NetApp Q4 2023 Earnings Call Transcript

Quartr
Provided by Quartr
May 31, 2023

There are 15 speakers on the call.

Operator

Good day, and welcome to the NetApp 4th Quarter and Fiscal Year 2023 Earnings Call. All participants will be in listen only mode. Please note this event is being recorded. I would now like to turn the conference over to Chris Newton, Vice President of Investor Relations. Please go ahead.

Speaker 1

Hi, everyone. Thanks for joining us. With me today are our CEO, George Kurian and CFO, Mike Barry. This call is being webcast live and will be available for replay on our Web site@netapp.com. During today's call, we will make a number of forward looking statements and projections with respect to our financial outlook and future prospects, including without limitation our guidance for the Q1 fiscal year 2024, our expectations regarding future revenue, profitability and shareholder returns and other growth initiatives and strategies.

Speaker 1

These statements are subject to various risks and uncertainties which may cause our actual results to differ materially. For more information, please refer to the documents we file from time to time with the SEC and on our website, including our most recent Form 10 ks and Form 10 Q. We disclaim any obligation to update our forward looking statements and projections. During the call, all financial measures presented will be non GAAP unless otherwise indicated. Reconciliations of GAAP to non GAAP estimates are available on our website.

Speaker 1

I'll now turn the call over to George.

Speaker 2

Thanks, Chris. Welcome everyone to our Q4 FY 2023 call. Our Q4 results Reflect solid execution in the face of ongoing macroeconomic challenges. We delivered revenue above the midpoint of our guidance With disciplined operational management yielding all time high quarterly operating margin and EPS above expectations, For FY 2023, we delivered record high annual operating margins and EPS Despite the slow demand environment and relatively flat revenue from fiscal year 2022, Even as customers are tightening their budgets in response to the macro, they are not stopping investments in applications and technologies That drives business productivity and growth. Digital transformation projects involving business analytics, AI, data security and application modernization, both on premises and in the cloud, Remain top priorities for IT organizations.

Speaker 2

This drives our confidence in the health of our market and future growth opportunity Despite the temporary macro headwinds, we are participating in the areas of priority spending With a modern approach to hybrid multi cloud infrastructure and data management, by providing customers with the ability to leverage data Across their entire estate with simplicity, security and sustainability, we increased our relevance and value And we continue to introduce new innovations to deliver greater customer value, further strengthening our position. On our last call, I outlined our three areas of focus to sharpen our execution to better deliver results, While at the same time, positioning ourselves for long term success. As a reminder, the focus areas are: Remain prudent stewards of the business, tightly managing the elements within our control reinvigorate efforts across the company in support of our storage systems business and build a more focused approach to our public cloud business. As you can see from our Q4 and FY2023 results, we have demonstrated success in managing the elements within our control and staying flexible to adapt to the ever changing environment. We remain committed to maintaining operational discipline As we move through FY 2024, adjusting is appropriate to drive operating margin expansion and EPS growth, while also continuing to invest for the long term.

Speaker 2

Turning to our Storage Systems business. Q4 Hybrid Cloud segment revenue of $1,400,000,000 was down 8% year over year and up 4% sequentially. Our all flash array business decreased 4% from Q4 a year ago To an annualized revenue run rate of $3,100,000,000 Similar to Q3, headwinds from large enterprises Weight on our products and ASA revenue. As you've seen, we are reinvigorating our storage portfolio, Innovating to deliver greater customer value, reach new customers and better address areas of priority spending and market growth. ONTAP AI and FlexPod AI are proven and tested reference architectures to help speed and simplify AI deployment.

Speaker 2

These solutions are designed around our all flash arrays, which are uniquely suited to meet the performance, multi protocol and data mobility demands of AI workload. In Q4, we demonstrated industry leading performance in the GPU Direct benchmark, Proof of our ability to enable customers to use the full power of GPU technology for AI. Our affinity to AI use cases doesn't stop at performance. ONTAP includes native data management tools That streamline workflows for data science teams and integrate multi platform, Multi site and multi cloud data pipeline. With new performance and data management features Planned in upcoming ONTAP releases, we expect to raise the bar again, not just for performance, But for total workflow solutions that help companies realize the benefits of AI faster and with better results.

Speaker 2

The new AFF C series, our comprehensive portfolio of QLC based all flash arrays, began shipping late in Q4. We are very pleased with the initial customer response. In addition to lots of quoting activity, we closed a good number of deals In the Q4, one of our early CCVs wins was a $15,000,000 deal at a large financial institution For business critical workloads in its cloud ready, service level defined environment, we beat the competition with a solution that was significantly denser and more energy efficient. Following this highly successful launch, We introduced the NetApp ASA A Series early in Q1. The ASA is a new line Of SAN specific flash storage systems that deliver high levels of performance, scalability, data availability, Efficiency and cloud connectivity with up to 50% lower power consumption and associated carbon emissions than competitive offering.

Speaker 2

The ASA complements our unified storage offering to address block only use cases, while avoiding the operational and data silos of competitors' product. We are also innovating to improve the customer experience. In Q4, we introduced NetApp Advanced, a portfolio of programs bringing predictability and adaptability, including the storage lifecycle program for non disruptive storage upgrade. At the start of Q1, We announced ONTAP 1, a simple way to buy and consume all the native software capabilities of ONTAP. We are enhancing the value of these built in capabilities with our ransomware recovery guarantee, which leverages ONTAP's unique combination of key built in security and ransomware protection features to detect, Stop and recover from ransomware attacks in real time.

