NetApp Inc (NTAP) 2014 Q2 法說會逐字稿

Welcome to the NetApp Second Quarter Fiscal Year 2014 Earnings Call.

My name is Eric.

I will be your operator for today's call.

At this time, all participants in a listen-only mode.

Later we will conduct a question-and-answer session.

Please note this conference is being recorded.

I will now turn the call over to Kris Newton, Senior Director of Investor Relations.

Kris, you may begin.

Hello, and thank you for joining us on our Q2 Fiscal Year 2014 Earnings Call.

With me today are CEO Tom Georgens, and our CFO Nick Noviello.

This call is being webcast live, and will be available for replay on our website at NetApp.com, along with the earnings release, our financial tables, a historical supplemental data table, and the non-GAAP-to-GAAP reconciliation.

As a reminder, during today's call we will make foward-looking statements with respect to our financial outlook and future prospects, all of which involve risk and uncertainty.

We disclaim any obligation to update our foward-looking statements and projections.

Actual results may differ materially from our statements and projections for a variety of reasons.

We describe some of these reasons in our accompanying press release, which we have furnished to the SEC on an 8-K.

A detailed discussion of these reasons is included in our risk factors included in our most recent 10-K and subsequent 10-Q reports, also on file with the SEC, and available on our website, all of which are incorporated by reference into today's discussion.

All numbers discussed today are GAAP unless stated otherwise.

To see the reconciling items between the non-GAAP and GAAP, you may refer to the tables in our press release or on our website.

In a moment, Nick will walk you through some additional color on our financial results, and then Tom will walk you through his perspective on the business this quarter.

I'll now turn the call over to Nick.

Thank you, Kris.

Good afternoon everyone, and thanks for joining us.

We delivered a number of positives in Q2, including strong non-GAAP gross margin and operating margin, both of which underscore the resiliency of our business model, as well as EPS over the high end of our previous guidance range.

However, we are disappointed with our overall Q2 revenue performance.

The continued uncertain macro-economic backdrop, combined with the US federal government shut-down and larger-than-expected decline in our OEM business impacted our top-line revenue growth.

As a result, total revenue came in $10 million below our previous guidance range.

Despite the conservatism we built into our Q2 guidance to account for uncertainty in US federal business related to sequestration and looming budget deadlines, we did not predict the degree to which sequestration, combined with the government's shut-down, would impact our ability to close business in our pipeline.

In addition, though we expected OEM business to be down in Q2, ordering patterns from our largest partners were off plan, reflecting their exposure to market dynamics.

Net revenue for the quarter of $1.55 billion was up 2% sequentially, and up 1% from Q2 of last year.

Branded revenue was 90% of our overall revenue, and at $1.4 billion, was up 5% year over year, and 4% sequentially.

OEM revenue continued to decline in Q2, and was down 28% from Q2 last year, and 9% from last quarter.

Indirect revenue through the channels and OEMs accounted for 83% of Q2 revenue.

Arrow and Avnet contributed 23%, and 16% of net revenue, respectively.

From a geographic perspective, our Americas commercial and EMEA revenues were up 3% and 2%, respectively, versus Q2 last year.

The US public sector revenue was down 8% versus last year, the largest year-over-year decline in the business we have seen in a Q2 since we began tracking it in fiscal year 2007.

Finally, Asia-Pacific revenue was flat on a year-over-year basis, and down 2% sequentially, continued evidence of macro-economic pressure in that geography, as well.

Non-GAAP gross margin of 63.6% was well above our guidance range, and benefited from particular strength in product gross margin.

Non-GAAP product gross margin of 57.3% was at its highest rate in nine quarters, illustrating our strong competitive position, and driven primarily by more highly configured systems and favorable mix.

Non-GAAP service gross margin of 58.9% was over a point better than last year, but down slightly from Q1.

Our non-GAAP operating margin for the second quarter was 17.5%, over three points better than last year, and over a point above our previous guidance.

Non-GAAP operating expenses were essentially flat as a percentage of revenue, and flat year over year.

Versus Q1, non-GAAP operating expenses were up 2%, reflecting run-rate benefits from our realignment activities, and prudent expense management, given the macro-environment.

Consistent with our previous guidance, Q2 diluted share count of 349 million shares decreased by approximately 11 million shares sequentially, primarily related to the full-quarter benefit of repurchase activity in Q1.

Non-GAAP EPS of $0.66 was up 29% from Q2 last year, and exceeded the high end of our previous guidance range by $0.01.

Now turning to the balance sheet.

We ended the quarter with approximately $5.3 billion in cash and investments.

Days sales outstanding at 35 and inventory at 20 turns reflect continued strong operational performance.

Deferred revenue of $2.9 billion was essentially flat versus Q1, but up $162 million versus Q2 of last year.

Cash from operations was approximately $363 million, an increase of 8% from Q2 of last year, and free cash flow with 21% of revenue.

In Q2, we spent $150 million in share repurchases, as well as $51 million in a cash dividend.

As expected, we successfully completed the first $1 billion of our $3-billion share repurchase program in September.

We remain on track to complete the second $1 billion of the program by the end of May 2014, consistent with our original guidance.

Today, we also announced our next cash dividend of $0.15 per share of the Company's stock, to be paid on January 22, 2014.

Separately, the warrants associated with the convertible notes that we retired this past June were exercised in September and October.

For the quarter, the warrants increased diluted share count by just over 1 million shares.

All settlements associated with the retired convertible notes and related hedges and warrants are now behind us.

Now to our fiscal Q3 guidance.

We remain well-positioned in our business, but must assume that the challenging macro-environment will continue.

Our target revenue range for Q3 is $1.575 billion to $1.675 billion, which at the mid-point implies 5% sequential growth, but flat revenue versus Q3 last year.

