Netapp Inc (NTAP) — Q2 2023 Earnings Call Transcript

Hi, everyone, thanks for joining us. With me today are our CEO, George Kurian, and CFO, Mike Berry. 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 third quarter and fiscal year 2023, our expectations regarding future revenue, profitability, and shareholder returns, our alignment with industry megatrends and expectations regarding the future growth in the number of cloud customers and their usage of cloud services, our ability to deliver innovation and focus on our strategic growth opportunities while optimizing our operating costs, and our ability to drive sustained growth in both our Hybrid Cloud and Public Cloud segments in a turbulent macroeconomic environment, 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 such as inflation, rising interest rates and foreign exchange volatility, the continuing impact and uneven recovery of the COVID-19 pandemic, including the resulting supply chain disruptions, and the IT capital spending environment, including the focus on optimization of cloud spending, as well as our ability to keep pace with the rapid industry, technological and market trends and changes in the markets in which we operate, execute our evolved cloud strategy and introduce and gain market acceptance for our products and services, and manage our gross profit margins and generate greater cash flow. 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 and Form 10-Q including in the Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors sections. 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 and welcome everyone to our Q2 FY 2023 earnings call. Coming off a strong Q1, our team delivered a solid quarter, with all-time highs for Q2 billings, revenue, gross profit dollars, operating income, and EPS. We remain focused on disciplined operational management and the execution of our strategy, which is tightly aligned with customer priorities. On today’s call, I will walk through four topics; one, we delivered a good quarter in a dynamic environment. However, we are disappointed with the deceleration of growth in our cloud services. Our conviction in the cloud opportunity and our ability to execute against it is unwavering. Two, we are aligned with the durable, megatrends of data-driven digital and cloud transformations. We continue to deliver innovation that furthers our already strong position. Three, we believe strongly in the opportunity ahead, but have slightly tempered our revenue outlook for the remainder of the fiscal year, due to near-term macro headwinds. Four, we understand the imperative to deliver shareholder value in a slowing environment and will focus on our strategic growth opportunities, while continually optimizing our operating costs. Let's start with the first point, our performance in the quarter. Q2 public cloud segment revenue increased 63% year-over-year to $142 million and dollar-based net revenue retention rate remained healthy at 140%. However, Public Cloud ARR of $603 million fell short of our expectations. As our cloud partners discussed on their earnings calls, growth has slowed as customers look to optimize cloud spending. This macro-related optimization caused some slowing of growth in our cloud storage services as well. Additionally, we had a few customers with very large project-based workloads like chip design, that came to their natural conclusion, resulting in capacity reductions in those environments. We expect these customers to kick off new projects early next calendar year, as the number of cloud customers and their usage of our cloud services grows, the impact of this type of workload will be smoothed over a much broader customer base. In our cloud operations portfolio, Spot is benefiting from the same desire to optimize cloud spending that was a headwind to our cloud storage services. Spot's value proposition is a strong engine for new logo acquisition and Q2 saw an acceleration of new Spot customer additions from Q1. As we've discussed on past calls, we continue to refine our approach to cloud insights and are seeing early positive signs, with the growth of new Cloud Insights customers in Q2. We continue to see healthy growth of new-to-NetApp customers and of existing NetApp enterprise customers adopting our cloud services and those customers are growing in scale as well. The number of customers with greater than $1 million in ARR has more than doubled from Q1 last year. Our public cloud services are highly differentiated and create customer preference for NetApp. We have a multiyear advantage over our traditional competitors in this critical market, positioning us well to deliver sustained growth. Compared to Q2 a year ago, Hybrid Cloud revenue grew 3% and our all-flash array business increased 2% to an annualized revenue run rate of $3.1 billion. Adjusting for the significant FX headwinds, Hybrid Cloud grew 8% and all-flash grew 7% in constant currency. All flash penetration of our installed base grew to 33% of installed systems. Our lower-cost, capacity-oriented all-flash arrays and FAS hybrid flash arrays both performed well. Onto the second point, our alignment to the industry megatrends and our continued innovation. The world is moving faster than ever, raising data-driven digital and cloud transformations to business necessities. NetApp helps meet these objectives with a modern approach to hybrid multi-cloud infrastructure and data management that we term the evolved cloud. We provide customers the ability to leverage data across their entire estate with simplicity, security, and sustainability, which increases our relevance and value to our customers. We believe strongly in the sizeable, durable, and growing opportunity created by these megatrends. As many of you know, we bring significant value to customers running VMware environments on-premises. With a series of announcements made in conjunction with VMware, we are now able to bring that same value to customers in the cloud. Our native cloud storage service integrated with VMware helps customers quickly, easily, and cost-effectively migrate enterprise workloads to the cloud and accelerate modern application development using Kubernetes. We are the only certified and supported third-party cloud storage solution for VMware Cloud, which creates significant new opportunity for us. At the start of November, we introduced BlueXP, the next big step in fulfilling our vision to give customers the simplicity, security, savings, and sustainability needed for an evolved cloud. It delivers true hybrid, multi-cloud operations by bringing storage and data services together in a single, unified control plane. BlueXP is a highly differentiated solution that enables customers to deploy, discover, manage, and optimize not only infrastructure and data but supporting business processes across multiple clouds and on-premises environments. In addition to bringing forward technical capabilities, we are helping customers achieve their environmental goals by creating energy-efficient products. We have added power and temperature reporting in Cloud Insights to give customers a real-time view into energy expenditure and our carbon footprint reports provide a reasonable estimate for the carbon impact of their NetApp systems. We enhanced our storage efficiency with a 4:1 efficiency guarantee for SAN workloads to help customers minimize their storage footprint and lower energy usage. We not only help customers practice sound environmental stewardship, we practice it ourselves. I am proud to announce that EcoVadis, the leading evidence-based ESG rating agency, awarded NetApp a gold ranking, placing us within the top 7% of evaluated companies. Now the third point, the macro environment and our business outlook. As we moved through the quarter, we saw increased budget scrutiny, requiring higher level approvals, which resulted in smaller deal sizes, longer selling cycles, and some deals moving out of the quarter. In Q2, we felt this most acutely in the Americas hi-tech and service provider sectors. We see no change to our underlying opportunity and are confident in our position. However, current economic realities and unprecedented FX headwinds are and will continue to impact IT spending, causing us to temper our revenue expectations for the second half. And finally, point four, driving shareholder value. In response to the slowing top line, we are being agile and taking action to lower operating expenses. Already, we have implemented a broad-based hiring freeze and are reducing discretionary spending, as well as further optimizing our real estate footprint. We will remain disciplined as we continue to shift resources away from lower yield activities to our biggest opportunities. In closing, we are clearly aligned with our customers' strategic priorities and remain confident in our long-term opportunity, despite the current external headwinds. By focusing on what we can control, we will aggressively seek to maximize the near-term return on our product and services portfolio, while leveraging our leadership position in all-flash, cloud storage, and cloud infrastructure optimization. I would like to thank the entire NetApp team for delivering a strong first half. In a challenging environment, we remain focused on innovation, execution, and operational discipline. I’ll now turn the call over to Mike.