Speaker 2

In addition to delivering significant innovation, We've also rebalanced our go to market effort, including focusing our broad sales organization on selling flash Through compensation plans and reinstating a specialist sales team for cloud. We believe these actions will allow the team To better address the large storage TAM, entering FY 2024, I'm confident that these actions will enable us To drive product revenue growth and regain share in the all flash array market. We are seeing early positive signs, But the full benefit of these changes will take time to develop and should be a driver for product revenue growth in the second half. While we are sharpening our attack on the storage market, we are not taking our eye off the public cloud opportunity. Public cloud ARR of $620,000,000 was up 23% year over year and ahead of our expectations, driven by strength in public cloud storage services.

Speaker 2

Our public cloud business in Q4 was back end loaded, Resulting in softer revenue and lower DB NRR than our ARR results would indicate. Public cloud revenue for Q4 was $151,000,000 and DB NRR was 114%. Our public cloud services are highly differentiated with a multi year advantage over our traditional competitors And they create customer preference for NetApp. The number of total cloud customers, customers using multiple of our public cloud services And customers with greater than $500,000 of revenue in the quarter, all continue to grow nicely. While like our cloud partners, we see continued cloud optimization, some of the customers whose optimizations Created significant headwinds for us in FY2023 have kicked off new projects that we expect to scale over the next 18 months.

Speaker 2

We believe that our first party storage services branded and sold by our cloud partners represent our biggest opportunity. We have aligned our sales specialist resources to our cloud partners' customer segmentation and go to market structure to tighten our alignment to and improve our execution against this opportunity. Over the course of FY 2024, We will scale our customer success team to further improve customer retention and expansion and develop a more focused Cloud channel model. Cloud operations remains an important market for us and we have dedicated go to market resources to address this opportunity. We have not wavered in our conviction that public cloud services has the potential to be a multibillion dollar ARR business for us.

Speaker 2

While the shift to cloud is experiencing an industry wide slowdown, the long term trend in favor of cloud is unchanged. In conclusion, while FY2023 was not the year we expected at its outset, our disciplined management Enabled us to overcome a number of headwinds to deliver all time high operating margin and EPS. The fundamentals of our business model are sound and our confidence in our strategy and the health of long term opportunity is unchanged. We are entering fiscal year 2024 with substantially more innovation and a new more focused operating model to attack the areas of priority spending. In this uncertain environment, we will remain agile and continue to be Disciplined stewards of the business.

Speaker 2

We believe our actions will drive margin expansion and earnings growth, while yielding top line growth in the back half of the year. Thank you to the NetApp team for their dedication and focus. I am pleased with our progress, but we recognize our work is not done. We look forward to building on this momentum and driving long term value for our shareholders. I'll now turn the call over to Mike.

Speaker 3

Thank you, George, and good afternoon, everyone. As George noted, we are laser focused on managing the elements within our control. Our focus enabled us to deliver strong P and L performance for the Full year and Q4. Before getting into the details, let me quickly highlight the key themes of our results and expectations for fiscal year 2024. As a reminder, all numbers discussed are non GAAP unless otherwise noted.

Speaker 3

We delivered record setting operating margin and EPS above our guidance range in both Q4 And fiscal year 2023. We will continue to prudently manage the business to position ourselves for long term success, while driving further operating margin expansion and EPS growth in fiscal year 2024. We are confident in the strength of our position and alignment to areas of priority spend. However, Macro uncertainties and FX headwinds have pressured IT budgets and lowered spending. We believe these headwinds are temporary and that the spending environment will rebound in time.

Speaker 3

We reached our product gross margin target of mid-50s ahead of expectation. In fiscal year 2024, We expect to maintain product gross margins at this level and drive improvement of public cloud gross margin. In fiscal year 2023, we returned 148% of free cash flow to shareholders and reduced full year share count by 4% from the prior year. We plan to continue a strong policy of shareholder returns in fiscal year 2024. Now to the details.

Speaker 3

Fiscal year 2023 billings of $6,410,000,000 were down 4% from fiscal year 2022. Revenue of $6,360,000,000 was up 1% year over year. Adjusting for the headwind from FX, Billings would have been down 1% and revenue would have been up 4% year over year. Disciplined operational management yielded All time fiscal year highs for operating margin and EPS. Operating margin was 24.2%, including a 150 basis point headwind from FX.

Speaker 3

EPS was $5.59 And included $0.57 of year over year FX headwind. Q4 billings of $1,670,000,000 were down 17% year over year, including roughly 2 points of FX headwind. Revenue came in above the midpoint of our guidance range At $1,580,000,000 down 6% from last year or 4% Adjusting for FX. The uncertain macro negatively impacted revenue in both the hybrid cloud and public cloud segment As customers continue to exhibit caution in capital expenditures and look to optimize cloud spend. CyberCloud revenue of $1,430,000,000 was down 8% year over year.

Speaker 3

Product revenue was $744,000,000 and down 17% from Q4 last year. Support revenue of $598,000,000 increased 1% year over year. Public Cloud ARR exited the year ahead of expectations at $620,000,000 up 23% year over year. Public cloud revenue composed 10% of total revenue in Q4 And grew 26% year over year to $151,000,000 We exited fiscal year 2023 with $4,310,000,000 in deferred revenue, an increase of 2% year over year. Growth of deferred revenue is the best leading indicator for recurring revenue growth.