We expect year-over-year branded revenue growth at just under Q2 levels, and OEM revenue to begin to normalize, but be very sensitive to the demand from our partners.

We expect consolidated non-GAAP gross margins of approximately 61.5% to 62%, and non-GAAP operating margins of approximately 18%.

Further, we expect our blended consolidated non-GAAP effective tax rate to remain relatively constant as we enter the back half of the fiscal year.

Based on our repurchases in the first 10 days of the quarter, we expect our diluted share count for Q3 to remain flat, at approximately 350 million shares.

We expect non-GAAP earnings per share for Q3 to range from approximately $0.68 to $0.73 per share, up from $0.67 last year.

Recall that EPS last year included a $0.03 benefit from a lower tax rate resulting from reinstatement of the R&D tax credit in January.

As we move into the second half of the year, we continue to expect macro uncertainty, which may intensify due to US government challenges.

That said, we believe we are well positioned to execute through these challenges.

Our expectations around margins and EPS growth for fiscal 2014 remain unchanged, though ultimately dependent on revenue mix and growth, we are reiterating our expectations for approximately 61% non-GAAP gross margin, and approximately 17% non-GAAP operating margin for the year.

We continue to expect full-year EPS growth in the mid-teens from operations, and further supplemented by our capital allocation activities.

We completed the first $1 billion of stock repurchases in September 2013, and are on track to complete the second $1 billion by the end of May 2014, consistent with our original plans.

At this point, I will turn the call over to Tom for his thoughts.

Tom.

Thanks Nick, and good afternoon, everyone.

As Nick said, our OEM and US federal businesses clearly presented a head wind, resulting in a shortfall to our revenue guidance, but other aspects of our business performed well in Q2.

We remain confident in our competitive position as we produce very strong gross margin, and continue to gain share, with branded revenue growth of 5% year over year, well ahead of any of our major competitors.

The robust gross margin, combined with prudent expense management, enabled us to deliver better-than-expected operating margin, and EPS just over the high end of our previous guidance range.

We have focused on delivering innovative best-of-breed solutions that are cloud-integrated and Flash-accelerated.

These solutions create a compelling value for our customers, which ultimately enable NetApp to gain share and deliver shareholder value.

Customers are increasingly adopting our latest innovations, and are confident that our strategy will enable them to navigate the future.

We offer a differentiated approach to cloud and software-defined storage, and have established leadership positions in key emerging areas, such as Flash and converged infrastructure.

During the quarter, we outlined our strategy to deliver cloud data management that spans both public and private clouds.

As IT organizations attempt to keep pace with rapidly changing business demands, the move to integrate cloud offerings with on-premise IT resources is inevitable.

This introduction of the cloud makes data governments even more complex.

Data ONTAP, the number one storage operating system, is uniquely positioned to integrate data management across hybrid on- and off-premise environments by providing data management and a common storage fabric.

Clouds using ONTAP can efficiently connect with on-premise and other ONTAP-based clouds to move data and workloads easily, utilizing NetApp's data movement and portability technologies.

This supports our customers as they evolve their IT strategies and organizations from builders and operators to brokers of services across multiple cloud providers.

Additionally, in Q2 we announced more cloud partnerships, expanding on our technology and cloud service provider ecosystem.

We deepened the integration with Oracle's cloud-enabling software, so that customers can more easily and effectively manage their data across public and private cloud environments.

We are at the core of Orange Business Systems' flexible computing solution.

With over 35 petabytes of NetApp storage, Orange now offers its customers superior availability and security.

We also announced that strategic collaboration with Verizon through e-Architect traditional cloud-based storage models, using Data ONTAP in a virtual machine running on top of their hardware.

Our partnership with Amazon Web Services continues to be strong, with tremendous customer interest, and a growing number of partners building service offerings on NetApp private storage for AWS.

With our partner ecosystem that helps connect on-premise infrastructure with cloud resources growing by the day, we offer customers more choice, simpler deployment options, and enhanced functionality as they move to a hybrid IT environment.

Software-defined storage is the next step in the evolution of virtualization and cloud architectures.

It is based on the core tenets that resources are defined in software, managed through policies, and available on a broad range of hardware.

We pioneered this value proposition with data on tap, as our customers can manage date on our hardware, other vendors' hardware, and on commodity hardware.

Our leadership in software-defined storage now includes increased investment for hyper-scale cloud service environments, more robust quality of service capabilities, and expanded API integrations, with emerging solutions like OpenStack and CloudStack.

The momentum of clustered Data ONTAP remains strong.

In Q2, we shipped more than 1,900 clustered nodes, an increase of almost 300% from Q2 a year ago, and almost 60% from last quarter.

37% of high-end systems, and 24% of mid-range systems were deployed in clustered configurations.

In Q1 of this year, we introduced Data ONTAP 8.2, which makes it easier for our installed base to migrate and reap the benefits of clustered ONTAP.

More than half of the controllers migrated from seven mode to clustered ONTAP have occurred since ONTAP 8.2's introduction.

Additionally, new customer acquisitions delivered by clustered ONTAP accelerated in Q2.

We also see strong adoption of our broad portfolio of Flash solutions, which enable customers to deploy the right level of performance, efficiency, and scalability for their specific needs and workloads.

Since the inception of our Flash program, we have shipped over 60 petabytes of flash, almost one third of which is in the form of all-Flash arrays.

The attach rate of our Flash Cache and Flash Pool solutions remains consistently high, at approximately 60% from mid-range and high-end systems.

In Q2, we shipped six petabytes of Flash as a cache, accelerating just over half an exobyte of storage.

In Q1 we began shipping Flash Excel, our software that combines application integration and enterprise data management with the performance capabilities of host-side Flash.

We are seeing strong customer interest with customers in varying stages of qualification.

Our all-Flash array, the EF540, is also seeing robust customer traction, with more than 200 units shipped in Q2.

