misses, while the other three have consistently ranged from $73 million to $77 million. This leads me to be somewhat concerned about achieving this lower product revenue when excluding ELAs. Given the turbulent environment and uncertainty, what gives you confidence that you can reach that midpoint?

You're talking about Q4?

Yes, there is sequential growth in product revenue compared to Q3. If I simplify my modeling of software maintenance and services, I find them to be straightforward. When I analyze product revenue, I exclude the $50 million, and the average seems to be around $39 million from one quarter to another.

Q4 has consistently been our strongest quarter for year-end sales. We have put significant effort into analyzing our pipeline. While we recognize that achieving our guidance requires strong execution and could be affected by disruptions such as the coronavirus, we are optimistic as it is the end of the fiscal year, and sales representatives who are performing well are likely to close deals. That’s the gist of it. As always, we enter the quarter assessing our pipeline, close rates, and the number of high, medium, and low probability transactions needed to meet our targets, and we've completed that analysis. The environment is uncertain, so we are proceeding cautiously with our forecasts, but we are doing thorough due diligence to ensure the quality of the bookings forecast we provide.

Okay. Thank you.

All right, thanks Lou. Next question?

Yes, you've given us some good clarity on the sales hiring effort. I was just curious where did our headcount finish up for January 31st? And where do you expect it ending the fiscal year?

So, it was roughly flat and hasn't changed much. We haven't been in a hiring mode except for the salesforce. We're keeping operational expenses essentially flat this fiscal year. Some of that is variable compensation, but it clearly indicates that we're not significantly increasing our workforce, just strategically in certain areas.

Are you continuing to pursue your college hiring cycle that typically brings on new employees in the first quarter, or has that been put on hold?

No, that's ongoing.

Okay. Thank you.

Thanks Eric. Next question?

Hi everyone. Good afternoon. George, we are hearing that HCI Systems are increasingly replacing traditional servers and storage systems. This indicates that the market might be shifting towards the enterprise-level applications that your product targets. Can you share your outlook for 2020 regarding whether you anticipate an increase in your HCI revenue in the upcoming year?

Listen, HCI addresses some of the use cases in the customers' data center, particularly ones that are single application use. I think that we have a good offering. It's differentiated for mixed workloads and has several elements for customers who require good data management capabilities even in a single application use. And we're focusing our efforts in HCI in that part of the market. We don't see HCI displacing the core of solid-state storage, right? I think fiber channel storage as well as high-performance scale-out NFS storage has still got actually many, many applications in the data center. And our original view that HCI might displace those isn't being proven true. And I think you'll see us push aggressively with our flash and hybrid flash products to address those use cases.

Got it. If I can follow up just quickly, are you willing to share what percent of customers are still at a proof-of-concept stage with CDS?

No, it's too early to comment on that. I can say that the majority of our customers today using CDS are in early production. They are in proof-of-concept for their first application deployment on our platform. They may be in production with that application, but it's just the first of many. They intend to transition to that platform. Generally speaking, until we eliminate ungated demand by removing what we call white-listing, every customer is essentially in proof-of-concept mode. Once we remove that, we expect to see much more automated onboarding of customers to the platform.

Got it. Thanks guys. Good luck Ron.

Thank you, Nik. Next question.

Thank you for taking my question. And best of luck Ron. George, could you maybe give us a bit more color on trends in North America? Are there any areas where you're seeing market share gains from a workload perspective? Are you starting to see any benefit from the streamlined purchasing model?

I think with regard to the use of consumption and consumption-based offerings, we see that our cloud data services plus managed services from partners are really good opportunities for customers to get going with us in a consumption offering. I think we made our subscription-type model available. We're seeing early interest that's very healthy, and we are working with a small group of customers on proof-of-concepts getting them onboard and going from there. With regard to the streamlined pricing and packaging of our platforms, I think that's a big part of why product gross margins continue to be healthy, right? I think that customers are able to understand the value that we offer in a much more streamlined way than we historically used to. And so it's another support element for product gross margins helping our sales force establish value with customers. With regard to some of the shifts we see going on in the market, as I mentioned, we are participating with the hyperscaler cloud providers in new market opportunities, especially in the public sector market. We'll tell you more about it as those become real, but they expand our total addressable market opportunity in a way that we didn't before.

All right. Thanks, George. Next question.

Yeah. Thank you. The year-over-year trajectory on the hardware maintenance went from declining mid single-digits to flat. Is there a narrative behind that?

Yeah. So actually if you remember even in Q1 and Q2 adjusting for currency, we were flat. This quarter it's up about 5%. What I tried to put in my prepared remarks, and we've actually started to see the benefits of some of the work we've been doing on renewals, so it's finally starting to pay off. Better renewal rates, better structures, better pricing, better discounting, so you'll have to wait until next year, but that's actually a bright spot that trend line is actually in really good shape.

Okay. Thank you.

All right. Thanks Nehal. I'm going to pass it back to George for some final comments.

Our Data Fabric strategy is creating value for our customers, NetApp, and our investors. Only NetApp has the strategy, the innovation portfolio, and customer experience to help customers succeed in hybrid multi-cloud IT. All these integrations with the leading public clouds and industry-leading technology for on-premises storage solutions give us a sustainable competitive advantage. We'll continue our strong focus on operational discipline, which enables us to make the strategic investments in sales coverage, customer experience, and hybrid multi-cloud solutions needed to capitalize on the opportunity ahead. We are seeing early signs of success by getting in front of more customers, which gives me confidence that our investments will pay off in future growth. Thank you all and look forward to speaking with you again next quarter.