Speaker 3

Q4 marks the 21st consecutive quarter of year over year deferred revenue growth. Q4 consolidated gross margin was 69% above our guidance. Total hybrid cloud gross margin was also 69%. Product gross margin was 55%, Well ahead of guidance, driven by lower premiums, better mix and lower FX headwinds. As we've described on previous calls, we expect to retain all the benefit from the reduction in premiums and will be responsive to market pricing of commodity component.

Speaker 3

Our recurring support business continues to be highly profitable With gross margin of 92%. Public cloud gross margin was 66%. Q4 again highlighted the strength of our business model and our operational discipline with operating margin of 26% An all time quarterly high. EPS of $1.54 was comfortably above the high end of guidance and included $0.08 of year over year FX headwind. In Q4, cash flow from operations was $235,000,000 And free cash flow was $196,000,000 Free cash flow for fiscal year 2023 of $868,000,000 Came in below expectations due to lower collections and timing of payment.

Speaker 3

As we noted on our last call, Q4 cash flow included certain one time restructuring and tax payments, together totaling approximately $85,000,000 Inventory turns of 12 were steady from last quarter and last year. During Q4, we repurchased $150,000,000 in stock and paid out $106,000,000 in cash dividend. For the year, We repurchased a total of $850,000,000 in stock and paid out $432,000,000 in cash dividend, representing 148% of free cash flow. Q4 diluted share count of 217,000,000 Was down 5% year over year. We have approximately $400,000,000 left on our current share authorization as of the end of fiscal year 2023 and today are announcing an additional authorization of $1,000,000,000 Our balance sheet remains very healthy.

Speaker 3

We closed the year with $3,070,000,000 in cash and short term investments. Now to guidance. Let me underscore our Confidence in our strategy and the strength of our position in addressing key customer priorities like business analytics, AI, data security and application modernization. However, we expect the macro to remain challenged With continued pressure on IT budget and the demand environment. As a result, we expect fiscal year 2024 total revenue to be down in the low to mid single digit measured on a percentage basis.

Speaker 3

Public cloud will continue to be a positive contributor With revenue growth expected in the mid teens. Implied in our fiscal year 2024 revenue guidance It's year over year growth in the second half driven by sales of recently introduced flash products and Benefits from our go to market changes. While we are hopeful that the macro economy will improve in the second half of our fiscal year, Our plans for fiscal year 2024 incorporate the environment we are seeing today and do not assume a material change to the economic or demand backdrop. We expect fiscal year 2024 consolidated gross margin to be roughly 70%. We believe that product margins will remain at approximately 55%, supported by lower premiums And a rotation to higher margin all flash product.

Speaker 3

To take advantage of record low NAND prices, We have made strategic purchase commitment to lock in pricing for a large portion of our expected fiscal year 2024 SSD demand. This will help us maintain product gross margin levels when component prices rise in the future. We expect to see public cloud gross margin improvement in fiscal year 2024, driven by revenue scale and lower depreciation expense. We remain confident in our long term public cloud gross margin target of 75 to 80%. We anticipate operating margins of approximately 25% and EPS Operating expenses roughly flat versus fiscal year 202023.

Speaker 3

Fiscal year 2024 OpEx Includes benefits from the Q4 reduction in force, offset by annual merit increases, a reset of variable compensation And incremental expenses to support our 1st in person sales kickoff and Incyte user conference since 2019. Operating expenses should be spread fairly evenly throughout the year. We expect a tax rate in the range of 21% to 22%. Operating cash flow will move in line with net income, Although there will be some quarterly variance based on working capital. As we stated before, fiscal year 2023 should be the peak For CapEx, with expenditures beginning to come down in fiscal year 2024.

Speaker 3

Our healthy cash generation Enables us to continue our strong program of capital returns to shareholders. In fiscal year 2024, We intend to return 100 percent of free cash flow to shareholders in share buybacks and dividends. We plan to hold our quarterly dividend steady at $0.50 per share throughout fiscal year 2024 With the remainder of free cash flow going to share buyback. We expect the timing of buybacks to be roughly similar The fiscal year 2020 3 and to reduce share count by at least 2% in fiscal year 2024. Now on the Q1 guidance.

Speaker 3

We expect Q1 revenue to range between 1,325,000,000 And $1,475,000,000 which at the midpoint implies a decline of 12% year over year. Remember that first half fiscal year twenty twenty three revenue, most notably product revenue benefited from elevated levels of backlog Supply chain constraints impacting the year over year comparison. We expect Q1 consolidated gross margin to be roughly 70% And operating margin to be approximately 20%. EPS should be in the range of $1 to 1 $0.10 Q1 cash flow will be impacted by payments associated with SSD purchase commitments, partially offset by lower incentive compensation payments year over year related to our fiscal year 2023 performance. In closing, I want to echo Georgia's appreciation of the NetApp team and their continued commitment in this uncertain environment.

Speaker 3

As I look forward into fiscal year 2024, I am confident in our strategy and our ability to continue to improve our execution and increased profitability. I'll now turn the call back over to Chris for Q and A.

Speaker 1

Thanks, Mike. Operator, let's begin the Q and A.

Operator

We will now begin the question and answer session. And our first question will come from Aaron Raccour of Wells Fargo. Please go ahead.