Soon we will introduce the next generation of the EF product line, with improved capacity, bandwidth, and performance.

In addition to strong growth of the all-Flash EF540, we continue to see growth in the total branded E-Series product line.

Unit shipments of branded E-Series more than doubled year over year.

Compared to Q2 a year ago, the FAS 2000 and 6000s were down slightly, and the FAS 3000 units grew 15%.

Across the board, we would have seen better growth in unit shipments had our federal business performed to expectations.

We have a clear positioning of our FAS-for-shared infrastructure and E-Series for dedicated workloads.

By targeting unique and non-overlapping segments, we continue to be best positioned to meet a broad range of customer requirements with the least amount of complexity.

We believe that the majority of enterprise demand will be met through integrated solutions, customer value integration, as evidenced by the converged solutions in general, and FlexPod specifically.

FlexPod has been available for three years now, and we have seen tremendous growth and success around the globe.

In conjunction with Cisco, we have expanded the FlexPod offerings to include FlexPod Data Center, a single flexible architecture for enterprise workloads, FlexPod Express, for small to mid-sized organizations, and FlexPod Select for dedicated high-performance workloads.

The FlexPod customer base has more than doubled from Q2 a year ago to almost 3,300.

It is available in 84 countries, delivered by greater than 90 channel partners, with 50 validated architectures.

Clustered ONTAP deployments also represented 45% of our FlexPod business in Q2.

Our focus on the customer and our decision to deliver the most cost-effective and flexible solution on the market has resulted in FlexPod's number one position in integrated infrastructure, as recognized by IDC.

For the past year, we've talked about the challenging environment in which we are operating.

The macro-economy is uncertain, and may get worse due to US government dynamics.

Unfortunately, I do not see any near-term resolution, and our guidance reflects what we believe is an appropriate level of conservatism.

Nonetheless, we are well-positioned, and we expect to continue to gain share regardless of the environment.

Customers place significant importance on our ability to provide value through integration, and the extension of that value beyond the single data center into the hybrid cloud.

Our ability to marry on-premise storage with cloud resources across hyper-visors makes this hybrid cloud a reality.

NetApp is at the forefront of a changing IT landscape, creating opportunity from perceived threats.

Our focus on innovation and emerging technology such as Flash and converged architectures, our unique position in cloud and software-defined storage, and our ability to leverage a strong partner ecosystem enables us to gain share, and deliver shareholder value.

Before opening up the call for Q&A, I would like to congratulate the entire NetApp team for again being ranked number three on the World's Best Multinational Workplaces list by the Great Place to Work Institute.

NetApp's unique culture is a differentiator that helps us produce great results for NetApp customers and partners in both good and challenging times.

At this point, I'll open up the call for Q&A.

As always, I'll ask that you be respectful of your peers on the call, and limit yourself to one question so we can address as many people as possible.

Thank you.

Operator?

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions)

Shebly Seyrafi is on line with a question.

Please go ahead.

Yes.

Very impressive product gross margin, 57.3%, up four points sequentially.

How much of that was due to brand versus OEM mix, and what's your outlook going forward?

Can you maintain around 57%, or do you think it will go back to say, 53% to 55% going forward?

Shebly, it's Nick Noviello here.

Let me walk you through the pieces to it.

I think that the comment on the top, I would say this to us really comes about as overall the competitive position we have, right?

That comes through in margins.

But let me walk you through some of the pieces to the sequential.

There's about a four-point difference between Q2 -- I'm sorry, Q1 and Q2 here.

I'm going to walk you through not only that, but what we expect to occur in Q3.

Between one and two points is really due to more richly configured systems in the quarter and volume, okay?

That's one to two points of the change.

We have just over a point from product mix.

Some of that is due to lower OEM volume than we originally anticipated, and some of product mix goes back the other way in Q3, because Q3 incorporates the calendar year end, which is when we expect generally a little bit heavier OEM business.

Then just over a point relates, frankly, to some timing of supply chain efficiencies, part of which will roll through in normal course through pricing to customers in Q3.

So there's a set of things that get you to those four points.

One to two on the configuration and volume, just over a point on product mix, just over a point on the supply chain and pricing side of the fence.

That's the four.

In terms of a Q3, moving from Q2 to Q3, what I would expect is some of that goes back the other way.

First of all on the product mix side of the fence because of heavier OEM business, that will go back, right, so maybe about a point there.

Then that point that I said on the pricing and supply-chain dynamics, that's normal course, that will go back the other way.

I would expect on a Q3 to look more like a 55% on the product gross margin than a 57% on the product gross margin.

Okay, if I could add a few things to that.

First and foremost, I think we are really pleased with the gross margin.

As a first indicator of overall competitiveness and strength of value proposition, I think that's a really important metric for us as a Company.

Nick talked about the OEM mix, strong quarter from our stand-alone software sales from some of the acquisitions we did, and also Company-wide initiative to really drive supply line and COGS efficiency.

But it's also not lost on us that this coincides with a very steep clustered ONTAP ramp.

I don't think it's purely happen-stance that they are both happening at the same time.

I think our team, I think our partners, and I think our customers are now a lot more confident and understand the value proposition, and that's translating through.

One quarter does not make a trend, but nonetheless a really positive development for us, and something we feel really good about.

Going forward, I think clearly depending on market dynamics, perceived elasticity, and strategic use, some of that we may protect and keep in the P&L, and some of that we may use for offensive force to move some new customer acquisition.

Overall, I think the clustered ONTAP component -- and really, I think, a much more firmer understanding and articulation of the value proposition across the entire industry -- is really a key contributor.

We are really pleased with that number.

Thanks.

Andrew Nowinski is on the line.

Please go ahead.

I'd like to get your thoughts on product revenue growth.