Thank you, George. Good afternoon everyone, and thank you for joining us. Before we go through the financial details, I think it would be valuable to walk you through the key themes for today’s discussion. Number one, as George highlighted, we delivered a strong Q2 in a dynamic environment, with all-time Q2 company highs for billings, revenue, gross profit dollars, operating income and EPS. Number two, we have adjusted our outlook for the second half of the fiscal year due to an increasingly challenging macroeconomic environment and unprecedented FX headwinds. Number three, as we navigate through the current macro environment, we are laser focused on driving operating margins and free cash flow generation. As George noted, we have taken actions to reduce our full-year expense envelope and will remain fluid in assessing further opportunities to take costs out of the business. Number four, as a result of these cost savings measures, the entirety of the Op margin and EPS guidance revision for the full year is being driven by the incremental one to two points from the deepening currency costs we have seen since our Q1 call; and number five, we continue to expect to generate greater than $1.4 billion in operating cash flow and $1.1 billion in free cash flow for the full year. From a capital allocation perspective, we will continue to pause Cloud Operations acquisitions for the remainder of fiscal '23. We now plan to return more than 100% of fiscal '23 free cash flow to investors through dividends and incremental share repurchases. Now to the details. As a reminder, I’ll be referring to non-GAAP numbers unless otherwise noted. Q2 billings were $1.6 billion, up 3% year-over-year. Revenue came in at $1.66 billion, up 6% year-over-year. Adjusting for the 540 basis points headwind from FX, billings and revenue would have been up 9% and 12% year-over-year, respectively. Even with the challenging Q2, our cloud portfolio continues to positively impact the overall growth profile of NetApp, delivering 3.5 of the six points in revenue growth. Hybrid Cloud segment revenue of $1.52 billion was up 3% year-over-year. Product revenue of $837 million increased 3% year-over-year. Total Q2 recurring support revenue of $607 million increased 3% year-over-year, highlighting the health of our installed base. Public Cloud ARR exited Q2 at $603 million, up 55% year-over-year. Public Cloud revenue recognized in the quarter was $142 million, up 63% year-over-year and 8% sequentially. Recurring support and Public Cloud revenue of $749 million was up 11% year-over-year, or 16% in constant currency, constituting 45% of total revenue. We ended Q2 with $4.1 billion in deferred revenue, an increase of 5% year-over-year, or 10% in constant currency. Q2 marks the 19th consecutive quarter of year-over-year deferred revenue growth, which is the best leading indicator for recurring revenue growth. Total gross margin was 66.3%, in line with our guidance. Total Hybrid Cloud gross margin was 66% in Q2, including a two-point year-over-year headwind from FX. Within our Hybrid Cloud segment, product gross margin was 50%, including a three-point year-over-year headwind from FX. Our growing recurring support business continues to be very profitable, with gross margin of 93%. Public Cloud gross margin of 68% was accretive to the corporate average for the eighth consecutive quarter. We remain confident in our long-term Public Cloud gross margin goal of 75% to 80%, as the business scales and an increasing percentage of our Public Cloud revenue is driven by cloud and software solutions. Q2 highlighted the strong leverage in our business model, with operating margin of 24%, including two points of FX headwinds. EPS of $1.48 came in nicely ahead of guidance and included a $0.21 year-over-year FX headwind. Cash flow from operations was $214 million and free cash flow was $137 million. Q2 included our annual repatriation tax payment and continued cash outflows for certain inventory and premiums for constrained trailing edge analog parts. Additionally, collections were lower than expected due to a backend-loaded quarter for invoicing linearity that you see in the higher accounts receivable balance. Our component purchasing strategy allows us to meet as much customer demand as possible, but remains a clear headwind to cash flow and gross margins. We are seeing signs of relief in supply availability. The timing of a full supply recovery remains uncertain, however, as our inventory levels start to normalize, it will be a tailwind to free cash flow as we go through the second half of fiscal '23. During Q2, we repurchased $150 million in stock and paid out $108 million in cash dividends. In total, we returned $258 million to shareholders, representing 188% of free cash flow. Share count of 220 million was down 4% year-over-year. We closed Q2 with $3 billion in cash and short-term investments. Now to guidance. As George discussed, we have seen softening in the macro backdrop, with customers taking a decidedly cautious approach to spending. Additionally, currency headwinds have only continued to increase. We now expect fiscal '23 revenue to grow 2% to 4% year-over-year, which includes five points of FX headwind versus the four-point headwind assumed in our prior guidance. We now expect to exit fiscal '23 with Public Cloud ARR of approximately $700 million, which equates to our Public Cloud segment driving three points of total company revenue growth for the full year. Three drivers are impacting the near-term growth rate of Cloud ARR. Number one, in this macro environment, we project continued optimization of storage services as we help our customers manage their spending, which benefits Spot, but will offset some incremental near-term storage services ARR. Number two, we expect that project-based workloads will grow in both number and scale, but as they ramp, it will take some time to materialize into sizable ARR; and number three, we continue to tighten up the Cloud Insights sales motion, but we don’t expect this meaningful cross-sell opportunity to materialize until we head into fiscal '24. In fiscal '23, we continue to expect gross margin to range between 66% and 67%, as elevated component costs and FX headwinds weigh on product margins. As you know, the vast majority of our bill of materials is procured in US dollars. We are optimistic that supply constraints will ease further in the second half of our fiscal year, reducing our dependence on procuring cost at significant premiums. We should also see a benefit from declining NAND prices in Q4. While the timing is uncertain, we remain confident that our structural product margins will normalize back to the mid-50s in the fullness of time. For the full year, we expect operating margin of approximately 23%, which now includes approximately two points of FX headwind and EPS of $5.30 to $5.50, which now includes more than $0.70 of currency impacts. It’s important to reiterate that we are offsetting the full year revenue adjustment with an extremely disciplined approach to our spending envelope. As a result, the entirety of the Op margin and EPS guidance revision for the full year is being driven by the incremental one to two points from the deepening currency costs we have seen since our Q1 call. We continue to expect to generate greater than $1.4 billion in operating cash flow and $1.1 billion in free cash flow for the full year. From a capital allocation perspective, we will continue to pause cloud operations acquisitions for the remainder of Fiscal 2023, as we sharpen our portfolio focus by refining the Cloud Insight value proposition and sales motion, accelerating the integration of Spot and CloudCheckr into a single FinOps suite, and driving the successful integration of Instaclustr. As I said earlier, we now plan to return more than 100% of fiscal 2023 free cash flow to investors through dividends and incremental share repurchases. Now on to Q3 guidance. We expect Q3 net revenues to range between $1.525 billion and $1.675 billion, which at the midpoint implies a 1% decrease year-over-year, or 4% growth in constant currency. We expect consolidated gross margin to be approximately 67% and operating margin to range between 22% and 23%. We anticipate our tax rate to be between 21% to 22%. And we expect earnings per share for Q3 to range between $1.25 and $1.35 per share. Assumed in our Q3 guidance is net interest income of $5 million and a share count of approximately 220 million. In closing, I want to thank the entire NetApp team for their continued commitment in such a dynamic environment. I’ll now hand it back to Kris to open the call for Q&A.