Speaker 4

Hi, guys. Thank you. This is Michael on behalf of Aaron. I just wanted to ask, you mentioned some customers have kicked off new projects Only a period of digestion or optimization. I'm just curious, can you give us a sense of how many customers you put in this bucket Versus once they continue to be cautious or maybe are becoming incrementally more cautious.

Speaker 4

Just trying to get a sense of how the demand environment has changed. Thanks.

Speaker 5

Broadly speaking, the Q4 demand environment was not substantially different from what we saw in Q3 And our plans for next year contemplate continuation of the same environment. We talked about in the cloud segment some of the larger customers who had Significantly optimized their landscape through the course of the prior quarters began to take on the projects that we anticipated Taking on, these projects take some time to ramp. We also saw strength in new customer additions And the number of customers that were using multiple products from NetApp, so all good signs for future revenue growth. That being said, customers on a broad basis still cautious about spending and particularly in the large enterprise segment.

Speaker 4

Got it. Thank you.

Operator

The next question comes from Samik Chatterjee of JPMorgan. Please go ahead.

Speaker 6

Thanks for taking my questions. I guess For the first one, if I could sort of you reiterated a few times, you're really not making any macro improvement To the guide, but you did highlight the opportunity to get back to revenue growth in the second half. Just wondering if you can help us Think through both of those pieces, particularly when I sort of put them against each other, it does look like you're calling for more of a share gain that Revenue rebound in the second half of the year, what sort of drives confidence in this sort of a sequential ramp in revenue through the year? And is there more to it than sort of share gain? And I have a quick follow-up.

Speaker 6

Thank you.

Speaker 5

I think broadly speaking, We are super excited about the recent portfolio introductions we've made. We've seen the benefits of improved focus in our field organization. It takes a few quarters to build. And I think if you look at the pattern of sequential linearity Through next fiscal year, it is similar to what we have seen in more traditional years. I think FY 2023 was a bit anomalous.

Speaker 5

And so we feel good about the progress through the year. I think with regard to the Macro, we are not we built our plan assuming the macro stays the same. Clearly, if there's upside to the macro, That should be a benefit to us over the course of the year.

Speaker 3

Hey, Samik, it's Mike.

Speaker 4

If I could just add Under that, I

Speaker 3

want to underline the one point George made. When we talk about our guide for 2024, when we talk about linearity, that's and we define that as Total revenue we expect in the first half versus the second half, that's much more at where we've been historically, which is about 48% 52% In those halves, so when you take a look at the year over year growth rates in 2024, just keep in mind that those were heavily influenced by the backlog Last year, so when you normalize for that, it looks like a much more normal linearity in 2024.

Speaker 6

Got it. On the cloud business, the growth expectations that you have for fiscal 2024, can you just outline how you're thinking about sort of retention business versus new business wins? And also curious if you obviously highlighted the AI opportunity, but you see that opportunity on the cloud revenue side as well? Thank you.

Speaker 5

Listen, I think, first of all, We are very pleased with new customer acquisition, the broadening of our workloads, clearly the performance And the efficiency and multi protocol capability of our storage is an advantage whether for AI Workloads, whether they are on premises or in public cloud. What we've seen in public cloud for AI is a lot of data science teams Using the prebuilt tools that are available on the public cloud to calibrate and get their learning models up the curve quickly, and that's Uniquely available with NetApp. I think with regard to our perspective for the full year, listen, cloud storage, especially the storage that's So alongside the hyperscalers will be the primary driver of our business next year. I think if you look at the total dollars, In any given year, the opportunity to expand existing customers is Substantially larger than the amount that new customers contribute because they are just small. But we feel good about the base of new customer acquisition.

Speaker 5

And now our installed base of cloud customers is very substantial. So there's a good opportunity to cross sell and up sell them more capabilities.

Speaker 6

Got it. Great. Thank you. Thanks for the color.

Operator

The next question comes from Meta Marshall of Morgan Stanley. Please go ahead.

Speaker 7

Great. Thanks. Maybe first question, you noted starting to kind of To notice seeing customers coming out as optimization periods are starting to add workloads, just wanted to gain a sense of are Seeing that more with larger or smaller customers or any particular types of workloads that they're starting to kind of add back? And then maybe second question, the Series C customer that you noted winning in the quarter, just Any commentary whether that was an existing customer and just, you noted efficiency and kind of Energy efficiency being the reason for the sale, but just kind of how long that sales cycle was, just any details there would be helpful. Thanks.

Speaker 5

Yes. So let me get to 2 questions. The first one is what we've seen in the cloud environment Is that customers are still progressing new workload deployment, meaning new applications, Analytics environments, AIML environments and so on, right? And that has not slowed down. I think there was a period of time where customers were monitoring their environments and optimizing the infrastructure, But the new deployments continue.

Speaker 5

I think where we have seen people being more cautious is about migration of On premises environments, for example, to public cloud, where they are benchmarking the total cost of each of those landscapes. We have a large and growing opportunity in public cloud on new workloads because of the capabilities and the certifications That we continue to bring, and so we're excited about that opportunity. I think with regard to the customer we mentioned, They are they were not using NetApp for the landscape that we won. We won we replaced a competitive environment And we did so based on the new C Series products that had a significant advantage over all the competitive products, Both in terms of our traditional advantages around multi protocol and all of the data management features, But we're also substantially more efficient from a power consumption and density standpoint.

Speaker 7

Great. Thanks so much.

Operator

The next Question comes from Steven Fox of Fox Advisors. Please go ahead.