Clearly, your branded revenue out-performed the competition this quarter.

But as a whole, October of 2012 is really the last quarter where you delivered product revenue growth at or above normal seasonality.

In the last four consecutive quarters, we have seen it slip well below normal levels.

Obviously I know the OEM component is weighing on that, but that's only 10% of your total revenue.

Are there any underlying trends you can point to that are consistently keeping your product growth depressed, whether it's migration of data to the cloud, or any sort of changing competitive dynamics?

Well, I think just kind of taking the competitive one on right away.

I think if you go back and you look at our product revenue over time, and you compare that to the competition, you know the numbers as well as I do.

We see the server vendors down double digits, we see -- you see EMC's numbers out there.

In fact, if you compare EMC's storage reported revenue against our branded revenue, the NetApp growth is actually bigger than theirs for five consecutive quarters now.

I think from a competitive perspective, I think clearly we got the upper hand on that battle.

We don't take it for granted, but I don't think there's a competitive dynamic at play.

I think clearly in an aggregate where you got NetApp and EMC as the fastest-growing players, and we're both in single digits; and you've got the server vendors with half the market down double digits.

Clearly, I think it's reflecting the overall growth rate of the business.

I think clearly industry growth rate is probably the biggest modulator on that number above anything else.

If anything, I think the competitive argument actually swings in our favor, just given the relative performance of NetApp compared to the rest of the group.

Andrew, the only thing I'd add -- and this is Nick -- is that you mentioned the OEM side of the fence, but the OEM side was down 28% year on year, so it's going to have an impact to the number.

Okay, guys, thanks a lot.

Amit Daryanani is on line with a question.

Please go ahead.

Thanks.

Good afternoon, guys.

Just a question regarding the Jan guide.

Given the softness you just talked about October quarter, maybe you can help me understand what gives you the comfort that Jan quarter will be much more closer to a seasonal -- kind of up 5%, call it.

I'm wondering if you just had some orders that were delayed and they will get pushed out in the Jan quarter, or if you think there's some share-gain opportunity.

Can you just talk about given the softness in October, why the comfort for a seasonal ramp back in Jan?

Thanks.

Well, no, we don't have any units that we didn't ship or anything like that, so there's nothing special about the end of the quarter transition in terms of backlog or anything like that.

I just think we look at the outlook.

It's -- I don't like to call flat as a optimistic world view.

We are certainly not happy with that at all.

But if I think we just look at our pipeline, we look at the business that's out there, we look where we are winning, where we are losing.

We certainly understand the federal side of this, and the fact there really was no resolution last time through.

We went through a shut-down, but still, we still have the end of the continuing resolution within our quarter once again in January.

I think all of those things factor in, but if I look at the business ex-federal, particularly this quarter that we just passed, this would have been a monster quarter, had another $50 million out of the federal business.

I think overall we held up pretty well.

While I'm not overly optimistic there's going to be a rebound in the macro sense, I think that a flat number is hardly anything to be proud of.

Maybe in the environment it is, but I don't think it's an overly aggressive number.

It's certainly something that we want to back away from at this point.

Thank you.

Srini Nandury is on line.

Please go ahead.

Thank you for taking my call.

You mentioned briefly that the mix helped you with the gross margins.

You also mentioned previously in your comments that your FAS 6000 has been down slightly, and FAS 2000 also has been down.

Can you comment what's driving the rich configurations there?

Well, the rich configurations is really a measure of software effects.

That's really what drives the gross margin.

That's what really drives the value that we can convey to our customers.

We also had some mix of our software.

Stand-alone software products had a pretty good quarter, and clearly they carry high gross margin.

It isn't so much -- and I think we talked about this on the call before -- is the 6000s generally carry a fair amount of software, but they also carry a fair amount of hard drives, which are not high-gross-margin items for us.

The flip side is the lower-end units, the 2000s, are not that heavy on disk drives, so they're not carrying a lot of the low gross margin.

Therefore, the variability and margin across the product line is actually relatively constant.

Therefore, over the years as we have seen a fair amount of volatility as the market expands and contracts of the relative growth of the different segments, the gross margin's actually been relatively consistent.

This is more about software value proposition, independent of the individual hardware component.

Aaron Rakers is on line.

Please go ahead.

Yes, thanks for taking the question.

Kind of building on that, part of that, can you talk about the capacity shipment growth this last quarter, and in that context, how we should think about deals such as one that you've signed with Verizon, how we think about that in terms of longer-term model?

If I heard you correctly, I think you said they were going to host your data on tap on their own machines.

I'm curious of how we should think about that in the context of, be it selling disk or selling hardware over the longer term?

Thank you.

Well, capacity growth -- just to give a direct answer to the question -- was a little over 20% this quarter.

I think that's the highest it's been in a while.

But I've also said on prior calls -- and one of the reasons why we don't report it anymore -- is that that's not a primary indicator of our business.

We do things like V-Series, we do things like Virtual Storage Array.

I don't think our business is as tied to disk shipments as perhaps some of our competitors are.

We are really about proliferating Data ONTAP.

I think the more data in the world that's written and formatted by Data ONTAP is an opportunity for us to add software to it, and add value, and add differentiation as time goes on.

Capacity is interesting, but I don't think it's the primary metric of the business.

Clearly we just had a great capacity quarter, but it was still a 1% revenue quarter.

Admittedly, 5% branded -- and strong growth to the competition, but I don't think that capacity correlates with overall NetApp financial health.

In fact, we just had capacity up and gross margins up quite a bit, as well.

As we think about things like Verizon and AWS and things of that nature, at our core, our differentiation is our software, and that's where we are going to derive our value.

The format in which we deliver that is clearly going to have to evolve as we pursue some of these very, large opportunities around these aggregators, whether they be traditional service providers or the hyper-scalers.

Generally and philosophically, I think this has always been true.