Thanks Mike. Operator, let’s begin the Q&A.

Can you hear me?

Yeah, we can hear now.

Okay. So this is Abdulla speaking in for Amit. So I think your guys' cloud ARR expectation is coming down by $100 million versus prior expectations. And I just wanted to ask whether you guys could perhaps touch on the softness there? Is this more on compute, storage or analytics? And maybe if there's one cloud provider where the ramps are more challenged versus not? I would appreciate any details here. Thank you.

We expect to see the continuation of some trends from Q2, particularly in our consumption-oriented cloud offerings, especially in cloud storage services, which were impacted by customers looking to reduce spending. This could mean they either use less capacity with our services or we assist them in migrating workloads from a high-performance tier to a more cost-effective tier, ensuring they continue to see value with us. Additionally, we noticed in Q2 that some project-based workloads, like large-scale semiconductor design, reached their natural conclusion. We expect some of those workloads to return in early next calendar year, but we are being careful with our expectations. Lastly, with our Cloud Insights product, we have been focusing on refining its use case. We have seen some initial success with acquiring new customers for Cloud Insights, but we remain cautious about its future growth rate until we see more evidence of success. Overall, I did not notice any significant differences among the various cloud providers. Our relationship with Microsoft remains the strongest, as we have collaborated with them the longest, and they experienced the most significant impact this quarter.