Speaker 4

Hi, good afternoon. Just one question from me. I don't think I'm alone in this, but the product gross margin surprised substantially the upside, 7, 8 Points of upside by my count. Can you just sort of break down how that happened? And whether any of that is Transitional, how much carries through the rest of the year in your full fiscal year plan?

Speaker 4

Thanks.

Speaker 3

Hey, Steven, it's Mike. So let's do the walk from Q3 to Q4, what we guided and where we ended up. Q3 product margins were about 46%. We guided approximately 50%, largely with the full expectation that We would continue to get relief from premiums that we've talked a lot about and my goal is to never mention the word premium is on another call going forward. That was about 500 basis point benefit to the quarter and we expected that to be.

Speaker 3

The 2 things that were incremental is Mix came in better than we expected. And by that, we mean the capacity per system came in a little bit better. If you remember in Q3, we talked about that that caused a little bit of a reduction in gross margins as well as a little bit better all flash margin. And then FX helped a little bit quarter on quarter as well. So that's the walk from 46 to 55.

Speaker 3

As we look into next year, we're assuming that we can retain that $55,000,000 There's a little bit of premium benefit left, But we're also going to make sure that we are flexible as the component pricing rolls through that we can be Competitive in the market. And then in addition, we also talked about, hey, we've done some strategic purchase commitments To lock in a large portion of the NAND supply for fiscal 2024 at today's prices. So we're excited about that being able to Not have to deal with that when in the likely event it starts to go up. As we all know, NAND pricing is at an all time low. So that is that's the walk from Q3 to Q4, how we did a little bit better and our outlook into fiscal 2024.

Speaker 3

Great.

Speaker 4

That's super helpful. Thank you.

Speaker 3

Thank you.

Operator

The next question comes from Amit Darya Nani of Evercore ISI. Please go ahead.

Speaker 8

Hi, thank you. This is Irvin Liu on for Amit. I wanted to double click on the drivers of the public cloud ARR outperformance during the quarter. I think you referenced cloud storage services strength. But can you talk about what you saw in data management and cloud optimization?

Speaker 8

Is there anything to call out Or spot, just given increased focus on optimizing cloud spend? And I also have a follow-up.

Speaker 5

The cloud ops Business was relatively flat sequentially. There were new customer additions and some optimizations within existing customers. The majority of the growth rate sequentially from Q3 to Q4 was driven by cloud storage, especially the consumption business with our cloud provider partners.

Speaker 8

Got it. Thank you. And then about 11% of your revenue is public sector. From a debt ceiling perspective, I wanted to ask, are there any direct impacts we should be thinking about as it relates to Your federal government exposure, is there a potential for a delay in your accounts payable or any potential changes in how you view the budget flush environment Looking through the back half of calendar twenty twenty three?

Speaker 3

Yes. So thanks for the question. At this point, we don't expect any meaningful change in that business from an AR perspective or from a bookings perspective. We'll certainly watch it. We would expect this thing to have to resolve itself in the relatively near term.

Speaker 3

At this point, we don't expect any material impact From all those discussions.

Speaker 8

Got it. Thank you.

Operator

The next question comes from Shannon Croft of Credit Suisse. Please go ahead. Thank you very much. George, you

Speaker 1

take a step back and maybe talk a bit from a higher level on how conversations with customers are going With regard to AI and I'm thinking not just in like near term, but I'm trying to understand or figure out because I think we all are, What the various roles IT hardware will play in the AI proliferation that we're seeing. So I'm wondering, Well, you've got training, so do you need fast storage and then you move to inferencing, so it could be more traditional storage or Is that not correct? I'm just I'm wondering because I know you're having probably a lot of conversations with customers that could be beneficial to us. Thank you.

Speaker 5

We have done exceptionally well in the analytics, AI, deep learning environments. We have both technology leadership across multi protocol, high performance scale out storage And multi cloud, which are super important buckets of what customers need to Drive these analytic applications and we have done we've doubled our business this past year to a very significant amount. I think the key use cases are business problems around, for example, in Financial Services, Sentiment analysis, recommendation engines, advanced recommendations engines in e commerce, Precision Medicine, cross department clinical AI solutions, and then even last quarter, we had a substantial win in A new form of metaverse around autonomous driving, right? So these are advanced analytics engines that are being deployed on very And today's environments are not the advanced LLM models. The majority of the business we see today are really around Re platforming from Hadoop to more modern environments as well as the use of advanced neural networks, We see the impending onslaught of ChatGPT and tools like that where customers will take the Open AI or open source generated AI models, but then build it on top of their own data sets, which require the storage that we have.

Speaker 5

So we're excited about the future, and we have real strong performance in our AI and analytics business today.

Speaker 1

Thank you. That was helpful. Mike, can you talk a bit about I know OpEx is supposed to be flat or you're planning on it being flat this year. But I'm wondering, you delayed some investments and you've had some cost cutting in that. I'm wondering, given the gross outperformance and relative strength you're seeing or improvement you're seeing, is there room to maybe Reaccelerate some of those investments or is it just too early to make that call?

Speaker 3

Yes, Shannon. So what I'd say is we actually have Accelerated some of those investments. We've talked about doing Converge, which is our sales conference in person as well as Insight. That's the first time in 3 years. We do a very good job.