The proliferation of our software is really the way NetApp is going to continue to do data management in the future, and the way we're going to continue to distribute our value.

From our point of view, I think opportunities to go to Verizon with an alternative model that's software only, that creates a very large pool of ONTAP written data, I think actually expands our opportunity over time.

I think I want to be really clear.

We're not a storage systems Company, per se.

We are a data management Company, and therefore it's about software ubiquity.

That's what we are trying to drive with those products and our product strategy, whether it be Amazon or whether it be Verizon, You should expect to see more like that as time goes on.

Dan [Rison] is on line.

Please go ahead.

Thanks a lot.

I wanted to ask a question about APAC and then just overall.

In APAC, is there anything more going on there?

I asked this question on the Cisco call, but there's been a lot of concerns around the NSA and US brands losing momentum in APAC.

The inability to book and recognize stuff into revenue is not something that seems to be the case just at NetApp.

I was wondering what you were seeing there?

When can APAC recover, depending on your answer to that question of are there NSA concerns, and when can that GO recover?

Is there anything bigger going on there?

Thanks a lot.

If I look at our APAC business in the aggregate this quarter, it had been historically almost robust business, and had very strong growth.

This quarter we backed off on that.

I think perhaps somewhat counter to some other commentary, where we saw the business strong, was China was strong again, [Ozion], basically south Asia, was very strong for us.

India actually had a bit of a comeback after being relatively slow for us.

Frankly, it's been Japan, after three very strong years, was off.

Australia's been off, and I think Australia is a bit more macro-centric.

Japan I'm not anticipating that that's going to be a trend.

I'm viewing that as timing of orders.

But I would -- the segments where we would be most vulnerable to some type of Snowden backlash, those businesses remained robust for us.

In fact, we are quite pleased with our China progress.

I think last quarter we reported China up 40%.

It wasn't quite that high this quarter, but still a very good number.

For us, it's actually been some of the more mature markets in Asia that have been more problematic for us.

I am expecting Japan to bounce back.

I think Australia there's a little bit more of a macro concern.

We certainly had some, over the last six months, some currency dynamics at play there as well, in all those geos.

Thanks a lot.

Appreciate the color.

Kulbinder Garcha is on line.

Please go ahead.

Thanks.

A question on the branded business, Tom maybe.

I was under the impression that the branded business would see accelerating growth from here on, which it didn't quite product.

I understand there were lots of different macro shifts in the world as we went through this quarter.

I'm kind of curious given the portfolio refresh, is it still something you expect going forward?

I think you have an ability, it seems, to gain share given the refresh on the portfolio there.

Then on the OEM revenue, are we at a level now in absolute dollar terms where it should stabilize, or is it vulnerable still to maybe surprising you on the downside in the coming quarters, do you think?

Many thanks.

Well, the one comment I would have on the branded side is I absolutely agree with you that we have an opportunity to gain share.

In fact, we are gaining share, and in fact we are out-growing the market with our branded business.

I think we are seeing all of that, but that's on the back-drop of obviously a weak macro and obviously federal.

To put federal in context, another $50 million worth of federal business would have made a big difference in our growth.

It would have got us substantially to where we guided.

To put -- just to give you -- we don't report bookings, but just give you a sense of the trajectory of our federal business, we entered this fiscal year in May fully cognizant of the sequester.

Our federal business was exactly on their annual plan, give or take $100,000 in Q1.

In Q2, they were off by $85 million, and that's what we saw, and that had a big impact on our business.

You put that $85 million back in the number, and this would have been a blow-out quarter across every metric, and we would have been seeing aggressive branded growth.

Now on the OEM side, I think there's clearly two factors at play there in the OEM business.

There's clearly the underlying fundamentals of our partners business, and there's product mix within our partners.

At IBM, clearly both of those are at play.

The surprise, and probably took us down more than we would have expected this past quarter was that, Taradata, who has been a great partner, has had a really strong run.

They also pre-announced the revenue shortfall that we clearly saw.

That was probably the thing that we were not expecting in the OEM business.

That's why the OEM business was short of the plan that we put out there.

But those two components, the federal side and the OEM side, you put those back in the number, and you translate that through our gross margin to EPS, it would have been a very strong EPS quarter.

Great.

Thank you.

Maynard Um is on line.

Please go ahead.

Hi, thanks.

I just have a question about -- in terms of the federal, I understand sort of the push-outs, and waiting for the continuing resolution.

I'm just wondering if these are types of deals and projects that are not so much lost, but at some point will then come back.

I guess the real question is are these just push-outs of the revenue to future quarters, and so the visibility of when it happens isn't that great?

It's not a question of when, but if it comes back?

I'm just curious if that's sort of your viewpoint, and we just have to figure out when the revenue starts to come back in?

Does that make sense?

Well, I think a few things happened, one of which was as we came upon the end of the government fiscal year, usually there's a lot of money sloshing around at the end, and it generates obviously a very frothy September.

I think in the context of the sequester, just how much of that money would really be around was a big concern.

I think the sequester certainly had a tempering effect on end of the year spending by the US government.

Now we go forward, really nothing has been resolved, right?

We just pushed a continuing resolution out until January and the debt ceiling presumably to February.

But it's likely that the sequester spending levels, no matter what happens, will remain intact.

This could further be just kicked down the road another 90 days.

I think the federal side, when we talk about bouncing back, we are talking about bouncing back most likely to sequester spending levels.

But in the mean time, there's a fair amount of uncertainty.

Probably my broader concern, frankly, is that companies like us that have a dependency upon that business -- and we see it slow down, and perhaps for a protracted period of time that has impacted on our spending.

If other companies are acting like we are, then clearly the impact of the government is going to spill over into the commercial side of the house.

We will see that going forward as well, and that is also reflected in our guidance to some degree.