Thank you. Next question please.

Yes. Thanks for taking my question. Two follow-ups. George, if I just take your guidance commentary, you suggest that all-flash array revenues should show Q-over-Q and year-over-year decline in January quarter?

We didn't provide specific guidance regarding all-flash array revenue. We have given guidance at the total company level and are being cautious about our outlook based on what we observed during the quarter and the ongoing macroeconomic conditions. We are not offering guidance for any specific product category at this time.

Just that's what I walked away with. Is that a realistic assumption for all-flash array revenues were to decline?

We're not guiding down to the product line, Mehdi. Sorry, that we can't help you with that.

Yeah, that's fine. At least I tried. Regarding your comment about chip design, there is clearly product migration, and new products for AI applications are expected to be introduced. You also mentioned that this should contribute to a rebound in cloud data services. I want to understand your underlying assumption. Do you believe that the product transition will ramp up in early calendar year? Is your guidance on cloud data services completely derisked due to this transition? Transitions sometimes take longer, and I’m curious about the key assumptions involved.

I think with our cloud outlook, we've been cautious to address three topics, right? One is consumption services on the cloud are being impacted by customers reducing spend either by optimizing the performance level that they use or the total capacity they use in our cloud storage services. That will happen for a period of time and then we will see build back. We don't see that yet in the outlook. I think with regard to project-based workloads, listen, there are lots of different customers with different projects. I think in this case; we saw a few large projects come off our environment. And we've been cautious about how many of those come back in terms of our outlook. It will take time for them to come back as new projects and new chip designs. We are the only option in the public cloud for semiconductor chip design technologies to be verified as a cloud service. So, we expect, over time, more and more customers will use our cloud services but that will take time. And then I think in our CloudOps portfolio, as I said, we are pleased with the work that we've done so far. There's still more work to be done. And so we're being appropriately cautious about how fast that product portfolio, especially Cloud Insights grows in the second half of this year.

Thank you.

Great. Thanks guys for taking my question. Hi George, hi Mike. Maybe just a big picture question on macro and linearity and how you thought about the quarter as it progressed because obviously, you did a good job of cutting costs, managing the business to the economic backdrop. But all-flash arrays were relatively weaker in the quarter, suggesting that obviously, you probably knew early in the quarter that customers were looking for more maybe cost conscious or cost-effective solutions. And you mentioned a lot of decisions were picked up to the CTO level or the CFO level. So, can you, kind of, discuss what you saw as the quarter progressed from a demand perspective? Was there a pivot point or was it just sort of a gradual bleed as we walk through each of the months? And how did it relate to, let's say, 90 days ago when we had this conversation? Thanks.

I believe the situation worsened gradually throughout the quarter. As a consequence, we are being carefully cautious in our guidance. The rapid rate increases certainly affected customers' business confidence, leading to a growing number of customers experiencing declines in that confidence as the quarter went on, which in turn deepened the impact on their spending. I didn’t observe any significant shifts in the product mix during the quarter. Hybrid flash has consistently performed well for several quarters, while all-flash has been steady as a portion of our total mix rather than increasing significantly. Therefore, I think our perspective on the product portfolio was less affected than our view of the overall business opportunities available to customers. I'm going to let Mike provide additional insights.

Yes. Thanks, George. So David. Per George's comments, when we saw linearity in the quarter, month one was relatively consistent with what we've seen in, I'll call it, non-Q4 quarters. What we really saw was month two push into month three. And typically, we will see, call it, mid 40% of transactions and invoices in month three. That pushed to almost 60% this quarter. So, what you saw was in the second month of the quarter really started to push into the third month. And that's what we saw that really back-end linearity that I spoke about in my prepared remarks.

Got it. And maybe just a quick follow-up for you, Mike. Just maybe on the currency headwinds, that incremental point or two. I know your business is primarily denominated in dollars. But can you kind of help us understand that transition from negative three to negative four to negative five, the US dollar has weakened a bit as of late. Just kind of want to get a better understanding kind of what's under the surface there and what's kind of driving that incremental headwind from an FX perspective? Thanks.

Yes. Sure, David, happy to. So, the significant foreign currencies we have like most international companies, it's euro, GBP, yen and Aussie dollar. And what we saw, again, across most of those is August and September was when the dollar was the strongest. So, that's when the most significant impact hit. That stayed largely through October. Now, what we saw after our quarter ended is, hey, it got a little bit better in November, the dollar weakened a little bit. Yes, we'll see if that holds. Everything we've put in front of you, we have used FX rates as of the end of October. So, it says a little bit better, that will be good. But making our living betting on FX rates, we're not going to try that. So we use October rates for the rest of the year.

Yes, that's helpful. End of the month is great. Perfect. Thanks, Mike. Thanks, George.

Thank you, David.

Hi. This is Angela Jin on for Samik Chatterjee. And my first question. So, I think in your prepared remarks, you mentioned that customer weakness was concentrated in Americas hi-tech and service provider sectors. Can we just dive more into the dynamics of each of your customer vertical/segments. Were there certain ones that held up better, enterprise versus SMB, for example? And what types of specific behaviors or patterns that you see in each vertical?