Speaker 3

I give the team a lot of credit for reallocating dollars internally to really to reallocate 2 growth initiatives. You've seen us react very quickly from a product perspective in the last couple of months, C Series and other things. So I think at this point, we feel good about where we are From an OpEx perspective, we'll see how we get through the year. And when we talk about prudently managing the business, for us it is Make sure we spend the money in the right areas, but we always want to make sure we're investing in growth. And that's what you have and that's what we put in the guide for the year.

Speaker 1

Great. Thank you very much.

Speaker 5

Thank you.

Operator

The next question comes from Ananda Baruah of Loop Capital. Please go ahead.

Speaker 9

Hey, good afternoon guys. Thanks for taking the question. Just picking up on Shannon's AI question. George, do you see an opportunity over time To have the product gross rate altered by AI on prem And actually, we just love maybe even similar question for cloud software as well. Thanks.

Speaker 5

I think the AI applications that drive business productivity are a topic of discussion in every CEO room Around the globe because it is a key way to bring speed And operating efficiency to companies. And so many of the applications that we talked about Help transform a company's business model. And so they will get prioritized in spending envelopes, And we are really excited about our opportunity to capitalize on that. We have done the work not only to build high performance storage, But in addition, build the integrations into all of the AI and data science toolchains that are common in the world And to enable a really flexible data pipeline that can start in the cloud where the tools are available, But then can be operated at scale on the data in your data center. So we're really excited about what the future holds And we're going to keep pushing forward.

Speaker 5

I see cloud and I see AI as 2 big opportunities for NetApp. We are super well positioned in both and we look to take advantage of both of them going forward.

Speaker 9

That's great. And I guess As the follow-up, could you just talk a little bit about the ability and I guess maybe even over what timeframe That the newer NAND technologies could have on share gain on premise Relative to HDD, just how should we think about that dynamic and over what period of time? Thanks so much.

Speaker 5

I think the lower cost NAND technology that we've introduced in our products will become a bigger part of our business through the course So fiscal year 2024 and will be the biggest part of the flash storage growth rate in the industry over the next 2 or 3 years. These HDD replacement cycles are multiyear, right? I think if you saw the high performance 15 ks HDD segment, it took multiple years to transition that footprint. And so 10 ks, Which is an even bigger part of the market, will take many years to transition, but we're excited about our offerings, the start that we've had And the opportunity over the next many years.

Speaker 9

Thanks a lot. Really appreciate it.

Operator

The next question comes from Krish Sankar of Cowen. Please go ahead.

Speaker 10

Hello, this is Robert Mertens on for Chris. Thank you for taking my questions. Congrats on the strong execution and guide with A targeted 2024 product margins of around 55%. Could you give a little bit more color on how the strategic Purchases of SSDs plays into the target. And on the flip side, if there's any risk to competitors doing the same or headwinds, If pricing declines, if there's any sort of elasticity there?

Speaker 10

And then I have one follow-up.

Speaker 3

Sure. Excuse me, it's Mike. So let's take both of those. So the guide of $55,000,000 assumes that's what we came out of Q4 with. There are some nice Continued tailwinds going into next year.

Speaker 3

1 is, of course, the continued shift to All Flash, which has higher margins. In addition to that, We do have a little bit of benefit from premium. So we feel good about the 55% number. The strategic purchases really help, I'll call it, hedge that number To lock the prices in that we have today, I would certainly assume given the lower price of NAND that other folks are doing similar Exercises. And why we're at 55, Robert, is we want to make sure that we have some flexibility around pricing to your very point.

Speaker 3

So To the extent that there are changes in the market pricing, we feel like we have that flexibility to stay within $55,000,000 but still be able to get to our product revenue Goals for

Speaker 4

the year. Got

Speaker 10

it. Thank you. That's helpful. And then just one more on the Public cloud, do you think the negative impact from cloud optimization efforts is behind us for the year? And would you Mind sharing just sort of which areas within your cloud portfolio are seeing the strongest growth?

Speaker 5

Thank you. I think it's premature to signal that cloud optimization is behind us. As we commented In our prepared remarks, I think that this customers will continue to manage their spend, whether that is Data center infrastructure or on public cloud, I think what we continue to see is the projects And applications that drive business performance, especially core business growth are getting prioritized and invested. Those could be analytics, those could be AI, those could be digital manufacturing projects and on and on, Right. I think where we have seen optimization and some amount of caution is in migration of Enterprise workloads from data centers, the old lift and shift, I think people are taking a hard look in benchmarking both environments, Whether it's public cloud or on premises.

Speaker 5

So I think that's where we continue to see some optimization. In the plan for 2024, The real focus is on accelerating our hyperscaler storage, the storage that is sold alongside our Cloud providers, it had a good quarter this quarter. We are uniquely positioned in the market and we are serving a wider and wider range Applications with the strength

Speaker 2

of our technology. So we're excited about that.

Speaker 10

Got it. All right. Thank you for letting me ask the questions.

Speaker 6

Welcome.

Operator

The next question comes from Tim Long of Barclays. Please go ahead.

Speaker 11

Thank you. 2 if I could as well. First, I was hoping you could talk a little bit, I think last quarter you talked about kind of increased focus given the Large enterprises were a little bit more macro impacted, a little bit more focused on small and midsized businesses. Can you give us an update there on How that push into that customer class is going? And then second, if I could just come back to the QLC based products.

Speaker 11

George, talking about it taking more share, I'm just curious how you think it's going to further proliferate your portfolio. So are you going Start moving it into different workloads, different use cases. How should we think about kind of progression of new products to help Gain more share of All Flash and grow as a percent of your business. Thank you.