I'm not expecting it to be as simple as one day a bill is going to be signed and suddenly there's going to be a flush of federal revenue.

I think last year is over, and I don't think that that's going to necessary flow into this year.

I think this year will be built around the current spending levels that will include the sequester.

If there's this big avalanche of business that's suddenly going to come our way to make up for what didn't get bought at the end of last year, I just don't believe that's the case.

That's helpful.

Thank you.

Ananda Baruah is on line.

Please go ahead.

Hi, guys, thanks for taking the questions.

Tom and Nick, wanted to get your thoughts on buy-back as we look through the year.

You're guiding the share counts to be flat Jan quarter versus October quarter.

What should be our expectation with regards to share count reduction as we look through the year?

I know you're saying that you're expecting to go through the $1 billion by May.

I guess from the share-count perspective, how should we expect that to manifest in the model?

Yes, Ananda, it's Nick.

Let me walk you through the pieces.

When we give guidance for the third quarter at 350 million shares, what we've included in there is what we have purchased so far in the quarter, which is 7 million shares, and really sort of where we are at today.

The reason for doing that is because in a situation where we can do a combination of open-market purchases, accelerated purchases, timing on all of those purchases, the amount and ultimate impact on diluted share count for the quarter can frankly move around pretty significantly.

At the end of the day, we will be consistent with what we have done in the past, which is say, expect us to do $1 billion between now and May.

As we enter a quarter, we will give you our best view given on the first -- given the first 10 days of where we are at.

As we exit a quarter, you'll obviously see in the cash-flow statement what we actually spent and we will talk about it, and do the same thing go-forward.

We will maintain a consistent approach here.

I think the overall theme that you should keep in mind is we will do the additional $1 billion, we are on plan to do that.

We will be opportunistic in that, but we will consider anything from open-market purchases to accelerated plans.

Okay, got it.

Nick, just to clarify that, sounds like you're saying as of right now this is your guidance, but the impact could be different as we move through the quarter, depending?

That's correct, because that 350 million is based upon the first 10 days of activity.

Just like the 350 million can change as a result of exercises as a result of share price, as a result of some other things, it can also move as a result of repurchases that we do in the quarter.

The ultimate timing of those repurchases will also impact how much shows up in a weighted average.

There's a lot of moving parts, so the definitive stuff we can give you is what's already behind us, which is the first 10 days.

I got you.

That's very helpful, thank you.

Okay.

Scott Craig is on line.

Please go ahead.

Hi, good afternoon.

Nick, you guys have done a really good job on the cash cycle, and it's two quarters in a row where it's been at a pretty low level, I guess, relative to historical.

Can you walk us through any pushes and pulls you see on that going forward?

Is this sort of a new level where we are setting the bar at now?

Thanks.

Yes, maybe you can clarify for me in terms of cash cycle.

Are you talking about how we are doing on the DSOs and on the inventory side of the fence, or are you saying something else?

Yes, it would be the total of the three components of it, just adding to a really good number over the last couple quarters.

Yes, I think there is some seasonality that will always happen on the receivables side of the fence, but what we've seen here is on top of the seasonality, some real operational improvement that's happened quarter after quarter.

When we look year over year, we can see that improvement.

So that is real.

On the inventory side, we had built-up -- frankly, we had built up as a result of the Engenio acquisition, and had to move through all the integration activity there.

We had inventory as a result of the Thailand drive crisis.

We've had inventory as we go through manufacturing transitions.

We do all of that, and we manage all of those things.

But again, I think very strong performance.

Our expectation was that inventory turns were going to come up this year and they are doing that.

I think across the board on the operational stuff, we are doing quite well.

Yes, we did -- I think that's three quarters now of inventory turns over 19.

Those are good numbers.

Particularly, there's an OEM business which has a lot of inventory that we hold on behalf of our partners, so I think integrating that business into NetApp and still pushing inventory turns near historical highs, I'm really pleased with the work that the team has done.

Overall, you see the cash-flow number.

That's pretty significant cash flow in a quarter where NetApp was roughly flat in overall revenue.

Clearly, I think the execution side of the house was very strong this quarter, and it proves that NetApp is a very strong cash generator, even in a tough environment.

Bill Shope is on line.

Please go ahead.

Okay, thanks.

Looking at the answers to some of the prior questions, particularly around gross margins, it sounds like you guys do think you can continue to ship more richly configured systems.

Outside of the software demand that you're seeing from the cloud-centric customers, and if we look at your traditional enterprise customer base, can you give us some color on what specific add-ons you're seeing the greatest incremental demand for?

Are there specific work loads that you think are driving this over time?

That's a good question.

I think -- if I think about clustered ONTAP overall, we talked about the use cases of clustered ONTAP -- some of which are clear, and some of which I think are new to NetApp.

A traditional use-case of NetApp is enterprise file services.

We've already got some of the biggest installations in the world, and clustered ONTAP allows us to supply that at scale.

I don't think that's new to anybody.

Likewise, virtualization is a big bet for us, and clustered ONTAP allows us to build much more significant infrastructures that allow customers to virtualize even more mission-critical applications.

I think the other part of it for NetApp is to be able to take this technology into a set of work loads where we previously had not been servicing, by virtue of now the scale, the performance, and the non-disruptive capability of clustered ONTAP.

A lot of those are software intensive.

I think it's a combination of the customer's understanding the value proposition, how to present it, how to price it.

But I also think it's opening up new work loads to us.

I think that's a big part of our new customer acquisition.

An interesting component of the FlexPod business, by the way, is roughly half the FlexPod business -- I think a little -- 45% or so of the FlexPods are actually sold with clustered ONTAP.

A lot of that is going into new deployments.

A lot of that is going into new customers, driven by our joint channel partners -- between us and Cisco, and some of our other partners.