We don't have a specific vertical that significantly contributes to our revenue. To start, the public sector performed well in both the Americas and internationally. The European team delivered strong results despite facing increasing challenges. Looking at the international markets, we remain cautious about Germany, where our team excelled in Q2, but economic pressures are mounting. In North America, our midsized enterprise segment did well, but we are wary of its potential due to its historical sensitivity to recessions and macroeconomic factors. The larger enterprise segments showed the most notable changes in spending, and we anticipate they will be cautious moving forward. Historically, last year's performance in high tech, service provider, and large enterprise segments was strong for us, and we are currently comparing this to last year's results.

Got it. And then for my follow-up, with the cloud ARR target lowered to $700 million, looking ahead to the out year, I'm not asking for you to predict how deep or long a potential downturn could be. But how are you thinking about risk to that $2 billion cloud ARR target by fiscal year '26. And what gives you confidence that you can accelerate ARR in those out years?

Hey Angela, it's Mike. So, as we both talked about, look, we still feel really good about the cloud business, both Cloud Storage and CloudOps. We have some things to work through this year. So even though Q2 was not where we would like, we still feel really good about the future. We will update our views of fiscal 2024 and the $2 billion when we give you guidance for next year. So we'll ask you to wait until we update our fiscal 2024 numbers in a couple of quarters.

I think where we are focused on at the moment with our cloud business is to make sure that we are a good partner to our customers so that we can optimize their spend where they need help doing that. We are going to be continuing to accelerate our focus on selling more of our cloud products to our installed base where today it's about 15% of our Hybrid Cloud customers have our cloud products. And we have grown the number of cloud customers and the number of them that are buying more than one cloud service. So there's lots of opportunity ahead. We're focused on blocking and tackling and executing on the opportunities in front of us.

Thank you.

Yeah, hi. Thanks for taking my question. I have two of them. I'll ask both of them upfront to either George or Mike. Thanks for the color on the cloud customer scenario. I'm kind of curious like one of your competitors just two weeks ago mentioned that the storage demand is still pretty strong from cloud customers. I'm kind of curious, is the weakness you're seeing NetApp customer specific, or is there any share loss due to competitive threats? That's the first question. And then the follow-up is on the cloud ARR from $800 million to $700 million, yet we spoke about a high retention rate. So is the challenge now signing new customers with ANF? Is this the ramp of AWS FSx? Any color there would be helpful on the ARR cut? Thank you.

What we observed during the quarter is that we have distinctive cloud services that are native, first-party offerings. These are consumption-based services provided to our customers and were the most affected. Our competitors do not have native, first-party consumption cloud services, as they offer them through the marketplace. Our marketplace business remained relatively stable, which aligns with expectations. The subscription business is less impacted by short-term usage fluctuations compared to the consumption business. The flexibility of consumption services, allowing customers to switch usage on and off, is beneficial when they aim to optimize spending. We strive to be a supportive partner for customers looking to achieve that, collaborating with our hyperscaler partners to provide more options for cost-effective spending. Our compute optimization platform, Spot, performed well this quarter. While storage consumption saw some impact from spending, Spot, which helps optimize computing costs, did very well. We are committed to assisting our customers on that path. Regarding growth opportunities, we are quite pleased with the increase in customer additions and the cross-selling momentum. Our dollar-based net retention rate has remained strong, indicating several positive developments in our cloud business.

Regarding the annual recurring revenue, there have been some inquiries about the decrease from $800 million to $700 million. Initially, when we projected $800 million, we anticipated it would reach around $650 million by the end of the second quarter. Looking at the second half of the year, we expect to grow approximately $100 million, all of which is organic growth as we do not have any acquisitions factored in. We expect continued growth in areas like cloud storage, specifically ANF, FSx, and GCP, where we foresee significant progress. We have adopted a cautious approach concerning the consumption business, as we expect it to rebound in the latter half of the year, although we are uncertain if that will occur in the third or fourth quarter. We are optimistic about achieving $700 million, which still represents considerable growth in that sector, but we have slightly adjusted our outlook based on the second quarter results and taken a more reserved stance on Cloud Insights. That summarizes the product perspective for the remainder of the year.

Got it. Thanks a lot George. Thanks a lot Mike.

Thank you.

Thanks for taking my question. Maybe a couple more on the public cloud side. So on the reported quarter, your public cloud revenue on an annualized basis was lower than your ARR exiting last quarter. Is it fair to say that there were some cancellations and maybe some restructuring of some of the deals based on the three dynamics that you guys talked about earlier. And if so, how do you feel comfortable about the future ARR would not be reduced from the churn level? And maybe I'll just throw in the next question here. If you look at your revised ARR for the $700 million, if I exclude the inorganic growth and then make some certain assumptions about dollar-based net retention, you still need quite a bit of ARR coming from new customers. So in terms of new customers, which offerings are you seeing the most traction at this point? Thank you.