Speaker 5

Yes. So, VB, I can start with the portfolio. We've introduced 3 major expansions of our portfolio in the all flash segment over the last 4 months to 5 months. We have capacity flash, the broadest, most feature rich, Most competitive capacity flash products in the industry, we've announced a set of entry flash products that are shipping, which brings our industry leading software in an all flash configuration At a price point that is perfect for midsized enterprises and we introduced Early this quarter, an ORF SAN array, which is a block Only storage configuration for customers that have large block storage environments and don't want to use unified storage So major expansion to our product portfolio, the most significant expansion since we introduced our Flash many years ago. So I'm excited about that.

Speaker 5

That gives us opportunity to both expand wallet share In enterprise customers, going after parts of the wallet that we used to not serve, but importantly, address The expanding opportunity within commercial customers, our commercial segment has outperformed the enterprise segment Throughout this fiscal year and again did so in Q4, representing the resilience of those customers To the macro spending environment. So we feel good about that. We moved some resources within our spending envelope. We reprioritized some more resources To cover the commercial market for fiscal year 2024.

Speaker 11

Okay. Thank you very much.

Operator

The next question comes from Nehal Chokshi of Northland Capital Markets. Please go ahead.

Speaker 4

Yes. Thank you. Congrats on the nice results. Your billings did decelerate quite a bit, A 15% year over year decline versus 7% year over year in the Q3. So given your guidance for average, it sounds like you do expect Billing represents a low point in terms of the billings trend.

Speaker 4

Is that correct? And if so, why is that?

Speaker 3

Yes. Hey, Nahal, it's Mike. So if you take a look at Q4, so total revenue was down year over year by about 6%. Total billings were down by about 17%. When you take a look at the difference between billings and revenue, product revenue and product billings are basically the same Because there is no change in deferred.

Speaker 3

What we saw in the second half, especially in Q4 is lower product bookings then correlated with less Support bookings specifically the multi year bookings that come with new sales. So we do expect to see that come back as we go through next year. That's going to be the difference that you see in billings and revenue. So based on the guidance for the year, which is revenue down low to mid single digit percent, we do expect billings to be more flat to Somewhere around plus or minus a couple of percentage points to do a little bit better than revenue, again, because of the contribution from support.

Speaker 4

Okay. Thank you very much.

Speaker 3

Thank you.

Operator

The next question comes from Simon Leopold of Raymond James. Please go ahead.

Speaker 12

Thanks for taking the question. I wanted to see if we could maybe unpack the public cloud Business a little bit. In that last quarter, it seemed apparent that some of it was very much a recurring revenue stream and some of it was more sensitive and consumption based. And I'd just like to get level set as to how to think of the composition of PCS as to what you would consider consumption based What you would consider truly recurring? Thank you.

Speaker 3

Hey, Simon, it's Mike. So we'll do this 2 ways. We've given There's detail in the past. So cloud storage represents approximately 60% of the total cloud ARR. Our cloud ops represents about 40% and stayed amazingly consistent through fiscal 2023.

Speaker 3

If you then look at what is consumption versus subscription, consumption is going to be more than half of the business and it's growing Faster than subscription because the 2 products that are growing the fastest that George referenced, ANF and FSX, which are our first party cloud Storage products are consumption based. So you should expect to see that percentage of consumption continue to climb as we go through 2024. And then it doesn't mean that subscription is declining. It means that the consumption business is growing faster. And by consumption, we mean there is no start or end date.

Speaker 3

It's not an annual or a multiyear subscription. It is a pay go relation.

Speaker 4

Thank you very much for

Speaker 3

that. Thank you.

Operator

The next question comes from David Vogt of UBS. Please go ahead.

Speaker 13

Great. Thanks guys for squeezing me in. So maybe this is a question for both George and Mike. When you think about sort of the product innovation engine and the new all flash offerings Versus sort of keeping your OpEx flat going forward, how should we think about sort of what you need to invest in the business as Theoretically, there should be sort of a pretty steep growth rate in storage demand by some of your customers over the next couple of years. And then maybe as a quick follow-up, When you think about AI and what it means maybe for your business, how do you think about productivity gains and the uses of those So does that flow through or is that reinvestment into the business, whether it's go to market channels?

Speaker 13

I'm just trying to get a sense for how you think about What's the benefit for AI would look like for you over the next couple of years as well? Thanks.

Speaker 5

Okay. Let me hit the sort of the broad picture, right, which is Listen, I think that we are disciplined managers of the business. We are balancing an uncertain macro With the strength of our product portfolio and the long term opportunity. And I think what you'll see us is we continue to invest in the areas where we The best returns so that we don't forgo the long term health of the business. If we see the year Outperform, we will certainly look at investing to further accelerate the business.

Speaker 5

But I think at this point in time, we want to be Prudent in terms of managing the business just given the macro landscape. I think the second is With regard to AI uses at NetApp, we have a broad range of users. We already use AI in our customer support and our product portfolio to help customers Be able to have much reduced management requirements, right? So we automate how data is managed in the system and automate Self healing of a system as well as give customers intelligent chat box, for example, so that they don't have to wait in queues For all of their basic questions, I think with regard to the big areas that We see opportunity is really in software development productivity. We have some exciting work already underway using some of these large language models.