By the way, I believe I misspoke on the prepared statements.

We have 900 channel partners selling FlexPod, not 90.

But overall, I think really the story at the end of the day here isn't so much the software attach rate.

It's really the aggregate business value of the product compared to the applications that we are deploying.

I think the better we understand and can articulate, and the better the customers can understand the value, the better we are able to defend the price, and therefore command a gross margin that's appropriate to the technology we provide.

Okay, that's helpful.

Thank you.

We have Lou Miscioscia on line.

Please go ahead.

Okay, great.

Tom, I want to drill down a little more about flash, in the sense it sounds like you're doing well.

But just curious, how much are you actually selling into the install base?

When you look at all the start-ups, collectively, whether they're hybrid array vendors or all- flash array vendors, they seem to be having a material amount of revenue.

Obviously, if they didn't exist, that would be growth most likely going to you.

Is one issue that for FAS and ONTAP that the legacy code really just doesn't work as well with hybrids or all-flash?

Actually, your flash rate isn't out yet.

Secondly, as for the FAS side, have you actually moved to MLC, or are you still using more expensive SLC?

Thank you.

Yes, I think on the flash question, I think the success and the raw performance of the EF540 should lay to rest the canard there's something magical about flash drives that work around prior disc technology somehow is irrelevant.

Frankly, the EF540 team has been doing this thing for a long time, and there's something to be said for code-stream optimization.

The fact that they can out-perform all the other supposedly flash-optimized products pretty much puts to rest that argument.

I think the real component here, though, is that ONTAP is really built around a very broad feature set around data management and things like that, which are not suited to necessarily an all-flash array.

At the end of the day, the all-flash array is about delivering performance and low latency to applications.

That's really the optimized design point for the EF540, and that's why it's been so successful.

The other thing that the EF540 brings with it that the start-ups don't have is if you look at the primary EF540 use-case that we see right now, it's been database acceleration, which is usually in front of some other basically mainframe or monolithic storage product.

Those are pretty significant and demanding environments.

The fact that the EF540 can bring very high performance and very mature HA to that environment is a key differentiator.

That pretty much knocks out a lot of the start-up companies, and the immature products from the other mature vendors out of that category.

If you look at what's moving the EF540, it's basically extreme performance, not from some brand new data layout, but from basically 20 years of experience in optimizing code lines, and the ability to overlay that with high availability, to go aggressively after these use cases.

Like I said, database acceleration is the classic one.

Another use case that we are seeing out there is basically taking monolithic arrays that have got short-stroked hard drives that are basically trying to derive performance out of the hard drive and replacing them outright.

We've actually had a couple installations who actually used the EF540s to replace traditional frame arrays.

We are pretty excited about that particular segment.

Overall, for all this talk about this market, NetApp from effectively a standing start in February, shipped almost 550 systems.

That's got to put us in the top two or three positions overall in the all-flash market.

If we stay on this trajectory, obviously we can go up from there.

How about, though, on the ONTAP side.

Because there's got to be use-cases there, too.

How do you resolve that?

Yes, I think that there's a pure hybrid use case, which I think is a much bigger opportunity than all-flash array.

I think the idea of basically using flash to accelerate very large pools of back-end storage, and then use all the other features of ONTAP -- the replication, the data protection, the application integration, the storage efficiency, and all of those things -- to basically marry those two technologies.

By no means do I see all-flash array as a substitute for flash integrated, like the Flash Cache and the Flash Pool within ONTAP.

I think they serve different use cases, particularly around the performance case.

In the end, I think the winning story here is basically the integration of those two; because I believe that in the end, all flash deployments are hybrid in nature at the macro level.

I think that the integration of flash with ONTAP is really going to be the long-term differentiator here, as opposed to stand-alone point product providers.

Thank you.

Steven Fox is on the line.

Please go ahead.

Thanks, good afternoon.

Just a follow-up on that last question.

Specifically from a market standpoint, it sounds like some of the newer competitors are sort of taking share from you.

It sounds like you're in a position to take share.

Can you just sort of talk about how you would say near term, before some of that evolution takes place, you would position yourself from a flash standpoint within the market?

Secondly, I don't know if you want to pass on this question or not, but there have been a couple of lawsuits filed by you and EMC regarding some companies planning on becoming public, or may come public.

I'm curious what that says about the competitive environment for some of the start-ups?

Thanks.

Well, a few things.

One of them is, as far as the start-up community, frankly only a handful of them are generating any revenue.

But it's still revenue, right, and in a low-growth market it all matters, so it's not something we take lightly, or something that we are ignoring.

But in the end, the long-term innovators and the long-term market share players in this space are going to be NetApp and EMC.

We certainly see EMC a lot more than we see anybody else.

In terms of the generic category of legal activity, clearly we are going to protect our intellectual property, and we're going to protect our confidential information, and we're going to take appropriate steps to do that.

We have taken a few actions, not all of them against small companies.

The one you referred to, Nimble, has been the latest one.

But there's nothing special about that one.

Frankly, the other two that preceded it have achieved a favorable outcome for NetApp, so these are not frivolous activities.

These are basically us protecting legitimate interests that have a legitimate grievance, and we will do more of them if necessary.

I would say it's not in a response to any specific competitive IPO dynamic or anything like that, because we have done them to big companies, to small companies, pre-IPO and post-IPO.

Great, that's very helpful.

One quick clarification.

I think I understood this correctly, but there's been no change in your road map on the all-flash array, if we look out over the next several quarters.

Is that correct?

Nope.

I think you will -- I think flash array beta this year, and availability next year, and EF540 and EF550 will be -- you'll see an upgrade to that soon.

Perfect.

Thanks so much.

Brian Alexander is on line.

Please go ahead.

All right, thanks.

Nick, you mentioned at the beginning that the margin guidance is unchanged for fiscal 2014.