Hey, Sidney, it's Mike. Let me start with the first point. We finished Q1 with $584 million in annual recurring revenue. If you divide that by four, you would expect to recognize about $146 million in revenue. However, the revenue recognized in the quarter was $142 million. The reason for this difference is that we typically expect the calculation to align well, but during this quarter, there were reductions in consumption and some project-based initiatives, particularly with our larger chip design wins. These occurred during the quarter, leading to some loss in revenue from the ARR at the start of the quarter. This situation is not expected to recur in the future. It’s a good question, but it mainly stems from those factors. Additionally, there was also back-ended linearity in some of the subscription business that correlates with our core NetApp business. So, those three elements contributed to the revenue being lower than simply dividing the ARR by four.

Great. And regarding the new customers, what is the Annual Recurring Revenue from them?

Listen, we had a good quarter in terms of new customer additions. We have two major vehicles for new customer additions. The first being the native cloud services that we help our cloud provider partners, Amazon, Microsoft and Google sell for us. Those continue to be good vehicles for new customer additions. And then Spark has continued to be a strong vehicle for new customer additions. So I feel good about the pace of net new customers.

Great. Thank you very much.

This is Victor Chiu in for Simon Leopold. You noted several customers that concluded several large projects and then drove capacity reductions. Can you help clarify what changed versus your expectations exactly because the way that you kind of described at the conclusions were kind of natural and then so we assumed it would have been somewhat expected. So, either did they conclude earlier? I think you mentioned there was some chip design kind of timing-related issues. Can you just help us clarify why this dynamic was not expected?

We have observed in the past that projects often wrap up within a quarter while new ones begin, sometimes even by different customers. This quarter, however, we had some notably significant projects that concluded, but the initiation of subsequent projects is delayed beyond the end of the quarter, which is not ideal. This situation reflects what transpired during the quarter. We are striving to gain better visibility into these dynamics, especially when we collaborate with another partner selling the service to the end customer. Our sales teams are actively working to understand the end customers' priorities and spending timelines better. We recognize this is something we can improve on, and I assure you we are committed to doing so.

Okay. And then just quickly, regarding your commentary on macro headwinds, are you observing explicit behavioral trends or having explicit discussions with customers that makes you confident that the slowing is specific to the macro environment versus a more secular shift like accelerating workload migrations to the public cloud?

We are actively working with a significant number of enterprise customers through our direct sales team in the midsized enterprise market, and we also collaborate with channel providers. Regarding customer behavior this past quarter, it mirrors a typical macroeconomic cycle, with more deal approvals, smaller deal sizes, projects being divided into phases instead of one large purchase, and some deals being pushed to the next quarter. However, this did not indicate that we lost any share to competitors, as we continue to have discussions about the upcoming phases of these projects.

Got it. That’s helpful. Thank you.

Great. Thanks. I just wanted to get a sense of whether we could get what the size of Hi-tech and service provider is as a percentage of the cloud revenue or just kind of any vertical concentration that we should be mindful of? And then maybe last quarter, you had given kind of the storage services as a percentage of cloud ARR. If we could just have an update there, that would be helpful as well. Thanks.

Yes, we are not going to break out specific verticals. However, I can say that hi-tech is a broad segment, and we observed a fairly conservative posture across that segment. Service provider is also a broad definition; it could refer to telcos, hosting providers, or various types of cloud providers. These categories are broader than a very specific definition, and we noticed a conservative stance among most of those customers.

On your second question, so two data points for you. Cloud storage continues to be almost exactly 60% of the total, and that includes, as of the end of Q2, Instaclustr and CloudCheckr which are in CloudOps. So there you see the great growth we've seen in cloud storage because overall, as a total number has stayed right around 60%. The other important number is we've talked about consumption versus subscription. As of the end of Q2, it's pretty close to 50-50, a little bit a couple of percentage points higher for consumption. We do expect by the end of the year with that $700 million for that to get much closer to 60% because that's where we expect the growth across ANF, GCP and FSx, those products as well. So those are the two data points we gave you that break down that cloud ARR number.

Great. Thanks, so much.

Thank you.

Hi, thanks guys for taking the question. Actually two clarifications, if I could. Mike, just the remarks you made a couple of times in the prepared comments about and this is really the clarification. FX driving sort of some portion of the guide down or whatever that context was. Could you clarify that that? And then I have a quick follow-up clarification as well.

Sure, Ananda. Happy to. During the Q1 call, we provided a midpoint EPS guidance of $5.50. Since then, due to the continued strengthening of the dollar and the weakening of the foreign exchange situation, the adjusted EPS of $5.40 is actually higher than what it would have been on an FX-adjusted basis, which is around $5.37. The key takeaway is that even with a lower revenue outlook for the second half, we are making every effort to manage costs and improve efficiencies to maintain the EPS target we communicated previously.

I understand, that's very helpful. As for my second question, you mentioned the timing of the pickup, which was the main point. However, Mike, I would like clarification on your comments regarding the anticipated demand return in the second half, as you were uncertain whether it would be in Q3 or Q4. Could you clarify if you are referring to fiscal Q3 and Q4, or calendar year 2023 Q3 and Q4? Thank you.