Speaker 5

And there's profound opportunity for innovation there that we are leading into. And you'll see the benefit of that in the ability to deliver more Software to customers in a faster period of time. And I think those are some of the key areas of focus for us.

Speaker 3

And David, it's Mike. If I could add one more from a go to market. We've talked a lot about building the customer success team, which adds productivity because we're able To shift renewals and cross sells and up sells and then create capacity for our core sellers. So that's another big initiative over the next couple of years. Great.

Operator

The next question comes from Sidney Ho of Deutsche Bank. Please go ahead.

Speaker 9

Great. Thank you. I have a cash flow question. So I know Q1 is going to be impacted by all these strategic buys. But, Mike, how are you thinking about free cash flow for the fiscal year, maybe the linearity of that?

Speaker 9

It sounds like you're expecting to return 100 And free cash flow to shareholders this year, at what point do you think M and A will come back to be a priority? Thanks.

Speaker 3

Yes. Hey, thanks, Cindy. So let's start at the top. So we ended the year fiscal 2023 with $1,100,000,000 of operating cash flow. We talked about the one time items, which was the restructuring and the Danish tax case.

Speaker 3

So we paid out about $85,000,000 Those two items in the quarter, so if you add those back, you get about $1,200,000,000 we would expect going into next year, I would call that kind of the floor for cash flow going into next year. Working capital then will Drive whether we can do a little bit better or not. We will have some lower cash outflows in Q1 because of the incentive compensation payments. So that will help Q1. The strategic buys will start a little bit in Q1 and then they'll build in 2 and 3.

Speaker 3

And then largely by the end of the year, it's not a big number. So it's more of an inter year impact. So and again, we do expect cash flow plus or minus a percent Sydney to be pretty close to non GAAP net income and it has been historically. As it relates to our capital allocation policy, hey, It's the continuation of what we talked about last March, 2 Marches ago with a little bit of a tweak. Going into the year, we've always said that we've spent about 70% of our free cash flow on return to shareholders in reserve, call it 30% for acquisitions.

Speaker 3

Going into fiscal 'twenty four, we'll over index on share buybacks, especially in the first half. It doesn't mean that we won't do any acquisitions. There's still a pipeline. We're still looking at them, but given where we are from an execution perspective and our focus on the business, we would rather reallocate that to share purchases Repurchases, excuse me, especially in the first half and we'll see where it goes in the second half of the year.

Speaker 9

Okay, great. Thanks.

Speaker 3

Thank you.

Operator

Our last question will come from Lou Mishoucha of Daiwa Capital Markets. Please go ahead. Okay.

Speaker 14

Thank you. George, I think you had said early in your script that you were going to regain some All flash array share, maybe you could go into that in any more detail. Do you think that you did lose some share, but obviously now with the new products coming out now in the second half that you're going to start to regain, maybe if you could mention how much you think you might have lost and what you think you might be able to gain back? And then just a quick follow-up after that.

Speaker 5

First of all, if you look at the recent print from our competitors, I think we took share already in the current quarter. So that's a good start to that Dynamic. I think with regard to our overall kind of focus areas, We talked about expanding innovation to support our storage business. And so we've done a lot of product Let innovation into the market as well as broad innovations in storage lifecycle management programs, The simplified licensing, the industry's most advanced and complete ransomware protection and recovery guarantees, so lots of Service innovations as well for our customers. We have aligned our go to market teams Starting fiscal year 2024 to be laser focused on our flash portfolio.

Speaker 5

We think we've got a strong opportunity there. Last year, as I mentioned in our Q3 call, we had a compensation plan that was complex, Having our frontline sales team sell a broad array of products and that impacted execution, we have sharpened that Starting FY 2024, per our commitments, and we have brought a much more focused approach to our cloud portfolio. So I expect us We have the strongest hybrid flash portfolio in the industry. We now have the broadest capacity flash portfolio in the industry And truly the only unified storage portfolio in the industry, unified now includes block, File, object and cloud and so we've redefined the landscape for Unified to take it to the next level. So we're excited about the portfolio.

Speaker 5

We've got to execute and we're focused on it.

Speaker 14

Okay. Then very quick follow-up. On the guidance of down mid to low single, What is the FX expectation for next year? I assume that you're giving guidance in the actual what you expect revenues to perform, Didn't know if you had an FX expectation in there.

Speaker 3

Yes. Hey, Lou, it's Mike. Our expectation is it's not going to be a big impact at all. Less than 1% based on where we sit today from a revenue perspective. So we don't think FX is going to be a big hit and that's a small benefit where we are.

Speaker 3

Who knows where FX rates go after all of the fund that we've had with the debt ceiling and other things. So we don't think it's going to be a big driver next year.

Speaker 14

Okay. Best of luck on the New Year.

Speaker 1

All right. Thank you, Lou. I'm going to pass it over to George for some closing remarks.

Speaker 5

Thanks, Chris. Our focused execution yielded solid Q4 results capping off fiscal year 2023 With record high annual operating margin and EPS despite the slow demand environment, the fundamentals of our business model are sound And our confidence in our strategy and the health of long term opportunity is unchanged. We will continue to prudently manage the elements within our control To drive margin expansion and improve profitability, I'm excited to enter FY 2024 with substantial new innovations and a more focused operating model to better address areas of priority spending within our customers. I look forward to updating you on our progress on next quarter's call.

Operator

The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.

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Earnings Conference Call
NetApp Q4 2023
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