If I back into what that implies for your fourth quarter based on the first-half results and the guidance for Q3, it would suggest that gross margins will be down materially in the fourth quarter versus the third quarter, and operating margins will be basically flat sequentially.

Can you just talk a little bit more about the margin dynamics beyond the third quarter?

You did a great job laying out the puts and takes for Q2 and Q3.

Am I reading your annual targets too literally, or do you think you could actually exceed those, based on the results and progress you've made this year?

Well, I haven't done anything other than say what the annual targets were at the beginning of the year, and reiterate the fact that that's what we believe we will be able to deliver.

At the end of the day, those are always going to be subject to revenue and mix and all of those other pieces.

I think what you should be thinking about, as well, is we started the year with an operating margin of sub-15%, right?

We did quite well in the second quarter.

You can see what we're guiding to in the third quarter here.

But the year is going to keep moving.

There's also moving parts there.

There's investments that we may or may not decide to make.

There are sets of dynamics in the business that we may or may not decide to do.

What I want you to take away is overall, that guidance, we are firm on.

We're also firm on being able to generate earnings-per-share growth from operations alone in the mid-teens, which has not changed.

Despite the fact that there is pressure out there on the revenue side of the fence certainly in Q2, we've got some obviously -- certainly versus where the street has guided conservative for Q3 based upon the macro condition -- we feel very good about the results that we can generate inside of that.

Great.

Just a quick follow-up, Tom.

On the service provider relationships that you've been announcing, just to be clear, you view these partnerships as incremental gross profit dollar growth opportunities, as opposed to cannibalizing existing sales, either to service providers or to enterprises that are moving to the cloud?

You view this as basically TAM expansion, if you will?

Well, clearly it ultimately depends on how this all plays out.

But I guess from a philosophical point of view, is if you look at our business overall and you look at our aggregate market share in the teens, one of the challenges that we have and frankly everybody has in the Company, everybody wishes they had more coverage, and everybody wishes they were able to reach more customers.

If entities are going to emerge that are going to consolidate substantial amounts of customer demand in one place, and we can participate in that, then I think that compared to our 16% enterprise share, there's an opportunity to participate in a much bigger percentage of the business, whether that's consolidated Amazon, whether that's consolidated Verizon, or Orange, or other players as we go down this list.

While we see them as a consolidator of demand and therefore a very interesting target for us, and if we can be successful there and get them to standardize on ONTAP-based technology, then there's enormous opportunity for us to continue to add value, continue to bring software to bear on those problems, and also to integrate on-promise and off-prem computing.

If we have a very strong premise at the cloud providers, both traditional service providers and hyper-scalers, what customers really want is a seamless data management interface between on-prem and off-prem that actually might generate demand on on-premise computing in the traditional market.

I think this is going to be and integral part of how people see the market going forward.

The more market share we can gain in the service provider community, and the easier we can make that technology to integrate with people's IT infrastructure, I think the stronger we become overall as an enterprise data management player.

From that perspective, TAM expansion on an incremental basis, I think it's a more strategic conversation than that.

I think it's about the ubiquity of ONTAP.

If the ONTAP is ubiquitous, I think that's a good thing for NetApp.

Okay, thanks a lot.

Our last question comes from Steve Milunovich.

Please go ahead.

Thank you.

Nick, I believe the Company was planning on about $30 million of savings this quarter based on prior head-count reductions and savings.

Is that the number that came through, and was that all reinvested, or did some of that drop to the bottom line?

How do you see that playing out over the next quarter?

Yes, that was pretty close to -- just under that was what we delivered in gross, from those activities we did at the beginning of the first quarter around realignment.

That is also reinvested, right?

All of those things take place, and that is all built into the operating expense line that we delivered for the quarter.

We did generate the savings -- not quite $30 million, just below that -- and we did reinvest in a number of areas across the Company with those savings.

You plan to pretty much reinvest 100% again next quarter?

What we had indicated as we opened up the year is that our plan is to reinvest, but we will use that as a lever.

Because to the degree market conditions change, we are also looking to deliver on an overall plan for the Company, both inside and outside.

We preserved that lever.

Some of the reinvestments are things that play out over longer periods of time.

Some of them have one-time, shorter-term impact.

We run and really drive all of those levers here as we run the Company.

Thank you.

If I could just follow on and add a little bit and wrap up.

I think to Nick's point, I think the execution intensity of the Company was very high this quarter.

We talked earlier about gross margins, we talked about DSO, we talked about inventory turns.

The realignment that Nick just talked about, we navigated that without disrupting the business.

We moved a factory in our first quarter with zero disruption overall.

The other thing about this quarter is the shut-down was complicated on a number of fronts.

Not only were purchasing people deemed non-essential, we had a lot of clients that weren't accepting deliveries.

We actually had complexity around shipping product that we already had orders for.

The other dynamic, a little subtle, is that our quarter ended on the 25th.

There wasn't a lot of time between the shut-down release and the end of the quarter, and I think the team's response to that was very strong, and I don't think we left much behind.

Overall, if I look at this quarter and just kind of a closing statement is that clearly it's a challenging environment.

The fed makes it only more challenging.

But I think within that, I think NetApp's competitive posture is demonstrated in the gross margin.

It's demonstrated in the branded product growth.

If I look at our portfolio, clustered ONTAP is still in its early days, EF is still in its early days, flash array on the way, E-Series is a new technology that was just really starting to get some traction in the channel.

I look at our portfolio, I see a lot of technology in the early days of its monetization.

I can't say with confidence that the macro's going to rebound and rebound strong, and when that's going to happen, but I can state that no matter what happens in the macro, NetApp is strong, and we intend to continue to gain share regardless of the world around us.

That's going to be our focus.

Thanks for your time.

Thanks for your interest in NetApp, and see you all in 90 days.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.