Sure. I can only discuss fiscal and calendar years. This was the second half of the fiscal year, which was directly related to the growth in cloud ARR. We ended at $603 million and we've projected to finish the year at $700 million. We will not provide guidance for Q3. However, we are optimistic about the second half because of some large project-based contracts and consumption. We're unsure if this will materialize in our fiscal Q3 or Q4, but we feel confident about the second half. There is some complexity regarding whether it's Q3 or Q4, which is why we're only providing year-end guidance.

Got it, got it, got it. Okay, cool. Thanks guys. Appreciate it.

Thank you.

Thank you. Good afternoon. George, on your outlook and Mike, on your outlook, you mentioned about slowing economic comments, which is understood. Any thoughts around inventory digestion, is there a sense that there's inventory digestion out there. And if so, how long or any double ordering, or is it just purely economic pausing and elongation of cycles?

We did not see any order cancellations or any of those things. As we have mentioned repeatedly, we have good line of sight into our customer’s spending priorities and behaviors and are directly engaged with the largest of them. I think as we saw in this quarter, and we continue to be cautious about looking at the second half of the year. These are clearly related to IT budget revisions, right, where they are reducing deal sizes or scrutinizing projects and things, we'll defer a portion of that project to a subsequent quarter or a subsequent part of the calendar year. So we have good visibility into the activities in our customers, and we did not see cancellations of orders because of prior orders or double ordering.

Thanks. Regarding inventory digestion, do you have any insights on whether there is still inventory being managed that might lead corporate or service providers to delay these revisions, or is there any concern about existing inventory?

Typically, during macro situations like these, we have seen customers sweat their assets. And so what we mean by that is they will drive a system to a higher level of utilization and so that they can defer either capacity augmentation or system upgrades for a period of time. Now that's not forever, right? Storage is consumed because data keeps growing. And so there's always that trade-off. We certainly see some of that behavior going on. Jim, I think, certainly in our service provider segment, we see that. And in some of the hi-tech verticals, we saw that as well.

Great. Thank you so much for the details and clarifications.

Yeah. Thank you.

It's actually George Wang on for Tim Long. I have two questions. Firstly, George, maybe you can elaborate on the current state of deal integration in terms of Spot, Instaclustr. And any thought process behind the following deal until FY 2024?

We have a strong portfolio of technologies already, and our main focus is to refine the use cases that align with the current macro environment, making it easier for customers to adopt, expand, and renew them. This operational focus is our top priority. We need to work on integrating the CloudCheckr capabilities into the Spot suite to create a cohesive offering instead of having two separate ones. We've made good progress, but there's still more to do. For Instaclustr, we offer two unique advantages: the integration of our cloud storage and Spot services, and the fact that it is a genuinely open-source data services platform. We're currently working on the first advantage, and we believe there’s significant value in our portfolio. We still have work to finish, and we want to keep our teams focused on technological advancements. On the go-to-market side, we are enhancing training for our sales teams to effectively position Spot, Instaclustr, and CloudCheckr within accounts. We feel positive about our efforts and need to complete them before exploring other opportunities.

Okay. Cool. Yeah, a quick follow-up is on the cost cuts. Maybe you can elaborate on the kind of disaggregate just components for the cost cuts, whether that's sales and marketing, the SG&A or kind of some of the R&D? Any color would be appreciated.

Hey, George, it's Mike. I just want to confirm that your question was regarding the cost reductions we are looking at for the second half. Was that correct?

Yes.

Thank you. There are several factors that will positively impact our profit and loss statement. To begin with, we anticipate some relief from our substantial premium-related expenses as the supply chain continues to improve daily, which will benefit the second half. Additionally, we expect NAND pricing to contribute positively. While we still have some inventory to manage, this will be evident in the third quarter, and we expect clearer results by the fourth quarter. Regarding operating expenses, we've implemented a headcount freeze and are assessing all discretionary spending, including travel, programs, and outside services, similar to other companies adapting to a hybrid work model. We will also critically review our facility costs. We have already initiated several measures in this area and will continue to evaluate them as we progress into the second half. There are multiple areas we can focus on. Furthermore, it's important to note that a significant portion of our operating expenses is associated with incentive compensation and commissions, which are expected to decrease in the second half as well.

Okay. Great. Thank you.

The total revenue guidance has been lowered by 400 basis points. This includes 100 basis points attributed to incremental foreign exchange impacts, another 100 basis points due to a reduced target for PCS annual recurring revenue, and the remaining 200 basis points resulting from weaker billings results on a constant currency basis this quarter, or from weaker billings results that began to emerge during the third quarter, also on a constant currency basis.

For the second half, Nehal, this is primarily related to product revenue, which will be substantially booked and recognized during the quarter. The backlog is mostly at normal seasonal rates that we usually expect. This will involve systems in the second half, which I believe addresses the third part of your question.

Excellent. Okay. And then dollar-based net revenue retention rate declined quite significantly, 192 to 140. Is this largely because of the project-related stuff?

Dollar-based net revenue retention was 150 last quarter, and it's now 140. So, step down as the base of customers expand, and we did see some churn in our consumption business, as we noted on our call, so we don't see that as materially different than what we would expect.

And to George's point, Nehal, we've been calling that for several quarters, which is add that ARR number gets bigger, that dollar-based net retention percentage will come down. We like to call it the 120, 130, where we think it will land, but we have been calling that percentage to continue to decline as that number increases.

That you have. Okay. And then just finally, Mike, the PCS GM did come down both Q-on-Q and year-over-year. Why is that?

The PCS gross margin came down because of the revenue scale relative to the infrastructure that we have deployed. Note that the consumption business, some elements of those are based on our deployed systems, right, in the cloud provider environments. And when they have less scale, you see less utilization, you see less gross margin.

It came down from 69.7% to 68.3%, so down slightly. And to George's point, that's largely due to scale. We continue to feel good, as I mentioned in my notes about the 75% to 80% as we drive that scale.

Thank you.

Yes. Thank you. I appreciate the fiscal year guide. But George, you were talking earlier about IT budgets and some caution around that. I was wondering if you could share some color on what you're hearing from customers more around calendar 2023 IT budgets? And what's your view on how you expect the storage market to grow in 2023 and your growth relative to that? And I have a follow-up.

I think for 2023, we are being cautious and not providing guidance for the next fiscal year, but we are wary about the beginning of calendar year 2023. Typically, in these macro situations, new budget allocations at the start of the year tend to take longer than usual, so we are careful about the new calendar year. Regarding the overall storage market, I believe it will be driven by new workload deployments. Some customers will need to upgrade their systems because their existing ones are reaching the end of their useful life or are lacking in capacity or performance. However, I think the majority will focus on new workload deployments and system consolidation to benefit from cost and energy savings. We are noticing that while cloud migrations are slowing slightly, it remains a long-term trend that customers will pursue for various reasons. Therefore, I expect cloud growth to outpace on-premises solutions in the broader market. In the on-premises sector, we see NAND contributing to the increasing role of flash technology moving forward. Our capacity flash products performed well last quarter, and our hybrid flash products also did well, aligning with customers' cost-conscious strategies.

Okay. That's helpful, George. And just a follow-up on your last comment about the NAND market. Every few years, you see the significant dislocation in pricing and this one is quite severe. You guys noted the benefit that you will recognize in gross margin terms. But can you just remind us on how you're thinking about the impact to revenues based on the NAND price decline? Are you expecting a deceleration in AFA revenues, or are you expecting elasticity of demand to offset that? Thank you.

Customers budget in dollars, the current macro environment has been spending less dollars, but they'll probably shift the mix to AFAs, if there's more value in the offering, right? So we see them budget in dollars, Wamsi.

Okay. But in aggregate terms, would you say that the customer budgets would be up or down like in full in aggregate, whether it's cloud on-prem, all put together?

I think overall, year-on-year, I think '23, we expect to be moderated and down relative to '22, certainly at the start of the year. '22 had a good start to the year. And so our start of the new calendar year, which is baked into our outlook for the second half of fiscal year, we think people are going to be more cautious overall, Wamsi.

Okay. Thank you so much, George.

Yes, thank you.

Thank you very much for taking my question. I was just wondering what you're hearing from customers on your Keystone offering. I think, as a service offerings, they are becoming a bit more attractive in an economic downturn. So I'm wondering what kind of traction you're seeing there?

It's early, but good traction. We are focused with a few channel partners who are enabled on selling Keystone. We've had good customer wins, good momentum in terms of our offerings. We brought new innovation to market in the last quarter, both a unified control plane so that you can use either a Keystone-based consumption offering in your environment or our public cloud offerings, and you can move workloads and licenses across those. So a good amount of innovation. And you're correct, we'll continue to see opportunities to help customers around whatever their kind of buying model is in this environment.

Great and thanks. And I look forward to seeing you on Thursday at our conference.

I as well look forward to seeing on Thursday.

Hey good afternoon. Thanks very much for the question. You touched on this a bit earlier, but not directly. But does the budget scrutiny that you're seeing right now from some subset of customers impact their decisions for provisioning the mix that they're provisioning of all-flash versus hybrid arrays at least for new projects. And I know you mentioned that our all-flash portfolio has leading cost efficiency, but do you expect the mindset to change on how much customers are willing to embrace more all-flash? Will the pockets of slowdown that you're seeing potentially pull everything back and the mix stays relatively on the same trajectory? Thanks.

Thank you for the question. We didn't observe customers reevaluating their technical decisions about the type of infrastructure to purchase. This allowed the technical team to determine the most valuable options based on the relative cost-effectiveness of disk versus flash. We noticed that the approval levels for deals increased; what would have previously been approved by a director is now going up to a VP, and approvals that used to come from a VP are now being elevated to a CTO. This is what lengthened deal cycles this quarter, as well as customers opting to reduce the amount they wanted to buy at once and instead phase their projects into multiple stages.

All right. Thank you, Kyle. I'm going to give it back to George for a couple of closing thoughts.

While there are near-term economic challenges for every company, we know that our opportunity ahead is substantial, durable and growing. The fundamentals of our business are strong and the value we bring customers is undeniable. Our strategic growth opportunities all-flash arrays, cloud storage and cloud infrastructure optimization are tightly aligned to customers' top priority and represent the potential for long-term sustained and profitable growth. We will continue to be disciplined stewards of the business, focusing on our strategic growth opportunities while continually optimizing our operating costs to drive shareholder value. Thank you.